By Michael Rapoport
No matter what happens with General Electric Co.'s dividend,
investors will still have to grapple with the fact it is nearly
impossible to tell how much of its earnings are backed by cash.
Until investors can figure that out, a pall could hang over the
battered stock and questions linger about the dividend, analysts
said. "I can't really build a quarterly cash flow for these guys
that has any credibility," said Scott Davis, an analyst with Melius
Research.
Mr. Davis recently blasted GE in a research note as "a company
in disarray." In an interview, he compared GE's earnings releases
to "an IQ test -- they give you 10,000 numbers and you have to
figure out which 10 matter."
In a statement, GE said, "Our goal is consistency and
transparency with data that our shareowners can digest. We are
looking at how we can report in a cleaner way, including a simpler
presentation."
On Monday, GE executives led by CEO John Flannery plan to unveil
a major update to its corporate strategy, which is expected to
address the fate of the dividend, plans for asset sales and
attempts to simplify the company's accounting.
The latter is a sticking point for investors and is tied to
questions about the company's ability to convert earnings into
cash.
The earnings-cash flow relationship has come to the fore since
GE last month slashed guidance for the rest of the year for both
measures.
"It's kind of opaque," said Brad Ginesin of hedge fund Polar
Capital LP, which owns GE shares. "There's a certain leap of faith
you take."
Ideally, a company's earnings should be fully backed by cash, to
demonstrate that earnings are high quality and that there is money
to do things like pay dividends to shareholders. But GE's
accounting has so many moving parts -- different ways of measuring
its performance, corporate changes and special items as well as
areas without a lot of disclosure -- that analysts say they have
trouble determining cash flow.
"When you're disposing of a lot of businesses as they are, it's
difficult to separate out what assets are here, what assets are
gone, and their effects on cash flow," said Charles Mulford, an
accounting professor at the Georgia Institute of Technology.
Even before last month's change to guidance, analysts had been
concerned about a divergence between earnings and cash flow. In
May, the company changed its methodology for calculating the rate
at which its operating earnings convert into free cash flow, in a
way that made it look better. Under the new method, the conversion
rate was 91% for 2016, versus 76% under the old.
The October outlook cut exacerbated fears. GE reduced its
earnings target by about a third but its cash-flow target by close
to half. That seemingly leaves the company needing a hefty
fourth-quarter slug of cash, far exceeding newly booked earnings,
to meet its target.
"The number looks extraordinarily challenging, and it's a little
unclear how they're measuring the number," said Jeffrey Sprague, an
analyst with Vertical Research Partners.
How challenging? GE spent $6.4 billion on dividends to
shareholders in the first nine months of this year, nearly double
the amount of cash it generated from operations, as calculated
under standard accounting rules. And that doesn't even take into
account the company's billions of dollars in capital spending.
Even under GE's preferred measures of earnings and cash flow,
there was a shortfall. In the year's first nine months, GE reported
$6.8 billion in industrial operating earnings with some GE Capital
businesses added in, compared with only $1.6 billion of adjusted
industrial operating cash flow.
To hit the sharply reduced 2017 financial targets GE issued last
month, that trend would have to reverse itself in the fourth
quarter. Calculations by The Wall Street Journal suggest that for
GE to meet its earnings outlook for the year, it would have to
produce about $2.3 billion to $2.8 billion in adjusted
fourth-quarter earnings. To hit reduced industrial operating
cash-flow targets it would have to generate an additional $5.4
billion.
GE's cash flow does historically tend to be weighted toward the
fourth quarter -- the company's customers tend to spend their
capital budgets toward the end of the year. And cash does often
come into a company at a time different from when the corresponding
earnings are booked -- that is partly why cash flow is reported
separately in the first place.
Part of the reason for the earnings-cash flow disconnect, GE
indicated during its third-quarter conference call, is a buildup of
inventory in its power-generation segment, which performed worse
than expected. The increased inventory means GE has committed
capital to build equipment that it hasn't yet been able to reap
cash flow from.
GE has also acknowledged part of the reason its cash-flow
outlook got slashed so much relates to its growing portfolio of
contract assets -- revenue the company books on long-term service
and equipment contracts before it has the cash in hand.
GE has assured analysts the company will ultimately realize all
the cash related to those contract assets. But "we need to get some
comfort and confidence that that is going to be the case," Vertical
Research's Mr. Sprague said.
Write to Michael Rapoport at Michael.Rapoport@wsj.com
(END) Dow Jones Newswires
November 10, 2017 13:10 ET (18:10 GMT)
Copyright (c) 2017 Dow Jones & Company, Inc.
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