Now GE has finally cut, but will they be able to maintain their AAA rating?

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I do not think General Electric is AAA company — far from it. Their finance arm GE Capital is at the center of the private equity and asset-backed security time bombs that have yet to explode. And this makes the cash flow expected from GE Capital vulnerable because they are under-reserving.  Translation: their financial results are artificially goosed by not reserving for likely losses.

In previous posts I have argued that GE must cut its dividend and that it will lose its AAA credit rating, despite an investment by Warren Buffett.  The following video which focuses on the under-reserving at General Electric demonstrates why.

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General Electric released its earnings report, posting net income in line with analyst estimates. And the world had a big sigh of relief. In posting its earnings, GE CEO Jeffrey Immelt defended his company’s dividend and AAA rating.

Immelt told investors Dec. 16 GE can sustain both the AAA and dividend in part because the finance business may have as much as $5 billion in profit this year and GE may generate as much as $16 billion in cash after capital expenses, mainly from the sale of industrial goods like jet engines and power turbines. That would be more than enough to pay the $13.4 billion dividend.

GE today repeated the December forecast for non-finance divisions collectively to have a profit gain in 2009 of no more than 5 percent, while GE Capital will decline to about $5 billion in profit. GE announced last month it would cease making per- share profit forecasts this year.

‘Got the Cash’

“I hate the fact that there’s so much speculation around the dividend and AAA,” Immelt said in an interview today on the company-owned CNBC television network. “I wish my words could end the speculation. The facts of what we’ve done here, I think, should let investors know that we’ve got the cash, and we’ve got the operating model that’s going to secure the dividend in this environment.”

GE had $48 billion of cash on its balance sheet at the end of 2008, compared with $16 billion at the end of the third quarter, the company said. General Electric used $5.5 billion of its $15 billion stock sale in October to bolster GE Capital’s balance sheet, reducing the leverage ratio to 7-to-1.

But, wait a minute; General Electric pays $1.24 a year on its dividend. In pre-market trading GE is down at $12.71. That comes out to a dividend of nearly 10%. Why is this company paying 10% in dividends when 10-year treasury bonds yield 3.5%? Yes, I understand that GE doesn’t want to send a negative signal to the market, but does Jeffrey Immelt really think the stock of GE will rise, say, 100% to cut that dividend to 5%?

I see this as the height of folly. The company is in trouble, trading at its lowest level in 13 years. Immelt is in denial and needs to recognize that paying out this much money in dividends is not appropriate for GE’s new earnings outlook. Paying out $13.4 billion a year in dividends is not sustainable.  In fact, as a commentator in the video below notes, GE’s AAA rating and the dividend are mutually exclusive.  The company will lose its rating if it continues to pay out almost 10%, as much on its common stock as it gives Warren Buffett for his preferreds.

Source
GE Profit Drops 43% as Immelt Backs Dividend, AAA – Bloomberg.com

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• Buffett to invest in General Electric
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An issue that has received scant acknowledgment in the media is the likely hole in pension funds books resulting from the recent rout in shares. Pension funds must invest the money they receive today in order to provide pensioners funds tomorrow. The problem is that pension funds have been overestimating the likely returns for years and now that we have hit a rough patch in the economy this poor actuarial accounting is about to catch up with them.

Volatile markets have saddled U.S. companies with a $409 billion deficit on pension plans, reversing a $60 billion surplus a year earlier, and will cut into earnings in 2009, consulting firm Mercer said.

As of December 31, pension plans among members of the Standard & Poor’s 1500 had $1.21 trillion of assets and $1.62 trillion of liabilities, Mercer said in a report released on Wednesday. At the end of 2007, pension plan assets totaled $1.66 trillion and liabilities totaled about $1.6 trillion, Mercer said.

The S&P 1500 is a broad portfolio representing large-cap, mid-cap and small-cap segments of the U.S. equity markets.

The shortfall suggests that more companies will have to pump cash into their pension plans to ensure they can meet their commitments to retirees.

Mercer estimated pension expenses will increase to about $70 billion this year from $10 billion in 2008, reducing overall profitability by about 8 percent.

“The decline in funded status will be capitalized and reflected in corporate balance sheets for many companies,” Adrian Hartshorn, a member of Mercer’s financial strategy group, said in a statement.

He said this will reduce balance sheet strength and could affect companies’ ability to make capital expenses, meet loan covenants and preserve their credit ratings.

Edward here. The fact is that pension funds have systematically used excessive projected returns in order to avoid paying into the fund. In fact, pension funds have been a large source of earnings for most companies.

How does this work? Say, you are an international company called American-British Consolidated. Each year, your workers contribute $100 million to their pension plan. In return, they are guaranteed a certain payout for life. This is called a defined benefit plan — something companies now loathe because they are on the hook for payouts. So they increasingly switch to defined benefit plans, or so called 401K’s.

Now, under Generally Accepted Accounting Principles (GAAP), one must calculate an estimated payout schedule and its net present value after subtracting the employees’ $100 million contributions All of this is complicated and requires assumptions on average life expectancy as well as average pension fund return.

Here’s the thing: if you run the numbers and they come too far short, you MUST cough up more money right now, today, to make the fund whole. What to do? Make optimistic assumptions, silly. If the fund returns 10%, that makes a future payout much less onerous than if the fund returns 7.5%. Everyone knows that.

Only during bear markets do these tactics come to light. Witness the following proposal from 2001 during the last bear market, still accessible on General Electric’s site (I have bolded the most important bits):

The Communications Workers of America Pension Fund, 501 Third Street, N.W., Washington, D.C. 20001-2797 has notified GE that it intends to submit the following proposal at this year’s meeting:

“Resolved that the stockholders request that the Board of Directors take the steps necessary to adopt a policy that future executive compensation will be determined without regard to any pension fund income, so that the compensation of senior executives will be more closely linked to their performance in managing the business.

“Supporting Statement: Accounting rules require the Company to include gains on the assets in its pension fund in calculations of income, even though no money is transferred to the Company. This distorts the principle of pay for performance because the Company relies on net earnings and earnings growth in determining the compensation of executives.

“GE reported $1.7 billion in pension income in 2000. According to a recent study by Credit Suisse First Boston (CSFB), this is the second largest amount reported of all companies in the S&P 500. This pension income amounted to 9.4% of GE’s reported pre-tax income for the year.

“While the impact of earnings calculations may vary, GE’s top five executives were given cash bonus awards of $23.7 million in 2000. They were given restricted stock units worth $89 million. They were given long-term incentive awards contingent on financial performance over a three year period, and were paid $58 million pursuant to the contingent awards that were made in 1997. In addition, they were given options with a potentially realizable value of $422 million if future earnings permit GE stock to appreciate at an annual rate of 10 percent over the option term.

“Executive compensation ought to be based on performance. It should not be distorted by ‘pension income,’ because that item of income does not represent money the Company has actually received, and does not reflect the operational performance of either the Company or its executives.

“As Business Week reported on August 13, 2001, when companies ‘are inflating earnings with income from pension plan assets, … their [reported] results look better than what’s really happening with their business.’ For this reason, a Morgan Stanley Dean Witter report declares that ‘net gains from pension assets do not deserve the same valuation … as true operating income.’

“A related concern, according to The Wall Street Journal (June 25, 2001), is the possibility ‘that companies can use pension accounting to manage their earnings by changing assumptions to boost the amount of pension income that can be factored into operating income.’ According to Business Week, ‘Companies can not only play around with the expected rate of return on assets but also with the value of the assets themselves.’ They can also boost pension income at the expense of employees and retirees by reducing anticipated benefits or withholding improved benefits.

“CSFB identifies several companies that ‘increased their expected rates of return on plan assets in 2000 even though their actual returns on plan assets declined.’ While such increases may well be an appropriate exercise of discretion, the proposed policy would reduce any temptation that senior executives may have to ‘use pension accounting to manage earnings’ for the purpose of increasing their own compensation.”

Your Board of Directors recommends a vote AGAINST this proposal.
This proposal requests the Board to make future executive compensation determinations without regard to reported pension fund income, purportedly to link more closely executive compensation to business performance. As discussed in the Compensation Committee Report at pages 16-19 (Compensation Committee Report), executive compensation is already closely linked to the performance of internal business units and to the appreciation of GE stock – which in turn is linked to GE’s overall business performance. Because your Board believes that senior executive compensation is already closely linked to business performance, and therefore to the long-term interests of the share owners, your Board believes this proposal is unnecessary and recommends a vote against the proposal.

Now, here’s the great thing about pension accounting. If your numbers are good enough, not only do you avoid a shortfall, you actually receive a windfall profit. Just as shortfalls must be topped up, windfalls must also be recorded and fall proportionately to the bottom line of the company. You will notice, however, these are phantom profits because they are non-cash items.

At issue with GE in 2001 was the fact that General Electric received nearly 10% of its earnings from fictitious, non-cash based net contributions from its pension fund. These profits boosted the bottom line and helped executives make a lot of money as their pay was directly and indirectly linked to the company’s profit. Some shareholders did not like this, so they issued the proposal quoted above. Of course, as you saw, the Board of Directors recommended shareholders vote against the proposal. So, the proposal failed.

Now that we have seen another massive drop in market returns, proposals like this are likely to resurface — especially given the $400 billion shortfall that Mercer foresees. We shall see if these new proposals have any more success than the ones in 2001 and 2002.

Source
U.S. companies face $409 billion pension deficit: study – Reuters
Share Owner Proposal No. 6 – GE Annual Report 2001

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A reader has recently corrected a claim I made on a recent blog entry regarding GE Capital. I would like to bring this error to your attention and make a few comments.

In my post, “Should GE be a AAA company,” I said “GE Capital isn’t even a bank. The FDIC only deals with depositary institutions. Are you kidding me? The U.S. Government is obviously willing to do anything to bail out financial institutions at this point. Forget rules and regulations. Just give them the money.”

The first statement is actually not correct. Looking at the FDIC Institution Directory yields two results:

Now, I certainly have to eat humble pie for not getting my facts straight here. My basic question as to GE’s worthiness of a AAA rating remains. However, this information does cast the TARP in a new light that I think bears remembering. Genworth Financial is one of man financial institutions that is trying to buy a small depositary institution in order to be eligible for funds under the TARP.

Reuters reported the following yesterday:

Life and mortgage insurer Genworth Financial Inc said on Sunday it applied for capital under a U.S. government program, after reaching a deal to buy a bank, bringing it under federal regulation.

With the move, Genworth joins Hartford Financial Services Group Inc, a large property and life insurer, in seeking to change its regulatory status in order to participate in the Treasury Department’s $700 billion Troubled Asset Relief Program (TARP).

Genworth declined to say what amount of capital it was seeking.

Hartford on Friday announced it was buying a small savings and loan, bringing it in line with a federal financial regulation requirement, and thereby making it eligible to raise up to $3.4 billion from TARP.

Genworth said on Sunday it had reached an agreement in principle to buy InterBank fsb of Maple Grove, Minnesota and filed a savings and loan holding company application with the Office of Thrift Supervision, a federal regulator.

InterBank is a community bank with about $1 billion in assets, according to its website.

Richmond, Virginia-based Genworth has been badly battered by investment losses, and concerns that it would run short of capital. Its shares have fallen from $25.45 at the beginning of the year, to as low as $1 last week.

So, here is Genworth buying an outfit for $10 million in order to get in line for bailout funds of as much as $3.4 billion. This seems like a fair trade to me and I would do the same if I were in Genworth’s position. Ostensibly, this would put GMAC in line for cash as GMAC Bank is also a depositary institution (GMAC is only partially owned by General Motors).

The question remains whether this is a good and systematic approach to providing relief to the financial services sector. From my perspective, it is not — and the Genworth-Hartford end-run shows why.

Source
FDIC Institution Directory – FDIC website

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The latest news in bailouts involves GE Capital. Apparently, the company has gone begging to the FDIC for a bailout. In fact, the FDIC has offered to back $139 billion in GE Capital debt. I have serious reservations about this move by Sheila Bair. In fact, I am outraged.

First, as I understand it, the FDIC has much less than $139 billion in capital on hand. And they have hundreds of banks to watch that are busy going broke. So, how is it possible that they can guarantee GE Capital’s debt? The answer is they cannot. American taxpayers are what is behind this move just as they were with Fannie and Freddie – not that we will get stuck with the bill as GE is not going under, but the FDIC certainly can’t pay. (UPDATE: a reader who writes the blog “Skeptical CPA” is not so sanguine about GE and passed on a post he wrote doubting GE Capital’s funding model.)

Second, how is GE a AAA company? As I understood it, AAA means bullet-proof, high quality, or excellent. If a company needs the support of the government, it is not possible to be considered AAA. Do you see Berkshire Hathaway going cap in hand to the government for a bailout? As a matter of fact, Berkshire assisted GE Capital by buying preferred shares at a steep price, which allowed the company to raise billions in capital. The difference is striking.

Third, GE Capital isn’t even a bank.** The FDIC only deals with depositary institutions. Are you kidding me? The U.S. Government is obviously willing to do anything to bail out financial institutions at this point. Forget rules and regulations. Just give them the money.

G.E.’s AAA rating is a sham.

General Electric said Wednesday that the federal government had agreed to insure as much as $139 billion in debt for its lending subsidiary, GE Capital. This is the second time in a month that G.E. has turned to a federal program aimed at helping companies during the global credit crisis.

GE Capital is not a bank, but granting it access to a new program from the Federal Deposit Insurance Corporation may reassure investors and help the lender compete with banks that already have government-protected debt, a G.E. spokesman, Russell Wilkerson, told Bloomberg News.

“Inclusion in this program will allow us to source our debt competitively with other participating financial institutions,” Mr. Wilkerson said.

The F.D.I.C. program covers about $139 billion of G.E.’s debt, or 125 percent of total senior unsecured debt outstanding as of Sept. 30 and maturing by June 30.

Source
F.D.I.C. to Back $139 Billion in GE Capital Debt – Deal Book

**UPDATE 17 Nov 2008 – 1700 ET: GE Capital actually is a bank. I have a new post addressing this correction here.

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Warren Buffett is all over the place these days. He was busy investing at Constellation Energy and Goldman Sachs. Now, he’s investing at GE — $3 billion at that. Judging by his market timing approach, it does seem assets are cheap enough that he’s willing to step in and take a risk.

But one must note, as is his usual wont, he is not taking equity. He is getting preferential treatment — literally. As with previous investments in troubled institutions like USAir, Salomon Brothers and, most recently, Goldman Sachs, Warren Buffett is getting preferred shares.

Nice deals, but usually not ones available to the likes of you and me. It’s a good thing GE is selling shares to the general public. I reckon, with Buffett in for $3 billion, these shares will sell like hot cakes.

General Electric Co said on Wednesday it would sell $3 billion of preferred shares to Warren Buffett’s Berkshire Hathaway Inc, with another $12 billion in common shares going to the public.

The news erased some of the decline in GE shares earlier in the day and left the stock down 3 percent at $24.74 in afternoon trading on the New York Stock Exchange. The stock fell as low as $23.09 on Wednesday.

The company expects to price the offering before the market opens on Thursday.

“GE is the symbol of American business to the world,” Buffett said in a statement. “I am confident that GE will continue to be successful in the years to come.”

The U.S. conglomerate’s current market capitalization stands at about $235 billion. Its stock has lost about 34 percent of its value so far this year as investors worried about deteriorating profits at its GE Capital finance arm.

“The economic environment remains volatile,” said GE chairman and chief executive Jeff Immelt in a statement. “However, the company’s performance remains on track with the earnings guidance we provided last week for 2008.”

GE last week warned that its 2008 profit could fall as much as 12 percent.

Sources
GE says Buffett to invest $3 billion in shares – Reuters
GE Announces Common Stock Offering – CNBC

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