One of the hard parts about studying companies is recognizing how singular transactions can change the risks associated with the business even though the outward appearance remains the same. It is hard recognizing in real time that the General Re acquisition began Berkshire Hathaway’s shift from relying on stock portfolio dividends towards relying on sourced profits from operating companies. It is hard recognizing in real time that Harley Davidson had grown its financing empire to such a point that more money came from the financing on customers’ motorcycles than came from the actual sales of motorcycles.
Obviously, as General Electric shareholders long remember, the company reached a point in which half of its profits came from GE Capital and the other half came from GE Industrial. Even though most analysts consider the breadth of GE’s financial operations to be a problem, my opinion is that there is nothing wrong with having a large finance arm as long as it is conservatively funded to handle unusually large rates of default.
What happened at GE Capital is that the liquidity was about 45% lower than it is now, and it owned low-quality properties (think New Zealand malls with only a 80% occupancy rate) and large chunks of consumer credit card debt on private labels (much of that has been going out the door with the Sychrony spinoff although the profits from these operations are quite large except during crises when the default rates quintiple compared to normal times).
Today, General Electric announced that it is taking another step forward towards reducing the size of its finance operations. It is selling all of GE Capital’s lending operations in Australia and New Zealand to Varde Partners, Deutsche Bank, and Kohlberg, Kravis, & Roberts (of Barbarians at the Gate fame from the RJR Nabisco leveraged buyout). The price tag is over $6 billion, and is about 3% of the size of GE’s overall business. Today marks another small but continual step in GE’s march to a 75:25 Industrial-to-GE Capital profit ratio for the long term.
It has taken longer than many people expected because GE has simultaneously shed non-financial assets over the past several years as well, and this dilutes the weight of GE Industrial against GE Capital. Heck, it even sold NBC and its legendary appliance division. The reason why ordinary consumers don’t know this is because companies like Electrolux bargained for the ability to still display the GE logo on the appliances they own (as long as certain quality standards are met). That is why you could go to ACE Hardware, see an item with the GE logo on it, and then the fine print on the back will notify you that the profits are really going to Electrolux AB now.
It is similar to what has been going on in the funeral industry for the past two decades. You’ll see that the funeral company is called “John & Son” or something like that, have a vague idea that it’s been around the community forever, and then you’ll figure it’s a good place to bury friends and relatives because it has that local family touch. Then, you look at the business registration through the Secretary of State’s Office (in Missouri, you would go to sos.mo.gov) and see that Service Corp. International bought them out in 2003 but still trade on the name. They call it John & Son because they want you to feel comfortable and confident that you’re getting the localized touch even though the funeral profits are getting shipped to the equivalent of a Big Box Funeral Company.
The most interesting thing about the report is that GE reportedly said that they sold the Australian and New Zealand finance arm of GE Capital because they were facing investor pressures to limit the size of GE Capital. I doubt they will ever get rid of GE Capital outright because things like aircraft leasing, energy lending, and healthcare financing are very lucrative and easily fit into GE’s natural business operations—GE will build you a pipeline and then will charge you interest on a secured loan to pay off that pipeline over the next twenty years. With today’s sale, the logic seemed to be: “Our finance operations in New Zealand and Australia don’t generate high profit margins, and the investor community doesn’t really like our lending operations, so let’s jettison it.”
It is hard for me to tell whether that is flawed thinking or not. On one hand, investors saw profits tumble, the dividend get cut to $0.10, and the price of the stock decline to $6 because the old GE Capital could not be managed properly. The baby-out-with-the-bathwater is an understandable response. On the other hand, the remaining GE Capital assets are of much higher quality than the 2008 GE Finance portfolio, and GE’s Tier 1 Capital Ratio is now 11% compared to 6-7% going into the financial crisis.
General Electric had some sales setbacks recently with the decline in oil prices (because energy companies grew reluctant to buy GE equipment that will dig for costly, hard-to-access oil because those projects don’t make sense right now) but the overall future remains bright high single digit earnings per share growth projected and a current 3.67% dividend yield. If the next dividend increase takes the dividend payment to $1 annually, you could be collecting over 12% of your purchase price in dividends alone over the next three years from a strong $250 billion company that is going to be around for a very long time to come. It continues to amaze me how fairly valued General Electric remains compared to other large things in the stock market, and it probably has to deal with the fact that people are applying assumptions about GE Capital that were true six years ago but are not the case anymore.