I liked General Electric (GE) stock at $6.92 on March 6 (see two previous blogs on GE); I do not like it at all at 12.39 (closing price April 17) , after analyzing their financial results announced on April 17.
It is not their declining earnings that worries me: that was within expectations. The problem lies on their balance sheet. GE shareholders' equity (book value) has declined from $104.7 billion to $101.0 billion. That doesn't sound like much of a decline, but the trend is in a bad direction and it has catapulted one financial ratio (Assets to Tangible Common Equity) into the danger zone (see below).
GE is primarily a financial company. It does make appliances, aircraft engines and wind power turbines, but its lending company, GE Capital has accounted for the bulk of its earnings for several years. GE Capital loans money to businesses and consumers all over the world. The company has borrowed most of the money that it lends out. Although GE's loan portfolio is well diversified, it does contain some potential clunkers, including credit card debt, mortgages in the U.K., and consumer loans in eastern Europe. GE also invests in commercial real estate and holds mortgages on commercial properties in this country, both areas of financial stress. As an AA-rated company (they were rated AAA until about a month ago), they borrow at a low rate and lend at a higher rate to less creditworthy borrowers. This business model works well as long as investors and lenders have confidence in General Electric.
But, worries about GE and other finance companies have arisen as debtors around the world are finding it harder to make their loan payments. Investors and lenders are wise to keep a close eye on GE's balance sheet, for that is where we can see financial resources available to keep the company going in case many of its loans turn bad.
At first glance, book value of $101 billion seems sufficient to back up GE Capital's loan portfolio of $348 billion.....except for one fact: $95.4 billion of GE's equity consists of intangible assets like good will and deferred tax credits. Goodwill is an accounting entry that represents how much GE paid above book value when it acquired other companies. Deferred tax credits are useful in saving taxes on future income, but are not good for any other purpose. Analysts subtract goodwill, deferred tax credits and other fluff from book value to arrive at a more realistic figure that is called tangible common equity (TCE). To see how much TCE underlies GE's common shares we take current book value of $101 billion and subtract the $3 billion in preferred stock that Warren Buffett pumped into the company last fall. That leaves $98 billion. Then we subtract the $95.4 billion intangibles (primarily goodwill, but also deferred tax credits, etc.) and arrive at a grand total tangible common equity value of $2.6 billion. That isn't very much - less than 1% of the $348 billion it has loaned out to its customers.
The company is not in imminent danger of insolvency. First, they hold $89 billion in cash (don't get too excited: that's all borrowed money). Second, the federal government is backing up this company. The FDIC has agreed to guarantee up to $139 billion in future borrowings, which GE will have to undertake (no pun intended) as their existing debt matures and becomes due to be paid off. Also, the Fed's commercial credit facility (thank you, Ben Bernanke) has provided short term financing to GE and will continue to be available should the need arise. So, I don't foresee any liquidity problems for GE; if its loan portfolio deteriorates, it will be able to borrow money to pay its own creditors and to fund operations.
But, here is the danger for common shareholders. Tangible common equity is gaining notice as an important metric among analysts. As pointed out in a blog by Rolfe Winkler, CFA, the Fed is starting to pay attention to the TCE of banks (looking at the ratio of loans to TCE) as an indicator that a bank may be in danger of failing. The Fed is expected to announce the results of the banks' financial stress tests soon. Winkler notes that TCE is likely to be discussed as part of the stress test results. Unfortunately, GE's ratio of loans to tangible common equity is several times worse than that of the banks, even the most shaky banks. There is a risk that GE will make headlines in the newspapers regarding this comparison and that will drive the stock price lower.
Now a new and more ominous headline risk has entered the picture. "Grant's Interest Rate Observer", in its April 17 issue (I am a subscriber), quotes a portfolio manager, Steve Eisman, of FrontPoint Financial Services) who cites TCE as a measure of corporate financial health. Eisman points out that General Electric's ratio of assets to TCE is so bad that GE's financial rating should not be AA, as it is currently, that it should be rated as junk. Eisman wrote this without the benefit of having seen Friday's earnings announcement by General Electric.
A quick calculation of figures on GE's hot-off-the-press balance sheet shows that GE's tangible common equity has been roughly cut in half, which means that the ratio of assets (loans, primarily), to TCE has roughly doubled. "Grant's" is a highly respected publication. Its "outing" of GE's very high assets to TCE ratio is likely to make the rounds of analysts and financial journalists. Others can make the same calculation as I did that Friday's announcement shows GE's TCE deteriorated further and that only a sliver of tangible common equity is supporting a large portfolio of loans. Such publicity will likely drive down the stock price in the near term and could easily lead to GE selling more shares of common stock in order to bolster its common equity and regain the confidence of the market. If that occurs, the dilution of shareholders' ownership by the issuance of new shares will drive the share price lower, still.
The bottom line: I liked GE at the bargain price of $6.92 on March 6, I do not like it now at $12.29, given the recent deterioration in tangible common equity on its balance sheet. I do think that the company will survive, thanks to support from the federal government, and the share price five years from now will be higher than what it is today, perhaps substantially so. But the recent emphasis on tangible common equity by the Fed and financial analysts is likely to spread to additional analysts and business journalists and they are likely to make the public aware that there is a gaping hole in GE's balance sheet. GE shares are not suitable for risk-averse investors at least until General Electric raises its tangible common equity and the current financial panic comes to an end.
Disclosure: None of my clients' accounts hold GE shares. I hold shares of GE in a family account currently and plan to sell them this Monday morning.