General Electric Company's (NYSE: GE) previous annual dividend of $0.96 per share has been reduced to $0.48, but is even this payout sustainable? The reason for the cut was that earnings and cash flow fell well short of expectations in 2017 and management needs to improve performance going forward. That said, let's take a look at the plans CEO John Flannery recently outlined at the investor update, and whether they make GE's new dividend truly sustainable or not.
What GE needs to do
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At the heart of the matter lies the question of GE's industrial free cash flow (FCF), or the cash a company has left from its income to spend on making acquisitions, buying back shares, paying off debt, or paying a dividend. If a company is forced to use all its operating income to provide cash for working capital (running the business) and/or to make capital expenditures, then it won't have any FCF left -- not good for investors hoping for a dividend.
Indeed, in the recent investor update, Flannery outlined the rationale for the dividend cut as follows: "[W]e thought the industrial cash flow generation would grow, that would grow into the dividend, that we'd end up in 2018 with a payout ratio that was quite comparable to what you'd see from our peers. The reality is that [that] hasn't unfolded that way."
He went on to acknowledge, "[W]e've been paying a dividend in excess of our free cash flow for a number of years now," and then concluded that it didn't make sense to do so in the future.
General Electric's cash flow generation
What Flannery is talking about can be seen in the table below.
Management has favored talking about industrial cash flow from operating activities (CFOA) in the past. This figure excludes the GE Capital dividend -- since GE has been selling its capital assets, industrial CFOA is a better underlying measure.
In the past, GE's management has focused on presenting industrial CFOA excluding deal taxes and pension funding (the excluded items are non-recurring, so it's seen as a better way to measure ongoing cash generation). For reference, it's the $7 billion estimate for 2017 that you can see in the table below. Now, to be clear, the former annual $0.96-per-share dividend required around $8.4 billion in cash, so the new annual $0.48-per-share dividend needs around $4.2 billion.
Free cash flow counts
However, that's not the end of the story, for two reasons:
- GE still needs to make capital expenditures on plant, property, and equipment (PP&E).
- While excluding deal taxes and pension funding makes sense, the reality is that the company still has to use cash to pay them.
So let's look at management estimates for 2017 and 2018 and how it plans to make the $4.2 billion dividend payout.
If you're wondering about the $6 billion in pension funding estimated for 2018, Flannery explained in the investor update that GE would take advantage of "the economics that are available to us right now, and borrow $6 billion and contribute that into our pension plan. And that will essentially prepay or pre-fund, if you will, cash contributions that we are obligated to make in our pension plan for 2018, 2019, and 2020."
In a sense, GE is adding debt in order to free up available cash that would have gone toward pension funding in the future. Essentially, management has brought forward a couple of years' worth of pension funding, which means in 2019 and 2020, GE might not need to do any pension funding.
Ultimately, Flannery is arguing that the $4.2 billion dividend in 2018 will be funded out of the $6 billion-$7 billion in industrial FCF, resulting in a dividend/FCF ratio of 60%-70% in 2018. This looks good, but if you assume, say, $2 billion in pension funding requirements (taking the $6 billion Flannery mentioned for 2018,2019 & 2020 and dividing by three), and then take it out of industrial FCF, then the dividend/FCF ratio is closer to 84%-105% in 2018.
Whichever way you look at it, GE needs to improve CFOA generation.
Don't forget asset sales
Flannery's plan to exit $20 billion of business in the next couple of years and exploring options with GE's stake in Baker Hughes would obviously result in a huge infusion of cash, which could be used to pay dividends.
That's fine and worthy, but transportation, oil and gas, and lighting have contributed nearly 9% of segment profit so far in 2017. In addition, transportation and lighting are businesses whose FCF conversion from net income is above 100%. In other words, it's reasonable to assume that the three businesses will contribute more than 9% of FCF in 2017, and selling them would reduce GE's ability to generate FCF in the future.
Is GE's new dividend safe?
Yes, but with caveats. Thanks to a combination of debt and potential asset sales, GE's dividend is safe for the near future. Moreover, Flannery is likely to make cash-generative acquisitions with the proceeds from asset sales (necessary because adding debt and selling assets can't be done indefinitely).
However, if the economy turns south -- and in particular, the cyclical aerospace industry slows -- then the sustainability of the dividend could be in jeopardy. All told, GE's dividend is safe, but don't count on it in the event of any significant economic slowdown.
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