Why GE Is Still a Good Short

Editor's note: Charles Ortel is managing director of Newport Value Partners LLC, which provides independent investment research to professional investors. His letter here is in response to a column on TheStreet.com about where GE's stock price is headed.

By Charles Ortel

As investors do more persistent homework for themselves concerning General Electric's ( GE) public disclosures, we believe they will come to appreciate the risks we see for the company in this challenging operating environment.
GM Through the Years

We do not share Warren Buffett's conviction that America in 2009 will bounce back as it has before. The period from 1945 to 1999 was unique for America. Companies like GE benefitted from strong tailwinds created by opening up of the global market-based economy and from demographic trends that added legions of prime buyers, persons aged 25 to 49, into the mix. Though many stubborn challenges obstructed progress at different moments, progress was sure, especially from 1982 to 1999 as nominal interest rates fell, asset values rose and household net worth steadily increased.

But this new millennium finds America and prime regions of economic activity awash in debt and in excess productive capacity with a very different, aging population mix. We do not believe large, established market leaders have much room to grow profits and free cash flows in their existing businesses. And we are quite certain that highly leveraged ones, whose own customers are also highly leveraged stand on dangerous ground.

Our firm has been analyzing publicly available filings concerning GE since early 2007. While we do read the many words written and uttered by management, our primary focus has been on those stubborn numerical facts that emerge from close reading of GE's detailed financial statements (see www.ge.com for more information).

After careful consideration, we realized that we could get much better understanding of GE's important value drivers by ignoring "segment level" scrutiny practiced by virtually all stock and credit analysts to instead divide GE's core continuing businesses into three main groupings: (1) GE's audited finance businesses, (2) GE's audited total business and (3) everything else.

By subtracting the published financial results of the financial holding company (GECS) from the results of consolidated GE, we arrived at fairly detailed figures for what we call "GED "-- GE's collection of diversified non-finance businesses. The virtue of this approach for us is that we were able to tie the two main driving forces of GE, line by line, to full cash flow statements and full balance sheets for the whole enterprise.

The work was laborious and really nothing more than repetitive arithmetic. But the results initially were quite confounding.

Overall, we saw a dangerous trend in climbing total debt, shrinking tangible common equity, rising revenue but falling "free cash flows" from continuing operations, all of which together have sunk companies in past times. But because we also have a strong view that trends in the wider macro world are far more challenging than most believe, we saw GE as heading for a sharp fall and expressed our written recommendation on Aug. 31, 2007, to purchase credit default swaps on GECC debt at 40 basis points, to short GE at $38.87 and to buy long-dated GE puts.

Because we also believed then that unwinding at GE would have wider negative repercussions for the market, we recommended purchasing an option on physical gold at $ 665 per share, shorting insurance companies, shorting regional banks and shorting Moody's.

Below surface level, one entry point for our conviction started with comparing GE's best known finance business (GE Capital) to companies one might deem comparable. To us, a fair potential "peer" seemed to be CIT Group ( CIT), and when we found through our work that GE Capital's key ratios actually appeared worse than CIT's, we struggled to understand how rating agencies could hold GE Capital to Triple A ratings.

We noticed on one Moody's report that GE Capital was deemed not to be a standalone Triple A but kept on its perch because of a "strong parental guarantee."

When we finally read the legal document held out by Moody's as a guarantee, we concluded that it was a best a weak "keep-well" agreement. So then we started thinking how strong the businesses outside GE Capital seemed to be from the standpoint of delivering reliable, growing "free cash flows," not simply imaginative slogans. After a lot of work, and well before the implosion in wider market value, we concluded that the "strong parental guarantee" would actually be little true comfort in a moment where savvy investors rushed to question GE and get to the heart of their dense disclosures.

In short, we felt in August 2007 and we feel now that the untapped credit capacity of GE (without government help) is not sufficient to shore up GE Capital. especially in weakening macroeconomic conditions that must hurt all of GE's businesses, perhaps more than most.

A second area of concern lies in the continuing SEC investigations that are not, at this writing, resolved. A key risk to our short recommendation was the possibility that GE would be deemed "too big to fail." Instead, because of this regulatory attention, we felt the U.S. government would have political difficulty affording significant continuing financial assistance to a company already under SEC scrutiny unless the government somehow admitted, credibly, that investigations, whose origin dates, according to GE, back to Jan. 20, 2005, were not all that significant or even in error.

Why are we so negative on GE now?

We note that GE remains highly leveraged as of 31 March 2009 and strongly suspect that the finance businesses need more conservative provisions, more equity capital and less debt.
From the GE 10-K for 2008 (Dollars in millions)
2006 2007 2008
Total Revenues
GE 128,280 145,876 163,374
Less: GECS 61,351 71,936 71,287
"GED" 66,929 73,940 92,087
Pretax, Pre-Minority Income
GE 24,150 27,528 19,782
Less: GECS 11,849 13,987 5,630
"GED" 12,301 13,541 14,152
"Pretax" Margin
GE 18.8% 18.9% 12.1%
Less: GECS 19.3% 19.4% 7.9%
"GED" 18.4% 18.3% 15.4%
Cash-Continuing Operations
GE 32,512 39,942 47,841
Less: GECS 21,579 25,015 31,204
"GED" 10,933 14,927 16,637
"CCO" Margin
GE 25.3% 27.4% 29.3%
Less: GECS 35.2% 34.8% 43.8%
"GED" 16.3% 20.2% 18.1%
Property Additions
GE (15,788) (17,803) (16,010)
Less: GECS (13,168) (15,217) (13,321)
"GED" (2,620) (2,586) (2,689)
Property Dispositions
GE 6,795 8,457 10,975
Less: GECS 6,795 8,457 10,975
"GED" - - -
All other Investing
GE (6,053) (9,910) 195
Less: GECS (5,995) (8,730) 5,979
"GED" (58) (1,180) (5,784)
"Free Cash Flow"
GE 17,466 20,686 43,001
Less: GECS 9,211 9,525 34,837
"GED" 8,255 11,161 8,164
"FCF" Margin
GE 13.6% 14.2% 26.3%
Less: GECS 15.0% 13.2% 48.9%
"GED" 12.3% 15.1% 8.9%
Source: Newport Value Partners

We also believe the company has limited capacity outside its finance business to find permanent private capital.

A Look at GE Debt
GE GECS "GED"
Short-term debt 176,320 175,676 644
Long-term debt 327,658 317,412 10,246
Total Debt (TD) 503,978 493,088 10,890
Less: Cash and equivalents 46,830 45,240 1,590
Net Debt (ND) 457,148 447,848 9,300
Total GE Shareowners' Equity 101,019 60,756 40,263
Less: Goodwill 80,640 24,437 56,203
Less: Other intangibles 14,758 3,416 11,342
Subtotal 5,621 32,903 (27,282)
Less: Preferred Shares 3,000 - 3,000
Tangible Common Equity (TCE) 2,621 32,903 (30,282)
TD/TCE (X) 192.3 15.0 (0.4)
ND/TCE (X) 174.4 13.6 (0.3)
Source: Newport Value Partners

Like others, we will wait to read GE's second quarter results with keen interest. But we believe the company is significantly undercapitalized and question how closely and effectively this company has been monitored by the board of directors and regulated inside the U.S. and in the many countries where it operates. It is never easy to raise capital, but experience in the "new financial world" that started around Sept. 15, 2008, has shown just how hard existing shareholders can get punished when overleveraged companies exhaust private sources of capital and reach out for extraordinary government support, under the harsh light of public scrutiny.

The author and his firm have no positions in General Electric stock.

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