New CEO John Flannery of embattled General Electric Co. (GE) is expected to announce a significant cut to the company's robust 4.8% dividend, Barron's reports. This announcement may come either at a major presentation to shareholders scheduled for Monday, November 13, or sometime in advance of that meeting. In any case, investors who focus on free cash flow rather than earnings already are anticipating this move.
The very thought that GE plans cut its dividend is symbolic of the tragic decline of what, once, was one of America's greatest corporations, founded by legendary inventor Thomas Edison. GE also is the only stock to remain in the Dow Jones Industrial Average (DJIA) from its inception in 1896 to today. But after outperforming the market for much of the 1980s and 1990s, GE's stock has fallen by nearly two-thirds from its 2000 highs as the conglomerate struggles to restructure. During that period, the stock market soared and left GE's shares behind.
While there have been many signs of GE's decline, an often overlooked one on Wall Street is GE's worsening cash flow.
Watch Cash Flow
In 1975, publisher Herbert S. Bailey wrote a parody of Edgar Allan Poe's famed poem, "The Raven," entitling his effort "Quoth the Banker, 'Watch Cash Flow.'" It soon became required reading in many business school accounting and finance courses. The point is that businesses must pay their operating expenses, their creditors, and their dividends in the form of real, hard cash. The upshot of various accounting conventions is that reported earnings do not necessarily equal the net cash generated by the business in the same period of time. Earnings according to Generally Accepted Accounting Principles (GAAP) may be higher or lower. In the case of GE, earnings are paltry, and free cash flow has been negative in recent quarters.
Operating cash flow represents the cash produced by a company's normal business operations. Deduct capital expenditures, and the result is free cash flow. Free cash flow, in turn, finances the payment of interest and principal to creditors, and dividends to shareholders. If free cash flow is insufficient, the company must draw down cash holdings, borrow, or issue more stock to make up the deficit. GE is in such a deficit position.
GE's Cash Crunch
For a detailed look at GE's cash flow problem, statements provided by Morningstar Inc. are instructive. During the most recent trailing twelve months (TTM), GE generated operating cash flow of $5.147 billion and spent $7.161 billion on capital investments, leaving it with a deficit of $2.014 billion in free cash flow. By contrast, net income available to common shareholders was a positive $7.089 billion, also per Morningstar.
Meanwhile, the company spent $26.686 billion on debt service, and $8.612 billion on dividends. This increased the total cash flow deficit to $37.312 billion. How did the company fill this yawning gap?
GE raised $9.651 from new issues of debt, drew down its cash balances by $15.096 billion (a 27% reduction), and produced the remaining $12.565 billion through a variety of investing and financing activities, including the sale of assets. CEO Flannery has announced that he plans to sell an additional $20 billion of assets in the next year or two, per Reuters.
While slashing the dividend is an obvious and necessary move to address the cash flow gap, this alone is insufficient to fix problem, as Cowen Inc. (COWN) indicates in a research note quoted in another Barron's article. Curtailing capital investments, for example, may jeopardize future growth. GE's problems also may stem from the fact, that the company may not be investing wisely, as noted below.
GE is a complex industrial and financial conglomerate with a crazy quilt of transactions between divisions, adding to the difficulty of analyzing its various businesses, according to Stephen Tusa, an analyst with JPMorgan Chase & Co. (JPM), as interviewed by Barron's. Meanwhile, the industrial side of GE generates a significant portion of its revenue from long-term contracts. Under various accounting conventions, such as the percentage of completion method, the company recognizes revenue either before or after cash payments actually are received from the customer. The ongoing cash flow deficit relative to earnings suggests that accounting conventions are driving the recognition of revenue, on balance, before cash is being received.
Worse yet, Tusa says, GE "is competing irrationally, giving away content and terms that underprice the risk," per Barron's. The company enters into many complex contracts involving the sale of both equipment and services, and often with durations of 18 to 24 months, Tusa indicates. Based on his analysis, they tend to bid aggressively on these contracts, underestimating the costs, and thus forcing writeoffs down the road. "That's a big reason their cash flow has been so weak relative to their earnings," he tells Barron's. Additionally, Tusa suggests that "they are making capital allocation decisions with bad or optimistic data."
"The best companies in my sector reinvest excess free cash into acquisitions to drive growth," Tusa comments to Barron's. Meanwhile, GE is forced to do the opposite, selling off businesses to raise cash. "If you're not generating free cash, there's a lack of resources for that," he continues. The result: "lower growth and lower-quality earnings," Tusa concludes. (For more, see also: 9 Stocks Outperforming by Investing in Growth: Goldman.)