Letter number 117 of December 2018

  • NEW

News : The tribulations of General Electric or conglomeratesÂ… coming around again

Around 15 years ago, most of our students were fascinated by General Electric and very keen to join the group which was well known for its young graduates training programme, with four 6-month stints in four different divisions in four different countries. 
At that time, General Electric had the largest market capitalisation worldwide ($400bn), its debt was rated AAA and Jack Welch, its recently retired boss, was a living legend.
Today, all of that has changed. The GE share has been evicted from the Dow Jones industrial index of which it had been a part since its creation and its debt rating has fallen to BBB+ (although that’s nothing to be ashamed about). Students now get more excited about Uber, Tesla, Amazon or L’Oréal. If General Electric were listed in France, it would be the 7th largest market capitalisation behind Total, LVMH, L’Oréal, Sanofi, Airbus and Christian Dior at €55bn. Since 2017, General Electric is no longer on the list of top 20 US market capitalisations which we publish in an appendix to the Vernimmen. 
A graph and a table do a better job of reflecting the situation than a long speach:
Graph showing the performance of the General Electric share since 1962:

We see that the share price has fallen by 75% from its historic high (runaway share price in 2001) and returned to its 1996 level. Now have a look at financial indicators in 2001 and 2017:

In other words, in 2017, General Electric recorded more or less the same sales as in 2001 (around $125bn) for a similar headcount (just over 310,000), but with negative EBIT of $9bn compared with a profit of $31bn 16 years previously. 
So what’s going on? 

The choice of businesses: it appears that since the 2010s, resource allocation has not been as felicitous as in the past

To help us answer this question, we quote Henry Mintzberg, professor of management at McGill University, Montreal: “You manage a conglomerate by not managing it. You choose good businesses and you choose good managers to manage them.”
After Jack Welch’s long term at the helm of GE, the board of directors was not as fortunate in its choice of managers. Welch’s successor (Jeff Immelt) was pushed gently towards the exit in 2017 at the age of 61, and his successor (John Flannery) was invited to leave after only 13 months.
As for the choice of businesses, GE has been even less fortunate in its allocation of resources since the early 2010s – sale in 2013 of NBC Universal, today, the value of media, TV and film assets are breaking records; sale of GE Capital assets after the 2008 crisis and before US finance made its sharp recovery with current high valuation multiples; acquisition of Alstom in order to strengthen its position in turbines for power plants when, thanks to energy transition, their market share is in sharp decline; increase in its share of equipment for the oil industry just before the fall in oil prices. 
Let’s be realistic. In the same way as it’s rare for one great man to succeed another, history has shown that it’s also rare to get two great managers in a row to manage an organisation as complex as a conglomerate.
In countries in which the financial markets are not very well developed, conglomerates are often a substitute and allocate scarce capital internally among their various activities. Take for example Reliance in India, Cévital in Algeria, Argos in Colombia or Schneider in France in the 1960s.
When financial markets are better developed, conglomerates find it difficult to keep ahead because very often, the group is worth less than the sum of its parts. Investors are confronted by two types of problem. The first is the complexity of the intrinsic analysis of a conglomerate made up of multiple activities with no synergies among them. This portfolio is imposed on investors who generally have the option, at their discretion, of exposing themselves to the various businesses of the conglomerate or not, by buying shares in mono-activity companies operating in the same fields as the conglomerate’s businesses. This results in a first-level discount. The second-level discount stems from the fear of a sub-optimal allocation of financial resources within the conglomerate, between activities that are highly profitable and those that are less so. The fear is that free cash flows generated by the former will be used mainly to support the latter, and not for the further development of the former. 
In mature financial markets, the only way to deal with this issue and to counteract this discount is by bringing unique managerial know-how to subsidiaries, often know-how that has been developed and conceptualised by a brilliant manager who has a great deal of charisma. Examples include Harold Geneen at ITT in the 1960s, where he introduced modern management techniques at many companies; Lord Hanson at Hanson Trust plc in the UK in the 1980s, where he revitalised UK companies that had become complacent and used to relying on generous overheads; Jack Welch at General Electric with the Six Sigma method which improved the quality and efficiency of processes. But once these managerial innovations have been applied, and then analysed and popularised more broadly, the conglomerate loses its competitive advantage and the question of its survival is raised, no longer a taboo when the legendary manager retires or passes away. In developed financial markets, a conglomerate rarely survives for very long once its Pygmalion is no longer on the scene. 
Is this then a death notice for conglomerates like the most famous of them, General Electric, which is in some way the tree that’s preventing us from seeing the wood made up of recently dismantled conglomerates? Alstom, Maersk, Philips, Siemens, the Fiat group, Lagardère, Kering, Benetton, and that’s just in Europe.

New conglomerates are currently emerging – Amazon, Alphabet, Tesla, Dyson, Alibaba, etc.

No, because new conglomerates are in the process of emerging. Amazon (distribution, IT services, TV production), Alphabet (internet, life sciences, cars), Tesla (cars, batteries, solar panels), Dyson (household appliances, cars), Alibaba (e-commerce, payments, IT services), etc. by leveraging their financial clout and unprecedented margins which enable them to fund research in all walks of life. And we have no doubt, that in the Vernimmen.com Newsletter No. 498 of May 2051 , we’ll be telling you all about their disappearance, but also about the arrival of a new generation of conglomerates.
In the meantime, here’s the name of the next conglomerate that won’t survive long after its legendary founder leaves the stage: Berkshire Hathaway.

Statistics : Percentage of cov-lite leveraged loans

A cov-lite leveraged loan is a leverage loan with very light covenants or no covenants at all.

 Their percentage among total leveraged loans is a clear indication of risk appetite for bankers and debt investors. It has never been so high since 2007.

It does not necessarily mean that another collapse in LBO financing is in the offing, but that it is a borrower market where lenders are chasing too few deals given the amount they want to invest in the class of assets. Hence borrowers are able to negotiate good deals for them with a low level of constraints.

If things start to unravel, lenders will not have the power to get fees and higher spreads to compensate them for solvency deterioration; nor to seat at the table to discuss financial reorganisation with borrowers. You can’t have your cake and eat it too!


Research : Environment, stakeholders and financial performance: complex relationships

With Simon Gueguen, Senior Lecturer at the University of Cergy-Pontoise


Taking all of a firm’s multiple interests into account is always a complex matter. Stakeholder theory, which arose in the 1980s, holds that the development and long-term survival of a firm depends on the interests of all of its stakeholders (employees, customers, suppliers, public authorities, the full range of its investors, etc.) being taken into account. This theory runs contrary to the shareholder-based vision, according to which the interests of shareholders prevail over all others. Many studies have been carried out over the years to determine whether these two visions are complementary or conflictual, i.e., whether the explicit factoring in of the interests of all stakeholders benefits or penalises shareholders.

Three researchers[1] decided to include environmental concerns into the equation. The idea is as follows: if this concern is shared by the firm’s various stakeholders, then factoring in the environment can help to resolve the conflict between shareholders and other stakeholders. The study covers two strategically chosen economic sectors: food and beverages on the one hand and household and personal products on the other. These two sectors are large consumers of natural resources and the public is particularly attentive to their impact on the environment.

This article is very solid technically. Working with experts and management, Brulhart et alii came up with a new measure, a firm’s “stakeholder orientation”. In the same way, they constructed an “environmental proactivity” index whose aim is to capture any affirmation of environmental awareness as well as environmental initiatives taken by management. Electronic questionnaires were sent to managers (responsible for environmental issues) at French companies in the two sectors concerned in 2009 and 2010.

The empirical study involved analysing the links between three variables: the two variables that were constructed for the study and a financial performance variable. For the latter, Brulhart et alii use the earnings to sales ratio (productivity) or the earnings to amount invested ratio (profitability) alternatively. Their first results show a weak and slightly negative link between stakeholder orientation and financial performance. In the sample studied, it would thus appear that explicitly taking all stakeholders into account is detrimental to the interests of shareholders. However, environmental proactivity has a positive impact on financial performance. More particularly, and this is probably the central result of the article, at environmentally proactive firms, the link between stakeholder orientation and financial performance becomes positive. In other words, being environmentally proactive leads to a reconciliation of the interests of other stakeholders with those of shareholders.

Brulhart et alii thus conclude that there is a complex complementary fit between environment, stakeholders and financial performance. The results are probably determined by the sample studied but this article does offer an interesting explanation for the contradictory results that have been obtained until now in this area. The interests of stakeholders are diverse and contradictory and the introduction of good practices in terms of the environment and sustainability could help to satisfy some of these interests without penalising financial performance.


[1] F. BRULHART, S. GHERRA and B. V. QUELIN (2017), “Do stakeholder orientation and environmental proactivity impact firm profitability?”, Journal of Business Ethics, pages 1 to 22.

Q&A : A few short questions and their answers

In an income statement by function can we say that the costs of sales correspond to the sum of all variable costs?

No, unfortunately, since costs of sales (COGS) also include fixed costs such as the amortization expense of production machinery. In addition, all variable costs are not in the COGS since the bonuses paid to salesmen are part of the selling and marketing costs whereas they are variable costs since related to the sales.

For more details, see Chapter 3 of Vernimmen.


Why in a construction company inventories are low and how to track the work-in-progress line that is important?

For a construction company, inventories are often low because it is supplied daily by its dealer in building materials, and it is the one which carries the bulk of inventories in this sector.

It is necessary to monitor over time the evolution of the item Work in progress in relation to the item Customer advances; and when Work in Progress grows faster than or exceeds the Customer Advances line, beware. This is either a sign of poor management, because in this sector customers are asked to pay as work progresses and well-managed companies always charge customers a little in advance of the completion of the work. Or the sign of a fraud if losses on a construction work are hidden by an overstatement of Work in progress, which do not forget, are nothing from an accounting point of view but costs that have been taken out of the P&L account to be written into an asset on the balance sheet, which improves margins in the P&L.


Should we take financial fixed assets in the computation of operating assets?

In the face of financial fixed assets, it is necessary to sort out those which are used for the activity (for example a deposit for a rent of stores, or a non-consolidated participation in its distributor in Saudi Arabia) and those which are non-operating assets (such as L'Oréal's 9% stake in Sanofi) The former is included in the operating asset, not the latter, for the calculation of the ROCE or for the calculation of the enterprise value. But normally, except perhaps for certain large groups, the second case is quite rare.

Non-operating financial fixed assets are then to be taken in reduction of the bank and financial debt when you move from enterprise value to equity value.


 What is the difference between the net present value and the present value?

Let's take an example. Someone promises to pay you 110 in a year if you pay him 100 today.

With an interest rate of 10%, the present value of this promise is 110 / (1 + 10%) = 100. The NET present value of this promise is equal to the present value of its future cash flows, 100, MINUS the price you pay today for this promise, 100, here 0.

This net present value simply means that this investment (paying 100 today to receive 110 in one year) will bring you exactly the required rate of return, that is 10%. You will not make a bad deal or a good deal, you will simply do a decent deal. If you now want a rate of return of 5%, the promise to receive 100 in a year is worth for you, at 5%, 110 / 1.05 = 104.8. It's its present value.

If you can buy this promise as previously for 100, its NET present value is 104.8 - 100 = 4.8. This positive net present value shows that you will make a good deal for you because you pay 4.8 less than you could, to make an investment that earns you the rate of return you want, 5% in this example. You will therefore enrich yourself of 4.8. This is also what the net present value measures, your enrichment if everything goes as planned.

For more details, see Chapter 16 of the Vernimmen.


Could you tell me if the long-term growth rate may be nil or negative in the discounted cash flow formula?

There is no reason why it cannot be negative in some sectors or for some companies, because if world growth is 4%, some companies grow at 20% or 30%, others necessarily have much lower growth rates, including negative ones. For example, at the moment, the magazine press in Europe: decrease of the diffusion and fall of the advertising receipts.


Why is inflation not a corrective factor of free cash flows for a DCF valuation?

To the extent that the cost of capital is equal to a risk-free rate plus a risk premium, and the risk-free rate is a market interest rate, it includes a premium for expected inflation.

Therefore, there is no need to deflate free cash flow for inflation. If you do it, i.e. if you take free cash flow in real terms, then you would have to also, by homogeneity, take a cost of capital deflated by inflation, by dividing (1 + your cost of capital) by (1 + anticipated Inflation Rate) and then deduct 1.

If you calculate the cost of capital by an indirect approach by computing it as the weighted average of cost of equity and of cost of the debt, things would not be different because you would also use market data that includes an inflation expectation.

New : Comments posted on Facebook

Regularly on the Vernimmen.com Facebook page[1] we publish comments on financial news that we deem to be of interest. Here are some of the comments published over the last month.

Index funds with management costs of 0%?

This was launched during the summer by Fidelity, known for its active management and not its passive management skills, to limit its losses of assets under management moving to index funds and ETFs. The success of this first product on the market with management fees of 0% is undeniable: its US equity fund and its non-US equity fund have raised so far more than $2bn in 6 months, a quarter of which for the international fund and 3/4 for the US equity fund, illustrating the domestic bias of investors.

 It's definitely two loss-leaders products for Fidelity. It is necessary to open an account at Fidelity to be able to subscribe, which allows the asset manager to offer other products more remunerative for it to its new customers, or de-incentives the current ones from moving to the competition. In addition to the volume effect necessary to reduce the costs invoiced to zero, Fidelity relies on indices that it has developed, which avoids having to pay royalties to the owners of indices like Dow Jones or MSCI; and practices securities lending on the shares held by these funds. Securities lending allows Fidelity to receive fees from short-sellers who needs to borrow shares to short-sell them. In a nutshell, it allows other investors to bet down securities prices held by Fidelity on behalf of its customers. . . This is the price to pay for having zero fees. As we say in the United States, there is no free lunch.


Maersk and Danske Bank

Denmark is home to the largest group of container ships in the world, Maersk, founded by the family of the same name, which is also the largest company in this country of 6 million inhabitants.

Since 1928, the Maersk family has been the largest shareholder (21%) of what has become Denmark's largest bank, Danske Bank. Not stupid indeed to carry out a wealth diversification whereas Maersk is in a very cyclical sector, nor to have a foot in a bank which knows you well to help finance heavy investments, a container carrier being worth a little more than a scooter.

The Estonian subsidiary of Danske Bank, visibly poorly controlled by its parent company, would have in nine years whitewashed several tens of billions of euros (some even speak of €200bn) from countries of the former USSR.

The revelation of this scandal led Danske Bank shareholders to separate from its managing director in September, and most recently from the bank's president. The representative of the Maersk family said: "We are a large shareholder and we have obligations and it’s only fair there are expectations on us. "

Centuries away, we can echo Hamlet that in the Kingdom of Denmark, everything is not rotten, as long as there are shareholders aware of their responsibilities.


Towards an evolution of notification thresholds for M&A transactions?

Generally speaking, the thresholds beyond which acquisitions must be notified to the antitrust authorities for approval are expressed in terms of turnover: €5bn at the European level, $84.4m in the USA, €150m in France, etc. As an exception, Spain has a threshold in terms of cumulative market shares (25%). Germany has just added a threshold expressed in equity value (and not in enterprise value) of €500m and Austria has done the same (€300m). In 2016, Europe decided not to change its position. France is currently reflecting on the subject after having launched two public consultations on this topic.

The reason is obvious: some companies can be highly valued without making a significant turnover that puts them below the concentration thresholds: in the digital sector of course, but also in pharmaceutical research, automotive parts, etc.

Another trend is to subject to the control of antitrust authorities not only the change of control, but also the acquisition of significant minority stakes. For example, in Germany, for equity investments giving more than 25% of the capital of a company.