Why Not Simply Buy Korea?

Although we have long been admirers of General Electric and of the management style you have insufflated into the company, we have not recently been shareholders. The reason is that, as value investors, we have had difficulty justifying the stock's high and rising valuation throughout the recent bull market.

In spite of your success at cost reduction in the last several years, there must be a limit to the speed at which these costs can be further reduced in the future. While the quality (six-sigmas) and cost-cutting credos have been engrained into your organization more deeply and more broadly than at most other firms, the challenge will increasingly be unit growth. This is a challenge which GE shares with many US industrial companies, at the close of a decade when most of the growth in profits has come from restructurations and cost-cutting.

In the industrial area, particularly, the inherent growth of your principal markets is seldom much greater than that of the local GDPs, with the United States remaining your largest market. It is hard, therefore, to envision unit growth for your industrial divisions much exceeding a 3%-5% range, while pricing power, as you often warn your managers, is becoming increasingly elusive. The company's new emphasis on industrial services looks promising, but its impact will necessarily be incremental at first, with a significant effect on overall growth several years away at best.

The industrial sectors of General Electric contribute about 60% of the company's overall, current earnings per share of approximately $2.70 -- say, $1.60. It would be hard for us to find value in an industrial company with high quality but moderate growth prospects at more than 20 times earnings. In fact, such a multiple would make a generous allowance for today's environment of inflated stock prices. Regardless, a price/earnings ratio of 20 on earnings of $1.60 would put a value of $32 on the company's industrial segments.

As for the financial arm of the company, GE Capital Services (GECS), it is intricate and difficult to analyze, as is the case for most diversified financial services companies. More importantly, constant innovation in product offerings and the variability of individual sectors' contributions to earnings from one period to the other make the forecasting of future earnings an elusive task. It has also been pointed out that GE Capital has enjoyed a significant competitive advantage from its parent company's AAA rating. As financial activities approach the point when they will contribute more than half of GE's total earnings, it has also been suggested that financing at AAA interest rates might soon be no longer available. For lack of a better benchmark, we look at another highly successful financial company, American International Group (AIG), which has had a great growth record, though not quite as spectacular as that of GECS. AIG is currently selling at 24.5 times earnings. As value investors, we would never pay such a price for a financial enterprise fraught, by definition, with future and unpalatable risks. Let us assume, however, that -- by comparison -- GECS is worth 27 times earnings of about $1.10. This would put GECS value at about $30 per GE share.

Give or take, therefore, a generously valued GE would be worth about $62 per share. Granted, the stock\'s overvaluation is less striking than it was only a few weeks ago. But, at around $80, it is still much too pricey in relation to either current earnings or growth prospects to be considered by value investors, who prefer to buy below fair value.

We have, however, a suggestion which would bring GE's earnings and potential growth rate to levels that would more than justify its stock's current price: Why don't you simply buy Korea?

The last we saw, the total capitalization of Korea's stock market stood at a bit over $40 billion (against $260 billion for General Electric), while the total debt of its corporate sector (at book) amounted to some $130 billion. This debt total would include some privately-held companies, but why quibble for a few billions? We suggest two simultaneous transactions:

1)GE offers to buy all of Korea's listed industrial companies (less than 300) in exchange for 500 million newly-issued GE shares.

2) GE offers to these companies' creditors to buy all of industrial Korea\'s outstanding debts for $65 billion in GE stock (810 million shares) and $39 billion in cash ($65 billion at 60 cents on the dollar).

Our guess is that, given the vogue in which GE's stock has been, both parties would gladly accept the swap, while you could easily finance the cash portion of the deal at 6% pre-tax or so, without any significant deterioration in your balance sheet (you are now acquiring debt-free companies).

GE would then own about 300 new, debt-free, industrial subsidiaries with combined revenues of about $180 billion dollars (more than three times your current industrial revenues) and superior sales-growth potential. You will notice that we did not put any value on, nor suggest that you buy Korea's financial sector, even though it would come out of this operation in much healthier financial shape: with one customer left, and a hard-bargaining one at that, we would not expect their future business to be particularly lucrative.

Given GE's exceptional management skills, experience of global markets and depth of human resources, we would expect you to quickly bring the after-tax margins of Korea's industrial sector -- now rid of its intractable debt burden -- toward at least 6% after taxes. This would amount to $10.8 billion in additional net profits or, after the interest costs on the new debt, about $9.2 billion. In one quick shot, GE' after-tax profits would more than double and, since the number of shares outstanding would only have increased by 40%, earnings per share would jump almost 45% -- from $2.70 to $3.90.

Suddenly, at $80, the stock of General Electric becomes much more attractively priced -- though not quite cheap enough for the hardest-nosed among value investors. But why stop there?

The stock markets of Indonesia ($13 billion), Thailand ($18 billion) and the Philippines ($26 billion) can be bought for a total of $57 billion, against GE's new stock market capitalization of $366 billion. Assuming that the ratios of corporate debt to market capitalizations are in the same ball park, you could engineer a takeover of these three countries' industries by issuing another 1.5 billion shares.

At the end of the exercise, General Electric would own the entire industrial sectors of four of the most populous and promising markets in Asia, while increasing its shares outstanding by less than 90% and doubling its earnings per share. Of course, this leaves out China, India and Japan. But you would still have one of the strongest balance sheets around and, with your new, much lower price/earnings ratio and increased growth potential, value investors like us would probably fight each other to acquire any new shares you might want to float.

We sincerely hope you will give due consideration to our proposal, and wish you good luck in this endeavor if you decide to proceed with it.

Sincerely yours,

François Sicart
Founder and Chairman
Tocqueville Asset Management

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