Friday, March 6, 2009

Voodoo maths and GE

Keith Sherin – the GE CFO – put out a press release that you can find here.  I just want to extract one paragraph.

Mr. Sherin said he expects the financial services business to be profitable for the first quarter and full-year 2009, and he addressed questions on the Company’s position on cash generation and loss reserves:  "Over a three-year period here, we expect GE Capital to be profitable, even after $35 billion of losses and impairments. We're looking today for GE’s total cash flow to be around $16 billion for the year. In our stress case we could be down in the $14 billion level.  In either scenario, we can fund the company. If conditions were to deteriorate beyond what is in our stress scenario, we also have the option of scaling back originations in GE Capital to conserve cash and capital."  Emphasis added.

Now when I pull apart GE I get embedded losses above 35 billion.  The more bearish get losses at 65-70 billion.  I am not convinced about such numbers but 55 is plausible.  Losses of course are unknowable - but 35 is plausible.

$35 billion in losses and impairments over three years may have sounded nonchalant.  This is substantially higher than 2008 where losses and impairments were only 7.5 billion.  

In other words Sherin is predicting a substantial downgrade in GE profitability.

No surprise there.  The market knows it.  However Keith Sherin’s prediction (reasonable – but high estimate of profitability in my view) is wildly inconsistent with Jeffrey Immelt’s shareholder letter.  Immelt’s shareholder letter says that they are “targeting returns [in GE Capital] to be about 15%”]  

$35 billion in three years is not consistent with 15% - so somewhere the message changed.  

Has the CFO just dumped the CEO in it?  No- the stock market did that first!

Now if the losses are going to be that elevated (and they will) then GE should be taking the provisions when it deems them likely.  That is when they are incurred.  If they were to do that then the tangible capital of the whole of GE goes negative.

However if they take the extra provisions over three years then pre-tax, pre-provision earnings (ie Voodoo maths) will see them through. 

Oh, if the losses are where the bears think ($60 billion range) and if the government supports GE’s liquidity (likely in my view) then voodoo maths will still see GE through – but the time period is five years and the dividend gets cut to zero.  

The stock may not be a buy - but on those sort of numbers the CDS is unnecessarily wide - and Warren Buffett will make money on his preferred.


Anonymous said...

What does this mean for the common?

If the company survives you would seem to be rewarded in the end, no?

John Hempton said...


If we work on 20 billion in pre-tax earnings and 60 billion in shortfall...

And we assume the pre-tax earnings go back to 10 times value (which given the industrial earnings of GE is likely)....

Then we get a market cap now of 200 billion minus 60 - or 140. The stock doubles from here IN CURRENT VALUE TERMS.

BUT... and this the problem - you have to get from A to B.

I know a few companies that are worth much more than current price if they survive - and I think they will survive - but survival is not guaranteed - at least without dilution.


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