Worrying New Disclosures From GE

Last Wednesday, the same day General Electric (GE) announced that Warren Buffett's Berkshire Hathaway planned to invest $3 bn in the conglomerate and that it planned a new $12 bn stock offering, GE shot a little noticed filing over to the Securities and Exchange Commission that gave fresh detail on the unhealthy state of the company.

In the filing, GE warned it may not succeed in its desperate moves to hold onto its coveted Triple-A rating, which helps it borrow cheaply in the credit markets.

It also tossed cold water on the positive effects of the government's historic $700 bn bailout bill of the financial sector, and noted it is still under regulatory investigation.

GE is expected to report its next quarterly earnings on Friday, Oct. 10. Despite avowals to the contrary, last week GE cut its earnings forecast  due to writedowns of as much as $500 mn 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 expects its finance arm, GE Capital, will see a 10% to 30% drop in profit, which means the unit will make up about 40% of the parent's annual earnings, down from 50% last year.

Quality of Earnings Problems

I've already warned you that GE has serious quality of earnings problems, including a debt load that swamps its net worth. GE also has on its balance sheet loads of illiquid securities that push its tangible book value, or net worth, under water.

And it uses off-balance sheet vehicles to house potentially bad debt, debt which, if loaded back onto its balance sheet, would swamp its tangible book value (see blog "What Buffett May be Missing at GE").

GE is on the SEC's list of companies whose stock cannot be shorted under the agency's temporary ban. Short sellers borrow stock betting that the price will fall, then return the shares after pocketing the difference when the shares do plunge.

Corporate risk disclosures are par for the course for publicly traded companies. GE's filing, however, is loaded with unusually pointed language and new information.

Poor Profit Outlook

General Electric's chief executive, Jeffrey R. Immelt is trying to shed slow-growing businesses in a restructuring that would reduce its divisions to four from six, as its as its stock trades near an all-time low. GE's shares have been underwater since its former CEO, Jack Welch, stepped down in September 2001.

Its market cap has fallen to $235 bn, as GE's stock has lost nearly half, 47%, of its value over the last 52 weeks as profits continue to erode.

GE has already cut its profit outlook for the year, and has said that the engine of its earnings growth, GE Capital, will deliver just 40% of its earnings, down sharply from 50%.  

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.

GE Capital is the country's largest non-bank financial services company and has been a profit driver for GE for years. The unit does all sorts of lending, from airplane leasing to credit cards, and with its parent's triple-A rating, GE Capital can borrow cheaply.

Although GE recently gave assurances that it can still easily borrow in the commercial paper markets, where it gets its short term funding needs, this new filing says the future here is grim.

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, a just under the wire, limbo game of last-minute moves it has typically executed to grease the way toward meeting or beating its quarterly earnings estimates. 

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.

Also, the fact that GE had to sell new common stock and give Buffett such a rich premium (a 10% dividend), 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.

Analysts Go Negative on GE

Already, Citigroup analyst Jeffrey Sprague has cut his earnings estimates for GE for not just the next year, but for the next three years. Deutsche Bank Securities has already 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."

GE's New Disclosures on the Credit Crunch

In the filing, GE said that the "capital and credit markets have been experiencing extreme volatility and disruption for more than 12 months, and "in recent weeks, the volatility and disruption have reached unprecedented levels."

In a significant disclosure, the filing warns that GE gets "a large portion" of its borrowings via the commercial paper markets, but that "there can be no assurance that such markets will continue to be a reliable source of short-term financing for GE Capital."

GE also warns that if the market continues to worsen, or if it can't unload assets to weed back its gangly operations, the company would hit a wall as it "would seek to repay commercial paper as it becomes due or to meet our other liquidity needs" using its recent $12 bn common stock offering "and the Berkshire Investment," as well as drawing upon its credit lines, "and/or by seeking other funding sources."

Meaning, more capital raises. It adds: "Under such extreme market conditions, there can be no assurance such agreements and other funding sources would be available or sufficient."

GE Says Bailout Bill May Not Be Enough

"Even if enacted, there can be no assurance as to the impact of this plan on the financial markets," GE warns, adding, "Even if adopted, there can be no assurance what impact the (bill) will have on the financial markets, including the extreme levels of volatility currently being experienced."

GE adds it does "not currently intend to sell securities to the U.S. Treasury" via the new plan.

GE Warns GE Capital is Hurting

"Difficult conditions in the financial services markets have materially and adversely affected the business and results of operations of GE Capital and we do not expect these conditions to improve in the near future," GE cautions.

It blames the housing market, increasing foreclosures and unemployment, triggering "significant write-downs of asset values by financial institutions," including at Fannie Mae and Freddie Mac as well as "major commercial and investment banks."

GE warns that it is in a neck-and-neck race with other companies seeking capital, as "write-downs, initially of mortgage-backed securities but spreading to credit default swaps and other derivative securities, have caused many financial institutions to seek additional capital, to merge with larger and stronger institutions and, in some cases, to fail."

GE Desperately Clinging to its Triple-A Rating   

"Failure to maintain our triple-A credit ratings could adversely affect our cost of funds and related margins, liquidity, competitive position and access to capital markets," GE warns.

The conglomerate also notes in the filing that it's been scrambling to maintain its triple-A rating with unprecedented moves to strengthen it capital and liquidity position.

That includes taking an axe to the dividends it gets paid from its GE Capital unit, "from 40% to 10% of GE Capital's earnings," as well as suspending stock repurchases, "reducing GE Capital's commercial paper debt to a level of 10 to 15% of GE Capital's total debt and reducing the size of our financial services business so that it contributes only approximately 40% of our total earnings by the end of 2009."

GE says that following its announcement of the moves, both Standard & Poor's reaffirmed its ratings as well as the ratings for GE Capital's "AAA" long-term and "A-1+" short-term corporate credit ratings. GE noted that Moody's Investor Services did likewise.

But watch out here.

GE also warns "however, there can be no assurance that we will successfully complete these steps or, in the event of further deterioration in the financial markets, that completion of these steps and any others we might take in response, will be sufficient to allow us to maintain our triple-A ratings."

It adds: "Failure to do so could adversely affect our cost of funds and related margins, liquidity, competitive position and access to capital markets."

GE's Limbo Dance Stymied

GE also confessed that the tight credit markets means less last-minute acquisitions and asset divestitures for it to execute each quarter, which could hurt future profits.

"The success of our business depends on achieving our objectives for strategic acquisitions and dispositions," GE says, but adds "we may not be able to identify suitable candidates at terms acceptable to us."

It also says that "when we decide to sell assets or a business, we may encounter difficulty in finding buyers or alternative exit strategies on acceptable terms in a timely manner," noting "or we may dispose of a business at a price or on terms that are less than we had anticipated," as tight credit markets have hurt financing for these deals.

GE Remains Under Investigation

GE is also still grappling with a range of regulatory investigations and lawsuits, which could hang up its profits for some time.

"These include investigations by the Department of Justice Antitrust Division and the SEC of the marketing and sales of guaranteed investment contracts, and other financial instruments, to municipalities by certain subsidiaries of GE Capital," GE say, the last being an ongoing investigation of alleged bid rigging involving GICs by a number of players in the municipal bond market.

GE also notes that it faces an investigation by the SEC of possible violations of the securities laws with respect to certain accounting issues." Specifically, GE has been under investigation by the SEC over its use of hedge accounting for derivatives, as well as the way it has accounted for its revenue and its cash flow disclosures.

And GE says it still faces a "sizable number of remediation actions to clean up hazardous wastes as required by federal and state laws," noting "these include the dredging of polychlorinated biphenyls from a 40-mile stretch of the upper Hudson River in New York State.

Finally, GE, its CEO Immelt and its chief financial officer face two shareholder class action suits in the United States district court for Connecticut, alleging the company and the executives "made false and misleading statements that artificially inflated our stock price between March 12, 2008 and April 10, 2008, when we announced that our results for the first quarter of 2008 would not meet our previous guidance and we also lowered our full year guidance for 2008," the filing notes.

GE also disclosed that the company as well as Immelt, the CFO and members of its board of directors face two derivative actions in New York State court alleging breach of fiduciary duty and other claims. These "cases are in their earliest stages and we intend to defend them vigorously," GE says.