Non-Earners vs. Reserves ?
Is GE Still a Buy at $6 ?
GE followed up its 2Q 09 Conference Call with a call last week (28.July) devoted to GE Capital. Managers provided another high quality presentation and appeared confident as ever. GE's managers are surely the masters of the powerpoint.
Mr. Market is pleased with the information provided. GECC CDS rates dropped 15 basis points to 340 points the morning of the call. $10 million of protection now costs a mere $325,000 per year on GECC coupons which have a weighted average interest payment of $483,300 per year.
It does not take Jack Welch to fathom the ramifications of a $325,000 imputed CDS cost does upon the value of $483,300 interest income in the secondary market. However despite the pessimistic view of GE's creditors, Owners should examine the situation independently.
The key questions for Owners remain:
- If management has provided adequate reserves to cover loan losses, GE Capital will spin off a fortune of cash. Quantifying how much cash is important for setting a price to buy GE.
- If reserves do not cover loan losses, then GE Capital will consume cash by the bucketful. The question in this scenario, will be the cash flow of the Industrial side of GE. Can GE's industrial side of the business carry GE Capital through if loan losses exceed reserves ?
Let's first try and answer the reserves question. The numbers, while large, are simple enough. GE's Owner have lent out approx. $500 Billion - of this $500 Billion; a mind boggling $13 Billion of these loan are 'Non-Earning'.
Non-earning means exactly what one think it does - non-earning. No late checks, no half-payments, it means the guy who are supposed to pay ain't paying nuth'g. If you are slow pay or behind on payments, then GE's managers put you in another bucket (say, in the 30+ days ) . The amount of loans which are paid to some degree (ie late or partially) are slightly less than $50 Billion !
Gudovac will argue that prudent Owners should include the 30+ days late in any analysis of reserves.
$50 Billion + $13 Billion = $63 Billion - let's round down to be generous, call it $60 billion of weak loans
GE Capital has some $60 Billion worth of weak loans.
Key question - How much has GE reserved against this $60 Billion of weak loans ?
Answer - $6.6 Billion
Management provided a masterful presentation of its recovery rates on various loan segments. The story behind the numbers is that GE will be brutal in collections. The phrase "GE work-out" is going to ring through the land. They are going to make Tony Soprano wince when it comes to collections.
Management is confident that less than $2 Billion will be unrecoverable out of the $60 billion in weak loans. Management projects that it will eventually recover 97% from the weak loans.
Management didn't provide any data on recovery rates for past recessions. Historic recovery data may have set the stage for a useful discussion.
Instead, Gudovac can only shake his head in sorrow at the naivete of management. What will the recovery rate be on this building ? How's about these CRE leasing numbers ?and how are those English mortgages doing ? What will the recovery rates be from these middle market debtors ?
It is a reasonable assumption that recovery for much commercial real estate will be less than 50% LTV - because the value of commercial real estate will drop 50% from peak numbers. Any reader who doubts this, can simply look to the English and Japanese real estate bubbles as a reference. Japanese real estate was still more than 50% below its peak 14 years later. GE will be underwater on virtually every last one of its real estate loans since it lent at 75% LTV.
Machinery and Equipment recovery rates will also be dramatically lower than management's naive estimates. Who believes that used machinery fetches more than a 30% LTV rate these days ?
Gudovac will guesstimate that 25% of the weak loans now sitting on GE's books will be unrecoverable. 25% equals $15 billion out of the $60 Billion of weak loans and $500 Billion in total loans.
What is the impact on GE if $15 billion needs to be written off ? $6.6 sits in reserves. That leaves approximately $9 billion to cover through ongoing cash flow.
$9 billion is about 14 months of GE's Cash Flow from Industrial Operations.
Gudovac believes that feeding 14 months Cash Flow to GECC will not wreck GE. Gudovac believes this cash flow drain will occur over a 36 month period. This is manageable.
The GECC presentation does not change Gudovac's price to buy GE common. GE is still a good company to Own at $6.
Note 1 - Management provided some good information on the ongoing business of GECC lending more money. They are wisely shrinking new lending. Gudovac believes the key question for GECC isn't new lending, rather it is existing loans.
Note 2 - Management did not provide any information on how much GE industrial goods are paid for with GE Capital financing. Owners will want their hired Managers to provide this data soon. GE's Management culture is one of meeting-your-numbers-or-else. Owners do not want to see GE turn into another Lucent.
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Don't Get Massacred !
Gudovac1941
A reader asked about GE's lending to middle market companies.
ReplyDeleteGudovac responds:
Among middle market private owners, it was generally recognized that GE Capital was among the worst lenders to get involved with. If you owned a medium sized business and needed say $10 - $25 million in debt - the preferred supply of credit would have been a regional bank such as Huntington, Fifth-Third, or National City. They were easy to work with and local guys.
The next tier down (from debtor's perspective) would have been the larger Banks (Wells, BofA,). Middle Market Owners perceived these lenders to be less 'friendly' than the regional lenders.
The next tier down would have been bulge bracket investment banks. Middle Market private owners disliked working with these guys, because they were always pushing expensive, complex, and useless investment banking services. Plus they were arrogant individuals who didn't appear to have any staying power.
Middle Market owners wanted a 5-10 year relationship with their lender.
Finally - at the lowest tier of desirability was GE Capital, CIT, and a handful of others. Only after exhausting all other possibilities would a Middle Market Owners go to GE Capital for credit.
Therefore, one can expect that GE Capital's middle market lending to be of slightly less quality than perhaps National Citys.