Ever since General Electric Company's (NYSE:GE) tumultuous third-quarter earnings report, there has been one overriding question on dividend investors' minds: Will the company cut its dividend? I happen to think there is a good chance that new CEO John Flannery will make the cut -- here's why.
1. Flannery was noncommittal on the earnings call
Flannery's comments on the recent earnings call suggested that cutting the dividend was an option. While it's true that he described the dividend as "a priority in our capital allocation framework" he also talked of a "balance of growth investment and dividend payout."
That's all well and good, but investing for growth needs cash, and given that GE's dividend payout dwarfs its forecast cash flow this year, a balanced approach could involve freeing up cash by cutting the dividend.
2. The numbers don't add up, at least this year
CFO Jeff Bornstein cut the outlook for GE's full-year industrial cash flow from operating activities (CFOA) to $7 billion from a previous range of $12 billion-$14 billion. If you're wondering exactly what industrial CFOA is and why GE targets this metric, then you're not alone. Indeed, incoming CFO Jamie Miller said she plans to "conform the GE definition to industry-standard on free cash flow" in order to report in a cleaner and simpler way. (To be clear, industrial CFOA is cash flow from GE's industrial operations -- it doesn't include GE Capital's dividend and doesn't account for capital expenditures.)
That said, let's play with the numbers to see how sustainable GE's dividend is. GE's industrial CFOA is now forecast to be $7 billion, while the dividend of GE Capital (the finance arm of GE) is forecast to be $6 billion-$7 billion for the full year. However, the Capital dividend has been deferred, pending a review of the assumptions used in calculating annual claims reserve in its insurance business. Net spending on plant and equipment (P&E) is forecast to be $3 billion-$4 billion, and pension funding requirements are predicted to be $1.88 billion.
Excluding the GE Capital dividend, this means GE has around $1.1 billion-$2.1 billion ($7 billion in industrial CFOA minus $3 billion-$4 billion in net P&E minus pension funding of $1.88 billion) left in cash flow to pay out, but its dividend paid in 2017 will be $8 billion. Even with the GE Capital dividend included, GE's dividend is not sustainable unless cash flow picks up substantially.
3. Selling businesses will reduce cash flow generation capability
Flannery announced that he was targeting to exit $20 billion worth of business within a couple of years. While any asset sales would obviously generate a lot of cash for the company in the near term, they are also likely to reduce cash flow generation in the long term because GE will lose the businesses' cash flow streams.
4. GE needs to restructure
Management made the need for restructuring clear in the earnings presentation. Flannery plans to make substantive changes at GE, but restructuring can cost money and use up cash. It's true that he's already increased GE's target for restructuring costs by $1 billion to a figure of $2 billion for 2018, but the power equipment business needs to be downsized to reflect overcapacity in the industry, and the structure of the power services segment "has also changed," suggesting more restructuring to come.
5. Speculation over a dividend cut will hurt the stock
This is a subtle but important point. Even if Flannery decides to keep the dividend at the current level, there needs to be a substantial margin of safety in the dividend coverage in order for the market to stop speculating on the possibility.
This means the market could send the stock lower as investors fret about the impact of a dividend cut. Indeed GE's dividend yield is nearly 4.9% as of this writing, suggesting that the market doesn't believe in the sustainability of the dividend. It might make more sense just to cut the dividend and reset investors' expectations in order to take away fear of a dividend cut.
6. Flannery needs to reset
The new CEO may well feel the need to reset investor expectations further in the upcoming investor day on Nov. 13, particularly as he hasn't completed his strategic review yet and hasn't given guidance for 2018, either. In other words, there could be more downside for investors to come, and cutting the dividend in response to a declining earnings outlook would make sense.
7. Power and oil and gas segments are hard to predict
The two problem areas for GE -- namely, power and, to a lesser extent, oil and gas -- are hard to predict at the moment. GE's management can make cash flow predictions all day long, but in reality, it's very difficult to predict where oil prices will go. Moreover, regarding the power end market, Bornstein spoke of "market demand for heavy-duty gas turbines" declining to "40 gigawatts this year, down from 46 gigawatts last year."
Will GE cut its dividend?
Ultimately, Flannery could decide that a combination of cost-cutting, improved working capital generation, better operating margin, near-term cash from asset sales, and more beneficial tax rates is enough to muddle through and sustain the dividend at current levels.
However, in my view, there is a bigger chance that Flannery will take the bull by the horns and cut the dividend to suit the cloth of GE's earnings and cash flow. Paradoxically, that might be just what investors need to see right now so that the management team can get GE back on track.