FOOL ON THE HILL

Dim Times at GE

General Electric's former CEO Jack Welch famously forecasted in 2000 that the conglomerate could continue to grow its profits at 18% per year. That's tough for a start-up, and for a company with $125 billion in annual revenues, it's nigh impossible. Now, two years later, GE's selling off some parts to keep its financial sector from overwhelming its industrial one.

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By Bill Mann (TMF Otter)
November 15, 2002

I'd like to ask for a show of hands, please. How many General Electric (NYSE: GE) shareholders actually knew GE had a big reinsurance division?

It's called Employer's Re, and it's the fourth-largest reinsurer in the world at well over $9 billion in annual revenues. It's a component of GE Capital, and it has turned into quite the tempestuous beast for the world's largest company. Its story, though a bit esoteric for most investors, is an interesting proxy for some of the problems dogging General Electric, and it's a big reason why I'm not a big fan of this company, from an investment perspective.

GE purchased the 88-year-old Employers Re in 1984. It has more than $37 billion in assets, of which more than $22 billion is held in investments. For many years, Employers Re was one of the magical capital generation machines within GE Capital, and the company used this money to make more than 100 different acquisitions. Yet since March of this year, GE has been trying to unload Employers Re. More importantly, the company seems willing to do so at a cost well below intrinsic value. This is one of the better reinsurance markets in decades, as premium rates skyrocketed following the 9/11 terrorist attacks. So why is GE selling?

The probable answer: GE has shed nearly 40% of its market capitalization this year, partially on the fear that its growth is too reliant on GE Capital. Employers Re is one of the more unstable components within GE Capital, and GE management famously hates instability. It's nearly impossible to know the real answer; GE's financial statements, for all of their improvements, are still inscrutable.

We do know this (and it doesn't necessarily give much comfort to GE shareholders): The only bidder for Employers Re is one of the true sharks in insurance, Berkshire Hathaway (NYSE: BRK.A). That means several things. First, other potential bidders (Swiss Re and Munich Re) are in less-than-ideal financial shape. Second, GE is selling in a buyer's market. Third, questions about Employers Re's potential liabilities have scared others away, whereas Berkshire CEO Warren Buffett doesn't mind treading. What's worse, the IPO market is so bad that it's unlikely GE would get sufficient cash from a stock offering of Employers Re, so it's selling the company, even though it will get hit with a hefty tax bill as a result.

Already this year, Employers Re has set aside several hundred million dollars to shore up reserves for potential claims from policies in force. And due to poor underwriting results and a horrible investment environment (investments are where insurance companies generally make their profits), Employers Re's loss reserves could require another $3 billion to $5 billion of shoring up. This amount of money doesn't challenge GE's AAA bond rating, but it doesn't really help.

GE Capital is also facing exposure to financial meltdowns at United Airlines (NYSE: UAL), so one or two multi-billion-dollar bites are not high on the company's wish list. Selling Employers Re to Berkshire, even if GE has to take a below-market price, could greatly assist the company. Even the contingent liabilities Buffett would likely demand would be worth the price needed to maintain that precious bond rating.

A kink in the growth engine
That rating is crucial, as GE is one of only eight companies that possess it. It also gives the company access to capital at interest rates barely higher than that of Treasury bills. For each step down in debt ratings, the company's cost of borrowing grows. That's no small thing: GE currently has well over $200 billion in debt. Increased capital costs make Welch's pledge of continued 18%-plus profit growth rates a really wonderful fantasy, and nothing more.

This seemed to be an absurd goal, at any rate; a company with more than $125 billion in annual revenues simply cannot grow at such a high rate for long... not unless we're planning to become the United States of General Electric. Truth be told, pension fund assets consistently helped the double-digit growth rates of the past several years. Should GE have to reduce its actuarial assumptions (and it should), the company's profits will suffer.

GE has built its growth engine on GE Capital. However, GE Capital has grown to be a larger and larger portion of the overall company, and that makes credit agencies nervous. Financial firms are simply more risky than industrial conglomerates. In order to keep its credit rating, GE will have to leave the mix between its industrial and financial divisions alone right now.

But the industrial side has been pounded over the last few years. The markets for some of its biggest divisions -- aircraft engines, power systems, and plastics -- have been decimated. The company could allow the financial side to grow unchecked, but companies that are primarily financial in nature don't deserve the top credit rating, nor do they merit being traded at growth stock multiples. A lowered financial rating for GE would make financing more expensive, which would make acquisitions less attractive and make the industrial side lose out on potential growth opportunities. That's a bad spiral.

One option: re-engineering
So one option, then, is to let GE Capital get a lot smaller, in a hurry, by unleashing Employers Re. It makes sense all the way around. Berkshire Hathaway gets control of an enormous pile of float and becomes, overnight, the largest reinsurance company in the world. Berkshire wouldn't maintain all of Employer Re's poorly priced policies, and it could handle the lumpiness such a transaction would cause its earnings. GE, for its part, would immediately get rid of a potential cash drain and make GE Capital a significantly smaller portion of total company revenues. Other components of GE Capital could once again start to grow faster than the industrial component, in order to provide the overall company captive financing.

What's clear right now is that nothing's clear at GE. It has always been (and will always be) a devilishly complicated company -- an organism that sells everything from long-distance service to lighting to turbines to insurance. But the financial engines that have helped GE to grow in the past are showing signs of hoariness. More importantly, they seem to be overwhelming the industrial components of the company. GE can't really afford to let this happen, but the question is, how expensive will it be for them to prevent it?

Fool on!
Bill Mann, TMFOtter on the Fool Discussion Boards

Any resemblance between Bill Mann and Eminem is purely coincidental. Bill owns shares of Berkshire Hathaway. He is the managing editor of The Motley Fool Select, where you can find his best Foolish stock ideas you won't find anywhere else. The Motley Fool has a disclosure policy.