FOOL ON THE HILL
Following Up on IBM and GE

New information about two of the companies Whitney Tilson flagged with signs of trouble have eased some of his concerns. Even so, he's unrepentant in his close examination of companies -- even and especially market darlings -- that might not deserve all the love they get. Investors should consider adopting similar habits.

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By Whitney Tilson
January 23, 2001

I recently read that, according to Zacks Investment Research, of the 8,000 recommendations made by analysts on the stocks in the S&P 500 at the end of last year, only 29 were sell recommendations -- a microscopic 0.4%. That has to be one of the lamest things I've ever heard! Heck, in last week's Stocks to Avoid I discussed six stocks -- including General Electric (NYSE: GE) and IBM (NYSE: IBM) -- and the reasons I thought investors might be wary of them.

The response to this column has made it even more clear to me why so few people -- analysts, writers, and the like -- are willing to go on record with their least favorite stocks. First, companies stop taking your calls. Second, some people become very attached to their stocks and view any criticism as a personal attack that calls for an even more personal riposte. Finally, if you happen to "pan" a stock that does well, at least in the short term, many of those who may have read the critique and sold will of course blame you rather than themselves.

Despite all of this, I plan to keep writing about problems I identify with companies that can foretell trouble ahead for the stock.

Clearing up some misperceptions
There are a number of things I'd like to clarify based on some of the emails I received from last week's column.

  • I was not advocating that anyone short the stocks I consider potentially troublesome. In fact, I think shorting is generally a bad idea.
  • When I say I don't like a stock, that doesn't necessarily mean I don't like the company. But there's a big difference between liking a company and thinking its stock represents a good investment opportunity.
  • If you're going to pick stocks, you have to do your own research and analysis and make -- and take responsibility for -- your own actions. If you don't have the three T's -- time, training, and temperament -- then stick with mutual funds or, better yet, index funds.
  • Fallen stocks can be both opportunities and harbingers of more trouble. It's important that investors know how quickly even the strongest businesses can deteriorate. Watching for the warning signs can be a valuable practice, as market value erosion is often slow to follow.
  • Finally, my discussion of GE and IBM last week was not a short-term prediction meant to time an upcoming earnings report. It was purely coincidental that GE and IBM reported earnings the day after last week's column was published.

Speaking of these two companies, now that we have new information, let's take another look.

IBM
IBM reported stronger-than-expected Q4 earnings last Wednesday, beating consensus estimates by two cents. The company said it was "comfortable" with earnings projections for 2001. Not surprisingly, the market reacted favorably. For the quarter, year-over-year revenues were up 5.9%, or 12% at constant currency.(Funny how companies never include this figure when it would reduce their growth rate, isn't it?), and EPS grew 32.1%. Net debt (total debt minus cash and marketable securities) grew 10.3% year over year, but fell 5.6% sequentially.

The bigger picture remains troubling, however. Over the past four years, revenue has grown from $78.5 billion in 1997 to $81.7 billion in 1998 to $87.5 billion in 1999 to $88.4 billion last year. That's anemic 4.0% compounded annual growth during perhaps the greatest technology spending boom in history. And growth was slowest last year, rising only 1.0%. In addition, despite the big jump in Q4, operating income last year fell 1.9%. IBM was only able to show a 7.8% increase in EPS due to a big drop in its tax rate (from 34.4% to 29.8%) and a 3.2% decrease in diluted shares outstanding.

Overall, there were enough positive developments last week that I am removing IBM from my least-favorite list. Based on what I've noted above, though, there are still some serious issues outstanding at Big Blue. 

GE
GE's Q4 earnings report last Wednesday met expectations and the stock hasn't moved much since then. In the fourth quarter, revenues were up a modest 6.5% and EPS rose 16%. Unfortunately, GE doesn't release a balance sheet -- much less a cash flow statement -- when it reports earnings, so we won't be able to really figure out the quarter until the 10-K is released in approximately two months.

The company did report, however, that "Cash generated from GE's operating activities for 2000 was a record $15.4 billion, up 31% from last year's $11.8 billion." I was initially confused, as operating cash flow for 1999 was $24.6 billion, but it turns out that GE was excluding GE Capital. Initially, I suspected -- call me paranoid -- that GE was trying to draw attention away from the big decline in GE Capital's operating cash flow (from $10.5 billion in the first three quarters of 1999 to $3.0 billion in the same period in 2000). Upon further review, however, I concluded that there was a good explanation for this decline.

In the first quarter of 2000, GE Capital acquired Toho Mutual Life Insurance of Japan, which was insolvent at the time. As part of the deal, GE Capital acquired $13.2 billion in cash, which appears under Financing Activities in GE's cash flow statement. Offsetting this to some extent has been a $6.7 billion use of cash in the first three quarters of 2000 -- due to Toho's "significant policyholder redemptions" -- that appears in the cash flow statement under "All other operating activities." This is the primary reason for the overall decline in GE's operating cash flow. Thus, it appears that it would be unfair to penalize GE for the drop in operating cash flow when the primary cause of this was offset by a large cash inflow that appeared in another section of the cash flow statement.

So let's look at the same tables I presented last week, but exclude GE Capital:

GE (excl. GE Capital)    Q3 99     Q3 00   % change
Cash                     1,659     5,461     +229%
Debt                     3,351     1,960      -42%
Net 
cash                    (1,692)    3,501     


GE (excl. GE Capital)  Q1-3 99   Q1-3 00   % change
Revenue                 42,814    50,698      +18%
Net 
income                   7,628     9,150      +20%
Operating cash flow      7,424     9,943      +34%
Capital expenditures     1,070     1,865      +74%
Free cash flow           6,354     8,078      +27%

This data indicates that GE's operations other than GE Capital are doing well, and there appears to be a good explanation for GE Capital's decline in cash flow. That's enough to move GE off my list of least-favorite stocks. My concerns about the impending retirement of Chairman and CEO Jack Welch, the integration of the Honeywell (NYSE: HON) purchase, and the stock's valuation remain, however. 

-- Whitney Tilson

Whitney Tilson is Managing Partner of Tilson Capital Partners, LLC, a New York City-based money management firm. Mr. Tilson appreciates your feedback at Tilson@Tilsonfunds.com. To read his previous columns for The Motley Fool and other writings, click here.