Bitcoin sets a new all-time high above $6,000 >>> READ MORE

The Good, the Bad and the Ugly of GE Capital

GE's financial services unit is healing, but it's still a big drag


In the wake of Moody’s (NYSE:MCO) downgrade of GE Capital Credit (GECC) and its parent General Electric (NYSE:GE), some investors are wondering whether GE’s financial services business as it currently exists is still a valuable asset to the diversified conglomerate.

On Tuesday, Moody’s Investors Service downgraded GE’s senior unsecured debt rating to Aa3 from Aa2 and GECC’s rating to Aa1 from Aa2. While the ratings downgrade isn’t expected to raise GE’s cost of borrowing and the cut isn’t a huge deal on its own — Moody’s analysts noted that their long-term ratings outlook is stable both for GE and GECC — storm clouds loom.

“Moody’s believes the risk profiles of market-funded financial institutions, including GECC, are higher than was previously reflected in their ratings,” the credit agency said in a research note. “While GECC has improved its liquidity and capital levels since the onset of the credit crisis, Moody’s believes that, notwithstanding these positive steps, there remain material risks associated with the firm’s funding model.”

GE has come a long way since the dark days of 2009, when GE Capital was ravaged by the havoc the Great Recession wreaked on credit markets. Prior to the financial crisis, GECC had been a powerful engine of growth for GE — at one point accounting for as much as half of its profits.

CEO Jeffrey Immelt and the company’s outside adviser, McKinsey & Co., were “seduced” by supersize profits and GECC’s growth potential and missed the downturn’s impact on the company, according to The New York Times. Investors paid the price of GE’s need for better cash flow when the company cut its quarterly dividend by 68% because of the financial crisis.

GECC has since clawed its way back. At GE’s last earnings call in January, Immelt boasted about the financial services unit’s fortunes, noting that it was “strong and profitable” and has “exceeded all of their performance goals.”

But the unit is not yet out of the woods and still is a big enough contributor to GE’s bottom line to affect its parent’s earnings. Here is the good, the bad and the ugly of GE Capital:

The Good: Immelt is well aware of the dangers of having a high proportion of riskier assets on his balance sheet, and he’s looking to shed them. GECC has been quietly replacing those with safe and sleepy retail bank deposits. GE cut a deal in December to acquire $7.5 billion in MetLife’s bank deposits. The company also has been buying back a lot of stock — including $3.3 billion in preferred shares that Warren Buffett’s Berkshire Hathaway (NYSE:BRK.A) bought in 2008. And GE is in the process of merging its commercial lending and leasing unit, GE Capital Services, into GECC to consolidate its financial services operations.

The Bad: Despite having better capital levels and liquidity, GECC could still hurt GE’s bottom line. “The critical driver of the revised Aa3 rating is Moody’s expectation that GECC will continue to be a source of somewhat higher long-term risk,” the credit agency’s analysts maintained. Unfortunately for GE, the MetLife deposits are relatively tiny — GE would love to have $30 billion to $40 billion of additional retail deposits — and GE won’t be able to acquire them in a lump sum.

The Ugly: Although Moody’s senior analyst Mark Wasden hailed the measures GE has taken so far to beef up its balance sheet, he noted that the conglomerate still faces “heightened risk.” Said Wasden: “We believe that GECC’s revised strategies do not fully mitigate risks to its credit profile associated with its high reliance on confidence-sensitive funding.”

Bottom Line: Although GECC has rebounded from the recession, it remains a potential drain on its parent’s earnings. GECC’s Aa1 credit rating is riding on GE’s coattails. GECC not only benefits from operating and funding opportunities by having a strong parent like GE, but it also has access to other benefits. On its own, Moody’s says GECC’s credit rating would be Baa1, meaning it would have only an adequate ability to meet its financial obligations.

GECC is likely to drag down its parent in the short run, but GE’s other units — particular aviation — should mitigate that. After all, this is a diversified conglomerate with a market cap of $206 billion. If management maintains its commitment to improving its balance sheet, doesn’t go on an acquisitions spree and the economy cooperates, it should remain a decent long-term play.

As a one-year target, I think $22 is about right, and I think the 3.5% current dividend yield is probably sustainable.

As of this writing, Susan J. Aluise did not hold a position in any of the stocks named here.

Article printed from InvestorPlace Media,

©2017 InvestorPlace Media, LLC