I’m a big fan of contrarian value investing, having recently taken stakes in two beaten down dividend stocks trading at 52-week lows.
So when I see a blue chip like General Electric (GE) trading at not just a 52-week low but also one of its highest yields in almost a decade, it certainly piques my interest.
BUT there is a big difference between being a contrarian and foolishly investing in something with horrible dividend growth prospects.
So let’s take a look at three reasons why I’m avoiding GE like the plague, and instead have 3M (MMM), and Illinois Tool Works (ITW) on my EDDGE 3.0 portfolio buy list.
GE’s Flailing Turnaround Drama Continues
After a failed 16-year tenure at GE, Jeffrey Immelt has left the company, to be replaced by John Flannery, who promises to finally unlock the company’s strong growth potential.
The problem is that while Flannery, a 30-year veteran of the company and former head of GE Healthcare, has a solid track record as a turnaround artist, the strategy he’s outlined is no different than Immelt’s.
Specifically, Immelt wanted to return to GE’s industrial roots by selling off the vast majority of GE Capital (the company’s most profitable and FCF rich segment) and focus on core industrial brands.
Now back in 2009, this made a lot of sense. After all, GE Capital’s implosion during the financial crisis is what nearly bankrupted the company and forced it to slash its dividend by 68% back then.
And with strict new banking regulations, GE didn’t want the headache of holding onto the financial businesses that aren’t directly tied to financing customer acquisitions of its industrial products.
However, where Immelt went so badly wrong is to use the one-time windfall from the sale of GE Capital to buy back copious of stock rather than reinvest into expanding the company’s industrial portfolio.
And since GE sold off not only its financial arm, but numerous other “non-core” businesses as well, the result has been a steady decline in sales, earnings, and especially free cash flow, which is what ultimately funds and grows the dividend.
Source: GE Investor Presentation
Now Flannery says he’s going to double down on Immelt’s failed strategy by selling off even more businesses, such as selling off its water division for $ 3.4 billion.
Now some GE bulls will argue that this water sale was necessary in order to close the acquisition of Baker Hughes (BHGE).
However, let’s remember that GE made a bunch of its energy investments at the top of the oil cycle (overpaid) and the merging of Baker Hughes with GE’s oil business, and then spinning it off as a separate company isn’t going to be a major needle mover for the company.
In fact, GE paid Baker Hughes shareholders a $ 7.4 billion special dividend, and because it now owns just 62.5% of the new company, even if oil prices recover to $ 60, and management realizes its planned synergies, the bottom line benefit to GE shareholders will be $ 0.08 per share in 2020.
In other words, if everything goes right (including much higher oil prices that management has no control over), then the deal will increase GE’s EPS by 10% over a three-year period or 3.2% CAGR.
Which basically shows the problems facing GE, specifically that management is flailing and churning through assets while burning cash in an effort to “do something” to hopefully refire the growth engines.
In the meantime, the company’s short-term moves appear nothing more than desperate window dressing to appease Wall Street.
For example, the company recently announced it was selling its five corporate jets to save money. However, as analysts have pointed out the cost savings will be minimal ($ 333,000 last year), and using charter planes could end up actually increasing expenses in the long run.
The company is also ending its company car program for 700 executives, as part of a $ 2 billion cost cutting effort (by the end of 2018).
Now don’t get me wrong, I applaud any effort to cut costs, especially by this much and this fast.
However, let’s be realistic. In 2016, GE’s total compensation to its top five executives was $ 78.2 million, $ 8 million of which was through perks such as company cars and private jet travel.
Which means that the savings that Flannery is talking about can’t be obtained by such PR stunts.
What’s worse? Even if GE’s is able to cut costs by $ 2 billion by the end of next year, given that it’s generated NEGATIVE $ 2.5 billion in free cash flow in the past 12 months, it would still not be FCF positive; much less be able to cover its $ 8.6 billion dividend.
Or to put another way, GE needs to grow to save its dividend and its status as a dividend investment, something it’s not been able to accomplish over the past decade.
3M And Illinois Tool Works: Dividend Kings With Far Superior Fundamentals
Whereas GE’s track record in the past decade has been terrible, 3M and Illinois Tool Works have proven themselves some of their industry’s highest quality names.
Now keep in mind that between 2012 and 2016, the world’s been in an industrial recession, thanks to the bursting of several commodity bubbles (due to China pulling way back in infrastructure spending).
Add to this the worst oil crash in over 50 years, and all industrial companies have struggled with top line growth.
However, the difference between GE and its far superior rivals is that they’ve managed to adapt their business models, through cost cutting and increased sales of their highest margin products, to generate impressive EPS and FCF/share growth.
|Company||Operating Margin||Net Margin||FCF Margin||Return On Assets||Return On Equity||Return On Invested Capital|
|Illinois Tool Works||23.2%||15.5%||13.8%||13.9%||44.6%||17.4%|
Sources: Morningstar, CSImarketing
In fact, when we look at these companies’ profitability profiles, specifically margins and returns on capital, a great proxy for the quality and effectiveness of their respective management teams, we see that GE isn’t even in the same ball park.
For example, Illinois Tool Works’ response to the industry turnaround has been to consolidate over 800 regional units into just 85 global ones.
Source: Illinois Tool Works Investor Presentation
The company has also sold off lower margin, commoditized segments, such as decorative surfaces and industrial packaging, to focus on higher margin segments, which are growing faster than the global industry as a whole.
This is why ITW now expects organic growth to be be at least 2.5% above the industry norm going forward.
Add to this steady cost cutting of over 1% a year, and it’s not hard to see why Illinois Tool Works is now one of the industry’s best FCF generating machines, which allowed the company to hike its dividend by an incredible 20% in 2017.
Better yet? ITW’s experienced management team believes its current strategy will be able to continue generating double-digit dividend growth (and total returns) for the foreseeable future.
Meanwhile 3M’s turnaround strategy has similarly been a great success, especially compared to the horror show at GE.
3M: Industry’s Innovation Leader
Just like Illinois Tool Works, 3M has responded to the global industrial recession with disciplined and well executed changes, especially a focus on streamlining its operations, and targeted bolt and highly accretive bolt-on acquisitions.
Source: 3M Investor Presentation
However, the company hasn’t skimped on its bread and butter, well allocated R&D spending that is the key driver of its historic innovation success.
This spending (5.9% of revenue in last 12 months) is expected to boost its healthcare sales by 2% to 4% a year, while $ 500 million to $ 600 million in cost cutting should further grow EPS by about 1.5% a year.
In the meantime, about 50% of 3M’s sales are in fast consumable products, resulting in far stronger recurring cash flow than GE (or most peers). The company also benefits from strong exposure to emerging markets (47% of sales) which should increase to 50% by 2020.
That in turn will allow 3M to grow faster than most industrial stocks, including about 10% EPS and FCF/share growth, which in turn should drive some of the industry’s best payout growth in the coming decade.
The bottom line is that while GE is churning assets, and burning through shareholder cash, both Illinois Tool Works and 3M have successfully proven their ability to adapt to tough industry conditions and continue growing investor profits.
This bodes extremely well for their dividend focused investors, especially now that the industry is recovering.
Dividend Profiles Are No Contest
|Company||Yield||TTM FCF Payout Ratio||10-Year Projected Dividend Growth||10-Year Potential Annual Total Return|
|General Electric||4.1%||-34.0%||3% to 4%||7.1% to 8.1%|
|3M||2.2%||50.9%||8% to 11%||10.2% to 13.2%|
|Illinois Tool Works||2.1%||45.4%||10% to 12%||12.1% to 14.1%|
Sources: Gurufocus, Morningstar, Fast Graphs, CSImarketing.com, Multpl.com
Ultimately as a long-term dividend growth investor, I’m concerned with three things: the yield, the safety of the dividend, and its long-term growth potential.
That’s because historically dividend growth stocks’ total returns follow the formula yield + dividend growth. And while true that GE’s yield is currently far superior to those of the market, and 3M and Illinois Tool Works, it’s also not sustainable.
After all, GE’s negative free cash flow means that it is having to pay the dividend out of cash on the balance sheet and or debt. And even once the company does return to FCF profitability, it will have to grow its cash flow at a torrid pace just to cover the payout, much less lower its payout ratio to a sustainable level of 40% to 60%.
On the other hand, both 3M and ITW have highly secure payouts, courtesy of conservative payout ratios and far stronger balance sheets.
|Company||Debt/EBITDA||EBITDA/Interest||Debt/Capital||Current Ratio||S&P Credit Rating|
|Illinois Tool Works||2.17||14.55||57%||2.32||A+|
Sources: Morningstar, Fast Graphs, CSImarketing
And let’s not forget that as dividend kings, 3M and ITW have grown their dividends every year for 58 and 53 years, respectively.
This means that both companies have far more shareholder friendly (and conservative) corporate cultures, with proven track records of sustaining and growing their payouts during even the most turbulent of economic and industry conditions.
That in turn has resulted in far superior total returns over the past decade; a trend I expect to continue long into the future.
Valuation: GE Isn’t As Undervalued As You Think
In terms of performance in the last year, it’s no contest. 3M and ITW have benefited from the Trump bump in industrial stocks, while GE has been falling steadily.
Of course, from a valuation perspective that’s not a good thing.
|Company||Forward PE||Historical PE||Yield||Historical Yield||% Of Time Yield Has Been Higher (Last 22 Years)|
|Illinois Tool Works||21.2||15.8||2.1%||2.2%||34%|
Source: Gurufocus, Yieldcharts
After all, it means that industrial stocks in general are trading at very high levels, with both 3M and ITW far higher than their historical PE ratios.
Meanwhile GE, at least from this short-term perspective, appears to be on sale.
This is especially true when we look at GE’s yield compared to its historical average. In fact, over the past 22 years, GE’s yield has only been higher about 1% of the time, while 3M’s has been greater 72% of the time, and ITW’s 34%.
However, when we take a longer-term, 20-year forward view, things look a bit different.
|Company||TTM EPS||10-Year Projected EPS Growth||Fair Value Estimate||Growth Baked Into Current Share Price||Margin Of Safety|
|General Electric||$ 0.80||5.5% (conservative case)||$ 9.47||17.3%||-61%|
|11.0% (bullish analyst consensus)||$ 14.59||-147%|
|3M||$ 8.77||10.0%||$ 167.62||13.7%||-29%|
|Illinois Tool Works||$ 6.18||10.7%||$ 119.91||14.0%||-27%|
Sources: Morningstar, Fast Graphs, Gurufocus
Normally, I like to use a discounted free cash flow analysis to determine an approximate fair value for stocks such as this. However, since GE is cash flow negative right now, we need to look at a discounted earnings model instead.
Using a 9.0% discount rate (the opportunity cost of money since a S&P 500 index ETF would have historically generated 9.0% CAGR since 1871), we find that indeed both 3M and Illinois Tool Works are substantially overvalued (meaning they are both “holds” right now).
However, GE is actually far more overvalued, even if you assume that the analyst consensus of 11% EPS growth over the next decade is correct. In reality, I think the company will generate far slower growth which means that its shares are far more overvalued than 3M and ITW’s.
And so while today may not be a good time to buy 3M or Illinois Tool Works, it’s an even worse time to add GE to your portfolio.
Risks To Consider
While I’m a huge fan of 3M and Illinois Tool Works, and eventually plan to own both, there are nonetheless some major risk factors to consider.
First, all industrial conglomerates are cyclical since their business is tied to the health of the global economy, and especially commodity sensitive industries such as mining and energy.
Currently accelerating economic growth and a recovery in commodity prices (especially oil) means that 3M and ITW’s bottom line growth prospects have the wind at their backs.
However, a global recession could quickly unravel this and throw up strong growth headwinds. And given the strong rally in the past year, both dividend kings could face a strong pullback in such a scenario (which will make for a potentially great buying opportunity).
Next we can’t forget that due to their international sales, both 3M and ITW also face significant currency risks. Specifically that a strong dollar (which is likely to result from rising US interest rates) could slow top and bottom line growth because their products would become more expensive overseas. In addition, local currency sales would be converted to fewer dollars for accounting and dividend payment purposes.
In the past year, the US dollar has actually declined significantly (helping boost both company’s profits), but given the natural volatility of currencies, and where the Fed is signaling that rates are going, investors can’t necessarily expect this trend to continue.
Bottom Line: GE Is A Wet Cigar Butt, While 3M And Illinois Tool Works Are Grade A Gems Worthy Of Your Watch List
Don’t get me wrong. GE is currently pricing in such low expectations that it’s possible that it might have a strong short-term bounce if only management can suck less than expected.
BUT as a long-term dividend growth investor, I’m not willing to speculate on such an eventuality, not when there are so many far superior investing alternatives right now.
And while 3M and Illinois Tool Works may not currently be attractively priced, I’m far more eager to place them on my watch list and wait for the next market correction to add these two dividend growth legends to my portfolio, than take a wild eyed gamble that GE can finally turn its ailing ship around.
And if you currently own 3M and Illinois Tool Works, then I recommend continuing to do so, as they both are epitomes of a “buy and hold forever”, sleep well at night (SWAN) dividend growth stocks.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.