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The Institutional Risk Analyst

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Narrative vs Debt: Tesla & GE

Writing this week in Barron’s, Harvard economist Martin Feldstein nails the proverbial issue of excessive debt square on when he notes that European Central Bank chief Mario Draghi has run out of runway when it comes to policy prescriptions. He writes:

“One of the goals of large-scale bond purchases—so-called quantitative easing— was to drive down long-term interest rates in order to stimulate business investment and housing construction. But with long-term interest rates now close to zero, bond purchases would not be able to lower them any further.”

But Professor Feldstein then concludes that when the inevitable economic slowdown comes in Europe, “an appropriate response to this dilemma may be a policy of coordinated fiscal expansion.” The fact that the world from Beijing to Brussels is literally choking on debt – thus Draghi’s infatuation with zero or even negative interest rates – does not dissuade Feldstein and other economists from recommending ever more debt-funded fiscal expansion.

Of course, if you ask ECB chief Mario Draghi, the ECB still has plenty of room to maneuver. All central bankers suffer from the deadly sin of hubris. Last week, we posted our thoughts on the tactical situation facing the new Federal Reserve Chairman-designate Jerome Powell on Zero Hedge. We asked: "How do you think, Governor Powell, equity markets will react if Chair Yellen inverts the yield curve on her way out the door?" Might ask Governor Draghi the same question.

As US interest rates rise and the policy gap between Washington and Brussels widens, our friends in Europe are going to be faced with some profound challenges. Chief among them is how to prevent Italy and other EU member states from defaulting on their debts. And the longer Draghi waits to “normalize” monetary policy, the more investors and markets will question the solidity of the European economic rebound.

Wolfgang Munchau writes in the FT: “Even after a decade-long recovery, the ECB may never be able to halt asset purchases.” Ditto. His comment implies that Europe is slipping into a Japan-like state of permanent debt repudiation via QE to manage the fiscal crisis for its weaker members. But insolvent countries are just the beginning of the world's debt problem.

Another important read in Barron’s this week features JPMorgan industrial analyst Stephen Tunsa talking about General Electric (NYSE:GE). Tunsa thinks that the dividend on the common shares -- now changing hands around $22 -- is going to be cut to better align with actual cash flow. He also sees the once high-flying GE, formerly a blue chip equity name, soon trading in the teens. Tunsa opines:

“I think most active managers expect a [dividend} cut, but a smaller one, to the 60- to 70-cent range. Certainly if it’s below 50 cents, the stock should go down. I don’t think this stock deserves a market yield, which is around 2%, so a 3% dividend yield on 50 cents or below gets you to a share price in the teens.”

Of interest, Barron’s reminds us that the financial-industrial conglomerate assembled by Jack Welch remains among the more complex financial services companies in the US even after shedding its status as a regulated financial holding company. Not only does GE Capital still finance much of the receivables of the industrial business, but the company also keeps many of these assets on its own balance sheet under complex leasing arrangements.

GE notes in its most recent 10-K that its non-US activities “are no longer subject to consolidated supervision by the U.K.’s Prudential Regulation Authority (PRA). This completes GE Capital’s global exit from consolidated supervision, having had its designation as a Systemically Important Financial Institution (SIFI) removed in June 2016.”

But past financial machinations still represent big a negative for GE shareholders. The company’s insurance unit, for example, remains a source of future potential financial risk due to poorly priced long-term care insurance contracts. In its latest public disclosure, which Barron’s notes is shrinking in terms of quality and quantity of its content, GE demurred on whether GE Capital will have to take additional reserves for its insurance unit.

“A charge related to a probable [reserve] deficiency is not reasonably estimable at September 30, 2017,” GE notes in its last 10-Q. “Until the above described review has been completed we have deferred the decision whether GE Capital will pay additional dividends to GE.” Really?

Could GE shareholders expect an unwelcome Christmas present from the new CEO John Flannery? Tunsa concludes: “If these issues are as bad as they seem from a cash-flow perspective, there’s a systemic problem that won’t be quickly fixed with cost cuts and portfolio tweaks.”

The problem with GE, or course, is that they are migrating back towards righteousness after years and years of high-risk financial engineering under Neutron Jack and his hyperactive management progeny. By aspiring to profitability and stability, the story has become entirely boring and subject to the laws of financial physics.

Flannery would do better to emulate Amazon (NASDAQ:AMZN) and especially Telsa (NASDAQ:TSLA) when engaged in corporate renovation. TSLA trades on a price-to-loss ratio, a unique measure that allows for unlimited growth. Unfortunately, Tesla shares closed down last week, in part because the Trump tax cutting proposal would scrap the $7,500 federal tax credit for electric cars.

Much like AMZN, TSLA is about selling the future rather than present day profits. With the setbacks recently reported by TSLA in terms of actually making cars, Elon Musk and his minions dare not even speculate about eventual profitability at this stage of the game. When confronted by the most recent failures to meet manufacturing goals, Musk pivoted on a dime and announced the construction of a new factory in China.

By comparison, GE sports a $175 billion market cap vs $51 billion for TSLA, which is still near its all-time high but is unprofitable and has $10 billion in high-yield debt. Cutting tax rates is great for the profitable, but of limited value to those like TSLA who have yet to report taxable income and can’t seem to hit operational goals. But investors love TSLA and hate GE, and perhaps with good reason.

Mark Twain said it is easier to fool people than to convince them they’ve been fooled, a statement tailor made for the TSLA phenomenon. Perhaps that’s why TSLA continues to raise new money to feed its growing burn rate, this even as GE sinks. Meanwhile, the major automakers show signs of ganging up on the new era car maker TSLA.

Short-seller Jim Chanos said last year, after the $2.6 billion merger with SolarCity Corp, that Tesla Motors is a "walking insolvency." Agreed. TSLA certainly has negative cash flow, but unlike GE, it has a positive narrative. Henry Ford said that you cannot build a reputation on what you are going to do, the polar opposite of the approach by TSLA founder Elon Musk.

Ford Motor Co returned its seed investors’ capital in full after the first year of operations, but investors in TSLA may never seen dollar one. Of course, a century ago cars were the new thing, while today electric cars are a strange novelty meant to make wealthy people feel responsibly green – even if lithium batteries are a dirty and expensive way to store and deliver energy.

In his effort to change the world, Musk is fighting the tides of history as well as the relentless logic of accrued interest. Musk's love child is also in a technological race with firms that want to put a sustainable propulsion source inside electric cars. The Economist reports that Mercedes-Benz is planning to introduce a plug-in hybrid SUV that combines a battery pack with a fuel-cell generator. This design is meant to replace internal-combustion engines when the EU plans to go entirely electric in 2040.

We continue to believe that hybrids are the answer for clean transportation, even if the auto industry must kowtow to political correctness and build absurd battery powered cars. But forget the batteries and firms like TSLA that are pursuing this retrograde technology. Call us when the all electric Ford F-250 Super Duty truck with a compact gas turbine for power is ready for a test drive.

And, no, we’re not buying or selling short TSLA or GE, but we are still accumulating a position in PayPal (NSADAQ:PYPL), one of the more interesting names in fintech.

BTW, hard copies of "Ford Men: From Inspiration to Enterprise" are again available on Amazon after a several week hiatus. Apologies for the operational issues.


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