5 Things Dividend Investors Need To Know About GE

| About: General Electric (GE)


Despite some strong ongoing headwinds, GE just reported fantastic quarterly results.

Management continues to execute well on its ongoing reorganization plan that should widen GE's moat and result in improved profitability going forward.

BUT dividend investors shouldn't expect the kind of impressive dividend growth they've seen since the financial crisis, at least for the next few years.

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Source: General Electric

General Electric (NYSE:GE) has had a fantastic year, outperforming industrial rivals such as Honeywell International (NYSE:HON), 3M (NYSE:MMM), as well as the Vanguard Industrials ETF (NYSE:VSI), and the S&P 500.

GE Total Return Price Chart GE Total Return Price data by YCharts

However, despite its recent run up, GE remains an excellent long-term dividend growth investment. Let's take a look at GE's most recent earnings to see five ways how this industrial blue chip is positioning itself to become a dividend growth titan over the coming decades.

Q2 earnings show solid growth despite global economic weakness

Source: Earnings release
Metric Q2 2016 Q2 2015 Year-Over-Year Change
Revenue $33.49 Billion $29.23 Billion 14.6%
EPS $0.30 -$0.13 NA
Quarterly Dividend $0.23 $0.23 0%
Payout Ratio 76.7% -177% NA
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Source: GE Q2 2016 earnings presentation.

As you can see GE had a terrific quarter compared to last year. Its nearly 15% revenue growth, and expanded industrial margins were especially impressive given ongoing global economic weakness. And while that kind of growth isn't likely to be repeated every quarter, nonetheless management believes it's on track to achieve organic sales growth of 2% to 4% in 2016, in line with last year's results.

Source: GE Q2 2016 earnings presentation.

However, what investors should really get excited about is GE's record order backlog, which increased 17% over the past year. Granted, new orders for industrial products fell, due to slowing economic growth, including a slowdown in US manufacturing. However, note that new orders for services actually rose 8.7% over last year's quarter. That continues a trend of its services backlog growing faster and more steadily then its industrial segments', over the past few years.

Source: GE Q2 2016 earnings presentation.

Why is that so important? Because it's the key to GE's investment thesis as a strong, long-term dividend growth stock. GE's strong competitive advantages in key, high-tech industrial sectors such as aviation, and medical diagnostic equipment, results in long-term sales growth in higher margin industrial products such as jet engines, and MRIs.

However what should really thrill investors is the fact that GE can turn those one time sales into recurring sales and cash flow because its strong customer relationships mean that it can gain long-term service contracts to maintain those products.

GE continues to widen its moat…

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Source: GE investor presentation.

Another key advantage GE is management's focus on turning the company into one of the world's leading "digital industrial" companies. Its Predix data analytics platform is a strong and fast growing entry into the industrial internet of things sector, which is likely to be one of the fastest growing industries over the coming century. That's because industrial productivity has slowed immensely over the past decade.

Source: GE investor presentation.

Data analytics offers companies a great way to boost future productivity growth, which would increase margins and cash flow. In other words, GE's fastest growing business segment is also the one that can help its customers maximize shareholder value.

Better yet, GE remains one of America's largest corporate spenders on R&D, which helps to keep its products state of the art, and keeps pricing pressure strong.

Source: GE investor presentation.

For example, as you can see, GE's aggressive investment into improving its aviation segment has resulted in not just strong sales growth, but also impressively improving profitability. With GE spending over $10 billion annually on R&D, or nearly 10% of revenue, I'm confident that the company's competitive advantage in its respective business segments will continue growing well into the future.

...and execute well on its reorganization plan

Source: GE Q2 2016 earnings presentation.

GE investors learned a hard lesson during the financial crisis when GE Capital loan losses rose and forced a massive dividend cut that cost the company its treasured dividend aristocrat status.

GE Dividend Chart GE Dividend data by YCharts

Fortunately GE has learned its lesson and under CEO Jeffrey Immelt, GE has rededicated itself to returning to its roots. That means selling off non-core businesses such as the vast majority of GE Capital. That will that help to strengthen GE's balance sheet, which due to GE Capital Loans, is far more leveraged than peers such as 3M and Honeywell.

Sources: Morningstar, Fastgraphs
Company Debt/EBITDA EBITDA/Interest Current Ratio Debt/Equity S&P Credit Rating
General Electric 9.55 19.83 1.69 2.04 AA+
3M 1.27 51.41 1.54 0.80 AA-
Honeywell International 1.53 24.81 1.09 0.50 A
Industry Average 4.05 NA 1.63 0.91 NA
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Don't get me wrong, even with what's left of GE Capital, the company can easily service its debts with existing cash flow. However, given how important a strong balance sheet is to maintaining a secure dividend during economic downturns, investors should be happy to see how dedicated management is to paying down its debt.

For example, despite record low interest rates, GE has slowed the rate of new debt issuances from $63 billion in 2012, to just $6 billion over the past 12 months. That's compared to $48.6 billion in debt repayments in the past year, which shows how committed management is to maintaining strong financial flexibility going forward.

Valuation is surprising reasonable given past year's strong rally

Sources: Yahoo Finance, Fastgraphs
Company Yield 5 Year Average Yield Price to Operating Earnings Historic P/OE Price to Operating Cash Flow Historic P/OCF Average Historic Premium
General Electric 2.9% 3.2% 22.6 21.2 12.5 14.3 1.1%
3M 2.5% 2.4% 22.7 20.0 17.2 17.6 -2.3%
Honeywell International 2.1% 2.1% 18.1 17.6 15.9 17.7 -2.5%
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In this age of ultra-low interest rates yield-starved investors have bid up the price of many blue chip dividend stocks to extremely overvalued levels. Yet, when you compare industrial blue chips like GE, Honeywell, and 3M to their historic yields, price to operating earnings, and price to operating cash flow ratios, you can see that they are actually reasonably valued.

In fact, according to Morningstar Analyst Barbara Noverini, GE is trading pretty close to its fair value. That assessment is based on expected industrial product growth of around 5% through 2020, as well as improving margins due to the company's increased focus on its strongest, core business segments.

Source: Morningstar
Company Morningstar Fair Value Estimate Current Share Price Premium to Fair Value
General Electric $30 $32.06 6.9%
3M $165 $180.44 9.4%
Honeywell International $112 $115.61 3.2%
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Which is a good thing indeed given that over the previous decades GE has suffered from "de-worsification", i.e. becoming overly diversified into industries that were beyond its circle of competence.

Sources: Morningstar, Gurufocus
Company Operating Margin Net Margin Return on Assets Return on Equity Return on Invested Capital
General Electric 14.0% 6.2% 1.4% 7.4% 10.06%
3M 23.3% 16.3% 16.4% 38.3% 24.93%
Honeywell International 17.8% 12.4% 10.1% 27.1% 20.52%
Industry Average 12.9% 8.1% 3.9% 13.4% NA
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This resulted in GE's current poor profitability, both relative to rivals such as Honeywell, and 3M, as well as the average industrial conglomerate. However, thanks to strong growth in GE's services and digital segments, which have operating margins as high as 30%, that is likely to change in the coming years.

Risks to consider

Like most industrial companies GE faces risks from a stronger dollar that threatens to hurt overseas earnings, as well as continued global economic weakness.

However, what I really think dividend investors should focus on is the security of the current payout.

Sources: Yahoo Finance, Fastgraphs, Morningstar, Factset Research, Ycharts, Multpl.com, Moneychimp.com
Company Yield TTM FCF Payout Ratio 5 Year Dividend Growth Rate Projected 10 Year Dividend Growth Rate Projected 10 Year Total Return
General Electric 2.9% 131.0% 14.4% 7.9% 10.8%
3M 2.5% 50.5% 14.5% 7.9% 10.4%
Honeywell International 2.1% 43.2% 11.8% 9.0% 11.1%
S&P 500 2.0% 39.1% 11.6% 5.8% 9.1%
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GE's dividend hasn't grown in six quarters, and as you can see the company is currently not covering its payout with free cash flow. Now that doesn't mean that the dividend is at risk, since management plans to fund 2016's $26 billion shareholder capital return program with both free cash flow and ongoing divestitures of non-core businesses, which is expected to come in around $30.5 Billion in 2016.

However, divesting so many businesses, including almost all of GE Capital, means a large short- to medium-term hit to free cash flow, which has fallen sharply in recent years.

GE Free Cash Flow (<a href= GE Free Cash Flow (NYSE:TTM) data by YCharts

Which means that dividend investors may be disappointed in the dividend growth of the next few years, which is likely to be far smaller than the impressive 14.4% CAGR of the last five years.

Fortunately for long-term investors, I remain confident that GE's strong brand and highly favorable customer relationships will result in strong pricing power, stronger profitability, and good free cash flow growth in the future.

In other words, while the last of GE's corporate reorganization may mean little or no dividend growth over the next few years, solid dividend growth should be just a matter of time once GE's cash flow grows large enough to cover, and surpass the current payout.

Bottom line: GE continues to strengthen its brand, and build a widening, state-of the-art moat to enrich dividend investors in the coming years and decades

While GE continues to face large scale challenges today, including slowing global economic growth, and a strong US dollar that dings earnings growth, I remain bullish on this venerable blue chip's long-term prospects. Management's dedication to refocusing GE's substantial capital resources on its core business segments, when combined with its massive R&D investments, and leading role in the digital industrial analytics technology, should mean GE maintains its position as one of the world's leading industrial giants in the coming decades.

With strong growth in its high margin digital services, and an increasingly sticky relationship with its growing global customer base, GE should be able to generate increasingly stable, recurring cash flow that is likely to mean strong, sustainable, long-term future dividend growth. Which in turn should result in long-term market beating total returns, even for shares bought at today's slightly overvalued prices.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.