Thanks to the accounting scandals and the flight of millions of shaken investors away from stocks, companies are providing more information in their financial reports.
But is it enough information, and is it the right kind of information?
My test: Investors need enough information to calculate the potential risk and potential return that would come from owning a specific stock. That calculation can be wrong, of course; events sabotage expectations and critical assumptions prove completely wrong all the time in investing. But investors ought to have enough information to complete their analyses without guessing at critical parameters. Otherwise, buying a stock is more like gambling than investing.
A classic illustration of this conflict comes from one of the market's most widely held stocks:
My conclusion in this case: General Electric has taken big steps in the right direction, but the company's GE Capital division, and especially its insurance unit, remains too much of a black box. I still don't have the information I need to make an informed buy/sell/hold decision on this bellwether stock. And since I still can't figure out critical trends at the company, I'll have to take a pass on the shares. I'm certainly not ready to buy anything on trust in this stock market.
A Wealth of New Detail
The stock was an investor favorite during the decade before the bubble popped, climbing 1,347% in the 10 years that preceded the stock's peak at $60 a share in August 2000. And despite the stock's 56% drop since that August 2000 high, GE remains among the most widely held stocks on the market and, with a market capitalization of $260 billion, among the most influential. And GE has just filed its quarterly 10Q financial statement with the
Securities and Exchange Commission
. This document gives investors a wealth of new detail.
Is it enough? I've written repeatedly that the lack of transparency at GE Capital is the primary problem with GE stock, so I'm going to focus on what the 10Q tells us about that business.
GE Capital is a huge business. Revenue in the third quarter came to $15 billion, or about 44% of total GE revenue. It held investment securities worth $115 billion at the end of September. It has fingers in almost every imaginable piece of the financial services pie: It finances airline purchases of airplanes and engines, buys telecommunications company bonds and runs a global insurance business.
I didn't pick those three areas of operation at random. It's GE Capital's exposure to those three businesses that has worried investors. With some airlines in bankruptcy, is GE Capital on the hook for loans that won't be repaid, for example? How much of the money lent to telecommunications companies won't be recovered because the borrowers will never recover? What's the exposure of the insurance company to emerging problems in insurance to cover directors and officers or guaranteed annuity benefits?
GE's most recent 10Q goes a long way toward quantifying two of the top three risk areas. Especially helpful is a section of the report called "Additional Considerations." As for exposure to troubled airlines, the company said it has about $25 billion in loans, leases, guarantees and commitments to the industry. Of that, $4.4 billion represents exposure to two very troubled airlines,
US Airways Group
, which is currently in bankruptcy, and
, the parent of United Airlines, which has said it may be facing bankruptcy. Exposure to the just-as-troubled telecommunications and cable industries comes to about $12 billion, according to the filing.
GE doesn't put a dollar figure on its insurance exposure. Instead, the filings offer this language: "Management continually updates loss estimates using both quantitative information from reserving actuaries and qualitative information from other sources. Based on the best information available at the time, management makes its best estimates of loss reserves and related incurred losses. The level of reported claims activity related to prior-year loss events, particularly for the 1997 through 2000 underwriting years, has continued to accelerate at a rate higher than anticipated, and has caused management to increase its estimate of ultimate losses -- a change that has been reflected in the accompanying financial information. The potential for further adverse loss developments in these areas is highly uncertain."
Two out of Three Isn't Good Enough
With a little work, investors can turn the information GE provides about its airline and telecommunications exposure into a decent understanding of the potential risk. The extent of GE Capital's exposure in the insurance business remains, at best, murky.
The key to turning these numbers into risk is understanding the nature of the loans, leases, etc. For example, Lehman Brothers calculates that GE Capital's lending to US Airways amounts to $2.2 billion in leases on 85 aircraft and $600 million in loan guarantees and receivables on aircraft engines.
At United, again according to Lehman, the exposure is in the form of leases on five aircraft, $775 million in senior debt secured by 34 aircraft, and $500 million in financial guarantees secured by 20 aircraft.
In other words, almost all of GE's exposure to these two airlines is backed by hard assets. The company says it has overcollateralized these loans and that the airplanes involved are new and have a relatively high resale value. Even in this slow market for airplane sales, GE looks reasonably secure on this front. The company estimates worst-case losses at $100 million to $200 million.
The picture isn't as reassuring in the telecom and cable portfolio. About 40% of this exposure is in the form of receivables financing. In other words, GE gets the company's future payments from customers in exchange for cash today. The receivables are secured by physical assets such as transmission towers. Another 40% or so (about $5 billion) is in the form of telecom and cable company bonds.
GE doesn't say anything concrete about how much of that $5 billion it thinks is at risk of default, or how much it has put aside in reserves against any such defaults. Even though the default rate on telecom and cable company bonds has been slowing, some of these issues are still likely to result in losses to GE. But do keep that $5 billion in context; GE Capital has a total of $115 billion in investment securities. The company estimates that it holds $800 million in impaired assets in its investment portfolio that may have to be charged off over the next 12 months.
It's a Little Mysterious
The company's insurance business remains mysterious, even in this 10Q, however. Investors know that GE Global Insurance has about $50 billion in assets, that claims are running heavier than expected and that the company has set aside a $650 million reserve. But that's about it -- no clue on what businesses GE is in, what its market share is, or how much insurance or re-insurance it has written.
This business is so opaque that in an otherwise detailed report on the 10Q, Lehman Brothers is reduced to noting that GE Global Insurance is widely thought to be the No. 4 player in the reinsurance market -- even though Lehman's own insurance analyst gives the company no more than a 5% share. (In fact, Fortune magazine recently reported GE is trying to sell the reinsurance business.)
Compounding the problem is that the lack of information involves an industry with huge problems. Some insurance industry analysts estimate that the reinsurance industry as a whole is underreserved (meaning, the money set aside to pay potential claims is less than the likely size of those claims) by as much as $100 billion. Of course, no one is quite sure which companies are most underreserved. In one recent report, J.P. Morgan concludes that GE Global Insurance is probably underreserved, but it doesn't put an exact figure on the shortfall.
Up until now, I've only talked about the potential risk to GE shares from these three divisions of GE Capital -- and I haven't discussed the potential reward from buying the stock. Unfortunately, one of the costs of the lack of better information on GE Capital is that the confusion makes it hard to figure out what the real growth trends are at GE.
Here's the problem: Over the past 10 years, GE has been such a stellar investment because the company has been able to use its immense cash flow to acquire businesses and then increase the return earned by those businesses and by GE as a whole. The GE return on equity has climbed from 20% in 1992 to 26% in 2001. And the operating margins in the industrial businesses climbed to 19% in 2001 from 14% 10 years ago.
But now, return on equity growth has stalled for three years in a row. The 25.8% of 2001 is only marginally better than the 25.2% of 2000 and the 25.2% of 1999.
The bearish argument against GE is that the company's days of generating 11% revenue growth (as the company did in 1998 and 1999) and 15% earnings-per-share growth (1999) are over. According to this point of view, analysts who are still projecting annual earnings-per-share growth of 12% a year over the next five years are still living in the past and still too optimistic.
I don't know if the bears are right, although I see some disquieting developments that support their case. Part of the power of the GE machine comes from the combination of GE Capital raising money at very cheap rates and the industrial side of GE then investing that capital in relatively high-margin businesses.
That formula has signs of breaking down. Turmoil in the financial markets has forced GE to switch some of its financing from the cheaper commercial paper market to the more expensive bond market. That move was necessary to defend GE's overall credit rating, but it did raise the company's relative cost of capital, at least in the short run.
More important, though, has been the gradual shift in balance inside GE between the industrial and financial businesses. GE Capital has been the faster growing of the two sides -- not a bad thing in and of itself, but a potential problem for return on equity and operating margins; financial businesses generally produce lower profit margins than the industrial businesses. The more successful GE Capital is at growing, the tougher the task of increasing profitability becomes for GE as a whole.
How serious are these trends? It's very tough to tell now because of all the writedowns, chargeoffs and losses currently being posted in the financial units. From this perspective, it's not the size of the losses that troubles me but the way these special charges hide the underlying trends in GE's businesses. It will be extremely difficult over the next few quarters to tell what the company's return on equity is, what the earnings per share trend is and how the mix between the financial and industrial businesses is changing.
In short, GE has, indeed, given investors more information -- and that's certainly a plus -- but it's not enough to give investors a clear picture of risk and reward.
GE still has more work to do.