In true British style, I have spent the last few of weeks building something up, only to knock it down. In response to recent posts, a friend observed, “General Electric shares also fell from $60 to $5 in 2009 because of GE Capital.”
GE had become an exemplary serial acquirer. Despite its well-known manufacturing legacy, GE had long been in the business of services. Through a series of acquisitions, its subsidiary GE Capital had become the largest US player in diversified financial services – larger that Fannie Mae and Freddie Mac, to give you a flavour of where this is going.
By the mid noughties, half of GE’s profits came from GE Capital. The relationship between GE’s traditional cashflows and the financial unit’s profits was a symbiotic one. GE’s reliable earnings afforded GE Capital a triple-A credit rating and a lower cost of debt than financial competitors without having to hold much capital on its balance sheet. GE Capital helped GE by financing the customers that buy GE turbines etc., and critically, enabling GE to “manage its earnings”. Due to the liquid nature of the financial assets, GE could quickly sell them at short notice to bring about GE’s legendary earnings results that regularly beat market estimates by a penny. Investors would happily pay more for predictable performance, and by the end of Jack Welch’s tenure in 2001, GE shares were trading at almost $60.
Between 2002 and 2006 interest rates were low, all assets seemed to be appreciating and GE Capital had decided to inject more debt into their acquisition programme. For example, the company had left the home mortgage business in 2000 but reentered it in 2004 when it bought the subprime lender WMC Mortgage. The financial crisis hit in 2007, and by April 2008, GE announced that first-quarter profits had fallen short of Wall Street’s expectations by $700 million, after reassuring the market investors a month before that it would hit its numbers. Bear Stearns had collapsed, causing credit markets to stall, which prevented GE Capital to deliver its usual “black box” magic to group earnings.
By mid-September and the failure of Lehman Brothers, things got much worse. GE had already tried to divest some of its businesses to raise funds, but no one would pay a respectable price under these conditions. Investors were gravitating towards risk free options. Eventually, GE had to strike a preferred stock deal with Warren Buffett’s Berkshire Hathaway in return for his investment seal of approval to coincide with a placing of $12 billion of common stock. This was not cheap capital and the markets knew it – GE was evidently desperate for cash to cover its debt obligations. By March 2009, the stock price dropped as low as $5.73.
GE survived on the back of its diversified portfolio (and more specifically its robust infrastructural division), as did Welch’s embattled successor Jeff Immelt, who set about scaling back GE Capital, to reduce its credit losses and to make it less volatile. He’s still there today.
Corporate development managers will know that acquisition growth programmes proceed through a number of fairly predictable stages: selecting possible acquisitions, narrowing the field, agreeing on a preferred target, assessing compliance with regulations, preliminary discussions, drafting a letter of intent, due diligence, negotiations, announcement, signatures, deal closure and integration. GE Capital were big contributors to the rule book on most of the processes and the market recognised that. $60 was evidently a premium stock market valuation.
I posit that the overvaluation, together with the drive of a new CEO, led to the overuse of the stock to buy assets of undervalued targets through merger. Combine this with the hubris and diminishing returns hypotheses mentioned previously in this blog, and what you have is an unhealthy feeding frenzy. Layer on top of that too much debt, an ambivalent (and almost dependent) market, unlucky timing and you suddenly have a recipe for failure. It has been said before, acquisitions are complex events that fail for numerous reasons.