Rapid Growth of GE Capital May be Greater Threat to GE Than Departure of its Chairman
The model ( created by Welch )
has been challenged at GE Capital,
whose former boss Gary Wendt
subverted Jack Welch's call for "boundaryless" behaviour
across the group by creating an empire within an empire.
It will be difficult for GE to recreate what Wendt did
at GE CApital, IMHO.
Wendt will create that at CNC,
TA
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Rapid Growth of GE Capital May be Greater Threat to GE
Than Departure of its Chairman
monitordaily.com
By John Plender, Financial Times
General Electric is the world's most highly valued company, with a market capitalization of Dollars 503bn (Pounds 335bn). Jack Welch, the chairman and chief executive officer who has presided over two decades of relentless growth, is probably the world's most admired manager.
With Welch set to retire next spring GE confronts an awesome transition. Can it maintain its extraordinary dynamism and capacity for self-renewal after the departure of a man who reinvented the company? The lacklustre stock market response to GE's better-than-expected second quarter figures last month suggests some doubts. Analysts have also noted that the retirement of charismatic leaders at Coca-Cola and Gillette were followed by revelations of weakness.
Yet if GE has a weakness, it may relate less to the succession to Welch than another aspect of business. For GE Capital Services, its financial services arm, is becoming an ever-larger cuckoo in the GE group's nest. Not only does it account for most of the assets and liabilities of this complex and diversified group. It also poses a continuing threat to GE's corporate culture, and ultimately to its finances.
Consider first the nature of that culture. Welch argues that two basic forces drive GE: its social architecture and its operating system. By social architecture he means an ethos in which the ideas of all employees are fully exploited because obstacles to the free flow of ideas and information within the group are removed. "There is," says Mark Vachon, who is responsible for investor relations at GE, "a premium on intellectual capital transfer. GE is an ideas laboratory, not a conglomerate. By moving ideas to the best place in the group we create value."
Welch's "operating system" is the process whereby GE turns its ideas into company-wide initiatives, run by the best people, with appropriate incentives and rewards. This is intended to secure an efficient allocation of capital and the highest possible returns. All GE's businesses, whether in aircraft engines or financial services, are required to conform to this carefully-crafted model, designed to outlive its chief architect.
The model has been challenged at GE Capital, whose former boss Gary Wendt subverted Jack Welch's call for "boundaryless" behaviour across the group by creating an empire within an empire. Since Wendt's departure GE Capital is firmly back in the fold under Dennis Dammerman and Denis Nayden, two trusted aides to Welch. But the subsidiary continues to grow, raising questions about the scope for future friction.
In the five years to the end of last year, the contribution of GE Capital's 28 operating businesses to GE's earnings rose from 36.7 per cent to 41.5 per cent, which makes it far more important than any other GE business. In 1999 alone, it provided 45.5 per cent of GE's earnings growth. This year the industrial businesses are bouncing back. Yet GE Capital contributed 41.7 per cent of total earnings in the first half.
GE Capital dominates the group balance sheet, accounting for 85.1 per cent of the group's assets and 89.6 per cent of its liabilities. And it is also the motor behind GE's rapid acquisition programme. In each of the past three years, GE has made more than 100 acquisitions, worth a cumulative Dollars 51bn. Keith Sherin, chief financial officer, says that GE Capital accounts for around two-thirds of that sum.
GE Capital has become accustomed to growing rapidly. "Acquisitions and unabashed growth are a permanent part of the structure and psyche of the company," says Robert Young of Moody's, the credit rating agency. Moreover, GE Capital expects to earn a return on equity of well over 20 per cent from its acquisitions. Few doubt that its purchases in Europe in the early 1990s and now in Asia have been well timed and executed. Yet recent growth has been won only at the cost of balance sheet deterioration, the result of paying increased goodwill on acquisitions.
After excluding such intangibles, the ratio of debt to equity has risen in five years from 15.7:1 to 20.1:1. This should not be taken as an absolute measure of leverage at GE Capital. The parent group, which has an immensely strong balance sheet, guarantees GE Capital's subordinated debt, and has agreed other support. Young says that leverage at GE Capital is high by industry standards and "a concern" for rating agencies. But GE Capital retains its top-rated status because of its management skills, size, diversity and unrivalled ability to generate profits and cash flow.
For his part, GE's Keith Sherin is unconcerned by the degree of leverage in GE Capital's balance sheet. "We allocate capital very effectively, and are prudent risk takers," he says. But growing leverage has been an integral part of GE Capital's financial approach: only this has enabled it to meet GE's demanding targets for return on equity despite a fall in its return on assets. This in turn poses the question of whether GE's aggressive corporate culture is appropriate for what is now one of the world's biggest financial groups.
Central bankers traditionally argue that finance is importantly different from other business because of its systemic implications. At GE, this boils down to the statistic that Dollars 129bn of GE Capital's Dollars 200bn borrowings are short term, consisting partly of commercial paper unsupported by bank lines. This could make the group vulnerable to funding shocks. Since it is the biggest non-bank financial group in the US, that could in turn pose a systemic threat.
At the end of last year, its balance sheet contained Dollars 330bn of tangible assets. Of this total, Dollars 168bn consisted of loans and receivables, including investments in financing leases in such industries as aircraft, rail and automobiles. A further Dollars 80bn consisted of investment in corporate, government and mortgage-backed debt, and equity holdings. It would take only a 3 per cent fall in the value of tangible assets, or a 5.9 per cent fall in the value of receivables, to wipe out its tangible capital base of Dollars 9.9bn.
None of this means that the company is likely to go bust tomorrow. But it is a very slender margin of safety against recession and financial shocks, even in a group as well run as this. In addition, it would only take a 5.7 per cent fall in the value of GE Capital's gross tangible assets to make the whole GE group appear technically insolvent. Since GE has guaranteed only a tiny part of GE Capital's debt, this matters less than might appear. But it shows that GE's boundaryless culture is at odds with legal reality; there is a boundary protecting GE from insolvency at GE Capital.
Given all this, there are grounds for arguing that GE Capital's culture ought to be considerably more cautious than the rest of the group. GE's Vachon questions the mystique of money, arguing that the company's operating disciplines extend well into the financial sphere. Indeed, some at GE argue that the group's collective ethos acts as a prudential force by restraining any tendency towards an over-individualistic culture within parts of GE Capital.
But these points do not fully address the potential conflict between aggressive profit maximization and the requirement for greater prudence in a hugely leveraged financial business. There is no escaping the fact that a prudent boost to GE Capital's equity base would reduce its high return on capital.
In an ideal world, Welch's successor - none of the candidates comes from GE Capital - would hive off the financial business. Yet that makes no sense while GE is valued on a multiple of earnings more than double that of Citigroup. It is worth more within GE than outside, and may thus be trapped there, unless investors re-rate GE down to a typical financial services multiple. This is a significant structural flaw in GE's otherwise superb business model. It will present Jack Welch's successor with a mighty challenge.
August 1, 2000 |
