GE: Quintessential American Finance Company

Does Ge (GE) finance company stand a chance in today's worsening economic environment? What blasphemy is this?!? Are these the words of yet another gloom-and-doomer pouring on the coals when we've already had enough bad news?

Why, GE is the bellwether of U.S. industry. It's the triplest of all triple-A companies! It's the quintessential American manufacturing company!!

Correction. GE is the quintessential American finance company. And highly leveraged at that.

Lending Activities

Just look at the balance sheet. Of 12/31/07 tangible assets of $698 billion, $461 billion, or 66%, are loans, leases, or some other explicit lending activity (i.e. as separate from, say, trade credit related to manufacturing activities). Another $57 billion, or 8% of total tangible assets, are real estate investments. Does this sound like a manufacturer? For perspective, this $461 billion in lending activity would make GE about the eighth largest bank in the country. Further, while perhaps not as risky as some of the largest banks' holdings of sub-prime mortgages, SIVs, and other exotic vehicles, GE's portfolio probably carries more risk than those of many smaller banks. This assertion, while admittedly somewhat speculative, is based upon the more transactional nature of GE's lending activity compared to the more relationship-driven lending activity of the typical commercial bank. Not to mention GE's own assessment in its 12/31/07 10-K report that one-third of its $30 billion U.S. portfolio of credit cards, installment loans and home equity lines of credit (through its GE Money subsidiary) could be considered sub-prime. Another $10 billion charge-off anyone?

Leverage

Referring again to the 12/31/07 10-K, total Liabilities of $672 billion compare to absolutely puny tangible Shareholders' Equity of $18 billion. A simple debt/tangible worth calculation suggests an astounding leverage extreme of 37:1, or its inverse, a capital ratio of 2.7%. Admittedly, discounting net worth by the entire amount of intangibles of $97 billion is probably overly conservative, but what, after all, is goodwill but accounting for the amount overpaid in the purchase of assets? Didn't we see enough write-downs of goodwill in the early 2000s to make us at least marginally suspicious of its value? Does goodwill provide any relief whatsoever in a liquidity squeeze?

For some perspective on leverage, the average commercial bank has a capital ratio of approximately 10% (admittedly with definitions of capital as generous as those used by GE), which equates to a debt/worth ratio of 10:1. I've always been amused when people say that we couldn't have a 1929 style crash today because we no longer allow 90% margin in the stock market. This is true, but it completely ignores the fact that virtually the entire remainder of the economy is leveraged at 90%. GE's Capital Services (i.e. the lending side of the company) is much more leveraged than most banks, and with much riskier assets. Something tells me we haven't seen the last of the forest fires started by playing with this kind of leveraged tinder.

Cash Flow

Ah. Cash Flow. The bottom line. Where the rubber meets the road. What is business all about except for cash flow? The manufacturing side of GE is strong, no doubt. But the real question here is GE Capital Services [GECS], which is what the numbers that follow are based upon, as separately disclosed in the 12/31/07 10-K.

A quick look at the ratio of EBITDA / Interest ($44 billion / $22 billion) looks pretty good at almost exactly 2.0X. However, adding Short Term Borrowings (of $192 billion) and Long Term Borrowings maturing in 2008 (of $56 billion) to that Interest Expense results in an atrocious ratio of EBITDA / Principal and Interest due in 2008 of .16X.

What?!? Can they be this far under water? Not so fast. You see, they won't actually retire those short- and long-term borrowings of $248 billion as they come due. They'll simply refinance them with new short term borrowings as they've been doing for years. Aye, there's the rub then. GECS seems to have a major mismatch on its balance sheet. They've got $114 billion more in Current Liabilities than in Current Assets. If they didn't issue any new debt this year, they'd need until early 2010 to pay everything that comes due in 2008.

But that won't be a problem, right? With credit markets so stable and all, they'll have no problem rolling over all that debt, will they? Debt, that is, like the 12/31/07 commercial paper balance of $106 billion. Not that there's been any jumps or jitters in the commercial paper markets in recent months… But it's GE, you might say. Who wouldn't lend money to GE? Indeed. Who wouldn't? Anyone would. Everyone would. Everyone will, right? Yes. Of course they will. Until they don't.

Perhaps we're on to something here. Perhaps it's the very historical strength of GE that allowed it to borrow as much as it wanted. At some pretty good rates, too. The proverbial drunken sailor on shore leave. The strength, reputation, and aura, that is, that allowed GECS to increase its lending portfolio (plus a few other assets, like real estate) by $148 billion (from $360 billion to $508 billion) from 12/31/04 to 12/31/07 by borrowing $146 billion of it. Hmmm. One hundred percent financing on the incremental portfolio growth. Why does that sound so familiar?

So, in the end, what do we have? We have a historically strong manufacturer (with $92 billion in Liabilities of its own, mind you, and in what appears to be developing as a uniquely challenging environment) wrapped (smothered, some may eventually say) in a massively leveraged portfolio of loans and similar beasts that includes home mortgages, auto loans, credit cards, prime and sub-prime home equity loans, and, last but not least, a boatload of commercial and industrial loans that seems recently to have contracted a bit of seasickness, particularly in the latter stages of Q12008.

Is this warning premature? Yes, almost certainly. But there's no benefit in yelling Fire! after the barn's already burned down. To borrow a phrase, predictions of GE's demise may, at this point, be greatly exaggerated, but don't expect it to fare any better than the average high-risk finance company if this economy gets much worse.

Volatility versus Technical Analysis

(Observer's note: a good point made by Bill Luby. I really enjoy reading his posts now. The comment below is from his 4/14 post.)

...... To answer the question "Is the VIX Impervious to Technical Analysis. I have to say that I am largely in agreement on the three main points made in the post:
Support and resistance don’t matter
Long term moving averages don’t matter
Correlation does not imply causation"

"... ... Last but not least, Tom Drake has an indicator that he calls the 2CS, which combines the VXO (the original VIX, prior to the 2003 modifications) and the CBOE combined put to call ratio to get a two dimensional view of options sentiment. In The 2CS Revisited, Tom discusses how he uses the 2CS to help identify market bottoms. His approach appears to be similar to mine in many respects. Also, the 2CS is clearly a relative of the OSI (Options Sentiment Indicator) that I publish and discuss in my subscriber newsletter.

I suspect the increased interest in the VIX is a by-product of the ongoing discussion in many circles that the VIX has not spiked enough to signal a textbook capitulation bottom, particularly given the magnitude of the macroeconomic concerns. I continue to think that while a VIX spike of 40 or more would placate many of those who are waiting for a more obvious sign of capitulation, this is not necessary to confirm a bottom, particularly given the current trading range of the VIX in the low to mid-20s."

Microsoft Undervalued, With Or Without Yahoo

(Observer's note: I don't currently have a position on Microsoft, but have been watching this stock for the past few months. This article is a good one for my own record.)

By Ben McClure

Yahoo (Nasdaq:YHOO) is scrambling to avoid being swallowed by Microsoft's(Nasdaq:MSFT) software empire. The Wall Street Journal reports that Yahoo and Time Warner (NYSE:TWX) subsidiary AOL are edging towards a deal aimed at spoiling Microsoft's takeover plans.Of course, Microsoft has a lot to gain from a buyout of Yahoo, but Microsoft investors shouldn't be overly dismayed if Yahoo escapes its clutches. Even without the internet company, Microsoft's stock is still strong. By my reckoning, Microsoft, sans Yahoo is still substantially undervalued.

Less Than The Sum Of Its Parts

Microsoft provides plenty of disclosure and guidance on its various software business realms, so let's consider the value of the sum of its parts. Start with Microsoft's client business, which concentrates on the Windows operating system. Of course, this would continue as a quasi-monopoly that pumps out loads of cash. Assuming sales growth of 13% in 2008, operating systems will produce about $16.9 billion in sales and operating profits of about $13 billion. Valued like a regulated monopoly, with an operating multiple of say 14, this group is worth $183 billion.

For convenience, we can lump together Microsoft's Office software unit with its enterprise server and tools business. Together they represent another cash cow. Assuming 17% growth this year, it will bring in about $40 billion in sales and operating profits of about $8.9 billion. Valued on the same conservative utility multiple, it's worth $124.6 billion. Give it a valuation multiple along the lines of software peers like Oracle (Nasdaq:ORCL), SAP (NYSE:SAP) or Red Hat (NYSE:RHT) and you get a higher number.

The online business holds Microsoft's email and instant messaging services, plus its internet offerings such as Live Search and the MSN portals and channels. While this group has yet to show signs of profitability, it ought to deliver more than $3.4 billion in revenue in 2008. Of course, it won't fetch Google's (Nasdaq:GOOG) 9-times sales multiple, or even Yahoo's multiple of 7. But even valued at just 4 times sales, the online business is worth nearly $13.6 billion. Throwing Yahoo into the mix yields a much bigger online business and valuation.

The final group holds Microsoft's new-fangled entertainment and device businesses, including the Xbox video games. Growing at 32% this year, sales could swell to $7.7 billion. Operating profits should top $900 million, easily justifying a multiple of 20-times and price tag of $18 billion.

The total value of the sum-of-the-parts, not including Microsoft's $23 billion cash pile, amounts to $339 billion in market value more than 23% higher than the stock's price today. (For a crash course on these calculations, check out Use Breakup Value To Find Undervalued Companies.)

Bottom Line

A market value of $339 billion, or $35.67 per share, represents a multiple of 16.5 times 2009 earnings. Considering that Microsoft is expected to lift its bottom line EPS to $1.87 from $1.43 this year, and to $2.11 in 2009, it's fair to say the stock is trading at a sizable discount.Investors shouldn't be shaken by the uncertainty surrounding Microsoft's pursuit of Yahoo The outcome doesn't change the fact that the software titan has a low valuation on its side. That alone should be enough to get investors to take notice.

To learn more, check out Conglomerates: Cash Cows Or Corporate Chaos?

Ben McClure is director of McClure & Co., an independent research consultancy. Before founding McClure & Co., Ben was a highly-rated European equities analyst at city of London-based Old Mutual Securities. He also spent several years as a business/technology journalist at the Economist Group. Mr. McClure graduated from the University of Alberta School of Business with an MBA.

At the time of writing, Ben McClure did not own shares in any of the companies mentioned in this article.

Blockbuster (BBI) tries to buy Circuit City (CC)

(Observer's note: I'm wondering whether this implies the ultimate triumph for Netflix (NFLX). The imposed merger between BBI and CC doesn't seem to make any sense to me. )

By Douglas McIntyre

Some mergers make less sense than others. The Blockbuster (NYSE:BBI) effort to buy Circuit City (NYSE:CC) makes no sense at all. It is based on the hope that putting together two zombies will create one live person.

According to Reuters "Blockbuster Inc. said on Monday that it has offered to buy electronics retailer Circuit City Stores." The price for the offer was in a range of $6 to $8 pending due diligence.

Why putting a consumer electronics business together with a movie rental company makes sense is anyone's guess. Each company is having remarkable trouble staying in business.
Blockbuster's current share price is just above $3, down from a 52-week high of $6.67. The company is being ruined by competition from online DVD sales and VOD products delivered over the internet or by cable companies. In its last fiscal year, Blockbuster made only $39 million on revenue of over $5.5 billion.

Circuit City is even worse off. It made a tiny profit in its most recently reported quarter, but has been losing customers to larger operators like Best Buy (NYSE:BBI) and Wal-Mart (NYSE:WMT). Circuit City shares are down from a 52-week high of $19.12 to $3.44
It is hard to see how a merger would allow for either cost cuts or revenue enhancements.

1+1=0

Douglas A. McIntyre is an editor at 247wallst.com.