... from new Pulitzer winner, Gretchen Morgenson
April 14, 2002
Wait a Second: What Devils Lurk in the Details? by Gretchen Morgenson
Are the glory days of nonstop earnings growth over at the General Electric Company?
Management doesn't appear to think so. Last Thursday, when G.E. reported its first-quarter results, Keith S. Sherin, the chief financial officer, was decidedly upbeat. Acknowledging that the business environment remains difficult, he pointed to the company's strong balance sheet and the diversity of G.E.'s businesses and said they enabled the company to produce what he called consistently excellent earnings growth. "The business model works," Mr. Sherin proclaimed.
But investors weren't so sure. Just moments after Mr. Sherin uttered those words, shareholders began dumping G.E. stock. By the end of the day, the shares of G.E., the nation's largest company by market capitalization, had lost 9 percent of their value, sinking to $33.75. By the close of trading on Friday, they had drifted down to $33.55.
It has been a long time since the gap was so wide between what G.E. management reported as a strong performance and what its investors were hoping for. In fact, while G.E. executives said the company had delivered "excellent earnings growth" as always, what they actually issued was a report that investors, and even some analysts, found lacking in both substance and performance. And that is raising questions.
"We went through a decade where we just accepted G.E.'s numbers," said Thomas K. Brown, the chief executive of Second Curve Capital, a hedge fund in New York. "Now the more we look at them, the more we say, `wait a minute.' I don't understand what's going on here, and the more I understand it, the more I'm concerned."
For the first quarter, G.E. reported that earnings rose 17 percent, to $3.518 billion — but those results excluded the effects of a mandated accounting change. Including the change, a charge to earnings for a writedown of good will, G.E.'s earnings actually fell 2.7 percent. Revenue, meanwhile, dropped in most segments of its operations, even at GE Capital Services, its powerhouse financing arm.
Robert A. Olstein, an accounting expert and fund manager, has turned decidedly bearish. "G.E. is going to stumble before the year is out," he said.
After the long boom, contending with a stagnant economic environment is unfamiliar territory for G.E., where Jeffrey R. Immelt took over as chief executive from the legendary Jack Welch just last September. Heightened investor interest, even suspicion, toward financial reports is a completely new challenge. Even for G.E., gone are the days when investors accepted at face value what corporate managements told them about their businesses and their books. Now investors are far more likely to dissect financial statements for themselves.
Mr. Olstein, who manages the $1.5 billion Olstein Financial Alert fund, is one of them. An expert in spotting accounting practices that burnish immediate results but that do not necessarily translate into long-term earnings growth, he has managed to deliver a 7.25 percent increase in the value of his fund this year and 22.7 percent a year, on average, over the last three years. He does it, in part, by avoiding companies that report results that look better than they actually are and by sticking with those that have solid earnings.
Having taken his pencil to G.E.'s financial statements, Mr. Olstein has sold a modest number of G.E. shares short in his fund, betting that they will fall.
"Reading the 10-K, I felt that after eliminating all the sources of lower-quality earnings, any attempt by the company to grow at 18 percent a year was a dream," Mr. Olstein said, referring to management's pledge of such gains. "After reading the quarterly results, my suspicions about the quality of their growth continue."
G.E. is doing nothing improper in its accounting, Mr. Olstein is quick to point out. Rather, he says a good portion of the company's earnings come from what he calls financial engineering, not growth in the operations that make aircraft engines, high-performance plastics and medical equipment, operate television networks and finance equipment purchases.
While such techniques produce earnings gains, they are not the kind of gains that investors typically pay a premium for, simply because they are not sustainable. As a result, he said a more appropriate value for the shares would be around $25, which is 25 percent lower than they are now.
In the year ended last December, G.E. earned $13.7 billion, or $1.41 a share, on sales of $126 billion. Although the profit figure was up 7.5 percent from the previous year, by Mr. Olstein's reckoning, about 25 cents a share, or 18 percent of the profits, came from nonrecurring sources at the company.
Several areas have produced gains for the company that may not be sustainable. First, some gains result from the sale of assets. The sale of a satellite unit, known as Americom, generated $642 million after taxes, equivalent to $4.7 percent of G.E.'s earnings in 2001. G.E. sold the unit to SES Global for a gain of $1.16 billion last November. Portfolio gains including this sale generated 6 cents a share in earnings for G.E., Mr. Olstein said.
Next, he calculated that a $1.5 billion gain in the company's pension plan, left over from the heady bull-market days, accounted for 8 cents a share in G.E.'s earnings last year. Even though such gains cannot be taken into a company's coffers, under accounting rules they can be added to earnings as a so-called noncash item. David Frail, a G.E. spokesman, said: "Pension income doesn't change all that much from year to year, so as far as being a contributor to earnings growth, it's not that much."
But a measure of how fleeting these pension gains can be is seen in the company's annual filing. It said the unrecognized gain in the pension plan had fallen to $3.5 billion in 2001 from $12.6 billion at theend of 2000. Assets in the plan also declined by 10 percent. "The company's gains from the bull market mania days are fast running out," Mr. Olstein said.
Gains on the packaging and sale of G.E.'s loans, known as securitization, to special-purpose entities that are off the balance sheet also helped earnings last year, Mr. Olstein said. The total gain was $1.3 billion, up from $500 million in 2000, and accounted for 6 cents a share in earnings last year. Such gains, however, cannot be counted on year in and out.
Finally, Mr. Olstein estimated that the entire gain shown by GE Capital, whose financing operations contributed 40 percent of G.E. profits in 2001, was a result of a significantly lower tax rate. That tax-rate decline added 5 cents a share to the company's earnings.
Adding all these gains together means that G.E.'s continuing operations produced earnings of around $1.16 a share last year, Mr. Olstein said. And at a stock price of $33.55, that means investors are paying 29 times core earnings to own G.E. shares even as its revenue is in decline. By contrast, Mr. Olstein says a cyclical growth company, growing at the same rate as G.E., should sell for a multiple of 20.
Other investors are growing uneasy about G.E.'s balance sheet. In its most recent annual report, G.E. for the first time outlined the size of the obligations that are off its balance sheet in special-purpose entities. Such potential liabilities could burden the company if its triple-A debt rating were to decline. At the end of last year, that figure stood at $43.2 billion. Some analysts say that taking a conservative approach to the balance sheet would require that those off-balance-sheet obligations be added to the total debt held by the company, which stood at $220 billion at year-end.
Those off-balance-sheet obligations would increase G.E.'s debt by 20 percent. Mr. Frail said that only the highest-quality assets are in the special-purpose entities.
Beyond these accounting queries, a new, tangible question has arisen about the health of GE Capital Services. In the fourth quarter of last year, G.E. gave GE Capital a $3.043 billion cash infusion. The contribution has made some analysts wonder whether GE Capital has experienced losses in its financing business that required the parent company to shore up its balance sheet. That $3 billion infusion to GE Capital was equal to one-third of the subsidiary's tangible net worth — shareholder's equity minus intangible assets — at the time. The $3 billion contribution offset a $2 billion decline in GE Capital's tangible net worth at year-end.
A casual reader of G.E's financial statements might not have recognized how significant the $3 billion contribution was to GE Capital's net worth. Such a conclusion requires consulting a completely different financial filing, that of GE Capital Services, in addition to the parent company's annual filing.
Neither stated any reason; the companies were not required to explain the infusion.
G.E. said it had not made any more cash contributions to the capital subsidiary in the first quarter.
The company said it had made the $3 billion contribution to GE Capital so that the subsidiary could acquire Heller Financial last year. As for the $2 billion decline in tangible net worth, Mr. Frail would say only that there was a mark-to-market loss of $890 million on derivatives at the company. "The rating agencies don't look at this as relevant," he said.
But the soundness of any financial institution, such as GE Capital, is judged on the basis of its tangible net worth, or book value, by investors, rating agencies and lenders. The company must keep certain financial ratios above set levels if it is to continue to have its debt rated triple-A. A decline in GE Capital's book value of $2 billion is nobody's idea of good news.
If GE Capital is experiencing losses in its business of financing consumer and company purchases of refrigerators and turbines or in its securities trading activities, it would not exactly be a surprise. Losses have mounted at many banks and financing companies in recent quarters. But GE Capital's earnings growth had held up remarkably well in the economic downturn that forced companies to curtail capital expenditures sharply. For the full year, earnings at the subsidiary grew 4.3 percent and accounted for 40 percent of G.E.'s earnings for 2001.
While the company's first-quarter results, made public last week, were not as detailed as reports that the company will file later with the S.E.C., they confirmed some investors' fears about the unsustainable nature of some of G.E.'s past growth.
For instance, one of the few areas of strength at the company came from its power systems subsidiary, which sells turbines to energy producers like Calpine and Entergy. But many of G.E.'s customers in this business have sharply curtailed their plant-building plans, leading them to cancel turbine orders. The customers were required to pay cancellation fees, generating $476 million in revenue at the subsidiary, or 9 percent of its total sales. This resulted in net profits of $326 million, or 3 cents a share in the quarter, that are unlikely to recur.
While canceled orders are producing increased sales and earnings now, the gains will not last. "It's real profit, but it won't be recurring," Mr. Olstein pointed out. "Besides, who wants to make money from cancellations?"
G.E.'s first-quarter results had one final peculiar aspect worth noting. The company's cash flow from operations declined by 53 percent, yet earnings grew by 17 percent. Careful analysts are always on the lookout for wide discrepancies between reported earnings and cash flows. When earnings growth at a company exceeds the growth in its cash flows, the disparity can be a sign that accounting gimmicks are being used to dress up reported earnings.
The company said the discrepancy reflected the decline in so-called progress collections, the intermediate payments customers make for purchases of turbines and jet engines while they are being built. The drop in cash flow reflected a drop in those payments as orders were canceled.
G.E.'s first-quarter results also indicate that the Capital Services juggernaut, which has powered the company's overall results for more than a decade, is finally slowing. Revenue at the subsidiary fell 6 percent — largely a result of a decline in sales, general and administrative expenses — while earnings rose 8 percent. The tax rate in the subsidiary fell again, to an extraordinarily low 20 percent.
The company said this was a result of a greater portion of its business being conducted overseas, where tax rates are lower than the 35 percent rate that is standard in the United States.
Robert E. Friedman, accounting analyst at Standard & Poor's equity research unit in New York, found another flaw. While GE Capital has fueled much of the parent company's growth, he said, it does not generate high returns on capital when its debt is stripped away.
"You cannot have a P/E of a magnitude such as G.E.'s and have a company that generates relatively low returns on capital," he said. "Sooner or later the chickens are going to come home to roost."
GE Capital's uncollectible debts, which it calls nonearning receivables, have also been rising, raising flags. In the full year 2001, these rose to 2.9 percent of receivables from 2.3 percent. And in the first quarter, they rose an additional $143 million, to $3.4 billion. Such increases point to the distinct possibility that reserves for bad debts will rise, cutting into earnings.
The company says it is comfortable with its current reserves.
Mr. Olstein, however, said: "G.E. is getting growth from things it can't keep doing. This leads us to believe that the company is going to have problems down the road."
Mr. Brown, of Second Curve, added a final concern for investors: "The more people analyze G.E., which is made possible by the increased disclosure by the company, the more they realize they don't understand this company. So then you have to say as an investor, `that's uncertainty.' And when you have increased uncertainty, you're going to pay a lower multiple for a projected earnings stream."
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