Despite everything you have no doubt read about General Electric over the past two or three years, the fact remains that it is a company earning $5 billion per year in profits (and would earn approximately $9.5 billion per year if you could snap your fingers and eliminate its debt load). I raise this point because investors often speak of particular investments in binary terms, as if some business insufficiency (even one lasting for an extended period of time) must somehow lead to zero, bankruptcy, or some type of absolute failure.
For nearly all of America’s largest 500 or so companies, insolvency is not a looming risk in the absence of technological obsolescence or an enormous debt load towering over a permanently down-sized base in earnings power.
In the case of General Electric, it is an industrial giant with about $25 billion in debt obligations that come due and owing over the next three years and it is also looking at anywhere from $5 billion to $20 billion in additional payments for long-term care policies that were underwritten in the 1980s and 1990s.
In theory, long-term care policies were great in that they offered large payments to the insurance company upfront that could be invested for an extended period of time (possibly even decades or never paid out at all). The test for payment is usually that someone needs to acknowledge impairment with two of six common daily activities in order to be eligible for long-term care, and because the receipt of long-term care is generally undesirable, the customer base is inherently reluctant to collect its benefits so the various long-term care insurers owned by GE failed to anticipate not only the medical advancements that prolong life, but also the rapid price increases in the price of long-term care as well.
As a result, GE consists of a wildly successful health-care (medical imaging and equipment) subsidiaries that earn approximately $2-$3 billion in profit per year as well as a collection of industrial companies that are market-leaders in complex machinery but can be quite cyclical because their customers tend to be agricultural or oil and gas industry participants that invest during good times and cut back during hard times to a greater degree than many other sectors.
The issue for the investor is that these cash generators are burdened by debt and unspecified long-term care expenses.
This brings me to an important point: General Electric’s dividend cut from $0.24 to $0.12 (quarterly) in 2018 and then subsequent cut to $0.01 per share (quarterly) in 2019. One area where I have found contrarian independent approaches to investing useful is in the context of dividend cuts.
When a company cuts its dividend, many long-term shareholders shuffle out and even speculative investors shy away because of the implicit recognition that profits will be dampened for a multi-year period.
But for those with a value-bent, the opportunity looks much more promising. When a dividend is slashed to a level like a penny per share, almost all of the profits become directed towards rehabilitating the company’s shortcomings and shoring up the obvious areas of need. When Bank of America cut its dividend to a penny per share, the fact that the company is earning $10+ billion today is a causative byproduct of yesteryear’s dividend cut.
With General Electric earning over $5 billion in profits while paying out a dividend of $300-$400 million per year, the $4.5+ billion in retained profits are going to stabilizing the company (especially because the firm is now managed by Larry Culp, who was one of the key executives responsible for the success of Danaher in years gone by).
It would not surprise me if General Electric were to return to the days of $10 billion profits within the next five years. By that point in time, it will have enjoyed tens of billions of dollars to repair and restabilize its competitive position. Right now, the stock is only valued at $80 billion. If it were to return to a $10 billion profit base, I would expect the valuation to return to the $150 billion to $200 range. In other words, I would expect the returns to be competitive with and even likely to exceed the S&P 500 from this point, but also, the investor probably isn’t going to be compensated anywhere near as well as the Bank of America investor facing the same situation.
But my point isn’t to discuss whether or not General Electric will beat the market. Instead, I want investors to focus on the mechanics of what is happening when a profitable company cuts its dividend payment. With only a penny per share in quarterly payouts, and $0.15 per share in typical quarterly profits, a lot of profits are now being retained to turbo-charge the company’s return. It would be a lot harder to fix GE if the $5 billion profit stream were being paid out to shareholders. The penny per share turns a decade-long rebuild into a two-four year rebuild.
