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:

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

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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