Newsletter Alert: Title Withheld – Members Only
publication date: May 15, 2017
author/source: Kris Rosemann and Brian Nelson, CFA
We’re as surprised as you are by this alert, but we’re removing GE from both newsletter portfolios. After rolling our discounted cash flow model forward (2017 first forecast year) and in light of GE’s release of its 10-Q late April, which showed surprisingly poor cash flow from operations conversion (negative $1.6 billion in industrial cash flow from operations) and only modest capital spending reductions (two key components of the Dividend Cushion ratio), we no longer have the confidence in shares as we did before. But why the change and why now? New information in the 10-Q, and new forecasts in our newly rolled-forward discounted cash flow model.
By Kris Rosemann and Brian Nelson, CFA
We had just finished saying how engine troubles weren’t going to derail General Electric (GE) and that we’d be keeping it in the newsletter portfolios when our update cycle prompted us to take another deep look at shares. We still don’t believe engine troubles will be an issue, but we can’t believe what our new forecasts imply. Looking toward the end of this decade as GE transitions to a purely-industrial entity (and support from non-core asset sales and its financials operations wane), our expectations for normalized industrial operating cash flow of about $12-$14 billion and industrial gross capital spending of ~$6 billion will put traditional industrial free cash flow generation (FCF) at $6-$8 billion, which is lower than current annual run-rate cash dividend obligations ($8+ billion). For context, GE’s adjusted industrial cash flow from operations came in at $12.2 billion in 2015 and $11.6 billion in 2016 against gross capital spending north of $7 billion for both years.
In light of the most recent update to our discounted cash-flow model, we’ve lost our appetite for shares. Will GE cut its dividend tomorrow, or this year, or next? Not likely. Why? For one, it is still generating gobs of traditional free cash flow, augmented by dividends from its financials operations (for the time being); and two, it has tens of billions in cash just sitting on the balance sheet. Said differently, there’s no need for panic, but still, we demand more from newsletter portfolio holdings, and GE’s 10-Q has been an unfortunate catalyst for us to part with shares (the poor cash flow from operations showing coupled with only a modest reduction in capital spending; we thought capex drawdowns would be much greater). We’ll be removing General Electric from both newsletter portfolios at a price of $28.04 per share. The exit price is higher than the cost basis in the Best Ideas Newsletter portfolio, but the idea has effectively been a wash for the Dividend Growth Newsletter portfolio after considering dividends received.
Our updated 16-page report and dividend report on GE are now available on the website. Concurrent with adjusted future free cash flow assumptions, we’ve also lowered our cash-flow-based fair value estimate of GE to $30 per share from the mid-$30s previously (we’ve also widened our fair value range), and our updated Dividend Cushion ratio, which is also based on GE’s future cash flow trends, now rests near parity (from much higher before), consistent with expectations for normalized industrial free cash flow to be roughly at parity with future cash dividends paid. As GE transitions away from being both an industrial and finance entity (and we set 2017 as our first forecast year in the model), we also no longer calculate an adjusted Dividend Cushion ratio for GE (something we do for MLPs, REITs, and conglomerates with financial arms). The lower free cash flow expectations and methodological adjustments are the main drivers behind its reduced Dividend Cushion ratio (now at 0.8). Generally speaking, we prefer dividend growth entities with Dividend Cushion ratios far greater than 1.
All this said, GE’s sprawling industrial portfolio has more than its fair share of attractive assets, and we expect it to play a pivotal role in the continued development of the next generation of industrial technology in our economy. Investors should even note the potential for an improved operating environment to drive shares to the upper bound of our fair value range, too. However, given the size of the company’s debt load--net debt was just over $45 billion at the end of the first quarter of 2017--and our expectations for industrial free cash flow to be far too close in covering future cash dividend obligations for comfort, we find the prudent move is to remove GE from both newsletter portfolios at this time. We’re available for any questions, and we’re sorry for the short term horizon on this one. Fundamentals change all the time--and we have to stay ahead of them.