POST OF THE DAY
General Electric Company
Re: General Electric Issues Equity?!

Format for Printing

Format for printing

Request Reprints

Reuse/Reprint

By babyfrog
March 11, 2004

Posts selected for this feature rarely stand alone. They are usually a part of an ongoing thread, and are out of context when presented here. The material should be read in that light. How are these posts selected? Click here to find out and nominate a post yourself!

[This thread is in response to Bill Mann's article, located here.]

JoelCairo,

Disclosure: as of this writing, I currently own GE shares.

For perspective, on GE's most recent 10K (annual report) filing, it mentioned that its Cash Flow from Operating Activities was $30,289,000,000 ($30.3 billion) for fiscal year 2003. GE could have paid $3.8 billion for Vivendi out of CASH FLOW FROM OPERATIONS without breaking a sweat. That works out to about 12.55% of the year's cash flow, or about 45 days worth of cash generated from running the business.

There are three primary ways to pay for something from within a business, either via debt financing, via cash flow from operations, or via equity financing. Each of those methods has advantages and disadvantages. Equity financing tends to be the most expensive for the shareholders, because it clearly dilutes the equity of the existing owners. If a company made $1,000 and had 1,000 shares, then the earnings per share of that company is $1. Let's say the stock is trading at $20. If a company issues another 50 shares for an acquisition (raising $1000), then the company needs to earn $1050, or 5% first year return on the acquisition, just to keep pace with the previous year's $1 per share.

Now, let's say the company borrows the $1000 and has a first year interest cost of 2%. Well the interest cost on that $1000 is $20, and the loan does not dilute the number of shares outstanding, so the company would still only have to make $1000 to keep pace on an earnings per share basis, which means that the acquisition would only need to add 2% or $20 worth of value the first year to not be a bad short term move for the company's previous shareholders.

Taking it to the extreme, if the company comes up with the $1000 to make the acquisition out of cash flow, as long as the acquisition adds $0.01 in earnings, it was a smart, short term move for the shareholders. Of course, the problem with using cash flow to fund acquisitions is the fact that it requires belt tightening and is keeps that cash from being able to be used elsewhere, such as to pay dividends.

In a low cost of debt environment, the only reasonable, shareholder friendly reason to use stock instead of borrowing money for an acquisition is if the company believes its stock is dramatically overpriced. If the stock is due for a fall anyway, using it as currency to purchase an asset can be less expensive than debt.

By using stock rather than cash flow or debt, GE was sending the clear signal that either it has lost its financial acumen (a bad sign), it was at risk of losing its AAA debt rating (another bad sign), it has stopped being managed for the benefit of the shareholders (a worse sign), or that it's stock was overpriced (an ugly sign).

Based on Bill Mann's comments, it would appear as though a motivating factor in the decision might have been the CEO's compensation plan. And when a CEO starts making decisions based on personal enrichment at the expense of shareholder value, it's often a sign of the start of bad things to come for the shareholders.

Of course, now that the choice has been announced and the cat is out of the bag, GE's stock has rightfully fallen, and that fall may be about enough to fairly balance the stock. I argued against Bill on the Bank of America board, (in this thread) that after the fact, there is only so far a solid company can fall when news like this is announced. And GE is certainly a solid company.

-Chuck


Become a Complete Fool
Join the best community on the web! Becoming a full member of the Fool Community is easy, takes just a minute, and is very inexpensive.