General Electric (GE) announced a 4% dividend increase on Friday, increasing its quarterly payout by a penny from 23 cents per share to 24 cents.
While General Electric’s dividend increase was perhaps smaller than some long-term shareholders desired, it was still meaningful because it marked the company’s first payout raise since late 2014.
General Electric is one of those companies that elicits strong feelings (to put it nicely) from many investors.
The company has a history of overpromising and under delivering, GE’s share price remains lower than it was a decade ago, and the painful dividend cut in 2009 will not be forgotten anytime soon.
Despite these grievances, General Electric’s future prospects could be better than investors have come to expect.
With many investors still focused on General Electric’s “lost decade” and unwilling to trust CEO Jeff Immelt and the company’s portfolio transformation that is well underway, I continue to believe an appealing investment case is building for long-term dividend investors.
In fact, we have held shares of GE in our Top 20 Dividend Stocks portfolio since mid-2015. In my view, GE’s dividend increase marks yet another step in the company’s overhaul.
General Electric’s Transformation
GE’s near-destruction in 2009 was the result of its highly leveraged banking operations (GE Capital), which had extended too far into risky areas for the sake of growth.
While the company avoided bankruptcy, thanks in part to Warren Buffett’s investment (see Buffett’s top high-yielding dividend stocks here), it was shaken to its core.
Fast-forwarding to early 2015, GE began an industrial transformation plan to reduce the risk of its operations and refocus on its strengths.
The plan calls for divestment of non-core financial services assets to increase the contribution of industrial earnings from 59% of total income between 2000 and 2015 to 90% of total income by 2018.
As seen below, GE Capital accounted for a relatively small portion of sales (9%) and profits (9%) in 2015.
GE’s remaining operations are easier to analyze (for a conglomerate, at least) and could result in a higher earnings multiple for the company’s stock, too.
During the company’s third quarter earnings call, GE noted it has “virtually completed” its pivot in financial services with $193 billion of asset disposal signings, nearly hitting its goal to dispose of $200 billion of assets within 18 months.
General Electric’s industrial business is the core profit driver now, and many investors could be underappreciating its value because of GE’s historically complex and rather opaque web of other businesses.
The company’s industrial services business accounted for 44% of the industrial segment’s revenue in 2015 and more than 75% of its operating profit.
GE’s equipment is very costly but essential for customers’ operations. The company’s service contracts ensure customers’ equipment remains up and running.
In other words, unlike equipment orders, service revenue is much stickier and less susceptible to economic cycles. In fact, GE’s industrial earnings dropped by just 13% and 7% in 2008 and 2009, respectively.
General Electric’s massive scale and distribution make it hard for rivals to compete. With over $100 billion in annual industrial sales, GE enjoys lower production costs on its equipment, which it can sell at extremely low prices (or even at a loss) compared to its competitors.
Accepting weak margins on equipment is worth it because it locks in years of high-margin, recurring aftermarket service business needed to keep customers’ equipment running.
With operations dating back to 1892, GE is also a preferred vendor because of the massive amounts of equipment performance data it has collected to strengthen its customer relationships and brand.
As General Electric continues investing in software analytics to improve the performance of its equipment out in the field with applications like predictive maintenance, its services business should become stickier with potential for even higher margins.
For example, GE noted during the third quarter that services margins expanded 220 basis points, driven by the increased use of analytical tools. Revenue from analytical applications and software continued its double-digit growth, rising 13% during the third quarter.
General Electric is never going to be a fast-growing company, but its high mix of industrial services revenue should result in much more predictable earnings going forward. This is a good thing for investors and for the safety of the company’s dividend.
Dividend Safety Analysis: General Electric
We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend.
Our Dividend Safety Score answers the question, “Is the current dividend payment safe?” We look at some of the most important financial factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more.
Dividend Safety Scores range from 0 to 100, and conservative dividend investors should stick with firms that score at least 60. Since tracking the data, companies cutting their dividends had an average Dividend Safety Score below 20 at the time of their dividend reduction announcements.
We wrote a detailed analysis reviewing how Dividend Safety Scores are calculated, what their track record has been, and how to use them for your portfolio here.
General Electric has a Dividend Safety Score of 52, indicating that the company’s dividend is reasonably secure.
Importantly, GE Capital is no longer a risk to the company following the divestments the company has made. As I discussed above, the remaining industrial businesses were resilient during the last downturn because of their high mix of recurring services revenue.
The company’s earnings payout ratio will likely come in at 62% this year, which is a little on the high side but will decline as earnings growth outpaces dividend growth the next two years.
Considering the relatively resilient performance of the industrial business in 2008-09, GE’s payout ratio isn’t a big concern to me today.
In fact, the company’s industrial businesses generated $17 billion of cash flow during the financial crisis, which compares favorably to the $9.3 billion in dividends GE paid out last year.
Turning to the balance sheet, GE maintains an “AA-” credit rating from S&P and has some capacity to increase its financial leverage, which it plans to take advantage of.
While I am not a fan of high debt loads or debt-fueled acquisitions for the pursuit of growth, it’s unlikely that GE’s balance sheet would put its dividend at risk.
The company’s business diversification also helps the dividend’s safety. When one end market is weak, another is likely strong. For example, despite the slump in oil & gas, GE’s organic sales grew 1% during the third quarter.
If oil & gas is excluded, sales increased 6% and are up 4% year-to-date. Organic sales in the fourth quarter are expected to be up 4% as well, signaling stability.
General Electric’s Dividend Growth Prospects
Our Dividend 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.
General Electric has a Dividend Growth Score of 39, indicating that is dividend growth prospects are slightly below average today.
There is no question that General Electric’s 68% dividend cut in 2009 devastated many dividend growth investors.
Source: Simply Safe Dividends
As a result, GE’s dividend is roughly flat over the last 10 years and, as mentioned above, the quarterly dividend sits 23% below its prior peak.
Source: Simply Safe Dividends
Incremental dividend increases are slowly helping close the gap, but there is still a ways to go.
General Electric’s dividend grew 9.5% per year from 2012 to 2015, but the latest increase of just 4% has many investors wondering what future rate of dividend growth they can expect.
General Electric targets a 45-50% payout ratio, which is a reasonable level for most industrial companies.
I think GE would be safe with a higher payout ratio (e.g. 60%) considering the more stable nature of its services business, but that’s not what management wants today.
Based on the company’s new quarterly dividend rate of 24 cents per share, General Electric’s expected full-year payout is 96 cents in 2017.
Analysts expect the company to generate $1.69 earnings per share in 2017, resulting in a forward payout ratio of about 57%.
With GE’s payout ratio already sitting above its long-term target, its dividend growth over the next couple of years seems likely to track or slightly trail its earnings growth.
For example, if earnings per share reach $2 in 2018 as GE has previously guided to, a 50% payout ratio would result in dividends per share of $1 – an increase of another penny, or 4.2%, compared to the new dividend GE announced today.
In other words, I think low-to-mid single digits dividend growth is likely for next year or two. Another penny increase at the end of 2017 wouldn’t surprise me, especially if industrial growth remains sluggish.
Beyond 2017 and 2018, GE’s dividend growth will likely track the company’s earnings growth unless management chooses to lift the payout ratio target, which would allow for faster dividend growth.
A company as large and diversified as GE is unlikely to generate organic sales growth in excess of the rate of GDP growth (2-4%). Earnings could reasonably grow faster than sales thanks to the growing mix of higher-margin software and services, continued productivity initiatives, and the company’s operating leverage.
My best guess is another 4% dividend raise next year, followed by mid-to-high single digits dividend growth thereafter.
Shares of General Electric currently trade at a forward P/E multiple of 18.7 and offer a forward dividend yield of 3%, which is slightly below its five-year average dividend yield of 3.2%.
The stock doesn’t appear to be a bargain at face value. However, assuming industrial earnings can grow at an upper-single digit pace, the stock has potential to deliver annual returns between 9% and 12% going forward (3% dividend yield plus 6-9% annual earnings growth).
End markets won’t always be agreeable, but management needs to prove it can deliver profitable growth over time while rebuilding trust with shareholders through intelligent capital allocation and consistent results.
The stock continues to look like a long-term hold and would be more attractive if it gets hurt by the strong and strengthening U.S. dollar (over 50% of sales are international), an unexpected drop in industrial demand, or a broader pullback in the market.
Closing Thoughts on General Electric
A dividend increase is better than nothing, even if it is a little less than some investors expected. GE is still transitioning through a transformational period that has completely reshaped its business mix and focus.
I believe these chess moves better focus the company on its strengths and will bring some redemption for long-term dividend growth investors as the years go on. I continue to like GE’s industrial services business and the company’s potential to gradually morph into a higher-returning enterprise thanks to continued productivity initiatives and growth in software analytics.
Despite its ups and downs, few companies have demonstrated the durability that GE has since its founding more than 120 years ago. Owning these types of companies that can survive and grow in value is an effective dividend investing habit.
While the stock’s valuation doesn’t look like a bargain, I believe GE’s best days are ahead for long-term dividend investors.
Simply Safe Dividends
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Source: Simply Safe Dividends