THE PACE OF change felt hectic inside GE, but outside its walls the absence of any signs of action was driving away investors. By the time the third-quarter results came in October, the stock was below $25, and it was quickly losing ground. GE warned that full-year cash flow from its industrial businesses would come in at just $7 billion, a massive miss of the previous projection of $12 billion.
The loss stemmed almost entirely from GE Power. As the service business had tweaked contracts to make them more profitable, it was boosting revenue and earnings but also delaying the inflow of cash. Meanwhile, the business was misreading the market for new turbines, building up expensive inventory, and further depleting its cash reserves.
The results were discouraging, and its plan for recovery was unclear. Too often, Flannery felt, the company under Immelt had failed to be adequately rigorous in making major decisions about how to spend its cash. And now, because of the opacity of GE’s decentralized structure, Flannery felt he needed more time for analysis and scrutiny of the disparate business units.
After working for years for a CEO who disliked dissent, some top GE executives found Flannery’s candid approach invigorating, but others quickly became unsettled and annoyed. Even Jamie Miller, the new CFO who had previously run the transportation division, would eventually grow weary of Flannery’s cautious approach. She was part of a group that thought he was being too negative and felt that his overcorrection for Immelt was making it harder to solve GE’s problems.
Regardless, Flannery was going to do it his way. His stubborn, deliberative approach stemmed in part from the belief that he had time on his side. CEO of GE was a long-term appointment, and Flannery felt his duty required him to make absolutely sure he was taking the correct course.
He preached that there were “no sacred cows” in his strategic review of the company portfolio. He had made a similar vow several years earlier when he led the deal-making team that moved to shrink GE Capital and sell GE Appliances. For Flannery, there was no room for sentimentality in operating a business, especially one under duress.
When the heads of GE’s major businesses presented their 2018 budget plans and projections, Flannery sent some of them back to redo their numbers and make even deeper cuts. At headquarters, he was clear that GE would be more open about its problems and that his turnaround efforts would be best measured by the company’s share price.
Mid-November came fast, and the investor update loomed for the new management team. All of Wall Street and the business press expected a major new plan for GE from the new CEO. Even though some advisers thought it was too early and worried that a final plan hadn’t solidified, Flannery, under unrelentingly heavy pressure from investors, was forced by the scheduled event to set a course.
Hundreds of investors, analysts, and reporters converged on a nondescript building in Midtown Manhattan and gathered in a wood-paneled room. The tone had been set hours earlier, as the sun rose, by a massive disclosure: GE would cut its dividend in half. Now it was time for details.
Flannery put some blame on the previous management of the Power business and alluded to Immelt’s shortcomings by declaring the failure of the so-called pivot strategy: “We’ve been paying a dividend in excess of our free cash flow for a number of years now,” he told the investors and analysts. This was a judgment that sounded even worse in plain speech. The supposed excess earnings the company had doled out to its shareholders had actually been borrowed. It was a dividend in name only.
Flannery’s admission at the investor update meeting was totally shocking. GE had been sending cash out the door to repurchase its stock but wasn’t bringing in enough cash from its regular operations to cover its dividend. GE had the finances to write those checks, but the practice wasn’t sustainable. Buybacks and dividends are generally paid for with excess cash.
Large companies regularly repurchase their own stock. The practice began in 1982, thanks to changes in securities rules. Buybacks can be a way to shrink the total shares in the market, thus reducing dividend payments; they can also offset shares issued as employee compensation. Buybacks can also shrink share counts to help nudge per-share earnings higher and, at some companies, produce healthy executive compensation.
Repurchasing stock is also a major capital allocation decision. Every dollar’s destination influences the success of the business. A dollar can be invested in the business, or spent on a deal, or used to repurchase stock.
Buybacks are controversial. Some see in them a lack of good ideas from management. Others see them as a kind of second dividend, a way to “return cash to shareholders.” The approach to deciding whether to buy back stock advised by Warren Buffett and his longtime business partner Charlie Munger has two simple prongs: a company must have plenty of capital to run its operations, and the shares it repurchases must be selling “at a material discount to the company’s intrinsic business value, conservatively calculated.”
It’s the second requirement that can be tricky. As the Berkshire Hathaway gurus note, “what is smart at one price is dumb at another.” And they flag perhaps the biggest risk of all: “Many CEOs never stop believing their stock is cheap.”
Buying back shares instead of making deals that significantly boost a company’s earnings can have disastrous consequences (assuming, of course, you would otherwise have made good deals). Repurchases provide easy money, however, if the shares are undervalued, as Buffett and Munger preach, because you are essentially buying a dollar for less than full price. But that only works if you buy when the shares are cheap.
If the shares fall, buying back shares is little different than simply setting the cash on fire. Paying a dollar for something that will be worth 80 cents in the future isn’t a great way to spend someone else’s money.
Jeff Immelt will not be remembered for wisely deciding how to spend GE’s cash. Buybacks were a regular fixture under Immelt, who spent more than $108 billion on them after 2004, when the SEC required companies to disclose their practices. At the end of 2018, GE’s entire market value was $67 billion. In Immelt’s last eighteen months as CEO, he spent almost $26 billion in cash on repurchases even as the stock fought to stay near $30 during that period. Just fifteen months later, it had dropped below $10.
When Immelt’s retirement was announced in June 2017 and the repurchases stopped, it was as though someone had grabbed the assailant’s hand. GE spent $153 million in June and only $18 million in July.