The recent change of CEO and a guidance cut at General Electric Company (NYSE:GE) are indications that GE's board feels a change of direction is necessary. I think one of the first things new CEO Larry Culp should be looking at doing is cutting the company's dividend. Let's take a look at why -- and at why that might actually be good news for investors.

What the latest news means for investors

In a nutshell, the recent announcements -- profit warning and change of CEO -- call into question the sustainability of the dividend and the existing plan (created by former CEO John Flannery) to improve the company's debt metrics in order to improve its rating with the credit agencies.

  • The previous forecast for free cash flow (FCF) meant the $0.48-per-share dividend was barely covered on an available-cash-flow basis, and the cut to guidance implies the dividend isn't sustainable from near-term cash generation.
  • The cut in earnings and cash flow guidance was met by a credit ratings downgrade by Standard & Poor's, while Moody and Fitch put the company under review for possible downgrades, which suggests GE will have to rethink its plan.
  • The cut to FCF guidance calls into question the viability of GE's existing debt-reduction plan and the wisdom of separating healthcare and distributing 80% of it directly to shareholders.

I'll deal with these points in turn.

Available cash flow won't cover the dividend

GE's deteriorating FCF generation -- principally a consequence of the ailing power segment suffering significant profit declines -- has long been a major gripe for bears watching the stock. GE's original FCF guidance for 2018 called for $6 billion to $7 billion, but Flannery lowered expectations to $6 billion on the second-quarter earnings call, and the latest communique calls for a figure of less than $6 billion.

But here's the thing. GE's existing dividend requires around $4.2 billion in cash, and the company has a large pension deficit to fund -- assume a figure of $2 billion for 2018 -- meaning that available FCF won't cover the dividend.

Granted, this year is supposed to mark a trough in GE's earnings and FCF, but given the deterioration in power and the need to use cash for restructuring, it's far from clear what kind of FCF GE will be generating in 2019. It would surely make more sense simply to cut the dividend and focus on using the cash to improve the business for the long term.

Credit ratings matter

GE's credit rating is extremely important for the future of the company, and the response of the credit rating to the latest disappointment means Culp will be under pressure to rethink GE's plans.

Not only is GE a highly indebted company, but it's also been criticized for using substantial amounts of short-term commercial paper in order to assist with its working capital.

GE Market Cap Chart

GE Market Cap data by YCharts.

To be fair, Flannery did attempt to reduce reliance on short-term paper, but events like deteriorating FCF generation have caught up with the company. If GE is going to improve its credit rating, then a dividend cut could be in the cards. It would likely improve matters with the rating agencies.

Culp could rethink GE's existing plan with GE Healthcare

Going back to the plan unveiled at the company update in June, it appears that events have superseded it, and it strikes me that Culp has a few options worth looking at:

  • Cut the dividend in order to pay down debt and help improve the net EBITDA (debt to earnings before interest, depreciation, and amortization) ratio from the debt side
  • Change the current plan by monetizing more of GE Healthcare for the company or even abandoning the idea altogether
  • A combination of the two

Of course, if Flannery was still in charge, making these changes to the company's plans would have made his position as CEO untenable, but with a new CEO in charge, investors might be more forgiving.

Such moves would free up cash to restructure the business and put it on a stronger footing for the future.

A GE gas turbine blade.

GE's problems with its power segment mean Larry Culp might have to rethink the dividend policy. Image source: Chris New for GE Reports.

The takeaway for investors

What counts in the end is making the company stronger for the long term. One of the big problems Flannery had was convincing investors that the company was on the right long-term track even while many had serious misgivings about his near-term earnings guidance.  

It wouldn't be surprising at all if Culp cut GE's dividend and/or adjusted/abandoned the healthcare spinoff, but if it's the best thing for the company in the long term, investors shouldn't be too worried.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.