Stock Soars on Hint of Dividend Cut, Huh?

Generally, when a company finds it necessary to slash its dividend it is a sign of significant trouble in the underlying business and most often the company’s stock drops in reaction to the cut. However, General Electric (GE) has turned conventional wisdom on its ear today as the stock is up more than 15% because it appears increasingly likely that the company will need to slash its dividend sometime in 2009. It goes without saying that GE got into big trouble, especially in its finance division, GE Capital. As a result, the blue-chip company’s stock has steadily declined more than 60% over the past year. The company had boosted its dividend each year for the last 32, but broke that streak by holding quarterly dividends steady at 31 cents per share last year . This impressive track-record had to be broken because of the extremely difficult economy and now it looks as if CEO Jeffrey Immelt will at least consider the possibility of slashing the dividend later this year in order to reduce the company’s negative cash flow. (GE paid out $11.5 billion in dividends last year.)

General ElectricThere has been growing speculation among analysts that GE will need to cut its dividend in order to preserve its AAA credit rating. The credit rating is a reflection of the health of a company and, were GE to lose this top-tier rating, financing its already massive debt burden would be much more costly. With more than $693 billion in liabilities on its balance sheet at the close of 2008, the company can ill afford any development which raises its cost of capital. So, although no CEO likes to cut dividends paid to shareholders, especially for a company with such a strong history of increasing those payments, Immelt may have to do just that. It seems that unless there is a tremendous improvement in operating conditions before the second half of 2009, by cutting the dividend, Immelt would be doing what is in the best interest of shareholders by preserving his cash. A dividend cut will not guarantee GE’s AAA rating, but it would be a step in the right direction.

Now, GE clearly has enough cash on hand to continue paying its hefty yield of nearly 10%; however, is it wise in this environment? The company earned $1.78 and paid out $1.24 per share in dividends last year. So, for last year the dividend payout ratio for GE was nearly 70%, which is certainly more than we normally like to see. Looking ahead, that payout ratio could continue to worsen as consensus estimates have the company earning $1.27 in 2009 and $1.34 in 2010. It is clear that if GE’s actual results come in anywhere near estimates that the current dividend cannot remain intact.

We currently see GE as Greatly Undervalued because, compared to previous years, the stock looks extremely cheap using price-to-sales, price-to-cash flow and of course dividends. However, we anticipate 2009 could be another very tough year for GE and, as discussed above, its is saddled with a ton of debt. While GE may be one of the most diversified companies in the world, in this case we would hold off investing in GE shares, especially after the 15% run-up today. If you own GE, it probably does not hurt to hold the shares for the long-term because the odds are that the stock will return to more normal valuations as the economy rebounds in the next year or two. However, do not be surprised if the dividend yield going forward is lower, as a cut will probably be necessary in the quarters ahead.

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