Sic Transit Gloria Funding – Takeaways From GE’s Pruning Of Finance Activities by Tom West, Columbia Management

  • Years of lean capital investment and restrained R&D spending raise concerns that the market might have a higher mix of finely tuned mature businesses and a lower mix of growth businesses.
  • We should look for several points’ worth of cushion when using today’s prices and adjusted earnings and comparing them to prior periods.
  • We still see areas to invest in innovation, and we see opportunities in large cap companies that have lost their growth luster but still have competitive advantage and trade at reasonable valuations.

Sic transit gloria mundi translates to “Thus passes the glory of the world,” but its general meaning is that worldly things are fleeting. The phrase seems a perfect fit for GE, which has long drawn fire for its use of short-term, wholesale funding. But more recently, this type of financing, coupled with its massive scale, earned GE the regulatory designation of SIFI, systematically important financial institution.  It’s nice to be important, but not when it comes to tighter regulations and higher hurdles that SIFIs face.  So GE recently announced plans to divest another 45% of GE Capital assets on top of those previously announced, stick to core financing activities, and seek de-designation as an SIFI. When all is said and done, GE Capital will shrink by about 75%.

This is no small business news story, but for a small community of GE analysts and watchers, the world shook a little. Like the passing of a 90-year old relative, the news was inexplicably surprising despite its inevitability. We knew the company was interested in a move like this, we just didn’t know how they would deal with the reduction in EPS.  As investors, we see a lot of lessons in this story, so it is worth taking a look back on how we got here.

A lost decade for GE earnings

Our analyst covering GE recently gave a revised earnings estimate and price target that sounded familiar. His price target was exactly the same as mine, except my target was from an initiation report I wrote as our firm’s analyst for GE in October 2003. My 2004 earnings estimate at the time was $1.62, 5 cents below consensus. In 2014, GE posted $1.51 in GAAP earnings, and $1.64 when adjusted for pension expense. Earnings did not stay flat in those 12 years, but they didn’t get anywhere either. The Irish have an expression when giving directions: “If I were going there, I wouldn’t start here.”

If I wanted to post solid earnings growth for a decade, I wouldn’t start with the earnings level and makeup that GE had in the early part of the last decade. GE Capital was about half of GE earnings, and the financial crisis was a big setback. And remember Thursday nights on NBC with Frazier, Friends, and Seinfeld?  The earnings power of that network and broadcast TV, in general, reached a peak that it will never see again. In 2001, GE had pension income of $2.1 billion, as opposed to the $4 billion in pension expense in 2014. That’s a 40 cent EPS headwind alone! The power generation business was starting its decline form the “power bubble” that saw peak sales of $12.5 billion in 2002, and a bottom of $3.9 billion in sales just two years later. Forget Jack Welch’s shoes. When Jeff Immelt became CEO of GE in 2000, he inherited an earnings base that was challenging to say the least. I struggle to think of a tougher hand dealt a CEO.

Was GE Capital an embarrassment of GE Industrial riches?

The industrial side of GE has generally been a market and profit margin leader in all their segments. And they walked the six-sigma walk, with some businesses posting negative working capital.  So even though they made capital goods, they didn’t use much capital to do it.  As one of my finance professors used to say: “They’ve got cash coming out the windows.” So is it any wonder that these cash flows went to drive the growth of GE Capital and acquisitions within GE Industrial?

Which of these finance businesses doesn’t belong?

Financing GE equipment where the company knows the landscape and the assets better than anyone.  Is that a core activity? Check. Other lending to those same or similar clients? Probably. Credit card services? Residential mortgage businesses? Office buildings in Stockholm? Following the company as a credit analyst 15 years ago, I was always impressed with GE Capital. They seemed to be a prudent lender; nimble, yet backed by enough fire power to swoop in and do large, profitable deals.  But two things seemed to happen:  the world became awash in capital, and it became harder and harder to find a good home for GE Capital assets that were cresting half a trillion dollars in 2003. GE has a lot of “feet in the street,” but it’s hard to find smart deals on that scale.

If it can happen to GE – Lessons for blue-chip stock investing

Play defense when playing defensive stocks: Any good bond investor will tell you that buying out-of- favor bonds is nice, but you outperform by avoiding trouble in the first place. It’s also a good rule for investing in large-cap stocks where the businesses are mature, stable, and already market share leaders.  Investors get stability in exchange for giving up exciting growth prospects.  But, as we saw with GE, mature businesses can falter, leaving the investor with neither safety nor growth- kind of like a default in a bond portfolio.

Every business has a life cycle:  Eventually, companies and industries transition from high-growth, high margin “halo” businesses to lower growth, lower margin, manufacturing-intensive businesses.  Appliances and plastics at GE are good examples of this. Rather than pass the torch, managers and companies generally double down on the technology or the brand. Sometimes it works, but it often just results in margins and PE multiples collapsing harder and at the same time. It’s not a question of whether any other large-caps are in a tough spot for earnings growth; it’s a matter of which ones and how acute the problem.

Beware of profit concentration:  Analysts used to make the offhand comment that GM made 300% of their profit on large trucks and SUVs. The figure was hard to prove, but not hard to defend. Eventually, gas prices spiked, SUV sales plummeted, and GM filed for bankruptcy.

Earnings quality: Earnings drive the stock until the stock drives the earnings. In the later stages of a stock or stock market rally, management teams are under pressure to keep posting earnings growth, and investors tend to get a little complacent. Rising stock prices tell us that the issues are priced in. It can get lonely shaking your fist at a market that keeps going up. But the issues eventually matter.

What does this mean for stocks right now?

The recovery in corporate earnings since the financial crisis has been more about cost management than demand growth. But I worry that a multi-year run of lean capital investment and restrained R&D spending  means that the market might have a bit higher mix of finely tuned mature businesses, and a lower mix of growth businesses. This does continue to put those true growth stories in the position of value due to their relative scarcity, and it might point large cap investors towards casting a net down into smaller capitalization companies.

I also worry that earnings quality is down a bit. If the dollar levels out at current exchange rates, the broad market will have to “spend” about a year’s worth of growth just to keep earnings in place. I also worry that investors have not applied an appropriate discount to overseas “trapped cash” and the low tax rates that helped create the cash.

And more broadly, we should also consider the ever-growing primacy of “pro forma” and “adjusted” earnings that add back pesky expenses like pension and stock options. I wouldn’t blame it on the companies- the adjustments are fully disclosed and posted right alongside the actual GAAP EPS. It just seems as though adjustments are more widespread and more broadly used by investors. I am no knee-jerk accounting grouch, but I would say that we should factor in a small cushion when comparing today’s earnings-based valuations to those further back in time.

All that said, we still see plenty of places to invest in innovation, and we also see opportunities in large cap companies that have lost their growth luster but still have good competitive advantage and trade at reasonable valuations. Investors should strenuously avoid the middle ground, where valuations reflect levels of forward growth that is unlikely to come to pass.

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