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Special Edition Two Wall Street, New York, New York 10005 • www.grantspub.com NOVEMBER 3, 2017

How GE came to grief: a Grant’s compendium

1 Monetary corporate welfare the 5 /4s were quoted Tuesday at a price Under the cloak of to yield 1.54%. As for the new notes, $7 billion worth, respectability (September 21, 2012) After the Lehm- they were briskly bid for at yields of an Brothers bankruptcy in 2008, the Bush 0.85% for three years, 2.72% for 10 years (September 18, 2009) Wall Street administration, on behalf of the mute and 4.16% for 30 years. The Fed’s tiny was away from its desk when the Se- American taxpayer, opened the federal interest rates now subsidize a company curities and Exchange Commission and vaults to Wall Street. Sheila Bair, in her that, except for its doting Uncle Sam, General Electric Co. came to terms on new memoir of that crisis season (“Bull might not be around today in just its August 4. To settle charges of book- by the Horns”), recounts the decision to current form to borrow so much as a cooking and earnings manipulation, push TARP funds into the not necessar- dime. (Vis-à-vis GE, the government Thomas A. Edison’s corporate brain- ily needy arms of the CEOs of nine of the was not entirely doting; on Aug. 4, 2009, child neither admitted nor denied country’s largest banks and broker-deal- the company, or rather its shareholders, guilt, but paid a $50 million fine and ers. “Yes,” relates the former chairman of paid $50 million to settle SEC charges vowed never again to commit the sins the FDIC, “it had come to that: the gov- that it had cooked the books and ma- to which it had not confessed. A sell- ernment of the United States, the bastion nipulated earnings during the great bull side analyst obliged a reporter at The of free enterprise and private markets, market of the late 1990s and early 2000s; Wall Street Journal with the comment was going to forcibly inject $125 billion of see Grant’s, Sept. 18, 2009). Among the that, really, the revelations didn’t mat- taxpayer money into those behemoths to underwriters of the new GE issue was ter. While the accounting practices at make sure they all stayed afloat.” none other than Citigroup, about whose issue might have been “frustrating,” he General Electric was not among the serial bailouts and inexpert CEO Bair’s claimed, “they were never material.” nine. But it presently took its place at memoir is particularly scathing. They were and are material—and the government’s all-you-could-eat steam “Citi had essentially bought into all the entertaining, too, in a shabby kind of table. When it received $139 billion in gimmicks to generate short-term profits,” way—we are about to contend on this, FDIC debt guarantees and placed $16 she recites: “poorly underwritten loans, the first anniversary of the great trou- billion in commercial paper with the Fed- high-risk securities investments, and bles of 2008. The crimes to which GE eral Reserve, this bluest blood of Ameri- short-term unstable liquidity. It desper- allegedly stooped reveal a management can blue chips—the last of the original ately needed an experienced, traditional besotted with its own share price. More Dow stocks still in the Dow—was rated commercial banker to right the ship. broadly, the SEC complaint invites re- triple-A. Not many federal supplicants [Vikram] Pandit had no experience in consideration of an era in which power- have ever cut a more awkward appearance commercial banking and wouldn’t have ful people did their all to smooth out with a begging bowl. known how to underwrite a loan if his life the bumps. At GE, it was the untidy This was four years ago—four long depended on it. But he was the guy [Rob- ebb and flow of revenue that manage- years ago, to be sure. On Monday, the ert Rubin] wanted and the N.Y. Fed and ment sought to pretty up, even to the very same GE—no longer rated triple-A, the OCC acquiesced, so he got the job.” point of employing, as the SEC puts rather a slice or two beneath it, but still a “Proceeds” from the GE offering “will it, “devices, schemes or artifices to de- deep-blue blue chip—showed its face in be used to repay all or a portion of the fraud.” At the macro level, it was the the credit markets to refinance $5 billion company’s $5 billion of 5% notes due ups and downs of the economy itself of 5% notes due next Feb. 1. In the high- Feb. 1, 2013,” S&P reported. “Any re- that the Federal Open Market Com- cotton days of 2007, the company had maining proceeds will be used for general mittee worked to flatten. The “Great 1 placed an issue of 5 /4% notes due De- corporate purposes.” Moderation” is what economists call cember 2017. If proof were needed that Artificial, ultra-low rates harm many. the 20 or so years in which these efforts nobody holds a grudge for long on Wall But they do benefit some. seemed to bear fruit. It was a golden Street, at least not against an institution, • time of shallow recessions, measured GE compendium-GRANT’S / NOVEMBER 3, 2017 2 expansions and high “visibility.” As to for which a little good news can still go “The response of our business the visibility, the case of the “Securities a long way.” And the analysts, with C. leaders was typical of the GE cul- and Exchange Commission v. General Elec- Stephen Tusa Jr. in the lead, add that, ture,” Welch relates. “Even though tric Company” is a reminder of how little “[i]n the look for non-consensus, catch- the books had closed on the quarter, we ever really know. up stories, GE stands out as the last, many immediately offered to pitch in The eye that the stock market turns in our view.” Not disagreeing with this to cover the Kidder gap. Some said to history is dim enough. The one it uses judgment, we hereby lift our own fatwa they could find an extra $10 million, to see, but yet not to see, the transgres- on GE (e.g., Grant’s, Sept. 5, 2008), now $20 million and even $30 million sions of the great and good is—actu- quoted at 10.3 times trailing net income, from their businesses to offset the ally—legally blind, at least during the half of the post-1990 average of 22 times, surprise. Though it was too late, their bull portion of the cycle. So it was that, a fifth of the 51 times peak multiple at willingness to help was a dramatic “[b]eginning in 1995 and continuing year-end 1999 and at a 40% discount to contrast to the excuses I was hear- through the filing of form 10-K for the the valuations of its global peers. How- ing from the Kidder people.” This period ended December 31, 2004, GE ever, our interest in this investigation was, to repeat, in 1994, after which met or exceeded final consensus analyst is not so much the share price as the the Six Sigma GE accounting depart- earnings per share expectations every remarkable story of the company that ment somehow was able to match or quarter,” as the SEC describes it. In a couldn’t seem to stop watching it. beat each quarterly earnings estimate better world, investors would collective- The infractions that the SEC com- through Dec. 31, 2004. ly face federal charges for being so gull- plaint identifies allegedly occurred on Be that as it may, Immelt was in ible as to fall for such a thing. the watch of CEO Jeff Immelt in 2002 command when the SEC’s investiga- It’s a fine irony that GE, the bluest- and 2003. But Immelt’s predecessor, tion turned up four kinds of account- blooded of American blue chips, triple- Jack Welch, had run the company for ing irregularities. One had to do with A-rated from 1956 until 2009, the last the preceding 20 years until Sept. 6, interest-rate hedges on commercial-pa- of the original Dow stocks still in the 2001, and it might just be that Welch per borrowings, a second with another Dow, wound up funding itself through had something to do with the corporate kind of interest-rate hedge and a third such public assistance programs as the culture that valued the price of GE com- with the accounting for spare parts for Commercial Paper Funding Facility mon above the kingdom of heaven. In commercial aircraft. The fourth seems (CPFF) and the Temporary Liquidity his unintentionally revealing memoir, closest to the everyday ruse of pressing Guarantee Program (TLGP). It’s an “Jack: Straight from the Gut,” published one’s thumb on the scale. It concerns even finer irony that the government in 2001, Welch describes the rallying the mistimed recognition of revenue was succoring GE even as it was inves- round of his lieutenants to the news from the sales of GE’s locomotives. As tigating it. “[W]e believe,” comment that a $350 million hole had opened up the complaint says: the equity analysts at J.P. Morgan in a in the balance sheet of GE’s brokerage- “In the fourth quarters of 2002 and September 8 research report, “GE will house subsidiary, Kidder, Peabody. The 2003, GE improperly recorded rev- go down as the least publicized ‘too big news had hit on April 14, 1994, as the enue of $223 million and $158 mil- to fail’ story in the crisis.” Street awaited the release of GE’s first- lion, respectively, for locomotives The Morgan report, incidentally, quarter earnings. They would be a little purportedly sold to financial institu- takes a guardedly bullish line toward the light, though not for want of loyalty in tions with the understanding that the stock, calling it “one of the last stocks the GE hierarchy. financial institutions would resell the locomotives to GE’s railroad custom- ers in the first quarters of the subse- Back from the abyss 55x 55x quent fiscal years. The six transac- General Electric’s price-earnings ratio tions were not true sales and did not 50 50 qualify for revenue recognition under GAAP. GE personnel at the business 45 45 level orchestrated these transactions 40 40 in order to improperly accelerate rev- enue recognition. A member of GE’s 35 35 corporate accounting group approved 30 30 P/E ratio the accounting for these transactions despite learning that GE maintained 25 Sept. 15, 2009: 25 significant obligations that (1) sug- P/E ratio 10.3 times gested that the risks of ownership for 20 20 the locomotives had not passed and 15 15 (2) should have precluded revenue recognition under GAAP.” 10 10 To convey some size of the scope of this apparent fiction, the locomo- 5 5 tive “bridge financing” transactions in 0 0 the fourth quarter of 2002 accounted 8/98 8/99 8/00 8/01 8/02 8/03 8/04 8/05 8/06 8/07 8/08 8/09 for 131 of the 191 engines ostensibly source: The Bloomberg sold in that period. “Inclusion of these GE compendium-GRANT’S / NOVEMBER 3, 2017 3

Not just light bulbs holder value is a result, not a strat- $800,000 $800,000 egy. . . . Your main constituencies are GE Capital Services’ total assets vs. total debt total assets: $651 billion your employees, your customers and 700,000 700,000 your products.” Welch’s auditors were possibly too astonished by this remarkable volte- 600,000 600,000 face to tax the corporate icon on the

in millions of dollars glaring omission from his short list of 500,000 vital GE constituencies. This was in 500,000 March—the panic was on—and GE owed its liquidity, if not its solvency, 400,000 400,000 to the U.S. government. In his mem- total debt: oir, Welch berates himself for taking $503 billion in millions of dollars 300,000 on faith the retrospectively implau- 300,000 sible proposition that Joseph Jett’s bond trades could legitimately gener- 200,000 200,000 ate almost a quarter of the earnings of the Kidder, Peabody fixed-income de- partment—and that that department 100,000 100,000 could legitimately account for more 1Q98 1Q00 1Q02 1Q04 1Q06 1Q08 2Q09 than 100% of Kidder’s earnings. “When source: The Bloomberg they [the bond people] spoke, the firm listened, and few questioned their suc- transactions significantly overstated Nobody can say that GE was para- cess,” recounted Welch. the performance of the GE Transpor- lyzed by contrition. It disclosed the By the same token, perhaps, nei- tation Systems,” according to the com- early-August settlement with the ther Welch nor Immelt delved deeply plaint, “significantly overstated the SEC in a press release asserting the enough into the sources of the monu- performance of the GETS business in corporate commitment “to the high- mentally unlikely success of the in- the fourth quarter of 2002, with GETS est standards of accounting.” A little house leveraged financial institution. revenues and profits being overstated awkwardly for a communiqué meant “So profitable and so fast-growing was by 45.1% and 39.6%, respectively.” to affirm the company’s fidelity to the GE Capital Services,” observes col- And again in the waning months of letter of GAAP, there was, at the top league Ian McCulley, “that it even- 2003: “bridge-financed” locomotive of the release, the familiar GE logo set tually accounted for nearly half of sales represented 42.8% of the quar- alongside the corporate motto, “Imagi- consolidated GE profits and more ter’s locomotive unit sales, overstating nation at work.” Just when GE de- than four-fifths of companywide as- fourth-quarter revenues and earnings, cided to walk the accounting straight sets. It was GECS’ heavy reliance on according to the commission, by 22.6% and narrow, the statement didn’t say, short-term funding sources that nearly and 16.7%, respectively. though the zeal-of-a-new-convert tone brought down the company last fall. Enron was crashing and burning in of a letter to the editor of The New York Absent GECS, GE would be basking 2001, but not until 2003 did the import Times that came shooting out of the in praise for preserving profit mar- of that fraud seem to register either on Fairfield, Conn., headquarters a few gins, generating lots of cash and gen- GE or its Wall Street enablers. Thus, days later suggests a relatively recent erally weathering the storm. Instead, the complaint relates, “In Decem- adaptation. Contrary to the insinuation management has Japanese real estate, ber 2003, the [GE] business team in- of Times columnist Floyd Norris, man- Hungarian mortgages and U.S. restau- formed the senior accountant that the agement protested, there was noth- rant financings to worry about.” financial intermediaries had requested ing Enronesque about the locomotive Then, again, without GECS, GE GE represent that the rail transactions transactions. “. . .GE locomotives were would hardly be recognizable today. had been disclosed to GE’s outside au- purchased and retained by our railroad It might have been said in 1990 that ditor and accounted for in accordance customers,” management pointed out. Jack Welch’s company was an indus- with GAAP. When he asked why the “GE prematurely recorded these sales trial business with a finance subsidiary financial intermediaries were seeking based on intermediate sales to finan- bolted on. By 2006, one could almost the representation, the senior accoun- cial institutions—an error that has led say that GE was a bank that happened tant was told they were concerned to improved controls. But there were to manufacture appliances, jet engines, about their risk of liability for helping no returns and no fictitious revenues.” locomotives and the rest. Certainly, influence another company’s financial As for Welch, he, too, turned over a the solvency of the industrial side was statements in the wake of a recently new leaf without acknowledging that hostage to the funding of the financial reported financial scandal. As in 2002, there ever had been an old one. In side, although that was not the kind of notwithstanding the above, GE’s cor- a March interview with the Financial observation that seemed germane dur- porate accounting group permitted GE Times, the most famous disciple of ing the Great Moderation. to recognize the revenue and income shareholder value asserted that, “On To allay lingering fears about sol- on year-end rail deals in the fourth the face of it, shareholder value is the vency and funding, GE in late July quarter of 2003.” dumbest idea in the world. Share- handed out a 63-page slide deck GE compendium-GRANT’S / NOVEMBER 3, 2017 4 brimful with reassurances about its of its TLGP issues, the 2s of 2012, at ‘Uncle,’ cries GE financial problem child. No capital the beginning of September to raise an raise was in the works, credit losses additional $1 billion on top of the $650 were in line with the numbers set out million it borrowed in late July. And so (October 3, 2008) “You know, we’re in the Fed’s stress test and GECS far in 2009, it has sold far more guaran- going through a normal credit cycle would be well-positioned coming teed debt than not.” here. . . . We’ve got unprecedented fi- out of the recession, was the gist of The Treasury doesn’t rent out its nancial market volatility.” —Keith S. the message. Kathryn Cassidy, vice gold-plated credit rating for nothing. Sherin, General Electric vice chairman president and treasurer of GECS, Since the inception of the TLGP and and chief financial officer, quoted on told listeners-in to a conference call CPFF programs last year, GE has paid pages two and three of the transcript of that GE had won approval from the $1.9 billion for the privilege of bor- the September 25 conference call FDIC to issue long-dated commercial rowing under the name of the United When financial conditions veer paper on its own hook—a hook now States of America. At that, GE must from “normal” to “unprecedented” rated only slightly lower than triple- consider the trade a bargain, saving in the space of two short paragraphs, A. “Our remaining guaranteed com- itself, as it did, interest expense on as they did in the remarks of CFO mercial paper will roll off quickly over the order of $750 million to $1 billion, Keith Sherin on last week’s GE earn- the next couple of months,” Cassidy while foreclosing the possibility of a ings call, you can bet that the world went on. “We have also made a lot of bankruptcy filing, a not remote risk is in flux. For the second time in progress in our long-term funding, during the credit upheaval. nine months, management lowered completing our total year 2009 plan Now that the crisis has passed, GE its 2008 profit outlook, to between and funding about $18 billion of long- is extricating itself from the arms of $1.95 and $2.10 a share from be- term debt towards our plan for 2010. its savior, as the latest 10-Q report dis- tween $2.20 and $2.30 a share. The We’ve issued over $12 billion in non- closed with evident pride: “At the re- principal cause of the ratcheting guaranteed, long-term debt so far this quest of GE Capital, on July 21, 2009, down was the shortfall at GE Capital, year in a variety of currencies—dol- the FDIC approved an application filed and the company promised no quick lars, euros and sterling. Last week, by GE Capital which positions it to fix. For 2009, now ventures the chair- we raised almost $3 billion worth of exit the TLGP. As a result, GE Capital man and CEO, Jeffrey R. Immelt, euros in a five-year transaction at an will no longer issue FDIC-guaranteed the finance subsidiary will earn up equivalent spread of mid-swaps plus commercial paper with maturities of to 30% less than what is expected in 190 basis points. We were pleased to 31 to 270 days and will be able to issue 2008. Henceforth, instead of its ac- see strong demand and a diversified non-guaranteed long-term debt with customed 50% or more contribution investor base.” maturities of 18 months to three years. to corporate net income, the mega- GECS is on a post-crisis, balance- The FDIC and GE have also agreed to nonbank will deliver 40%. sheet weight-loss plan, but the shrink- reduce GE’s aggregate limit under the The Grant’s analysis (see the Sep- age will be gradual. Borrowings at program, resulting in approximately tember 5 issue) was thus abruptly af- June 30 footed to $503 billion, down $14 billion of remaining long-term firmed by GE management itself. On not much from $515 billion at year- debt capacity under the TLGP at July September 14, a reassuring set of bullet end 2008. There was $173 billion of 21, 2009.” The last of the TLGP bor- points had gone forth from the investor- short-term debt and $329 billion of rowings won’t roll off until 2012. relations department. It was a cranky long-term debt. Short-term loans fea- Some day, financial historians will and unobliging reader who, upon re- tured $82 billion in bank deposits and try to make sense of it all: the mere ex- viewing it, still harbored doubts about only $50 billion in commercial paper. istence of a $100 billion GE commer- the company’s $91 billion commercial In that year of innocence, 2006, GECS cial paper program (the number today real estate portfolio, its $28 billion of had issued as much as $100 billion in seems incredible); the ideal of “share- U.K. mortgages and its capacity to fund CP, and $72 billion was outstanding holder value” carried to the point of itself in tumultuous markets. Far from as recently as December 31. The com- alleged institutionalized fraud; an in- fleeing GE Capital’s commercial paper, pany would like you to know that it has dustrial company recreating itself as Sherin insisted last week, the market stopped issuing into the Fed’s CPFF, a highly and precariously leveraged is actually flying to it. Nevertheless, a step on the road back to capitalism. financial institution with nary a peep he disclosed, management would cut This purportedly blue-chip paragon of protest from the stockholders; the back the size of the commercial paper of financial strength, however, remains close brush with insolvency of a com- program as it proceeded to de-lever the very much beholden to the taxpayers. pany still bearing the imprimatur, GE Capital balance sheet, to 6:1 from At last report, GE had borrowed $69 triple-A. Finally, the historians of the 7.2:1. Corporate share repurchases billion through the TLGP, consisting future will scratch their heads to un- would be suspended. of $21 billion of commercial paper and derstand why Jack Welch and Alan GE long ago made its corporate bed, $48 billion in longer-term debt. “To Greenspan, icons of the late 20th cen- and a fine piece of furniture it had compare,” observes McCulley, “TLGP tury, put so much stock in an idealized seemed to be. Not just any company consists, in toto, of $320 billion, so GE “stability” that can only appear to exist is going to earn $20 billion in this un- has something like one-fifth to one- in a dynamic world but that can never prosperous year, Immelt reminded quarter of total issuance. And even be present in fact. To these historians, listeners-in. “Our industrial segment though GE can access capital markets we say, Good luck! earnings should be up between 10% on its own at a price, it reopened one • and 15% in the quarter, excluding com- GE compendium-GRANT’S / NOVEMBER 3, 2017 5

Flight to safety? finance subsidiary was grafted on to a 6% 6% manufacturing superstructure. GE Capital 60-day commercial paper rates GE Capital is our featured topic, and we are bearish on it, just as we are on 5 5 the GE share price. Our indictment comes in two counts: No. 1, Capital is setting aside too small a reserve against 4 4 future credit losses; No. 2, the soften- 3.51% ing world economy will take a greater-

rate than-anticipated toll on the parent’s 3 3

rate sales of aircraft engines, railroad loco- motives, power plants, wind turbines and other staples of the great 21st-cen- 2 2 tury infrastructure boom. Our previous analysis of the great- est corporate brainchild of Thomas A. 1 1 Edison (“Mythical triple-A,” Grant’s, November 30) concluded with a credit judgment: On the merits, GE deserved 0 0 a downgrade to single-A, a two-notch 4/4/07 7/5/07 8/27/07 10/25/07 1/25/08 4/28/08 9/30/08 demotion from top-flight, we said. source: The Bloomberg Some scoffed, but we’ve been proven overly sanguine, not hypercritical. mercial and industrial,” he said. “Our tangibles. On the liabilities side of the When we last wrote, the annual cost financial services earnings will [be] in balance sheet can be found $202 bil- of insuring the obligations of the par- excess of $9 billion in 2008, dramatical- lion of short-term borrowings. ent and subsidiary against default over ly outperforming their peers. And the “Finally,” Portales advised, “we re- five years was 64 basis points and 66 company remains financially strong.” mind investors that the SEC formal in- basis points, respectively. Today, five- Besides, the CEO added, the shares vestigation, which started in 2005, into year credit-default swaps are quoted at yield 5% (the $1.24-per-share common GE Capital’s use of hedge accounting 125 basis points and 166 basis points, dividend is graved in stone through for derivatives is still ongoing.” respectively. These are levels that im- the end of 2009), and that vital, un- Serving up bad news, GE executives plicitly place GE and its finance sub- questioned, company-defining triple-A manage to sound like Oprah. Earnings sidiary in the marginally investment- credit rating remains intact. aren’t reduced bu0t “reframed,” finan- grade bin marked “Baa3,” according Why did the company say what it cial services aren’t shrinking but are to Moody’s Market Implied Ratings. said, just when it said it? A little-known being “resized,” and 0 consumers (For the record, Egan-Jones Ratings, fact about GE, noted the sharp analyti- aren’t broke but “challenged.” Howev- the advertising of which sometimes or- cal eyes at Portales Partners, New York, er, for one brief, manly moment, Sherin naments the back page of this journal, last week, is that GE Capital Services, did find his tongue and speak plain calls GE double-A-minus.) holder of every share of GE Capital, is English. Would GE consider drawing In his 2001 memoir, “Jack: Straight a “regulated entity,” and its regulator is on its $62 billion of bank lending facili- from the Gut,” the hard-charging Welch the Office of Thrift Supervision. Em- ties? an analyst asked. “Absolutely not,” describes his dawning realization that barrassed by IndyMac’s costly keeling the CFO replied, before rattling off a the business of lending and borrowing over, OTS is under “pressure to review long list of the company’s sources of li- was, or could be, a gold mine: “Since I the business models of ‘non-bank’ en- quidity. Come the day that GE changes had been involved in making things all tities for safety and soundness issues, its tune on this point, take cover. Then my life, pounding and grinding it out to particularly in light of the failures of again, most of us are already doing busi- make a nickel, I couldn’t believe how American International Group, Lehm- ness from under our desks. easy this ‘appeared’ to be.” So GE Cap- an Brothers and Bear Stearns.” • ital’s footings grew and grew, to $696 And why might OTS have leaned billion in 2008 from $11 billion in 1980. on GE to rein in its financial sub? Por- Over the past three years, Capital has tales ticked off a number of possible Not your father’s GE contributed an average of 48% of GE’s reasons; e.g., Capital has only $60 bil- net income. On June 30, this one, mas- lion in shareholders’ equity, against (September 5, 2008) General Elec- sive subsidiary accounted for 82% of which it holds $82.5 billion in “other tric under Jack Welch, like the Fed company-wide assets. assets,” mainly real estate, the afore- under Alan Greenspan, was an enter- You’d suppose it walks on water mentioned $91 billion in commercial prise seemingly touched by the gods. It the way it defies the worldwide credit real estate, $15 billion of Level 3 as- launched a thousand case studies—for storm. It is as if there were no such sets, $53.2 billion of securitized assets growth, profitability, reinvention, glo- blow—or, rather, that the seas crashed (including $22.6 billion of credit-card balization and all-around, Six Sigma and the winds shrieked only for oth- receivables held off-balance sheet) excellence. And a wonderful business ers. Thus, in the 12 months to June and $31.6 billion of goodwill and in- only became more lucrative when a 30, Capital managed to increase its GE compendium-GRANT’S / NOVEMBER 3, 2017 6 assets by 17%, though its earnings Britain’s own bear market dropped by 6%. Not only does it seem 30% 30% to be untouchable, but it has also man- change in U.K. house prices, measured year-over-year aged to profit by others’ misfortunes. 25 25 In this year of salty credit tears, Capi- tal has acquired a Merrill Lynch mid- 20 20 dle-market finance business, which tacked on $10 billion of assets in the 15 15 first quarter, and a Citigroup commer- price change cial-leasing and equipment business, 10 10 which added another $13.2 billion of assets in the third quarter. 5 5

“If you have the capital and you can price change do the underwriting,” Keith Sherin, 0 0 GE’s vice chairman and chief financial officer, told listeners-in on the second- -5 -5 quarter call, “there are great opportu- Aug. 31, nities available. We have got $24 bil- -10 -10.5% -10 lion of year-to-date volume at about a 30% return on equity. We are raising -15 -15 1/92 1/94 1/96 1/98 1/00 1/02 1/04 1/06 1/08 our price across our flow businesses.” Capital’s financing-receivables book source: The Bloomberg summed to $428 billion on June 30, up from $388 billion at year-end. Double gages held by GE Money, $29 billion with introductory, below-market that increase and Capital would log a are in the U.K., a nation suffering its rates that are scheduled to adjust at 20% rise in receivables for all of 2008. own swoon in residential property future dates, with high loan-to-value It would be like growing strawberries in prices. “Everything we do in the U.K. ratios at inception and whose terms Vermont in January. is originate-to-hold,” Sherin assured permitted interest-only payments or “We believe that the company is re- his conference-call audience. “We have resulted in negative amortization.” ally in fine shape to face the types of our own in-house appraisal and servic- As for the commercial side of the economic conditions we see today and ing group. These are experienced GE business, GE exudes Welchian opti- in the near future.” So declared Welch’s employees who go out and validate the mism. It makes senior secured loans. successor, Jeffrey Immelt, on the same values of every property. We have insur- It operates in middle markets. It has conference call. Granted that GE is an ance on properties that are more than (in its mid-market leasing business) a American, indeed, a global, icon, it still 80% loan-to-value.” million customers. It is hugely diversi- does business on planet Earth. What It speaks well to the industry, not to fied across markets and regions. It has kind of economic conditions was Im- mention the fleetness of foot, of GE’s “incredible credit and restructuring ex- melt, the CEO, referring to? “in-house appraisal” group that it has pertise,” which is self-explanatory, and Approximately half of GE Capital’s found the means to “validate the values “deep domain expertise,” which, to us, $696 billion of assets falls under the of every property.” If GE lent against is not. “We are not traders or specula- heading of commercial finance, while properties at the average U.K. price of tors,” Sherin assured his audience on consumer lending contributes 32% (the £165,000, and if it lent at a nice, low, the call. “We don’t borrow short and remainder is related to aviation and en- prudent loan-to-value ratio of 71% (as lend long. We are match-funded, so we ergy financial services). GE Money is it says it does), it owns no fewer than focus on credit or asset risk. We are not the consumer lender; it deals in credit 131,000 individual mortgages. That’s a a passive buyer of packaged assets.” cards, mortgages, home-equity loans, lot of front porches to inspect. Be that And, it has 20 years’ experience in the personal loans and auto loans across as it may, Britain’s own property bub- financial realm. 50 countries, in some of which—e.g., ble is fast deflating, with house prices This last point, we absolutely dis- Turkey, Hungary, the Philippines—it down by 10.5% year-over-year and 11% count—Citigroup, after all, has been owns a bank. GE Commercial Finance below their 2007 peak. Standard & dancing since 1812—and we have our provides loans and leases and conducts Poor’s disclosed the other day that U.K. doubts about the others, too. Lenders a real-estate financing operation. In the prime mortgage delinquencies reached don’t earn 25% on equity or grow by second quarter, revenues and earnings 2.94% in the second quarter, the high- 20% a year in a credit storm just by be- in Commercial Finance grew by 14% est since record keeping began in 2004. ing extra prudent. A case in which GE and 7%, respectively. GE Money, not “That GE’s non-American mort- Commercial Finance trod where oth- keeping up, logged a revenue gain of gage portfolio is not of uniformly ers could not, or would not, tread was 6% and a net-income decline of 9%. pristine credit quality can be gleaned a $960 million collateralized loan last Just reading the papers, you would from an interesting footnote in GE’s spring to iStar Financial, the reeling doubt that the consumer business can 2007 annual,” colleague Ian McCul- nonbank commercial real estate lend- long continue to do even that well. It ley relates. “It discloses that ‘ap- er. Proceeds paid off the bridge loan came out on the conference call that, proximately 26% of the [non-U.S. that financed iStar’s ill-omened pur- of the $79 billion of non-U.S. mort- mortgage] portfolio comprised loans chase of the commercial and construc- GE compendium-GRANT’S / NOVEMBER 3, 2017 7 tion portfolio of the Fremont (Calif.) However that may be, America’s in- ever, the slowdown in traffic in Asia General Bank. The GE credit matures sured depository institutions boosted and the Middle East. Thus, in June in three years and pays Libor plus 340 their allowances as a percentage of 2007, Middle Eastern carriers logged basis points with a floor of 6.25%. Be- loans and leases to 1.8% at the end of year-over-year growth of 18.1%. By fore the credit crisis burst out into the June from 1.08% at year-end 2006. As May of this year, their year-over-year open, iStar paid Libor plus 165 points for reserves expressed as a percentage growth had subsided to 12.8%; in June, for similar accommodation. Plainly, GE of nonaccruing loans, they have fallen it was down to 9.6%. It may be, just is earning more for the risk it’s bearing to 89% from 172%—a decline, yes, as Immelt insisted on the conference than preceding creditors did. Whether but one not nearly so steep as GE’s. call, that, in the interior of China and it is earning enough is the open ques- Some may object that the comparison India, “[t]here are cranes everywhere, tion. In the past year, iStar’s share price is apples to tangerines, or to mangoes, and you just don’t see the kind of slow- has plunged to $5.59 from $37. because half or more of GE’s loan down driven by the U.S. consumer.” If Operating as it does on this planet, portfolio is outside the 50 states. But that’s the world we live in—no longer in these markets and in this crisis, GE that is only to underscore how heavily dependent on American consumption is susceptible to credit-related losses. the company is exposed to the weak- but thoroughly decoupled—then GE You would hardly know it, however, by ening economies of Europe and Asia. may be the stock for you. a glance at Capital’s reserve against im- It would cost GE $6.2 billion, or 62 It is, of course, the demand from paired assets. “The allowance,” McCul- cents a share, after tax, to restore its Asian and Middle Eastern airlines that ley notes, “currently stands at $4.5 billion, loan-loss reserves to 2.5% of loans and has put the bulge in the Boeing and or 1.05% of gross receivables, compared leases, the level prevailing in 2003. Airbus order books. That both manu- to $4.2 billion, or 1.08% of gross receiv- It’s the equivalent of about a quarter- facturers are sold out at least through ables, at year-end. The reserve has actu- and-a-half’s net income. 2011 encourages the GE faithful. But ally gone down, not up, since 2003, when Not many companies could prosper order books are the kind of volumes it was 2.5% of receivables. Over the same in a recession overlaid on a credit con- that never get set in type and are forev- span, the allowance for loan losses as a traction. And though GE Capital pro- er subject to cyclical expansion or con- percentage of nonaccruing assets has fall- fesses to be making hay in the current traction. “Deferrals and cancellations en to 69% from 147%. It’s a pretty stark disturbances, we doubt that either the are beginning to trickle in,” McCulley contrast to open the new FDIC quarterly financial sub or the parent will exit the reports, “and it’s unlikely that every banking profile.” cycle unscarred. For instance, GE’s avi- plane ordered will actually be built and Of course, in GE’s eyes, it is no mere ation-related businesses, which prof- delivered with GE engines hanging on bank, far from it. “We have got great risk ited from the tailwind of growth in air- the wings. Safran, GE’s French joint- management,” to quote Sherin again. line travel, stand equally to suffer from venture partner, reported disappoint- “Our loss averages over the last 20 years the headwinds of recession. According ing earnings at the end of July and ven- have been far below the banks’. We man- to the International Air Transport As- tured a downbeat outlook for the rest age the company as a triple-A from the sociation, global air-passenger traffic in of the year (upon which its share price board of directors, down to the Capital June was up by just 3.8% from the year broke).” In another sign of the times, board, down to the management teams. before, the smallest such gain since Kingfisher Airlines, a fast-growing Indi- Everything we do is about making sure 2003. Weakness in domestic U.S. air an carrier, took steps last week to defer we keep it triple-A. . . .” travel may be old news. Not so, how- delivery of some Airbus planes it had ordered to 2010 through 2012 instead of 2008 and 2009. Kingfisher is “one of So much better than a bank? 200% 200% the biggest stakeholders in the Airbus reserve coverage ratio of GE vs. that of FDIC-insured institutions order backlog by number of planes,” as Reuters notes. 175 175 GE has another touch point on the softening airline business. Through its aircraft-leasing subsidiary, GECAS, it 150 150 owns 1,479 planes with a value of $30 billion. Through GE Capital, it holds $12 billion of aircraft loans. Dowa- ratio 125 125 ger 737s and other gas-guzzling nar- ratio FDIC: row bodies make up perhaps 9% of 88.6% the overall GE aircraft portfolio. That 100 100 these flying antiques may be recycled for service in poor nations, rather than mothballed in the American desert, is 75 75 the ardent hope of the GE front office. “Infrastructure” is the GE division GE: 69.2% that overshadows all others. Aviation, 50 50 transportation, fire detection, oil and 12/03 12/04 12/05 12/06 12/07 6/30/08 gas, water, power plants, wind tur- sources: FDIC, company filings bines: the sum of these disparate busi- GE compendium-GRANT’S / NOVEMBER 3, 2017 8 nesses produced $17.6 billion of reve- If, as we judge, the CDS market is Mythical triple-A nues and $3.2 billion of segment profit on to something, the stock market is in the second quarter, up 26% and 24%, missing something; they can’t both be respectively, from the year-earlier pe- right. Just how violently they disagree (November 30, 2007) GE’s new riod. “Solid performance in a tough en- shines through in a sum-of-the-parts high-thrust jet engine, the GEnx, is vironment,” said GE, with a modest pat analysis of the house that Welch built. expected to go flying off the produc- on its own back. An impartial observer Ex-Capital, continuing operations at tion lines and onto the wings of the might, instead, shout, “Bravo!” Over GE have produced $11.8 billion in forthcoming Boeing 787. But that isn’t the past three years, Infrastructure’s earnings in the last 12 months. McCul- the kind of flight now under discus- revenues and profits have surged by ley observes that there is no company sion. Rather, the subject at hand is the 40%. More than any other segment’s exactly like it—and perhaps, for the flight to quality, a kind of mind travel contributions, they have powered cor- true believers, that is the real point. induced by credit disturbances. porate growth. All the more reason, Nevertheless, United Technologies, Since the turn of the cycle last sum- then, to hark to the story in last week’s Emerson, Siemens and Rolls-Royce mer, the destination of many such Wall Street Journal about the evident do provide some points of comparison. anxiety-propelled flyers has been the turn in the investment cycle. “Morgan They change hands in the market at triple-A-rated balance sheet of General Stanley recently estimated that 8%, or from 12 to 16 times trailing net in- Electric Co. On the third-quarter con- $60 billion, of the $750 billion of infra- come. “Give Jeff Immelt the benefit ference call, Keith Sherin, GE’s chief structure projects slated for 2008 are of the doubt,” McCulley suggests, financial officer, told the story of how, being delayed or cancelled,” the paper “and say that GE’s particular business one scary Friday in August, a certain said. “That is four times the historical portfolio is better than average, with state pension fund phoned to ask GE if cancellation rate of 2% a year.” faster growth and higher margins. Put it would accept a $5 billion investment. Hydra-headed, the credit markets a 16 multiple on it. That values the We are about to propose that those hold not one monolithic view of GE, nonfinancial side of the company at frightened stewards of other people’s but two, at least. There is the verdict $188 billion, or $18.80 a share. money called the wrong number. of the money markets, bullish, and “The financial side of the business,” As the world has learned to its cost, that of the credit default swap market, McCulley winds up, “has a tangible triple-A is a judgment handed up by guarded. “Funding in terrific shape,” book value of $28.5 billion. Delinquen- fallible human beings who draw their the company’s second-quarter hand- cies and nonaccruals are—apparently— pay from the very borrowers they out boasts of GE Capital: Out of $80 under control. Better-quality financials rate. GE is a hugely successful, globe- billion to $85 billion in required 2008 are valued at two to 2.5 times tangible girdling corporation that—contrary to funding, Capital has already secured book. A 2.5 multiple values Capital popular perception—is not so much $60 billion. The commercial-paper at around $71 billion. The combined an industrial giant as a financial one. market is the willing financier of $97 value of both businesses comes to $259 Measured year-over-year in the first billion of GE’s and GE Capital’s un- billion, or a little less than $26 a share. nine months of 2007, revenues deliv- secured IOUs—and would gladly take The stock, in contrast, changes hands ered by financial services jumped by more, management says. at $28.63 a share.” 18%, as opposed to 8% growth on the The ratings agencies (ex-Egan-Jones) On Wall Street, the consensus of industrial side. No less than 42% of the broadly concur with management. And analytical guesswork has GE’s earn- behemoth’s $124 billion in nine-month listening to Sherin on the call, one can ings growing by 7% in 2009 and by revenues derived from lending, borrow- hardly imagine the agencies changing 10% in 2010. An unscripted decline ing and investing. In all but name, GE their minds. The company and the ana- in worldwide economic growth would is a bank within an industrial company, lysts who rate it could almost be reading reduce industrial earnings while turn- or—based on the comparative revenue- one another’s minds, the CFO suggest- ing up the heat on GE’s massive credit growth curves—an industrial company ed. “It is really not anything like being exposures. In such a scenario, it is not within a bank. Yet it discloses much limited to an annual review,” he said. so farfetched to expect that multiples less about its financial position than a “It is a real-time, open-book, constant- would contract and that GE com- comparable-sized American commer- communication relationship.” We will mon—seemingly so cheap in the high cial bank has to tell. And it leans heav- not say that, in the face of this full-court 20s—could become even cheaper. ily on the sometimes-flighty commer- press, Moody’s or S&P wouldn’t dare Coming soon from NBC Universal, the cial paper markets. GE is unequivocally to issue a downgrade. But if they did GE entertainment subsidiary, is “Burn a strong, investment-grade credit, but choose to snatch away that sacred triple- After Reading,” with George Cloo- it is scarcely the triple-A fortress it A, the explosion at GE headquarters in ney and Brad Pitt. Clooney, we allow once was and still pretends to be. Fairfield, Conn., could be plainly heard ourselves to imagine, plays the chief This verdict won’t shock the credit- at the Manhattan offices of Moody’s and Moody’s analyst at one of the grander default swap market, which, in fact, has S&P. All the more important, then, to Wall Street broker-dealers. Pitt is an beaten us to the punch. Last spring, attend to the credit-rating relationship analyst at one of the great bond-rating the cost of insuring GE debt obliga- that GE can’t manage, i.e., the cost of institutions. Each has an interest to tions against nonperformance was 12 insuring its obligations in the credit- protect. . .and a secret to keep. Now basis points per annum for five years. default swap market. As noted, those there’s a popcorn movie. By Labor Day, the cost was more than prices imply a rating much lower than • 40 basis points, and it was 64 basis the one in place. points this week. The kind of issuer GE compendium-GRANT’S / NOVEMBER 3, 2017 9

This is triple-A? the speaker phone, “is very well posi- 70 70 tioned in this environment with our cost of GE Capital Corp. credit default swaps November 27, 66 bps global strength, our infrastructure 60 60 technology, our diverse business mix, tremendous triple-A-rated balance sheet and risk management. . . .” 50 50 Third-quarter credit results were no less rousing than the CEO. Thus, in basis points 40 40 delinquencies in commercial finance were just 1.35%, up 13 basis points from year-end 2006 but flat year-over- 30 30 year. Delinquencies in GE Money,

in basis points the worldwide consumer finance sub- 20 20 sidiary, were 5.24%, essentially un- changed from year-end 2006 and lower year-over-year. Nonearning assets, i.e., 10 10 those 90 days or more past due, were 1.5% of the combined portfolios on September 30, and were down 10 basis 0 0 points from year-end. Those, of course, 1/2/07 3/1 5/3 7/2 9/1 11/1 were historical data. Hearing the howl- source: The Bloomberg ing of the cyclical winds outside its Fairfield, Conn., headquarters, what that should expect to be quoted at that cial market risk is repricing. This shows did management do about reserves for level is typically rated Baa1, according up in phenomenal growth numbers. future credit losses? It left them un- to Moody’s Market Implied Ratings; Our revenues were up 12%, orders up changed, at 1.1% of gross receivables on 64 basis points indicate a rating seven 20%, assets up 23% and organic growth September 30. As recently as year-end notches below the one that another at 8%.” On the isolated evidence of 2005—before the skies blackened and branch of the Moody’s credit enter- that report, an observer might wonder the rains came—they stood at 1.6%. prise has actually assigned to GE. if the global credit tumult had ever hap- GE’s many admirers see in these As with the parent, so with the sub- pened. Certainly, he or she would not numbers further confirmation that sidiary. General Electric Capital Corp., have guessed that it was about to flare the mega-bank cum manufacturer is— the largest nonbank finance company up again or that GE, within five weeks just as it claims to be—a “disciplined in the United States, has itself been of the conference call, would choose growth machine.” Unusually in this day taken down a few pegs in the CDS to allow the investors in one of its own and age, GE chooses to keep most of its market. The annual cost of insuring short-term bond funds to absorb a 4% loans and leases on-balance sheet. Now GECC stands at 66 basis points, up loss of principal rather than buy their there is a bankable expression of confi- from 13 in the spring. For perspective, good will by making them whole with dence on the part of the underwriter, five-year CDS on United Technologies an outlay of, perhaps, $24 million. the bulls contend. On September 30, (rated A2 by Moody’s and single-A by GE did write off $890 million, after such assets footed to $361 billion. Se- Standard & Poor’s) are quoted at 24 tax, on a Japanese consumer-lending curitized assets held off-balance sheet basis points, while those of Siemens subsidiary and $43 million, also after totaled $51 billion, for which GE was (A1/AA) trade in the low 40s. Five-year tax, on a North American mortgage obligated to provide $2.9 billion of li- protection on 3M (Aa1/AA) and Procter lender. But such is the GE way: Iden- quidity support and $2.5 billion of & Gamble (Aa3/AA-minus) are quoted tify underperforming businesses early, credit support. in the mid-teens and mid-20s, respec- dispose of them promptly and direct The illustrious corporate name is tively. In some phases of the credit analytical focus away from “discontin- no small source of GE’s ratings stat- cycle, it doesn’t pay to be a bank. ued” lines to the thriving continuing ure. The numbers alone don’t quite You wouldn’t suppose that a com- ones. And Immelt did acknowledge measure up to triple-A. “On a consoli- pany with a $384 billion market cap, to his conference-call listeners that dated basis,” colleague Ian McCulley a $762 billion balance sheet and a sto- American consumer delinquencies observes, “the ratio of debt to trailing ried 115-year history could hide much were “trending up slightly” and that 12 months’ EBITDA is something like from the scores of analysts who swarm housing finance and subprime mort- 8:1, though that is a misleadingly high around it like the Lilliputians poking at gages were “still tough.” But he gave figure because a lot of this debt is sup- Gulliver. But GE has done it. It hides no sign of concern that the American ported by assets held at the GE Capi- its secrets in plain sight. In his intro- subprime crisis is actually a global tal level. So the ratings agencies make ductory remarks on the third-quarter credit crisis in which GE is bound to their adjustments. They analyze GE as conference call, Jeffrey Immelt, the be caught up, so extensive are its ex- an operating company and GE Capital chairman and CEO, delivered the good posures across market segments and as a financial company. GE, standing news in staccato fashion: “The environ- time zones. He instead gave the im- alone, has $13 billion of debt against ment, we believe, remains good for GE. pression that the company is above $27 billion or so of EBITDA and $8 Global markets are solid, and the finan- it all. “GE, we believe,” he said into billion of cash—a profile much more GE compendium-GRANT’S / NOVEMBER 3, 2017 10

in keeping with a top-drawer rating. today and presented themselves at the current rating. . . . The actual as- GE Capital has $620 billion of assets Moody’s tomorrow, neither could ex- signed rating of triple-A,” the comment against $562 billion of liabilities and pect to be crowned triple-A. Moody’s continues, “incorporates GE’s strong $56 billion of equity, for a ratio of eq- itself, in a recent comment on GE, management, conservative financial uity to assets of 9%. The loan book is seems to admit as much: “Utilizing the policies and predictable cash flows de- widely judged to be first class.” ratings factors identified in the Heavy rived from its leading market positions Yet, as McCulley also observes, if Manufacturing rating methodology, globally in a broad range of products GE and GECC didn’t exist yesterday, GE’s rating drivers suggest an Aa2 rat- and services.” And there is this consid- but materialized in their present form ing which is two notches lower than eration: As one of the world’s most pro- lific debt issuers, GE is what is known in the ratings industry as a very good General Electric Company customer. To demote it from triple-A (in $ millions, except per-share data) may or may not be a sound credit deci- sion (we judge it to be sound). For the 12 mos. to first agency to pull the ratings trigger, 9/30/07 12/31/06 12/31/05 12/31/04 it would certainly be a questionable Sales of goods and services $106,436 $100,700 $92,589 $84,705 business decision. GE Capital Services 69,187 59,957 55,430 48,712 Just as Moody’s notes, GE’s prod- Other revenue 1,391 2,734 2,223 1,582 ucts—from desalinization plants to gas Total revenue 177,014 163,391 150,242 134,999 turbines to wind-generation technolo- Cost of goods and services (76,753) (74,110) (66,814) (61,759) gy to jet engines, etc.—are dazzling. So Interest and other financial charges (22,860) (19,286) (15,138) (11,611) dazzling are the company’s industrial Investment contracts, achievements, in fact, that it is easy to insurance losses and annuity benefits (3,451) (3,214) (5,474) (3,583) forget how extensive is GE’s banking Provision for losses on financing receivables (4,855) (3,839) (3,841) (3,888) business. GE Money is a global con- Other costs and expenses (40,888) (37,414) (35,271 (33,096) sumer finance business with operations Minority interest (907) (908) (986) (728) in more than 50 countries. Its stock-in- Earnings from continuing operations 27,300 24,620 22,718 20,334 trade encompasses credit cards, mort- Income taxes (4,396) (3,954) (4,085) (3,708) gage loans and personal loans. At year- Earnings (loss) from discontinued end 2006, more than 75% of its $157 operations, net of tax (838) 163 (1,922) 534 billion portfolio was outside the 50 Net income 22,066 20,829 16,711 17,160 states, and its assets over the past doz- Diluted earnings per share 2.14 2.00 1.57 1.64 en years have grown at a compound an- Cash 19,848 14,275 9,011 12,152 nual rate of 18%. Eleven months ago— Investment securities 45,209 47,826 53,144 56,923 that being the latest parting of the Current recievables 12,705 13,954 14,851 14,233 curtain—assets included $58 billion of Inventory 13,319 11,401 10,474 9,778 non-U.S. mortgages, $36 billion of non- Net financing receivables 361,684 334,205 287,639 282,699 U.S. revolving credit and $25 billion of Other GECS receivables 16,704 17,067 14,767 11,340 non-U.S. auto credit. There were five Net property, plant and equipment 76,292 75,966 67,528 63,103 banks under GE Money’s wing, includ- Net intangible assets 94,317 86,433 81,726 78,456 ing GarantiBank in Turkey, GE Money Other assets 114,257 97,112 87,425 89,667 Bank in the Czech Republic and Kep- Assets of discontinued operations 7,372 0 46,756 132,266 pel Bank in the Philippines. Total assets 761,706 697,239 673,321 750,617 The GE consumer finance franchise Short-term borrowings 180,403 172,153 158,156 157,195 does not entirely skirt the 50 states; Accounts payable 18,716 21,697 21,273 19,137 domestic credit-card programs totaled Other current liabilities 28,524 26,664 25,498 23,805 $29 billion at year-end. But the com- Long-term borrowings 311,220 260,804 212,281 207,871 pany has wisely refused to export ag- Investment contracts, insurance liabilities gressive, boom-time American under- and annuity benefits 34,074 34,499 45,432 48,076 writing practices. Globally, GE Money Deferred income taxes 10,758 14,171 16,312 15,308 says, it hews to an average loan-to-value Other liabilities 55,363 46,884 40,632 42,779 ratio of 70% and a debt-to-income ratio Liabilities of discontinued operations 2,309 475 36,332 112,935 of no more than 35%. It says it does no Total liabilities 641,367 577,347 555,916 627,106 negative-amortization lending. Minority interest 7,508 7,578 8,054 12,603 In short, if you believe that foreign Shareholders’ equity 112,831 112,314 109,351 110,908 economies have “decoupled” from the slightly weary U.S. model, GE Money Shares outstanding (millions) 10,257 is the business for you. No doubt, Mc- Price per share $37.45 Culley advises, GE Money has done its Market capitalization 384,125 customary crackerjack job of underwrit- Price/earnings 17.4x ing in foreign parts. “But,” he goes on, Price/book 3.4 “the simple fact is that credit booms GE compendium-GRANT’S / NOVEMBER 3, 2017 11 in emerging markets sometimes end on the dollar, rather than, say, 100 cents busiest issuers of corporate bonds. badly, as, indeed, do credit booms in de- on the dollar, GE issued a press release (GE’s bonds are denominated in 19 dif- veloped countries. Recall South Korea’s stating that “GE and GE Capital have ferent currencies, its commercial paper experience with credit-card defaults no exposure to special [sic] investment in nine.) On September 30, the finance earlier this decade. Some of GE’s new vehicles (SIVs) and less than $50 mil- subsidiary had outstanding $178 billion borrowers had, before GE came along, lion in collateral [sic] debt obligations in short-term debt, of which $65 billion never been able to raise a mortgage loan. (CDOs).” If we were Jeff Immelt, we was in U.S. dollar-denominated com- Now they are happily enjoying home think we would do as he did—let the mercial paper, $27 billion of non-U.S. ownership, and will keep on paying their outside investors absorb a small loss, let dollar-denominated commercial paper, interest and principal unless and until people talk—if we expected that more $53 billion of maturing long-term obli- the global economy turns down. Surging losses were in the offing and we did not gations and $5 billion of asset-backed asset growth is always a good thing in a want to establish a potentially costly commercial paper. The long-term debt boom. Not so much in a bust.” precedent of reimbursing the investors, was very largely unsecured and stretch- Just 29% of GE’s loan book exists of whom there are many, indeed. GE es out to 60 years in maturity. At the to support GE’s industrial sales; the manages $96 billion of outside money, other end of the funding curve, GE de- purpose of the much bigger remainder including, according to the GE Asset pends on the health and confidence of is to generate earnings growth for the Management Web site, a certain num- the sometimes-fragile paper market. parent. The operations of the commer- ber of funds with structured products in Today, there seems nothing frag- cial finance subsidiary are as eclectic their portfolios. ile about the GE paper program. The and far-flung as those of GE Money. To us, and to any who believe that finance subsidiary is paying 4.51% to At year-end, the commercial segment the 2007 credit drama is still unfin- borrow for 30 days, only a quarter-point held $76 billion in equipment lease ished, it’s a foregone conclusion that higher than the federal funds rate, and obligations, $49 billion of commercial GE must bear more losses. No global last month’s conference call elicited not and industrial loans and $28 billion of financial institution can hope to escape one anxious question on the quality of real estate loans. Nor is GE exclusively untouched. There was, as noted, no the loan book. In an August bulletin a lender against real estate collateral; such concession on the third-quarter on funding, or liquidity, risk, Moody’s as of 11 months ago, it also owned $27 conference call last month. But, to judged that GE was sitting pretty. Back- billion of property in its investment ac- judge by the response to the bond-fund up lines of bank support appeared more counts. In the nine months to Septem- dustup, management might be chang- than adequate, the agency decided. ber, such loans and investments gener- ing its mind. They sum to $61 billion, of which 60% ated $5.1 billion in revenue, roughly The principal risk to GE investors, can be drawn for longer than one year. 20% of commercial finance sales, up we believe, is the gap between percep- For ourselves, we don’t doubt that this from $3.4 billion for the like period a tion and reality—between the compla- virtual nation-state of a global corpora- year ago. The grand total of assets as- cent belief in Fortress GE and the risks tion will sail through the 2007 credit dis- sociated with real estate jumped to $72 presented by the huge pile of assets locations. What we do doubt is that the billion as of September 30, compared and liabilities in the midst of a plan- equity and money markets will continue to $54 billion last December 31. etary credit blow. As to the liabilities, to ignore the risks that every credit crisis In the wake of the disclosure that GE does most of its borrowing through must present to every leveraged financial one of its short-term bond funds was re- GECC, the largest commercial paper is- institution. CEO Immelt insists that GE deeming its investors’ shares at 96 cents suer in the world and one of the world’s is triple-A. Moody’s agrees in a hedged Finance outgrows manufacturing sort of fashion. The bond market de- 30% 30% murs, while the CDS market is adamant GE’s quarterly revenue growth, measured year-over-year 25 25 that the risk is that of a borrower rated no better than Baa1. Grant’s judiciously es- 20 financialfinancial, 20 timates that the truth lies somewhere in 16% the middle—in the neighborhood, say, of 15 15 a strong single-A credit. As for the bond 10 10 and stock markets, we judge that they believe, with Immelt, in Fortress Triple- growth rate 5 5 A. It may come as a jolt when they’re dis- abused of that myth. 0 0 • growth rate -5 industrial,industrial -5 13% -10 -10 Saps take umbrage -15 -15 (May 4, 2007)Doormats to private- -20 -20 equity promoters, real-estate specula- tors and hedge-fund titans, creditors -25 -25 have actually staged a revolt. They 12/00 12/01 12/02 12/03 12/04 12/05 12/06 9/07 have ordered the rotten apples re- source: The Bloomberg moved from the barrel of collateral that GE compendium-GRANT’S / NOVEMBER 3, 2017 12 was to support a pending sale of com- million, one-third of the new price, On the basis of recent sightings, mercial mortgage-backed securities. only three years earlier. credit is tightening for commercial Otherwise, they said, they would sit on Such valuations may or may not be real estate as it already has for resi- their wallets. The issuer, none other justified by the real estate fundamen- dential. If so, it’s a good thing for than General Electric, submitted. tals (we’re certain they’re not); what the lenders—and a very bad thing for “In a highly unusual restructuring,” makes them possible are willing lend- property valuations. the April 27 Commercial Mortgage Alert ers. But the mutiny of the CMBS inves- reported, “an underwriting syndicate tors suggests that lenders are changing • this week was forced to pull $277 mil- their minds. They have every reason to. lion of loans from a $4.2 billion fusion Earlier in April, Moody’s raised its The most imperfect investment offering after bondholders raised con- voice against overgenerous lending cerns about credit quality. The deal terms in the commercial real-estate (November 8, 2002) On the third- (GE Commercial Mortgage Trust, branch of structured finance. The quarter General Electric conference 2007-C1) ended up pricing at signifi- agency pointed to record-high loan-to- call, management virtually asserted cantly wider spreads than the prevail- value ratios, the surging popularity of that GE is cycle-proof. In so many ing levels after a much-extended mar- interest-only deals (85% of first-quar- words, Jeffrey R. Immelt, CEO, de- keting campaign.” Five such overripe ter conduit transactions had featured clared that it’s business as usual in pieces of fruit were extracted, includ- them) and the evisceration of junior Fairfield, Conn.—bear market, credit ing a $201 million interest-only loan tranches (the shock absorbers for the contraction and post-bubble syn- to a Long Island apartment complex. investment-grade tranches). drome notwithstanding. According to Moody’s, the loan had a “The negative credit implications “So no issues, now, Jeff, on pric- “stressed” loan-to-value ratio of 138% of the ongoing erosion of conduit loan ing?” inquired an analyst of the man and a “stressed” debt-service coverage underwriting, particularly the increase who succeeded Jack Welch. “I mean, ratio of 0.63:1. in leverage, now exceed the benefits the concern is that as customers, your Many were stressed by this unac- of generally positive property funda- airline, especially, and power custom- customed show of spine by members mentals,” said an April 10 Moody’s ers get squeezed, that they’re looking of the creditor class. In the contraction bulletin (“US CMBS: Conduit Loan to get some room within the contracts phase of the cycle, of course, lenders do Underwriting Continues to Slide— on service.” talk back and frequently forget where Credit Enhancement Increase Like- “I think just the opposite. . . ,” Im- they put their checkbooks, but then ly”). “As a result, real estate capital melt replied. “I’d say that pricing has they act on fear more than conviction. market participants can expect to see stayed very attractive, particularly in “The changes amounted to more than higher subordination levels phased in power and engines and in medical, be- the ordinary tinkering that can occur to Moody’s-rated CMBS deals over cause of the value created in the cus- at the last minute,” the Alert said. “In- the next few months.” tomer.” In fact, according to Immelt, deed, market players described them as But that was not the most arresting so formidable—so “unbelievable”—is among the most extensive ever seen in news concerning a sanctioned debt- the management team of the aircraft the late stages of a conduit marketing rating agency in the second calendar engine unit that GE stands aloof from campaign. More importantly perhaps, quarter of 2007. According to the April the threatened serial bankruptcies of they marked the first time that invest- 20 edition of the Commercial Mortgage the airline industry. “[W]e think in any ment-grade investors won a concession Alert, Fitch has already increased its environment for the aviation business, from dealers in the form of kicking a subordination levels for CMBS transac- this situation is manageable,” he said. large loan out of a deal.” tion deals. It has bumped them up by “GE will earn $4.1 billion in the The uprising attracted little atten- 10%. And, it has already paid a price fourth quarter, up 25%,” the boss tion in the general press. Then, again, for it. Since imposing the tougher new prophesied (he spoke on October 11, as colleague Dan Gertner observes, standard, said Fitch, it had been hired less than two weeks into the quar- it’s the coincident indicators, not the to rate just four of 11 deals; at the start ter). “This is approximately the same leading ones, that usually garner the of the year, it had won 14 of 17. amount we earned in all of 1992, and ink. Certainly, the coincident indi- Zanda Lynn, a Fitch managing direc- I’m proud of our team’s effort. . . . cators of the commercial real-estate tor, told the Alert that lenders think Here’s what we’ll deliver in 2002: Solid market glow with good health. Tues- nothing of valuing a property on the ba- earnings growth. Strong cash flow.” day brought news of the sale by HSBC sis of distant projections. “In some cas- The nation’s second most-valuable of its London office tower to Metrova- es,” said the Alert, attributing Lynn, “. company is always topical, but it’s cesa, the Spanish property company, . .lenders have used rent increases pro- more timely than ever for the readers of at a cap rate of only 3.8%, a yield well jected 15 years out to underwrite loans Grant’s. Already heavily leveraged, GE below the sterling-denominated base- with terms of only three years.” Lynn Capital last month filed a shelf registra- lending rate of 51/4% (HSBC will told the newsletter that, to make such tion for $50 billion in new debt securi- obligingly advance the funds). And on a deal work, you needed two things: ties. Then, too, the 11th-hour scratch the same day came word of the sale of the rent to go up and never go down, from the October 24 conference lineup the old House of Error, The New York and “a take-out lender to refinance the of Ravi Suria, credit analyst of renown Times headquarters building in mid- property just as aggressively as the cur- (his topic was “GE Capital—Fact, Fic- town Manhattan, for $525 million; the rent lender has. It’s an excessive prac- tion and Book Value”), has left the seller, Tishman Speyer, had paid $175 tice, and we’re seeing it a lot.” Grant’s community with a sense of GE- GE compendium-GRANT’S / NOVEMBER 3, 2017 13

Comparing balance sheets... pervious to the business cycle and the credit cycle, it is, in fact, capitalized to GE Capital Services vs. CIT, as of September 30 profit in one particular phase of those (in $ billions) cycles. The favored phase is the bullish one, naturally. GE is a bull market en- GECS CIT terprise, structured by American opti- Assets mists and geared to rising asset prices. Cash and investments $124.1 $2.3 The risk to the creditors of GE Capital Earnings assets1 232.1 35.3 is that asset values do not rise but stag- ntangible assets, net 22.5 0.4 nate or slump. In such a setting, GE ther assets, PP&E 4.6 4.8 would suffer the same kind of credit otal assets 43.4 42. troubles borne by those lenders who put their pants on one leg at a time. Liabilities and equity Responding to difficulties in its im- Short-term borroings 128.3 8. mense book of business in credit cards, ong-term borroings 133.3 23.8 leveraged leases, mid-market business otal debt 261.6 32.5 leases, consumer loans and aircraft inoritpreferred 4.4 0.3 leasing, it would step up its allowance Shareholders’ euit2 31.6 4.8 for credit losses. So doing, it would re- otal capitaliation 2.6 3.5 duce its contribution to the peculiarly predictable parental earnings stream. eservesfinancing receivables 2.64% 2.3% Our analysis proceeds from bedrock Euitassets 6.6 11.14 principles of life and finance. No. 1, if something is too good to be true, it 1includes financing receivables, operating lease euipment, other GECS receivables and mortgage portfolio probably isn’t. No. 2, business cycles 2as reported. and credit cycles happen to every large financial institution, even to GE. No. deprivation. The following analysis at- GE constitutes a living symbol of the 3, a triple-A-rated credit has nowhere tempts to fill the void. U.S. economy. It is seemingly invin- to go but down (an adage we borrow In it, we examine the global icon’s fi- cible. It is a hothouse of productivity- from Michael Milken, 1980s’ junk- nancial leverage (growing), its free cash enhancing technology. It is seemingly bond impresario). Jack Welch, in his flow (negative, as we define free cash ubiquitous (among the many business- 2001 autobiography, “Jack: Straight flow), its asset quality (riskier), its dis- es in which GE Capital engages—busi- from the Gut,” marveled at GE Capi- closure (artfully unforthcoming) and nesses you might not have heard of—is tal: “Looking back over the years of the risk-reward proposition presented the business of buying GM receivables uninterrupted double-digit growth,” by its debt securities (little upside, at a discount from GM suppliers). he wrote, “it almost seems surreal.” much downside). In the past decade, GECS, though a global enterprise, is as What, to us, is more surreal is the GE has become less of an industrial American as apple pie in its increasing claim that this globe-girdling unregu- enterprise and more of a financial insti- application of leverage to higher-yield- lated bank is somehow detached from tution. The same company that makes ing assets. Though represented as im- the credit cycle. aircraft engines, power plants and loco- motives also houses one of the world’s ‘It’s risk management’ 3.5% 3.5% biggest unregulated banks. In 2001, GE’s and CIT’s reserves for credit losses the industrial side of the business con- as a percentage of finance receivables tributed 56% of revenues and 65% of 3.0 3.0 pretax income; the financial side ac- counted for 90% of liabilities. The GE balance sheet is one of the most ne- 2.5 2.5 glected documents in the SEC trove. In its financial capacity, GE is a gi- C 2.0 2.0 ant arbitrage engine. It borrows at low, GE triple-A rates and invests at higher, riskier ones. It does what banks do 1.5 1.5 but without taking deposits and with- out submitting to the prying of federal regulators. The issue before the house 1.0 1.0 is whether the bank of GE—i.e., GE Capital, or GECS, which we use almost 0.5 0.5 interchangeably—is as sound as its tri- ple-A rating. We conclude that it isn’t. As big as it is—$555.5 billion in con- 0.0 0.0 solidated assets as of September 30— 12/31/98 12/31/99 12/31/00 12/31/01 6/30/02 9/30/02 GE compendium-GRANT’S / NOVEMBER 3, 2017 14

A contrarian may wonder if the bad Split decision news on GE isn’t already fully dis- 4.0% 4.0% counted. The stock, which is down by allowance for loan losses (as a percentage of total receivables) 56% from the August 2000 peak, trades rises in the industrial business at a discount to the S&P 500 market 3.5 3.5 GE current receivables multiple. Bearish critiques have re- cently appeared in Fortune magazine GECS finance receivables and The Economist (and before that—on 3.0 3.0 March 29—in Grant’s). Eight months have gone by since the manager of the world’s biggest bond fund criti- 2.5 2.5 cized GE Capital’s habitual reliance on commercial paper financing not fully supported by backup lines of credit 2.0 2.0 (through the 1990s, a decade in which GE was regally above criticism, com- mercial paper represented half of total 1.5 1.5 GE indebtedness). To placate the mar- ket, GE subsequently replaced billions of dollars worth of that paper with lon- 1.0 1.0 ger-term obligations. However, as Im- 1995 1996 1997 1998 1999 2000 2001 9/30/02 melt explained over the air waves, the company absorbed no incremental cost The GE 6 3/4s of Sept. 11, 2003, are observer that the color is actually red. by moving to the higher-yielding end quoted at 103.96, a price to yield a GE is that proverbial color black. It is of the yield curve. This was because it little less than 1.98%. All the way out one of the last 12 triple-A-rated U.S.- swapped long yields back into short. In on the long end of the curve, the GE based corporations. Tracing its origins a policy statement on its Web site, GE 6 3/4s of March 15, 2032, are quoted to Thomas Alva Edison and the Edison Capital is at pains to assert that it nev- at 104.05, a price to yield 6.14%. (GE Electric Light Co., it is the only sur- er speculates—not in currencies, de- Capital does the corporation’s public viving original component company of rivatives or emerging markets. It is at borrowing under its name.) Such low the Dow Jones Industrial Average. At pains to assert its devotion to matched nominal interest rates, as much as they $264 billion, its stock-market capital- funding, i.e., to the practice of offset- please the borrower, deprive the lender ization represents 59% of that of the ting interest rate risk on one side of the of the margin of safety. The possible entire German market (as measured balance sheet with interest rate risk on disasters that could befall a creditor by the DAX index), to pick a global the other. With all that said, GE must of a triple-A company between 2003 benchmark. At year-end 2001, calcu- have a greater net sensitivity to short and 2032 would fill more than these 12 lates Egan-Jones Ratings, pretax cor- rates than to long ones. pages. If the dollar were debased, GE’s porate income covered fixed charges by Though no longer the corporate yields would climb, whatever feats of 25.1:1. For the full 12 months, net in- ideal of the Welch days (and of the management virtuosity the company come produced a 25% return on equity. days of Gary Wendt, longtime head performed. In that case, the bondhold- GE did not get its reputation as an of GE Capital, who quit in 2000 to ers would be the losers. Yet, if the dol- all-season profit machine for nothing. mastermind the supposed turnaround lar were not debased but—on the con- In the 1990s, Wendt would rally his of bankruptcy-bound Conseco Inc.), trary—gained purchasing power, the GE Capital troops with the battle cry: GE is still, by the market’s acclama- bondholders would also very likely be “We’re going to win the war. You’ve got tion and that of the leading rating the losers. A deflationary environment to take ground.” And they took it. Con- agencies, triple-A. GE Capital, too, is would harm GE’s creditworthiness by cerning the perils of the credit cycle triple-A rated, although an S&P ana- degrading the quality of the tens of bil- (on which this essay heavily leans), a lyst observes that the bank of GE is lions of dollars of loans and leases that Standard & Poor’s analyst has pointed not cut from exactly the same triple-A fill the GE investment portfolio. to cyclically induced opportunities. In fabric as the parent. “On a stand-alone The words “GE Capital” and “triple- the early 1990s, when the banking sys- basis,” says Lisa J. Archinow, director, A” together signify “the best.” Actu- tem was clogged with bad real estate financial services ratings, of the capi- ally, the bonds are among the worst. loans, federal regulators shifted from a tal subsidiary, “it’s AA-ish.” And if it They would depreciate amidst infla- posture of unwarranted leniency to one were deserving of more than a double- tion but not necessarily appreciate of unwarranted severity. They required A rating before the 2001 acquisition of in the absence of inflation. They will the banks to make special capital allo- Heller Financial, the big mid-market not—repeat, not—be upgraded. Is cations against loans that, though still finance company, it could hardly be so there a worse bet in the bond market? performing, might one day become afterward; before GE bought it, Heller None so widely owned, we believe. nonperforming (these “nonperforming was rated A-minus. When 99% of the investment world performing loans” were a regulatory GE Capital isn’t paying noticeably agrees that a certain color is black, it sore spot of the elder Bush’s one-term more to its creditors, in relation to falls to the dissenter to produce the presidency). “One of the few available Treasury yields, than it did a year ago. evidence to persuade a fair-minded buyers of such loans was GECC,” re- GE compendium-GRANT’S / NOVEMBER 3, 2017 15 calls S&P, “whose asset management the telecommunications and cable in- mean, “No.” Admittedly, CIT and GE skills, coupled with the deep discount- dustries. It admitted to a $600 million Capital are not perfectly comparable ed purchase prices and low funding rise in impaired receivables “primar- (the former is relatively small, the lat- cost, enabled it to generate strong re- ily associated” with its Heller com- ter absolutely immense, its immensity turns on those assets over time. This mercial finance subsidiary, increasing encompassing consumer debt as well strategy of opportunistically purchas- “nonearning and reduced-earning re- as commercial). But we are stumped ing distressed assets at discounts and ceivables” from 1.4% of outstandings by GE’s evident imperviousness to the managing through the credit risk over at year-end to 1.7% at September 30. cyclical tides that seem to be washing time enabled GECC to reap substan- And it announced plans to wind up over everyone else’s feet. GE has pro- tial benefits later in the cycle.” its $3 billion private equity fund. Yet, vided an answer. It has plotted its loss- Today, there are plenty of distressed in the main, GE Capital has suffered es in consumer and commercial credit assets for sale, and GE is no doubt op- fewer slings and arrows than the aver- (measured as a percentage of average portunistically buying some of them. age outsized financial institution in outstandings) against those of the top However, it also owned a good many this cycle. According to the September 100 banks; since the mid-1990s, its re- of them as they were becoming dis- 10-Q, non-earning consumer receiv- sults are consistently superior. tressed. Many will contend that GE ables have declined by 50 basis points However, we notice an intra-com- can operate in the current down cycle since the start of the year, to 2.4% of pany anomaly. The industrial side of as nimbly as it did a decade earlier. outstandings. And the overall credit re- the company began to raise its allow- S&P does so contend. So great is GE serve for finance receivables at GECS ance for losses on current receivables Capital’s diversification, both by prod- declined in the third quarter: at 2.64% in 1998, and continued to raise them uct line and geography, says the agen- of receivables, it was the lowest since at least through 2001 (no more cur- cy, that it can maintain “consistency in December 1998 (reserves hovered be- rent data are available). Is the credit its consolidated profitability through- tween 2.7% and 2.8% over the preced- experience of the industrial side of the out the business cycle. . . .” What S&P ing seven years). business so different from that of the believes, we doubt. The accompanying graph plots GE’s company bank? In a generalized credit crisis, diver- reserve for credit losses against that of It’s not as if GE Capital were only sification would count for little. What CIT, formerly the bank of Tyco and buying Treasury bills and gold bars. has befallen the domestic credit mar- now, post-spin-off, a freestanding com- Making its capital sweat, the finance kets post-bubble is a long way from mercial finance business again. It shows division has been reaching for yield in that, but it does suggest what could that, while CIT set aside significantly its loan and lease operations. Exhibit A happen. The investment-grade wing less than GE from 1998 to 2001, it sud- is the upsurge in “leveraged leases” as of the corporate debt market, never denly stepped up its provisioning in a percentage of overall leases. Exhibit mind the junk division, is roiled by 2002. Colleague Peter Walmsley asked B is the boom in so-called middle-mar- downgrades. U.S. Airways has filed for a CIT representative if best practices ket financing, which embraces com- bankruptcy protection, and its debt in the matter of credit allowances had mercial equipment financing, vendor obligations secured by aircraft collat- come in for redefinition since the com- financial services (“financial solutions eral (so-called equipment trust certifi- pany left the executive oversight of L. and services to over 100 equipment cates) are quoted at 15-20 cents on the Dennis Kozlowski, former Tyco CEO. manufacturers and more than 4,500 dollar. The public, unsecured debt of “Don’t even go there,” the spokes- dealers/distributors”) and, of course, such power-plant customers as Calpine person said, by which she seemed to Heller Financial, which extends com- and Mirant is quoted at 40 cents on the dollar. Household International and Reaching for yield 50% 50% Sears, among other seasoned consumer GE’s mid-market financing divided by total loans lenders, have admitted to credit woes. 45 (consumer and commercial) 45 CIT, recently divested from Tyco In- ternational, has lifted its reserves for 40 40 credit losses. As for junk bonds, it was noted in the previous issue of Grant’s, 35 35 40% of the issuance from 1997-99 has already defaulted. Did GE Capital, go- 30 30 ing for growth, not also succumb to the underwriting errors of the manic phase 25 25 of the boom? In the three years of the junk-bond bacchanalia, assets of the 20 20 bank of GE grew to $345 billion from 15 15 $227.4 billion. In recent disclosures, GE owned up 10 10 to $4.4 billion of exposure to U.S. Air and United Airlines and made “provi- 5 5 sions for probable losses” (amounts not specified). It identified $12 billion of 0 0 investments in, and commitments to, 1995 1996 1997 1998 1999 2000 2001 GE compendium-GRANT’S / NOVEMBER 3, 2017 16

Leverage grows in the lease book quoted price, however, is $3 million to 13% $10 leveraged leases (left scale) vs. leveraged leases $3.5 million, or a small fraction of the as a percent of finance leases (right scale) cost of a new Gulfstream V. 12 GE, though it has acknowledged an unspecified loss in its exposure to leveraged leases 11 U.S. Airways and United Airlines, has 8 leveragedfinance leases admitted to no general impairment leveragedfinance leases of the value of its airplane fleet—a 10 spokesman characterizes it as new and coveted. However, we think, impaired 6 it must be. And impaired it will be if United gives up the ghost. Then, again, in whistling past the graveyard, GE is 5 8 in billions of dollars whistling in a duet, if not in a larger ensemble of optimists. “Despite the 4 slowdown in commercial aviation,” comments Hank Greenberg, chairman 3 6 and CEO of AIG, concerning the third- quarter results of the insurer’s aircraft leasing subsidiary, International Lease 2 5 1995 1996 1997 1998 1990 2000 2001 Finance Corp., “there continues to be strong market demand for ILFC’s mercial credit to operating businesses including aircraft and engines.” True, modern and efficient fleet. Virtually all with annual sales of as little as $5 mil- of course. But, given the parlous condi- planes coming off lease in 2002 have lion (and as much as $250 million) and tion of the airline business, the ques- been placed with other airlines, and all to real-estate concerns with assets of as tion is how much the collateral is worth. deliveries of new aircraft for the bal- little as $1 million (and as much as $40 General Electric Capital Aviation Ser- ance of 2002 and scheduled for deliv- million). Are Heller’s customers bullet- vices (GECAS) owns 1,000 commercial ery in 2003 have also been successfully proof? Is Heller? aircraft and manages another 300. Its leased.” We scratch our heads. We can- To listen to Immelt and to surf the list of client airlines numbers 200. It’s not reconcile the expressed optimism GE Web site is to be invited to believe easy to remember which major carri- of the aircraft lessors with the desola- that “six sigma quality, digitization, ers are at risk of bankruptcy. All are at tion in a broad segment of airline debt customer centricity” and the other risk. Besides slumping travel demand obligations, secured and otherwise. celebrated GE management meth- and high variable costs, the airlines are How can cost compression and lease re- ods can trump the credit cycle. We up against the logic, or illogic, of the jection be anything but bearish for the wonder how. Employers Reinsurance American way of bankruptcy. Emerging owner of 1,000 commercial airplanes, Corp., GE’s underachieving insurance from Chapter 11 proceedings with its late-model or new? subsidiary, has had trouble conquering debts reduced, U.S. Airways is expect- No company in America will breathe the insurance cycle. Its actuaries are ed to operate with a cost structure con- a deeper sigh of relief than GE if the presumably as six-sigmatic, customer- siderably smaller than that of the day it stock market, by rallying, is foretelling centric and digitized as any in the filed. Reconfigured in this fashion, it is the end of this painfully slow economic business. Yet, by underestimating the ideally equipped to drive its competi- recovery. To gauge GE’s prospective claims resulting from business written tors into bankruptcy. happiness, consider the growth of an in 1997-2000, they have brought about An investor we know is an owner of asset called “estimated unguaranteed insurance losses sufficient to deflate privately placed U.S. Airways equip- residual value of leased assets.” De- the earnings growth of GECS in the ment trust certificates. These are construct the phrase: “estimated,” as just-ended quarter. “I’ll tell you,” said amortizing debt obligations secured in Kentucky rifle windage; “unguaran- Keith Sherin, GE’s chief financial of- by aircraft, and the aircraft are leased teed,” as in no promises; and “residual ficer, “it’s disappointing to be talking to the carrier. However, the carrier re- value,” as in an uncertain future value. about ERC again.” On watch for pos- jected the leases—its privilege under In a footnote to the GECS balance sible downgrade by Moody’s and S&P, the Bankruptcy Act. Before the rejec- sheet, estimated unguaranteed re- Employers Re is also thought to be on tion, the certificates paid $200,000 per sidual value of leased assets totals $9 the block for possible divestiture (one plane per month. Now, our source re- billion, equivalent to the subsidiary’s rumored buyer is Berkshire Hathaway). lates, they will pay $90,000 per month tangible stockholders’ equity. On October 30, CBS MarketWatch. (owners of public certificates may have The story of the equity is intimately com corrected a previous day’s report to settle for $75,000 per plane per connected with the story of what we’ll that GE expected “probable losses” month). The aircraft that secures our call the corporate “mystery meat.” GE’s of $4.4 billion in connection with its friend’s certificates is the Boeing 737- mystery meat is assets of uncertain exposure to United Airlines and U.S. 300. This, the workhorse of the civil provenance, and it comes in two variet- Airways. Actually, noted MarketWatch, aviation fleet, cost $27 million per copy ies: “intangibles” and “all other assets.” “only part of that amount is at risk, be- to build and retains a so-called blue- The sum of these line items was $134.2 cause the loans are backed by collateral book value of $9.5 million. The current billion on September 30—$44.6 billion GE compendium-GRANT’S / NOVEMBER 3, 2017 17 of intangibles and $89.5 billion in “all is approximately equivalent to equity. ter-to-quarter view of the profitability other assets.” If, suddenly, there were no net mys- of the business. But to take an even Some of the mystery is dispelled by a tery meat—if an auditor were to take longer-term view it helps to turn to reading of the footnotes in the 10-K re- an eraser to it—there would be no eq- the cash-flow statement. Here you port (you won’t find it in the 10-Q). In uity. We do not say that it deserves to have three vantage points. No. 1, cash Note 17 is a partial listing of these “all be written off. We do not assert that it from operations, comprised of earnings other assets,” $80.5 billion strong at deserves to be discounted heavily from plus a variety of non-cash adjustments year-end 2001. Included, for example, the value at which it is being carried that trace the changes in balance-sheet are “prepaid pension assets,” “mort- (not knowing exactly what it is, we items like working capital, asset depre- gage servicing rights” and GECS’ real are in no position to assert any such ciation and amortization and deferred estate portfolio. In a spirit of generos- thing). All we say is that the public tax changes. No. 2, cash from investing ity, we mark these items at par. documents do not instill confidence in activities, which shows mainly what a We are less inclined to assign par val- it, whatever it is. company spends on M&A and on fixed ue to the items of deeper mystery, i.e., In any case, the balance sheet is assets. Its special relevance to GE by name, “net mystery meat.” Included not the document that GE would pre- is that it highlights the costs of GE’s is $15.6 billion of “other other” assets, fer we pay attention to. Immelt has fabled active portfolio management. the unexplained residue from Note 17 decreed that a spotlight be turned on No. 3, the difference between operat- (“all other assets”); $2 billion of “de- segment information of the income ing and investing cash flows, which an- rivative instruments”; $9 billion of the statement, the better to “improve swers a definition of ‘cash flow.’” previously cited “estimated unguaran- investors’ ability to understand these Admittedly, cash flow is one of the teed residual value of leased assets”; businesses and benchmark them most expansive concepts in finance. and $31.6 billion of intangibles, most of against their peers.” This is, however, Immelt avers that his company is cash- which are goodwill but which include as colleague Walmsley points out, a flow positive. By cash flow, he means $1 billion of “other intangibles” and— red herring. What investors need is a cash flow from operations. Grant’s as- a favorite around here—$2 billion of brighter light on the balance sheet— serts that GE is free cash-flow nega- “present value of future profits.” and on the cash-flow statement. tive. By free cash flow, we mean the Interestingly, this net mystery meat “The income statement,” to quote difference between cash from opera- has grown in lockstep with equity and Walmsley, “shows a smoothed, quar- tions and cash used in investing activi- ties, calculated over a span of years. From 1993 through 2001, the differ- Mysterious assets grow with equity $0 $0 ence between cash flow from opera- GE consolidated tions and cash used in investing has 60 60 consistently been negative. The accompanying graphs plot one net mster meat 50 50 in billions of dollars of the anomalies of triple-A GE. The reported euit industrial business has, by the cash- 40 40 flow criterion set out by Grant’s, been consistently profitable. Yet, the con- 30 30 solidated enterprise—GE in full—has, by the same cash-flow criterion, been

in billions of dollars 20 20 consistently unprofitable. Where is the cash coming from? Where is it going? 10 10 On the evidence, the cash is coming from GE Capital. Where it is going is to 0 0 the parent. In the March 29 issue, we 1995 1996 1997 1998 1999 2000 2001 wrote, “Between 1989. . .and 1993, the ratio of GECC assets to GE assets was $45 $45 GE Capital Services virtually unchanged, at around 47%. By 40 40 1997, the figure had grown to 75%, and now it stands at 76%.” So it stood on 35 net mster meat 35 September 30. At year-end 1995, tan- in billions of dollars 30 reported euit 30 gible equity at GECS represented 3.3% of GECS’ assets. On September 30, 25 25 2002—6 3/4 years later—tangible equi- 20 20 ty at GECS amounted to 1.9% of GECS’ assets. Not knowing better, you would 15 15 suppose that the finance business had in billions of dollars been dead in the water. On the con- 10 10 trary, it has been making flank speed. 5 5 The graph shows how the cumulative net income of GECS would have grown 0 0 1995 1996 1997 1998 1999 2000 2001 if the front office had left the money GE compendium-GRANT’S / NOVEMBER 3, 2017 18 where it was earned. Instead, however, the money has been dividended up to Cash flows upstream at GE $40 $40 the parent. Since 1994, at GECS, on a GE’s consolidated cash flow compound annual basis, tangible equi- 30 30 ty has grown by 10%, while intangibles have grown by 21%. 20 20 At the top of this article, we taxed

GE with “artfully unforthcoming” dis- 10 10 in billions of dollars closure. There is no better example of the nondisclosed disclosure than a $3 0 0 billion capital infusion last year from GE to GE Capital (which, don’t for- -10 -10 get, is the subsidiary with its name on -20 -20 the public debt). The fact is divulged in billions of dollars at the back of the 2001 10-K report -30 -30 in a statement of supplemental cash flows. No blinking lights highlight -40 -40 the number, and no text explains it; Gretchen Morgenson, Pulitzer Prize- -50 -50 winning correspondent of The New 1993 1994 1995 1996 1997 1998 1999 2000 2001 York Times, was the first to drag it out into public view. $20 $20 Naturally, a fact so deeply buried GE Industrial cash flow concerning so large a sum of money has caused tongues to flap in that intimate 15 15 circle of people who read financial foot- notes. Some have suggested that the reason for the transfer had something 10 10 in billions of dollars to do with the acquisition of Heller Fi- nancial by GE Capital late last year. It was the biggest acquisition in the his- 5 5 tory of the bank of GE, and it cost $5.3 billion in cash. Yet, the footnote read-

in billions of dollars 0 0 ers observe, Heller was less leveraged than its acquiror (on Sept. 30, 2001, Heller showed a debt-to-equity ratio of -5 -5 6.37:1; GE Capital’s ratio was 7.36:1). Why, then, they wonder, would GE Capital have had to put money into -10 -10 it? Walmsley put the question to GE 1993 1994 1995 1996 1997 1998 1999 2000 2001 spokesman David C. Frail: “The $3 bil- lion transferred,” said Frail, “it didn’t $20 $20 go to Heller. It went to Capital to sup- GE Capital Services cash flow port the transaction, to maintain. . .the 15 15 leverage that the rating agencies re- 10 10 quire for GECS overall. It’s not going 5 5 to show up at Heller.” By now, the reader will have sur- 0 0 in billions of dollars mised that we harbor doubts about GE, -5 -5 GE Capital and the titans who man- -10 -10 age it. Many people do not. Many will refuse to believe that GE would stoop -15 -15 to obfuscation, dissimulation or the

in billions of dollars -20 -20 lower forms of financial engineering. But there is strong inferential evidence -25 -25 to the contrary. For one thing, Welch -30 -30 himself has described how his corpo- -35 -35 rate lieutenants rallied round following -40 -40 the shocking $350 million loss booked 1993 1994 1995 1996 1997 1998 1999 2000 2001 by Kidder Peabody in 1994. “Some said they could find an extra $10 million, operating investing operating and investing $20 million and even $30 million to GE compendium-GRANT’S / NOVEMBER 3, 2017 19

Feathers for GE’s nest insurance cycle. And we have argued $35 3.5% that, in pursuit of growth, it has taken GECS’ net income, intangibles and tangible equity on a bigger book of riskier assets. Possi- vs. tangible equity divided by assets bly, GE, its stockholders, its stakehold- 30 3.0 ers and its bondholders may disagree with a point or two. However, few impartial professional investors would 25 2.5 tangible euitassets dispute that there’s more to fear than cumulative net income to like in GE Capital’s debt securities. 2.0 20 intangibles In triple-A-rated, gold-plated, widely owned, institutionally certified invest- tangible euit , intangibles in billions ments, it was ever thus. The brighter 1.5 15 tangible euitassets the luster, the greater the downside. As for the GE Capital balance sheet, 10 1.0 we commend a study of its wonders and mysteries to the dean of the School of Management at Cornell University, net income, euit 5 0.5 Robert J. Swieringa. An accounting professor by trade and a past mem- ber of the Financial Accounting Stan- 0.0 0 1995 1996 1997 1998 1999 2000 2001 LTM dards Board, Swieringa was elected last month to the board of General Electric offset the surprise,” wrote Welch in his First Boston agreed to provide $445 as a non-executive director. GE needs autobiography (see page 225), describ- million in loans, and planned to replace him and so do its bondholders. ing a corporate culture exactly suited to $235 million of that with high-yield earnings management. Welch is gone, bonds. Last week, the GE Commercial • if not forgotten, but the culture still Finance unit decided to buy the $235 seems to thrive. Read carefully Bloom- million of bonds, freeing CSFB of its After the cult berg’s account of the recent sale of commitment, for the purpose of ‘expe- GE’s B2B e-commerce unit: diting the closing’ of the sale, Moody’s (May 10, 2002) At the recent GE New York, Sept. 27 (Bloomberg)– Investors Services said. . . . annual meeting, chairman and CEO General Electric Co. lent $235 million Alternatively, we would speculate, Jeff Immelt lodged a complaint about to the buyer of its electronic-commerce GE agreed to buy the bonds for the pur- the share price. “To be specific,” said unit because money wasn’t available pose of “expediting the achievement of the man who succeeded Jack Welch, from the bond market. Buyout firm an earnings target.” Timing gains on “the stock is where it was three years Francisco Partners LP was unlikely to sale to the advantage of reported earn- ago, and since I became chairman, it’s raise sufficient funds to finance the ings is hardly unique to GE, but GE is dropped more than 15%. I hate where $800 million purchase price of Global the subject at hand. Thus, in 1995 and our stock price is today.” eXchange Services given that “the 1996, GE’s 10-Ks do not show any un- GE changes hands at $30.65 a share, bond markets were not good in June usual gains or charges. In 1997, a large the equivalent of 21 times trailing when we announced the agreement, gain was booked on a complex asset earnings and 18.5 times the consen- and they’ve gotten worse since then,” swap with Lockheed, a gain matched sus 2002 estimate. Only one year ago, said GE spokesman David Frail. The by charges for restructuring and other with Welch at the helm, the Greatest option to provide financing was in the special events. No transactions of note Company on Earth commanded a 40 original agreement, Frail said. . . . occurred in 1998. In 1999, GE sold In- P/E multiple. Immelt sounded as if he GE, which has businesses ranging ternet assets to NBCi, a publicly traded wanted to break Mr. Market’s leg. from power plants to credit cards and affiliate, and took unusual charges that “Our stock price doesn’t reflect plastics, will have a profit of $300 mil- netted out to the exact amount of the the performance of this company or lion from the sale of the Web-based gain. In 2001, there was a gain on the its value,” he told the meeting con- business-to-business marketplace. sale of PaineWebber but it was partially vened in Waukesha, Wis., home base That will add 3 cents a share to third- offset with losses on the liquidation of of GE Medical Systems. “In 2001, we quarter profit, which GE said yesterday Montgomery Ward. In 2001, no charges grew our earnings by 11%. In the first will rise 24%. GE announced the sale of offset the sale of stock in Americom, a quarter, we grew our earnings from op- Global eXchange Services on June 24, satellite company. It contributed 6% to erations by 14%. These performances and said at the time it planned to close pretax profit. compare with the decline in the S&P the transaction by Oct. 31. The busi- The purpose of the foregoing has 500 earnings of more than 20%. In fact, ness no longer fits with GE’s Internet been to show that this most admired our company now makes more money, strategy, GE said. corporation is growing in leverage but 50% more money, than we did three As is typical with most buyouts, not in free cash flow (as we have de- years ago.” Francisco Partners initially got a com- fined it). We have contended that it In the past three years, the chairman mitment from an investment bank to is no more disengaged from the credit proceeded, GE generated $35 billion of finance the GE purchase. Credit Suisse cycle than Employers Re was from the cash. Revenues actually grew in 2001 GE compendium-GRANT’S / NOVEMBER 3, 2017 20

What price GE? ducted from equity these unidentified $0 14 other assets, in addition to deducting GE’s price per share (left scale) vs. price-to-book multiple (right scale) intangibles to get a modified tangible book value, you would see that GE’s 60 12 a , 2002, ratio of assets to modified equity has $30.65 increased to 65.1 times in 2001 from 50 10 32.8 times in 1993.” So, in addition to its trademark Six Sigma-caliber opera- tions, its unparalleled culture of excel-

40 8 priceboo lence, its unprecedented devotion to corporate reinvention and customer satisfaction, GE has generated higher 30 6

price per share returns through financial leverage. In this, it has done what many other com- a , 2002, 20 4 panies have done, not each and every 5.5 one of them great. All of which is by way of seeking an 10 2 answer to Immelt’s poser: Does the share price deserve to be hated? Immelt has predicted earnings per 0 0 1/6/95 1/5/96 1/3/97 1/2/98 1/1/99 1/7/00 1/5/01 1/4/02 share in 2002 of $1.65 to $1.67. Sea- soned GE watchers will expect noth- source he loomberg ing less than $1.68 a share, a penny (up 4%), a recession year, and are ex- cost advantage generated by a triple-A per share above expectations. Spread pected to grow again in 2002 (by 5% to balance sheet, Capital is on track for over 10 billion shares, $1.68 would 10%). All this in a perfectly forgettable excellent earnings growth in 2002 and imply $16.8 billion of net income. As- global economy. 2003. The importance of GE Capital is sign a multiple to these earnings more Citing years of extraordinary returns, that it can use GE’s financial and in- to Immelt’s liking and the share price Immelt declared that GE excels in all dustrial strength.” would become less ridiculous (as Im- seasons and cycles. Yet, alluding to the Possibly short of time, Immelt did melt views it). At, say, a 25 multiple, it post-New Economy, he went on, “we not allude to the Grant’s critique (see would be $42. live in a new age. Performance is not the March 29 issue) in which colleague That would be a stretch, we think. enough.” Rattled by the usual financial Peter Walmsley traced the soaring A 25 P/E multiple would imply a 7.7 and psychological bear-market disloca- growth of “other assets.” As you may price-to-book multiple. “They are an tions, investors have turned to doubt- remember, this “other” is significantly industrial company that has morphed ing from trusting. “You want to know greater than year-end shareholder eq- into a financial services company,” even more about GE,” Immelt ac- uity—for the parent, $81 billion of recently observed Robert McCarson, knowledged, “and that’s fine with me; “other” assets on $55 billion of equity; director of corporate relations for Fan- I welcome it.” for GECC, $52 billion of “other” assets nie Mae, concerning GE. As a descrip- During the boom, no particular on $32 billion of equity. tion of the balance sheet, McCarson knowledge of General Electric was Search the footnotes with a flash- hit the nail on the head. At year-end sought or required. It was enough to light, you wouldn’t find an explanation, 2001, GE Capital Corp.’s assets con- know that Welch was at the helm. Now, let alone an appraisal, of $16 billion stituted 77% of consolidated assets. Immelt is having to explain what used of this mystery meat. Concluding his As for the income statement, GECC to be self-evident. “It really is simple analysis, Walmsley wrote: “If you de- contributed about 40% of net earnings. and powerful,” he said of GE. “You see leadership—number one businesses, Name your price a strong and accountable culture, and GE value per share, based on assumed price/book and massive financial strength.” He men- tioned “long cycle” businesses (four price/earnings multiples* in all: power, medical, engines, trans- portation) and “short-cycle” ones (e.g., price/book (GECC) NBC, plastics, materials, industrial). 1.0x 2.0x 3.0x 4.0x 5.0x He mentioned finance. “We have the 10.0x $12.4 $15.80 $18.66 $21.52 $24.38 world’s most diversified financial ser- 15.0x $1.8 $20.84 $23.0 $26.56 $2.42 vices business with consumer finance, 20.0x $23.02 $25.88 $28.4 $31.60 $34.46 mid-market financing, insurance, 25.0x $28.06 $30.2 $33.8 $36.64 $3.50 equipment management and specialty 30.0x $33.10 $35.6 $38.82 $41.68 $44.54 segments,” Immelt said. “We’re grow- 35.0x $38.14 $41.00 $43.86 $46.2 $4.58 ing assets in GE Capital by 15%. With 40.0x $43.18 $46.04 $48.0 $51.6 $54.62 [a] favorable interest rate environ- ment, strong risk management, and the matri assumes GECC contributes 40% of estimated 2002 earnings per share of $1.68 GE compendium-GRANT’S / NOVEMBER 3, 2017 21

GE, therefore, is neither a bank nor a price, the lower the risk. There may yet We know Welch’s state of mind nonbank, but a little bit of each. It is be the chance to invest in a very good because it’s recorded in the new, bank enough, however, not to trade at corporation at a very good price. It’s an best-selling autobiography, “Jack: 7.7 times book. opportunity worth waiting for. Straight from the Gut.” And from the For clarity, Walmsley has performed same source we know the attitudes of a breakup analysis. “We’ll be gener- • Welch’s top lieutenants. ous,” he openhandedly begins. “Apply “The response of our business lead- the fattest plausible multiple to the Welch comes clean ers was typical of the GE culture,” bank, i.e., three times book. Attach a Welch writes. “Even though the books 25 times P/E multiple to the nonbank. (March 29, 2002) In the issue dat- had been closed on the quarter, many If we assume that the bank will contin- ed July 17, 1998, Grant’s asked how immediately offered to pitch in to ue to generate 40% of net income, $6.7 GE could deliver perfectly predict- cover the Kidder gap. Some said they billion of this year’s $16.8 billion would able stair-step earnings growth, year could find an extra $10 million, $20 be bank-derived. The industrial side of in and year out. How could a company million, and even $30 million from the company would contribute $10.1 so big, so leveraged and so exposed to their businesses to offset the surprise. billion. The 10-K says GECC’s book the vicissitudes of the world economy Though it was too late, their willing- value ended 2001 at $28.6 billion.” never miss? ness to help was a dramatic contrast to Apply these multiples as in the near- After due consideration, GE has the excuses I had been hearing from by table and you get a value for GE of framed a reply. “This is a confusing the Kidder people.” around $338 billion. Over 10 billion time for investors,” the 2001 annual In the wake of the Kidder crisis, The shares, you get a share price of $33.78. says. “. . .[I]t is a time when consis- Wall Street Journal published a two-part According to this exercise, Immelt tent, excellent performance confuses report on the astonishing predictability was right. GE is, today, $3 per share some pundits [sic], who then imply of the GE earnings stream. In denying too cheap. “We’re not like everybody that it is ‘managed.’ It is almost as if an that the company took charges against else,” Immelt reminded the hometown earnings ‘miss’ would be more virtuous earnings with the intent of smoothing crowd last month. than meeting your commitments dur- reported net income, Dennis Dam- “We are blessed to have the most ing tough times—but that is not GE.” merman, the GE chief financial officer, talented leadership team in the world,” Perhaps not. But once upon a time, said, “It’s not like we’re creating some Immelt said later on. “This is con- GE was ready, willing and able to man- big cookie jar.” firmed by magazines, polls, and even age its earnings. Jack Welch, the retired Fast-forward to the present and to by other recruiters. We’ve retained this CEO who somehow can still get his last week’s Bill Gross-GE melee. In his team through a leadership transition name in the papers, admits it. instantly famous posting on the Pimco and a recession. We are a performance- The year was 1994, and Kidder Web site, Gross, manager of the world’s driven group. We like to make numbers Peabody, a GE subsidiary, had sprung biggest bond fund, renewed the long- and we look at the stock price as a way a $350 million leak. Welch was heart- simmering charge that it isn’t through to keep score. But above all else, we sick—he had nobody to blame but him- pure excellence that “the best com- value the reputation of this company. self. There would be a black mark in pany in the world” (as Dammerman No one, not one leader in this place, the first quarter’s press release, due in put it in 1994) can put up 15% annual would ever put personal gain ahead of two days. earnings growth in fat years and lean. the company. We perform and we al- ways do it with integrity.” General Electric—bigger balance sheet, greater value? Either GE is an institution truly $600 $600 impervious to the weakness of the hu- man flesh and the vicissitudes of the total assets business cycle, or it is merely a very 500 500 maret cap good corporation. We say it’s a very good corporation. So saying, we expect

that before the bear market runs its 400 400 in billions of dollars course, GE’s multiples will contract. Possibly, the $16 billion of other as- sets holds a bearish surprise. Maybe 300 300 the corporation that never, ever miss- es a number will miss. It would be a rare thing—though, to be sure, not in billions of dollars 200 200 an impossible thing—for a leveraged financial institution to trade at three times book at the bottom of a bear 100 100 market. The accompanying table sug- gests a range of possibilities. Immelt may gnash his teeth, but 0 0 patient holders of cash are already 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 the beneficiaries. The lower the share source he loomberg GE compendium-GRANT’S / NOVEMBER 3, 2017 22

GE vs. the financial crowd possibility: Supposedly, the unfolding business slump will happen to lesser (in $ billions) companies but not to the one that ac- total assets price/book assets/equity counts for 1.3% of the U.S. GDP. Citigroup $1,051 3.1 11. Eric Fry, editor of GrantsInves- annie ae 800 3.2 31.8 tor.com, led a team of analysts to get .P. organ Chase 64 1. 16. behind, among and in front of the an of merica 622 2.2 12.8 numbers. “Wading through the latest reddie ac 61 2. 31. 10-Q,” he writes on behalf of his col- GE 45 6.8 .0 leagues Rose Ann Tortora and Robert organ Stanle 483 2.8 21.0 Tracy, “we discovered that even as the G 46 3. 8.8 company increases reported EPS, its errill nch 41 2.3 18.5 operating cash flow is declining and G 324 1. 10.1 its ‘all other operating activities’ line is looking conspicuously unhealthy. source he loomberg, compan filings By our calculations, consolidated cash flow from operations dropped by 30%, To make the numbers, Gross charged, “A deeper look into the balance or $4.9 billion, through the first nine GE imprudently feasts on the low-cost sheet raises more questions,” Walms- months of 2000 compared with the portion of the yield curve. It scoops up ley continues. “Both GE and GECC year-ago period.” acquisitions and generally imposes on have ‘other assets’ on their balance Only by excluding General Electric the trust and hospitality of the U.S. fi- sheets significantly in excess of their Capital Services (GECS) from the cal- nancial markets. Dammerman, now a shareowners’ equity: GE’s is $81 billion culation, as Wall Street is wont to do, GE vice chairman, called Gross to show on $55 billion of equity, while GECC’s can cash flow from operations be made him the error of his analysis. According is $52 billion on $32 billion of equity. to appear positive. Expressed in this to Gross, each party hung up shouting. Most of this gets explained in the foot- light, without the dragging financial Not long after, there was a greater notes, except for a few billion dollars business, it was up by 34% through and louder spectacle, as Fannie Mae worth of unidentified ‘other’ within the nine months. But that would be accused GE of opacity and hypocrisy. the ‘other assets.’ Like the Russian an analytical half-truth. Fancy GE complaining about the qual- dolls that you keep opening and find- “The main culprit,” Fry goes on, ity of Fannie’s disclosure, said Robert ing more inside, and eventually open “appears to be GECS’ acquisition last McCarson, the GSE’s director of corpo- the innermost doll, thus do GE’s other March of Toho Mutual Life Insurance rate relations: “We know less about the assets finally come to an end. Co. of Japan. As the GECS September financial condition of GE Capital than “Consolidated GE’s innermost doll is Q explains, ‘The decrease in cash from we do about any bank.” $16 billion of unidentified other assets operating activities. . .was largely at- Just so. For all its promise about that can be found only in the footnotes, tributable to policyholder redemptions greater disclosure in this age of glas- which do not describe their contents at associated with the Toho acquisition nost, GE is only a lighter shade of all, much less appraise their value. If and a smaller decrease in mortgages black. “They are an industrial com- you deducted from equity these un- held for resale.’ The ‘insurance li- pany that has morphed into a financial identified other assets, in addition to abilities, reserves and annuity benefits’ services company,” added McCarson, deducting intangibles to get a modified line on the cash-flow statement listed right again. tangible book value, you would see that a negative $1.9 billion for the nine “It’s on the balance sheet that GE’s GE’s ratio of assets to modified tangi- months vs. a positive $2.8 billion the dependence on GECC shows up prin- ble equity has increased to 65.1 times year before. This $4.7 billion decrease cipally,” observes colleague Walmsley, in 2001 from 32.8 times in 1993.” in GECS’ cash from operations largely “and where the black-box nature of “GE is a company you can trust,” explains the $4.9 billion decline report- GE’s financial reporting is most evi- writes Jeffrey Immelt, Welch’s successor, ed in cash flow from operations for GE dent. Between 1989 (when Grant’s first in the new annual. You have no choice. as a whole. looked at GE) and 1993, the ratio of “GE’s Edison Life subsidiary res- GECC assets to GE assets was virtually • cued the insolvent Japanese insurer unchanged, at around 47%. By 1997, last year,” Fry goes on, “paying more the figure had grown to 75.3%, and it General inspection than $2 billion for Toho’s ‘business now stands at 77%. From 1993 to 2001, rights’ and its three million poli- goodwill at consolidated GE grew by (February 16, 2001) General Elec- cies. Japan’s Policyholder Protection 17% a year. Over the same span, good- tric, the House that Welch Built, is the Corp. kicked in about $3.6 billion will at GECC grew by 32% a year.” biggest company in the world by market to facilitate the acquisition by GE. Strip away goodwill and intan- cap and the only surviving member of Six months into the deal, the results gibles, and you’re left with tangible the original 12 Dow industrials. (Long seem underwhelming. No doubt, GE book value, a useful thing to know. In GE and short Distilling & Cattle Feed- anticipated some policy redemptions 1993, the ratio of parent assets to par- ing was the pair trade of 1896.) It is so within its new insurance subsidiary. ent tangible equity was 16.3 times. In great and powerful that it has managed But we wonder if it was prepared for 2001, it was 21.4 times. to persuade Wall Street of a near im- the staggering number it got.” GE compendium-GRANT’S / NOVEMBER 3, 2017 23

General Electric’s nearly invisible red ink in nature. Yet when GE delivers the $4 $4 goods—the customary Six Sigma pre- GE Capital Services’ cash flow dictable rise in after-tax profits—an analyst can be counted on to marvel, 0 0 in effect (as one recently did in fact): “It’s the certainty at GE.” In his new book, “Contrarian In- vestment Strategies: The Next Gen- -4 -4 in billions of dollars eration,” David Dreman demonstrates that securities analysts usually fail to -8 -8 forecast earnings to within 5% of the actual number. In fact, he calculates, the odds of their getting to within a 5% tolerance for 10 consecutive quarters in billions of dollars -12 -12 are 1 in 200,000. The inverse of this analysis ought to be true, as well, we have been think- -16 -16 ing: The odds of a company disclosing a number that comes within 5% of the analytical consensus for 10 consecutive -20 -20 1995 1996 1997 1998 1999 9 mos./’00 quarters also ought to be 1 in 200,000. (The probability calculations are de- ‘all other operating activities’ accumulated total rived from a study conducted by Dre- man and his collaborator, Michael Ber- If cash flow from operations on the 1997 and has been consuming bil- ry, of approximately 500,000 analysts’ capital side of GE had climbed by lions of dollars a year ever since.” forecasts committed to paper between 72%, Wall Street would certainly not What do they say about triple-A cred- 1973 and 1996.) have neglected to mention it. But a its? Nobody’s going to upgrade GE. Yet, as Koby Oppenheim of this staff decline in cash flow of that magni- has determined, GE uncannily beats tude, not offset by a correspondingly • the odds. The analytical consensus was large positive number, has struck the easily within the implausibly difficult analytical community dumb. What One in 50 billion 5% range for the past 10 quarters in a does it mean when consolidated cash row. It was, in fact, within 2%. For the flow from operations drops by 30%? (July 17, 1998) General Electric Co. past 20 quarters, the consensus was At the least, it means that it’s no easy earned in the second quarter exactly within 2.37% of the mark. The odds of matter to manage a $431 billion bal- what analysts had somehow known it such a display of clairvoyance on Wall ance sheet in the interest of expand- would earn: $2.45 billion, or 74 cents Street, according to Dreman, are 1 in ing a $468 billion stock-market cap a share. 50 billion. Who says that bull markets and generating to-the-penny, seven- In the house of John F. Welch Jr., make you stupid? sigma-quality earnings results. total quality management extends Which, however, begs the question: “We found a second curiosity,” even to the quarterly earnings re- How does a company that sells every- Fry proceeds—”a $6.5 billion nega- port. As in jet engines, light bulbs thing under the sun almost everywhere tive swing in another GECS line and financial services, zero defects under the sun generate a perfectly pre- called ‘all other operating activities.’ and absolute reliability are the orders dictable earnings stream? It’s the very Included in this category, according of the day (you know how Jack hates size and diversity of the enterprise, a to the Q, are ‘adjustments to current surprises!). So advanced is quality spokesman responds, that “equals sta- and non-current accruals and defer- control within the finance depart- bility and consistency.” rals of costs and expenses, increases ment that GE was able to report Be that as it may, the July 13 is- and decreases in progress collections, year-over-year growth in net income sue of Business Week contains a adjustments for gains and losses on of 11%, plus or minus a few tenths bombshell on the quality of blue- assets, increases and decreases in as- of a percentage point, for eight con- chip corporate earnings in general (it sets held for sale, and adjustments to secutive quarters. (In the June 1997 does not mention GE in particular). assets.’ Asked to elucidate, John Oli- period, which ended the string, net Tucked away in an advertising sup- ver, spokesman for GE, promised to rose by 13.1%. Evidently, somebody plement are the results of a poll of investigate; no wonder he was still at slipped up.) 160 delegates to the magazine’s sev- it as we went to press. Within such Green Tree Financial, Laser Mort- enth annual forum for chief financial a line-item casserole, it’s impossible gage Management, Oxford, Boston officers last April. Employing “audi- to tell if a change in consistency was Chicken, Sunbeam and Cendant all ence response electronic keypads,” produced by too little mayonnaise or stand as testament to the risk of poor the attendees, drawn from what BW too much celery salt. Whatever it is, and/or questionable corporate finan- probably did not call the Fortune it doesn’t taste good. The ‘all other cial disclosure. The perfectly predict- 500, were asked to respond to the operating activities’ turned down in able earnings stream does not occur following proposition: “As CFO, I GE compendium-GRANT’S / NOVEMBER 3, 2017 24

Loans grow faster than salesóstill stock price. . . ,” he says. “[H]uman na- 25% 25% ture being what it is, the wealth of ex- C & I loans vs. business sales; year-over-year growth plotted monthly ecutives tied to the stock price, I would imagine there is heavy pressure on the 20 20 accountants to push the envelope.” “There is a lot of fudging going on,” says Chanos, who sells stocks short for

15 15 year-over-year growth a living. “While maybe it isn’t compa- ny-killing, like at Oxford, you are still 10 10 corrupting the marketplace. Compa- nies will do anything they can not to 5 5 miss somewhat aggressive earnings es- timates when the penalty for missing

year-over-year growth by a penny or two is, in some cases, 0 0 to see a high P/E multiple cut in half. That is the corruption. The incidents of the Sunbeams, Oxfords and Boston -5 -5 Chickens are still in the great minor- ity. But everyone has gotten used to -10 -10 the nudge and the wink about the 1/74 1/76 1/78 1/80 1/82 1/84 1/86 1/88 1/90 1/92 1/94 1/96 6/98 abilities of companies to massage the C & I loans business sales shaded areas indicate recession bottom line through a variety of sub- sources: the Federal Reserve and the U.S. Department of Commerce; Moodyís terfuges and artifices, so there is not even a slight disappointment. have fought off other executives’ re- Martin Capital Management, Elkhart “What I have a problem with,” Cha- quests that I misrepresent corporate Ind., we are inclined to trust in BW. nos goes on when asked to name his results.” What’s right with accounting, says pet peeves, “is when, in addition to the The responses were: Meyer, our principal source on the goodwill write-downs [which, he says, 55%Yes; I fought them off. Coca-Cola story in the June 19 issue are not objectionable], you see these 12%I yielded to the requests. of Grant’s, are the standards promul- kitchen-sink restructuring charges 33%Have never received such a gated by the Financial Accounting that write down all sorts of things or request. Standards Board. They are absolutely set up reserves that aren’t needed. For In other words, observes James S. rigorous. However, Meyer goes on, hu- example, a company will write down Chanos, paid-up subscriber and gim- man nature at Dow 9,300 is working accounts receivable as uncollectible let-eyed reader (it was he who picked strongly against rigor: “[T]he salaries at acquisition and then collect them, up on the BW revelations), two-thirds and wealth of senior executives [are] with no cost associated. Writing down of the magazine’s sample set have linked to options like never before, and perfectly good plant and equipment to been asked to lie about the numbers. there is a massive temptation there to zero, and then having no depreciation On the other hand, he notes, lend- do everything possible to increase the expense against it. And then my favor- ing balance, fully one-third have not been asked to lie. Preceding this rev- Zeroñdefect earnings management elation into print by a few days was 25% 25% an “Abreast of the Market” column quarterly growth in General Electricís net income in The Wall Street Journal in which the argument was advanced that cor- porate accounting has become more conservative, not less. Companies are 20 20 writing down more assets not to bury year-over-year increase future expenses but to acknowledge mistakes in a forthright way, the the- sis went. “With accounting questions 15 15 playing a big part in some spectacu- lar recent stock blowups,” the ar- ticle said, “investors might wonder just how believable are the earnings year-over-year increase now fueling record stock prices. Rest 10 10 easy: They are more believable than in previous decades.” If the Journal’s argument is right, it seems to us, Business Week’s poll re- 5 5 sults must be wrong, and vice versa. For 9/93 6/94 3/95 12/95 9/96 6/97 6/98 reasons ably laid out by Albert Meyer, of source: The Bloomberg GE compendium-GRANT’S / NOVEMBER 3, 2017 25 ite, setting up accrued liabilities, sort of be prepaid, downgraded or defaulted 11.4% average annual rate. (The dif- nebulous future charges, and reversing on. GE would seem to be vulnerable on ference is, of course, enormous: $1 at them as no such costs are incurred. We all counts. 11.4% over 25 years becomes $14.90; $1 noticed that in Sunbeam. And mergers Proof that this is not the consensus at 19% over 25 years becomes $77.40.) give you all sorts of opportunities for opinion is evident both from the valu- Over the past five years, the divergence accounting chicanery.” Mergers and a ation of the stock and the tone of the has narrowed somewhat, with compa- one-way stock market. company’s press. “Big challenges, big nywide profits growing at 12.9% a year, plans, big resources—and day by day a Capital’s at 16.1% a year. • bigger reputation,” wound up a piece The previously cited Fortune article on GE Capital Services in the Novem- is the last word on how well Capital has No upgrade possible ber 10 Fortune. “But ultimately, what’s succeeded, how fast it has grown (head most interesting about Capital is that count has leapt to 53,000 from 30,000 (November 21, 1997) General Elec- the risks it confronts are so different in the past five years) and what pains tric, as big as the Great Lakes, earns from those of the businesses it com- it has taken to stay out of trouble along upwards of $8 billion a year from con- petes with. Most companies are ter- the way. The 27 businesses that Capi- tinuing operations and generates $87 rified of a recession. At Capital, many tal comprises are so widely diversified billion a year in revenues. “Arguably people hope for one. A recession would (both as to function and region) and so the world’s most successful company,” bring down asset values, they say, let- tightly managed, the bullish argument to quote Fortune, GE has the biggest ting Capital do more of what it does goes, that no mere Asian crisis could do stock-market capitalization in the best—pounce on trouble.” any serious damage to them. And as for greatest bull market in the world: $217 If a recession would be bullish for the parent, a spokesman sums up the billion. In Jack Welch, it has arguably Capital, we wonder, would an even situation as follows: “We’re on record the most admired chief executive of- greater prosperity be bearish? If a re- as saying we’re going to have another ficer in the world. In Gary Wendt, it cession would be bullish for Capital, record year. We’re going to participate has arguably the most admired head would it also be bullish for the larger in the region and may see some oppor- of a financial subsidiary in the world. capital goods division? Would it be tunities for acquisitions.” Triple-A up and down the line, the bullish for the holders of GE common? For ourselves, we have no pet the- company is valued as it has never been It would not be bullish for the ory as to how Asia-related troubles valued since at least 1972 (except for stockholders, we are sure. Then, might surprise to the downside. If the a moment at the peak of the market again, at these levels of valuation, not so-called currency crisis is really an last summer). The current valuation even perfection would likely measure economic crisis, the growth of capital parameters are: 2.5 times revenues, up. As much as most companies in the spending will be bound to slow, inside 27.4 times net income and 6.4 times great bull market, GE is priced for the Asia and out. As Welch himself admits, book value. ideal outcome. there’s no shortage of productive ca- We turn to GE because the world And ideal its outcomes have almost pacity in place today. Or perhaps the has turned against it without Wall continuously been, Capital’s most of Asian debt contraction is going to be Street seeming to notice. In sup- all. Thus, over the past 25 years, net transmitted to the rest of the world port of this hypothesis, we invoke profits at the financial-services divi- via banks and the emerging econo- the CEO himself. “[T]he challenge sion have grown at a 19% annual rate, mies, provoking a global contraction in is that there is excess global capacity significantly higher than the company’s lending and borrowing. Or perhaps no in almost every industry,” the Finan- cial Times quoted Welch on October 1. Capital looms larger “Pricing pressures are dramatic across 50% 50% sector after sector.” GE Capital Services revenues as a percentage At GE, financial services (insurance, of GE corporate revenues credit cards, leasing etc.) complements capital goods (aircraft engines, power 40 40 Capital

generation and transmission equip- s ment, locomotives etc.) and consumer and miscellaneous products (appli- s revenues to parent 30 30 ances, broadcasting, licensing revenues etc.). This combination has delivered average annual growth in net profits over the past quarter-century of 11.4%. 20 20 Now comes the Asian crisis, featur- s revenues to parent ing industrial overcapacity and debt s contraction. It is a deflationary world Capital in which, it seems to us (and seems as 10 10 well to a reader of ours, William M. Mc- Garr), the marginal unit of capital ex- penditure is likely to be postponed and 0 0 the marginal dollar of debt financing to 1971 1977 1984 1991 1997 GE compendium-GRANT’S / NOVEMBER 3, 2017 26 such dire eventuality will come to pass. Leaving the pack in the dust Maybe the worst that will happen on 2,000 2,000 the other side of the world is a puny share price performance of GE vs. the S&P 500, 1972 97 little growth recession. However, we believe, GE stock- holders would be at risk even in that 1,500 1,500 benign outcome. They would be at risk even if Jack Welch were elected co-President of the United States and GE vs. the S&P Wendt were named co-Treasury Sec- General Electric retary (each man retaining, of course, 1,000 1,000 his post at GE). Although we hap- pen to think that GE is in for rough sledding in capital goods, we do not GE vs. the S&P rest our bearish case on the possibil- ity. The root of the trouble, we think, 500 500 lies in Wall Street. Nobody—not even Welch and Wendt—could live up to S&P 500 the expectations embedded in current GE valuations. 0 0 One way to test the proposition that 1972 1976 1980 1984 1988 1992 1996 GE is overpriced is to compare its valu- ation to those of its peers. The method 500-stock index). The S&P 400 trades proximately 15.6 times. Multiplying is to assign a multiple to the earnings at 25 times trailing net income; thus, Capital’s earnings—$3.16 billion— of the major parts and compare those the $5.5 billion of GE’s industrial earn- by that P/E yields $49 billion. That multiples with the competition. GE ings “should be worth” $137.5 billion in is what Capital’s earnings “should be itself lends a hand in this exercise by the marketplace. worth” in the marketplace. comparing its performance to that of On to the financial component. GE Combining the two capitalized the S&P 500 (and to the Dow Jones itself makes no separate comparison sums—$137.5 billion and $49 billion— Industrials as well—the numbers are of Capital’s performance. In doing the makes a grand total of $186.5 billion, published in the proxy). As the graph job himself, Shirley followed the lead or about 14% less than the actual $217 points up, Welch, Wendt & Co. long of Travelers Group. The yardstick to billion market cap. “That really stands ago left the index behind. which Sandy Weill & Co. compares out,” notes Shirley, “when you remem- To sharpen the focus of the analy- itself is a smorgasbord of S&P in- ber that both of the peer group mul- sis, Ken Shirley of this staff divided dustry-group indices, including S&P tiples are at or near all-time highs. Fur- GE into its two basic parts, industrial Personal Loans, S&P Property/ Casu- thermore, the industrial portion of the and financial. Starting off with indus- alty Insurers, S&P Multi-line Insur- multiple is overstated by the inclusion trial earnings, he capitalized them at ers, S&P Money Center Banks etc. of GE’s own high multiple. GE makes the multiple prevailing on the S&P Companies in the relevant industry up 3.168% of the S&P 500 (a break- 400 (i.e., the industrial segment of the averages trade at a multiple of ap- down of the 400 isn’t available), by far the biggest component of the index. Price-to-sales breaks to new highs To summarize: relative to a peer group 3.0 3.0 that is itself trading at historically high GE market value relative to prior-year revenue multiples, a buyer of GE chooses to pay a premium of 14% to own the stock.” 2.5 2.5 Each to his own. Then, maybe, GE is cheap in its own terms, relative to its own history? No, again. As noted, GE trades at 2.5 times 2.0 2.0 price-to-sales ratio revenues; the previous high in this de- partment going back 25 years (leaving 1.5 1.5 aside the slightly higher peaks reached last summer) was 1.35 times, set in the fourth quarter of 1972. Today, the

price-to-sales ratio 1.0 1.0 stock trades at 27.4 times net income; the 25-year high, prior to 1997, was set—once again—in the fourth quarter of 1972. The multiple then was 28.1 0.5 0.5 times. Incidentally, the all-time record for the past 25 years was set last sum- 0.0 0.0 mer, at 30.7 times. As for book value, 1971 1979 1985 1991 1997 the Nifty-Fifty high of 4.7:1 is a pale GE compendium-GRANT’S / NOVEMBER 3, 2017 27 shadow of the current ratio of 6.4:1 or Am I being paid enough to weather the brokerage houses, thrift institutions or of last July’s 7.2:1. storm if something does go wrong? insurance companies, as GEFS does “Since 1972 was the last great peak General Electric makes aircraft en- today. It earned $115 million through in GE,” Shirley writes, “what would gines, medical equipment, light bulbs, secured lending and financial leasing, the return have been for a buyer at power-generation equipment, refrig- and its field of operations was domes- the top? Not including dividends, the erators, satellite heat shields, satel- tic. Now, to quote the latest annual re- lucky GE stockholder lost 14.6% over lites, television shows, locomotives, port, which does not exaggerate, GEFS the next five years, and earned 5.0% electric motors — and loans. It makes “is one of the world’s leading suppliers compounded over 10 years, 7.7% over all these things by the carload, and of capital, packaging sophisticated fi- 15 years and 8.9% over 20 years. Only its financial parameters never fail to nancial products uniquely tailored to through the magic of the newest new suggest a comparison with the Hong customer needs.” In 1989, the financial era has a 1972-vintage GE stockholder Kong GNP. It is the largest U.S. com- division earned $927 million through done well. The compounded rate of re- mercial-paper issuer, with $28 billion leveraged buyouts, consumer credit turn from then until now is 11.8% (our outstanding. Its revenues last year to- cards, commercial real-estate lending, unit of measure, by the way, is stock taled $55 billion; earnings, $4 billion, junk bonds, computer leasing, aircraft market cap).” and assets, $128 billion. leasing, auto leasing, auto auctions, Can growth explain these gener- General Electric Financial Services railcar leasing, dry van cargo leasing, ous, even unprecedented, valuations? (GEFS) is the name of the financial di- mortgage insurance, reinsurance and You be the judge: Over the past five- vision. General Electric Capital Corp. securities sales and underwriting. It and 10- year periods, net profits have (GECC) is GEFS’s principal, triple-A- operates worldwide. In the Decade of risen by 12.9% and 14.1% per annum, rated and fabulously successful com- Debt, the compound annual growth of respectively. Over the same spans of pany. Employers Reinsurance Corp. is its operating earnings was 26%. time, revenues have grown by 8.8% and the No. 2 financial holding and Kidder GEFS, as you may or may not re- 6.2% per annum, respectively. The P/E Peabody Group is No. 3. member, played an instrumental role multiple is, as noted, 27 times. In 1980, the forerunner to GEFS in financing one of the decade’s first GE, a brilliant company, is priced competed exclusively with other in- miracle deals, the Gibson Greeting for the perfect outcome, but the times dustrial finance companies. Except in- Cards leveraged buyout of 1982. That are increasingly imperfect. Where’s the directly, it did not compete with banks, year did not mark the beginning of margin of safety? • Hot Light on GE (September 14, 1990) There being no quadruple-A bond rating, as what’s- his-name from Beverly Hills was always saying, the credit of a triple-A company has no place to go but down. By defini- tion, it cannot be improved, but — the times being what they are — it can eas- ily be disimproved. Only 12 American industrial corporations still command the top debt rating of both Moody’s and Standard & Poor’s. General Electric, one of that elite number, makes a provocative case in financial evolution. In size and gravitas, it is the ultimate triple-A. Its bonds yield only a little more than the govern- ment’s, and that interest-rate spread is now as thin as a dime. Perhaps, inves- tors have come to favor cash-flow-posi- tive debt issuers (e.g., GE) as opposed to cash-flow-negative ones (e.g., the Treasury), even if the cash-flow-neg- ative issuer can tax and print money. Or perhaps investors are so hungry for extra yield that they have forgotten to ask the most basic fixed-income ques- tion in the book: What can go wrong? And the inevitable follow-up question: GE compendium-GRANT’S / NOVEMBER 3, 2017 28 debt (as 1963 marked the beginning of leased planes and cars, insured munici- rants in its corporate-finance clients, sex, according to the poet Philip Lar- pal bonds, lent against the collateral of such as Tiffany. And we had prepared kin), but it suggested the infinite pos- commercial real estate, financed lever- a follow-up question: In the light of sibilities of a leveraged balance sheet aged buyouts and became the largest the bear market in stocks, aren’t war- to a new and historically innocent issuer of private-label credit cards in rant values fast eroding? We’d looked generation of bankers and investors. the country. It became a bank-of-the- forward to hearing what the brass at With Gibson, the 1980s were off and future: an unfettered “niche” institu- GE would say to the proposition that, running, and almost nobody ran faster tion with a triple-A balance sheet. Like in a credit contraction, trouble begins or farther than GE. the First National Bank of New York in at the fringe but eventually visits the Many of the runners have stumbled the 1920s or Dai-Ichi Kangyo Bank in center, no matter how strong the cen- (some into the arms of the law), and the 1980s, it basked in its reputation ter is, or seems to be. the rate of expansion of debt is slow- as the holder of vast “hidden assets.” In the time saved by not visiting GE ing. At the margin, we think, the ex- Everyone knew that GE Capital Corp. headquarters in Stamford, Conn., Jay pansion of private-sector debt may be had taken equity positions in the buy- Diamond, our associate publisher, com- grinding to a halt. The possibility of outs it helped to finance. And everyone piled a fascinating historical table. The stagnation or even contraction has not was familiar with the prevailing, indeed information describes the parent com- yet engaged the attention of the cor- inevitable, direction of equity values in pany’s consolidated finances in a suc- porate bond market, except for the successful leveraged buyouts: up. Thus, cession of business downturns, starting junk-bond branch, which thinks about as Standard & Poor’s put it last fall, “Eq- with 1932, which happens to be the nothing else. uity positions, taken by GECC as part of year in which the forerunner to GECC We happen to have a little theory: its leveraged buyout financing activity, was started. It ends in what may or may The bear market in junk is of a piece have grown to a substantial size and are not prove to be a recession year, pend- with the bear markets in bank stocks, expected to make a large contribution ing statistical revisions, 1989. Evolu- commercial real estate and so-called to future earnings as gains are realized.” tion has meant more leverage, thinner stub stocks (i.e., the equities of lever- Note the bull-market construction, “ . . coverages, lower returns on assets and aged corporations). They are of a piece . as gains are realized.” A year later, the rising contributions to consolidated in- with the bear market in Japan. What correct turn of phrase has become, “ . . . come by financial activity. each disturbance has in common is the if gains are realized.” Interestingly, GE’s debt rating refusal of formerly willing lenders to We had a list of questions for GE al- hasn’t changed in the past 58 years, say yes. The breadth of the downturn most as long as its arm. We’d wanted even though its financial profile has. At raises urgent questions, one of which to ask about the cable-TV loans (re- the bottom of the Great Depression, provoked this essay: If a very good com- ported to total $1.8 billion), the $740 long-term debt was negligible, interest pany — indeed, a triple-A company — million junk-bond portfolio (acquired coverage was massively redundant and actively participated in the 1980s, how from Kidder Peabody last March), the the current ratio was better than 2:1. In could it not actively participate in the buyout portfolio and, more generally, 1989, a non-depression year, long-term 1990s? How could a company profit so the prospects for consumer lending, debt constituted 77% of equity, inter- handsomely by the expansion of debt now that a business slowdown has been est coverage was less than 2:1 (surely yet not suffer through the contraction? overlaid on a real-estate slump. We had a remarkably low reading) and the cur- GEFS is the decade of the 1980s un- hoped to ask if GEFS, to improve its rent ratio was less than 1:1. der one roof. It financed leveraged ca- return on equity, has been stepping up To the universal question, So what?, ble-television deals, insured mortgages, the sale of its “hidden assets,” i.e., war- we can offer several answers. In the first place, the leveraging of GE is emblem- atic of the leveraging of America. For another, the stability of GE’s debt rat- ings over the years is proof that “triple- A” is a subjective and relative term, like “thin.” By the lights of 1990, GE stands as straight as an arrow. By comparison with its weakest years in the past half- century or so, however, the company slouches and has difficulty touching its toes. To us, the second most striking line on the table, after the melting of interest coverage, is the one that shows the rising contribution of financial ac- tivity to the consolidated bottom line. Let us agree that the alchemy business has seen its best days and that the war- rant value of leveraged companies is go- ing down. In that case, the profit con- tribution of GE’s financial businesses is bound to decline, and perhaps quickly. GE compendium-GRANT’S / NOVEMBER 3, 2017 29

perimposed on the short one. We are, we think, beyond the manic phase of this consolidated cycle and into the depressive one. In the depressive phase, credit contracts, asset values fall and business slows down. Among financial institutions, failures prolif- erate. Failure begins at the margin but eats its way into the middle, like a mouse. Thus, junk bonds show the strain before home-equity loans, and Drexel Burnham Lambert fails be- fore Bank of New England. In a se- vere contraction, even the strongest lenders are tested, as the process of shrinkage and deflation nullify the financial assumptions that, in the boom, had seemed conservative. Fitch does not declare a credit theory. It seems to imply, however, that every On the trip to Stamford we didn’t (not that they are now, he added). As institution rises or falls on its merits and take, we’d meant to ask GE about for the parent, Martin Knoblowitz, that good management overcomes prob- the significance of GEFS. “Do you S&P’s analyst, said that its diversifica- lems. The authors salute the capital see what we see?” we were going to tion and sheer mass were so great that company’s asset quality — “surprisingly ask the person across the table, apro- a troubled GECC (if there ever were good and consistent given the loan port- pos of the credit contraction. “And if one) would not immediately threaten folio’s fairly high-risk profile” — and you do, do you anticipate any circum- GE’s triple-A rating. As for the issue of commend its management. They ac- stances in which the parent’s credit whether the triple-A halo has lost some knowledge that the GE executives are might be needed to assist the finan- of its wattage over the years, Knoblow- only human because there were energy- cial subsidiary’s?” The rating agencies itz said, “We don’t go in terms of num- related loan losses in 1986. They do not seem to agree that, standing by itself, bers alone in looking at credit quality.” deny that GE managers are any less hu- GE Capital Corp. would not command Next, we turned to a new report on man in 1990. But they do not directly the triple-A debt rating it now does. GECC by our friends at Fitch Investors address the possibility that real estate “Although no guarantee or formal sup- Service. Although bullish, the report is and corporate finance produced bigger port agreement exists between GECC fact-filled, and it can be usefully read and more dangerous bubbles than en- and General Electric Co.,” S&P, for in- by bears and independents. ergy, with the corresponding likelihood stance, comments, “the parent histori- The summary addresses the com- of large future loan losses at GE. cally has provided considerable support pany’s size, intercontinental reach (20 We do worry, of course — that is our to its financial services subsidiary, a sig- businesses, each well-established in its lot in life — and the coolness of Fitch’s nificant factor in GECC’s ratings.” respective market) and strength-giving prose only makes us sweat more. For Excusing themselves, the GE affiliation with GE. As for HLTs and instance, concerning the most lucrative spokespeople told us that what they commercial real estate, we are advised GECC business line, corporate finance, had to say about credit they would say not to lose any sleep over them: “Fitch the authors write: to the rating agencies. So we called the does not expect that potential deterio- Senior and subordinated financing agencies. To our question of whether ration in related asset quality will hurt and equity investments in leveraged they worried about the highly lever- the company’s financial integrity, since corporate restructurings total $7.9 bil- aged transaction (HLT) portfolio, the profits and the underlying capital/reserve lion. This has been a high profile and real-estate and cable TV loans and the base provide a substantial foundation.” high profitability business for GECC junk-bond and warrant portfolios, their Every financial idea stands on a for a number of years. The company’s composite answer was, “Yes, a little, theory, even if the proponent of the approach can be differentiated from but there are offsetting factors.” Ro- idea doesn’t consciously know what it others in the industry by its willingness drigo Quintanilla, the Moody’s analyst is. Our theory is that attitudes toward to take control of and manage business- on the GECC case, admitted the po- credit are cyclical. Collectively, lend- es, which reduces losses. The portfolio tential for problems. He acknowledged ers and borrowers progress from being is diversified among over 100 borrowers that the GECC portfolio is untested by brash to being timid, not pausing long and by industry, with a slight concen- recession. But he cited, among other at the midfield marker of reasonable- tration in media and cable, which to- mitigating circumstances, the subsid- ness. There are long cycles and short, gether represent 26% of loans. . . . iary’s presumed call on its rich parent. the long having to do with the passing Strong credit management and a And he added that, if GECC’s debt of generations and the short having to very sizable unrecognized gain from rating ever did come in for scrutiny, do with the rise and fall of business the warrant portfolio are sufficient to the bonds, not the commercial paper, activity. Once in a blue moon — now, cover the variance in credit quality that would be the candidates for downgrade for instance — the long cycle is su- is anticipated. GE compendium-GRANT’S / NOVEMBER 3, 2017 30

So, barring a recession, rabbits of eq- To that extent, therefore, GECC is an uity will be plucked from the corporate important source of the very strength hat. Fitch does have one anxiety. It is that it may one day seek to lean against. that the good old deal days are over: If GE’s and GECC’s credit rat- Of perhaps more concern, is the ings cannot get any better, neither dearth of leveraged buyout activity can the companies’ standing on Wall in the current market environment. Street. In a Barron’s poll this week, However, while this business has rep- GE turned up as one of the stocks resented such a strong profit contribu- most favored by institutional equity tor to the company (a full 25% of 1989 investors. As for the bond market, in- results), the slowdown so far has not vestors increasingly prefer GE to the had a material effect on profitabil- United States government. ity, as other businesses have provided Maybe the credit contraction is a greater earnings. figment of our imagination. Or maybe The more we thought about GECC’s GECC will glide through whatever con- call on the financial strength of its par- traction there is, unscathed. In either ent, the more circular it became to us. case, markets are priced accordingly. If GECC itself has contributed an ever not, there will be some adjustments. larger share to the parent’s net income. •

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