The Good News And Bad News For Long-Term General Electric Shareholders

| About: General Electric (GE)
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Since General Electric (NYSE:GE) is currently my largest personal investment behind Johnson & Johnson (NYSE:JNJ), I spend most of my time monitoring developments at GE Capital because I perceive that to be the biggest risk to the industrial/financial giant (and I believe the collapse at GE Capital during the financial crisis demonstrate what happens if the financial division is mismanaged).

The 2012 Annual Report (as well as some recently announced divestitures) from General Electric offers some clues about the direction of GE Capital, and for investors that enjoy seeing GE return more to its industrial roots, there is some good news. First of all, we are starting to see some tangible proof that GE is beginning to scale back its real estate commitments: GE recently announced the sale of $1.5 billion worth of Australian office property, and while that amounts to less than 5% of GE's total real estate books, it is a good signal that GE actually is moving in the direction of shrinking GE Capital's real estate arm.

On page 7 of the 2012 GE Annual Report, the management team revealed the long-term plans about GE's commitment to financial services:

At the same time, we are creating a smaller, more focused financial services company-one that has a lower risk profile and adds value to our industrial businesses. We will continue to reduce the size of GE Capital from the $600 billion of assets it was in 2008 to a goal of $300-$400 billion in the future. GE Capital has a sound fiscal position, with Tier 1 capital above 10% and strong liquidity. We can generate returns above our cost of capital. Over the next few years, we plan for GE Capital to return about $20 billion of dividends back to the parent. We will purposefully reallocate capital from financial services to infrastructure and grow it faster. Our goal is to have infrastructure earnings reach 70% of our total over time.

As a GE shareholder, I am happy to see GE Capital shrink. I hope the company reaches its target to cut GE Capital by 30-50% sooner rather than later, and I hope they cut it even more after that. I'll consider it a welcome development when GE Capital becomes less than a third of the company's earnings. GE is a whole lot easier to value (and earnings are a lot more stable) when you are looking at profits from light bulbs, locomotives, appliances, oil and gas infrastructure, and aviation equipment. It's much harder reading through GE Capital financial statements about legacy leasing businesses in South Korea or consumer banks in Latvia and Argentina that have consumed capital infusions in the past.

And plus, GE shouldn't have any trouble finding things to do with the $20 billion dividend that GE Capital was able to source to the parent company. As of the April 19th report, CEO Immelt mentioned that the backlog for equipment and services have hit new highs, totaling $216 billion. It's not like GE is struggling to find industrial uses for its profits.

Another thing that the April 19th report mentioned is this: GE Capital's Tier 1 Ratio is at 11.1%. While this is the metric that is traditionally cited, what I pay attention to is the liquidity of the bank. After all, Bank of America (NYSE:BAC) had a Tier 1 Capital of near 10% in 2009 before diluting shareholders to the tune of two billion shares. Also, a lack of liquidity is what brought Wachovia to its knees during the financial crisis. The bank had developed a reputation for both excellence and innovation, and the bank even had a book value of nearly $40 per share before imploding, for heaven's sake. Plenty of intelligent, conservative investors became blindsided because they did not recognize the disconnect between Wachovia's book value and how quickly its liquidity could dry up in the event of a crisis.

In fact, I'm not even speaking hypothetically in the case of GE. Let's not forget what happened in October of 2008, as chronicled by Geoffrey Colvin in an excellent piece that appeared in Fortune Magazine at the time:

Warren Buffett walked into the kitchen, still wearing an old robe he likes, and announced to a breakfast visitor that he had agreed to send General Electric $3 billion of Berkshire Hathaway (NYSE:BRK.B) money in return for a new issue of preferred stock and warrants allowing Berkshire to buy an equal amount of common stock over the next five years.

It was the beginning of one of the more dramatic days in GE's 130-year history.

By 11:23 AM the price of credit default swaps - lenders' insurance - on the bonds of GE Capital had rocketed: The market was saying that the bonds of this great and storied company, one of only six corporations on planet Earth with a triple-A credit rating, were junk.

So here's what had just happened: General Electric had arranged to raise $15 billion on a few days' notice. For perspective, remember that in March, Visa (NYSE:V) had culminated months of preparation by staging the largest stock offering ever, raising $18 billion. In other words, GE needed a sudden, huge, and utterly unexpected emergency infusion of cash. Only six days before, when a Wall Street analyst had asked GE chief Jeff Immelt about the possibility of the company's selling new equity, Immelt had answered unequivocally: "We just don't see it right now. We feel very secure about how the funding looks." The idea that GE might ever be desperate for cash would have seemed ludicrous a year ago and looked unworthy of concern even this past summer. After all, this is history's most famously well-managed company.

This is why watching a company's liquidity is so important: if you don't pay attention to it, you can be lulled into a false sense of security that everything is fine. After all, GE had a AAA credit rating. It had an excellent reputation. The CEO described the company as "secure" in its feelings about funding at the then current time. Next thing you know, the stock price is cratering by 10% as the company desperately raises $15 billion. That's why I pay more attention to the liquidity figures than the Tier 1 Capital ratios.

By the way, if you want to own General Electric, it becomes the responsibility of a prudent investor to always be reading company releases like this one to determine whether GE Capital has an adequate liquidity level. The company's end goal is to run a $300-$400 billion financing arm. You can't escape the fact that this company is both an industrial powerhouse and a supersized lender, and because of the debt relative to equity involved, you will always have to keep with GE's quarterly releases and annual reports. You can't sleep on a company with a lending arm the way you can a packaged goods company like PepsiCo (NYSE:PEP) or Nestle (OTCPK:NSRGY). It's up to you to determine whether the time commitment is worth it, and whether you have the skill to properly evaluate GE Capital (the best investors stick to their circles of competencies, and there is no shame in staying away from financials. Being completely honest with yourself when it comes to this kind of stuff is one of the best ways to prevent a lot of misery in the long run).

The good news for investors is that GE Capital is shrinking. The company has (hopefully) telegraphed its intentions appropriately, and I look forward to seeing whether management follows through on its promises to source GE Capital profits into growing the infrastructure units. If done right, this could be great for shareholders. But despite this, General Electric remains very much a financial company. You have to keep tabs on its liquidity figures to monitor against a repeat of 2008. There are over 15,000 publicly traded stocks to choose from. It's up to you to determine whether General Electric's growth prospects are worthy of the time commitment necessary to constantly monitor developments in the financial division.

Disclosure: I am long GE, BAC, JNJ. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.