Monday, May 4, 2015

GE Leads the Way Out of the Dark

By Roy C. Smith

from Financial News, May 4, 2014

GE is right to sell GE Capital – strategies change over time -- but it got credit from the market for making the change only when it said it would dump the whole thing, not just a few pieces. There is a lesson in this for the big banks.

In the 1960s and 1970s the most exciting companies in the US and the UK were multi-business “conglomerates”. These were publicly traded predecessors of today’s private equity funds. They were typically run by an aggressive, charismatic guy who promised to grow returns on investment (and stock prices) and based his conglomerate’s investment appeal on three attractions: making lots of acquisitions, ramping up leverage, and minimizing taxes.

These companies outperformed markets for years until they collapsed under the burden of managing the hundreds of dissimilar companies they had bought. In the 1980s most of them were broken up.

But one new chief executive in the early 1980s saw something valuable in the example of the conglomerates.  When 46-year-old Jack Welch took the helm at GE in 1981, his burning ambition was to turn the tired, legacy-driven electrical engineering firm into a powerful, change-driven growth engine. Welch’s contribution to the industrial conglomerate he inherited was to get out of weak businesses, acquire high-growth businesses, and do it all with leverage.

GE’s sleepy “captive finance company”, GE Capital, would have to help.
Under Welch, GE Capital grew to become a formidable financial conglomerate in its own right, operating in nine business areas with little or no connection to GE.
Because it was consolidated into GE’s business, GE Capital’s debt was rated AAA, which gave it the lowest cost of capital of any financial firm. Through its various tax shelters, GE Capital enabled GE to reduce its tax rate to levels well below 20%.
By the end of the 1990s GE was in 21 businesses. Its stock was trading at nearly 60 times earnings and valued at $500 billion, more than any other company in the world, with a return on equity of 25%. 

(Welch was aided by the world’s greatest bull market. From its low in the summer of 1982 until the close of 1999, the Dow Jones index rose fourteen-fold - a compounded growth rate of 16% for 17 years).

Welch retired as a business superhero in 2001, just in time to miss the bursting of the dotcom bubble that year, the 9-11 attacks that September and the financial crisis of 2008, stressful years for GE Capital as for all financial institutions. 

But even Jack could not have prevented the leverage working the opposite direction. By 2009, after struggling through two recessions, a major liquidity crisis, credit and trading losses, volatility spikes and market changes, GE Capital had become much more of a liability than an asset. GE’s exposure to GE Capital has dragged down its operating metrics and its stock price. Today GE’s market capitalisation is $286 billion, down 43% from 2000 high, and its ROE is half what it was then. 

Since the financial crisis, GE has lost its AAA rating and the US Financial Stability Oversight Council has designated its financial unit as a “systemically important financial instruction”, causing it to be as strictly regulated as a bank by the Federal Reserve.

Worse, from its investors’ point of view, is GE’s stock performance, which over the last 10 years has lagged well behind its peers and the market.  In that time Honeywell’s stock increased 180% and the S&P index 90%, while GE’s stock dropped 10%.
The strategic factors that caused Welch to load assets into GE Capital have now completely changed. The only question is why it took so long for GE to see the light.
Efforts at a gradual adjustment of the size and influence of GEC on GE by spinning off Synchrony, its consumer financing business (which it did last year), and selling a substantial portion of its real estate holdings (which it did last month), made little difference to GE’s stock price. 
The message did not get through to investors until the announcement by chief executive Jeff Immelt on April 10 that GE would get rid of all but a few necessary customer-financing parts of GE Capital. The GE Capital share price gained 10%, which it has held on to since. Clearly the market likes the idea of getting out of the dangerous finance businesses that for most of the last 15 years have contributed more problems than value. 

This continues to be true at several large global banks with large problem-causing investment banking and other units that they have nonetheless been reluctant to part with. Their reluctance comes from a fear of losing prestige, of facing the humiliation of shrinking and because shedding these units in current markets is difficult to do (but doable).

So far, the banks have done things piecemeal instead, cutting back here and there, instead of separating the business into independent companies – changes the market has not credited with being “strategic” enough to boost prices.

We are told that several banks are taking a fresh look at separating out their investment banking units, but don’t hold your breath.  Deutsche Bank just announced it would stay the course rather than combine, then shed, its retailing businesses, a strategic change favoured by many observers. Barclays has promised a report this spring, but so far has stuck to trimming rather than cutting. UBS is under pressure from an activist investor to get rid of the investment bank, but hasn’t responded. Credit Suisse has recruited a new chief executive, Tidjane Thiam, to apply an independent view to its business model, but we will have to wait to see.

The GE news should be instructive to these banks. Of the four banks mentioned, and the two US laggards (Citigroup and Bank of America) there ought to be one or two to test the water. 

It may be the only thing left they can do to improve their miserable market valuations.

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