There’s little doubt that tomorrow’s third quarter earnings report from General Electric–due before the market opens–will be one of those kitchen sink quarters. New CEO John Flannery is sure to want to mark his accession to the corner office two and a half months ago with big job cuts, even more cost reductions than the $2 billion announced for 2017 and 2018, further asset sales, and a reset to the now outdated goal of $2.00 a share in earnings for 2018. (The company is expected to report earnings of 49 cents a share for the third quarter after reporting 28 cent a share for the second quarter. Credit Suisse projects earnings of $1.54 a share for 2018, barely above the $1.52 it estimates for 2017.)
This is going to be one of those odd quarters where Wall Street will cheer a CEO delivering bad news–as long as it comes with drastic remedies. Analysts have already cut target prices going into the earnings report. The target at JPMoran is now $20 a share, at Deutsche Bank $21 a share, at Goldman Sachs $23 a share. The stock closed at $23.58, up 1.99% today as some investors decided that the damage has been done. After all the stock is down 25.4% for 2017 as of the October 19 close. But General Electric still trades at a premium to industrial peers such as 3M (MMM) and Honeywell (HON). Those two stocks trade with price to earnings ratios of 24.9 and 22.2, respectively. The PE at General Electric was 26.5 today.
But the big question, the one that has put big pressure on the stock over the last few weeks is “Will Flannery cut the dividend?” Right now General Electric pays out a dividend of 96 cents a year for a yield of 4.11%. Might that dividend–or at least part of it–be among the things that get the ax tomorrow?
The truth is that nobody knows, but everyone has an opinion. Including me. (After all General Electric is a member of my Dividend Portfolio.)
My read is that General Electric won’t cut its dividend. That $20 a share marks the likely bottom for the stock. And that the industrial core of the company is in good shape to show rising cash flow in the future. On the downside, the company’s huge pension deficit will (should) mean an end to the share buybacks that kept the stock from breaking lower during the later stages of former CEO Jeff Immelt’s tenure.
I think operations at General Electric’s industrial core are better than the most bearish voices believe. In the second quarter cash flow from operations turned positive and after the most recent round of divestitures this core looks well positioned for increasing cash flow–as long as the economy doesn’t reverse course. Organic revenue growth of 3% to 5% a year seems attainable as projected by management.
The problem, though, is that operations, industrial or otherwise, aren’t General Electric’s biggest use of cash. That “award” goes to the company’s woefully underfunded pension fund. In July 2017 the company was facing a pension short fall of about $31 billion. Projections put the company’s pension obligations at $50 billion over the next decade.
How did the company dig itself this big a hole? Immelt and team decided that it would fend off the activist investors that had begun circling the company by upping the cash it spent on share buybacks. In 2015 General Electric spent $23 billion in buying back its own shares–that had the effect of both propping up the share price by those direct purchases and adding to earnings per share by decreasing the count of outstanding shares. In 2016 shares buybacks came to $22 billion. (That’s a total of $45 billion–not quite the entire pension obligation but close.) I don’t think it’s a coincidence that the stepped up buybacks came shortly after Trian Fund Management, the vehicle of activist investor Nelson Peltz, bought a stake in General Electric and began advocating an increase in buybacks to support the stock price and return cash to investors. (The trouble is that not only did the buybacks eat cash that the company needed for pension obligations and capital investment, but they also didn’t work. General Electric’s stock is up about 20% from October 2015, the time when Trian announced its stake to the close today. That’s about half the gain of the industrial sector of the S&P 500.)
Now that the new CEO at General Electric has, apparently, decided to stop trying–expensively–to fend off Trian and now that Trian has gained a seat on the General Electric Board–it will be interesting to see what Trian proposes. It’s obviously in Trian’s self-interest to see the stock price climb–and probably the biggest impediment to that is the worry that General Electric will cut its dividend. Trian also ought to realize that cutting its dividend again–as Immelt did (he really didn’t have a choice) in the aftermath of the global financial crisis because of GE Capital’s central role in the debacle–is a great way to alienate shareholders and investors for a long, long time. If you want to put a company in the doghouse and assume that the share price won’t go anywhere for years, cutting the dividend is a pretty good move.
And it’s not like General Electric can’t fix its pension hole in another way. It can borrow to fill part of the gap, for example, since the industrial businesses still look to have leverage left (although the company as a whole shows a hefty $130 billion in debt.) And, of course, it could get the share price up, which would fill part of the pension gap. General Electric’s pension fund owns 32.9 million of the company’s shares.
So, in short, my opinion, my speculative opinion, is that the company will be extremely aggressive on cost cutting, job cuts, and asset sales tomorrow–but that it will leave the dividend alone.