Immelt had served as GE’s CEO for 16 years and wasn’t exactly the most popular executive with investors, to put it nicely.
Questionable capital allocation decisions, the dividend cut during the financial crisis, the lack of capital returned to shareholders, bureaucracy, and non-GAAP accounting complexities are all reasons why GE has been one of the most unloved stocks in America.
In fact, shares of GE have seen their price decline by more than 30% since Immelt succeeded Jack Welch at the end of 2001.
Immelt will be replaced by John Flannery, a 30-year GE veteran with experience running GE Healthcare, overseeing the large acquisition of Alstom, managing GE’s operations in India, playing key roles at GE Capital, and more.
Let’s take a closer look at GE’s leadership change to evaluate what it means for long-time dividend investors and the company’s dividend safety.
Prior to this announcement, GE’s stock had drifted lower by close to 12% year-to-date, trailing the S&P 500 Index by about 20%.
Investors were frustrated by the company’s weak cash flow generation in the first quarter, Immelt’s recent comments that GE’s 2018 earnings per share target might be out of reach, and weakness in the important oil & gas market.
As a result, GE’s shares were trading at a forward P/E ratio of 16.9, representing a discount to the broader market (17.7 forward P/E) and reflecting lowered expectations.
When combined with investors’ pent-up frustration with Immelt, it’s not much of a surprise to see GE’s stock reacting favorably to the news, climbing by more than 3% in early trading.
However, one effective dividend investing habit is to never make a decision based solely a stock’s short-term price performance. Instead, an investor should decide if the news actually impacts a company’s long-term future and whether that development appears to be fully priced into the stock.
After all, the short-term rise in a stock’s price could be just another overreaction by the market to an event that really doesn’t matter.
Is This Noise or News?
A CEO transition is a big deal. The CEO is in charge of guiding a company’s overall strategy and capital allocation decisions, which can significantly affect the long-term path of a business and the value it creates for shareholders.
GE says that its CEO transition process was set in 2011, so today’s news probably shouldn’t have come as a huge surprise; however, the timing of the transition away from Immelt was likely a bit sooner than many investors expected.
Incoming CEO John Flannery seems unlikely to really rock the boat at GE since he has been with the company for three decades and served in leadership roles that are largely aligned with the company’s current strategic direction (e.g. shedding GE Capital, acquiring Alstom).
I don’t view this change in leadership as a reason to go out and buy GE’s stock, but I think it’s an overall positive for the company as it works to get the most from the business transformation it’s gone through over the last five years.
With that said, there is a lot of room for GE’s new CEO to begin restoring credibility with investors by instilling more financial discipline (especially on cash flow), unlocking the value of GE’s world-class industrial assets, and executing better on activist investor Trian’s profit improvement plan.
However, given GE’s massive size and slow-moving nature, it could take at least a couple of years for any changes Flannery makes to begin bearing fruit.
There are also many examples of new CEOs “clearing the deck” by slashing guidance shortly after taking the helm in an effort to keep expectations low.
Given Immelt’s recent shakiness around the company’s ability to meet its 2018 earnings-per-share target and continued challenges in the oil & gas market, I wouldn’t be surprised if Flannery resets or removes GE’s 2018 earnings goal later this year.
This wouldn’t matter much for long-term investors (if anything it could prove to be a timely buying opportunity), but it could negatively affect the stock’s short-term performance and possibly result in more concerns about GE’s dividend.
Is GE’s Dividend Safe?
Some investors began to worry about GE’s dividend safety earlier this year when the company’s first-quarter cash flow missed guidance by $1 billion (for comparison’s sake, GE’s annual dividend payments total about $8 billion, so it was a large miss).
Deutsche Bank analyst John Inch published a bearish note on GE shortly after it reported earnings and suggested that the company might have to eventually cut its dividend given the weak cash flow performance.
Here’s a highlight from his note:
“Per GE’s cash guidance of $27bn (CFOA) in 2017-2018 (total $25-29bn), this implies $13bn CFOA (midpoint target this year) and $14bn next year. After subtracting capex of ~$3.5bn and required pension of ~$1.8bn/yr for 2 years, FCF of $7.7bn in 2017 would fall short of the required ~$8bn of common dividend funding and just above next year. Note, too, that $7.7bn would equate to roughly 85 cents of free cash flow this year and roughly $1.00 in 2018. However, GE pays out 96 cents in annual dividend, or significantly more than the 85 cents of 2017E Industrial FCF and roughly in-line with the $1.00 in 2018E. Considering that proceeds from Capital dismantlement and asset sales eventually go away, this high dividend payout would not appear sustainable…
We believe the stage is being set for GE to cut its common dividend, likely as part of an earnings “reset” lower and possibly in conjunction with eventual future leadership change.”
Executive leadership changes can sometimes result in major capital allocation changes too, including the amount of dividends paid.
However, I believe GE’s dividend will likely remain safe with moderate growth potential going forward. The company maintains a Dividend Safety Score of 58, which suggests GE’s dividend is very close to the “Safe” bucket and has a rather low risk of being cut.
Investors can learn more about Dividend Safety Scores and view their real-time track record here.
Starting on the cash flow front, scrutinizing a three-month period of time is a bit short-sighted. Almost anything can happen in 90 days, especially for a business that manufactures and sells expensive pieces of industrial equipment.
GE’s management noted that the first-quarter cash flow shortfall was driven by a build up of working capital to support growth and several one-time items, which are expected to reverse in the second quarter.
Management also reaffirmed full-year cash flow guidance and shot back at Deutsche Bank’s report by subsequently issuing the following statement:
“The Deutsche Bank alert is totally wrong – the analysis is faulty. The GE dividend is safe. We will generate $12-14B of cash flow from operations this year and we have $8 billion in cash on our balance sheet as of the end of first quarter. In addition, we just did an investor presentation at EPG where Jeff outlined that we will buy $11-13 billion in stock back this year and we have $8-12 billion unallocated cash in our framework. We clearly stated that the dividend remains a priority – we would prioritize the dividend over buyback.”
The company made several other comments about its dividend commitment during a recent conference call as well:
“And so this is the way we think about free cash flow conversion going forward and in terms of how we’re going to talk about it how we’ll describe it and what to think about. And that just leads into a discussion on capital allocation really for the next two years so let’s say ’17 and ’18 we have $72 billion or $74 billion of capital to allocate inside the company. If you add up what I would call just the bed rock of the company, keeping it safe and secure the dividend funding new products kind of the first four things the pension, that’s roughly the half of the cash we have available to allocate…
So the company’s incredibly strong from a balance sheet standpoint. You should look the capital allocation decisions around dividend and buyback and things like that, these are things that we’re committed to…
So very strong, very committed to the capital allocation choices we have made, especially the dividend and this is the way to think about GE and the strength of the company going forward.”
Commentary aside, a closer look at the numbers appears to support GE’s dividend as well. In 2017, you can see that GE expects to generate total free cash flow, including asset dispositions, between $16 billion and $20 billion. That amount at least double’s the dividend payments expected this year.
Given that management would prioritize dividends over share buybacks, there is even more wiggle room if operating cash flow does come in below management’s current expectations for the year.
Looking at 2017 and 2018 combined, we can see a picture of flexibility as well. GE expects to have $72 billion to $76 billion of cash available that it will use to grow its business and return capital to shareholders.
Buybacks and unallocated capital total $23 billion to $27 billion of total cash use and presumably take the backseat to dividends, once again providing a nice cushion in the event that industrial cash flow falls short of the plan.
Investors should also note that GE maintains an investment-grade AA- credit rating from S&P, which should provide ample access to cheap financing if the company needs it.
GE’s dividend has only been cut twice in the company’s 121-year history, and I have a very hard time believing there is risk of another cut anytime soon – even with a new CEO and the potential for 2018 earnings to come in below expectations.
That’s especially true when considering the rather defensive nature of GE’s industrial businesses, which are expected to account for more than 90% of the company’s profits next year.
While many of GE’s end markets are cyclical in nature, volatile equipment orders actually make up the minority of GE’s profits. GE’s service business generates over 75% of the company’s operating profits and is far more stable.
Service contracts help customers protect their massive investments in mission-critical equipment sold by GE and generate much more predictable revenue. In fact, industrial earnings were down only 13% in fiscal year 2008 and 7% in 2009 – a testament to the stickiness and high profitability of GE’s services business.
The company appears to have the financial resources necessary to continue paying dividends, credit market conditions remain very favorable, management is very committed to the dividend (even over share buybacks), and GE’s industrial business is more defensive than many investors might realize thanks to its large and lucrative aftermarket services.
All of these factors lead me to believe that GE’s dividend remains on solid ground and is likely to continue growing at a low to mid-single-digit rate.
Closing Thoughts on GE’s Leadership Change
CEO transitions can be a big deal for a company’s long-term future. Removing Immelt seems to be a step in the right direction for GE, if for nothing else than beginning the long road ahead to restoring GE’s reputation with shareholders, putting more muscle behind margin and cash flow improvement plans, and breathing some new life into the company.
GE has experienced a substantial business transformation in recent years, but the potential of its massive industrial businesses has yet to really be unlocked and appreciated by the market. For investors interested in learning more about GE’s competitive advantages and unique industrial businesses, I suggest reviewing my initial thesis on the company here.
As a long-term shareholder, I plan to continue holding my shares of GE. I don’t view the leadership change as a reason to go out and buy the stock today, but it’s an incremental positive in GE’s ongoing evolution as a business. GE’s dividend appears to remain safe, and I will be watching for continued improvement in the company’s cash flow and margins throughout the rest of 2017 and beyond.