Financial Planning and Investor Communications at GE (With a Look at Why We Ended Earnings Guidance)

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  • VOLUME 22 | NUMBER 4 | FALL 2010


    A M O R G A N S T A N L E Y P U B L I C A T I O N

    In This Issue: Payout Policy and Communicating with Investors

    Financial Planning and Investor Communications at GE (With a Look at Why We Ended Earnings Guidance)

    8 Keith Sherin, General Electric

    The Value of Reputation in Corporate Finance and Investment Banking (and the Related Roles of Regulation and Market Efficiency)

    18 Jonathan Macey, Yale Law School

    Maintaining a Flexible Payout Policy in a Mature Industry: The Case of Crown Cork and Seal in the Connelly Era

    30 James Ang, Florida State University, and

    Tom Arnold, C. Mitchell Conover, and Carol Lancaster,

    University of Richmond

    Is Carl Icahn Good for (Long-Term) Shareholders? A Case Study in Shareholder Activism

    45 Vinod Venkiteshwaran, Texas A&M University-Corpus Christi,

    and Subramanian R. Iyer and Ramesh P. Rao,

    Oklahoma State University

    Drexel University Center for Corporate Governance Roundtable on Risk Management, Corporate Governance, and the Search for Long-Term Investors

    58 Panelists: Scott Bauguess, U.S. Securities and Exchange

    Commission; Jim Dunigan, PNC Asset Management Group;

    Damien Park, Hedge Fund Solutions; Patrick McGurn,

    Risk Metrics; Don Chew, Morgan Stanley. Moderated by

    Ralph Walkling, Drexel University.

    Blockholders Are More Common in the United States Than You Might Think 75 Clifford G. Holderness, Boston College

    Private Equity in the U.K.: Building a New Future 86 Mike Wright, Center for Management Buy-out Research and EMLyon, and Andrew Jackson and Steve Frobisher,

    PAConsulting Group Limited and Center for Management

    Buy-out Research

    Should Asset Managers Hedge Their Fees at Risk? 96 Bernd Scherer, EDHEC Business School, London

    Measuring Corporate Liquidity Risk 103 Hkan Jankensgrd, Lund University

    The Beta Dilemma in Emerging Markets 110 Luis E. Pereiro, Universidad Torcuato Di Tella

  • 8 Journal of Applied Corporate Finance Volume 22 Number 4 A Morgan Stanley Publication Fall 2010

    Financial Planning and Investor Communications at GE (With a Look at Why We Ended Earnings Guidance)*

    * This is an edited version of the authors presentation at the University of Notre Dame Center for Accounting Research and Education (CARE) conference on Financial State-

    ment Analysis and Valuation: Forecasting Firm and Industry Fundamentals held at Coral Gables, Florida on April 9, 2010.

    Bood morning, and thank you for inviting me to participate in this conference with so many distinguished academics. One of the things Ive discovered here is that there are real opportuni-

    ties for companies like GE and my financial planning team to do a better job of staying connected with the academic research capability. And I think youll get a sense of those opportunities as I go through my presentation.

    Let me start by giving you a brief overview of GE and its businesses. And lets begin with our infrastructure businesses. Our largest business is our energy business. It produces about $40 billion of revenue and accounts for 40% of our earnings. We make gas turbines that generate power. Weve got a huge wind turbine business. We have a large oil and gas business in which we sell heavy equipment for compression and distribu-tion of oil and gas products. And weve got a water business that has a couple billion dollars of revenue and is focused on industrial water reuse.

    We also have a technology infrastructure business that accounts for another 40% of the companys revenue. A major part of that business is a $17 billion health care business. We make a lot of technical equipment, including CAT scanners, MRI equipment, X-ray, ultrasound, and a lot of health care IT. Were also heavily invested in life sciences and biosciences.

    We also have a huge aviation business. Were number one in the world in making aircraft enginesand that has a tremendous installed base and a great service business. We also have a large locomotive business, where we make diesel locomotives and provide services around the locomotives and railroad management generally. And, of course, we have a significant financial services business, with about $600 billion of assets. Since the financial crisis, it has not been a big business in terms of revenue, and earnings have collapsed. But as things have turned out, having a smaller financial service business has created opportunities for us, encouraged us to change the portfolio in a positive way coming out of this crisis.

    Finally, although we still own NBC, we are in the process of selling 51% of it to Comcast. Over the next seven years, we will probably sell down our 49% stake to zero, and put that capital back into our infrastructure businesses. We also

    have an appliance and lighting business that most of you are probably familiar with.

    So, our business modelthe common thread in all these different businessesis to make significant investments in technology that enable us to win orders for large equipment that in turn provide us with the installed base for our services. We provide these after-market services to help our customers maintain their productivity. In fact, as part of our sales of equipment and services, we often guarantee improvements in our customers operating results. And when compared to our equipment sales, our after-market services business is a higher-margin business with higher cash-on-cash returns on investment. So, its sort of like the combination of razors and blades in Gillettes business. We dont make a lot of money selling an aircraft engine. But over the next 35 years, we will make good money providing the spare parts for that engine.

    So, thats our fundamental business strategy. We have about $150 billion of revenue, and about 55% of our revenue comes from outside the U.S. Were a very global company, with around 300,000 employees. We report $11 or $12 billion in net income, and produce about $15 billion of cash flow.

    In short, GE is a large, complex, global enterprise. And my plan this morning is to talk about the corporate disclo-sure environment from our perspective, about the kinds of information that we now provide the investment commu-nity and how thats changed over the last ten years. In so doing, I will talk about why we stopped providing quarterly earnings guidancethough we still provide an annual frame-work showing directionally how we think our businesses will performand why we think that has made GE a better company. But I will start by telling you about how we prepare the forecasts and financial plans that I present to our leadership team and board of directors. And then I will talk a bit about how we communicate with investors and analysts, and some of the challenges that we face in our post-guidance world.

    The Forecasting and Financial Planning Process When I became the CFO back in 1998, it was a much differ-ent world in terms of what information analysts and investors got from a company. Our 10Qs consisted of just 17 pages of


    by Keith Sherin, Vice Chairman and Chief Financial Officer, General Electric

  • 9Journal of Applied Corporate Finance Volume 22 Number 4 A Morgan Stanley Publication Fall 2010

    reinsurance business; when we owned that business, I couldnt bear to listen to weather reports, or watch TV during hurri-cane season. My second happiest day was when we announced we were ending quarterly earnings guidance. Ending the firms longstanding practice of holding up earnings targets to the Street, and then trying to meet them, helped us rid ourselves of so many needless pressures and burdenspressures that can get in the way of managing for long-run growth and profitability.

    In fact, if we had it to do all over again, I think we would have taken this step 10 years ago. We thought about doing it a number of times before; but every time we considered doing it, we always found reasons why we couldnt. It was the financial crisis in the fall of 2008 that drove our decision to end guidance. When we got into the crisis, we absolutely had to stop guiding earnings because we had a lack of visibility around the earnings from our finance business. But ending guidance has helped in ways that none of us completely foresawand Ill come to that after Ive told you more about our forecasting process.

    To come back to our internal forecasting process, its important to keep in mind that there are major differences between what were trying to do with our internal forecasts and what equity analysts are trying to do to determine the valuation of the company. Our main objective in forecasting is to make sure that we understand how we think our businesses are going to perform, to create a baseline set of expectations if you will. We want to understand the kind of returns were going to get for the investments we plan to make, the kind of growth we can expect, and what our margins and cash flow will bebut most important is the ultimate return on invested capital. This kind of information will help us in deciding which opportunities to allocate capital to.

    To produce this information, we have two main planning events each year. Starting in the spring, we put together a strategic plan that we call our growth playbook, which is a three to five-year plan for each of our businesses. Using our own version of Michael Porters five-factor model, we ask all of our business teams to analyze and understand the environments they compete in, to answer questions like: Whats happening from a technology perspective? What are suppliers doing? What are the risks that are coming? What are the macroeconomic factors that will affect supply and demand in their businesses?

    We have about 45 profit and loss centers in the company that go through this process. Its a bottoms-up process that starts in April. And for some of the businesses, we bring in outside parties to challenge our own assumptions about the industries we operate in and to develop multiple scenarios. Our analysis ends up producing a base case, which we view as the most probable outcome. But equally if not more important, at least from my perspective, we also produce a distribution and range of outcomes, including worst-case and best-case scenarios.

    financial informationand our 10K was 77 pages. For quar-terly earnings, we used to put out a press release on Thursday night, and on Friday morning our investor relations team would start calling our biggest investors first. There were no conference calls and no disclosure of business results; it was just a two- or three-page press release with an income state-ment. There wasnt really even a balance sheet back then.

    At that time, we had two big meetings with investors a year. We would have our strategy meeting in the springwhich we still doand we would have an outlook meeting in the fall where our CEO would talk to both sell-side and buy-side analysts for a couple of hours. In addition, we would provide an estimate of the next years and next quarters earnings, or so-called guidance, with narrow ranges. There used to be a widespread perception that GE never missed a quarter, but that has not been true during my tenure as CFO. In the past 12 years, there have been many quarters when we missed previous guidance for quarterly estimates.

    If you go back to the early 2000s, with the collapse of the tech bubble, the corporate world was facing some major accounting and governance problems that became clear with the failures of companies like Enron and WorldCom. As a fairly direct consequence of those problems, we ended up with legislation and changes in disclosure regulation that I think have been mainly constructive. The passage of Reg FD, with the aim of giving all investors equal access to information, was absolutely necessary. And although I think Sarbanes-Oxley has an awful lot of bureaucracy in it, there are some important fundamental improvements. One of the most important is that the CEO and CFO now have to sign and certify that everything in the financial statements is accurate to the best of their knowledge, and that nothing of material importance has been left out. These requirements have had major effects, mainly for the good, on how companies present their finan-cials and how they go about preparing them.

    But if such changes have improved the quality of disclo-sure, they have also increased the quantity. Today our 10Q is 90 pages longand we spend a ton of time preparing it. And the 10K is more than two and a half times that length. We participate in over 20 events a year with investors. And today everything is available on the Web. We put the charts on the Web and replay the webcast over and over for investors. Today, we have over 25 hours of webcasts onlineand I think thats a great thing. There are now over 1,000 pages on our website for investors that describe the past performance of the company. And as I will discuss in more detail later, we also use our website to provide some forward-looking information about important business indicators and trends.

    But starting with the fourth quarter of 2008, we stopped giving guidance on quarterly earnings. And I have to tell you that, since taking this job 12 years ago, there have been two decisions by senior management that have made me especially happy. The one that made me happiest was the sale of GEs

  • 10 Journal of Applied Corporate Finance Volume 22 Number 4 A Morgan Stanley Publication Fall 2010

    During the third month of each quarter, we use these rolling forecasts as the basis for a discussion of performance with the heads of our 40 or so operating businesses. We typically start these discussions by presenting the financials on total company performance and then each of the business leaders talks about his or her operations along with best practice models that might be shared across the portfolio. During the second and third months of each quarter, we have operating reviews of each of our businesses in which the CEO, the CFO, and their operat-ing leaders spend a day reviewing their business operations with our corporate leadership team. During the third month of each quarter, our planning and analysis leaders do a call every week to discuss the performance of their business operations versus expectations. And at the end of each quarter, we have a major performance update with our investor relations team to prepare for our quarterly earnings release.

    So, GE has a clear financial orientation and strong finan-cial controls and goals. Its a discipline that permeates the place. Every discussion between our CEO, Jeff Immelt, and the CEO of one of our operating businesses is intended to ensure that we have a thorough understanding of where we are in terms of performance and where we need to be. Theres a huge amount of preparation and oversight that goes into our financial reportingand this all takes place even though we no longer provide quarterly guidance. As I said earlier, the corporate goal is not setting up earnings targets and then meeting them. Our goal is to deliver the performance that we expect to achieve, subject to general market and industry conditionswe expect all our businesses to perform in the top quartile of their competitors. If we can meet our own expectations, we think we will provide the level of returns that we need to justify our use of investor capital.

    So, thats a quick look at the forecasting and financial planning process at GE. And let me just add that because the output of this process is the result of a thorough bottoms-up process, we understand how challenging it is for sell-side analysts to look at a company like GE and develop a financial model. My guess is that most of the analysts who follow us are using Excel spreadsheets that take information about our past performance and combine it with some forward-looking indicators that we provide and with the guidance provided by many of our competitors. Our internal finance team has the advantage that our analysts are sitting with the business teams. They know what the orders have been. They know what the equipment units are going to be. They know what the margins are going to be on the long-term contracts, and have a pretty good feel for the timing and the volume of those deals. And, of course, the complexity of GE makes things even more challenging. But even in the case of a single product line business, if its got more variables than a business driven just by consumer demographics, we recognize that it is challenging for outside analysts to get their hands around something as specific as our next quarters earnings.

    When this process of proposing and challenging is finished, we end up with a three-year financial model that has a full balance sheet, an income statement, and a cash-flow statement for the entire company. In July, we summarize this information in a presentation that we make to our board of directors on each of the 12 main business segments that we report on separately in our financial statements. Out of this board presentation and the surrounding discussion, we end up with a list of seven to ten strategic priorities for each business segment and for the company. The growth playbook also provides the basis for the financial projections for each of our businesses, and for the company as a whole, for the next three years. It provides our long-range financial plan.

    So, this exercise that we go through each year as a firm to produce our growth playbook is a serious undertaking. Its a highly involved, externally focused review of all our businesses that provides the basis for our internal forecasts of growth in earnings and cash flow, and of our returns on capital. And those forecasts of growth and returns are the main determinant of how we allocate capital among all the opportunities throughout the company.

    Another important function of the planning process and growth playbook is to identify risks to our business plan, and to come up with ways of managing them down to accept-able levels. For example, some of our business teams may be faced with extreme competitive pressure, or perhaps a product shortfall or a regulatory issue. One purpose of our planning is to ensure that we have anticipated these downside risks and have either found a way to limit them, or have a plan to respond to them quickly if they materialize.

    But now lets move from the playbook to our second main planning event, the formulation of the budget. In the fall, all the finance and the operating teams start out by updating the spring forecasts in the playbook using another six months of data. And along with updated forecasts that reflect the new information, they provide detailed budgets for every operat-ing business. We then present those updated forecasts and budgets in summary form to our board. Those budgets also provide the basis for the annual update with investors that takes place each December and presents our outlook for the next year.

    So, again, each year we have two company-wide financial planning and analysis sessions that are spaced six months apart. And the point I want to impress on you is that there is a tremendous amount of thought and effort that goes into our forecasting and financial planning and analysis. We also produce short-range outlooks as well as longer-term ones. In the middle of every quarter, for example, our financial teams submit income and cash-flow statements and balance sheets for the current quarter, the following quarter, and the entire year. By so doing, we create what amounts to a rolling capability to look at our future performance and set our expectations.

  • 11Journal of Applied Corporate Finance Volume 22 Number 4 A Morgan Stanley Publication Fall 2010

    I get that quickly as well. So information moves quickly in this company. If theres something thats different than what people expected in any material way, it comes up immediately through the system. And then we figure out how to respond to it. And Ill come back to that question when I talk about how we deal with the investment community.

    So, when you look at all of the financial processes that we have in place at GE, it is just a continuous rhythm of analysis, forecasting and planning. We do a lot of planning. And when new results come in, we go back and see how we performed against the plan, and what if anything went wrong. What did we learn about the company from actual results that were different from expectations? And what do we need to do differently going forward?

    Communicating with InvestorsThis brings me to my second main topic: How do we take the tremendous amount of communication and feedback in our internal forecasting and planning system and try to convey that information and the thinking behind it to the market-place? How do we deal with analysts and investors?

    Sell-side analysts basically do their own study of the industries they cover. The analysts who follow us have their own view of what our competitors are going to do. The analysts get information from other companies about how they expect to perform in our industry segments. And the analysts are also provided with our outlook, or what we call our framework. The framework has some forward-looking information about how we expect our businesses to perform, as well as lots of historical data, but no specific quarterly or annual EPS estimates.

    Using this information, the analysts develop their own model and earnings estimates. And these analyst forecasts of earnings then get aggregated in some way into First Call, into point estimates of revenue and earnings. But what people then do with these estimatesthe importance attached to these estimates and the amount of attention they receiveis to me just crazy. Its out of all proportion to what those numbers really tell us about a companys long-run profitability and value.

    Next Friday is our earnings day. We will put out a press release with our results and then CNBC will make some pronouncement that we made or missed revenue and/or earnings estimates. And I think its complete nonsense. We have about 15 analysts who cover us, and probably about six or seven who actually put out a revenue number on a quarterly basis. From a press perspective, that forecast becomes a kind of public benchmark of our performance. But from where I sit, the only real effects of setting up these fabricated bench-marks is to create the volatility the trading world lovesand to distort the decision-making of those corporate managers who allow themselves to be driven by the process. Earnings guidance is a mechanism that feeds the short-termism that critics of U.S. business practices love to focus on.

    We have some 3,000 finance professionals at GE who are part of this financial planning and analysis process. And they are constantly getting real-time feedback that enables us to compare our performance with what we thought we were going to do. They are dealing with the changes in the environ-ment in real-time and then trying to make adjustments that reflect their own knowledge of the businesses.

    Now there are some things that we do at the corpo-rate level to try and ensure consistency in our forecasting. We provide exchange rates in the different businesses for people to use when translating projected overseas revenues back into dollars. And the same goes for commodities and sourcing forecasts for people who dont have things already contracted forward. But having said that, we continue to have big internal debates about how to forecast, say, the future price of oil, which affects the profitability and value of an awful lot of our businesses. In our planning process, our analysts have to make judgments about the future price of oil or gas when estimating the cost of our own operations, and also when evaluating the condition of our customerssay, when looking at the efficiency of a gas turbine versus a coal plant based on gas prices, or how profitable the airlines are going to be based on what they have to pay for fuel. We also have to make some guess about the extent to which oil companies are going to reinvest in the oil and gas business.

    And let me make a quick point about the purpose of forecasting at GE, because Im not sure this is well under-stood. The goal of forecasting, from our organizations point of view, is not to get the most accurate point estimates. In fact, Im not sure weve ever gotten one exactly right. What we really care about is the quality of the thinking and the dialogue among our managers that takes place around the forecasting process. The assumptions behind our numbers are challenged at every step of the process. One of the positive things about the GE culture is that it is very open; candor and debate are encouraged and very much in evidence. We look for the opposing point of view. We look for the risks to the forecast. And after we debate the question, we make a decision and we move forward.

    So, we begin with the understanding that our forecasts are going to be wrong. They are point estimates with large distri-butions around them that are supposed to reflect the risks. And thats really the purpose of our forecasting processto understand those risks and the distributions of possible outcomes that result from them.

    Another way of saying this is that we hate surprises. By understanding the major assumptions behind and risks to our forecast, we are in a good position to say, Okay since this assumption didnt pan out, or this risk materialized, our forecast needs to be modified accordingly.

    Another thing we hate is not getting important informa-tion in a timely manner. Our CEO, Jeff Immelt, gets the good news immediately. As CFO, I get the bad newsand

  • 12 Journal of Applied Corporate Finance Volume 22 Number 4 A Morgan Stanley Publication Fall 2010

    points. Perhaps analysts and investors were really demanding more informationbut at any rate we provided it.

    Now, given that our goal as a company is to make signif-icant investments with the aim of building medium- and longer-term shareholder value, we came to the conclusion that providing 150 guidance points was not the best way to operate the company. And by the mid-2000s, we had backed off from giving many of the detailed data points. We were still giving a lot of guidance, but we deliberately broadened the ranges around the point estimates. We were effectively saying to Wall Street, Heres the plan that our operating managers are going to be evaluated against. But by widening the range of estimates, we were also saying, The reality is that there is a lot of volatility and uncertainty around this forecast; things are almost certainly going to happen that are different than what you forecast.

    The appropriate reaction to such a statementor the reaction we expected from long-term investorswas, What is your plan to respond to those sources of volatility? How are you managing these risks? But thats not what you hear in most public discussions of earnings. Instead you hear, You missed your guidance; there must be something wrong inside the company.

    So, again, if earnings guidance were part of a constructive dialogue between companies and their long-run investors, then earnings variations would be more routine. They would be expected, not the exception, in a world with so much uncer-tainty and variability. And our response to this reality of risk has been to provide lots of actual data on leading indicators and on historical performance as well. Virtually every metric or statistic we use in evaluating our own performance is now publicly available. But, again, all that information is historical, part of the past. What we have stopped doing, for the most part, is to use that information to predict future earnings. Were supplying the framework of how we think about our operations, and most of our operating metrics, but without converting that into a forecast of next quarters EPS.

    And I think its a better place to be. But its still a real challenge. We aim to achieve a high degree of transparencyand we provide a lot of access to leadership. Our leadership team spends time at many investment banking conferences giving overviews of the company. In the spring, we will do a long-term strategic conference called the Electrical Products Group Conference, where we present a tremendous amount of forward-looking information around operating metrics without EPS-specific guidance. And in the fall, as I already mentioned, we provide the overview of our framework.

    And just to give you an idea of how were trying to communicate in a non-guidance world, here is an exhibit from our framework that was presented in December of 2009.

    Without giving any EPS data, it shows both general trends in historical performance along with our expectations for the near future. For example, the exhibit shows that we

    But in terms of valuation, quarterly earnings announce-ments are a milestone, one that has little to do with the underlying process of how companies get valued in the marketplace. My experience suggests that, at least over the business cycle, our stock price is set mainly by long-term fundamental investorsby people who dont overreact to an announcement about an individual quarter unless its very different from expectations. What theyre really looking at are the longer-run trends and the underlying earnings power of the company. Does the company have profitable businesses, and is it continuing to invest in them?

    But having said that, the amount of trading that happens in the companys stock that has nothing to do with fundamen-tals is probably as much as 60% or 70% on an average day. And during the two-week period before and after earnings, that percentage no doubt gets considerably higher.

    And its not just the shortsightedness of earnings announcements that I find disturbing. Just as troubling is the artificiality, the illusion of precision, that surrounds these numbers. In arriving at an EPS number for most companies, there is uncertainty about the future and hence manage-rial discretion in a number of areas that are part of the final earnings number. Although earnings clearly provide useful information, its just one piece of data that long-term inves-tors use when making their investment decisions and setting stock prices.

    But as I said earlier, its not just the imprecision of the earnings number that made us stop giving guidance at GE. As a result of the financial crisis, it became almost impossible to predict our financial services results. Our range of outcomes had many factors beyond our control, especially over three-month timeframes.

    But even though weve stopped giving quarterly guidance, in most public discussions of our performance we continue to be evaluated against some consensus estimate. And that creates a challenge for usand for all companieswhen trying to communicate our long-run prospects to investors. Although we communicate as generally and broadly as we can, we continue to be subjected to reporting conventions that create volatility in our stock price without us having any say in itand thats a source of frustration.

    But let me say a bit more about some of the changes in how and what we gave for guidance over the last ten years. During the early 2000s, we were giving some 150 different guidance points, including quarterly EPS with very narrow ranges, or margins for error, that amounted to as little as $100 million around our point estimate for the entire company. That was much too narrow to allow us to manage shortfalls, or to explain them to our investors. It took considerable time and effort to come up with all these estimates, of course, and it was much more time-consuming to provide explanations for why you missed six of the 150 guidance points. I really dont know how we got to the point of providing 150 guidance

  • 13Journal of Applied Corporate Finance Volume 22 Number 4 A Morgan Stanley Publication Fall 2010

    the revenue will grow based on the growth of our installed base and how companies are using our products.

    So, in this way, I think we are giving outsiders a good sense of the foundation for our own internal plans without translating them into an EPS number. Were trying to give investors accurate and useful information that they can use to do their own forecasts of EPS, or whatever variables they think are most important in setting values.

    In Closing: Major Challenges in a Post-Guidance WorldBut even without getting boxed into guidance, there are some major challenges in forecasting and communication that we have to work through. And let me close my remarks by mentioning a few.

    Number one, what do you do when your internal results are different than the consensus estimate? Ive faced a number of events like that during my time at GE. For example, we insured some of the planes that hit the buildings in the World Trade Center. And we insured some of the buildings in our reinsurance business. These events were a total shock to our business model.

    What do you do? You have an analyst meeting and you talk about your fundamentals. When you have an event like that, you have to throw your guidance out the window and communicate with investors to the best of your ability. During the fourth quarter of 2002, because of our reinsur-ance business I couldnt even watch The Weather Channel when the hurricanes were rolling through. When our team told us that we had experienced two once-in-a-100-year events in a short time period, we said, You may need some new models! They couldnt predict the risks and couldnt price them. And the volatility from that business alone constantly made us miss.

    expected our industrial or infrastructure businesses to be flat in 2010. Now you might interpret flat as plus or minus three percent, or plus or minus ten percent. But what it says to me is that economic uncertainty makes it impossible for us to predict the outcome with precision; and by refusing to give EPS guidance and committing ourselves to some point estimate, were refusing to pretend that we know, refusing to pretend that theres less uncertainty around those outcomes than there is.

    We also showed in this exhibit that we expected our finance business to be about flat. For those of you who are forecasting in the financial services world, the volatility and the amount of losses that financial companies have sustained over the last couple of years has created a real challenge. In fact, this was the main reason we stopped giving guidance. We were unable to predict the performance of that business within any band I felt comfortable with because of the uncer-tainty about future events and parts of our portfolio.

    Our new approach is much better, but it still needs to evolve. We try and give some indicators about our new products, and about the strength of our services businesses. As I said earlier, 70% of the profits in our industrial businesses come from service, which has continued to grow even during the recession. And we will forecast the number of units we expect to sellhow many commercial and how many military engines were going to ship, and how many gas and wind turbines. We talk about our equipment backlogsand thats useful to analysts since we have pretty strong historical relationships between whats in backlog at a certain point in time and what will convert into revenue and when. We also talk about the mix of our services. About $35 billion of our revenue was expected to be in high-margin services that are a little more stable because theyre not tied to an order flow based on supply and demand. And analysts and investors can then predict whether

    Profit 2010E Drivers

    Industrial ~Flat + NPI, service growth, lower cost, global Excess capacity remains, invest in growth

    Media + Cable, improved ad markets Olympics

    Capital Finance ~Flat + Higher yields and lower costs CRE losses

    Corporate ~Flat Pension costs higher Restructuring TBD

    CFOA $13-15B + Working capital improvements Lower progress payments

    Dynamics +/- Financial & economic risks in balance May do more restructuring to improve GE for the future

    Exhibit 1 Example 2010 Framework

  • 14 Journal of Applied Corporate Finance Volume 22 Number 4 A Morgan Stanley Publication Fall 2010

    My second main point is that the thinking behind and output of these internal processes are the essence of what were trying to communicate to analysts and investors. Instead of holding up a single earnings target, our communications with investors are intended to create a continuous flow of commu-nication and feedback. And I want to emphasize that the challenging of assumptions, by people both inside and outside the firm, is an essential part of this ongoing dialogue. I dont know whether we will decide to give outsiders more forward-looking information in the future. But we are committed to continuing to provide large amounts of historical and current operating data. And however that gets extrapolated by analysts, were all for it.

    Let me stop here and see if there are any questions from the audience.

    Q & A SessionAudience: Do you have hurdle rates that you use when evalu-ating whether to go ahead with investments? And if so, do you use the same rate for all investments, or does it vary accord-ing to the kind of business?

    Sherin: Our best guess today is that our overall cost of capi-tal is somewhere around nine or ten percent. But our hurdle rates when evaluating some major investmentsparticularly mergers and acquisitions that require significant amounts of capitalare considerably higher. In general, our goal on most M&A deals has been to get close to a 15% cash-on-cash ROI by year five. Given todays price multiples on EBIDTA and the premiums you have to pay, this is a pretty aggres-sive targetbut its meant to be aspirational rather than a barrier to acquiring a business that really fits our strategy. If were looking at something thats of great strategic value, we will use a lower hurdle rate.

    But we use a somewhat different capital budgeting process when evaluating opportunities for organic growth. Take aircraft engines. Because were already in the aircraft engines business and committed to be a leading player there, we take a long-term view of our organic growth opportunities. Were just now finishing the development of the first version of the GEnx engine that will go on Boeing 787sand this kind of project has a 20-year cash flow break-even. But as I said earlier, the service component that comes out of such investments is expected to provide us with a very high rate of return down the road. Twenty years ago, our predecessors developed the GE-90 engine. Today, that engine is going into its early service phases and providing us a tremendous amount of cash flowbut the 15-year period in between did not provide great returns. Its a fundamental part of our business, and we will continue to make the investments we consider necessary.

    So, to come back to your question, we dont spend a lot of time trying to estimate the cost of capital for each of our businesses. But all of our businesses are evaluated according to

    In the first quarter of last year, we learned we werent going to achieve either our own expectations or the consensus estimate. What do you do? It really depends on the timing and the magnitude of the issues. When you have a discon-nect between your internal expectations and what youve communicated externally, youve got to be transparent about it. Youve got to get the information out there as soon as you can, and deal with the consequences.

    The second point I would make is that even if you stop providing guidance, people will continue to ask for it. My guess is that some 50% or 60% of our investors and analysts want us to give more guidance than were giving today. And I understand their frustration: Were a large, complex, global enterprise; and many of them may not think they have the time or resources to do the work that would be required to provide good analytics and forecasts around something as complex as GE. And theyd like us to just tell them the answer.

    But I dont think were going back to that. As I said earlier, the point estimates that come out of even the best forecast-ing process are too artificial, too uncertain, too lacking in precision to justify all the weight that gets put on them. And its become very clear to us that the costs associated with guidance, including legal liability as well as shortsighted decision-making, just dwarf the benefits.

    The third challenge is responding to the rumors that tend to arise, especially in periods of extreme stress. From the fourth quarter 2008 to the first quarter 2009, we were forced to deal with three or four rumors a week. I would come into work in the morning and hear a story that we had drawn down our bank linesor that we were going to write off $20 billion in some kind of mortgage portfolio that we didnt in fact own. The pace of information flow in the todays marketplace, especially given the Internet, and its capability for creating volatility and general havoc is extreme.

    The first requirement in dealing with such rumors is to be completely sure of your results and the surrounding facts. Once youre sure of the facts, the next step is to get your information out. We now publish our responses on the Web. We have set up a separate website called that enables us to respond to rumors quickly. At the top of the site it says, Here are some facts about the business. On most days we use it to provide some bits of new information about or communication from the company. But its greatest value comes in times of stress when we can use it to respond by posting our story without going through the logistics of setting up an analysts meeting in the form of a webcast.

    To sum up, then, theres a tremendous amount of corpo-rate thought and energy that goes into our forecasting and planning. And the goal of this internal analysis and planning is to make sure that were allocating capital in a way that will increase the value of the company to our investors over time, and to help us identify and manage major risks that could interfere with our ability to carry out our plan.

  • 15Journal of Applied Corporate Finance Volume 22 Number 4 A Morgan Stanley Publication Fall 2010

    expectations and standards. When our people meet their operating plan, were pretty confident that theyve done a good job by industry standards. So, yes, I agree that the businesses will generally try to come in with estimates that may be a bit lower than managers think they can do. But our dialogue ends up stretching people, and I think the outcome is reasonably close to an unbiased estimate.

    You dont want people to just lowball everything. But you also dont want to hold out unrealistic targets. And so weve been looking for the middle ground. And while we probably havent found it, I think we have a workable system. Its one that ensures that if you perform well when evaluated against your industry peers, you will be recognized and rewarded.

    And I think thats a reasonable solution to this problem. Thats the goal that were trying to get to when we go through this budgeting and planning process. And I think weve learned a lot from the process itself. Were now doing much more scenario planning than we used to do. We start by saying, Okay, this is the base caseand meeting it requires excellent execution. And here is the volatilitythe downside and the upside. And I think our managers really value this flexibility that is built into our systemthe fact that the standard shifts with changes in factors beyond their control. And as I said a moment ago, running the company without guidance gives top management the flexibility to evaluate its operations in this more realistic way that takes account of the market environment.

    Enterprise Risk Management and LiquidityAudience: My question is about the risk management process and especially financial risks. How important is it in your forecasting process?

    Sherin: One of the most important things that Ive learned over the last couple of years is the importance of enterprise risk managementits far greater than we ever thought. In our financial services business, we have world-class credit risk managers. They are fantastic at assessing the probability of losses for certain asset classes. But when it comes to detecting systemic risk, they were not so good. So, I think that one big lesson from the crisis is that every company has to be better at acknowledging and dealing with systemic risk. We were all lulled to sleep by the amount of liquidity in the systemand its ability to cover up risks that were building.

    So, weve had to change how we forecast. In addition to building a base case, our managers have long been provid-ing ranges of possible outcomes. But in the past few years, weve made ever greater use of scenario planning. It gives us a much better picture of what we have to deal with in terms of volatility and tail risk. And as a result, weve made some major changes in how we run the company. Today we run the company with $60 billion of cash, as compared to $15 billion three years ago. We used to have $90 to $100 billion of

    their return on capital employed. And in the three-year strate-gic plans I told you about, the business heads put together plans that show how they expect to increase those returnsand their performance is evaluated against such plans.

    Sometimes we make decisions to reduce our investment in a business. We recently made the decision that allocat-ing capital to the media business, for example, was less of an opportunity for us than allocating capital into oil and gas and energy and aviation and health care. That decision was based on our view of the industry, on our view of how much capital we thought we needed to participate in the ongoing consolidation of that business, and what we thought the returns were going to be. And in this case we used our financial planning process to make substantive changes in the portfolio of the company.

    The Effect of Guidance on Internal Decision-MakingAudience: Have there been any notable changes in internal decision-making from stopping earnings guidance?

    Sherin: I think stopping guidance has helped to strengthen our focus on our internal performance evaluation process. Instead of having people fixated on a three-cent range on the second quarter, they are now completely focused on meeting their operating plans. We havent really changed our internal evaluation process, but we have eliminated a potential distrac-tion. And that has given us a lot more flexibility. Last year, for example, we took $2 billion in restructuring charges that I dont think we would have taken in a guidance world. We wouldnt have made those investments to reduce the long-term cost structure of the company. In a non-guidance world, we have more flexibility to think about some things that may reduce your earnings in the short-term, but improve your outcomes in the long run.

    Limiting Sandbagging in the Budgeting ProcessAudience: I have a question about the budgeting process and how you set internal targets. Your managers presumably know more about their business than you do, and theres got to be a strong temptation to use that knowledge to underpromise and then overdeliver. How do you keep your managers from managing down their targets?

    Sherin: Thats a great question. Our leaders want to get the best performance we can out of the businesses; and as I already mentioned, we expect top-quartile performance from all of our businesses. But in our budget reviews, we sometimes hear reasons why we should expect different results. Although we approach such discussions with a healthy skepticism, we are willing to listen and to make exceptions where we think theyre warranted.

    But having said this, I would say the bias of our evalua-tion systemif it has a biasis toward higher performance

  • 16 Journal of Applied Corporate Finance Volume 22 Number 4 A Morgan Stanley Publication Fall 2010

    GE Capital part of GE is that the losses in financial services from time to time can offset gains in other businesses, thus lowering our tax bill. And under our internal accounting system, GE Industrial actually pays GE Capital for the tax shield provided by those losses.

    So, are those tax credits useful, valuable in themselves? How should investors think about them? For me, in a time of crisis, getting a tax credit functions as a source of additional capital. But at the end of the day, it was the additional capital that provided a buffer against the possibility of additional distress. And in that sense, our financial business can be seen as part of our overall risk management strategy.

    So, in this case, Im willing to live with lower quality short-term earnings which are generating additional capital. But in the long term, our goal is to have sustainable pretax earnings and an explainable tax rate. And thats the only way that you can get a meaningful valuation of the company. If you look at GE today, probably the number one concern of investors is our real estate business and what will the losses turn out to be. But among the top five concerns I would cite uncertainty about our future effective tax rates and, as a result of that, about our earnings quality. One of the goals of our strategic plan is to get us back to the point where GE Capital has sustainable pretax earnings and a normalized tax rate. But to get to that point, I think we would really benefit from international tax reform in the U.S. that gave us a tax system on a territorial basis that was similar to that of all the other developed countries in the world.

    But, again, I think its a great question. In the short run, were willing to live with questions about our earnings quality if our tax losses are a source of real cash and capital. But once youve established that youre going to weather the crisis, you dont get paid for those kinds of earnings. Over the long-term, as I said, you need sustainable, explainable earnings and a consistent tax regime. Thats what long-run investors are looking for.

    keith sherin is Vice Chairman and CFO of General Electric, a position he has held since 1998. He has held a number of jobs since joining the

    company in 1981, including Executive Audit Manager, Finance Manager

    at GE Aircraft Engines Commercial Engine Operation, Finance Manager

    for GE Plastics European Operations, and Finance Manager at GE Medi-

    cal Systems. He has a B.S. in Mathematics from the University of Notre

    Dame and an MBA from Columbia University.

    short-term commercial paper, with $60 billion of bank lines. And we always said, If we have a problem, we will sell assets. But what weve learned is that when you get into a problem, everyone else tends to have a problem tooand you cant sell the assets at appropriate values at such times.

    So, the whole concept of managing liquidity risk has become very important. And that has changed how we forecast. Our cost of capital is now different because you cant run with short-term borrowings without a backup line and a cash pool against it. And I think most companies have come to the same conclusion. Most now have their top enterprise risk managers reporting to their boards, and have new policies around liquidity risk management.

    The second major lesson from the crisis, from a risk perspective, is that companies need to do a better job of monitoring their asset concentrations, especially in financial services. On individual credit decisions, as I said earlier, our team is fantastic. But we allowed some concentrations to get too large, especially commercial real estate. And we kidded ourselves that not having concentrations in any single geogra-phy or asset class gave us enough diversification to withstand severe stress. What we learned is that the asset correlations go to 1.0 when risks become systemic.

    The Question of Earnings Quality and ValueQuestion: To the extent you think about earnings when evalu-ating your own performance, how you think about the quality of your earnings? Are some kinds of earnings more valuable than others?

    Sherin: Thats a great question. I like to think of myself as a student of earnings quality. And of the nine lives allotted to every CFO, I think Ive used up a few of them on issues of earnings quality.

    To give you just one example, take the one-time large tax credits we had last year in our financial services business. These are considered a source of low-quality earnings. In other words, they are clearly not the recurring earnings of a profitable enterprise. And the question this raises is: How should we treat these earnings in our discussions with inves-tors? Here we are in the first quarter of 2009 having just come through financial Armageddon, with people asking questions about the viability of our financial services franchise. Will there be a return to profitability?

    But now lets think of the financial services business as just one part of our portfolio. One of the benefits of making

  • 17Journal of Applied Corporate Finance Volume 22 Number 4 A Morgan Stanley Publication Fall 2010

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