General Electric, (GE), a bellwether stock for the US economy, reported a 12% drop in third quarter earnings, as the credit crisis continues to hammer its finance unit, GE Capital, a big profit driver for the industrial conglomerate.

On closer examination, GE's earnings report has a number quality of earnings issues. Investors should sit up and take notice of the danger zones.

The Bright Spots

GE's infrastructure units are still powering ahead. GE energy infrastructure saw a 31% increase in profit, with its tech infrastructure division eking out a 2% gain. GE says it has a huge $170 bn orders backlog, with its equipment backlog up 19% and its service backlog up 22%.

And GE's NBC Universal unit had a 35% rise in sales, translating into a 10% hike in profit, its eighth straight quarter of growth, the company said in its earnings release. The unit's revenues are up 15%, and its earnings are up just 4% for the last nine months versus the same period a year earlier.

GE Capital Continues to Stumble

GE Capital is the country's largest non-bank financial company, a unit that deals in commercial real estate, credit cards, mortgages and airplane leasing. With $678 bn in assets--82% of its parent's assets--GE Capital is in the league of the top ten largest financial companies in the country.

As its market cap has fallen to $189 bn, GE's stock has lost 55% of its value over the last 52 weeks as profits continue to erode at its GE Capital finance arm. GE says its finance unit will now fuel 40% of its profits, down from 50%.

The weak third quarter report comes fast on the heels of a $15 bn capital raise in the form of a $12 bn common and a $3 bn preferred stock offering purchased by Warren Buffett's Berkshire Hathaway (BRK.A).

Earnings per share were in line with the company's earnings forecast, which has already been lowered twice this year. EPS hit the mid-range of expectations, at 45 cents a share, off from a July forecast of 50 cents to 54 cents a share.

Earnings from continuing operations were down 33% at GE Capital, 16% on a nine-month basis. That profit result strips out all sorts of items. The parent's earnings from continuing ops was down 12% this quarter, 9% over the last nine months.

On a bottom-line basis, GE's earnings are down 22% in this quarter versus the third quarter of last year, down 12% over the last nine months. GE Capital's earnings are down 1% in this quarter versus the third quarter of last year, down 5% over the last nine months.

Revenues at GE Capital came in flat at 2% versus the year earlier period, to $18 bn. Industrial sales were up 17% from the third quarter of 2007.

GE has already reduced its full-year forecast to a range of $1.95 to $2.10 a share, from a previously lowered $2.20 to $2.30. The change translates to as much as $2 bn less in profit for 2008, analysts estimate.

"While GE Capital is not immune from the current environment, we continued to outperform our financial services peers," Jeff Immelt, GE's chief executive, said in a statement. "We are improving our margins and focusing these businesses on the right products and markets."

GE's Capital Raise Spells Trouble

That the company had to resort to a $12 bn common stock offering, with a separate $3 bn capital infusion in the form of a preferred share investment by Buffett's Berkshire Hathaway, (an investment now under water), should tell investors that GE is having difficulty accessing the credit markets and is struggling with a problematic balance sheet that has a sizable debt overhang, at last count $54.7 bn in illiquid securities it can't readily sell, and off-balance sheet vehicles that house $53 bn in debt securitizations that it doesn't want hitting its weak asset and liability picture.

If loaded back onto its balance sheet, those off-balance sheet sums would swamp its tangible net worth, or book value based on its hard assets (see blogs "What Buffett May be Missing at GE" and "Worrying New Disclosures From GE").

It's worth noting that Berkshire's investment is just a 0.1% stake in GE, paling in comparison to Berkshire's investments in Coca-Cola (9%), American Express (13%), and Burlington Northern (19%).

GE Fights to Hold Onto its Triple-A Rating 

GE is one of six industrial companies that sport a gold-plated triple-A rating, which allows it to borrow cheaply in the credit markets. Keeping its triple-A rating is vital to its business.

Historically, GE's triple-A rating enabled GE Capital to borrow cheaply and buy its way to profit growth.

Specifically, GE Capital uses that triple-A rating to help its parent execute its acquisitions and divestitures on the cheap, a just under the wire, limbo game of last-minute moves it has typically executed to grease the way toward meeting or beating its quarterly earnings estimates. 

But as the commercial paper market has frozen, GE has hit a wall in conducting its short-term borrowings to run its business and to make its last-minute moves.

GE has $88 bn in commercial paper, borrowings it needs to fund its day-to-day operations. Those borrowings have steadily risen in cost.

The Federal Reserve now says it will help backstop commercial paper borrowings for non-banks, a radical, unprecedented move for the US central bank, which analysts infer was a lifeline tossed GE's way.

GE has made unprecedented moves to protect its triple-A status. Besides the $15 bn stock offering, including the Berkshire investment, GE has frozen its dividend, the first time in 32 years, it has halted stock repurchases, and is attempting to trim borrowings at its finance unit, GE Capital.

GE's Flash Warning

Last Wednesday, the same day General Electric announced that Buffett's Berkshire Hathaway planned to invest $3 bn in the conglomerate and that it planned a new $12 bn stock offering, GE shot a little noticed filing over to the Securities and Exchange Commission that gave fresh detail on the unhealthy state of the company.

Publicly traded companies are required to make periodic risk disclosures about the state of their businesses, however, GE's disclosures were unusually pointed and detailed.

"Failure to maintain our triple-A credit ratings could adversely affect our cost of funds and related margins, liquidity, competitive position and access to capital markets," GE warned.

GE said that following its announcement of its recent capital raise, Standard & Poor's reaffirmed its ratings as well as the ratings for GE Capital's "AAA" long-term and "A-1+" short-term corporate credit ratings. GE noted that Moody's Investor Services did likewise.

But watch out here.

GE also warned: "however, there can be no assurance that we will successfully complete these steps or, in the event of further deterioration in the financial markets, that completion of these steps and any others we might take in response, will be sufficient to allow us to maintain our triple-A ratings."

It added: "Failure to do so could adversely affect our cost of funds and related margins, liquidity, competitive position and access to capital markets."

In a significant disclosure, the filing warns that GE gets "a large portion" of its borrowings via the commercial paper markets, but that "there can be no assurance that such markets will continue to be a reliable source of short-term financing for GE Capital."

GE's Limbo Dance Stymied

GE also confessed that the tight credit markets mean less last-minute acquisitions and asset divestitures for it to execute each quarter, which could hurt future profits.

"The success of our business depends on achieving our objectives for strategic acquisitions and dispositions," GE said, but added, "we may not be able to identify suitable candidates at terms acceptable to us."

It also warned that "when we decide to sell assets or a business, we may encounter difficulty in finding buyers or alternative exit strategies on acceptable terms in a timely manner," noting "or we may dispose of a business at a price or on terms that are less than we had anticipated," as tight credit markets have hurt the financing for these deals.

GE's Cash Flow Weakens

Cash from GE's operating activities in the first nine months dropped 18% to $13.6 bn, down from $16.7 bn for the same period a year ago. That cash drop was due to a $3.6 bn decrease in the dividends the parent gets from GE Capital, among other things.

GE's Creaky Balance Sheet

A look at GE's latest balance sheet shows the industrial conglomerate's leverage ratios, the amount of money it borrowers against its assets, are rising. GE is still struggling to pare back its debt load and to improve its asset picture.

GE has $548 bn in borrowings, $536 bn of which sit at its finance unit, GE Capital. The total of $548 bn is up 7% from $514.1 bn at year end 2007, but as GE is trimming its borrowing lately, that figure is down slightly from $556 bn in the second quarter.

However, here's a danger zone.

The parent's net worth has dropped in value, to $112 bn from $118 bn just a quarter ago, and $116 bn at year-end 2007. On just this basis, GE leverage ratio looks okay, at five to one, meaning for every dollar of assets GE has borrowed $5.

However, a whopping $99 bn of that $112 bn in assets is in the form of goodwill and intangible assets, hard-to-pin-down ephemera that represent the premium (or potential overpayments) GE paid in acquisitions as well as things like the value of its patents, among other items. It's a price tag the company assigns itself to these assets, with the help of auditors.

So GE's tangible book value, its net worth based on its hard assets, is just $13 bn. On that basis, GE is levered up 42 to one. Factor in its $53.2 bn in off-balance sheet debt, its debt picture blows out to $601 bn. In turn, its leverage ratio balloons to 46 to one.

Similarly, GE Capital's net worth has dropped in value, to $56 bn from $60 bn in the second  quarter ago, and $58 bn at year end 2007. That $56 bn supports $536 bn in borrowings, a leverage ratio of about 10 to one.

However, a full $30.5 bn of GE Capital's $56 bn in net worth also is in the form of ephemera. Similarly, GE Capital's tangible book value, its net worth based on its hard assets, is just $13.5 bn. On that basis, GE Capital's leverage ratio blows out to nearly 40 to one.

What is Not in GE's Disclosures

As noted, GE Capital has shoved into off-balance sheet vehicles a big $53.2 bn in securitizations, assets backed by credit-card debt, commercial and equipment financings, as well as trade receivables. This information is not in GE's latest third quarter earnings release.

These vehicles get to sport GE's gold-plated triple-A rating, even though these assets are backstopped by a weak $2.7 bn in credit support.

The vehicles come with triggers that force GE to pony up credit or buy them back, say, if a spike in defaults occurs. Putting them back on the balance sheet would hurt GE Capital's debt to equity ratios-as well as the ratios for the parent.

Moreover, GE Capital has $15.9 bn in illiquid assets, the toxic level 3 assets, that the company can't get a price tag on because there is no market to mark them to. So they sit dormant waiting to be unloaded. Again, this information is not in GE's latest third quarter earnings release.

It's got another $38.8 bn in level 2 assets, which may be more easily sold than its level 3 assets, though the credit markets for them still largely remain in blackout mode.

These sums in total easily swamp the $13 bn tangible book value of GE.

GE's Commercial Paper Problems

GE currently has around $90 bn of commercial paper, and with interest rates spiking higher, GE is facing a lot of trouble with higher funding costs--a reason why it did the capital raise in the form of a new $15 bn stock offering.

A report indicates GE says it has been "overfunded every day for the last two rates that are well below Libor and at or below the average Fed Fund rate." LIBOR stands for the London Interbank Offered Rate, used in debt financings around the world.

GE says its common stock offering, as well as the Berkshire investment, gives GE some breathing room for now to not have to draw on its $62 bn in bank credit lines or tap its nearly $60 bn cash and marketable securities.

However, the company does say in this report that "the volatility in the Fed funds rate has been a recent influence on pricing as has the spike in LIBOR," although it claims "the affect on our entire CP [commercial paper] portfolio is not significant." It does add that it hedges its interest and currency risk "over time." 

GE Elbowed Out?

GE is undergoing a massive restructuring which involves asset divestitures, but it could be elbowed out in a bum's rush to a very crowded exit door in its asset sales by Citigroup (C), JPMorgan Chase (JPM), and Bank of America (BAC) and just about any other financial services firm caught in the downdraft.

Analysts Go Negative on GE

Already, Citigroup analyst Jeffrey Sprague has cut his earnings estimates for GE for not just the next year, but for the next three years. Deutsche Bank Securities has already lowered its earnings per share estimates by 9% for 2008, to $2 and to $1.95 in 2009, and cut its stock price target to $26 due to "deterioration at GE Capital, driven by tighter credit markets, asset shrinkage and a debt pay-down."