GE: Quintessential American Finance Company

Does Ge (GE) finance company stand a chance in today's worsening economic environment? What blasphemy is this?!? Are these the words of yet another gloom-and-doomer pouring on the coals when we've already had enough bad news?

Why, GE is the bellwether of U.S. industry. It's the triplest of all triple-A companies! It's the quintessential American manufacturing company!!

Correction. GE is the quintessential American finance company. And highly leveraged at that.

Lending Activities

Just look at the balance sheet. Of 12/31/07 tangible assets of $698 billion, $461 billion, or 66%, are loans, leases, or some other explicit lending activity (i.e. as separate from, say, trade credit related to manufacturing activities). Another $57 billion, or 8% of total tangible assets, are real estate investments. Does this sound like a manufacturer? For perspective, this $461 billion in lending activity would make GE about the eighth largest bank in the country. Further, while perhaps not as risky as some of the largest banks' holdings of sub-prime mortgages, SIVs, and other exotic vehicles, GE's portfolio probably carries more risk than those of many smaller banks. This assertion, while admittedly somewhat speculative, is based upon the more transactional nature of GE's lending activity compared to the more relationship-driven lending activity of the typical commercial bank. Not to mention GE's own assessment in its 12/31/07 10-K report that one-third of its $30 billion U.S. portfolio of credit cards, installment loans and home equity lines of credit (through its GE Money subsidiary) could be considered sub-prime. Another $10 billion charge-off anyone?

Leverage

Referring again to the 12/31/07 10-K, total Liabilities of $672 billion compare to absolutely puny tangible Shareholders' Equity of $18 billion. A simple debt/tangible worth calculation suggests an astounding leverage extreme of 37:1, or its inverse, a capital ratio of 2.7%. Admittedly, discounting net worth by the entire amount of intangibles of $97 billion is probably overly conservative, but what, after all, is goodwill but accounting for the amount overpaid in the purchase of assets? Didn't we see enough write-downs of goodwill in the early 2000s to make us at least marginally suspicious of its value? Does goodwill provide any relief whatsoever in a liquidity squeeze?

For some perspective on leverage, the average commercial bank has a capital ratio of approximately 10% (admittedly with definitions of capital as generous as those used by GE), which equates to a debt/worth ratio of 10:1. I've always been amused when people say that we couldn't have a 1929 style crash today because we no longer allow 90% margin in the stock market. This is true, but it completely ignores the fact that virtually the entire remainder of the economy is leveraged at 90%. GE's Capital Services (i.e. the lending side of the company) is much more leveraged than most banks, and with much riskier assets. Something tells me we haven't seen the last of the forest fires started by playing with this kind of leveraged tinder. Cash Flow

Ah. Cash Flow. The bottom line. Where the rubber meets the road. What is business all about except for cash flow? The manufacturing side of GE is strong, no doubt. But the real question here is GE Capital Services [GECS], which is what the numbers that follow are based upon, as separately disclosed in the 12/31/07 10-K.

A quick look at the ratio of EBITDA / Interest ($44 billion / $22 billion) looks pretty good at almost exactly 2.0X. However, adding Short Term Borrowings (of $192 billion) and Long Term Borrowings maturing in 2008 (of $56 billion) to that Interest Expense results in an atrocious ratio of EBITDA / Principal and Interest due in 2008 of .16X.

What?!? Can they be this far under water? Not so fast. You see, they won't actually retire those short- and long-term borrowings of $248 billion as they come due. They'll simply refinance them with new short term borrowings as they've been doing for years. Aye, there's the rub then. GECS seems to have a major mismatch on its balance sheet. They've got $114 billion more in Current Liabilities than in Current Assets. If they didn't issue any new debt this year, they'd need until early 2010 to pay everything that comes due in 2008.

But that won't be a problem, right? With credit markets so stable and all, they'll have no problem rolling over all that debt, will they? Debt, that is, like the 12/31/07 commercial paper balance of $106 billion. Not that there's been any jumps or jitters in the commercial paper markets in recent months… But it's GE, you might say. Who wouldn't lend money to GE? Indeed. Who wouldn't? Anyone would. Everyone would. Everyone will, right? Yes. Of course they will. Until they don't.

Perhaps we're on to something here. Perhaps it's the very historical strength of GE that allowed it to borrow as much as it wanted. At some pretty good rates, too. The proverbial drunken sailor on shore leave. The strength, reputation, and aura, that is, that allowed GECS to increase its lending portfolio (plus a few other assets, like real estate) by $148 billion (from $360 billion to $508 billion) from 12/31/04 to 12/31/07 by borrowing $146 billion of it. Hmmm. One hundred percent financing on the incremental portfolio growth. Why does that sound so familiar?

So, in the end, what do we have? We have a historically strong manufacturer (with $92 billion in Liabilities of its own, mind you, and in what appears to be developing as a uniquely challenging environment) wrapped (smothered, some may eventually say) in a massively leveraged portfolio of loans and similar beasts that includes home mortgages, auto loans, credit cards, prime and sub-prime home equity loans, and, last but not least, a boatload of commercial and industrial loans that seems recently to have contracted a bit of seasickness, particularly in the latter stages of Q12008.

Is this warning premature? Yes, almost certainly. But there's no benefit in yelling Fire! after the barn's already burned down. To borrow a phrase, predictions of GE's demise may, at this point, be greatly exaggerated, but don't expect it to fare any better than the average high-risk finance company if this economy gets much worse.

Disclosure: None

Comments

[chrism1962]

If GE have to write down 10% of their commercial property loans and their own real estate, that could be in excess of $50 Billion of write downs!

Refinancing the short term borrowings, even for GE, could cost more than their current terms. At 0.75 over their current rates, could cost an extra $1 Billion pa.

I mentioned last week, that their AAA rating may be at risk (CRE risks), if their paper is re-rated, then potentially it may cost them over $5 Billion pa.

Chris Marshall

[PacificGatePost]

In the recent violent fluctuations, and dire pronouncements, there is underlying good news coming right from the American consumer….

pacificgatepost.blogsp...

Not all is doom and gloom.

[philo_alpha]

The time of cheap money is well past. Let it be because the Fed induced a bubble with artificially low rates, or because a considerable swath of America is in a sense defaulting, unable to cover its subprime and consumer loans, or because oil and commodities are turning scarce just as China and India increase demand for these goods, or because the inflation rate in the U.S. is made for optimistic pipe dreaming (see the current Harper's for more).

So G.E. is going to have to adjust to pay far more to sustain their leverage. If even less than most for the virtue of being G.E. (yet do we see a naked emperor now?) a very large shock might be coming to the stock.

Add to this that G.E. has engaged in buying mature full price companies some of them of disjoint or overlapping endeavours... Is G.E. is an Iceland in the offing?

Yet at the same time G.E. has been the darling of Business Schools and investors everywhere and an incubator of more than one much admirer CEO, and their business methodology is emulated often. This might be a great challenge to the company, but if one company can pull it off, it might be G.E.!

[No Moss]

Well, I have to agree with Joe that GE, through GECS and GE Money, have gone way beyound the financing of purchases of things that GE produces. Here's that GE model:

GE produces complex stuff, like wind and gas turbines, power plants, airplane engines, diagnostic equipment etc. They make a profit on the sale, and they make profits on servicing and supplying spare parts for those businesses. Further, they make money by financing the purchase of this equipment, usually through what are know as capitalized leases, or leases where the ownership of the property passes to the customer upon full payment of the lease. Although the last is not without risk, at least GE has a relationship with the customer that at least keeps them abreast of the customer's credit quality.

This model exists in infrastructure, healthcare, and in the enterprise solutions part of consumer & industrial.

But in addition, GE finances commercial loans and leases (Commercial Finance) and consumer credit cards, auto loans, and other debt (GE Money, which is ex-US for everything except credit card & installment debt).

Joe has a great point. Because of its great credit rating and reputation, GE has been able to issue commercial paper, a market that has dried up for a lot of companies. That's short-term paper and well over half of GE's short-term borrowings. The other thing is that GE has been able to securitize and sell debt. They get an origination fee for this, of course.

They got caught with this in Q1, because some of their debt was "in the warehouse", i.e., between having been securitized and sold; it had to be written down. As is usual, the markdown was more than necessary; they'll make it back when they sell it.

But if GE's finance model failed, it would heavily impact GE, requiring releveraging, that is, selling loans on the open market with the consequent losses on the sale that every financial company dreads.

That's not likely to happen, fortunately. GE has taken steps to get out of the US mortgage lending market (they sold WMC in 2007) and the insurance business (likewise sold), and the Japanese portion of their credit business. They're planning to sell private label credit cards (PLCC) this year.

On the other hand, they just bought CitiCapital (commercial lending and leasing). Hope they got a good price.

Hope they can further reduce the consumer side of lending and also get rid of NBCU. They need to clear the decks and concentrate.