Investors have long been frustrated with GE. The share price is lower than it was 10 years ago. The company has generally overpromised and under delivered for years, leading many to question whether or not CEO Jeff Immelt is still the right man for the job. And who can forgive and forget the 2009 dividend cut after the company had defended its dividend plan for months?
We believed the pessimism surrounding GE was deserved but underappreciated the quality of GE’s industrial services business and the chance for GE to “get it right” this time for shareholders with its portfolio transformation.
As a result, we added GE to our Top 20 Dividend Stocks portfolio in July 2015 and, while it’s still too early, were pleased to see the company’s encouraging third quarter results. You can read our initial thesis by clicking here.
Industrial segment organic sales grew 4%, and operating margins expanded by 100 basis points. Backlog ($270 billion) is also $9 billion higher than it was exiting 2014 despite weakness in oil & gas markets.
While foreign currency headwinds are reducing reported sales growth by about 5%, GE’s exposure to longer-cycle infrastructure businesses such as power generation, jet engines, and energy management is serving it well as the world economy’s recovery lengthens in duration.
GE’s stock has gained over 30% since bottoming out in late August, driven in large part by the company’s transformation plan tracking ahead of expectations – as of mid-October, GE had signed agreements to sell GE Capital assets worth more than $125 billion (well ahead of its $100 billion divestiture target for 2015) and has closed asset sale transaction worth about $60 billion. This week, GE also announced the Synchrony share exchange rate, which will reduce shares outstanding by about 6.6%.
With a lost decade’s worth of disappointed investors to continue winning over, GE’s stock could have a long ways to run as it continues executing on its transformation plan and profitably growing its industrial business.
In case you have been living under a rock, let’s quickly review GE’s industrial transformation plan. GE is divesting its non-core financial services assets with plans to grow industrial earnings to 90% of total income by 2018, up from 37% in 2001 and 57% in 2014. The remaining business should be easier to analyze and potentially result in a higher earnings multiple for the stock.
We think GE’s industrial business is an extremely attractive asset that has possibly been overlooked in the past due to GE’s web of other operations.
Many investors might be surprised to learn that GE’s service business delivered 42% of its industrial segment’s sales and over 75% of its operating profit last year. Most of GE’s equipment is extremely expensive and mission-critical to customers’ operations. Service contracts help customers protect their investments and keep them up and running.
GE’s massive scale and distribution reach keep its production costs low and its service network wide, allowing it to underbid many of its competitors for new equipment orders. Customers also like working with GE because the company has been around for well over 100 years, accumulating valuable equipment performance data and establishing trust with customers.
Winning equipment orders with little to no margin is worthwhile for GE because it often results in years of high-margin service revenue to help customers keep their multi-million dollar gear up and running.
Not surprisingly, service revenue provides consistent cash flow compared to cyclical equipment orders. GE’s industrial earnings only fell by 13% and 7% in fiscal years 2008 and 2009, respectively, in large part because of the sticky nature of its services revenue.
Even during Q3, when GE’s order growth fell by 26%, service orders actually rose 2%, including currency headwinds. Services also account for about 75% of GE’s backlog and should see continued growth as customers invest more in analytics to improve the productivity of their equipment with applications such as predictive maintenance and machine control.
To this point, GE reported that orders for its software and analytics grew 16% in Q3. While GE’s endless banter about the “Industrial Internet” and the company’s potential to grow into one of the world’s 10 largest software companies by 2020 is tiresome, we do believe increased use of data and analytics will further help GE secure future service contracts while raising the switching costs faced by customers.
Overall, GE hopes to organically grow its industrial segment’s sales by 2-5% per year while realizing continued productivity gains to drive faster earnings growth. We believe these targets are reasonable given the large size and diversity of GE’s markets and the recurring profit base provided by its services business. If success, GE will be in great position to reward dividend investors over the next decade.
The Dividend Looks Great for the Long Term
GE’s dividend yield sits at 3% today, perhaps not high enough for those living off dividends in retirement but it comes with solid long-term growth potential.
For starters, the GE’s dividend is very safe. There is no material credit risk from the company’s bank operations anymore, and GE’s industrial business is very resilient because of its high mix of recurring services revenue. The company’s balance sheet is also healthier, and the company has around $45 billion available in unused credit lines.
Over the trailing 12 months, GE’s dividend has consumed just 41% of its free cash flow. Generally speaking, payout ratios less than 50% provide plenty of safety and opportunity for future dividend growth.
According to the company’s near-term capital allocation plans, GE’s dividend is in a holding pattern for now and is unlikely to increase by more than 4% next year, representing a one penny increase.
Beyond 2016, however, GE has potential to grow its dividend at a 7-10% annual rate given expectations for upper-single digit annual EPS growth and a sub-50% free cash flow payout ratio. Patient dividend investors will likely be rewarded with income growth well ahead of inflation as GE attempts to climb its way back to dividend aristocrat status over the coming decades.
Valuation
GE trades at about 20x fiscal year 2016 earnings estimates. Investors have clearly started to reward the company’s transformation plan, perhaps leaving GE with less room for execution mishaps over the next year or two.
With a dividend yield of 3% and potential for upper-single digit industrial segment earnings growth, GE’s total return prospects don’t appear to be bad for long-term investors despite the current earnings multiple premium. As long as GE executes it can grow into its earnings multiple pretty quickly, but it does seem to require bullish investors to look further out into the future to justify buying more GE stock today.
For that reason, we think the stock looks more like a long-term hold. Should a pullback occur due to the stronger US dollar, sluggish industrial demand, or a hiccup with GE Capital’s asset sales, the stock would start looking attractive again for new investment.
Conclusion
Few things in life are ever linear, and GE’s transformation will likely be no different. We like where the business is headed and think it is exiting financial assets at a particularly opportunistic time given where interest rates have been and the market’s current appetite for risk.
As long-term focused dividend investors, we like durable businesses that can continue growing in value and rewarding us with pay increases every year. We think GE’s industrial operations check these boxes and are particularly attracted to the company’s services business, which should enjoy continued growth as the world economy expands and more data analytics are demanded across the industrial landscape.
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