Shares of General Electric (NYSE: GE) seemed to have found their footing earlier this year, as the struggling conglomerate started to put its house back in order under the leadership of new CEO Larry Culp. However, investors have been dumping GE stock this month, even after the company raised its full-year guidance in late July.
GE just suffered an even bigger blow, as an accounting team led by Harry Markopolos -- who became famous for having uncovered Bernie Madoff's Ponzi scheme well before it fell apart -- accused the company of accounting fraud. Indeed, GE stock plunged 11% on Thursday, as Markopolos claimed that the concerns he identified would cause the company to go bankrupt.
GE Stock Performance, data by YCharts.
However, while Markopolos' report raises some important questions about GE's liabilities, most of it reads as sensationalized fluff. What's more, Markopolos and his partners stand to make a huge profit if GE stock declines, calling their objectivity into question.
What Markopolos' team is saying
At 175 pages in length, the presentation prepared by Markopolos' group might seem extremely thorough at first glance. However, a huge portion deals with past events that have been public knowledge for years.
The report meticulously details the various losses, writedowns, and other scandals that have plagued GE over the past quarter-century -- and particularly in the last couple of years. But investors already knew all that. Assuming you reinvested your dividends, a dollar invested in GE stock at the beginning of the year 2000 would be worth about $0.28 today -- just a tenth of what you would have if you had invested in an S&P 500 index fund instead.
GE Stock vs. S&P 500 Total Return, data by YCharts.
The more substantive parts of the report deal with potential ongoing accounting fraud. GE needs to immediately increase its insurance reserves by another $18.5 billion, according to the authors -- above and beyond the $14.5 billion it's contributing between 2018 and 2024. Additionally, Markopolos and his co-authors allege that GE already should have booked losses based on its entire investment in Baker Hughes, a GE Company (NYSE: BHGE).
The report also includes allegations that GE's numbers are too good to be true -- especially in its prized aviation unit. However, there isn't any substance to back up these claims -- just a lot of innuendo implying that the company is probably covering up problems in GE Aviation because it has previously been slow to acknowledge losses in other businesses.
Suspect motives -- and not on the side you might expect
The authors of the report spend plenty of time skewering management -- deservedly so, in my opinion -- and argue that GE executives have historically swept problems under the rug in order to enrich themselves. There's some truth to that claim. That's why investors should believe the report and not management, according to the authors.
GE executives have made plenty of bad decisions over the years. Image source: General Electric.
However, GE has refreshed most of its leadership over the past couple of years. CEO Larry Culp had no association with the company until last year. The leaders of GE's insurance business all joined the company in 2018. Five of the company's 10 board members have been appointed since the beginning of last year -- two others joined in 2017. None of these people were involved in getting GE to where it is today, and none of them have any logical motive to collaborate in the giant cover-up that Markopolos alleges.
By contrast, Markopolos acknowledged upon releasing the GE report that he's working with an unnamed hedge fund that's betting against GE stock. If the trade is successful, Markopolos and his partners will get to share a portion of the profits. Culp described it as "market manipulation, pure and simple."
The sensationalized nature of the group's report supports GE's claim of market manipulation. Through a series of logical leaps and fallacious analogies, it compares GE to Bernie Madoff's Ponzi scheme and says the company is engaged in a fraud "bigger than Enron and WorldCom combined" that will end with a bankruptcy filing. These claims don't hold up to serious analysis and seem like a cynical ploy to generate headlines and drive down GE's stock price.
The allegations are overblown
One of the two main claims in the report -- regarding how GE is accounting for its investment in Baker Hughes -- is essentially an irrelevant dispute about the interpretation of accounting rules. General Electric announced last June that it would sell its entire stake in Baker Hughes over the course of several years. That process began late last year.
Due to its interpretation of the relevant accounting rules, GE hasn't recognized all of the losses it expects to incur upon selling more Baker Hughes shares. However, it's not hiding anything from investors. General Electric owns just over half of Baker Hughes, a GE Company. That stake's value is currently a little less than $11 billion -- about $1.20 per share of GE stock.
The claims about GE's long-term care reinsurance business still needing additional reserves are more plausible. That said, the new leadership team of that business said earlier this year that the company's 2018 claims experience was in line with the new assumptions applied at the end of 2017 (which triggered the $6.2 billion charge recorded in Q4 2017).
GE's insurance subsidiaries face rising claims. Image source: Getty Images.
Moreover, Markopolos and his partners repeatedly stress the differences between how GE and other insurance companies account for their long-term care liabilities. However, there's a good reason for that: unlike the others, GE is gradually winding down its insurance business.
Statutory reserve requirements assume "moderately adverse conditions" -- i.e., there's a margin of safety built in. That's necessary because the amount of future claims is uncertain, and regulators want the insurance companies to be sure that they can pay whatever they may owe. However, as GE winds down its long-term care insurance operations -- the average policyholder is already 77 years old -- the amount of uncertainty about future claims will gradually decline. After the last claim is paid, no margin of safety will be needed whatsoever.
GE shareholders shouldn't assume the company will never need to increase its insurance reserves after completing the current funding plan. But it's also unlikely that GE will have to contribute the full $18.5 billion of extra funding that Markopolos claims it will need.
Even if GE did have to come up with another $18.5 billion, it would hardly be the bankruptcy-inducing disaster that Markopolos alleges. Free cash flow is set to surge over the next few years as GE's restructuring winds down. Additionally, GE will get over $20 billion just from the pending sale of its biopharma business, not to mention the nearly $11 billion in Baker Hughes shares it will sell.
Culp certainly doesn't think Markopolos' allegations have any merit. He bought another $2 million of GE stock with his own money after the stock plunged, according to CNBC. Based on the available evidence, I'm still putting my money on Culp and company, too.
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This article was originally published on Fool.com