When you look back to fifteen or so years ago, you will see that General Electric (NYSE:GE) was growing its profits at a steady but somewhat unimpressive rate. Profits of $1.29 in 2000 grew to $1.41 in 2001 and then to $1.51 in 2002 and $1.55 in 2003. During the four-year measuring period of 2000-2003, General Electric managed to grow its profits by 20% cumulatively. It was a conglomerate that seemed destined for growth in the 4%-6% range, barely increasing wealth for shareholders at a rate that exceeded inflation.
This is where GE Capital began to more prominently enter the picture: With the industrial side of the company only delivering moderate growth, the next step for GE involved lowering the Tier 1 Capital Ratio of the GE Capital division significantly and investing heavily in debt and property that would not endure through the lean times. Of course, it made for some fun profit growth while it lasted: Between 2004 and 2007, General Electric grew its earnings from $1.61 to $2.20 per share, improving its growth rate 1.5x over the previous four-year measuring period as GE Capital came to account for well over a half of the famous conglomerate's profits.
We all know what happened over the next two years: General Electric saw its earnings collapse from $2.20 to $1.03, and the quarterly dividend got slashed from $0.31 to $0.10, and has still not reached that level since growing the dividend each year following the collapse. In the aftermath of actually experiencing the deep pain caused by an overleveraged and low-quality credit balance sheet, General Electric began the process of discarding high-risk-of-default properties and raising its Tier 1 Capital Ratio at GE Capital so that the business would at least survive, if not prosper, through the next storms that hit the financial sector.
The reaction to GE's decision to lower the influence of GE Capital has been generally positive with most long-term shareholders eager to see General Electric return its focus to the industrial operations that long made it famous. A question that has long gone unasked, however, is this: Are there any negatives that come with the decision to diminish the role that GE Capital plays in determining the overall returns of General Electric shareholders? The answer to that question is this: In good and ordinary times, profits from GE Capital tend to grow much faster than GE Industrial.
The commentary on GE Capital has often gone the route of a Hobson's Choice stating that General Electric must either shed GE Capital or brace itself for a repeat of 2009 during the next crisis in the financial sector. The truth is that a third option could have been explored: Continuing making GE Capital a co-equal source of profits to the industrial segments and run it more conservatively than had been the case in the years leading up to the financial crisis. I don't blame General Electric for choosing to shed the bulk of GE Capital's assets (with the recent Synchrony (NYSE:SYF) split being the latest example of GE's willingness to become more industrial) because the temptation to raise risk in order to increase growth will always face the financial industry, and the quality of GE's earnings are safer, if less lucrative, due to the decision to reduce GE Capital to 35% of the company's profits.
That shift in GE's asset mix is the backdrop against which we must evaluate the decision for the most recent dividend hike in the amount of 4.5%. As GE shifts towards a larger industrial focus, the earnings will be a bit choppier (e.g., if oil continues to be as volatile as it has been the past six months, the oil and gas division earnings will cause more fluctuations in GE's overall profits in a way that we did not see during the 1997-2007 stretch).
To account for more volatility in earnings, GE has to keep a dividend payout ratio that permits for dividend hikes even during the next recession when profits might fall a bit due to the increased cyclicality of its business models. Right now, the new $0.92 annual dividend accounts for 54% of the company's total profits, which are at $1.70. The need for conservatism is that, if oil continues to fall significantly and we have a general cool-down across the 100 countries in which GE operates, profits could come down to $1.50 and eat up over 60% of GE's earnings during a time when it would be expected to raise its dividend.
In the broadest sense, here is how I think about GE's recent 4.5% dividend hike: This is a result of GE's renewed focus on industrial operations, which comes with the effect that profits will be a bit more cyclical over the short term. Shrewd managers of cyclical companies know to give you lower dividend increases in good years than the actual growth rate of profits because during bad years you will need to give dividend increases that outstrip the actual business performance. When you look at GE's business performance over the course of a full cycle, you will see that the industrial division grows around 8% annually. A dividend increase smaller than that is not a concession that GE is on the road to low growth, but rather conservative management of the dividend ratio is necessary to better prepare for the next economic storm so that a dividend cut does not happen again.
Disclosure: The author is long GE.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.