Generally Un-Electrifying
GE’s response to the Times is a huge whiff
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Article date: 04/18/02
Thomas Brown
Director, bankstocks.com
tbrown@secondcurve.com
One word comes to mind to describe General Electric’s response to that negative article about it in Sunday’s New York Times: Incoherent. What to make of such a lame document, from a company said to be run by the smartest people in the world?
On many key points, for instance, GE “refutes” the Times’s writer, Gretchen Morgenson, by…agreeing with her! When the Times observes that GE Capital Services’ revenues dropped by 6% in the first quarter, for instance, GE’s blistering retort is that: “the facts of the revenue declines at GECS were articulated on the conference call, as they have been each quarter by analysts that follow the company.”
Say, what? GECS’s revenues fell last year; Gretchen Morgenson said so, and GE says so, too. What exactly is the controversy? Just because GE had already disclosed the decline doesn’t mean that it’s not material evidence that GE isn’t the growth thoroughbred it once was. Actually, it’s compelling evidence of just that.
Similarly, the Times points out that $326 million of GE’s first quarter earnings came from cancellation payments on terminated Power Systems contracts. GE thunders back that “CFO Keith Sherin clearly stated on the earnings conference call that the contribution to earnings from termination payments was 2 cents per share in the quarter. That is the after tax equivalent to $326 million net of costs associated with the terminations.” But regardless of what Sherin said, and when, collecting cancellation payments is no growth business. It is the just opposite—exactly Morgenson’s point.
Morgenson argues that if first-quarter earnings were adjusted to reflect the change in goodwill accounting, GE’s reported 17% earnings rise turns into a 2.7% earnings decline. GE’s response: “These are exactly the results that GE communicated.” Is there nothing in the article the company actually disputes?
Actually, there is; they’re the points the Times makes that GE seems to simply not understand. When the paper cites an S&P analyst’s observation that the company inflates its returns by using leverage, GE’s response is that “GECS return on equity was 21.8% in 2001 and 21.7% for the first quarter of 2002.” Okaaaay. So the company earns a relatively high ROE—just like the Times and the fellow at S&P said! As to whether that high ROE comes about from smart capital allocation or is the result of simpleminded borrowing is left unanswered. The man at S&P is said to have done the work that shows GE’s debt-adjusted returns are only so-so; GE offers no evidence to show that he’s wrong.
It gets worse. For example, GE is shocked that Morgenson points out that GE uses special purpose entities that are held off balance sheet. “GE follows the accounting instructions of the FASB for special purpose entities,” the company huffs, “and of course will continue to do so if the accounting treatment for these entities changes.” How reassuring. What the company doesn’t point out (presumably because it knows it won’t help its case) is that the Enron fiasco proved that the FASB’s rules for SPE accounting are inadequate.
It is almost embarrassing to watch the company flail. Morgenson points out that 25 cents per share of first-quarter earnings came from non-recurring sources such as capital gains. A sensible concern. GE’s response? The company says she’s engaging in “cherry-picking.” “All these items were fully disclosed and highlighted,” the company says (yeah, yeah . . . ). It then adds that the gains were offset by a laundry list of non-recurring expenses, including a restructuring charge, lower gains on investment securities (how’s that a positive?) and “losses associated with the events of September 11.”
Please. This is precisely the sort of earnings-gaming that’s made investors so suspicious lately. And GE seems proud to be doing it! Why? Why should shareholders be reassured the company took a $656 million restructuring charge in its first quarter? If they’re smart, they’ll take it as a sign that operating expenses in future quarters will be artificially low, and those reported earnings suspect.
Likewise, the company seems pleased its first-quarter cash flow matched its earnings gains if adjusted for something called “progress payments.” It is odd that GE is crowing about is cash flow, inasmuch as the company doesn’t generate nearly enough of it to fund its business. Against the $2.2 billion of operating cash flow the company generated in its first quarter (ex-progress payments!), GE paid out $4.6 billion to keep its business going, for items such as dividends ($1.8 billion), stock buybacks (to offset option grants, $700 million), capital spending ($400 million), acquisitions (central to GE’s growth strategy, $1.7 billion). It’s of course no mark of shame for a company to chronically depend on outside financing. But it’s no mark of honor, either—particularly if the company in question is about to sell $50 billion of new paper simply to fund a rating-agency mandated restructuring of the liability side of its balance sheet! Creditors have their limits.
In all, it’s impossible to read GE’s response to the Times piece and not conclude that Gretchen Morgenson is on to something. Why, that mighty GE even spent the time and effort to respond at all can be taken as evidence that the folks up in Fairfield might be more antsy about the company’s outlook than they’re letting on.
And as long as the company has taken the time to make a point-by-point rebuttal, what are investors to make of the points in the Times piece that the company left unchallenged? Along that line, the GE response may be as notable for what it doesn’t discuss, as for what it does:
There is that mysterious $2 billion decline in GE Capital’s tangible net worth at the end of 2001, for instance. Morgenson reports that GE would only say that one reason for the decline was an $890 million mark-to-market loss on a derivative’s position. The rest is obscure. Then in GE’s subsequent response to the Times, not a word more. Perhaps investors can assume that something ominous is happening at GECS. From my experience as a financial services analyst who’s seen more than a few large, acquisition-driven financial services companies implode without warning, that would come as no surprise.
Similarly, Morgenson leaves the clear implication that the company is hiding credit losses at GE Capital. She points to a rise in uncollectible debts, to 2.9% of receivables at yearend, up from 2.3%. Morgenson adds that uncollectibles rose some more in the first quarter. “Losses have mounted at many banks and financing companies in recent quarters.” She notes with a tone of irony, “But GE Capital's earnings growth had held up remarkably well in the economic downturn that forced companies to curtail capital expenditures sharply.” Easy to refute, one would think. That GE refused to is telling.
Not so long ago General Electric was seen a paragon of can-do management that would do whatever it took create value for shareholders. Now they just seem like whiners. If GE doesn’t like what the media has to say about it, it should keep quiet, get its numbers up, and prove us doubters wrong. Instead, the company seems to be alternatively agreeing with its critics, distorting their objections, and stonewalling. This can’t be encouraging to the company’s bulls. This stock, in my view, is headed lower.
What do you think? Let me know!
/TKB/
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The author is a Manager of a hedge fund and co-founder of bankstocks.com. His fund often buys and sells securities that are the subject of his articles, both before and after the articles are posted. Under no circumstances does this article represent a recommendation to buy or sell General Electric. This article is intended to provide insight into the financial services industry and is not a solicitation of any kind. Neither the author nor bankstocks.com can provide investment advice or respond to individual requests for recommendations. However, we encourage your feedback and welcome your comments on any of the articles on this site. Neither the author nor bankstocks.com has undertaken any responsibility to update any portion of this article in response to events which may transpire subsequent to its original publication date.
Key words and companies mentioned: General Electric, GE, Gretchen Morgenson, The New York Times
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