In SumZero's inaugural podcast episode, our CEO Divya Narendra is joined by Albert Meyer of Bastiat Capital to parse Harry Markopolos' GE report and make sense of the fraud accusations levered against the company last week.
Meyer has researched General Electric extensively for over ten years and has never bought the stock for his own clients, citing discomfort with GE's share-based compensation and other red flags in their corporate governance. According to Meyer, GE's insurance division is its Achilles heel and poses a major threat to the business as a whole. Coupled with a slew of bad acquisitions and ill-advised stock buybacks, Meyer believes these vulnerabilities could prove to be "almost fatal".
Finally, he invokes the cautionary tale of Enron: "How come such a respected company like Enron could just fold overnight? Very simply, because of a run on the bank. No company can withstand a run on the bank and in other words, your creditors and your financiers and your banks etc just suddenly freeze on you and the market drives your stock price down" to a point of no return.
Listen to the episode here and read the full transcript below. Please reach out to email@example.com if interested in a warm introduction to Meyer & his team or if you'd like to sit for our next installment.
Avery Pagan: Good morning everyone, this is Avery Pagan from SumZero. Today we welcome an exclusive conversation on General Electric’s recent turmoil in the markets between our CEO Divya Narendra and Albert Meyer of Bastiat Capital. Meyer is the founder/PM of his Dallas-based long-only fund and a forensic accountant by trade. His lengthy career is marked by high-profile fraud calls on Tyco and New Era Philanthropy and he sees some distinct vulnerabilities within GE’s accounting and compensation practices. Meyer is relentlessly objective, relies on his instincts and the principles of accounting and we look forward to a great conversation today. Welcome Albert.
Divya Narendra: Can you hear me?
Albert Meyer: Yeah Divya, I can. Thanks.
DN: Awesome, well, I guess most of this is going to be on you since you are the expert but just having read some of the news on GE and at least following this story as it’s developed, you know, it seems like the report is pretty explosive, you know, anytime someone calls fraud - calls out fraud especially for a company of GE’s size, people are going to notice. There was obviously the move in the markets 11 or 12% on the day the news came out. Just at a really high level, when I look at the business, it’s got a market cap of around $70B but with over $100B of debt, maybe $95 - 100B of net debt. It’s not exactly a balance sheet that - at least for value-oriented investors - seems to be super compelling but that said, I think calling it a fraud is a whole different - it’s a much bigger step and a much bolder statement altogether. You’ve obviously read the Markopolos report in detail. One of the issues that sort of jumps out at you is the insurance claim or the increase in claims payments over the years… do you see that as an indication of fraud or do you see that as more of a degradation of that business that may just not be fully appreciated by the markets?
AM: I think my initial reaction was that using the word “fraud” was too much of an emotive term and maybe defamatory et cetera. But you have to give him credit for having gone to the insurance filings, the statutory filings and detailing some information that apparently was not given to analysts at the so-called “teach in” and I think that’s where he comes up with fraud, saying you should have detailed that information to us.
AM: And we can look at a few of the rather startling findings. So yeah, give him credit for having gone to the statutory filings and in a way, he’s doing the capital markets a massive favor because he’s saying to all the insurers, public companies ‘you know what, you’ve got your statutory filings out there and some of the short-sellers are going to look at it very closely and you better be sure what you tell investors gel with that or if it doesn’t, that you make a very good case why a gap still allows certain leeway as far as reserves are concerned. At the end of the report, he lists other incidences of what he calls fraud and SEC - settlements they made with SEC etc - so if you just look at that briefly, there’s a bit of a history with GE. Unfortunately, there’s a bit of history.
AM: So, whether it’s fraud or not, theres’ definitely misrepresentation. There’s definitely been some misrepresentation because they’ve been adding to their reserves - very little to their reserves - compared to their two main companies Prudential and Unum, and then suddenly at the end of 2017, beginning of 2018, they suddenly increased that by 15B - that’s from 1.2B to 15B - that kind of jump suggests the reserve was much higher in prior years but they delayed adding to the reserve because they didn’t want to impact their earnings.
DN: Albert, do you think that part of the problem is just FASB requirements on segment reporting, making it easier for GE to, you know, punt issues down the line or just simply not disclose things because they’re not actually required to, whereas maybe a Prudential would be? Or is this something more intentional on their part?
AM: Well, I think when you have these large segments, the more detail the better. Leslie Seidman alluded to that - if that is what investors want, you certainly will give it to them. But, you know, it really comes back again, looking at the statutory filings and he compares the difference between the reserve that they show in their statutory filings and the reserve they show on the GAAP numbers, there’s a 52% gap. Whereas with Unum its 11%, Prudential 7%, Genworth 6%. So the gap is just too large not to highlight when you’re talking to investors. Saying this is our reserve for GAAP purposes and there’s a 52% gap and with other insurers it’s much less and that is startling. That’s a big difference that he highlights.
DN: It’s interesting you mention Seidman. I was just watching an interview she did on CNBC where she was 100% confident - or at least appeared to be 100% confident - in GE doing things the right way from an accounting standpoint and you know, she seems like a credible person given her background as former chairman of FASB. But I just thought that was such a stark contrast to some of the claims. But overall, it sounds like her argument - and I’m just playing devil’s advocate here - is you know, these problems aren’t new, we’re working through them, but the idea that there is any fraud - which is a willful intent to deceive - that that’s just totally preposterous. That’s kind of her point of view. Is there any way to reconcile that point of view with what you’re saying, which is to say the way they’re treating these claims and the reserves balances against them, that they can be so much larger than their competitors without an intent to deceive the markets or an intent to deceive investors.
AM: Well, I also listened to that interview and yes, she did a good job in trying to settle the nerves but she did admit that there are a lot of assumptions and inputs. In other words, there’s a lot of subjectivity. And unfortunately, there is a lot of subjectivity and I would blame FASB for that to some extent because if we just take goodwill - let’s just take goodwill - where management can decide where the goodwill’s impaired or not. And in fact, with the Alstom acquisition, they came up in 2018 and said well, it’s impaired by 22B. Then they explained how they calculate that impairment and it really doesn’t make sense. It’s very opaque. And my argument has always been with goodwill - because we used to amortize it over 40 years - now there was an arbitrary period but at least it put an expense in the income statement. But a better way would have been - and this is what I do it when I analyze companies - I take the five best companies in their peer group and I calculate the peer group’s return on assets over a three year moving average and then I calculate the company I am analyzing return on assets. And if it falls below the peer group, to me, it’s an indication that goodwill is impaired because you’re buying super profit. You’re buying companies that’s going to make better profits than the average in your peer group and so that’s a very objective way, a sensible way of calculating impairment. Otherwise, you are getting these sudden $22B write-offs every now and then and it’s very subjective. Now the same with FASB in the case of the reserve ratios - the big gap between GAAP and the statutory requirements, it is a problem and FASB addressed that because in 2021 they’re going to have to bring that very much closer, if not totally in line with the statutory requirements.
DN: Would you say the $52B or so they have currently on their balance sheet as goodwill, I guess how far off do you think that is? Do you think that goes to zero?
AM: Well they have no return on assets, do they? They haven’t made any profit for 2 years and their return on assets in 2000 was 3%, by 2007-2008 it was down to 1%. So they’ve had a goodwill impairment problem going back a long way. Sometimes I just take a rule of thumb of 8% and say man, you’ve got to earn at least 6-8% return on assets.
DN: Just to meet your cost of capital, yeah.
AM: Yeah and it’s frightening really, because its 60B in goodwill and 30B in equity, so you just have to cut goodwill by half.
DN: And your equity’s gone, yeah.
AM: Then also, another way perhaps, which is just a rule of thumb, you take the difference between the net book value and market value - which I think, in this case, would be about $40B and you say, well let’s just say 50% of that’s valid, so $20B - so goodwill should be about $20B, maybe $30B at the most. The market value between book and market, there’s some justification that that represents goodwill but let’s give that a bit of a haircut.
DN: What would you say - and I was watching a guy, I think it was William Blair but it was another interview, one of these sell-side analysts - talking about GE and just looking at consensus numbers on a forward basis. You know, forward earnings multiple on GE is something like 11x call it, which implies that they will be turning a profit next year. What are they missing? What is the street just not understanding with respect to GE?
AM: Well I think based on Markopolos’ numbers, they’re missing the fact that GE has got to increase its reserves by about $29B and if you do that, you’re not going to have earnings. Whether you do it over 7 years or 2 years or 1 year, you’re not going to have really good earnings. And by 2021, they’re going to have to conform to the new accounting rules which will lead to $10-20B in increased reserves, so I think they’re missing that - because Markopolos points out that Prudential has a loss ratio of 185% and their reserve represents $113,455 per policy whereas GE with a much higher ratio only has $79,000 per policy. Then, GE has 26% of its policies not paying a premium whereas Prudential it’s 2%. And 70% of GEs policies are lifetime benefits, whereas Prudential is on 24%. So, the ratios when you compare Prudential with GE, the ratios are starkly different. That’s where we have to give Markopolos credit, you have to give a guy credit that he went and looked and did a very in depth analysis.
DN: Yeah. Oh and the markets have definitely given the guy a lot of credit. My sense is that the headline alone, you know, “the Madoff guy calls out GE”, just given his background, that’s obviously enough, without people having even looked at the report, to give the guy credit to the tune of a 12% stock price drop. So, on the subject of the insurance business, just talking about Prudential a bit, do you see that division as something that GE can turn around? In theory, I”m assuming that these services are somewhat commoditized. I mean I don’t know what Prudential does that GE couldn’t in theory replicate. Or is it just that they’re really bad at pricing these policies. What do you think the problem is in the insurance unit that has resulted in it being an ongoing liability for them vis-a-vis the other players in the market that are in a healthier position?
AM: Ok, again according to Markopolos, they have been very slow in building up their reserves and as a result, you get these humongous charges. Secondly - now I don’t think GE wrote all the premiums, I think they’re the reinsurers, but according to some slides they split some of the insurance between LifePlan and GE and Life Plan got all the nice premiums and GE got all the toxic policies and they are toxic because he points out the payment schedule which went up from 2017, was it 300M to over 500M in 2018, $596M. So the payments are humongous, suddenly just jump. These are because the policy holders are getting older and are now moving into their critical age group. And he says you can’t sell this business, nobody is going to buy this, it’s just full of toxic policies and that may be a little bit emotive but it does seem like they have a major problem in the insurance division.
DN: Yeah. Let’s move on to Baker Hughes. I know you had a lot to say about that in terms of them consolidating Baker Hughes on to their own financial statements. What’s your view on that for folks who are listening?
AM: Well, again, it’s the defense GAAP made me do it. It certainly makes the cash flow operations look better by consolidating, it makes their current ratio look better and also it makes the earnings look better because if they treated it not as a consolidated entity but as an investment, they would have had to recognize about $7B - or $9B - in loss of market value on top of the $22B impairment charge, that would’ve been a real hit. But then Markopolos has the FASB variable interest model, a flow chart produced by Ernst & Young and it’s clear in terms of that flow chart that only Baker Hughes should consolidate that variable entity, so it’s problematic.
DN: And Albert, maybe it would be helpful to explain that a little bit because from what I understand, GE does own more than 50% of Baker Hughes but there are some control issues that would also play. So what’s the exact rule on consolidation and how does it apply to Baker Hughes? If you could just walk us through that, that’d be helpful.
AM: Well you have to have power and benefits of the entity and the question is - is there a single decision maker or is power shared? There’s a single decision maker which is Baker Hughes. Does the decision maker have benefits concerning both direct and indirect interests? Yes. That’s the flow chart and the flow chart does not show GE as having any shared control or decision making. And also, the fact is they’ve actually decided to divest themselves. But if I believe this flow chart, very clear that Baker Hughes consolidates and not GE.
DN: Got it. What’s the word on the divestiture? Is that something that you see happening in the near term?
AM: Yeah, Steve Winniker, who I think is the head of Investor Relations. He makes a point that we are going to sell it in the near future and they said when we do, we’re going to recognize another loss of $7B; “We expect to take a loss in Q3 18 of $7.4B”. So they want to sell it.
DN: What did they pay for their stake in Baker Hughes?
AM: Oh, I have it somewhere here. I don’t know. But, they made a very bad acquisition with Alstom, they took a 22B impairment hit and the Baker Hughes joint venture didn’t work out either. See this is the problem, GE might be a wonderful company with the world’s best engineers and great products and I believe it is, but what happens when they make all that money, you have - in the corporate office - executives who are just clueless. In my report I showed how they bought back 686M from 2001 to 2007 at an average of about $36 per share. I mean it’s just outrageous and 404M of that 686M, they actually gave to employees. So they spent two-thirds of that buyback money just to mop up dilution and so the actual share count only came down by 182M and then when the credit crisis hit, they had to issue exactly the same number of shares - 686M - at a much reduced price just to remain liquid and Warren Buffet actually took advantage of that and he actually got his Preferred Shares, he got his 13% coupon and then that got redeemed and then he got his warrants which he exercised and then, I think the summer of 2017 he sold out.
DN: Before we get to Buffet, which is another interesting discussion point, what is your take on the CEO vis a vis stock buybacks? You’re saying they’ve got a history of poor capital allocation just as it relates to buybacks. Do you feel like that would happen under [Larry Culp’s] watch as well?
AM: No, it won’t and that is important. What happened didn’t happen on his watch. So in 2013 to 2015, they bought back another 616M at $25 a share and from 2016 to 2018 another 874M shares at $29. So, considering today’s price, that was $30B just totally misallocated. But that didn’t happen on his watch and it’s true when Leslie Seidman said ‘this is not the GE I know’. Well, it probably isn’t because she only got there 18 months ago and she only became the chairperson of the audit committee in April, so I think they all have a lot to learn still. But to say that this analysis is beyond the pale, it’s like shooting the messenger. A better response would have been to say, we note the criticisms and we realize that our policies are more difficult perhaps than Prudential and she did say that we’re doing an insurance review in Q3. Now if they do a review, are they going to come out with an increased reserve at the end of September? Or are they going to say we haven’t quite completed it, we will provide for the reserve in the 4th quarter. Either way, I think Markoplos is saying that you’re going to need another $18B to add and then in 2021, when the new accounting standard comes in, there will be another $10B. So we’re all looking and saying, is it going to be $18B or $8B or much less? And it’s going to be very difficult for them to get to a number that’s going to satisfy the investment community, knowing what they’ve seen in Markopolos’ analysis.
DN: But you think it’s likely Buffett comes in and buys some preferred shares with a really sweet coupon?
AM: I don’t know how likely it is because, you know, I think when companies are in trouble they come to Buffett and he doesn’t always bite. But if they come out with a really sweet deal again, he’s sitting on a lot of cash and he probably knows that if he does provide 20B or 30B, the price could go up to $20 in a hurry and these warrants would kick and then he could ease out again. I mean, he could do a replay and if I’m a short seller - which I’m not - then I’ll always be worried about that. I;ll be worried that Buffett steps in and saves the day for them.
DN: Given the risk of a Buffett stepping in - or maybe it’s not Buffett, maybe it’s someone else - what would you say is the fair value of GE stock today? If we took Markopolos’ word, I mean he’s basically saying this is a zero. But what would you say is a realistic fair value for the business today?
AM: Well, you have to conclude that these reserves are going to be added and it’s got to be funded. And then you have to look at the cash flow generation over the past seven years which I think came to about $14B or $15B and a lot of that is just going to go to fund these insurance reserves. And if you don’t have free cash flow and you’re sitting on 100-odd billion in debt, then it’s very difficult. He also points out that if you are going to reserve for this, it’s going to wipe out the current equity. Now it all depends how profitable they are in 2019, 2020, 2021 to rebuild that equity but the problem is all this money that they’ve spent on stock buybacks and really crazy acquisitions, it’s almost fatal. It’s very difficult to put a value to GE. I mean, if you could get rid of the insurance group, then it’s very viable but this could sink the ship.
DN: But you don’t think there’s a buyer for the insurance group?
AM: Well not according to Markopolos, it’s impossible to sell a broken company like this. Because it’s going to be negative cash flows all the way. THey’re not collecting enough in premium income to meet these claims.
DN: Right, well that’s what I asked earlier. What is about the claims they have that they just can’t - I guess all those contracts must have just been mispriced...
AM: Yeah, they were mispriced and if they were seeded to GE under the reinsurance agreements they weren’t properly valued. The discounting rates and the claim, these things weren’t calculated properly.
DN: What would you say are the growth opportunities for GE in the next couple years outside of insurance. Where do you see opportunities for them to help support some of the failing businesses?
AM: Well, I think the industrial side is probably any day as good as nanotechnology, Honeywell etc. They’re pretty good, decent companies and you know, health care, bio pharma, apparently they want to sell that part. I would say healthcare. I don’t know about the appliances where are tehy really making a lot of money. It’s very tough. I’m not that into all the various segments. Now, he also points out that there is a problem in the leasing business and I didn’t actually get into that part of it. It’s very difficult, very difficult.
DN: You don’t sound very bullish.
AM: [Laughs] I’m trying to be objective, you know. I’m trying to be objective but I know that if you buy bad assets and you squander capital.. And you know, you say ‘why did I stay away from it?’. I stayed away from it because when you have a difficult company with many moving parts, one good starting point would be to look at corporate governance and read the proxy, read the proxy and find out what are they at and it’s all about enriching insiders. You give them stock options and truckloads of it and when something bad happens, then you double up on it and you say ‘well, we have to do this to retain it’ and then you say ‘well, who’s going to hire them away’. They’ve just destroyed a company with a stock price of $54 and it’s down to 5 bucks and they’ve bought back 600M shares and now they’re issuing 600M shares at a real buy high/sell low sort of model and then you talk about value creation, things like that, in the proxy which just makes no sense. And so by just looking at the way they structure their compensation - and you’ve got to remember, I always stress this and I hope people figure that out too - the FASB rules are just wrong. In fact, in the proxy they point out ‘we use stock-based compensation because of the very favorable accounting cost associated with stock awards’. I mean they’re basically saying FASB is making it possible for us to understate our compensation expense, so why wouldn’t we issue options? Well, it’s a mirage because when you spend billions of dollars - tens of billions of dollars - to buy back that stock, which doesn’t help the shareholder because you’ve inflated the share count and now you’re just trying to bring it back, then that cash cost is actually compensation expense.
DN: Well, you know, it’s a huge problem in the technology industry where this sort of stuff happens rampantly.
AM: See, I think people in the technology - Apple, Microsoft, Google etc have kind of grown out of it. They use restricted stock units but they use it in a very modest fashion. The stock option overhang in 2011 was 4.6% and now it’s 5.4%, even though those options are going to expire worthless now. The fact is they haven’t followed the example of others - for instance, Bank of America when Moynihan took over, he threw out all the options and he lowered his own compensation to $3M, I think the previous CEO got over $20M a year. So he brought in some real discipline and he realized that stock options is just going to destroy shareholder value. But that didn’t happen at GE, they didn’t learn that lesson.
DN: And you don’t see any of that changing with the new management?
AM: Well, they issued - they had 400M options outstanding and they issued another 108M in 2018, which is, to me, more of the same I’m afraid. More of the same.
DN: Right, right. Any other highlights? Any other points worth delving into? Actually going back to Markopolos a little bit, let’s just walk through the comparison to Enron. His statement, which you said earlier was emotive, was ‘this is a fraud that’s bigger than Enron and WorldCom’ combined. What’s your view on that?
AM: Yeah, I don;t know if it’s worth them combined or not. But I think Skilling made a valid point when they asked him about ‘how come such a respected company like Enron could just fold overnight’ and he said ‘very simply, because of a run on the bank. No company can withstand a run on the bank and in other words, our creditors and our financiers and our banks etc just suddenly froze on us and the market drove our stock price down and that was fatal, terminal. So what you need at GE is a lot of confidence from banks and creditors and everybody else to say ‘no, we are happy to add to your credit lines’ or whatever. But they are also going to have to be very transparent. When they finish this review with Leslie Seidman that they’re doing now in the fourth quarter. When they finish that, it’s going to have to be very well supported by the underlying evidence and the gap between the statutory reserve and the GAAP reserve has got to come down and it’s got to be explained. Why is it so large or not large? I mean, it’s crunch time.
DN: So what are their current credit facilities in place right now if they were hit with some sort of - you mentioned 2021, when that rule changes and they’re going to have to increase their reserves - but any sort of surprise event where they’d have to inject liquidity into the business, what levers could they pull?
AM: Well there was one analyst who came on CNBC and he said, well they have got various assets they can sell and they’ve got existing credit lines and he felt they could have 100B in liquidity a hurry. I think that would go a long way, that could be fantastic for them but if they want to sell their bio pharma and other divisions like that under a fire sale situation, they’re not going to get the price they want.
AM: You know, it’s not an easy time but I think it’s time for the bankers to step up and help the CEO. I don’t blame him. I think he inherited this and I don’t know if it’s true or not, but somebody suggested that he probably doesn’t understand the insurance industry. When he took over from Danaher, he came from an industrial world into a world of finance with toxic insurance policies and he might have misread the situation. I don’t know but I don’t blame him. You know, the Board and the executives own 98M shares, which meant the stock came down by 10 bucks, they lost a billion dollars and again, you’ve got to ask yourself, if you as a collective have a billion dollars on the line, why were you so careless in so many decisions? But again, it’s probably not them, I don’t know how new the Board but I think these buybacks were done by a previous Board, so it’s tough when it happens on your watch but you’re not totally responsible.
DN: Yeah, I mean, what is his current exposure - Culp’s current ownership in the business?
AM: He owns 5.6M shares.
DN: Ok, so he obviously took a pretty significant hit.
DN: Alright, well I think that’s all we had on our end. Albert, this has been great. If there’s anything else you want to add, feel free to chime in but if not, I think this has been really educational.
AP: And that is a wrap, hope you enjoyed listening. We want to sincerely thank Albert again for his time and expert insights today. Please reach out to firstname.lastname@example.org if interested in a warm introduction to Albert and his team or if you’d like to sit for our next interview. We will certainly be watching this GE story as it unfolds, which I’m sure it will. Thanks again for listening, have a great day.