Forget the shares, GE's debt is the thing to watch

With common shareholders being treated like amoebas, there has to be an upside

By Kevin O'Leary

Kevin O'Leary is the Chairman of O'Leary Funds Inc., the Manager of the O'Leary Global Infrastructure Fund TSX:OGN.UN and the O'Leary Global Equity Income Fund TSX: OGE.UN

Globe Investor Magazine Online, March 4, 2009

As Barack Obama moves through the first 100 days of his presidency, he has made the ailing U.S. economy his No. 1 priority. As a result the financial markets have been given unrelenting scrutiny by the popular press.

The naturally left-leaning media is having a field day reporting with boring repetition the trials and tribulations of financial services CEOs as they squirm like ants under a magnifying glass. While this provides for some interesting reading, it provides little guidance for investors who are contemplating what to do next.

Here are the facts: For all the promises of stimulus packages and bailouts, the equity markets have continued to trade down. Equities trade on earnings, not political rhetoric or bailouts, and currently there is no visibility on S&P earnings. Last week, for example, Goldman Sachs revised its 2009 S&P earnings estimates to $40 (U.S.) from $53. The truth is they are just guessing like everybody else. Analysts that don't publish estimates get "whacked," and even they have to eat. So they are cursed to publish numbers that they are constantly revising. The market has figured this out and mostly ignores these forecasts, instead focusing on the hard-core reality of actual company earnings. On that front, the news is bad.

If there ever was a "grandmother and orphan" common stock is has to be General Electric Co., and it stands as a good case study for the times. After months of repeatedly denying that the company would cut its dividend for at least the remainder of 2009, the board reneged. Last week GE cut its dividend for the first time since 1938. The reduction will save the company $9-billion annually and therein lies the hint for investors that seek to put new money to work in this market.

GE does not care about its common shareholders, who have already been slaughtered. Today the stock is a "hat size" trading at $7 and change.

What the GE board is worried about is its debt rating. Currently, GE debt is triple-A, as good as it gets. If you want to see a good contortion act over the next 18 months, you can watch GE chief executive officer Jeff Immelt try and keep that credit rating. I'm sure he is a very nice man, but the fact that he still has his job is amazing. His failing was not to jettison the "black box" financial-services division of GE while he had a chance - instead it has become the cancer that is slowly killing the patient and it has his name all over it.

GE cut its dividend to service its debt. In the kingdom of GE, finance debt is the lion and stock is the single cell amoeba you find floating in a pool of dirty water. When GE's credit rating is cut, which I think is inevitable, several events will occur. First, the debt will lose up to 30 per cent of its value almost overnight. It will be a compelling buying opportunity in one of the world's most interesting infrastructure plays. GE's new CEO will move quickly to get the company out of the business that nearly killed it, by significantly paring back its black hole financial-services division. This will end the lack of visibility that has wiped out the company's market capitalization, even though many of its divisions are performing relatively well in this global downturn.

This process will take time, and investors in GE common stock will learn the true meaning of the word "zombie" as they watch in horror as their common stock wanders around aimlessly for years.

In the meantime, investors in the GE debt are likely to be paid as much as 9 per cent as they wait for the company to turn around. They will see significant capital appreciation in their bonds' value if and when credit markets normalize.

Special to the Globe and Mail