How Does GE Grow?
Jack Welch had it easy. For years, investors simply basked in the glow of General Electric Co.'s (GE ) double-digit earnings growth and roaring stock price. Who would demand hard data from such a celebrated chairman when he brought home the bacon quarter after quarter, year after year? But that was before the failed merger with Honeywell International Inc. (HON ), a teetering economy, and the double whammy of Enron Corp.'s implosion and the continued accounting questions surrounding rival Tyco International Ltd. (TYC )
Suddenly, investors are angry and full of questions. And GE is hardly immune. That's making life awfully challenging for the new guy, CEO Jeffrey R. Immelt. In the months following the problems at Enron and Tyco, they demanded that he fork over more financial data to clear up, once and for all, just how GE makes all that money. He produced fresh charts at meetings and a beefed-up annual report that included a breakout of earnings by business unit. And Immelt has promised more in the months to come.
So did Immelt get a big pat on the back for GE's newfound candor? Hardly. One of the financial community's most respected figures, bond investor William H. Gross, has delivered a stinging critique of GE, its lack of financial disclosure, and most important, GE's legendary business model. It almost didn't matter that Gross got important facts wrong in his Mar. 20 report. Gross, the managing director of Pacific Investment Management Co. hit a raw nerve. GE shares tumbled more than 6%, to close at $37.45 on Mar. 21. Within hours of release of Gross's remarks, some of the 30-year bonds issued by the Aaa-rated GE in a record $11 billion offer on Mar. 13 were trading at a level closer to that of a company Moody's would rate Aa (or, in Standard & Poor's notation, AA).
Ouch. The latest panic has put GE on the defensive and raises questions as to whether, without more disclosure, Immelt & Co. may face similar attacks in months to come. Despite having to backtrack on some of the issues he raised, Gross's criticisms went to the heart of GE's identity as one of the world's best-managed companies. Gross accuses GE of inflating earnings through acquisitions rather than through innovation or gains in productivity. And, he charges, the company relies on investors' enthusiasm to prop up the cheap debt and high-value stock needed to fund acquisitions, making earnings especially volatile and unsustainable. In his view, GE is nothing more than a "conglomerate financed by a money machine--its subsidiary GE Capital."
Is Gross on to something? Clearly, GE assumed for too long that results simply speak for themselves. How the $126 billion company got those results and communicated them to the market was secondary. Immelt has opened the door to more disclosure, but it's not yet enough for investors to get a clear understanding of GE's businesses. Gross also raises a tough question anyone investing in GE should ask: How can a company with substantial debt and mediocre revenue growth--on a reported basis, it dropped 3% last year--keep generating high-quality double-digit earnings?
For Gross, the answer begins with GE Capital Corp. The finance unit makes up 40% of GE's earnings and accounts for almost all of its debt, with roughly $240 billion in debt on the books by the end of last year. Given the unit's growing heft in recent years, Gross argues, GE "should be viewed more as a finance company than an industrial powerhouse." He has a point, as Capital's revenue and profit growth have outstripped GE's industrial business over the past decade. But Immelt has said repeatedly that the company will limit Capital's earnings contribution to no more than 45% of the overall company, although he notes that acquisition opportunities could hike the percentage in the short term.
So what's the problem with that? Certainly, there's nothing wrong with running a finance company. But even the perception that GE is primarily a finance operation could have a huge impact on the company's business. To start, it might pull down the share price because capital-intensive finance companies typically command much lower price-earnings ratios than industrial players. It could also affect GE's Aaa rating--a top grade awarded to only nine U.S. companies by Moody's Investors Service. In a Mar. 19 report, Moody's noted that on its own, GE Capital would be rated lower than the Aaa level. Among other things, the unit's appetite for acquisitions and high level of unsecured debt makes folks at Moody's nervous. But it gets Aaa because it enjoys the explicit support of GE, a strong and diversified parent.
Rates are so low for GE, in fact, that Gross argues the company has an added incentive to borrow cheap commercial paper and buy its way to that famous double-digit growth. Even some rating agency analysts say the unit's overall debt-to-equity level, which sits at more than 7 to 1, is on the high side. Still, it's within the range of normal and the industrial side of GE balances out the picture with negligible debt.
GE's short-term debt is another matter. Commercial paper, which often comes due every two or three months, is a cheap and flexible way to finance operations. Because they expose companies to constant interest-rate swings or shifts in investor sentiment, such debt is not supposed to be used for long-term liabilities. And companies are only supposed to borrow what their banks are willing to cover. With $117 billion in commercial paper at the start of the year, GE had three times as much commercial paper as the amount covered by bank lines. Gross blamed that on a lack of market discipline caused, in part, by persistent faith in the Aaa-rated company.
While GE said it had no trouble tapping demand for such debt, it acknowledges that it was too heavily weighted in such paper and blamed the situation on bond market turmoil after September 11. It has since increased bank lines, locked in more long-term debt, and scaled back commercial paper to $103 billion, or 42% of total debt. It plans to go as low as 25% of debt by the end of the year, well within acceptable levels. Gross, it seems, was merely telling GE to do what it was already in the process of doing. And even he doesn't seem to harbor real fears of a liquidity crisis at GE. The company has too many other sources of funding and generates more than $17 billion in cash from its industrial businesses.
But Gross argues that GE uses such cheap short-term debt and its high-powered shares to fund acquisitions. On the stock question, GE says he's clearly wrong. The company rarely uses its stock for acquisitions, and short-term debt is merely used as interim funding until a deal is at the state where longer-term debt is justified. More important, GE counters his assertion that acquisitions are the primary driver of growth. In the 2001 annual report, Immelt said acquisitions totaled $23 billion for the year, and Chief Financial Officer Keith Sherin last week said 2001 purchases made up only $200 million, or 15% of earnings growth.
But those figures don't tell the whole story. The company doesn't strip out such details as acquisitions by business, which would show the hot areas of core growth. And, because each acquisition is a one-time boost to business, GE must constantly consume smaller fish in order to keep up deal-driven growth. Given the slowdown in sales, that leaves cost-cutting, productivity improvement, and acquisitions to boost the bottom line. When annual revenues rival the gross domestic product of a small industrial nation, that can be a daunting task. Sure, GE has bought hundreds of companies over the years. But, a decade ago, it was also half the size.
While Gross hardly uncovered a hot scandal at GE, he is not alone in his frustration--or in raising questions. While the company has clearly stepped up the level of disclosure in recent months, it still has a way to go in telling people what they need to know to understand the quality and sustainability of earnings. Among the items on Gross's wish list: the level of earnings-per-share growth from acquisitions, the company's options expenses, and more breakdowns by business units, "among many others." And GE would do well to share its strategy on things such as funding that growth. Otherwise, testy investors and angry bondholders aren't likely to leave Jeff Immelt alone.
By Diane Brady, with Susan Scherreik and Heather Timmons, in New York