General Electric Company and Eaton Corporation plc are both industrial companies with exposure to power markets, and they both currently sport dividends of around 3.4%, but that's where the similarity ends in terms of the investment proposition. GE has its benefits, but for dividend investors, Eaton Corporation is a better stock to buy. Here's why.
Eaton Corporation vs. General Electric
The key differences between the two can be summarized as follows:
- Eaton's 2018 dividend is significantly better covered by its forecast free cash flow (FCF), and its FCF outlook is significantly better than GE's.
- GE faces challenges to its 2018 earnings and FCF, and it's by no means certain that it can maintain its current dividend in 2019.
- Eaton has been quietly improving operating margin in the last few years, and has an outlook for further margin expansion. Meanwhile GE may have a long-term structural problem in its core power segment , given the shift toward using renewables for electricity production, rather than GE turbines.
- Eaton has some favorable end markets this year (trucks, process automation , and aerospace ), and management believes the majority of its businesses are in the early to middle stages of the economic cycle.
All about free cash flow
All these points boil down to the greater certainty dividend investors can feel about Eaton's FCF outlook for 2018 onwards compared to GE's. This is not to say that GE is not a worthy investment -- after all, the company has two top-performing segments in healthcare and aviation. Furthermore, if GE can stabilize its deteriorating power segment and significantly boost its FCF generation in 2019 from the $6 billion to $7 billion expected in 2018, then the stock has substantial scope for appreciation .
However, as you can see in the following table, Eaton's near and mid-term outlooks are more certain than GE's, and Eaton is paying out significantly less of its FCF in dividend than GE is:
2018 FCF Forecast
Dividend/FCF for 2018
Post-2018 FCF Outlook
Eaton Corporation plc (NYSE: ETN)
$2.3 billion to $2.5 billion
$8 billion over the next three years
General Electric Company (NYSE: GE)
$6 billion to $7 billion
Data source: Company presentations.
It gets worse for GE
Moreover, GE also has potential cash calls in the future from its significant pension deficit, some $28.7 billion at the end of 2017. By way of comparison, Eaton's pension deficit was $1.05 billion at the end of 2017 and, as outlined above, Eaton expects to generate $8 billion in FCF over the next three years.
In fact, GE is pre-funding its pension for the next three years by putting in $6 billion in 2018 and it's borrowing the money in order to do it. In other words its only thanks to a combination of debt and asset sales that GE is able to pre-fund its pension and pay its dividend. FCF of $6billion to $7 billion wouldn't be enough.
Moreover, GE has already lowered earnings expectations toward the bottom end of its guidance range for 2018 ($1.00 to $1.07), and it's fair to assume that FCF could come in at the bottom of the range.
It gets better for Eaton
In contrast, Eaton's recent presentation at the Electrical Products Group Conference saw CEO Craig Arnold affirming that the company is on track for its 2018-2020 goals:
- 3%-4% annual organic revenue growth, and 4%-7% annual reported revenue growth
- 11%-12% EPS growth
- FCF representing 10% of sales
- Segment margin expansion from a forecast 16.4%-17% in 2018 to 17%-18% in 2020 (Eaton's segment margin was 15% in 2015-2017)
Operating margin expansion is particularly important because Eaton's core segments -- electrical products, and electrical systems and services -- aren't typically seen as high-growth areas. For example, electrical products segment revenue only grew 3.1% from 2015 to 2017; revenue in the electrical systems and services segment was actually down 4.5% in the same period.
Which stock to buy for dividend investors?
Eaton isn't going to be a high-growth business anytime soon, and GE stock arguably has more upside potential. However, GE also has downside risk to its earnings and FCF forecasts. Moreover, Eaton's combination of margin expansion and strong FCF generation means investors can sleep safely, knowing the dividend is safe.
In a nutshell, investors in Eaton are buying a stock with a 3.4% dividend and given that 2018 FCF is forecast to be more than 7% of its current market cap, there is every reason to expect dividend increases to come -- Eaton has increased its dividend annually for over a decade. That's good enough to make it a buy for value and income-seeking investors alike.
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