Dividends, part III

I don’t know where you are while you are reading Our Little Corner of the Internet, but the weather outside is frightful here in Santa Fe…brrrr…and there is lots of snow…and since we’ve no place to go…then let the Blog flow! OK, so I didn’t miss my calling as a poet. Before getting to the third part of the dividends post I wanted to tell you that I revamped part II of the dividends post to make it more readable.

At this juncture, and I obviously have practice at this, it has taken me less than one minute to pull up General Electric’s Annual Report. These steps are simple and do not take much time…the investment for you (and that’s what this blog is about, yes?) is to actually follow along.

Step 8: Once we scroll down to “Item 15” we discover that GE does not have the financial statements here either. Hmmm. No biggie. Again, it is fairly common for businesses to have this minor-labyrinthine path to the gold. So hit the back button on your browser and go back to the page that says at the top, “SEC EDGAR Filing Information.”

Step 9: Notice under the “Size” column the file sizes listed for GE’s 10-K? As a “rule of thumb” the financial documents, being voluminous, are usually the biggest section of the 10-K. Do you see the biggest file size listed there? It is “ex13.htm” at “5880782” bytes, or 5.8 megabytes. Click on its link.

Step 10: This takes us to “Exhibit 13” of GE’s annual 10-K report. The first portion of this page shows a table of contents that seems to contain the remainder of the 10-K that we discovered was truncated in Step 8. Remember that we are looking for GE’s “Cash Flow Statement.” Do you see it listed there? I do. It says that it is located on page 68 and as the similarly named, “Statement of Cash Flows.” So now we need to scroll down the webpage until we find this information. Please do that. (We’re almost there.) Notice that the page numbers are on the right hand side of the browser window?

Step 11: So we arrive at “GE 2007 Annual Report Page 68.” At this point we have probably expended about 5 minutes worth of time. Not a big deal. Now we are finally ready to do our calculation as to whether or not GE has the cash available to pay its dividend. So we are going to exit these steps and start another set of them.

First, cash flow statements have a requirement to be in one of two formats, and the overwhelmingly preferred choice is the format that GE has for its cash flow statement. That means that once you get comfortable with the format then you can do the calculations that I am going to show you for any company. Grab a calculator, or open a spreadsheet, or pen and paper – just something with which to calculate some quick numbers.

The first section of the cash flow statement is called by GE, “CASH FLOWS – OPERATING ACTIVITIES” and like all companies this shows how much money GE generates by simply being in business. It is very straightforward. You run/operate a business, you generate cash flows. So…

Step 1: How much cash is GE creating from its business? Look at the 2007 column and look for the last number listed in this section, “CASH FROM OPERATING ACTIVITIES.” The number for GE is more than you and I make, I am certain: $45,967 million! That’s a somewhat fancy way of saying $46 billion. However, and this is a big however, do you see that the figure includes monies from “discontinued operations?” Look at the line above $45,967 and you will see that it says, “Cash from (used for) operating activities – discontinued operations.” Discontinued operations are business lines that GE is in the process of ridding itself of. Consequently, we do not want to include these numbers in our calculations. So the relevant number for us for all businesses is going to be “Cash from operating activities – continuing operations.” GE’s was $42,985.

This is interesting, but numbers really don’t have much meaning in an absolute sense, only in a relative sense. So we always have to ask ourselves: “$43 billion compares to what?” Or, another great question is: “What comparisons should I make that will help me to understand this business better?” So let’s compare that $43 billion to the Firm’s sales figure.

Step 2: We will need to scroll back up to find GE’s “Income Statement.” This turns out to be on page 64 and the name of the financial statement is actually, “Statement of Earnings.” Same, same, but different. Sales are sometimes described as “revenues” and that is the case here for GE. Can you find the “Total Revenues” figure? It is $172,738 million, or $172.7 billion! Yikes!

Step 3: Here is a question that we want answered if we are going to invest in GE for dividends: How much of each dollar of sales is turned into cash? That is, “What is the cash profit margin?” We can find that figure by pulling out the calculator and running the following:

cash from operating activities / total revenues = cash margin…

$42,985 / $172,738 = 24.9%

This is pretty amazing, don’t you think? Alright, I know, many of you haven’t been at this for a long time so you may not have an effective point of comparison. So how do you know that 24.9% is amazing? Think of your own life and your own situation. You have your wages or salary, yes? How much, as a percentage of your total wages or salary, do you have left over as cash each month after all of your expenses have been deducted? Does that help to give you some perspective? OK. Now, dividend collectors like constancy right? You don’t want your dividends to suddenly disappear. So wouldn’t it be nice to know if GE’s cash profit margin has been improving over the last several years? I’m glad you agree with me. So grab your calculator and…

Step 4: I want for you to calculate the same number above for both 2006 and 2005. All the data is there for you to do it. Go right ahead and do that…NOW. I’ll wait for you.

What did you discover? I’m not going to hand you the answer, you’re going to have to discover this one on your own.

Step 5: Because of the result in Step 4, I think it is clear that GE has a certain level of cash flows that occur each year, without an increasing trend. Can you think of a number that we could calculate that would give us a sense of this average? OK, yeah, the average itself might be good. That number turns out to be 22.7%. However, we are dividend investors and we do not want to assume that cash will be high. We want to know if GE will be able to pay us cash in the worst-case scenario. The worst case was what? 21.1% in 2006. That is still a very high number. Do you see why GE is renowned as a company that is managed to generate cash?

Step 6: The next section of the “Statement of Cash Flows” is called “CASH FLOWS – INVESTING ACTIVITIES.” Just like it sounds these are the things that GE invested its money in. Remember in the “dividends, part I” posting I said that businesses assume that their internal projects will make more money than whatever you could possibly invest in? Well, this is the section where you see how a company spent its money in the aggregate. For 2007, GE invested $69,701. Can you see where I got this figure? That’s right, again, we want to focus on investments at a firm’s continuing operations. So why is the figure listed peculiarly as (69,701)? On financial statements parentheses are used to show a negative number. Why is this number negative, when GE actually invested $69,701? Shouldn’t that number be positive? The answer is no. The reason is that because GE is spending the $69.7 billion it actually decreases its cash flow. That is, it is being subtracted from its total cash. Does this make sense?

Step 7: Again, numbers are not interesting as absolutes. For numbers to have meaning we have to…what? That’s right, we have to compare them to something else. Wouldn’t it be nice to know if GE is investing more money than it is earning from its operations? That might be a good indication as to whether the firm is overextended, don’t you think? Again, think of your own personal situation, if your spending exceeds your wages or salary for a long time that leads to…bankruptcy, yes? So GE’s $69.7 billion of investing compares to its operating cash flow of $43.0 billion not so favorably.

$43.0 billion earned – $69.7 billion invested = $(26.7 billion)…yikes!

How could this be? How is this even sustainable? We will answer these questions in a moment. First, though, I want you to notice that the overwhelmingly biggest investment dollars are deployed to something referred to as, “Net increase in GECS financing receivables.” A portion of GE’s business is financial. I know that because I know GE. How would you have known that? You would have known it because before you were willing to invest in a business you would have read its annual report, wouldn’t you? Thought so! As you probably know by now, the world of finance was ON FIRE for many years and many firms had cash that was being pumped into these businesses in order to sustain and increase their growth. Does this make sense? So the excessive amount of investment dollars makes sense in that context. However…

What would happen if the world of finance suddenly had its fires quenched? Ouch. Chances are that GE has seen a precipitous decline in its business due to the decline in the financing business. But that is outside the scope of this post.

So how do businesses afford to expend more than they earn? The easy answer is to again compare a business to your own personal finances. How do you afford to expend more than you earn? That’s right: OPM. What is OPM? Other People’s Money. Businesses either borrow the money or get people to want to be owners in the business; in exchange for their cash new owners receive a share of ownership in the business. Ergo the next section of the “Statement of Cash Flows”: “CASH FLOWS – FINANCING ACTIVITIES.”

Step 8: Here we can see that GE raised $28,364 million net in money from outside sources. Do you see in this section the SUBJECT AT HAND? Yes, I am talking about dividends. Yay! We have finally arrived at our destination. “Flight attendants, please prepare the cabin for landing.”

Step 9: Notice that GE raised more money than its deficit? $28.4 billion raised vs. deficit of $26.7 billion. If nothing else that let’s us know that GE’s creditors have confidence in the Firm’s ability to repay its obligations, right? But that begs the question: how sustainable is it that GE spends more in investments than it takes in? The answer is that it is not sustainable forever. Eventually creditors or shareholders have to get paid back or they will stop providing capital to a firm. So as dividend investors we would want to read through GE’s annual report and be looking for language pertaining to the Firm’s investment activities and what sorts of rates of return the Company is expecting on those investments. This pattern of investment outlays exceeding cash inflows is characteristic of businesses that are growing quickly so in the short run (5-7 years) this is not alarming. Why? Because the investment outlays for GE are most likely elective. That means that they could stop them if they wanted to in order to hoard cash.

What that means is that in our evaluation of GE’s ability to pay its dividend we want to take out the elective investments being made. Does that make sense? Let’s do that now for GE.

Step 10: Generally the only non-elective investing a business has are those investments that sustain a business’s assets. If they let the quality of the assets decline then they lose the ability to make money for the firm. Think about your car and what happens if you postpone maintenance and repairs for a sustained period of time. The auto will eventually break down and stop serving you, right? Same for a business. So in the case of most businesses, it has been my experience that only 40-50% of investments are non-elective. This figure is known in the parlance as “maintenance capital expenditures,” or sometimes you will see the name, “maintenance capex.” So if we look at GE’s investments only the section entitled, “Additions to property, plant and equipment” is relevant for our analysis. So let’s apply the 40-50% maintenance capex rule of thumb to “Additions” as these are the actual necessary investments/expenditures that GE is making. So that number would be:

50% x $17,870 = $8,935 million, or $8.9 billion

How does that number compare to the cash that GE generated from its operations?

Step 11: $43 billion of cash generated – $8.9 billion of maintenance capex = $34.1 billion of free cash flow. Free cash flow is one of the most critical numbers to wrap your arms around as an investor. And here we have an estimate of General Electric’s FCF for 2007. Again, how does this compare to revenues?

Step 12: Free cash flow margin = free cash flow / revenues, or…

$34.1 billion / $172.7 billion = 19.7%

This is an excellent margin. So now we have a good grasp of whether or not GE can pay that rascally dividend. How much does GE pay out to shareholders in the form of dividends?

Step 13: Return now to the section called “CASH FLOWS – FINANCING ACTIVITIES” and note the category called, “Dividends paid to shareowners.” Did you find it? GE paid out to shareholders/equity owners/people like you and me: $11,492 million, or $11.5 billion. So how safe is that dividend? Here comes the finale…[cue triumphant music]…

Step 14: What we need is a calculation of GE’s ability to cover its dividend…[imagine Dr. Evil of Austin Powers fame]…”We will call it the, ‘dividend coverage ratio.‘ Wuh–hah–hah–hah–hah!” This is calculated as:

free cash flow / dividends paid = dividend coverage ratio…

$34.1 billion free cash flow / $11.5 billion dividends paid = 2.97x

We read this as “GE covers its dividends by 2.97 times.” That’s a fancy-pants way of saying that General Electric has almost triple the amount of money necessary to pay its dividends. Now, in a perfect world, you would want that ratio to be really high to ensure absolute safety, right? NO. The reason is that if businesses have huge dividend coverage ratios then the question becomes, “Why the heck aren’t they paying out more cash to me since they have so much on hand?” Does that make sense? So what’s an appropriate ratio. My preference, or the number that gives me comfort, is at least 3.0x coverage. In GE’s case they are right at that number. Let me definitively state it:

I am comfortable with GE’s ability to likely pay its 2007 dividends to shareholders.

Before concluding…I wanted to point out to you some timing issues that should be addressed. First, three years may not be a long enough period of time over which to evaluate a business. Why? Well again, if we are going to be collecting money from a business we want to know how it is going to do in bad years, when we ourselves are most likely to be in need of cash, right? OK, so ideally you would want to run these numbers going back between 5-7 years. That will require you to repeat the steps above for multiple years worth of 10-Ks. The question is: what degree of analysis will give you comfort enough to invest? Only you can answer that question.

The other issue of timing that I wanted to address is that we are looking at GE’s 10-K and it was published, at the time of this blog posting, almost a year ago. The data are stale. So what can we do? Well we can pull up the quarterly equivalent of the 10-K, the 10-Q and calculate the data for the last 4 quarters for which we have data. This rolling four quarters calculation is one of the BIG secrets of analyzing a business. So in this instance we would go back to GE’s 1st, 2nd, and 3rd quarter 10-Qs to calculate the same numbers as above. Does this make sense?

That ends the discussion on dividends. I hope that you find this useful. If not now, then bank it for later and know that this resource is here for you should you need it.

Respectfully,

Jason