Monday, October 13, 2008

GE: A microcosm of the American economy

Fortune printed a brilliant article titled GE under siege. GE is a staple firm in American life – generations of Americans know and love the GE repairman, whose biggest burden is biding his time while his GE appliances funtion perfectly and our daily lives continue uninterrupted.

GE is so much more than that. The parent company, GE, depends on its financial affiliate, General Electric Capital (GE Captial) for financial management and roughly half of its profit base. At the same time, GE Capital depends on its parent company’s, GE’s, successes so that the entire firm can maintain its Aaa credit ratings and enjoy low-cost financing loans.

This is – as the article implies – a microcosm of the American economy. The U.S. financial system and the U.S. macro-economy are very much intertwined: one cannot exist without the successes of the other.

Here is a portion of the Fortune article that highlights the structure of GE that led to its imminent downfall, but the whole article is definitely worth a read:
"The source of GE's strength - and its problems

To see how GE got so badly beaten up, consider first what the company really is. Its strength and curse is that it looks a lot like the economy. Over the decades GE's well-known manufacturing businesses - jet engines, locomotives, appliances, light bulbs have shrunk as a proportion of the total. Like America, GE has long been mainly in the business of services. The most important and profitable services it offers are financial. In fact, though the average citizen probably thinks of GE as a great industrial company, its industry classification in the Fortune 500 is diversified financials. It is by far the largest company in that industry group. The next biggest - and here we begin to glimpse GE's troubles - are Fannie Mae (FNM, Fortune 500) and Freddie Mac (FRE, Fortune 500).

The reality is that for years, about half of GE's prodigious profits have come from General Electric Capital, a 100%-owned affiliate that files its own reports with the SEC. GE Capital, headed by 29-year GE veteran Michael Neal, has ventured into practically every kind of financial service, from making car loans in Europe to investing in commercial real estate in Florida. If you have a credit card from Wal-Mart or Lowe's, it's really from GE Capital. The business owns almost 1,800 commercial airplanes and leases them to 225 airlines. Until last year it made subprime mortgages in the U.S.

But GE Capital is more than just a major profit contributor to GE. The relationship is symbiotic. GE Capital helps GE by financing the customers that buy GE power turbines, jet engines, windmills, locomotives, and other products, offering low interest rates that competitors can't match. In the other direction, GE helps GE Capital by furnishing the reliable earnings and tangible assets that enable the whole company to maintain that triple-A credit rating, which is overwhelmingly important to GE's success. Company managers call it "sacred" and the "gold standard." Immelt says it's "incredibly important."

That rating lets GE Capital borrow funds in world markets at lower cost than any pure financial company. For example, Morgan Stanley's cost of capital is about 10.6% (as calculated by the EVA Advisers consulting firm). Citigroup's is about 8.4%. Even Buffett's Berkshire Hathaway (BRKA, Fortune 500) has a capital cost of about 8%. But GE's cost is only 7.3%, and in businesses where hundredths of a percentage point make a big difference, that's an enormously valuable advantage.
And thanks to the earnings strength of GE's industrial side, GE Capital can maintain its rating without holding much capital on its balance sheet.

GE Capital also performs another critical function: It helps GE manage earnings. Though earnings management is a no-no among good-governance types, the company has never denied doing it, and GE Capital is the perfect mechanism. Since financial assets are, under normal conditions, far more liquid than tangible assets, the company can buy or sell them in the final days of a quarter so that reported earnings rise with comforting smoothness, right in line with Wall Street expectations. Investors happily pay extra for companies whose profits rise steadily rather than erratically, so this function is valuable. Michael Lewitt, president of the hedge fund Harch Capital Management, says GE Capital "has become such a necessary part of GE's legendary earnings results that General Electric could not perform as well or consistently if anything happened to it."
RW: The article further highlights the downfall of GE. Basically, it is a story of poorly-chosen and poorly-timed investment decisions that risk the future of this American icon.

Rebecca Wilder


  1. Oops! It also is a multi-national, I believe. Still think it is in play.

  2. Hi Janie,

    No problem if it is multi-national . Just compare GE to the American economy as measured by Gross National Product (including net-income earned abroad), rather than Gross Domestic Product.

    Thanks for being my number 1 reader!


  3. and I just got used to referring to it as the GD!P rather than the GNP of old...GE had a yield of 3%as of 3/31/08 - have no idea what it is now (4.2% on 6/30/08). Wouldn't you hold on to it?


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