Wednesday, November 15, 2017

General Electric Cuts Dividends For The Second Time In A Decade

You probably heard the news that General Electric is cutting dividends for the second time in a decade. The previous time when General Electric cut distributions was in 2009, during the financial crisis.

The dividend cut was not surprising, given the fact that the conglomerate had a high payout ratio amidst a stagnant trend in earnings per share.

For example, the company earned 99 cents/share in 2009, the first year after the financial crisis. By 2016, GE earned $1/share. At the same time, dividends per share grew from 61 cents/share to 93 cents/share. The company is expected to earn $1.07/share for 2017 and has paid 96 cents/share in dividends. The payout ratio was obviously too high, and unsustainable.

When you cannot grow earnings, and have a high payout ratio, you cannot pay dividends.

A lot of commentators saw the dividend cut as evidence against dividends however.

This doesn’t make any sense.

GE’s story is actually a cautionary tale against share buybacks.

A lot of investors are told that dividends and share buybacks are the same thing. It is a popular narrative that share buybacks and dividends are the same thing.

This is an incorrect statement.

We have discussed before that share buybacks and dividends are not the same thing. When a company declares a dividend, every shareholder receives the same amount per share of ownership. When a company declares a share buyback, some shareholders reduce their ownership by selling, while the remaining shareholders have a higher stake in a company that could be more valuable if successful, or less valuable if unsuccessful. For example, when Eastman Kodak bought shares in 2008, this only made money for those lucky souls who left the firm as investors. However, when Henry Singleton bought shares in Teledyne in the 1970s to the tune of 90% of shares outstanding, remaining shareholders enjoyed excess total returns.

Basically, dividends are more sticky and reliable. Once company management establishes a dividend policy, they stick to it, for as long as company fundamentals allow them to do it. Share buybacks are treated on an adhoc basis on the other hand. Share buybacks are implemented when companies are flush with cash, but managements don’t want to commit to a higher dividend payment. However, they are canceled quickly when things get more difficult. Unfortunately, when companies are flush with cash and do buybacks, this is usually the time when share prices are high. When companies decide to cancel share buybacks, their share prices are usually low. In other words, companies waste shareholder resources on buybacks, since they do them without any intelligent determination as to whether stock prices are overvalued or not.

The problem with that incorrect thinking on dividends vs buybacks is that ultimately, managements will shift their preference to share buybacks rather than dividends. Since shareholders are being told incorrectly that dividends and buybacks are the same thing, they won’t mind if dividends are slowly phased out altogether, in favor of share buybacks.

Going back to the company in question today, in 2015 GE announced that they will stop growing the dividend, and instead announced a $50 billion share buyback program.

They spent over $21 billion on share repurchases in 2016, when prices were close to $30/share. At todays price below $18/share, shareholders are at a loss.

In the case of General Electric, management has spent the past two decades routinely repurchasing shares at high prices, only to stop them or reissue shares when prices are lower.

General Electric is the poster child for terrible timing of its share buyback. For example, right before the financial crisis, the company spent tens of billions of dollars repurchasing shares when prices were high. In 2007 the company spend $12.319 billion bbuying back stock, which reduced the share count from 10394 million to 10218 million, or a decrease of 176 million shares. The high and low prices of GE stock in 2007 were $42.15 and $34.50 respectively. Facing a liquidity crunch in 2008 the company was forced to sell $12 billion worth of stock at $22.25/share, much lower than the price is had paid for buybacks over the past 4 years. Back in February 2009, the company cut its dividend as well in order to conserve cash.

They locked in several billion in losses with the stroke of a pen.

When management buys 500 million shares at $35/share, and then sells an equivalent amount for $22/share, you are reducing shareholder equity in the business by several billion dollars.

Then management spent billions repurchasing shares when prices were much higher.

Management essentially wasted tens of billions on share buybacks, that only enriched the investors who left the company.

Patient, long-tem buy and hold investors were not better off with the buybacks.

In retrospect, shareholders would have been better off with special dividends, rather than share buybacks.

Again, the incorrect thinking that dividends and share buybacks are the same, can lead you to poor outcomes.

For example, plenty of investors today focus on the taxation of dividends. However, nothing is certain in investing. It is better to be taxed on a certain gain, than have management lose your money in a tax efficient way.

In another example, plenty of investors today also believe that selling shares is the same as receiving a dividend. They forget that a dividend is cold hard cash deposited in your account. You can keep it in cash, spend it, reinvest it as you please. If you rely on selling, you are at the mercy of the share price. It can be high, or it can be low.

To summarize, ultimately, GE is a cautionary tale against share buybacks, rather than dividends. Shareholders would have been better off with special dividends, rather than share buybacks.

It is also a cautionary tale that you need to be diversified, and continuously monitor the earnings behind those dividend payments you are receiving.

In my case, I sold my GE shares in 2009. Back in 2014, it looked as if the company had turned around. As a result, I initiated a position back in 2014 and added to it 2015. A portion of my position was sold in 2016, when I moved my tax-deferred accounts to index funds from individual securities. For any remaining shares I hold, I will keep holding them. If the share price falls enough, I may even consider increasing my position in the company, particularly if shares fall to $15 - $16/share or even lower. I believe that while the company has been poorly run under Jeff Immelt, we may be able to get some turnaround in place over time by the new management. This is mostly a play on a turnaround from a low valuation, triggered by fear and mass exodus after the dividend cut. Of course, my investment decisions depend on the opportunity cost - the availability of other attractively priced companies.

What is your opinion on GE?

Relevant Articles:

Share Buybacks and Dividends Are Not The Same Thing
General Electric (GE) Cuts the Dividend
Dividends versus Share Buybacks/Stock repurchases
How to determine if your dividends are safe

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