Finance arm still weighing on General Electric (GE)

After reading about GE Capital’s Political Minefield in today’s Wall Street Journal, I went back and looked at some of my commentary on General Electric (GE) from earlier in the year.

In this post on March 3, I suggested that the GE was oversold. Most of my reasoning was based on the fact that everyone was forgetting about the company’s industrial business and only focusing on GE Capital. Only a few weeks later I posted in my March 19 note:

“Investors have become somewhat single-minded in their focus on GE Capital as they fear the unit’s $637 billion balance sheet (as of 12/31/08) is full of souring assets like commercial real estate loans and securities that make the unit and its parent vulnerable to future losses.”

While I was correct that GE didn’t face the threat of nationalization like other U.S. bank holding companies, it never occurred to me that the government may alter the way GE Capital is classified and, thus, change the rules of the game – although considering how often the government changed the rules throughout the financial crisis, I am not really surprised.

After steadily climbing from its lows, GE’s stock price did a U-turn after Obama administration issued their proposal for reforming the U.S. financial system. The declines were a result of investors’ refocusing attention towards GE Capital – and for good reason.

GE Capital is one of the world’s largest and most diverse financial operations. If GE Capital were classified as a bank holding company, then it would be the nation’s seventh largest by assets. While GE has benefited from more relaxed regulation than bank holding companies, the reform proposal could lead to GE Capital being classified as a “Tier 1,” or systemically important bank. In this case, GE Capital would be subjected to tighter regulation, higher capital ratios, and bigger loan-loss reserves. And any increased restrictions on the industrial activities could very well lead to a spin-off of GE Capital from its parent company.

A break-up, however, causes a few problems and makes the finance business worth less to GE shareholders than the value it provides as part of GE as a whole. First, GE Capital would almost certainly have its credit rating downgraded without the financial safety net of its former parent company. Consequently, large collateral calls would be triggered in response to a GE Capital credit downgrade.

Second, the company would almost certainly need to raise capital to enhance its Tier 1 ratio and bolster its loan-loss reserves, both of which are well below the largest four U.S. banks. Even more, GE Capital could be forced to reduce assets like their $36 billion in real-estate equity investments, which banks are typically not allowed to hold, at “below-value” prices and resulting in large losses.

It’s easy to see why shareholders consider GE Capital a more valuable business when combined with the parent company than on its own. GE shareholders who would likely receive shares of a spun-off GE Capital would likely see negative earnings as the company adjusted to new regulatory requirements and may also see their shares diluted if GE Capital taps the equity market for fresh capital.

Despite all of these concerns, I wouldn’t be hurrying to shed your GE shares. Although there is less upside for the shares than there was in early March, GE is trading at a fairly reasonable valuation and still offers a great value for the long-term investor.
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Peter J. Lazaroff