The Rittenhouse Review

A Philadelphia Journal of Politics, Finance, Ethics, and Culture

Monday, April 15, 2002  


At The Rittenhouse Review we normally are not impressed by Gretchen Morgenson, business columnist at the New York Times. In fact, we were rendered speechless when she won her Pulitzer Prize last week. However, credit must be given where credit is due, and such is the case with Morgenson’s article in the April 14 edition of the Times.

Morgenson starts with a question, “Are the glory days of nonstop earnings growth over at the General Electric Company?” Our esteemed editor has been asking the same question about General Electric for more than three years. In fact, the editor of TRR has long viewed with skepticism G.E.’s extraordinary ability to manage its earnings, the inflated reputation of the “legendary” Jack Welch, and the market’s fawning acceptance as gospel truth any word that came from Welch’s mouth.

Since the well eventually runs dry at companies that manage earnings, G.E.’s planned acquisition of Honeywell Corp., the brainchild of Jack Welch that ultimately failed on regulatory scrutiny, struck our editor as a desperate move intended to provide G.E. with the tools it needed to manage earnings going forward. More research is needed, but it may well be that G.E.’s inability to acquire Honeywell is a major factor behind the company’s current and projected earnings woes.

But we digress.

G.E.’s stock has dropped 20 percent in just the last six weeks, a decline induced by the company’s disappointing first-quarter results, tough questions raised by influential fixed-income portfolio manager Bill Gross of Pimco Advisors, and greater scrutiny of G.E.’s financial statements. Morgenson’s article adds fuel to the fire.

Among those taking a closer look at G.E.’s financials is Robert Olstein, manager of the Olstein Financial Alert Fund, which has $1.5 billion of assets under management. Olstein, whose fund has a small short position in the stock, according to the Times, told Morgenson, “Reading the 10-K [Ed.: The annual report filed with the Securities and Exchange Commission.], I felt that after eliminating all the sources of lower-quality earnings, any attempt by the company to grow at 18 percent a year was a dream. After reading the quarterly results, my suspicions about the quality of their growth continue.”

Although Olstein emphasizes that G.E.’s accounting practices are not improper, he maintains that a significant portion of the company’s earnings come from “financial engineering” rather than growth in its core operations, which include aircraft engines, turbines, plastics, medical equipment, financial services, and broadcasting.

G.E.’s financial engineering includes such strategies as booking gains on asset sales, pension fund earnings (a non-cash item on which the company doesn’t have a claim but which can be used when calculating earnings per share), gains on the securitization of loans, and changes in the effective tax rate used to calculate earnings.

Balance-sheet concerns include $43.2 billion of off-balance sheet obligations, according to Olstein, an amount that if put on the balance sheet would increase G.E.’s debt by 20 percent. And, in a little noticed move, G.E. provide G.E. Capital Services with a $3 billion cash infusion in the fourth quarter of 2001, an amount equal to one-third of G.E. Capital’s net worth, raising doubts regarding the quality of the subsidiary’s portfolio of loans and leases.

Olstein argues, correctly in our opinion, that G.E.’s favored techniques produce earnings growth, they do so in a manner for which investors historically have not been willing to pay a premium. Olstein believes shares of G.E., which closed at $31.85 today (and which traded at nearly $60 in the fall of 2000), would more appropriately be valued at $25.

There’s much more in the article, which we highly recommend.

And we believe there will be more bad news for G.E. in the months ahead.

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