What Happened at GE?
GE’s stock peaked at $60 in 2000 and currently trades at 10%-15% of that value 20 years later.
This is a study in the “tell me where I’m going to die so I never go there” category.
As an investor who has pretty strictly tried to focus on “quality” companies, I wanted to learn how a business with seemingly pretty competitively advantaged industrial businesses managed to destroy so much shareholder wealth, so that I can avoid situations like it in the future.
The quick elevator pitch on GE was/is that its products are oligopolistic, require extremely precise engineering and create long term lock-in that GE will monetize through profitable long term maintenance and service contracts.
Like….how do you fuck this up? :
55% market share in aircraft engines (40% is through CFM JV with Safran) - #1
#1 in ultrasound machines, #1 in MRI, #2 in CT scan
~70% market share in diesel locomotives - #1
45% market share in worldwide gas turbine market - #1
NBC - one of 3 national broadcast networks - divested 2009-2013
So what went wrong?
The last 30 years of GE can be broken down into two periods - the Welch and Immelt era - both of which, I think, were net negative for the company long term even though a lot of the decline in stock price happened soon after Immelt stepped down as CEO.
Welch Era:
With Welch as CEO, GE stock compounded at 20% per annum for ~20 years.
He took over a sleepy but pretty solid industrial company in 1980 at a 10x PE and stepped down as CEO when GE had a 35x-40X PE 20 years later.
GE’s profits grew at ~11% CAGR for those 20 years. GE Capital profits grew at ~19% a year under Welch as GEC went from about 7% of profits to about 35%-40%. The rest of the company grew ~9% a year, which is good, not superlative. In fact, excluding the first 5 years of his tenure and looking only at the last 15, GE Capital grew at 22% per year and the rest of GE grew at only 6% a year.
From very early on, his whole message was that he would find a way to deliver steady, smooth earnings increases of >10% to his shareholders, and he was successful. EPS compounded at ~11% per annum over his tenure. There was extreme pressure put on everyone down the chain of command to ‘make your numbers’. Advancement and success in GE became all about if you could deliver to Welch the earnings number that he wanted.
The main driver of delivering the number to Welch was GE Capital.
The game at GE Capital was the same as what prompted Buffett to sell his Freddie/Fannie shares in 2000. GE was one of the few, safe blue chip companies with a AAA rating. Welch used this rating to basically borrow 100s of billions of dollars and buy higher yielding assets with the money.
So GE bought everything from real estate, private label department store credit card programs and payday lenders in foreign countries. As long as the yield on the financial assets purchased was 400 to 500 bps higher than the cost of the money that GE could raise to back those purchases, GEC was an easy way to grow overall profits. That ‘borrow at AAA rates to buy BB assets’ trade was something that seems to have been a popular profit juicer in the 1990s and 2000s up until the GFC, when the AAA rating essentially disappeared.
GEC was mostly just a vehicle for endless growth and reporting higher EPS. Quite explicitly so sometimes. For a while, GEC would sell some of its equipment from its leasing units to an unconsolidated SPE at a gain and record the profit in order to hit EPS targets. It was mostly just money going from the left pocket to the right pocket. Under today’s accounting rules such SPEs would be consolidated.
I think any analyst can understand the argument that you want to have an efficient capital structure. If a business can (1) handle a bit of debt and (2) it is available at very low rates and (3) there are places to put the money at much higher rates, it’s pretty logical to follow that strategy.
What was just plain dumb was how greedy GE mgmt became. More than 50% of the borrowings at GEC were from commercial paper. Borrowing that short to lend medium/long is just a dumb idea.
In 2000, the last full year Welch was CEO, GE had 290B of GEC assets (excluding insurance) financed by 210B of debt. Ok, 80B of capital in a financing business with 290B of assets isn’t the craziest thing in the world. Except 125B of the total debt was from short term commercial paper borrowings that you literally have to refinance every few weeks!
This is pretty much the sole reason that GE almost went bust in late 2008. GEC debt had grown to 500B by this point, of which 200B was short term debt! They were purportedly weeks away from not being able to make payroll and would’ve gone under if not for an effort by Hank Paulson and Immelt to get Sheila Bair of the FDIC to agree to insure GE’s commercial paper at the time, including new issuances.
As a part of the Malone / Liberty fan club, I abhor inefficient capital structures. But what is impressive about Malone is that the structuring is pretty conservative. He issues relatively long term, fixed rate debt. You will not see Charter financing buybacks through commercial paper or 2 year bonds. GEC’s rapid expansion already exposed the company to all kinds of risk but one that could’ve easily been avoided and led to the company coming within a hair’s breadth of failure was the huge reliance on short term debt.
This is an easy thing to call out in hindsight but in the moment, it’s not necessarily easy to convince people that such structures are risky or vulnerable. Because it only matters when the tide goes out and you sound chicken little-ish warning about this 95% of the time.
A contemporary example is a large asset manager in Canada. To me, they basically run the same business model as GEC. I don’t think its management team has ever seen a loan or borrowing available to them that they didn’t take. Let’s borrow as much as we can and just keep buying slightly higher yielding assets and we will always keep making more money. What’s really interesting though is that this company buys long dated infrastructure assets but 60% of their property level debts mature in 5 years or less. They have something like 12B-20B of maturities every year for the next 5 years! No commercial paper financing by any means but still pretty aggressive. To have higher leverage ratios than other people in the same industry and also have the debt be mostly shorter term is a very interesting combination.
It reveals an over aggressive management team. If you cannot finance your assets profitably by semi- matching debt maturities to the assets’ or if you cannot make the math on an asset purchase work with 20 yr bonds instead of 5 yr bonds...well I think that company is run too close to the edge.
Back to GE.
The other big risk at GEC that was underwritten during Welch’s tenure was the acquisition of a reinsurance company (Employer’s Reassurance) that reinsured the long term care policies of many life insurers and also wrote some policies directly. At one point, GE held 4% of all American long term care policies. These policies ended up being the classic case that gets insurers and reinsurers in trouble. A source of premiums for a very far off into the future liability that is a new growth area where insurers compete aggressively for business but where, when payouts begin, each variable sees adverse developments (cost of care, life expectancies etc.).
Imagine running a company on a strict make the numbers culture and allocating capital to reinsurance! That is a leadership team that does not understand (or doesn’t care to understand) the true nature of the business that they’re allocating capital to. In the short term, reinsurance is a ‘report whatever profit you want’ endeavor.
This block of reinsurance business already started blowing up soon after Welch left. Immelt had to increase reserves and spin off most of the insurance liabilities into Genworth Financial. They couldn’t get rid of all of it however. Genworth Newco signed reinsurance deals for the long term care policies with GE because Genworth’s management did not want to take those liabilities with them.
So, I would say overall, Welch did indeed do some decent things at GE. He divested some of the commoditizing businesses, grew GE aviation massively under his tenure (partly luck, growth of Asia). NBC was a pretty good investment (though I don’t know how much credit he should get if GE was forced to sell it to Comcast in 2009 because of problems in GE Capital). But the unhealthy obsession with reported EPS targets ultimately destroyed the company. That obsession with smoothly 10%+ growing EPS led ultimately to the extreme risk taking inside GEC which destroyed so much value.
The other thing I do want to touch on was that under Welch, GE developed a culture of playing with the accounting regularly in order to hit targets. It is pretty striking to read reports and articles on GE from 1995-2000 where analysts kvetch about GE’s ‘earnings management’ or writers at business publications ask skeptical questions about the smoothness of GE's EPS growth. None of this was a secret.
Some accounting games:
Increasing return assumptions on the pension plan
Amortizing the gains on an overfunded pension plan surplus into earnings in periods where the rest of the business was weak, in order to hit the double digit EPS growth target
Playing tax games like IBM on a quarterly basis (i.e. on a weak quarter, report a much lower tax rate in order to hit EPS target)
Smoothing: When results were very strong, GE would book non-recurring restructuring charges to keep EPS growth in the 11%-15% range. In the next year, the lack of such charges would be an automatic boost to EPS growth.
To me Welch was Robert California and Immelt was a pretty good Michael Scott. No analogy is perfect but this one just made sense to me. Welch was basically a manipulative sociopath who gamed the system and the accounting and walked away with a few 100s of millions when all was said and done.
I think Immelt, who was once a star salesman, was just a bad businessman and a bit of a bumbling, deeply insecure fool.
Immelt era:
I think what he did wrong in terms of the top level capital allocation is pretty well understood.
He spent 10s of billions of dollars assembling a collection of oil and gas equipment and services companies in the early 2010s when oil prices were very high and such assets were growing quickly. These companies have pretty high operating leverage so when oil crashed in 2015 the value there evaporated pretty quickly. (i.e. both Halliburton and Baker Hughes have gone from ~$70 in 2014 to ~$13 today).
When oil crashed and his oil bets didn’t look so good but the Power unit was doing better than any other business inside GE, he decided to shell out ~10B to buy gas turbine maker Alstom. Of course, just 2-3 years later, the market for nat gas turbines collapsed due to the growth of renewables.
Impressed by all the lofty tech and SaaS stocks, in 2014, Immelt proclaimed that by 2020 GE would be a top 10 software company. Meanwhile the coders and business heads inside the different units didn’t even know what the software was supposed to do exactly.
He was a charming, star salesman who did not know how to allocate capital and spent most of his time chasing whatever was hot. Certain businesses do well with evangelistic leaders (i.e. single product start up software company) but large multi business conglomerates should mostly be run by logical, emotionless number crunchers.
What got GE into real trouble under Immelt, at the end of the day, was the same thing that Welch overdid under his tenure. An over-reliance on targets and trying to get there in any way possible.
In 2015, Immelt laid out that by 2018, GE would earn at least $2 per share. EPS in 2015 was 1.31. The whole company now desperately tried to make Immelt’s numbers as he was trying to cement his legacy imo.
What was scary about GE is that almost the whole company is in fact an insurance company. They do not make an upfront profit on their engines or their gas turbines. These are sold at a loss to build the install base into which to sell long term maintenance and service contracts.
And essentially, like insurance, there is high discretion on reserving for future costs to be incurred for maintenance. The NPV of the contract can be booked as profit today. You can also discount the long term maintenance contracts or sign dumb long term deals and show lots of unit growth and tell your investors the business is building a large install base for future FCF growth. It’s very hard for investors to judge what the NPV will be. The accounting at GE/Rolls Royce etc. when it comes to properly showing investors the profitability of long term engine contracts is pretty complicated and gives mgmt lots of discretion.
As I said, running a strict ‘make your numbers’ culture inside what is essentially an insurance company is just insane.
The units, Power especially, started firstly the easy work of adjusting their long term cost assumptions on the maintenance contracts to book non-cash profits to hit Immelt’s $2 EPS target. Going further, the Power unit got the company into tremendous trouble by basically signing discounted long term deals and taking market share where the economics of the deal through its life would be very poor. Power started to bleed cash rapidly as soon as Immelt left and Flannery had to deal with the fall out.
Some of the salespeople and higher ups inside the Power unit thought about telling the head of Power that he was going to damage the business for the long term, but they decided against it. If the head of Power ever became CEO, their own futures would be a lot brighter tagging along with him to ever higher and more lucrative positions inside GE.
The other extremely suspect thing that happened was that pretty much as soon as Immelt left the CEO position and Flannery took over, the CFO told the new CEO that in fact, their insurance reserves were too low by a figure of $15B! Flannery, who was now CEO of the whole company and had worked in GEC as part of his rise up, didn’t even know that the long term care liabilities were still inside GE. He assumed almost all of the problems had been spun off with Genworth.
Of course I wasn’t there and am not qualified to make a judgement, but the 15B of sudden under-reserving discovered soon after Immelt left was suspect.
How to ruin a great business - Summary:
Strict “Hit your targets or else” culture in a finance / insurance / any business where
Mgmt has high discretion of accounting, esp over very long term assumptions that impact earnings today
The gap of time between when you can make a sale and a full accounting of profitability is large
Basically run a carry trade where you use your AAA rating to borrow cheap and short to buy BB assets long - building a low quality earnings stream to push EPS growth
Over leverage the company so that when there is a crisis, the company has large refinancing and financial crisis risk
Borrow short, lend long
Conduct mega-deals, chasing whatever vertical is hot
Buffett (Financial Crisis Inquiry Commission) talking about why he sold Freddie/Fannie in 2000
“I mean, it isn’t given to man to be able to run a financial institution where different interest-rate scenarios will prevail on all of that so as to produce kind of smooth, regular earnings from a very large base to start with; and so if people are thinking that way, they are going to do things, maybe in accounting -– as it turns out to be the case in both Freddie and Fannie –- but also in operations that I would regard as unsound,” Buffett said. “And I don’t know when it will happen. I don’t even know for sure if it will happen. It will happen eventually, if they keep up that policy; and so we just decided –- or I just decided to get out.”
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PS. I recommend Lights Out. A great book if you are interested in corporate histories, how incentives and power work within large bureaucracies and how capital is really allocated inside large businesses.