Is Pelz really a shareholder or is he merely an opportunist?

Midterm Paper

– double space

– use only what have been provided (no outside sources)

Attachments:

“mid term winter” is Main paper need response to

all other attachment is sources that were used in class

GE’s Problems

This note refers to the Bloomberg article entitled What the Hell is Wrong with General Electric. This is listed on Blackboard in the Information Tab as GE Report from Bloomberg. Please read this note cross-referencing it with the Bloomberg report.

For more than a century General Electric has been one of the greatest companies in the world. It is the only company that remains on the Dow Jones 30 Industrials since that index was founded. Under Jack Welch who ran the company from 1980 until 2000, GE had a resurgence in growth. With a strong cash flow and limited opportunities to invest in high growth industries and opportunities the company switched a significant part of its business to financial services. This was a high growth segment of the American economy and is a segment that allows lots of leverage.

Why was this true?

Upon Welch’s retirement he was succeeded by Jeff Immelt. Immelt continued Welch’s strategy of growth in the financial services sector. Is this a strategy that can permit a sustainable advantage?

As the financial crisis loomed in 2007 the wheels began to fall off. GE was in trouble in 2008, and after a brief recovery, began sliding again in 2011 and afterward. Now GE’s survival as an independent company is being questioned.

The remainder of this paper relates to the article from Bloomberg magazine called “What the Hell is Wrong”. The page numbers are the pages of the article and the bold face lines are the beginning of the paragraph that I want to call your attention to. I also use bold face to identify questions I want to discuss with you in class.

P. 44

Beginning: “The past year…

In your opinion was Immelt fired or did he retire

Why was the dividend cut?

Beginning: Then in January…

6.2 billion charge from more than a decade ago…

How can this occur?

GE’s new CEO, John Flannery, has grimly promised, “All Options are on the table”, including the once unthinkable option of dismembering the company entirely.

In our first class, I described how Nelson Pelz had laid siege to P&G trying to get a board seat and use his board presence to divide the company into five separate companies based on lines of busines. He failed in this attempt. At the same time Pelz had bought about 1½% of the stock in GE. He was successful in getting one of his nominees on the board of directors. In that position Pelz was able to nominate John Flannery asCEO. This is an example of activist (vulture) investing. The major shareholder says the board has a fiduciary responsibility to maximize shareholder value. This may mean dismembering the company. Once that has been done Pelz will cash in his stock and walk away. Is Pelz really a shareholder or is he merely an opportunist? Will the US economy be better off it GE is broken up?

Beginning “since Coffin…

In a way, GE’s dominant product has been its management. Managers would be sent to Crotonville for executive courses to improve their skills. The article says that managers would be “imbued with the company’s values” – sounds like a lesson in core values.

Beginning: Jones’s successor was a chemical engineer named John Welch Jr who’d…

During Welch’s tenure, GE became a factory for elite corporate talent. He was ruthless on pruning poor performers from the company. Simon Sinek described this as “rank and yank”. Based on their performance appraisals, the top 10% of employees would be eligible for promotion and the bottom 10% would be fired. What do you think of the approach vs. the Barry Wehmiller approach?

P. 45

IBM was often described as “I’ve Been Moved”. GE managers also were moved about the world as they progressed up the corporate ladder. Is this good for learning new ideas and skills? What is the cost to the employee’s family?

Beginning: The company’ mandarin confidence…

GE retained senior managers in the top position for ten or twenty years. The typical large company CEO is 62 or 63 when he takes over the position. He will probably retire at 65. Which is better for the company in your opinion: CEOs who can serve for 2 to 3 years or those who can serve for a decade or more?

When Welch announced his retirement, there were three candidates who could have succeeded him. Because GE management was thought to be so strong, it was recognized that the losers would easily get top CEO jobs at Fortune 500 companies. Some said the winner might really be the loser because the winner would have to fill Jack Welch’s shoes, and Welch had been named manager of the century by Fortune magazine. Jeff Immelt got the top job, candidate two, Bob Nardelli moved to CEO of Home Depot, and candidate three, James McNerney became CEO of 3M.

Nardelli ran Home Depot for about five years. He turned over about 31,000 employees, old hands who knew the product line but were too expensive. Among the replacements were 19,000 ex-servicemen. His objective was to impose the GE numbers driven system and military style discipline on a company that had always put a premium on the worth of the individual. After five years, Home Depot’s profits were up but it had fallen from first to last in its peer group for customer satisfaction. Nardelli was fired and given a $210 million golden parachute to go away. He then moved into Chrysler as CEO just as the Great Recession was beginning and promptly drove Chrysler into bankruptcy.

An article in the Wharton School executive magazine said this about Nardelli: With strategic missteps, an outsized compensation contract and a knack for alienating employees and shareholders, Home Depot’s Robert Nardelli turned out to be a star-crossed leader.

Wharton faculty members and other experts say Nardelli, a talented former executive at General Electric who came within a hair’s breadth of replacing Jack Welch as head of the giant conglomerate, brought the wrong toolbox to the job after he was recruited for Home Depot’s top spot in December 2000. He did not know the retailing business and mistakenly thought that what had worked at GE could be readily transplanted to Home Depot’s more freewheeling, entrepreneurial culture. After years of a declining stock price — and a now-legendary 2006 shareholders meeting where an imperious Nardelli refused to answer questions — Home Depot announced the CEO’s resignation on January 3. He walked away with a package worth $210 million. Nardelli was immediately succeeded as CEO, chairman and president by Frank Blake, who had served as Home Depot’s executive vice president since 2002. Before joining the Atlanta-based company, Blake also held senior positions at GE. “While GE is a great source of management talent, the style of leadership that works at GE doesn’t necessarily readily carry over into a company that does not have GE’s traditions or GE’s riveting focus on performance,” says management professor Michael Useem, director of Wharton’s Center for Leadership and Change Management. “GE has a deeply held, corporate cultural value around the idea of performance. If you don’t get results, you just won’t hold your position long. An executive leaving GE will attempt to bring what worked in the past, but at Home Depot the way of operating was decentralized. Managers had a lot of discretion and there was a free-flowing, exciting feel to working there. Nardelli tried to streamline some 2,000 stores to get control over them, which might have worked at GE, with its focus on performance. But at Home Depot, that approach to leading did not work well, given the history of the company.”

(There is a management lesson here. What works well in one company will not work well in every company. The new CEO has to analyze the situation at the new company and modify his style to fit that new situation. There is a saying, “Foolish consistency is the hobgoblin of little minds.” To slavishly apply a successful plan to a new failing situation will definitely make the situation worse. Home Depot was not in a desperate situation to begin with, but the misapplication of a particular management style definitely damaged Home Depot.)

According to Barry Henderson, an equities analyst at T. Rowe Price, the Baltimore, Md.-based mutual fund company, Nardelli made “two big mistakes” at Home Depot: He alienated employees and angered stockholders. Henderson says the alienation of the rank-and-file at the home improvement retailer has been largely overlooked by the business press in analyses of Nardelli’s departure. “The Home Depot culture is distinct in retail,” Henderson explains, describing it as having been “extremely entrepreneurial and very customer focused” when Nardelli arrived. Nardelli concentrated on overhauling Home Depot’s business processes, which did need to be addressed, but he “overfocused” on the processes and swept aside the elements that made Home Depot special. For one thing, Nardelli angered people by firing long-time Home Depot executives and bringing in GE alumni, according to Henderson. (New CEOs often do this because they trust the people they have worked with before). He also increased the number of less knowledgeable part-time workers at Home Depot’s stores, which left full-time employees fuming and led to a diminishment of customer service, one of the company’s strengths. From the very beginning of his tenure, Nardelli, now 58, “damaged morale, and he was seen as a real threat to the Home Depot culture,” Henderson says. James McNerney’s adventures at 3M also were difficult. An Inc. Magazine article described: “Revered for decades as one of the world’s most innovative companies, 3M lost its innovative mojo when it began using Six Sigma (This was used extensively at GE) to try to improve its operational efficiency. James McNerney, the CEO named in 2000, was a Jack Welch protégé from GE. He introduced the Six Sigma discipline as soon as he took the helm of the firm, streamlining work processes, eliminating 10% of the workforce, and earning praise (initially) from Wall Street, as operating margins grew from 17% in 2001 to 23% by 2005. “But when McNerney tried to apply the Six Sigma discipline to 3M’s research and development processes it led to a dramatic fall-off in the number of innovative products developed by the company during those years. And 3M had been famous for its innovations, in a wide variety of areas, from Scotch tape to Post-it Notes. “Many breakthrough innovations come by happy, unanticipated accident rather than by plan, but Six Sigma is all about planning, predicting, documenting, adjusting, and improving. Applied to R&D, Six Sigma attempts to turn the innovation process into a repeatable routine, which ends up favoring incremental improvements over disruptive innovations and breakthroughs. “Many of the researchers and scientists at 3M bridled at the requirement to fill out constant reports and justifications for doing the kind of “tinkering around with things” that usually led to the more important creative ideas. According to one participant in the process, after a briefing on how the Six Sigma program was to be applied to R&D, “we all came to the conclusion that there was no way in the world that anything like a Post-it note would ever emerge from this new system.” Inc. does not say how or why McNerney left 3M. The article only said the company had lost its mojo. McNerney then went to Boeing as CEO and had a successful end to his career.

Why do you think both Nardelli and McNerney failed when they left GE? What lessons can you learn from their careers?

Beginning: Under Welch…

Profits grew from $1.65 billion to $12.7 billion but employment shrank from 404,000 to 313,000. What had happened?

This paragraph describes GE’s move into financial services. In financial services, you can generate huge increases in assets and really bulk up the balance sheet. The way it works is as you become a “bank” you can raise money from short term inexpensive deposits and lend it long term at higher rates. Because of GE’s outstanding credit (they could borrow at the same rate as the federal government) there was a large spread between GE’s cost of borrowing and GE’s lending rate on long term investments, loans, notes, mortgages, etc.

Beginning: In the hands of GE’s financial executives and tax lawyers…

GE would borrow US funds then lend them to overseas GE projects. There were low or no taxes on the foreign earnings in the host country and no taxes by the US government as long as GE left the money overseas. In the meantime, GE would have to pay interest to the lenders who provided the funds that GE lent overseas. These interest costs to GE are deductible to GE as a cost of doing business and reduced or eliminated GE’s taxes since the foreign earnings were sheltered from the IRS as long as they stayed in a foreign country.

The Old Testament says the Jews must lay the land fallow for one year every seven years to allow the land to rest. Today’s agricultural techniques allow land to be worked every year by chemically restoring its fertility. What the Jews in Israel do is sell the land every seven years to a compliant non-Jew who holds it for a year and then sells it back to the Jews. The trustee receives a reasonable profit for his services. The law is precisely honored although that was not the original intent of the law. In a same fashion, GE would sell it highly liquid financial instruments that will not yield a profit until they mature to a friendly third party on Dec 31 and then buy them back at a preset price 31 days later in the New Year. GE recognizes a realized loss on the December transaction and deducts that loss form its income taxes. The net effect is to postpone the taxes until the financial instrument finally matures. In the case of a 30-year mortgage loan, this could postpone the tax obligation for up to thirty years.

P. 46

Beginning: The risks became clear only when…

Immelt took two body blows in the first two years of his tenure: 9/11 and the dot.com bubble. Since shareholder value was the final measure of quality management, it became necessary to do deals. These would grow revenue, hopefully increase combined profits and paper over weaknesses in GE’s core businesses. Carly Fiorina did something similar when she became the first woman CEO of a major corporation landing the job at HP. When earnings appeared to be turning down she bought Compaq Computer. This was a low margin business but she was able to camouflage the poor performance of HP’S mainline business with the extra Compaq revenue. Fiorina was later fired and HP has never fully recovered.

P. 47

Beginning: Immelt also publicly pledged…

Immelt reversed deep cuts in R&D. R&D is investment in future products and potential earnings but is an expense today. Welch may have cut R&D to fluff up earnings in his last year as CEO. This is a common tactic among retiring executives. Cut R&D, advertising and hiring to the bone to make the highest possible earnings and highest retirement bonus as you leave. Then leave those underfunded areas to your successor to fix things up. In your opinion, is this right and is it ethical? Would you do it to enhance your retirement bonus?

GE long held that its executives could run any business. Earlier in the article (P. 45) it said “during the 1980s, as conglomerates were increasingly written off as lumbering and opaque, GE was lauded as…a “premium conglomerate”. A conglomerate is a company made up of businesses in unrelated industries. Their expected advantages are that earnings in one industry segment will offset losses in another segment as the economy fluctuates. The corporate umbrella provides “genius” top management and controls finance for all the operating companies.

Do you think this type of multicompany or conglomerate company makes sense in the 21st century?

Beginning: The 2008 financial crisis revealed…

GE was relying heavily on short-term debt, and when the market froze, GE lost its magical tool. Short term rates, sometimes borrowed overnight and repaid the next day through issuing a new debt instrument, were used for long-term loans on boats, planes, trains, mortgages and the like. GE had great credit and could borrow in the short-term market at super cheap rates. They would then lend long at market rates. There was a very large spread between GE’s borrowing and its lending rates. If you can’t roll over your short term paper, you are screwed because you can’t collect those long-term loans except as the loan matures. GE avoided insolvency just as narrowly as did Global Ditchpin.

GE’s strategy was high risk but high reward approach. Would you have recommended this strategy for the company? If not, how would you respond to investor’s demands for continuing high rates of growth in sales and earnings?

In October, GE had to raise $15 billion through an emergency stock sale, $3 billion of it from Warren Buffett’s Berkshire Hathaway Inc. At that crisis time Warren Buffett was the only person in the worlds with access to $15 billion in cash. The credit markets were frozen. Buffett’s investment was very high cost to GE. However it helped GE survive its solvency crisis by giving GE enough to pay its debts as they became due. Within a few days the credit markets thawed and business could be conducted again. It also gave GE additional capital to finance its GE banking business. At that time GE’s banking interests made it one of the largest banks in the world in addition to being a large industrial company. Banks are required to keep a minimum capital base to support its loans. The bank may be able to lend $30 to $35 dollars for every dollar in their capital account. With the sharp decline in market values at that time GE banking was in danger of exceeding those limits and of being in default. The new money helped to shore up that capital.

Beginning: In the decade after the harrowing experience…

There was no let up on Immelt. Investors expected him to deliver new growth in sales. When you are a very large company it becomes virtually impossible to grow the business organically as a rate to satisfy the investors’ appetite. The only course open to such a large company is to grow by acquisition. As we discussed in class, most acquisitions don’t turn out well. Why? Poor due diligence, getting a bad fit, culture clashes, lack of knowledge about the unique elements of the acquired company’s business. Also you can buy at the top of the market which is what Immelt did.

What alternatives to the acquisition Immelt made would you have advised him to do?

P. 48

Beginning: GE wasn’t the only company to miss …

The article notes that GE would have been able to protect its dividend from being cut in half if it had not spent $9 billion in stock buybacks. What is the purpose of dividends? What is the purpose of stock buybacks? Under what conditions should you pay dividends or conduct stock buybacks? If you cut dividends what happens to stock prices.

P. 49

Beginning: John Flannery has a reputation…

Already, Flannery is moving decisively to address problems he inherited – something his predecessor, in hindsight waited too long to do. Had you been Immelt what would you have done when you inherited the opportunities and problems from Welsh?

John Flannery: “Complexity hurts us.” He is betting on a future where GE doesn’t require management wizardry to run properly, because wizards turn out not to exist.