Should income investors give General Electric a second chance?

Back in December, General Electric (GE) raised its quarterly dividend to shareholders by 15.80% to 22 cents/share. This marked the fourth consecutive annual dividend hike for this conglomerate, which is organized in the Oil & gas, Power & Water, Energy Management, Aviation, Healthcare, Transportation, Home & Business Solutions and GE Capital segments. The company has now raised dividends for four years in a row, since the decision to cut distribution in 2009.

I was one of the investors of General Electric back in 2009, who sold immediately after the dividend cut was announced. The quarterly dividend was cut from 31 cents/share to 10 cents/share, which was the first reduction in distributions since 1938. Prior to that event, management had continuously reassured investors that the dividend was safe for at least 4 – 5 months. Unfortunately, the credit markets froze in 2008 – 2009, and the company obtained a $3 billion vote of confidence from Warren Buffett. As it also sold stock to other investors, it became apparent that maintaining adequate liquidity might get a higher priority than the dividend.

I lost money on General Electric, but this is not the reason I have not bought back the stock. I had found other attractive opportunities for several years that were easier to understand, and I thought had repetitive sales to customers that were more durable in nature. I had purchased my stock at $28.97/share and sold it at $8.63/share. The tax credits on my loss of approximately 30%, add in another $6.10 to the sale price. Later on, I reinvested the proceeds into Abbott Laboratories (ABT) at $45.06/share. If GE had simply kept the dividend, I would have likely kept the stock, but allocated distributions elsewhere. Back when I was building my portfolio in 2008, I held a small position in M&T Bank (MTB), whose dividend was growing prior to that. For the past six years however, the dividend has been flat, yet I kept holding on to the security. I have recovered almost 20% of my purchase price merely from the dividend in 5 years. This fact proves the point that dividends serve as cash rebates on your purchase price.

General Electric (GE) has had a pretty terrible timing of its share buyback plan over the past decade. The company spent billions between 2005 and 2007 repurchasing 513 million shares at average prices of $34.99, $35.92 and $38.83/share. By 2009 the company had issued 517 million shares at $22.25/share, in order to obtain liquidity in the wake of the global financial crisis. This does not look like intelligent capital allocation. Of course, the world economy experienced an unprecedented liquidity crunch at the time, which executives could not have reasonably forecasted between 2005 and 2007. Currently, the company is planning on repurchasing up to 700 million shares, and bringing the number of shares outstanding to 9.5 billion.

Over the past decade, earnings per share have increased from $1.55 in 2003 to $2.20 in 2007, before falling to $1.03 in 2009. General Electric earned $1.39/share in 2012, and is expected to earn $1.63/share in 2013 followed by an increase to $1.73/share by 2014. The forward annual dividend of 88 cents/share translates to a roughly 50% payout ratio, which is sustainable.

The factors that could trigger growth in earnings per share over the next five years include:

1) Industrial backlog – The company’s backlog has increased to $229 billion, up almost 14% from prior year levels, as a result of expansion in equipment and service businesses. The company has a large installed base, where it provides its customers the ability to service their equipment. This large installed equipment base creates the opportunity to generate recurring service revenues from maintaining and servicing the equipment, which the client is happy to do, in order to avoid the hassle.

2) Cost cutting initiatives – The company plans to reduce administrative costs by $1.5 in 2013 and by $1 billion in 2014. Overall, General Electric is trying to simplify its business, and reduce the proportion of SG&A to revenues from 15.50% - 16% to 12% in 2016.

3) Share buybacks – The company has managed to reduce the number of shares outstanding from 10.678 billion in 2010, to 10.368 in 2013. The company is also planning to further reduce number of shares outstanding to 9.50 billion by 2015.

4) Strategic acquisitions – The Company is planning to make strategic acquisitions whose size does not exceed $4 billion. However, the dilutive effect of shrinking the Finance operations will more than overshadow the acquisitions portion of GE’s growth strategy.

5) Increasing demand for its core products and services – As the economy keeps expanding, and as the company brings in new solutions to its existing markets, chances are very high that revenues will be increasing over time. In addition, GE expects that the industrial segment should account for 70% of earnings by 2015, from 55% at present levels.

6) Scale – The scale of the company operations makes it more difficult for competitors to match General Electric, given the breadth of business units over which it could spread costs for R&D and expenditures. In addition, business units in different sectors can leverage best practices that are learned in other sectors.

7) Macro trends – The increased buildup in global infrastructure, growth emerging markets such as China etc

The company is reducing is reliance on GE Finance for its long-term growth, which is based on the difficult lessons it learned during the financial crisis. This is going to reduce earnings per share growth by anywhere between 0 to 5%/year for the next few years. I generally do not like to see shrinking in the major profit generators of a business, which account for 1/3 of profits. However, this seems to be offset by growth in other areas such as Industrial for example.

General Electric constantly changes the mix of businesses under its umbrella, a strategy pioneered by former CEO Jack Welch. The company tries to be number one or two in a given sector, and is also looking for growth in that segment of the business as well. As a result of this policy, one of the most important factors to evaluate with General Electric is management. They have to be able and honest, otherwise the capital allocation decisions they make could have a pretty bad outcome on your investment. Overall, I believe that Jeff Immelt to be a decent manager, who unfortunately was dealt two bad cards. He took reigns at GE at a time when the stock was very overvalued in 2001, and he also managed to preside over the worst recession since the Great Depression. Of course, the culture at General Electric is another important advantage for the company. If you are a long-term holder, you should realize that you are betting more on management to make the smart decisions on which businesses to keep, which to buy and which to dispose of in an intelligent manner. As a result, the type of business units within General Electric would be different 20 – 30 years from now.

Despite the fact that the company has only raised dividends for four years in a row, it looks attractively priced today at 16.50 times estimated 2013 earnings and a nice yield of 2.80%. I would be the first one to admit that it looks like a decent value at current levels. In addition, it also looks like the company is recovering and earnings per share could grow at 4-7%/year for the next five years. It is very likely that GE should do fine for a long-term holder with a 20 – 30 year horizon. Depending on the availability of ideas at the time of capital availability, I would consider GE for potential inclusion to my dividend portfolio. Of course, if I find a company that has grown dividends for ten years in a row, yields around 3%, sells for less than 17 times earnings, and can grow dividends by 6 – 7%/year for the next five years, chances are I might choose the other company instead.

Full Disclosure: Long ABT and MTB

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