GE ready to play defense
Conglomerate's shares rally after it vows to keep dividend and credit rating - despite questions about GE Capital's loans.
NEW YORK (Fortune) -- General Electric shares rallied more than 13% Tuesday after executives vowed to preserve the company's dividend and work to maintain its triple-A credit rating - a designation that keeps GE's borrowing costs lower than almost any company in corporate America and gives it a significant advantage over its competition.
The pronouncements cheered investors who have been worried about the company's finance unit, GE Capital. But it is still difficult to understand how GE (GE, Fortune 500) can realistically keep either promise.
Tuesday's presentation focused only on GE Capital, in an effort to assuage fears about how well or poorly the finance company will weather the current credit storm. But a few questions still remain.
One great relief was news that GE will preserve its $1.24-a-share annual dividend through 2009. But that cash might better be used elsewhere, given the headwinds that GE Capital will face in the coming quarters.
Using GE's estimates for 2008, the company will generate $15.4 billion in cash from GE and GE Capital, not including asset sales, which are non-recurring items. It will use $12.4 billion to pay its dividend.
In 2009, the company will generate about $14 billion and pay out $13.4 billion in the form of a dividend. That leaves only a slim cash cushion to offset the headwinds faced by GE Capital alone over the next few quarters.
The cash on hand could be scant to cover losses in the company's wide array of financial services business.
As of the third quarter, GE Capital has issued $120 billion in loans to U.S. companies, municipalities and infrastructure projects. It has issued $245 billion in credit to U.S. consumers, mostly in the form of private label credit cards at retailers such as Wal-Mart (WMT, Fortune 500), Lowe's (LOW, Fortune 500), and the Gap (GPS, Fortune 500). It bought $13 billion of troubled assets from Merrill Lynch and $13 billion in middle market commercial financing from Citibank. And the loans that it underwrites, it generally holds on its books.
GE has been overly optimistic when it comes to loss reserves. For example, losses on the U.S. consumer portfolio have jumped 4.13 percentage points since 2004 to 8.15%, according to the presentation, but reserve coverage increased by only 1.04 percentage points over the same time period to 4.07%.
GE says it will set aside about 6% in reserve coverage for 2009, but the loss picture will sure deteriorate from 8.15% as consumers grapple with higher unemployment rates and falling home prices.
It is hard to tell how much the company should set aside. According to GE Capital's third-quarter earnings report, 38% of the unit's assets are considered "level 3", which means there is no way to value the asset save mark-to-model accounting. Nearly all of GE Capital's liabilities are considered "level 2" assets, meaning that they are relatively illiquid assets whose value is determined by using quoted prices for similar instruments in active markets and models.
As for the triple-A rating, no other banks or finance companies are so richly blessed, and GE Capital certainly doesn't seem to have the strength to warrant such an honor.
Most glaringly, GE had to take part in two government assistance programs to shore up faith among potential debt buyers in the long-term bond and commercial paper markets - the FDIC is backstopping its bonds and the Federal Reserve is backstopping its commercial paper obligations.
In press releases announcing that the company would tap these programs, GE said it was participating largely to show support for the government as it moved to restore faith in the credit markets.
During Tuesday's conference call, the tone had shifted. Treasurer Kathy Cassidy and GE Capital CEO Mike Neal said repeatedly that these programs "leveled the playing field" for GE Capital. One can only assume that they meant against unfair credit markets rather than against other banks, since no financial services competitor is in as privileged position as GE.
Either way, the shift in tone shows that GE has become more willing to acknowledge that the debt markets no longer treat GE or GE Capital as triple-A rated borrowers.
The ratings agencies have blithely ignored these signs that GE isn't truly strong enough to deserve the same credit designation as cash generating machines such as Exxon Mobil (XOM, Fortune 500) and the U.S. government. And neither the ratings agencies nor GE are willing to talk specifics on how that rating is calculated.
GE will say that it is managing to that rating by drastically deleveraging its balance sheet, hopefully moving to 6-to-1 leverage from 8-to-1 currently, and changing its debt sources in order to keep Moody's and S&P happy.
"Our plans reflect a very difficult environment," GE chief financial officer Keith Sherin said. "For 2009, we are targeting to reduce leverage to 6-to-1, lower outstanding commercial paper balance to $50 billion, and reduce our overall funding needs."
But the market wants to know about the quality of the assets on GE Capital's books, and that is a question that is still open to debate. Remember if you will that Washington Mutual hit a wall due to bad assets, not high leverage.
GE successfully used Tuesday's call as an opportunity to lower expectations, a move that Citigroup analyst Jeff Sprague had noted the company needed to take in order to calm markets. GE lowered guidance just enough so as to prepare markets for a grim 2008 and 2009, but not so much to scare them from the stock.
And yet, if bearish voices (and prescient critics) such as Nouriel Roubini and Lazard CEO Bruce Wasserstein are to be believed, repayment problems will surely continue to roll through the commercial real estate, consumer credit card and overseas markets at much higher levels than GE anticipates.
Moreover, sales of the industrial products for which GE is so well-known could shrink as businesses slash spending and conserve cash, and that could erode the businesses that GE hopes will offset the downsizing of GE Capital.
Let's just hope that when GE gives its outlook for the rest of the company on Dec. 16 that management still looks realistically hopeful rather than foolishly rosy. 
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