What is the material weakness GE disclosed, and why does it matter to investors?

GE did not have adequately designed procedures to designate each hedged commercial paper transaction with the specificity required by SFAS 133. The SEC staff's Office of the Chief Accountant concluded the program did not meet that standard, so GE restated its previously reported results from January 1, 2001 by eliminating hedge accounting for the related interest rate swaps and restated the 2006 interim periods. Management concluded internal control over financial reporting was not effective at year-end 2006, and KPMG issued an adverse opinion on internal control. The issue concerns reliability of financial reporting and controls, not an admitted misstatement of cash flows, and GE says it eliminated the program in 2007.

How did GE's earnings change in 2006, and what drove the increase?

Net earnings rose to $20.8 billion from $16.7 billion, and EPS was $2.00 diluted versus $1.57. Continuing earnings were $20.7 billion, up 11%. Drivers included organic growth at Infrastructure (segment profit up 16% to $9.0 billion), Commercial Finance (up 17%), GE Money (up 15%) and Healthcare (up 18%). The 2006 results also benefited from one-time gains and lower tax rates: GE's effective tax rate fell to 16.1% from 17.8%. Partly offsetting this, NBC Universal segment profit declined 6% and pension costs rose.

What is the status of GE's insurance exit?

The exit was substantially completed in 2006. GE Insurance Solutions' property and casualty and reinsurance businesses and European life and health operations were sold to Swiss Re for $9.3 billion, including $1.7 billion of assumed debt, with $5.4 billion received in cash and $2.2 billion in Swiss Re stock (a 9% interest). GE Life was sold for $0.9 billion, and the remaining 18% of Genworth was sold in March 2006. These are reported as discontinued operations for all periods shown.

What are the main leverage and credit risks for investors?

Most borrowings sit in GE Capital, with total GECS borrowings of $426.3 billion and a debt-to-equity ratio of 7.52:1. About $173.3 billion is due in 2007. GE maintains AAA/Aaa ratings, and it guarantees a minimum earnings-to-fixed-charges ratio of 1.10:1 at GE Capital. Certain downgrade triggers could require GE to provide up to roughly $4.7 billion of capital to specific entities or $8.0 billion in substitute liquidity for certain securitization entities. The company says it has never violated any such conditions and views a significant effect as remote, but a downgrade would raise funding costs.

What is the outlook for GE's businesses and capital returns?

The filing points to continued growth in Infrastructure (with a $39.2 billion backlog and orders up to $51.1 billion), expansion in Healthcare, and strong growth in Commercial Finance and GE Money, with the Japanese lending law expected to pressure GE Money's Japan operations over three years. Management expects pension costs to stabilize in 2007, has no required contribution to the GE Pension Plan in 2007, and plans to issue about $75 billion of long-term debt in 2007. The company expects a dividend increase to continue and intends to keep executing its $25 billion share repurchase program, subject to the outcome of any business disposition.

GE 10-K FY2006 Annual Report — Revenue, Net Income, EPS

01—Abstract

Summary

Summary of the 10-K filed February 27, 2007. Cited figures are marked; the original filing is the authoritative source.

General Electric's 2006 Form 10-K (filed February 27, 2007) reports record consolidated revenues of $163.4 billion^a (up 10% from $148.0 billion in 2005) and net earnings of $20.8 billion, or $2.00 per diluted share, versus $16.7 billion ($1.57) in 2005.

The results were lifted by the planned exit from insurance, which was substantially completed in 2006 through the sales of GE Insurance Solutions and GE Life to Swiss Re and the final Genworth stake, with those businesses now reported as discontinued operations. Continuing earnings from operations rose 11% to $20.7 billion^b. Dividends were raised 12% to $0.28 per quarter, and the company declared $10.7 billion in dividends for the year.

The central investor issue is a material weakness in internal control over financial reporting. GE restated its interim 2006 results after the SEC staff, through the Office of the Chief Accountant, concluded that the commercial paper interest rate swap program at GE Capital did not meet the SFAS 133 specificity requirement, so hedge accounting was eliminated back to January 1, 2001. Management and KPMG both concluded that internal control over financial reporting was not effective as of December 31, 2006.

An SEC formal investigation into the matter is ongoing, and GE has eliminated the program pending clarification of the accounting rules. Leverage is high at GE Capital (debt-to-equity of 7.52:1), while GE industrial debt remains low at 8.7%^c of total capital. The portfolio is shifting toward infrastructure, healthcare and industrial growth, supported by acquisitions.

Notable deals include Smiths Aerospace (about $4.8 billion^d, announced January 2007), Vetco Gray (closed February 23, 2007), IDX Systems, Biacore and ZENON. Management flagged a potential sale of the Plastics business.

NBC Universal results were described as disappointing, and Industrial profit was pressured by higher material costs. Overall, GE posted strong operating momentum, but investors should weigh the control weakness, the SEC investigation, and the leverage embedded in GE Capital.

02—Key points

Key Highlights

Record 2006 consolidated revenues of $163.4 billion (+10%) and net earnings of $20.8 billion ($2.00 diluted EPS), up from $16.7 billion ($1.57) in 2005.
Material weakness in internal control: GE restated 2006 interim periods after the commercial paper interest rate swap hedging program failed SFAS 133 specificity; management and KPMG concluded internal control was not effective at December 31, 2006.
Insurance exit substantially completed: GE Insurance Solutions ($9.3 billion sale to Swiss Re) and GE Life ($0.9 billion) sold, and the remaining 18% Genworth stake disposed of; these are reported as discontinued operations.
Ongoing SEC formal investigation into hedge accounting at GE and GE Capital, with the company stating it continues to cooperate fully.
Shareholder returns: $10.7 billion in dividends declared (per-share $1.03, +13%), quarterly dividend raised 12% to $0.28, and $7.8 billion of share repurchases in 2006 under a $25 billion program running through 2008.
Leverage at GE Capital is high (debt-to-equity 7.52:1 vs. 7.09:1), though GE industrial total debt was only 8.7% of total capital and the AAA/Aaa ratings were maintained.
Portfolio moves: acquisitions of Smiths Aerospace (~$4.8 billion, pending), Vetco Gray (closed February 2007), IDX Systems and Biacore, and a review of the Plastics business for potential disposition.

03—Questions

Frequently Asked Questions

What is the material weakness GE disclosed, and why does it matter to investors?
GE did not have adequately designed procedures to designate each hedged commercial paper transaction with the specificity required by SFAS 133. The SEC staff's Office of the Chief Accountant concluded the program did not meet that standard, so GE restated its previously reported results from January 1, 2001 by eliminating hedge accounting for the related interest rate swaps and restated the 2006 interim periods. Management concluded internal control over financial reporting was not effective at year-end 2006, and KPMG issued an adverse opinion on internal control. The issue concerns reliability of financial reporting and controls, not an admitted misstatement of cash flows, and GE says it eliminated the program in 2007.
How did GE's earnings change in 2006, and what drove the increase?
Net earnings rose to $20.8 billion from $16.7 billion, and EPS was $2.00 diluted versus $1.57. Continuing earnings were $20.7 billion, up 11%. Drivers included organic growth at Infrastructure (segment profit up 16% to $9.0 billion), Commercial Finance (up 17%), GE Money (up 15%) and Healthcare (up 18%). The 2006 results also benefited from one-time gains and lower tax rates: GE's effective tax rate fell to 16.1% from 17.8%. Partly offsetting this, NBC Universal segment profit declined 6% and pension costs rose.
What is the status of GE's insurance exit?
The exit was substantially completed in 2006. GE Insurance Solutions' property and casualty and reinsurance businesses and European life and health operations were sold to Swiss Re for $9.3 billion, including $1.7 billion of assumed debt, with $5.4 billion received in cash and $2.2 billion in Swiss Re stock (a 9% interest). GE Life was sold for $0.9 billion, and the remaining 18% of Genworth was sold in March 2006. These are reported as discontinued operations for all periods shown.
What are the main leverage and credit risks for investors?
Most borrowings sit in GE Capital, with total GECS borrowings of $426.3 billion and a debt-to-equity ratio of 7.52:1. About $173.3 billion is due in 2007. GE maintains AAA/Aaa ratings, and it guarantees a minimum earnings-to-fixed-charges ratio of 1.10:1 at GE Capital. Certain downgrade triggers could require GE to provide up to roughly $4.7 billion of capital to specific entities or $8.0 billion in substitute liquidity for certain securitization entities. The company says it has never violated any such conditions and views a significant effect as remote, but a downgrade would raise funding costs.
What is the outlook for GE's businesses and capital returns?
The filing points to continued growth in Infrastructure (with a $39.2 billion backlog and orders up to $51.1 billion), expansion in Healthcare, and strong growth in Commercial Finance and GE Money, with the Japanese lending law expected to pressure GE Money's Japan operations over three years. Management expects pension costs to stabilize in 2007, has no required contribution to the GE Pension Plan in 2007, and plans to issue about $75 billion of long-term debt in 2007. The company expects a dividend increase to continue and intends to keep executing its $25 billion share repurchase program, subject to the outcome of any business disposition.

04—Continue

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