GE is Likely to Lead Stock Market Lower During Second Half of 2009
In my October 2, 2008, blog posting “GE and Its Shares Are Skating On Thin Ice” I said that “GE’s share price will consistently erode to new lows”. That was the day after GE’s shares had rallied and had closed at $23.16, up 7% from their low of $21.65, after the company made the announcement that Warren Buffet’s Berkshire Hathaway had invested $3 billion into newly issued GE preferred shares. GE had also announced that it was raising an additional $12 billion from the sale of its shares via a secondary offering.
After I read the initial October 1st news announcement on Buffet and the secondary offering for GE I was completely stunned. I had not recalled a single instance when GE had to sell newly issued shares at any price in my 31 years that I had been involved in the securities industry and the stock market. From all of my experience, I knew that it was a big no no for a pristine blue chip company such as GE to have to grovel to sell new shares especially at prices which are at or near a multi-year low. The move by GE smacked of desperation.
In fact, for as long as I could remember General Electric, one of the world’s largest and best run companies, has had a long-term track record of consistent share buy backs. For the three year period ended on December 31, 2007, GE had purchased $25 billion of its own shares at what would prove to be a 50% premium over the price that it sold shares at in its announced October 2008, secondary offering. Even in the six months ended June 30, 2008, only three months before its secondary offering, GE had purchased $1.5 Billion of its own shares at significantly higher prices. Big blue chip companies are supposed to be smart enough to issue new shares at their highs and buy them back at their lows and for GE exactly the opposite happened.
The sudden reversal in GE’s financial condition over such a short period of time and the inability of its management to get a grasp on it was telling. To me, it was a huge red flag that underscored the serious underlying problems of global economy and capital markets. If arguably one of the world’s largest and best run companies like GE was having problems what did that mean for the thousands of lesser companies? It led me to change my position from being a bull to a super bear. Its announcement was not just a warning it was the equivalent of the dropping of an atom bomb. Their announcement was so profound that it became the impetus for my founding of www.bearmarketnavigator.com, which is a web site that is dedicated to educating investors about Super or secular bear markets and how to navigate in them. The announcement by GE and the subsequent developments including the passing of the TARP by Congress, which occurred over the next six days led to my blog posting “Look out below” on October 7, 2008. In that blog, I said that “the stock market would continue in its free fall”. Note: October 7th was the very last day in which the S&P 500 and Dow 30 Industrials Indices traded at above 1000 and 10,000 respectively.
Since October of 2008, I have paid little attention to GE except for the fact that its shares had bottomed in the high $5 range during March of 2009. After all, I had said in my October 2, 2008 blog posting that GE shares would continue on to new lows when they were trading in the low $20s. My antennae perked up on GE after I recently read a story and watched a web video that covered an analyst who is predicting that its share price is going to $2.00, See story.
Based on the analyst’s rationale I realized that GE’s financial condition had deteriorated significantly and at a much faster rate than I had even expected. GE’s current problem is that its tangible net worth has fallen for four consecutive quarters from a high of $18.0 Billion to a current low of $5.6 Billion even though it received an injection of over $15 billion of tangible equity from Buffet and the public only two quarters ago.
The deterioration in GE’s tangible book value is disconcerting because the ratio of GE’s tangible book value or net worth to its total liabilities is now 0.84% or less than one percent. The ratio means that there would be less than one percent left over if GE had to liquidate all of its $664 billion of tangible assets to pay off $659 Billion in total liabilities. Since it would be extremely difficult for any company to liquidate their assets with such a narrow spread this poses a big potential problem for GE. Why? Because all companies including GE who borrow are normally required to enter into and maintain debt covenants with their lenders. These covenants generally require that they maintain sufficient financial ratios including the tangible book value to debt ratio. Otherwise the bank has the right to call the loan and force repayment. Since GE’s ratio has dropped from over 2% to under 1% the odds are high that GE may be required to raise more equity capital via the issuance and sale of more common shares. Should GE be required to do so the price of their shares would most likely decline sharply.
Another problem that GE has is that its ratio of tangible assets to total assets is also very low. Should the value of GE’s total $760 Billion in assets fall by even one percent, which would be the equivalent of $7.6 billion, all of GE’s tangible book value would be wiped out and it would be left with a deficit. In the current economic environment its would not be hard to argue that GE’s assets could have already fallen by five percent in value. If that were to actually happen GE’s tangible book value would go to a deficit of $30 billion. Such a drastic change in this metric for GE could create a cascade of loan covenant defaults. The resulting capital calls by its lending banks could generate significant dilution for GE shareholders.
The bottom line is that GE has little room to maneuver and has no margin for error. For this reason I believe that the probability is high that GE will have to raise $20 to $30 Billion by the end of the year. The only way that GE could avoid having to raise capital is if the economy were to miraculously have a strong rebound in the second half of 2009.
The price action of GE shares, which have come down from their Bear Market Rally high of $14.53 in May to a current price of $10.86 indicate that I am not the only one who is worried about GE and its financial well being. Given that the bloom is now off the rose and that the economy is now expected rebound sometime in 2010 instead of this year it will be difficult for GE shares to generate any upside momentum for the duration of 2009. I now believe that the probability is high that GE shares will continue to drift lower and that they will likely test their 2009 March low of $5.87 by the end of the year. I also believe that the negative announcements that are likely to come from GE will be the catalyst, which will cause increased overall market volatility and significant declines for the major indices over the next six to 12 months.
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