Page 74 - The Economist Asia January 2018

58 Business
Schumpeter The fog of war The Economist January 27th 2018

Iftheyare to save the firm, General Electric’s bosses and board need farbetterinformation
Perhaps GE has a better, parallel accounting system that it
keeps under wraps. But the public one reveals eight problems.
First, ithasno consistentmeasure ofperformance. This yearithas
used 18 definitions of group profits and cashflow. As of Septem-
ber2017, the highestnumberwasdouble the average one. There is
a large gap between most measures ofprofits and free cashflow.
Second, GE’s seven operating divisions (power, for example,
oraviation) are allowed to use a flatteringdefinition ofprofit that
excludes billions of dollars of supposedly one-off costs. Their to-
tal profits are almost twice as big as the firm’s. It is the corporate
equivalent of China’s GDP accounting, where the claimed out-
puts ofeach province add up to more than the national figure.
Third, GE does not assess itself on a geographical basis. Does
China yield solid returns on capital? Has Saudi Arabia been a
good bet? No one seemsto know. Thisisunhelpful, given thatthe
firm does half its business abroad and that the long-term decline
in returns has taken place as the firm has become more global.
Fourth, GE pays little attention to the total capital it employs,
which has ballooned by about 50% over the past decade (exclud-
ingitsfinancial arm). Itsmanagersrarelytalkaboutit and have set
no targets. It is unclear which parts ofthe firm soakup dispropor-
N THEIR documentary “The Vietnam War”, Ken Burns and tionate resources relative to profits, dilutingreturns.
ILynn Novick, the directors, dwell on the flawed information Fifth, it is hard to know if GE’s leverage is sustainable. Its net
that American politicians got from Indo-China. The generals on debtsare 2.6 timesitsgrossoperatingprofits, again excluding itsfi-
the ground focused on the “kill ratio”, or the number of enemies nancial arm. That is high relative to its peers—for Siemens and
killed per American or South Vietnamese soldiers killed. That Honeywell the ratio is about one. Some ofthose profits are paper
bore no relationship to victory—North Vietnam quickly replaced gains. And the average level ofdebt duringthe yearis much high-
its dead soldiers. And it corrupted behaviour, leading American erthan the figures reported at the end ofeach quarter.
troops to embellish numbers and count dead civilians as “wins”. Sixth, the strength ofGE’sfinancial arm isunclear. The new in-
The curse of rotten information can strike companies, too. surance loss will lower its tangible equity to 8% of assets. This is
That seems to be the case with General Electric (GE), which has well below the comfort level, although regulators seem to have
had a vertiginous fall. Its shares, cashflow and forecast profits granted it forbearance in ordergradually to rebuild its capital.
have dropped by about 50% since 2015. On January 16th it dis- Seventh, it is hard to calibrate the risk this poses to GE share-
closed a huge, $15bn capital shortfall at its financial arm due to a holders. GE likes to hint that its industrial and financial arms are
revision in insurance reserves. And on January 24th it revealed a run separately. But they are umbilically connected by a mesh of
$10bnlossforthe fourth quarter. In itscore industrial arm, returns cross-guarantees, factoringarrangements and othertransactions.
on capital have sunkfrom 20% in 2007 to a puny 5% in 2017. Eighth, is GE sure that its industrial balance-sheet accurately
GE’sboss, John Flannery, an insiderwho tookoffice in August, measures its capital employed and its liabilities? Some 46% ofas-
must clear up the mess made by his predecessor, Jeff Immelt. He setsare intangible, which are hard to pin down financially: forex-
seems to recognise the gravity of the situation. In November he ample, goodwill and “contract” assets where GE has booked pro-
gave a frank presentation to investors. This month he suggested fitsbutnotbeen paid yet. Heftyliabilities, including pensionsand
that GE might be broken up. Yet an unnerving sense lingers that tax, are also tricky to calculate. Based on GE’s poor record offore-
no one fully understands what has gone wrong. casting, it seems that large write-downs are possible. On January
Is the conglomerate formerly known as the world’s best-run 24th GE said that regulators were lookinginto its accounting.
firm a victim ofweakdemand forgasturbines, a lowoil price, lav-
ish digital initiatives, timing lags in client payments, morbidity Time forsome command and control
rates, bad deals, cost overruns or a 20-year squeeze in industrial- GE’s situation is like that of the global bank conglomerates after
equipment margins because of Chinese competition? You can the financial crisis. Citigroup, JPMorgan Chase and HSBC did not
imagine GE’s12-man board blinkingat this list, like Pentagon gen- entirely trust their own numbers and lacked a framework for as-
erals huddled around maps ofthe GulfofTonkin which they are sessing which bits oftheir sprawl created value for shareholders.
too embarrassed to admit they do not understand. Today, after much toil, the people running these firms know
Schumpeter’stheoryisthatGE’sflowoffinancial information whether, say, loans in California ortradingin India make sense.
has become fantastically muddled. There is lots ofit about (some This does not happen naturally. If neglected, financial report-
200 pages are released each quarter) and it is audited by KPMG. ingbecomesa hostage to internal politics, with different constitu-
But it offers volume and ambiguity instead ofbrevity and clarity. encies claiming they bring in sales, while arguing that costs and
It is impossible—certainly for outsiders, probably for the board, capital are someone else’s problem. Mr Flannery is a numbers
and possibly for Mr Flannery—to answer central questions. How guy who wants to slim GE to its profitable essence. But he is
much cashflow does GE sustainably make and where? How trapped in a financial construct that makes it hard to pursue that
much capital does it employ and where? What liabilities must be mission intelligently. Until he re-engineers how GE measures it-
serviced before shareholders get theirprofits? self, he will be stumblingabout in the murk. 7