GE Capital Opens the 'Black Box'


In a six-hour session for investors, the company's financial-services unit lays out a variety of earnings scenarios

General Electric (GE) said on Mar. 19 that it continues to expect its financial-services unit to be profitable in the first quarter and for all of 2009. The statement, made during a marathon meeting with investors on the state of GE Capital, was designed to reassure investors that there are no hidden problems in the unit.

Although some investors have been questioning whether GE should split off its struggling finance unit, GE's chief financial officer, Keith Sherin, who led the session with a team of at least 15 GE Capital executives, reiterated the parent company's commitment to GE Capital. He also restated that the company sees no need to raise external capital, even in the company's worst-case models.

Weathering the Storm

GE executives, who stressed the company's secured loans and originate-to-hold approach, laid out three scenarios of how loan losses, provisions, and other economic factors would play out across its various businesses, which range from consumer mortgages in Eastern Europe to commercial real estate and equipment financing. These scenarios included the outlook GE initially framed in December and two outcomes that use guidelines from the Federal Reserve, which assume unemployment of 9.3% and 10% and declines in gross domestic product of 2% and 3%, respectively.

In the best case, the company said, loan losses and impairments would reach $10.6 billion, with earnings for the unit at $5 billion. The worst "adverse" case, meanwhile, could result in $18.4 billion in losses and impairments, with earnings for the unit flat. Sherin also stated that the ratio of assets to tangible common equity, a closely watched measure of financial strength, would be at least 6%, even in the worst scenario.

While analysts attending the event appreciated the further disclosure, some weren't clear where GE stood in terms of its outlook. "We're not in the prediction business," said GE Capital's chief executive, Mike Neal. "We're just trying to be informative based on different ways you might think about the environment we're in." Executives noted that things had worsened since its initial outlook and were much closer to the mid-range scenario.

Distorted by Tax Credits

Some analysts also questioned whether the "adverse" conditions were too rosy, with Morgan Stanley (MS) analyst Scott Davis calling the worst of the three "more like a base case if macro conditions stay on the current downward path."

In addition, some investors and analysts noted that GE Capital's earnings would benefit from tax credits, eroding the quality many investors look for. "Their whole tax situation is anomalous," says Peter Sorrentino, portfolio manager for Huntington Funds. "It's not real income…. I would rather stick with real numbers, not play the tax-credit game."

The six-hour, 176-slide presentation, which for the first time delved extensively into GE's commercial real estate and consumer mortgage businesses, is a far cry from the brief earnings releases issued under CEO Jeffrey Immelt's predecessor, Jack Welch. And it dove even deeper than did a lengthy December investor meeting devoted to GE Capital.

Investors have long called the financial-services side of GE's business a black box, with far less disclosure than traditional banks. However, in the era of cheap money and housing bubbles, investors didn't worry as much about the unit's transparency. But as credit tightened amid the financial crisis, shareholders became increasingly wary of what lurks on GE's books. When it comes to financial stocks, says Scott Lawson, a portfolio manager with Westwood Holdings (WHG), "if in doubt, people sell."

A Moody's Downgrade, Too?

How much the new disclosures will quell those doubts remains to be seen. While shares rallied on the news in early trading, they closed down 1.8%, to 10.13.

The company's push for greater transparency comes at a time when management is fighting what some investors have called a credibility gap. Shortly before announcing first-quarter earnings in 2008, Immelt—who was not at the Mar. 19 session—said the quarter's results were "in the bag," only to miss the quarter's number significantly.

Then last fall, Immelt said the company would not need to raise new capital—not long before it sold $3 billion in preferred stock to Warren Buffett and announced plans to offer at least $12 billion in stock to the public. More recently, GE slashed its dividend 68% for the second half of 2009, following months of stating that it would maintain its dividend for the year.

On Mar. 12, Standard & Poor's (MHP) downgraded GE's vaunted AAA credit rating. A rating change by Moody's (MCO) may also happen before the end of April. GE shares rallied on the S&P rating change, which was not as deep as some expected. But any negative outlook from Moody's will likely leave uncertainty surrounding the stock.

Disclosure Handicap

A key test will be whether the greater disclosure the company provided on Mar. 19 brings back such investors as Mark Phelps, president and CEO of investment manager W.P. Stewart. A year ago, Phelps' funds, which concentrate in a limited number of stocks, had one of the biggest bets on GE shares at the time, according to Morningstar (MORN), at about 7% of holdings. Last summer Phelps and his team decided to sell the stake because of lower earnings quality—he was concerned about last year's first-quarter earnings miss following GE's inability to make real estate sales—and the limited clarity into GE Capital's portfolio.

"We just couldn't really get a view of how bad the exposure would be in terms of potential losses," Phelps says. "There was just no clarity."

Would he reconsider with more insight into GE Capital? "You never say never. I think there are some other issues in terms of quality we'd have to get over, as well, but it is still a good set of businesses."


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