Jay Holland is a global equity analyst at HNW Capital, a value- and research-driven private investment firm. The below investment thesis was originally posted on SumZero, the leading community for hedge fund and mutual fund investment analysts where professional investors share investment ideas exclusively with one another. Through The Motley Fool, select content from SumZero is now available to individual investors. 

Thesis
General Electric (NYSE: GE) needs capital. If the balance sheet were marked to fair value just considering the items disclosed on the June 30, 2010, quarterly report, the company would have tangible shareholders' equity (book value) of $3 billion to support a tangible asset base of $654 billion. The recent earnings report paints a rosy picture of the ongoing business, which generates strong cash flow relative to its market cap, but a look at the balance sheet is scary.

As of June 30, 2010, tangible shareholder equity or book value equaled $25 billion after deducting goodwill, intangibles, and the goodwill hidden in "assets of businesses for sale" for NBC. (See the table for more detail.)

Note 15 in the 10-Q discloses that "Financial Instruments" are carried at $9.4 billion greater than fair value. If or when the balance sheet is marked to fair value, shareholders' equity will be reduced by this same amount.

Page 69 discloses that the value of the real estate carried on the books is $6.3 billion greater than the estimated fair value. If or when the balance sheet is marked to fair value, this amount will be deducted from shareholders' equity.

Level 3 assets, which are assets with no discernable inputs to determine fair value, were carried on the balance sheet at $21.5 billion. GE does not disclose the nature of these assets, but with its background in fair value disclosure I suggest at least a 30% haircut on this value. This would reduce shareholders' equity by another $6.4 billion.

These reductions in shareholders' equity are the result of the disclosed differences between carrying value and estimated fair value. This does not include the $5.9 billion in impaired loans that are not included in allowances for losses, because management believes that some are recoverable. It does not include any negative predictions for commercial or residential real estate, which would negatively affect the balance sheet.

The balance sheet will look slightly different after the close of the sale of NBC, if approved. This would improve tangible shareholders' equity, because $11 billion of goodwill of the total $22 billion in NBC goes to Comcast (Nasdaq: CMCSA). GE will continue to hold 49% of the joint venture, allowing it to move another $11 billion off its balance sheet for accounting purposes. However, it still retains a substantial economic interest and exposure to this entity. I contend that a true picture of GE's tangible shareholders' equity must include all exposures to goodwill that almost certainly have no value. Goodwill is a plug value that balances the accounts but does not generate cash flows. In the second quarter, GE quietly incurred a $4 billion liability in NBC, which reduced the net asset value (NAV) by the same amount. There was no mention of this reduction in NAV in the presentation.

After the sale of NBC, tangible equity improves to $11.5 billion, which highlights the reason why GE would sell NBC at a loss, to move goodwill off its balance sheet. However, this still seems tiny compared to the stunning $750 billion in assets or $654 billion in tangible assets that it supports. The result is a lofty leverage ratio or tangible asset/tangible book value ratio of 57.

Why is tangible shareholders' equity important? This is the first part of the balance sheet to be hit with an impairment. Of course, many investors only care about the quarterly earnings projections and whether they are met. I will leave an analysis of those earnings to them. This report only considers what I believe the equity market does not care about, but should. However, debt markets care, and for a company addicted to the capital markets, this could be important because it has a ratio of earnings-to-fixed charges of 1.78. In other words, if this were my interest coverage ratio, I would not qualify for a mortgage.

Summary
I do not anticipate GE's bankruptcy, because it owns some good businesses that continue to chug along in this low-interest-rate environment, yet it will surely need to raise capital. This would cap any long-term upside. Most disturbing is the attitude of management, which announced an increase in the dividend at a time when the company desperately needs capital. Recommendation: underperform.

Variant view
Most sell-side analysts only look at the income statement; however, GE Capital is highly leveraged, needs constant access to capital markets, and holds a lot of assets that are deteriorating. If or when the assets are marked to fair value, the company will have to raise capital, diluting the wonderful earnings the company continues to report. This does not seem discounted by the market.