photo by Tony Webster
The embattled leaders of General Electric Co. likely hope that most consumers think of their company as the titan it was a couple of decades ago. At a minimum, they’d like consumers not to link GE to words like “Enron” or “Madoff.”
Unfortunately for GE, an accounting expert recently made exactly those connections in an online report.
Harry Markopolos is best known for alerting regulators of investment manager Bernie Madoff’s misdeeds in the early 2000s. But the whistleblower recently turned his attention to GE. In a 175-page analysis of the company, Markopolos claimed that GE was hiding $38 billion in potential losses. He wrote: “The $38bn in accounting fraud amounts to over 40% of GE’s market capitalization, making it far more serious than either the Enron or WorldCom accounting frauds.” He also asserted that GE is insolvent.
GE has denied Markopolos’ claims, calling the report “meritless, misguided and self-serving speculation.” In its response to the report, GE noted that Markopolos disclosed that he would receive compensation from an unnamed hedge fund. The company said his report was merely an attempt to move the share price and profit as a result. In a gesture meant to show confidence, GE chief executive Larry Culp bought $2 million of GE stock on the day Markopolos published his report, following a $3 million purchase earlier that week.
Regardless of the merit, or lack thereof, of Markopolos’ claims, his accusations roiled the company’s stock price. GE shares fell 15% following news coverage of the report. At closing that day, the stock was down 11%, the worst one-day fall for GE stock in 11 years. GE shares have since recovered, seeming to indicate that investors have dismissed, or at least heavily discounted, Markopolos’ report.
Still, this is a hard fall for a company that was once a leading example of American industry. When I was in college, GE was not only a strong American company – it was a role model for other companies around the world. Business courses used it as an example to emulate. As The Wall Street Journal observed in late 2018, “General Electric Co. helped invent the world as we know it: wired up, plugged in and switched on.”
The past decade has represented a harsh decline from those golden days. The Great Recession hit GE hard, and the company has never really bounced back. Unlike many other U.S. companies with large market capitalization, GE’s stock price never returned to its pre-2008 highs. The past two years have been especially difficult; GE’s share price was above $30 in early 2017 and fell to about $7 by the end of 2018. Reuters noted that Markopolos’ report echoed previous assertions of Wall Street analysts who have raised alarms about GE’s low cash flow and allegedly opaque financial reports.
Perhaps the biggest drag on GE is its long-term care insurance holdings. Larry Elkin wrote in this space in early 2018 about reports that GE was considering breaking up its major divisions, in part to insulate better-performing units from the problems inherent in the LTC insurance sector. In his report, Markopolos claimed that LTC is an even bigger liability than GE has admitted. The report estimated that GE would need to boost its LTC insurance reserves by $18.5 billion in the next two years, in addition to its previously announced $15 billion expansion over the next seven years. GE is far from the only company that has suffered from the implosion of these policies. But the sector’s problems have put pressure on a corporate infrastructure that was arguably stretched too thin already.
Recently, GE has tried to streamline its operations. GE abruptly removed former CEO John Flannery and installed Culp last October. It also now boasts a leaner, mostly new board of directors. Culp has emphasized reducing costs and restructuring many of the company’s divisions. Business experts once considered a big conglomerate like GE among the safest ways to operate, because its wide array of products and services represented built-in diversification. Even if one area suffered, others could make up the difference. GE today illustrates the drawbacks of this approach. When a company does so many unrelated things, it becomes much harder to value, and an underperforming business line can threaten to drag down the whole company.
If you need proof of the complexity of GE’s structure, consider its annual report for 2018. In its 185 pages, the report covers eight diverse segments ranging from aviation to health care to renewable energy. Once you wade through those details, GE’s proxy statement is another 68 pages of dense analysis. I wonder how many shareholders actually read and understand all this complex information before deciding how they feel about GE’s future. Each segment represents potential pitfalls, and it is not self-evident how the company should balance these risks.
Even so, many investors remain optimistic. They often cite GE’s storied history and the fact that it still makes products that are integral to our society. A company that makes power turbines, jet engines and MRI machines should still have plenty to offer in the 21st century, GE’s boosters argue.
Yet none of these assumptions are bulletproof. Plenty of businesses with long histories of success have eventually reached the end of the road. Consider Sears, which once dominated the American retail landscape and filed for Chapter 11 bankruptcy last year. Or Washington Mutual, which was the largest savings and loan association in the United States until it collapsed in 2008. And while it is true that turbines and jet engines aren’t going anywhere in the short term, companies other than GE make them. GE might recover, but if it does, it will not be because it is irreplaceable.
GE was once a juggernaut, but that is no guarantee it cannot collapse. GE may be at risk even if it has done nothing wrong in its accounting practices. A company can honestly miss the mark on its estimates and projections. Valuation, by its nature, is not always accurate. The challenges in valuing a business accurately become even more acute with a large enterprise operating in many unrelated sectors.
At Palisades Hudson, we do not pick stocks, and we do not recommend our clients try it either. We generally invest in equities through mutual funds and exchange-traded funds, and thus avoid any attempt to predict the future of a particular company. I don’t know whether GE is doomed. It could still course-correct, but there is no guarantee that it will simply because of its successes in the past.
From the outside, we cannot know whether Markopolos’ allegations are accurate. But we can say with certainty that they are a sign that GE still has a long way to go if it wants to recapture its former glory.