Saturday, March 7, 2009

Bill Gross Made the Call on GE in 2002

GE's equity value has fallen by about 80% over the past three years, compared to a 40% decline in the Dow Jones Industrial Average. The legendary Jack Welch talked about GE growing its earnings at 15% per year for "several decades." Logically, this makes no sense, as this would mean that earnings would double every five years. And this would occur in a company largely made up of businesses with long selling cycles (nuclear reactors, jet engines) and that are cyclical in nature (appliances, and media susceptible to advertising and new program cycles). So, the dealer had to have one or two cards up his sleeve.

Indeed, acquisitions and GE Capital were the two cards. As an equity analyst for many years, I loved to read the work of credit market analysts and portfolio managers, who did rigorous modeling work and who had much more conservative and skeptical natures than did the lap dog cheerleaders in the equity market. Bill Gross, who is must reading for me wrote in 2002, "It (GE) grows earnings not so much by the brilliance of management or the diversity of their operations, as Welch and Immelt claim, but through the acquisition of companies....using high-powered, high multiple GE stock or cheap near-Treasury Bill yielding commercial paper." (March 21,2002 on So, as Thorton O'Glove would have said, their "quality of earnings" was very low.

At the heart of things, the business model was flawed. The portfolio of businesses was simply not geared for generating earnings growth of 15% per year. So, earnings were managed consistently in an era of liquidity and declining interest rates. GE disclosures were so uninformative, and yet no analysts ever complained or even asked uncomfortable questions. The financial press wrote about Six Sigma, the GE culture, and about the Croton management training academy that taught the "Tao of GE."

Unfortunately, it's hard to believe that management didn't realize earlier than today that the dealer would have to fold soon. Now all credibility has been lost, and once it's lost, it's very difficult for the same team to get it back. Wall Street loves to pile on, and that's what is happening now.

Some lessons to be learned:
1. Beware of the cult of personality and the association of a company's value with the personal charisma of any one individual, even Jack Welch;
2. No large-scale, public business can predictably grow at 15% per year "for decades," without caveats galore.
3. Earnings quality matters.
4. Disclosure and communications are not for flaks and PR agencies. Informative disclosure is the lifeblood of the marketplace and professional investors. As Bill Gross wrote in 2002, "I would like GE and other companies to be more candid in terms of disclosing exactly how they do these things....If they grow earnings, then let's hear about it and find out how much comes from these types of maneuvers (acquisitions, low cost financing, and other financial engineering)"
5. Credibility, as much as a credit rating, has to be maintained. A market decline can be retraced, but a loss of credibility is very difficult to recover. Again, Bill Gross noted, "The fact is that GE is a conglomerate financed by a money machine...but unlike Berkshire Hathaway, its foundation is vulnerable because its survival depends upon the confidence of outside investors..."
6. The GE brand in the consumer market place was heavily associated with the appliance business, which GE has long said it wanted to exit. With the current lack of buyers at the right price, this has significantly damaged the consumer brand equity. Increasingly, this puts the future with the industrial businesses. Green is nice, but it's a long way out before it can move the needle on this behemoth. Cyclicality and economic sensitivity will increase in the future, as earnings flexibility disppears under the weight of the GE Capital anchor.
7. Six Sigma godan black belts don't help make the quarter. Nice for magazine articles but little else.

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