What Buffett May Be Missing at GE

General Electric fell nearly 10% in trading today amid concerns about its earnings and after it sold $12 bn in common stock at $22.25, a 9% haircut to its close on Wednesday.

The news that Warren Buffett's Berkshire Hathaway will buy $3 bn in preferred stock, which sport a rich 10% dividend, in General Electric (GE) isn't enough to stop the downturn in the conglomerate's shares.

Also, there is a quality of earnings danger zone in GE's earnings. What flies under the radar screen of Wall Street analysts, as those who cover this manufacturing conglomerate tend to be industrial and not financial analysts, is the earnings engine that is GE Capital, an earnings engine that fuels GE's profits but now seems to be running on fumes.

When it reports its next quarterly earnings on October 10, don't be fooled by any big PR push from GE on the steadier industrial side of its business, selling train locomotives, water treatment plants, wind turbines, light bulbs and the like.

On Wall Street, GE is an entity to be feared, oderint metuant, but a look at the balance sheets at GE and GE Capital shows some startling numbers.

Use this article as a roadmap of the earnings problems submarined in GE's footnote disclosures, which are about as transparent as a bucket of tar. GE's numbers are weak on closer look.

GE is on the SEC's list of companies whose stock cannot be shorted under the agency's temporary ban. GE has also publicly stated Congress needs to pass the $700 bn rescue plan. "We believe action on a financial stabilization package must be taken--and urgently," GE spokesman Peter O'Toole told Reuters. Read below to understand why an industrial conglomerate--which houses a sizable lender--is advocating for this bail-out.

Stock Plunge

This usually steady Dow Jones Industrials performer, which historically beats earnings estimates by a penny under former chief executive Jack Welch, has seen its shares underperform by a steep 33% below what they were trading at when Welch stepped down in September 2001.

As its market cap has fallen to $235 bn, GE's stock has lost nearly half, 47%, of its value over the last 52 weeks as profits continue to erode at its GE Capital finance arm, a unit which has fueled GE's earnings growth for the last two and a half decades.

GE Capital is the country's largest non-bank financial company, a unit that deals in commercial real estate, credit cards, mortgages and airplane leasing. With $696 bn in assets--82% of its parent's assets--GE Capital is in the league of the top ten largest financial companies in the country.

Worries About its Triple-A Rating

GE desperately needs its triple-A rating, a rating that could be in trouble and which it confers on its finance unit, GE Capital, so the finance division can borrow cheaply in the commercial paper markets.

Historically, GE's triple-A rating enabled GE Capital to borrow via cheap commercial paper and buy its way to profit growth.

Specifically, GE Capital uses that triple-A rating to help its parent execute its acquisitions and divestitures on the cheap, moves it has often made last minute to grease the way toward meeting or beating its quarterly earnings estimates. 

It's a just under the wire, limbo game of last minute asset sales done to placate Wall Street.

The fact that GE can't readily get its GE Capital unit to unload and sell assets when the markets are in blackout mode poses problems when it comes to meeting Wall Street's earnings expectations. Disappointments here have hammered its stock.

Also, the fact that GE had to sell new common stock and give Buffett such a rich premium, along with fears it may have to tap its $62 bn in credit lines, is raising concerns on Wall Street about whether GE is well-capitalized and whether its coveted triple-A rating is in jeopardy. 

Of concern, too, is the fact that GE had to shore up its balance sheet by stopping its stock buyback program, freeze its dividend for the first time in 32 years, scrap the sale of its credit card unit and curtail borrowings at GE Capital.

And despite avowals that all was fine, GE last week cut its earnings forecast  due to writedowns of as much as $500 man and credit losses. It says its profit for the year will be $1.95 to $2.10 a share, down from the expected $2.20 to $2.30 it had previously guided, and down from Wall Street's $2.43 a share expectations.

GE also assumes its finance arm will see a 10% to 30% drop in profit, which means the unit will make up about 40% of the parents annual earnings, down from 50% last year.

Deutsche Bank Goes Negative on GE

Deutsche Bank Securities lowered its earnings per share estimates by 9% for 2008, to $2 and to $1.95 in 2009, and cut its stock price target to $26 due to "deterioration at GE Capital--driven by tighter credit markets, asset shrinkage and a debt pay-down."

It also noted that GE Capital expects to incur $300 mn to $500 mn of mark-to-market losses on its bad assets and substantially lower real estate gains, leading Deutsche Bank to revise its estimate for a 28% decline in GE Capital's earnings to $2.1 bn.

GE's Debt Overhang

Start with GE's debt, which looks huge when you compare it to its cash and its net worth, meaning, its assets minus its liabilites.

At the end of the second quarter, GE had $19 bn in cash and equivalents on its balance sheet. It also had $45.9 bn in investment securities it (hopefully) could easily liquidate.

That $64.6 bn total is against a pretty sizable $555 bn in short- and long-term borrowings. It looks worse if you use only the $19 bn, as most valuation models do. 

In this debt overhang sits $90 bn in commercial paper borrowings, short-term, cheap borrowings done in as little as one month. But those borrowings are not cheap any longer. Amidst the credit squeeze, GE's commercial paper costs have risen.

At the same time, insuring the debt for GE Capital has soared as well, as spreads on the unit's credit default swaps have risen to between 540 basis points to 740 bps.  

Why GE Capital Matters to GE

A huge 40% of GE's revenue and half of its earnings comes from the notoriously opaque black box that is GE Capital, its finance unit whose disclosures are as transparent as a vat of molasses.

Thanks to its triple-A rating, GE Capital can cheaply borrow funds short-term at low rates and then lend to businesses at higher rates. The problem is, the credit squeeze has pushed higher GE Capital's borrowing costs.

But the last several quarters have been calamitous for GE, as it couldn't grease its numbers with instantaneous asset sales it's so used to doing to hit its numbers, or exceed by a penny, an earnings uptrick that seems to have been going on for years.

This unit's revenue growth underperformed in the first half, growing a somewhat tepid 7% to $37.2 bn versus the same period a year ago.

GE Capital's Net Worth Loaded With Ephemera

GE Capital's net worth gets weaker upon closer look. When you strip out the vapors from its net worth, you'll see that both GE Capital and its parent are highly levered.

Teetering atop GE Capital's teensy $60 bn in shareholders equity (or net worth) are $545 bn in short- and long-term borrowings, a sizable leverage ratio of about nine to one.

But look closely and you'll see a stunning 53% of GE Capital's net worth, a total of $31.6 bn, is in mushy ephemera, goodwill and other intangible assets. Meaning, it's got $28.4 bn in hard assets.

Goodwill and intangibles are often smoke and mirrors term, both somewhat of an accounting artifice, as they are typically the price tags given by accountants and actuaries to assets picked up in acquisitions, for things like the brains in an R&D operation, the future value of licenses and patents, and such. 

Remember, more than half of GE Capital's net worth, its book value is, well, your guess is as good as mine.

Strip out the ephemera, and on a tangible book basis, using just its hard assets, GE Capital is levered up 19 to one, meaning for every dollar of hard assets it has borrowed $19.

GE's Net Worth is Even Shakier

Same creakiness holds true for the parent, GE. GE recorded $118.4 bn in shareholders equity, but a whopping $100.4 bn of that was in goodwill and intangible assets, a huge 85%. Meaning, GE has just $18 bn in hard assets.

Sitting precariously atop its $118.4 bn book value are $556.1 bn in borrowings, a leverage ratio of about five to one.

Strip out the ephemera and, on a tangible book basis, GE, the parent, is levered up 31 to one, meaning for every dollar of hard assets it has borrowed $31. Similar leverage ratios have caused problems for Wall Street firms like Bear Stearns, Lehman Bros. and Merrill Lynch (MER).

What Ephemera Exactly Did GE Buy?

Wandering through the impenetrable fogbank that is GE's disclosures, often feeling like they are written in the typefont of pharmaceutical warnings, you'll see that GE attributes its goodwill to its acquisitions of Bank BPH, Merrill Lynch Capital, CDM Resource Management, and its NBC Universal unit's purchase of Oxygen Media, among other items.

Specifically, one of the largest goodwill balances comes from acquisitions its purchase of Merrill Lynch Capital" ($581 mn) and Bank BPH ($508 mn).

GE picked off Merrill's middle market lending business when Merrill started its asset fire sale last December, in the midst of record writedowns and the credit crisis bearing down on the markets.

Included in this deal was Merrill Lynch Capital's corporate, equipment, energy and healthcare finance units, but not the commercial real estate unit.

Given the unhealthy state of the financial sector, it's right to question whether Merrill's former unit and Bank BPH will deliver to GE's bottom line in the near-term.

The fact that GE is doing such purchases is important because chief executive Jeffrey Immelt made a first quarter promise to slash GE's exposure to the wobbly financial sector. 

Off-Balance Sheet Vehicles House Debt

Submarined in GE's footnotes you'll see a cursory disclosure about GE Capital's off-balance sheet activities with little explanation. The sums, if added back onto the balance sheet, would make its leverage ratios look worse.

GE Capital has shoved into off-balance sheet vehicles a big $53.2 bn in securitizations, assets backed by credit-card debt, commercial and equipment financings, as well as trade receivables.

These vehicles get to sport GE's gold-plated triple-A rating, even though these assets are backstopped by a weak $2.7 bn in credit support.

The vehicles come with triggers that force GE to pony up credit or buy them back, say, if a spike in defaults occurs. Putting them back on the balance sheet would hurt GE Capital's debt to equity ratios--as well as the ratios for the parent.

Load in the off-balance sheet items, and on a tangible book value basis, GE Capital is levered up 21 to one.

GE Capital's Toxic Assets

Moreover, GE Capital has $15.9 bn in illiquid assets, the toxic level 3 assets, that the company can't get a pricetag on because there is no market to mark them to. So they sit dormant waiting to be unloaded.

It's got another $38.8 bn in level 2 assets, which may be more easily sold than its level 3 assets, though the credit markets for them still largely remain in blackout mode.

These sums in total easily swamp the $18 bn tangible book value of GE.

Does GE Deserve a Triple-A Rating?

But seemingly without plumbing the depths of these mysteries, Standard & Poor's has given GE a triple-A rating, an honor not given most other financial concerns and one conferred on GE Capital because its industrial parent backs its debts, (it also has a triple-A rating from Moody's Investors Service).

Only nine or so other companies enjoy a triple-A rating, last I checked (excluding supposedly government-backed companies such as Fannie Mae).

The list is: Berkshire Hathaway, ExxonMobil, Pfizer, American International Group, Bristol-Myers Squibb, Johnson & Johnson, Merck and United Parcel Services, and General Electric.

GE Elbowed Out?

GE is undergoing a massive restructuring which involves asset divestitures, but it could be elbowed out in a bum's rush to a very crowded exit door in its asset sales by Citigroup (C), JPMorgan Chase (JPM), and Bank of America (BAC) and just about any other financial services firm caught in the downdraft.

Oh and by the way--the IRS is now auditing GE's tax returns for 2003 to 2005.