Saturday, February 20, 2010 5 comments ++[ CLICK TO COMMENT ]++

Opinion: GE's problems appear to be a bit worse than I thought

When it came to the financial crisis, one of the most shocking things for me was when industrial giant, GE, ran into liquidity problems. It is not wholly surprising that companies like Lehman Brothers, Bear Stearns, Citigroup, Fannie Mae, and others, faced serious problems given their business involved mortgages. But I was truly surprised when it looked like GE, which I had perceived as very strong (I think it was even rated AAA—but don't remember), looked like it was toast.

GE's profitability had been strong for the last 20 or 25 years (with some moderately-sized issues along the way) and it is one of the few firms that consistently matched market expectations. I didn't know a huge chunk of its profits in the last decade was from their financial operations but even then, most of its assets were pretty solid.

When the commercial paper market locked up, only then did I learn that GE relied heavily on short-term debt. In any case, my impression was that GE's problems started after the fall of Lehman Brothers. Yet, after reading a summary from The Economist of Henry Paulson's latest book, “On The Brink: Inside the Race to Stop the Collapse of the Global Financial System,” it appears that GE started having problems long before the Lehman Brothers bankruptcy. There were rumours of problems but, until now, I didn't realize that GE was in such a bad state that it had to get the US government to support it, even before the really bad results from the Lehman Brothers bankruptcy materialized! GE is apparently denying Paulson's recollection of the events but my feeling is that Paulson is telling the truth here:


On September 8th that year, a week before Lehman Brothers filed for bankruptcy and triggered the market meltdown, “Jeff Immelt called to tell me that his company was having problems selling commercial paper. This stunned me,” writes Mr Paulson. “If GE couldn’t sell its paper, what did that mean for other US companies?” A week later, on the day of Lehman’s bankruptcy, the book says Mr Immelt stopped by the then treasury secretary’s office at 6pm, “following up on a phone call from the week before when, just after the takeovers of Fannie Mae and Freddie Mac, he’d mentioned that GE was having problems in the commercial-paper market. His report had alarmed me then.”


On October 12th, says Mr Paulson’s book, Mr Immelt voiced his support for a Treasury programme to guarantee bank debt that did not extend to GE, only to change his mind overnight, asking for the company to be included in the programme after all, because “I’m worried about my company and our ability to roll over paper in the face of this.”


I have a feeling that GE is not out of the woods. The European exposure and their credit card debt exposure did not look pretty a few years ago. I doubt that they managed to work their way out of those problems. A prominent bear apparently isn't so convinced either:
 

Mr Paulson’s comments have also added to the worries of influential GE bears, such as Charles Ortel of Newport Value Partners, an investment adviser. As long ago as August 2007 he was worried that all sorts of lousy investments were lurking in GE’s opaque finance division, GE Capital, and that “a gathering storm of liabilities will swarm the parent company”. He now fears that, for all Mr Immelt’s well-publicised efforts to clean house by reducing the amount of risk within GE Capital and reducing its reliance on short-term commercial paper, GE is one of the likeliest candidates to spring a nasty surprise on the global capital markets this year—one that might send the markets into another meltdown.


Quite a number of bears are prema-bears who appear correct at times but are ultimately wrong. However, I suspect the bear case here is probably more credible than the bullish case. I have a feeling the final chapter isn't written yet and GE will be making the headlines—again, for all the wrong reasons.

Black Mark for Warren Buffett

GE is also another black mark for Warren Buffett. Like the Goldman Sachs situation, Buffett appeared to have profitted solely due to government support, which he has lobbied for (although I'm not sure if he was caling on the Treasury to aid GE.) We basically ended up with the socialization of huge losses. GE even paid out common dividends—still does—while all this was going on. Even many of the banks couldn't manage to transfer cheap money from the taxpayer directly to the shareholder, but GE somehow managed to do it.

Some Lessons

An important lesson I learned from the financial crisis is that companies are not what they seem. Investors shouldn't take anything for granted. Yes, that seems obvious but I never quite took it to heart before. I never would have thought an industrial giant like GE would be so vulnerable to a total collapse (if it weren't for government support, GE would defintitely have ended up bankrupt.) I even worked at GE for a summer when I was younger and always felt it was a solid company (I wasn't an investor back then so this was more of a general view.) Yet, it was as bad as any of those banks dabbling in mortgages.

These days, if I ever look at a company, even an established giant like Siemens or Emerson, I pay more attention to the capital structure. Who knows how the foundation for the house is built?

I suspect one may avoid some of these problems if they looked at mid-caps and small-caps instead. The large-caps and mega-caps are all over the place and even long-term GE shareholders probably had no clue what their company was involved in.

One final observation, which most already know, is that it is sooo hard to read management. Even an astute observer like Warren Buffett misread GE's management. Warren Buffett held Jack Welch in high regard, and even suggested in one of his letters that Jeff Immelt was one of top CEOs in America. Yet, management either didn't know what they were doing or were culpable in destroying their company.

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5 Response to Opinion: GE's problems appear to be a bit worse than I thought

Ross
February 20, 2010 at 4:02 PM

I see you did very well on your Lexmark investment. Well done. I was definitely wrong about that being a value trap. Are you still long?

Sivaram
February 20, 2010 at 4:56 PM

grrr... I never went long :'(  I haven't followed it lately but I'm not sure if any of the original arguments would be different now. Some of their product launches seem to have gone off well but remember, I try to be a long term investor and the long-term business case for Lexmark is largely the same as it was last year or two years or three years ago. I think your value trap thesis may still be valid (I'm not sure; I haven't followed the company lately.)


The biggest missed opportunity for me is actually Expedia (EXPE). Tourism has been hit hard over hte last year but Expedia keeps chugging along. I still don't like Expedia's corporate governance (dual class structure; questionable capital allocation; etc) but its moat keeps getting bigger by the day. It's one-of-a-kind of business whereas Lexmark is just another player in the crowed printing/imaging business (although I don't expect it to happen right away, let's not forget that if e-readers and tablets take off, companies like Lexmark can easily plunge to zero.)

Doctor Stock
February 20, 2010 at 11:26 PM

Interesting post... That will prove very interesting in the weeks and months ahead.

ckortel
February 21, 2010 at 11:23 AM

If you would like to see some of our more detailed research on GE please explain how I can email it to you...all the best...charles ortel

Sivaram
February 24, 2010 at 8:26 PM

Sorry I didn't get back to you sooner... but... yes, I would like the report if it's ok with you. You can e-mail me at (REPLACE XXX with a DOT): sivaramXXXvelauthapillai@gmailXXXcom

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