11 May 2009

GE illuminates again


General Electric Co (GE), an American institution with a prodigious 130-year history, is among the most admired companies in the world. Many see it as somewhat of a proxy for the US economy.

GE is known as an industrial giant that makes jet engines, turbines, locomotives, appliances and light bulbs. What is not apparent to most people is that a large part of GE’s revenues and earnings is actually contributed by its wholly-owned subsidiary General Electric Capital Corp (GE Capital) which does business financing, asset leasing and consumer credit.

GE Capital shares a symbiotic relationship with GE. It was set up to provide credit to GE’s customers to finance large equipment purchases. The strength of GE and demand for its products sustained a strong business model for GE Capital. In turn, GE Capital contributed, until the onset of the current financial crisis, almost half of GE’s profits. This allowed GE, until recently, to enjoy an AAA credit rating, one of only six companies to have this best possible credit rating.

GE Capital raises capital by issuing debt papers and because of GE’s “perfect” credit rating, it is able to enjoy one of the lowest cost of capital on its borrowings. In a business where a few basis points make a big difference, it is able to lend out at competitive rates and make a healthy margin for itself.

GE Capital is not a listed company, thus is not subject to disclosure regulations for listed companies, as GE is. Although it is a lender comparable in size to the sixth-largest bank in the US, it is not regulated as a bank holding company. Unlike US banks, it is not required to mark to market its assets. It is not required to follow the same reserve requirement as banks and in fact has a lower reserve ratio. This gives it a cost advantage over most banks.

The financial crisis had brought about a tighter credit market, asset shrinkage and debt defaults. Faced with that scenario, cracks began to appear in GE Capital’s business. Early last year, rumours abound that GE Capital may not be able to roll over its commercial papers.

Indeed, there was something wrong with GE Capital but the GE management chose to keep up appearances. Due to the less-regulated space that GE Capital exists on, GE’s management was not required to, and chose not to, reveal the operations of GE Capital. The latter was potentially a “black hole” in GE, but there was a blackout of information on it.

First, GE assured investors, just 18 days before the quarter ended, that it would meet its 1Q2008 market consensus earnings target. When the results came out, it was short of the target, which by its own high standards was exceptional.

Then, GE said it would not need to raise capital. Six days later, the market found out that GE raised US$3 billion through the issue of preference shares to Berkshire Hathaway. This came at an expensive coupon rate compared to what it would normally get for its borrowings, but it got GE a valuable endorsement from Warren Buffet. GE needed further cash infusion and sold about US$12 billion worth of shares at about US$22 per share which it had bought as part of its share buyback programme earlier at prices in the US$30 range. Clearly, it needed emergency rescue but was not transparent about it.

GE assured the market that it would be able to uphold its triple A credit rating, which it had held for over 50 years. But speculators bid up credit default swaps on GE and GE Capital debts papers to junk bond status, meaning that they were betting the company would default on its debt, rendering the rating superfluous.

GE also said it would maintain the same quarterly dividend rate of 31 cents per share. Soon after that, it slashed dividends to 10 cents per share.

The denials, false assurances and over-optimistic persuasions by the GE management shook the market even more. With little information and much glossing over on GE Capital, speculation set in. Analysts and market commentators assumed the worst and shareholders sold down their stakes. Throughout this period of misinformation, GE’s share price plummeted to around US$6 from a high of US$40 before the crisis.

Only when it became apparent that the market’s reaction was causing unmitigable damage, did GE’s management realise it needed to change course. It was probably more out of necessity than virtue that they eventually did so, unfortunately after having lost much credibility.

In March this year, GE briefed analysts and financial journalists for over five hours. This time, management showed the workings of GE Capital. How the numbers are derived or forecast was revealed. It demonstrated a stress test of how economic factors would affect GE Capital’s results. Shareholders, analysts and investors were assured that GE remained robust and that GE Capital would break even at least.

The market welcomed the sudden openness of GE Capital. Rather than continue on the path of misguidance, cover-up and disengagement, doggedly attempting to protect GE’s performance in a failing economy and severely damaging its reputation in the process, management opted for transparency. This was necessary as GE recognised that it needed to reclaim the loyalty of its longstanding shareholders, bondholders and also consumers.

What is admirable is that GE faced up to its failings and made the appropriate remedies. It took steps to illuminate the investors and the market is applauding its move. Hopefully, GE will continue to uphold good investor relations and governance and recover from this economic malady as the world-class company that it is.

This article was published in The Edge Malaysia on 11 May 2009.

No comments:

Post a Comment