Can GE Survive Its Cooked Books?

Jack Welch gives himself an F for picking his successor, Jeff Immelt. And GE’s accountants were not doing their jobs when Immelt was CEO.

Those are two things I learned from a long December 14 Wall Street Journal article about GE (whose shares are in my portfolio).

Part of me is grasping at the idea that holding GE stock at this price is a lottery ticket on the chance that CEO Larry Culp can revive the company’s revenue growth.

The more realistic side is thinking that JPMorgan analyst Steve Tusa was wrong on December 13 to upgrade his rating on GE from sell to neutral because most of the bad news about GE was reflected in its stock price.

This makes me wonder whether GE can survive its cooked books — and where GE’s auditor, KPMG — whose contract with GE is up for bid and could end in 2020, according to Bloomberg — was when all this was happening.

A KPMG spokesman said in a statement December 14, “We’ve been privileged to work with GE for many years and are proud of our work and our teams. It is good governance, and a responsible activity, for strong audit committees to review and assess their external auditor relationships. We welcome the future opportunity to work with all the stakeholders to demonstrate the value KPMG can continue to deliver.”

Before getting into that, let’s take a look down memory lane. 17 years ago, you’ll recall, Enron went bankrupt — creating $74 billion in losses, sending thousands of Enron employees on the street, and wiping out accounting giant Arthur Andersen.

If — as Mitt Romney famously said in 2011, “Corporations are people too, my friend.” — Enron was a hypocrite and a liar.

As I wrote in my 2003 book Value Leadership, Enron executives behaved in direct opposition to its values — including what it wrote about Respect: ”We treat others as we would like to be treated ourselves. We do not tolerate abusive or disrespectful treatment. Ruthlessness, callousness and arrogance don’t belong here.‘’

And of course Enron cooked its books — which got famous short-seller Jim Chanos curious about why Enron’s revenues were rising and its cash flow was not. As it turned out, Enron was hiding its debt in off-balance-sheet entities and Arthur Andersen signed off on it.

What does this have to do with GE? It started with Jack Welch — who was famous for a consistent string of double digit earnings per share increases — that beat expectations by a penny — abetted by GE Capital.

As the Journal wrote, GE Capital was

A handy, deep bucket of financial spackle with which to smooth over the cracks in quarterly earnings reports and keep Wall Street happy. Sometimes that meant peddling half a parking lot on the final day of a quarter, or selling a part interest in a power plant only to purchase it back after the quarter closed.

Immelt was different than Welch in that he thought leadership was about being optimistic and making people feel good. But he also had an ego that made him want to create a legacy for his tenure at GE.

So Immelt overpaid for a cash flow sucking maker of trains, rail equipment, power turbines and generators, France’s Alstom. After that deal closed in November 2015, demand for the turbines flagged.

GE Power executives — losing the cash flow from GE Capital $310 billion whose assets had been sold — took a page from Welch’s strategy: to make it appear that GE Power was meeting its revenue and profit targets, they manipulated the numbers to come out better than GE Power’s economic reality.

And in so doing, they brought Enron to my mind. According to the Journal, “GE executives assured one another they were making accounting maneuvers [that] were legal, if aggressive. But [these maneuvers] also meant that the profits were mostly on paper. Rarely was a new dollar of profit flowing in the door.”

Indeed those maneuvers — which included giving GE Power customers discounts on service contracts in exchange for paying earlier — contributed to a $1 billion cash flow shortfall from GE’s Industrial businesses that came to light in April 2017.

This shortfall “raised red flags about aggressive accounting and whether the company could make its goals,” according to the Journal.

This was not the only accounting problem facing GE. In 2004, GE spun off most of its insurance holdings into Genworth Financial — selling most of the remainder to Swiss Reinsurance Co. two years later.

But not all of that corporate cancer was surgically removed — instead, GE held onto long-term-care insurance — that covers nursing home and assisted living expenses.

The problem was that GE’s 300,000 policies — 4% of those sold in the U.S. — were money losers. This problem fell to Immelt’s successor, John Flannery.

In a November 2017 presentation on his strategy for fixing GE, the shortfall between premiums received and losses paid was worse than expected.

Two months earlier, GE’s CFO Jamie Miller had estimated the shortfall at $3 billion. But in Flannery’s presentation — the figure was more than $6 billion. What’s more insurance regulators demanded that GE come up with $15 billion in reserves against future costs, noted the Journal.

In September 2018, Flannery sealed his doom with a presentation to directors in which he announced GE would miss its cash-flow targets and would have to take a charge of more than $20 billion to write off Alstom and other previous acquisitions.

To paraphrase Michael Corleone from Godfather II, if anything in this life is certain — if history has taught us anything, it’s that a CEO who cuts corners on accounting will kill the company. Enron’s CEO did.

I hope that Welch and Immelt did not plant the same seeds of destruction.

GE’s board needs to conduct an exhaustive independent audit to get to the bottom of its accounting problems.

With KPMG — which has audited GE since 1909 and earned almost $143 million in audit fees in 2017, according to the Journal — slated to continue as GE’s auditor until at least 2019, how can that happen?