FWIW, here is the FT article on GE cited in tonight's Doug Noland rant:
search.ft.com
COMMENT & ANALYSIS: GE's hidden flaw: The rapid growth of General
Electric's financial services arm presents a greater threat to the world's most
highly valued company than the departure of its chairman, argues John
Plender:
Financial Times, Aug 1, 2000, 1,166 words
General Electric is the world's most highly valued company, with a market
capitalisation 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 Mr 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 Mr 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. Mr 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."
Mr 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 Mr Wendt's departure GE Capital is
firmly back in the fold under Dennis Dammerman and Denis Nayden, two trusted
aides to Mr 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. Mr 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 Mr 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 maximisation 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, Mr 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. |
