Business

Wall Street's illogic leaves GE flat-footed

General Electric's Jeff Immelt cannot seem to please anyone.

Back in April when the company reported first-quarter earnings per share that came in 7 cents shy of expectations, traders hammered GE stock, and numerous analysts renewed their long-standing demand that Immelt “break up the company” by selling off various underperforming divisions. Few news accounts that week failed to note that since Immelt had taken over from hall of famer Jack Welch as captain of the sprawling industrial and financial giant, share prices had fallen 25 percent.

But when Immelt last week announced that GE would sell its appliance division, which had equipped American households with stoves and refrigerators for more than a century, others complained that it was another sign of the uncompetitiveness of the U.S. manufacturing sector, even at a company renowned for deep pockets, global reach and Japanese-like efficiency.

The irony, of course, is that Jeff Immelt is probably one of the best corporate executives on the planet.

In six years, he has managed to increase GE's revenue by 60 percent and double its profit while shedding $80 billion worth of assets and buying $50 billion worth of others. For a conglomerate that has recently relied on financial services to generate half of its profit, General Electric has managed to remain remarkably profitable, despite some write-offs, while limiting the hit to its share price to less than 25 percent.

Don't get me wrong: Immelt has made his share of missteps.

In hindsight, it is clear that he should have resisted the urge to join the rest of the financial sector and jump with both feet into the subprime mortgage market in 2003. He made noises about selling off some or all of GE's consumer-facing businesses — from dishwashers to credit cards to old-fashioned light bulbs — but it's a bit late into the global downturn for a company that likes to boast of knowing when to buy and when to sell.

Nor has Immelt articulated, in any convincing way, how owning television and cable networks and theme parks and overpaying for Hollywood studios fits with the “core” strategy of an industrial conglomerate that produces and finances airplane engines, gas and wind turbines, railroad locomotives, medical equipment, water treatment plants, and compressors for oil and gas drilling rigs.

But that's the thing about General Electric. Its genius has always been in its ability to constantly update its portfolio, moving out of low-margin commodity businesses while using the cash and knowledge it has generated to move up the value chain. In that respect, General Electric remains a metaphor for the dynamism and strength of the U.S. economy.

Over time, this strategy has made GE the stock to own for long-term investors looking for “a safe and reliable growth company,” as Immelt likes to put it. Unfortunately, under his predecessor, this wonderful reputation somehow got transformed into a solemn promise to deliver double-digit earnings growth every quarter, and to do so in a way that precisely matched the earnings guidance provided by the company. To meet those expectations, GE has become suspiciously adept at booking revenue and expenses and timing asset sales to meet earnings estimates with amazing precision and consistency.

The extent of this earnings management was revealed last month when an embarrassed Immelt explained that GE's failure to hit its quarterly number was a result of the credit crisis, which in the past two weeks of the quarter had suddenly and unexpectedly reduced the market value of securities holdings and prevented it from completing anticipated real estate sales. But rather than acknowledging the folly of predicting quarterly results in the midst of a financial panic and worldwide economic downturn – particularly for a company reliant on financial services and “lumpy” industrial sales – Immelt prostrated himself before analysts and promised it would never happen again.

Analysts, however, were not satisfied, and they jumped at the chance to read into the earnings a fundamental flaw in General Electric's long-term strategy.

“GE has to take a look at the portfolio and reduce the complexity — not only for financial management — but to provide better predictability for investors,” opined Steve Tusa, a J.P. Morgan analyst, as if quarterly predictability were the key to creating value for shareholders.

“We appear stuck in a framework where something is always underperforming,” said Citigroup's Jeff Sprague, who seemed to have forgotten that the very rationale for investing in a diversified conglomerate is that it includes companies that are up while others are down.

Having decided that GE's earnings surprise was the result of flawed corporate strategy, it was easy for Wall Street's analysts to take the next leap of illogic and conclude that salvation could come only from buying and selling assets. That, by coincidence, just happens to be the only course that generates fees for Wall Street brokers and investment bankers. If Immelt had dared to tell them the truth – that he needs the cash generated from some of these maturing businesses to invest in new markets and new technologies for the long term – he would have sent GE shares into a tailspin.

Immelt has the right strategy for General Electric, and he's the right man to execute it. But he risks being frustrated in his efforts if he cannot transform his company's relations with investors and opt out of the mindless earnings-expectation game. General Electric didn't become a great company just by buying and selling assets — it did it by creating innovative products and continually finding better ways to produce them. It won't remain a great company if it allows stock flippers and Wall Street analysts to distract it from its mission.

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