Tuesday, June 17, 2008

What’s a nice girl like you doing in a place like this? A comment on General Electric’s corporate lending business

Avid readers will know that I rather like General Electric at these prices.

Here I point out just how good the weak USD is to them.

And here I point out just how fantastic GE’s asset sales have been. [Just imagine if GE still owned FGIC and Genworth. The former is in deep trouble. The latter is merely problematic.]

Regular readers will also know that I subscribe to the GE press-release blog which you will find here.

But when I am long a stock I always look at what is wrong with the story. Indeed the central investment trap I fall into is to ignore the positives in my shorts and ignore the negatives in my long. This post is a conscious effort to correct that.

The negatives

With GE I point to a few negatives:

  • The acquisitions in medical have a head-scratching character – as Jeff Matthews points out here.
  • The domestic media business is not exactly great either.

Indeed my summary of GE is as follows:

  • If it is US domestic driven it is bad.
  • If it is export driven it is good
  • If it something China needs, where the competitor is European and where GE produces the most thermally efficient product it is stunningly good. There are plenty of examples in GE.
  • If it is consumer finance it is much better than it would have been had GE not taken all the asset sales (but remains problematic), and
  • If it is corporate finance driven its not bad to the best of my knowledge but I am left scratching my head about bits of it.

So I get a little puzzled at this press release.

In it GE announces that it has lent Kinney Drugs $125 million secured by some undisclosed assets to finance (of all things) the employee stock ownership plan. My interpretation – GE is financing the exit by the existing management of part of their holding – purchased by staff.

Apart from the fact that this deal reeks of late 2006 early 2007 when financing LBOs was all a rage it is very hard to see what GE brings to the table other than spondulick$.

But first let me digress into good-and-bad corporate finance businesses at GE and elsewhere.

Xerox – the model of a bad corporate finance business

Once upon a time (that is just a few years ago), Xerox used to sell lots of copiers to small businesses. Their once-grand marque had been superseded by the Japanese. There was no particular reason to buy a Xerox copier over a Fuji or a Ricoh or Cannon or any of a few brands. Xerox had inferior technology in colour and had formed a joint venture with Fuji (Fuji-Xerox) to sell that stuff. This was mostly a mix of Fuji technology and Xerox distribution.

This all appeared to work well. The copiers were sold by salesmen with maintenance contracts – which were really finance contracts. The sales kept up with something reasonable and the stock was fairly strong.

The problem was that the inferior technology and price proposition was being masked by a superior sales proposition led by credit. A large number of customers (small businesses and the like) shopped with Xerox because they did not have the finance to buy from another supplier.

To tell this as an investor you probably needed to get your fingers dirty and study the business well. It was not easy. But the problem sequence was a classic – with minor problems in the finance business leading to a tightening of credit standards and a loss of sales. The stock came crashing down. The stock went from over $60 to under $5 in a matter of months wiping out a decade of good (but in retrospect dodgy) gains.

It is iconic in investing that you need to be very scared of any manufacturing business which sells inferior technology to inferior credits backed by its lending business. Some would also say the Lucent backing of One-Tel (a bankrupt Australian mobile phone company) was the same sort of arrangement.

By contrast let’s describe some good equipment finance businesses:

  • Suppose you have the superior product (say the most fuel efficient jet engine) and
  • Suppose the product needs regular contracted maintenance or it kills people (such as a jet engine) and
  • Suppose the product is able to be repossessed and resold and because you have the best distribution system you have the best ability of anyone to repossess it. Besides because of the maintenance schedule you know exactly where it is (like a jet engine).
  • Finally suppose that the technological obsolescence cycle is say a decade or more so when you repossess it the product is worth something – so you can’t be stuck in the position that Lucent was when it repossessed One-Tel’s mobile phone system. Hey – like a jet engine.

Then you have the makings of a truly brilliant finance business. It can make good money almost regardless of the economic cycle of its customers.

Notice that this finance business does not even require the airlines to be solvent. It only requires that the product has a technological edge, can be repossessed and does not lose too much value when remarketed. Moreover the best sales network for new product is also probably a good sales system for repossessed product. GE has a competitive advantage in engines (which I think is beyond dispute), is good at selling them and hence has a competitive advantage in financing them.

There have been lots of airline insolvencies but the GE finance business skated through unscathed.

One step down from jet engines is say how the hospital business works. GE sells big kit (x-rays, cat scans, MRIs etc). The kit requires installation and training to work (which sounds like a jet engine). The buyer is a hospital or a consortium of doctors. The finance of the hospital is sometimes difficult – but even when they go bust they continue to operate. The kit requires some staff training to use and some maintenance.

If you have a superior finance/training package the hospital administration will buy your package. You will clip the coupon when the patient (or their insurance) pays several hundred dollars for a scan. Its going to be less good when the government cuts back on medicare rebates for radiology. But it is not the sort of business that can really kill you. GE can sell the equipment offshore. People still need their MRIs and the equipment can be repossessed without baseball bats.

It’s a good finance business then if what you bring to the table is adequate technology, the ability to repossess, and the customers are the sort that are not going to default. That is what the medical business looks like.

That is – to the best of my knowledge – most of GE commercial finance. [It is not the state of their consumer business. The consumer business is far more problematic but I do not believe can really hurt.]

The credit data in the last accounts suggests that the credit at GE commercial finance is not too bad. The conference call transcripts note that commercial finance delinquencies are 136bps up 10bps from a year ago – which was historic low levels. I have been comforted by that – there being no obvious problem in commercial finance.

Well there is one obvious problem in commercial finance – the real estate business.

The commercial finance business owns quite a deal of straight property as well as loans. The owned portfolio is about 40 billion worth. They used to roll a bit of this off every quarter – and lo-and-behold make a profit. Pure speculation in my view even though the annual report describes GE has having world beating expertise in commercial property.

General Electric found out last quarter that they couldn’t do the deals towards the end of the quarter – and that was – according to the conference call transcript – the most obvious problem in the finance business and the core reason for the failure of GE to meet its earnings even after guiding well a few weeks prior. Here is an extract from the conference call:

Jeff Sprague - Citigroup – Analyst and one of Wall Street’s Finest

I guess one thing we will all be struggling with here today is just trying to get comfortable that we have got a baseline we can have some confidence in and I guess just a couple of things that I am wondering is although you are looking for lower gains, if you could give us some sense of how important gains still are in your earnings outlook for the remainder of the year?

Keith Sherin - General Electric Company - Vice Chairman & CFO

I think the biggest place here is real estate, obviously, Jeff. If you look at our real estate book, about 50% of the assets are debt and about 50% are equity. The real estate business made about $2.3 billion last year as I said. They are going to be down somewhere between 15% and 20% we would anticipate and the gains are going to be 60% of their year probably. So we are selling a lot of real estate. We are lowering what we thought we would have. We had as we entered the year an embedded gain of over $3 billion in the properties that we have. We have still got a pretty robust global market, but we are counting on real estate property sales as part of that business model to continue to be a significant piece of those earnings.

At the same time, all the investment we are making is on the debt side of the business to remix it and that gives us more of a spread business going forward. So we sat down with Mike Neal and Ron Pressman and the commercial finance team. Obviously, we spend a lot of time on this and these numbers take into account the pressure they have seen and what they think will happen as we go forward on real estate. And certainly as far as visibility into the second quarter, we think we have got our hands around what the second quarter looks like and we have got pretty good confidence on that for commercial finance. So there is still more in the quarter to get done and more in a year to get done, but we think we have captured what that exposure is for us.

Now I know the transcript is a mess – but that is the final transcript as downloaded from the GE website. (Does anyone read these things?) But the earnings from the real-estate business are in my view going away. That is $2.3 billion (pre-tax) that is disappearing. That will offset – at least this year – most of the good stuff.

This business has a (profitable) past. At one stage – unbelievably in my view – well over a percent of GEs profits came from self-storage facilities. They sold most of them for big profits.

Lets get really horrible and assume the real estate business is all bad. The real estate bit has been an increasing part of GE Commercial Finance. This is the extract from the last annual report:

There are 79 billion in real estate assets – about half loans and half equity according to the conference call transcript above.

That does not look pretty. If the real-estate falls by 30% (which does not seem unreasonable) then the debt is probably worth 90c in the dollar (for a loss of $4 billion) and the equity gets cut by the full 30% (for losses of about 12 billion). These losses would be offset by the $3 billion in unrealised gains as at the end of the year – but the pre-tax losses would be about 11 billion compared to 26.5 billion of pre-tax earnings (24 billion before the real estate business) for the whole of GE.

Nothing here looks unmanageable – but the possibility that GE loses six months income – say $13-15 billion pre-tax on this business – is not zero. The bears out there (and there are plenty) would think it likely.

If you look at GE Real Estate’s website http://property.gerealestate.com/ and you click through to property for sale (which is stuff they own) there is not much. Indeed when I clicked through there were only 4 properties in the whole USA – but they were all duds. Indeed they were all multi-family residential including such gems as a 200 apartment building in Michigan. (If you read my post on Royal Bank of Scotland and Charter One you will know what I think of Michigan.)

But the encouraging part of this is the website only has 4 properties for sale in the USA. According to the last annual apartment buildings were only 14% of a 40 billion dollar portfolio. Half was office buildings and only half was in the North America.

This can hurt but it cannot kill. However if you don’t expect GE to take some (large) charges you are not thinking. Here is the disclosure from the last annual report:

REAL ESTATE: . We review our real estate investment portfolio for impairment regularly or when events or circumstances indicate that the related carrying amounts may not be recoverable. Our portfolio is diversifi ed, both geographically and by asset type. However, the global real estate market is subject to periodic cycles that can cause significant fluctuations in market values.

While the current estimated value of our Commercial Finance Real Estate investments exceeds our carrying value by about $3 billion, the same as last year, downward cycles could adversely affect our ability to realize these gains in an orderly fashion in the future and may necessitate recording impairments.

(Memo to Jeff Immelt. We are waiting. Accounting integrity here = charges.)

The other ugliness in GE Commercial Finance

There is in my opinion no real reason why GE is in direct real estate ownership. They don’t seem to bring anything to the table except a AAA credit rating. But hey – I can own real estate myself. The obvious thing to do is to sell the real estate – take the $10 billion charge and use the 30 billion freed up to buy back another $20 billion in stock. I can’t see under any reasonable circumstances – why GE is capital impaired if they take $10 billion in charges.

But the press release at the beginning of my article – that is a real head scratcher. I will repeat it all here.

GE Corporate Lending Provides $125 Million Asset-Based Credit Facility to Kinney Drugs

NORWALK, Conn.--June 3, 2008--GE Commercial Finance Corporate Lending today announced it provided a $125 million asset-based credit facility to Kinney Drugs, a NY-based drug store chain. The loan will be used to fund the company’s employee stock ownership plan. GE Capital Markets arranged the transaction. GE also provided the company with interest rate risk management.

Kinney Drugs opened its first store in Gouverneur, NY, in 1903. Since then, the company has grown into a regional drug store chain, operating more than 80 locations throughout NY and VT.

“We valued GE’s industry expertise specific to drug store retailing,” said Craig Painter, chairman and CEO for Kinney Drugs. “They worked closely with us to understand our needs and provided the capital to meet our requirements.”

"An in-depth knowledge of the retail sector means smarter capital for our clients,” said Jim Hogan, managing director of GE Corporate Lending's Retail group. “Whether the borrowing need is for working capital, acquisition finance, turnarounds or ESOPs, we are dedicated to finding the right solution to help companies execute their business plans."

Industry Specialization

To better meet the unique financing needs of customers, GE Corporate Lending has a team of Industry Leaders supported by research analysts. These industry experts help build smarter financing solutions for companies across key industries: Aerospace & Defense; Automotive; Chemicals & Plastics; Construction; Food, Beverage & Agribusiness; Financial & Business Services; Forest Products; Metals and Mining; Restructuring; Retail; Technology & Electronics; and Transportation.

About GE Corporate Lending

With $16 billion in assets, GE Commercial Finance Corporate Lending is one of North America’s largest providers of asset-based, cash flow, structured finance and other financial solutions for mid-size and large companies. From over 30 offices throughout the U.S. and Canada, GE Corporate Lending specializes in serving the unique needs of borrowers seeking $20 million to $2 billion and more for working capital, growth, acquisitions, project finance and turnarounds. Visit www.gelending.com/clnews to learn more.

Can somebody please tell me what – if anything GE brings to the table here. I cannot work out a single reason why GE has a competitive advantage in this business. Its not turbines or tubine finance. Its not the good finance business I described above.

The only saving grace. This business is small.

Finally – its time for GE investor relations to contact me

When investor relations at a company like GE go “radio silent” its usually a very bad sign. Ambac went radio silent before they blew up. (I know – I like and still respect the former CEO Robert Genader. He didn’t answer my emails though.)

I have been trying to get GE investor relations to return my email. No luck. Will somebody please contact me.

My address is attached to the “about me” section of this blog.

If you don't allow a bull to tell the story then you leave the door open for the (usually prescient) Reggie Middleton to tell the story. Reggie is far more bearish than I would be.

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The content contained in this blog represents the opinions of Mr. Hempton. Mr. Hempton may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Hempton's recommendations. The commentary in this blog in no way constitutes a solicitation of business or investment advice. In fact, it should not be relied upon in making investment decisions, ever. It is intended solely for the entertainment of the reader, and the author.  In particular this blog is not directed for investment purposes at US Persons.