The Financial Times has produced an editorial piece titled “Learning the Lessons of GE’s Steepening Decline.”
The subtitle captures the meat of FT’s opinion: “Once mighty conglomerate relied too much on financial engineering.”
Looking toward the future, it is important to understand what GE did with its use of financial engineering and how it fit into its conglomerate construction, because the picture being drawn of the “new” Modern Corporation and it’s use of financial engineering must be seen in a different light.
I have written a lot on what I have called the “new” Modern Corporation over the past seven months and the generalization of this “new” industrial structure is captured by two fundamental characteristics.
The first is that the “new” Modern Corporation primarily works with intangibles, like intellectual property. These intangibles can be transformed into platforms generating networks that can achieve substantial scale economies.
The second fundamental characteristic is the use made of the “new” Modern Corporation of financial engineering.
The “new” Modern Corporation generates massive amounts of cash from its scale economies, one reason being that these scale economies are achieved at zero or near-zero marginal costs. If anything, one of the major problems these “new” Modern Corporations have is determining where these troves of cash can be used. This is where the financial engineering comes into play.
But, before we get too much into the characteristics of the “new” Modern Corporation, lets return to the GE situation as described by the Financial Times.
The opinion piece in the Financial Times claims that “There are five key lessons,” that can be learned from the GE experience.
First, “debt always catches up with you.”
Second, GE did too many share buybacks in good times.
Three, GE achieved a lot of its growth through acquisition.
Four, “financial engineering is not the same as real engineering.”
Five, “the nature of the economy has fundamentally changed in recent decades from industrial to digital.”
Well, we can start out with the fifth of these, because the Financial Times editorial argues that GE made some attempts to shift to a more digital structure, especially with its move into the financial area and the focus it put on GE Capital.
GE, the editorial goes on, “was unable to sell investors on its shift from industrial to financial to high-tech services. Companies that cannot make the transition from an economy based on tangibles to one based on intangibles are likely to face the same fate as the once-mighty GE.”
But, GE never transformed itself from the framework of the “old” inherited mindset. GE was… and remained… constructed around the concept of a linear business model. Alex Moazed and Nicholas Johnson, in recent book “Modern Monopolies” describe a “linear business model” as one where companies create a product or service and sold it to a customer. Valued flowed linearly and in one direction through the company’s supply chain.”
It is this model that differentiates the old, legacy corporate structure and the new, intangibles based form of the “new” Modern Corporation.
GE, being a conglomerate, constructed a portfolio of “linear supply chains” and attempted to mange them… and the conglomerate as a whole… as a group of independent entities. Consequently, GE had to integrate these “linear” businesses through its financial engineering at the holding company level, producing the results necessary to satisfy its stockholders. Stock buybacks were a part of the overall effort to produce “company” results.
GE achieved growth through acquisition and amassed debt in large amounts to underwrite the expansion; the editorial argues, “Over several decades GE became so large and complex that it could not manage its own business model.”
But, the kind of financial engineering GE used to “manage and control” results was “not the same as real engineering” The editorial continues, “GE Capital…could be used to hide myriad accounting high jinks.”
During the time that Jack Welch built up the “modern” GE, financial engineering and financial innovation were supported by the credit inflation that the US economy was experiencing. Many companies were guilty of the same expansive use of financial tools in order to achieve their results. The Financial Times editorial alludes to this practice and claims, “After a decade of easy money, it is a fair bet that there are corporate numbers games waiting to b discovered at many companies.”
One does not have to say much about the fact that “debt always catches up with you.”
Other conglomerates are facing what GE faced. For example, United Technologies Corp., (UTC), “one of America’s last industrial conglomerates,” announced that it is splitting itself into three operations by spinning off two of its major subsidiary areas.
“Greg Hayes, UTC’s chairman and chief executive officer, “has opening expressed his preferences for smaller more focused companies.”
UTC has expanded over the years by debt-financed acquisition, much like GE. “GE was once several times the size of UTC, but the combined market value of UTC and Rockwell Collins (recently acquired by UTC) is almost twice GE’s market value.” This, however, after the spin offs, will be the primary focus of UTC.
So, UTC is attempting to “right size” before it is hit with troubles similar to those of GE.
But, the debt issue still hovers over the big acquisition wave of the previous decade. William Cohan writes, in the New York Times, about how major corporations, like GE, “have been gorging on acquisitions” taking advantage of the easy availability and low cost of debt. Not only is GE included in this list, but AT&T, CVS Health, Sherwin-Williams and Campbell Soup are also included.
These “well established companies…went on acquisition binges fueled largely by cheap borrowing.” GE just serves Mr. Cohan with “Exhibit A of brewing trouble…”
‘Mr. Cohan writes, “Debt is very unforgiving,..” and something we must be concerned about.
Note, however, that you don’t find any of the FAANGs here. No “new” technology companies. Their business model, as discussed in the book “Modern Monopolies” cited above, is different. Financial engineering, consequently, is used within a different environmental context.
This subject needs to be discussed at much greater length going forward, something I am planning to do.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.