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By Philip Guziec, CFA | 02-19-2010 02:37 PM

What’s the Downside Risk for GE?

Morningstar OptionInvestor co-editor Phil Guziec sits down with analyst Daniel Holland to look at the potential worst-case scenarios for GE.

Phil Guziec: Hi, I'm Phil Guziec, co-editor and portfolio manager of Morningstar OptionInvestor newsletter, and I'm here with Daniel Holland, Morningstar's General Electric analyst. Welcome, Daniel.

Daniel Holland: Hi there. Thanks for having me, Phil.

Guziec: So, we've recommended customers write a put on General Electric, and I wanted to talk to you about the valuation of General Electric, scenarios around that valuation. You think the company's pretty undervalued at current prices and that it's worth $25 in a downside scenario, or a consider buy scenario is $12.50.

I would like to talk to you about how we get there, what they do besides make light bulbs, and break down their business and the potential outcomes for the different pieces of the business.

Holland: Sure. Well the first thing when I'm thinking about General Electric, you always want to split it up into two businesses: the industrial business, which has the light bulbs and the gas turbines, and all those things that people are familiar with coming out of General Electric, and then GE Capital, which is their bank or their financing arm, where GE funds a lot of different kinds of businesses, lends money, things like that.

Guziec: So why don't we think about those scenarios going forward for GE Capital. What's the dire scenario, and how well positioned are they for that dire scenario? I know they have some commercial real estate exposure, and that's one of the sources of concern right now in the market. Versus a baseline scenario, or what you think is more likely to happen.

Holland: Right. The biggest sore point with GE Capital is that exposure to commercial real estate. Of their, say, $450 billion financing portfolio, roughly $80 billion of those assets are sitting in commercial real estate. Either GE owns the property itself, or it's a lender in the property as properties capital structure.

So whenever you hear about fluctuations in commercial real estate market, big job losses, unemployment, things like that, you get a little bit concerned about what GE's position is, and how they're going to be able to weather that.

One of the good things that, or one of the things that have helped give us a little bit of confidence about commercial real estate with GE, is the fact that it's balance sheet is relatively strong, and that in a dire case where the tenants leave, GE doesn't necessarily have to sell a property or force somebody to sell a property in order to make whole on its deal. That's a good thing when asset prices are down double-digit percentages.

Guziec: So for GE, if it's a credit issue, it's purely a credit issue, it's not a liquidity issue because they're now well-capitalized.

Holland: That's right. So the ability to rework the terms of the loan, figure out if we need to change payment structures, get new tenants in, change the management team, whatever it needs to happen with regards to the property, GE has the flexibility to actually go in and make those kinds of things happen.

That said, it gives the firm, it gives us, a bit of confidence that in worse case scenarios, GE Capital still comes out OK. So last year when we were talking about the commercial real estate exposure, folks were like, let's just whack off 50% of the book and just write it off, it's worthless. Today that just doesn't seem appropriate, it doesn't make sense.

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