GE is one of the most unloved blue chip stocks. Almost anywhere you read a GE article on the internet, commentators are quick to rip into CEO Jeff Immelt, the company’s poor capital allocation decisions, the dividend cut during the financial crisis, the bureaucracy, the lack of capital returned to shareholders, the company’s deceptive PR efforts, and more.
And why not – there is plenty to be frustrated about if you are or were a long-term GE shareholder. Since Immelt took over the role of CEO from Welch in 2001, GE’s total shareholder return (includes dividends) is a whopping 0%. Without dividends, the stock is down more than 35% compared to the near doubling of the rest of the industrial sector.
As seen below, GE’s total shareholder return (“TSR”) has trailed the market just about every year since 2000 (represented by a falling line). The financial crisis dealt the company a huge blow in 2008, but the stock has actually performed more in line with the market since then, compounding at a respectable 14.4% annualized rate from 2010-2014.
With so many investors still anchored on GE’s lost decade and expressing distrust toward Immelt and his ongoing portfolio transformation efforts, we see an interesting investment case building for long-term dividend investors and include GE in our Top 20 Dividend Stocks list.
Most analysis on GE is quick to rip the mistakes the company has made over the last 15 years – selling NBCUniversal not long after the financial crisis, possibly leaving significant money on the table; overpaying for a biotech firm acquired in 2004 for $10 billion; overextending into too many non-core markets; mismanaging its bank operations, resulting in a shocking dividend cut during the crisis; overpaying management and diluting shareholders, etc. While taking a few potshots at GE is easy, the factors that have made GE an industrial giant in the first place and that persist today are just as easily overlooked.
Of the 12 firms that constituted the original Dow Jones Industrial Average in 1896, GE is the only one still on the list. Surviving for more than 100 years is no small feat and speaks to the company’s historical innovation and managerial skill. R&D has been at the core of GE’s industrial operations for more than a century, and the long-term track record of many of its technologies are likely a key selling point when it comes to bidding on new deals – given the mission-critical nature of GE’s products, customers would prefer to buy from a vendor that can provide decades of equipment performance data. Today, GE invests about $5 billion per year into R&D to ensure its products remain competitive and further benefits from sharing insights between its industrial divisions, which often share technologies like turbines or imaging capabilities.
The future GE will look quite different from the GE of the past, assuming management executes successfully on the current plan. As seen below, GE’s industrial earnings are expected to grow from 57% of total earnings in 2014 to more than 90% of total earnings by 2018 (up from just 37% in 2001) as the company divests its non-core GE Capital assets. The remaining financial operations will focus on providing commercial and industrial loans and equipment and aircraft leasing, supporting the industrial core. GE Capital almost killed the company during the financial crisis and adds significant complexity to analyzing GE’s business, so this is a very welcome change from our perspective.
GE’s industrial core consists of a handful of business lines selling multi-million dollar products such as gas turbines, aircraft engines, oilfield equipment, locomotives, and medical imaging. The majority of revenues are overseas. To understand the dominant market share GE has accumulated across most of its markets (e.g. 30% in the global engine & turbine market vs CAT at 19%; 49% in wind turbines vs Vestas Wind Systems at 18%), a closer look at the company’s three competitive advantages is needed – economies of scale, long-term customer relationships, and continual investment in R&D.
GE’s sheer size provides it with tremendous purchasing power over its suppliers. When combined with the company’s long focus on lean six sigma, GE can underbid most competitors for contracts to supply customers with large equipment. Once GE has secured a deal, it enjoys service contracts lasting 10-20+ years to keep customers’ mission-critical equipment up and running. This is where the real money is made because service contracts generate 30%+ margins, keep the customer further locked in with GE, and elevate switching costs.
In addition to cost, GE’s experience in most of its industries spans multiple decades (e.g. GE sold its first jet engine over 70 years ago). Many of its customer relationships are equally long. Importantly, many of the products GE sells are mission-critical pieces of equipment used in mission-critical applications. Utilities can’t afford to have their power generation abilities compromised, airlines can’t afford to have faulty jet engines, and hospitals can’t afford to have a faulty MRI reading.
The risk of moving to the latest and greatest technology or competing supplier is too great. In many cases, like in aerospace, the entire project might have to be redesigned to switch to a competitors’ jet engine, requiring high costs and lengthy qualification periods. GE also brings a more comprehensive understanding of a customer’s business when it has worked with and innovated alongside that customer for so many years.
For these reasons, GE has maintained leading market share across many of its divisions, and global competition is often limited to only a handful of major players in most industries.
Despite the attractiveness we see in GE’s remaining industrial divisions, some investors have expressed concern about the increased volatility GE’s future earnings will have due to the cyclical nature of many of these end markets. Unfortunately, less time is spent understanding GE’s lucrative service business, which delivered 42% of the industrial segment’s sales last year but accounted for more than 75% of its total operating profit. While equipment orders are cyclical, the sustainability and growth of service profits is the more important factor driving GE’s future cash flow.
Service contracts help customers protect their massive investments in mission-critical equipment sold by GE. While companies like IBM see GE’s juicy service margins and are trying to use big data to better understand how machines work, when they need maintenance, etc., OEM’s like GE presumably know their gear and customers’ needs best (for now). GE is investing heavily in the “Industrial Internet” to protect and enhance its services business, spending more than$1 billion over the last four years to create a $1.4 billion predictive analytics software business.
The company has even stated that it hopes to be one of the 10 largest software companies in the world by 2020. While this claim certainly appears ambitious, we believe increased use of data and analytics will further protect GE’s ability to secure lucrative service contracts, increase its attach rate of long-term maintenance contracts, and further raise customers’ switching costs.
There are several examples of how more data and software can help GE protect and grow its services business. With more intelligence built into jet engines, GE can better understand when those engines will develop problems and schedule maintenance before those problems occur. As a result, airlines could save millions by having fewer rescheduled flights. Wind farm operators could know how and when to adjust individual blades on each turbine to improve the overall efficiency of the wind farm, increasing power output within the existing system.
The “Industrial Internet” could ultimately have as large of an effect on the industrials sector as lean manufacturing did in past decades. We are still in the early stages as GE surprisingly doesn’t yet have access to most of the data its machines produce. Jet engines already have hundreds of sensors, but data was only collected at takeoff, at landing, and once midflight. GE now has a way to get all the flight data, but it underscores how slow the internet has been to revolutionize industrials. Caterpillar (CAT) is also investing heavily in analytics, and our full analysis of the stock can be seen here.
While we have analyzed the fundamental strengths of GE’s business, we will take a moment to address some of the naysayers’ remaining concerns.
For those griping about Immelt’s “incompetence,” he will likely retire within the next two years. He turns 60 in February 2016, and the bulk of his transformation efforts will conclude by the end of 2016. It’s unknown if GE will replace him with someone from within the organization or from the outside, but no more Immelt would likely be a welcomed move by investors.
For those complaining about GE’s lack of meaningful capital return to shareholders, your patience could finally be rewarded over the coming years (unlike the past). From a buyback perspective, shares outstanding declined at a 0.5% annual rate over the past decade. Hardly anything to write home about and a signal that management’s compensation was benefiting the most from GE’s buyback activity. However, GE expects to reduce total shares outstanding by 15-20% over the next three years and recently changed its compensation system. For the last 30+ years, bonuses were tied to metrics at a higher GE level. The system was changed to be tied more to metrics specific to each business earlier this year – revenue growth, cash generation, margin expansion, and operating profit growth.
From a dividend standpoint, GE has stated that the dividend will be maintained in 2016 (we predict a $0.01 per quarter increase, representing no more than a 4% rise) with intent to grow it thereafter.
While GE has had its share of good and bad acquisitions and divestitures, we believe the company’s decision to spin off Synchrony and dispose of numerous financial assets could not have come at a better time. With near-zero interest rates around the world, very strong stock market returns over the past five years, generous credit terms flowing to all companies (i.e. low customer default rates), and an ever-growing appetite for M&A across most industries, we could be much closer to the peak of the current credit cycle than the trough. As such, the proceeds GE will receive for many of these assets could eventually make its decision to shrink its finance arm now look like on the smartest moves the company has ever made.
Let’s take a look at the dividend.
Dividend Analysis
We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend. GE’s long-term dividend and fundamental data charts can all be seen here and support the following analysis.
Dividend Safety Score
Our Safety Score answers the question, “Is the current dividend payment safe?” We look at factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.
GE scored a Safety Score of 41, a ranking that suggests GE’s dividend is safer than 41% of all other dividend stocks. The company’s high debt load, financial operations, and cyclicality are working against it, but the dividend should appear much stronger after GE’s ongoing financial asset divestitures are complete.
Over the trailing twelve months, GE’s dividend has consumed about 40% of its free cash flow. Looking at longer-term trends in payout ratios can be even more helpful. Our dividend tools let you view a stock’s EPS and free cash flow payout ratios over the last decade. As seen below, GE’s payout ratios have remained around 50% or less.
Source: Simply Safe Dividends
For dividend companies with enough operating history, it’s always a prudent exercise to observe how their businesses performed during the financial crisis. Our Stock Analyzer tool lets us see how a company performed during the financial crisis in one click. GE’s reported sales were down 15% in fiscal year 2009, but its reported EPS fell 40% due almost entirely to the company’s weak financial division, which saw its earnings plunge 80% (industrial earnings were down only 13% in FY 08 and 7% in FY 09 – a testament to the stickiness and high profitability of GE’s services business).
Source: Simply Safe Dividends
High quality companies are able to generate cash flow year in and year out. Rising cash flow is very important because it supports continued dividend growth without expanding the payout ratio. While GE is a cyclical, capital-intensive company and experienced extreme duress during the financial crisis, it has generated free cash flow for each of the last 10+ years, a testament to its high-margin and generally stable services business:
Source: Simply Safe Dividends
While payout ratios, margins, industry cyclicality, free cash flow generation, and business performance during the recession help give us a better sense of a dividend’s safety, the balance sheet is an extremely important indicator as well.
As seen below, GE’s long-term debt to capital ratio has been fairly high over the past decade but has decreased in recent years as GE has shed some assets. The company’s leverage situation should continue improving as it exits more financial operations, which are included in the numbers below.
Overall, GE’s leverage situation isn’t that bad. On April 10, 2015, Standard & Poor’s Rating Services affirmed GE’s AA+/A-1+ ratings and GECC’s AA+/A-1+ ratings each with a stable outlook. GE also has about $45 billion available in unused credit lines. The credit metrics below include all of the line items on GE’s balance sheet from its financial division. Once GE’s transition out of non-core financial operations is more complete in the next couple of years, credit metrics should look healthier.
Dividend Growth Score
Our Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.
GE’s Growth Score is 49, meaning its dividend’s growth potential ranks in line with the average dividend stock’s growth potential. The company’s large size, elevated leverage, and ongoing restructuring efforts work against it, but the company’s moderate payout ratio, continued industrial growth, and more focused business operations provide longer-term support for growth.
As seen below, GE’s dividend payments grew by 12% in 2014 but have gone nowhere over the last decade as a result of the steep haircut the company made to its dividend during the financial crisis. For the next year, GE’s dividend is in a holding pattern and will likely increase no more than 4% (a 1c raise) next year, given what the company has publically stated about its near-term capital allocation plans. Beyond 2016, we see good potential for GE to be a double-digit dividend grower given our expectations for 5-10% annual EPS growth and a payout ratio below 60%. Until then, patience is the key.
Valuation
GE’s dividend yield is 3.6%, a Yield Score of 65 in our database – this means that GE’s current dividend yield is higher than 65% of other dividend stocks in the market. We expect the safety and growth characteristics of GE’s dividend to look much more attractive within the next year, making the stock look attractive today for long-term dividend investors.
GE also trades at less than 17x fiscal year 2016’s consensus earnings estimate. Higher quality industrial players trade at 17-18x next year’s earnings estimates, but GE’s earnings should grow at a considerably faster rate over the next few years as it repurchases shares (15-20% reduction in shares outstanding expected), takes more cost out of its industrial operations, and continues to generate organic growth.
Sell side analysts believe GE can earn more than $2 per share in 2018 – while we don’t put much weight on analysts’ estimates, especially that far out, GE’s implied 2018 P/E ratio (12.5x) would be 20% lower than its industrial peers’ 2018 average multiple.
Conclusion
GE receives a lot of flak and skepticism from the investor community. The last 15 years have been greatly disappointing for shareholders, but the current negativity, coupled with GE’s intact competitive advantages and structural transformation, create an appealing long-term investment opportunity today. Within three years, higher-quality industrial operations could account for 90%+ of earnings (up from < 60% today), Immelt could be retired (a welcome change for many investors), the dividend could be growing at a 10% annual clip (5-10%+ annual EPS growth; implied 2018 EPS payout ratio < 55%), lucrative service revenue will become even more lucrative (continued software / predictive maintenance advancements), and maybe, just maybe, sentiment around the stock will start to improve. With a 3.6% dividend yield and a reasonable P/E multiple, GE’s stock appears to be an attractive investment opportunity for long-term dividend investors and is in our Top 20 Dividend Stocks list.
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