Tuesday, April 25, 2006

GE's annual report

GE's 2005 annual report cover has the title "go Big". All I could think of when I saw it was holding my children's arms up when they were babies and saying "so Big". Anyway GE is an amazing company but it recently has not been an amazing investment. There are nine bullet points on the inside cover. Eight are superlatives about the company's performance. But the other bullet, in the middle of the list, includes this sentence, "total return for GE shareholders was negative 1.4% versus the S&P 500's total return of positive 4.9%".

Hmm. What follows is a brief critique of what stood out to me in this annual report.

Go Big. "We think big is beautiful...our goal is not just to be big, but to use our size to be great"(Tony the Tiger comes to mind). That is the beginning of the Chairman's letter. The second paragraph then explains why "big" can be bad in many companies, and the third explains why that is not the case at GE. The cat's out of the bag already? Maybe investors have been saying that they want to invest in a specific company and not the whole economy when they buy a stock. But GE will go on the offensive, go big.

Having a lot of capital can be great, having big clout with vendors can be great, having the ability to be global can be great, but only if, in GE's Chairman's words, "We expect every business to be a leader in its industry". Of GE's six major businesses, four seem to make that cut--Infrastructure, Commercial Finance, Healthcare, and Industrial. Those four also seem to tie together well, with three businesses producing major equipment and Commercial Finance having the ability to finance their customers needs to buy GE product and, with a foot in the door, lots of other stuff as well. Two businesses don't make it. The most obvious is NBC Universal. This business is unrelated to GE's core focus. It is not a leader in many of its businesses and most of the veteran senior folks at GE do not have much experience here. The returns are certainly not bad, and the growth outlook is ok but not up to GE standards. Their industry is highly competitive to say the least and in a period of significant change. It represents just 10% of GE. It's strong enough to spin off or IPO or sell, but not "so big" or strong that it will materially impact GE in a negative way. The message of increased focus and the willingness to manage their portfolio of businesses for strategic fit is a "great" message for investors that could materially impact GE in a positive way.

I should note that GE has stepped up to the plate recently on business portfolio management by selling much of its insurance business, but they waited until underperformance more or less forced their hand rather than deal with it earlier for strategic reasons.

The other major business that is not a strategic fit is likely consumer finance. It's just a hunch. There is no information in the annual explaining what consumer products the company sells, just four short paragraphs that say: that the ROE was 29%, 70% of the business is outside of the U.S., and they expect 15% growth in this business that represents 15% of GE profit. Sounds "great". The question is whether this business is related to GE's core businesses or whether it is just an opportunistic move by a company with tons of capital and great debt ratings(low cost of funds) to build an investment portfolio of consumer credit. There's nothing wrong with that, but it is not a market leader, I would be surprised if it is a brand in any traditional sense, and it creates one more issue for investors to ponder when valuing GE. How much are those earnings worth? Is it a business or an investment portfolio? What is the vulnerability to a credit cycle? This is complicated. To sum up this ramble, GE consumer finance looks great, but how does it fit and does it help the investment thesis?

As usual this GE annual report is filled with the usual well written gibberish about Six Sigma, culture, values, and a full page circle chart called "Execute for Growth". There's nothing wrong with this either. But GE was so successful putting out these kinds of messages during Jack Welch's reign that now it's almost boilerplate in corporate America. For such length, there seems to be nothing new here, nothing thought provoking or even really interesting.

The last page of the Chairman's letter begins with the title "Our Commitment to Investors". The first 7 paragraphs of this section(almost three quarters of the section) are spent on praising the Board of Directors. It can only be looked at as humorous. The section should have been titled "Our Board of Directors is Great". Each Director gets their own individual mention related to a specific expertise or contribution. Unfortunately the only one of these Directors whose "work" I know well is praised for a contribution that is ludicrous(unless of course he has been through a late life six sigma experience).

GE is, as I said at the beginning, an amazing company. It is global, innovative, and influential in many ways. By almost all accounts it has a strong management culture. It is "So Big" that every institutional investor must own it, and few can take the risk of underweighting it. But it has lost some of its aura and has become a conglomerate again, a "great" one of course but still a conglomerate where, as the Chairman says, "Size and diversity create consistent and strong performance for investors"(does this bring to mind that conglomerate dirty word "cross-subsidy"). It sounds good but it does not sound exciting. It certainly deserves at least the 17 forward p/e that it currently has, but not so long ago GE was a company that often sported a 25 to 30 p/e and during the boom extravagently higher. My overall question today is "Has GE become too satisfied with itself?"

I do believe that the relative performance of GE will soon become more positive than in 2005, and with continued performance in a stable market the stock may move up to $40 in 2006. And if GE begins to look and act a little more fiesty again, there is upside from there.


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