Commentary: Was Jack Welch's Run All It Was Cracked Up to Be?

When Jack Welch stepped down as CEO of General Electric Co. (GE ) last September, he bequeathed many gifts to his successor, Jeff Immelt. Among them: operating companies that are No. 1 or No. 2 in their market, a deep bench of executive talent, and a stock seen as near bulletproof. All in all, an enterprise that Goldman, Sachs & Co. analyst Martin Sankey calls "a prototype of a postindustrial company."

Welch was mythic, and under him GE had become so, too. After all, Welch's management practices and strategic insights have become the stuff of B-school case studies. Constant improvement through a Six Sigma quality push. The notion that an industrial manufacturer could offer low-margin products as a base for building high-margin service businesses. An unparalleled focus on training and retaining talent. The transformation of a U.S.-focused firm into a global powerhouse. These are all lasting contributions from Welch.

But other aspects of his reign are coming under sharp reassessment. More than anything, what set Welch apart from his peers was his uncanny ability to make the earnings numbers he promised investors. Quarter in, quarter out, GE hit the mark. In the past 10 years, the company says it has only missed twice. But in the seven months since Welch left GE, people have begun to question that performance. Following blowups at Enron and Tyco International and revelations that even blue chips like IBM have used questionable accounting to make their numbers, GE has come under fire. No one is claiming fraud, or even that GE broke accounting rules. But critics are asking one very tough question: Was GE's great performance under Welch too good to be true?

Welch, of course, says absolutely not: "GE has a multitude of businesses, it has strong cash flow, it has enormous productivity." Many who know the company well, like Sankey (who recommends the stock to his clients), agree. Sankey notes that quarterly growth in GE's cash flow from operations excluding progress collections, has closely tracked its net income over the past three years. (Progress collections are installment payments that GE gets on gas turbines and jet engines. Because this number fluctuates widely, analysts and GE both prefer to exclude it when analyzing cash flow or comparing it with earnings.)

That's comforting because cash flow is widely perceived to be the hardest number in the financial statement to monkey with. If cash is growing at a comparable rate to net income, it's a sign that the net income number hasn't been fudged. "In the annual report, there is a chart that shows GE expanding earnings over economic cycles between 10% and 17% since 1979. No down years, no big write-offs," Sankey says. "That kind of performance reflects business management, not accounting fiction."

The balance sheet also stacks up. GE is one of only eight companies in the U.S. with a triple-A debt rating, a grade it's had for 21 years. Thanks to its industrial operations, which carry negligible debt, it has been able to comfortably handle the debt carried by its finance arm, GE Capital. Concerns that it was overly dependent on short-term commercial paper have been addressed by issuing longer-term obligations, including an $11 billion bond offering in March. An Enron-style meltdown couldn't be less likely.

But in today's market, 20 years of nonstop growth seems more a cause for suspicion than celebration. Partly, GE is suffering from a more critical approach to valuing all companies' earnings. For years, General Electric has, along with other industrial giants like IBM and Lucent Technologies, benefited from the combination of an overfunded pension plan and a bull market. The result: a noncash earnings booster called pension income. In 1999, GE gained $1.4 billion in pension income, or 16% of its operating earnings. No one minded that boost back then, and there's nothing underhanded or illegal about the accounting, but these days, when quality is an issue, noncash earnings look bad.

In addition to gains from accounting wrinkles, GE has also benefited from rules that have kept its expenses low. As a big advocate of pay for performance, Welch transformed GE into a large issuer of stock options. Because stock options are not expensed as cash compensation is, this too resulted in savings of hundreds of millions of dollars and, by some measures, inflated income.

This isn't the first time GE has come in for criticism of its accounting. In general, though, the company has been singled out far more often for its smart management, financial discipline--and its ability to turn accounting and tax rules to its advantage. "Shorts and skeptics for years were ignored. They were backwater guys, nobody was particularly paying attention," says Lehman Brothers Inc. accounting expert Robert Willens.

But since Enron, "these guys are the oracles. These are the people everyone's listening to."

GE's stock price makes that clear. On Apr. 15, GE fell to a six-month low after a story appeared in The New York Times questioning the quality of its earnings in the first quarter. In late 1999, the heyday of Welch, GE stock traded at a price-to-earnings multiple of 48, well in excess of the Standard & Poor's 500-stock index's p-e of 33. Today, that's flipped, with GE trading at a discount to the S&P 500.

This is despite the fact that over the same period, GE's earnings per share have grown much faster than the S&P 500's. In that, accounting consultant Thornton L. O'Glove sees a sensible reconsideration of the sustainability of GE's earnings and the value of contributors like pension income, which do not generate cash. "The market's peeling off layers of earnings now," he says. "[Investors] are asking `Why would I give a high multiple for a paper item that doesn't even impact cash?"'

That's a question Jack Welch never had to face.

By Nanette Byrnes

With Frederick F. Jespersen and Diane Brady in New York

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