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Morningstar | GE CEO Culp's Tough First Inning Culminates in Dividend Cut and Power Reorganization Plan

Narrow-moat-rated General Electric reported third-quarter earnings that were broadly in line with our full-year expectations, except for the power business. However, GE Capital has performed stronger year to date than we anticipated. We’ve made some puts and takes in our model, but our long-term outlook is the same. We expect to raise our fair value estimate by a dime, to $16.20 per share from $16.10, primarily due to the time value of money. There were two big-ticket items in the earnings release, in our view. First, the firm is cutting its dividend effective December, to $0.01 per share from $0.12. Second, GE is reorganizing the power business and is separating it into two units; one will focus on the gas business, while the remaining portion will center on the steam, grid solution, nuclear, and power conversion business. But as we expected, new CEO Lawrence Culp is sticking to the aviation, power, and renewable energy plan that former CEO John Flannery laid out.

We’re not surprised by the dividend cut. If anything, we’re surprised by the firm’s intention to keep the dividend at all. As of the second-quarter earnings release, GE had paid just over $2.2 billion in dividends year to date, but it was in the hole for industrial free cash flow at negative $1.4 billion. Prudent capital allocation dictates that excess cash should be returned to shareholders, but GE has a narrow window of free cash to reinvest to remain competitive in its businesses. This will continue to be an issue as Moody’s and Fitch re-examine GE’s credit rating. It would have been our preference for the dividend to be eliminated in its entirety. Culp says the move should allow GE to retain about $3.9 billion of cash per year compared with its prior payout level.

On the bright side, industrial free cash flow was surprisingly strong this quarter, at over $1 billion. Updating these figures for the third quarter, GE has paid out about $3.3 billion in dividends but is now nearly flat for the year in terms of industrial free cash flow (negative $335 million year to date). Based on our arithmetic calculations, we think an equity raise, while possible, is unlikely. On the call, Culp also backed our assessment regarding the unlikely nature of an equity raise.

As for the power business, we have our suspicions regarding the move. On the call, Culp said he spoke with GE Power CEO Russell Stokes and they mutually determined that the segment had become too complicated. Based on a comparison of GE Power with Siemens’ power and gas segment, we concur that GE Power is complex and has been run inefficiently. Our research uncovered that GE has run at about a 55% rate of efficiency (as measured by segment profit per employee) compared with Siemens. That number probably undersells the efficiency rate, because it employs the company’s reported segment figures and doesn’t incorporate corporate and unallocated expenses and employees. For reference, GE has over three and a half times corporate expenses per unallocated employee versus Siemens.

Additionally, Culp is eliminating the power headquarters structure, a move we like, given the inefficiencies we cited. The segment's two units will report directly to Culp. This is straight out of the Danaher playbook, and we’re unsurprised by this. Danaher only had about 50 employees at its corporate headquarters when Culp ran the business. These 50 employees were largely responsible for evaluating potential deals and reported directly to Culp.

We anticipate we’ll hear more regarding plans for power for "the road ahead," as Culp indicated on the call. We would not be surprised if Culp and his team wouldn’t at least explore selling certain business lines, as we indicated in our third-quarter earnings preview note Oct. 29. We ran some numbers in the weeks before the call. Assuming current margins for the steam business, we believe the net present value of selling this business is about 40% greater than for GE to retain the business, even when baking in a lack of marketability discount for certain portions of the business related to Alstom. While we’re not certain a sale is impending (this is pure speculation), we do believe Culp will continue re-evaluating the timeline for healthcare as well as delineating the differences between core and noncore business for potential divestitures.