Should GE Be Broken Up?

It's an enormous, sprawling firm that is exposed to the credit crisis and the health of the global economy. A blue-chip institution whose stock has lost over half of its value over the last twelve months. No, I'm not referring to ailing banking giant Citigroup (NYSE: C  ) , but rather to industrial and financial conglomerate General Electric (NYSE: GE  ) . Is a break-up the answer to the challenges it faces?

The idea of a GE breakup has never gained much traction, as the company has historically been held out as the paragon of a well-managed business. However, in the context of the post-bubble environment of conservatism and transparency, there is an elephant in the room: GE Capital, the firm's financial arm.

GE Capital: The elephant in a credit-constrained room
The creature comparison is appropriate. With $680 billion in assets, GE Capital Services was bigger than Wells Fargo (NYSE: WFC  ) at the end of last year. Wells Fargo is one of the nation's largest lenders. Among those assets are $51 billion in real-estate debt securities. Investors are now much less forgiving when it comes to this level of risk and leverage than they were two years ago.

GE management understands this. It has committed to shrinking GE Capital's contribution to the firm's earnings and reducing its reliance on short-term financing -- the limits of which became clear when Bear Stearns' funding dried up and it was forced into the arms of JPMorgan Chase (NYSE: JPM  ) .

The problem with hiving off GE Capital from its parent is that it's far from clear if it would retain its AAA rating and the funding advantage that goes along with it. Still, that argument could become moot: Last month, S&P inched toward a potential credit rating downgrade, revising GE and GE Capital's outlook from stable to negative. S&P estimates the chance of a GE Capital downgrade in the next two years at one in three.

One example of a conglomerate breakup
So, should CEO Jeff Immelt break GE up? The academic literature on whether or not there is a "conglomerate discount" -- that is, that  conglomerates trade at a discount to the sum of their parts -- isn't clear-cut. Here are some numbers relating to a recent breakup, that of Tyco, which took place just prior to the start of the credit crisis:

Company

Total Return
(from July 2, 2007)

Tyco International (NYSE: TYC  )

(55.1%)

Tyco Electronics (NYSE: TEL  )

(56.1%)

Covidien (NYSE: COV  )

(12.6%)

Tyco spin-off (weighted average return of the three component stocks)

(41.9%)

Let's compare that to General Electric and a couple of benchmark indexes:

Company

Total Return
(from July 2, 2007)

General Electric (NYSE: GE  )

(55.7%)

S&P 500 Industrials

(43.5%)

S&P 500 Financials

(70.1%)

S&P 500

(40.7%)

Two remarks: First, the Tyco "spin-off" has outperformed GE since the start of the credit crisis. Second, appropriately enough, GE's performance lies between that the of the S&P 500 Industrials and Financials indexes.

Is GE cheap enough?
When a market leader like GE underperforms its industrial peers, it's strongly suggestive that GE Capital is the basis for a conglomerate discount. That would be entirely consistent with the investor risk aversion that is dogging virtually all financial companies right now. This represents a return to order; after all, GE Capital's earnings are higher risk than those of GE's other business lines.

One could argue that this discount won't persist indefinitely and it shouldn't be the basis for a major corporate restructuring. Perhaps the former is true, but I believe that a GE Capital-related discount is warranted, regardless of the environment.

In some sense, an investment decision always comes down to price in that there is always a price at which any asset is a compelling investment. I'm not a huge fan of GE because of its size and complexity, but I have to recognize that we may now be approaching levels at which the risks of GE Capital are more than accounted for. GE shares now look likely to provide adequate long-term returns for investors; if the share price were to remain at this level for a sustained period, the breakup logic would certainly gain weight.

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Alex Dumortier, CFA has no beneficial interest in any of the companies mentioned in this article. JPMorgan Chase is a Motley Fool Income Investor pick. Tyco International, Tyco Electronics, and Covidien are Motley Fool Inside Value picks. Try any of our Foolish newsletters today, free for 30 days. The Motley Fool has a disclosure policy.


Read/Post Comments (10) | Recommend This Article (26)

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  • Report this Comment On January 13, 2009, at 4:50 PM, n33437 wrote:

    GE should have been split up when there was some value

    now at 15 what can you expect 3 or 4 dollar values for shares of operating units that no one wants

    get a life ***already

  • Report this Comment On January 13, 2009, at 6:18 PM, TMFAleph1 wrote:

    n33437,

    Perhaps I'm being obtuse, but I don't understand your comment -- can you share a more detailed argument with me?

  • Report this Comment On January 13, 2009, at 8:59 PM, Seano67 wrote:

    Nice article, Alex.

    You have to also question the security of GE's dividend, as the S&P has intimated that GE may have no choice but to slash its dividend in order to keep its AAA rating. GE has reaffirmed its commitment to maintaining the dividend through at least 2009, but still, in light of this, you have to wonder.

    As a GE shareholder, I'm hoping that doesn't come to pass- but the possibility of it is definitely out there.

  • Report this Comment On January 13, 2009, at 10:34 PM, stevemcgee99 wrote:

    (not really an argument based on what the current shareholders would earn, but on the financial environment our central economic planners have created and how it leads to burgeoning company sizes).

    Yes, it should be broken up - but only by voluntary decision of the management and/or owners. No anti-trust laws should intervene.

    But to prevent unfair monopoly, the process for granting government contracts should be reformed. My preference would be to significantly reduce the contracts altogether.

    I believe GE should be broken up for a few reasons. One is that the large company structure is tuned to the financial environment artificially created by the US Federal Reserve. If interest rates were where they should be (priced by the market, not central-planners), leveraged business models would be unattractive.

    Using current liabilities to fund current liabilities - short-term loans to pay salaries and vendors - is not a sound way to run a business. If capital (cash) didn't depreciate so quickly, which is caused by artificially-low interest rates, businesses would once again have a natural incentive to save and invest.

    Smaller company sizes would be a better format for investing in capital. Currently, the financial environment motivates businesses to remove capital from their balance sheets. Inflation causes depreciation to be more significant for long-term assets.

    It makes more sense to value a company based on its abilities PLUS resources. If capitalism is based on the ownership of the means of production, why have we allowed our financial system to discourage this?

  • Report this Comment On January 14, 2009, at 3:12 AM, JakilaTheHun wrote:

    Good article. Right now does not seem like the most ideal time to split up GE, but in general, I would normally think it was a good idea. I think GE's capital raising efforts have somewhat suffered as a result of their incoherent conglomerate status.

    Of course, I'm biased --- I don't like conglomerates for the most part. I like small- to mid- sized companies because I think it's a lot easier to analyze their operations as an investor. When a company has 400 operating units, the numbers you get are really kind of meaningless and even when the company does some segment reporting on their financial statements, it's bulky, sprawling, difficult to analyze, and suffers from selective bias (the company might only chose to show you the favorable info).

    It would be nice to see this stock market crash result in something productive and I think the death of mega-cap conglomerates and these oversized banks would be wonderful.

  • Report this Comment On January 14, 2009, at 9:40 AM, TMFAleph1 wrote:

    Thanks for the positive comments and interesting feedback -- it is much appreciated!

  • Report this Comment On January 21, 2009, at 12:34 PM, TwitchyBoy wrote:

    At current prices, I bought GE at an 8% dividend. Even if GE halved its dividend, this is still a great buy for this company at current pricess, IF you are going to hold long term.

    If you are concerned about investing in a conglomerate, as one commenter is, here is another perspective: investing in GE is like investing in a mutual fund where risk is diversified...except you don't have to pay those freakin' fees...and regular dividends are icing on the cake.

  • Report this Comment On March 07, 2009, at 9:14 PM, rsinj wrote:

    And since this article was originally written, GE shares hves lost about 60% of their value.

    Today GE stock is $7. July 2007 it was $40. $2.14 in dividends have been paid since. That's giving me a total return of about -80% (being generous).

    Conglomerates like GE must be broken up...Tyco finally realized that creating and operating the blob served little purpose other than financial engineering. GE should minimally be broken up into GE Capital, GE Consumer Products, and GE Industrial Products.

  • Report this Comment On March 07, 2009, at 9:17 PM, rsinj wrote:

    TwitchyBoy - how's your 8% dividend looking now?

  • Report this Comment On March 11, 2009, at 5:57 AM, saneguy50 wrote:

    Hey GE CAPITAL BANKS are crooks , with the intrest they charge for a personnal loan you could put them in the category of loan sharks. Hello Tony Soprano

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