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General Motors (GM US)

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March 20, 2017 – Comments (0)

General Motors, the largest automobile manufacturer in North America, is characterized by its high return on capital, shareholder minded management, and the long-term growth potential of global auto market. On the other hand, the stock is trading at only 6x 2016 normalized EPS, which is close to the historical trough level since its relisting in 2010, and below most of its peers’ valuations. Behind the cheapness are investors’ concerns about earnings outlook, but these concerns are either short-term focused or overdone or both. Based on its normalized earning power, I estimate GM’s current intrinsic equity value is around $86bn, or $58 per share, implying about 60% upside of current share price. Moreover, due to the above qualities, I believe the company’s intrinsic value will keep growing in future.

Reasons of recommendation

1, Good return on capital

The reborn GM did not just come back with solvency, but with high capital returns as well. Moreover, the company has maintained and even improved such returns over the years. The ROE-adjusted, which is based on EPS-diluted-adjusted, averaged 19% in FY2012-2016 and 22% in FY2015-2016. The OROE-adjusted, which is based on EBIT-adjusted, averaged 24% in FY2012-2016 and 29% in FY2015-2016. And the ROIC-adjusted, the company’s preferred metric, averaged 22% in the past five years and 28% in the past two years. Excluding the financial services segment, ROIC-adjusted of the automotive business was more impressive, averaging 26% in the past five years and 32% in the past two years. 

*Note: EPS-diluted-adjusted is EPS-diluted adjusted by non-recurring factors. EBIT-adjusted is EBIT adjusted by non-recurring factors and includes equity income. ROIC-adjusted is based on EBIT-adjusted. The adjustments are in line with what the company discloses in annual reports, as I generally agree with the way the management makes adjustments.

Table 1: GM’s capital returns

Such track record of capital returns is superior to many of its peers, and is a result of years of restructuring efforts. Here are a few highlights: 1) At the center was the battle against labor cost rigidity, which was one of the key reasons behind the old GM’s bankruptcy. The 2007 labor contract with UAW defeased UAW retiree healthcare liabilities, introduced lower pay for new hires, and eliminated many head count inflating work rules, and the labor cost reduction accelerated further in the later bankruptcy. As a result, net US pension and global OPEB decreased by 67% from $49bn in 2007 to $16bn in 2015, and US hourly workforce by 33% from 78k in 2007 to 52k in 2015. By aggressively reducing labor costs, the company finally freed itself from the pressure to postpone investment and cut price in order to keep factories working and workers paid. 2) Largely thanks to the 2007 UAW labor contract and the bankruptcy, NA capacity was cut from 4.8m units at end of 2008 to just over 3m in 2010. GMNA now has a US industry SAAR (EBIT) breakeven even unit of 10m-11m, more than 30% reduction from the ~16m level in 2007. 3) The company has learnt to be more focused. They reduced brands in NA from 8 to 4, now having a leaner brand portfolio. Outside NA, they exited markets where they struggled to make money, with the most recent example being the sale of European business.

Going forward, the company’s effort in improving profitability will continue. It is targeting 9%-10% EBIT-adjusted margin by early next decade. The following measures should help the firm achieve this goal. 1) The company has a plan to cut annual operational and functional cost by $6.5bn through 2018 compared to 2014 level. This was revised up in Feb 2017 from the previous $5.5bn target, after about $4bn cost savings had been realized by end of 2016. 2) The company has adopted a flexible vehicle set strategy, aiming at shifting from 14 core and 12 regional architectures in 2015 to more flexible modular approach with 4 vehicle sets by 2025. It expects this strategy will save annual capex by around $2bn in long term. 3) The company is trying to grow top line and market share by product renewal and lift margins by product mix improvement. It expects the proportion of its global volume from new or refreshed vehicles to grow to 38% in 2017-2020 from 26% in 2011-2016. Crossovers, trucks and SUVs, which have higher margins and market shares/brand powers than other vehicles, are expected to increase to 52% of GM’s global volume of new or refreshed vehicles in 2017-2020 from 38% in the prior six years. 4) The company continues reviewing its regional portfolio, and may take additional restructuring and rationalization actions to improve long-term profitability. After the exit from Europe, the next targets could be South America and certain Asian markets.

2, Good management

The current management has shown a strong focus on capital returns and shareholder returns. In their capital allocation program, they make it clear that they will reinvest at 20% or greater ROIC-adjusted, maintain a strong investment grade balance sheet, including a target cash balance of $20bn, and return remaining free cash flow to shareholders. Track record of the past few years show they have done a good job achieving these targets.

ROIC-adjusted averaged 22% in the past five years and 28% in the past two years, and the company expects over 25% in 2017. The recent sale of European business demonstrated that management put profitability above top line size. The exit from Europe, where GM has been struggling for years to make money, should push up overall EBIT-adjusted margin by ~1% and free cash flow by ~$1bn. Furthermore, the exit lowers the company’s overall breakeven level, reduces its risk exposures to foreign currency, geopolitics, tightening European emission regulation, etc., and enables management to focus more on the more profitable and promising regions.

With regard to shareholder returns, the company announced in Jan 2017 purchase of up to an additional $5bn own shares with no expiration date. In the past two years, the company returned a total of $10.6bn cash to shareholders in the form of dividends and share buybacks, equal to 19% of its market cap as at the beginning of 2015. Assuming such pace is maintained, going forward annual dividends and share buybacks combined is likely to generate over 10% yield on current share price.

On the other hand, it is encouraging to see that the company doesn’t seem to be underinvesting for future. Management expects ~$9bn capex annually (before sale of GME), which is more than 5% of 2016 revenue. In addition, R&D expense has been near 5% of revenue. The company has been actively investing in ‘new trends’ such as connectivity, ride-sharing/car-sharing, autonomous technology and electrification, and has achieved industry leading position in some areas. While near-term return may be low, I think such investments are necessary for growth and competitiveness in long term.

In addition, the design of executive compensation aligns management interest with shareholders. GM’s compensation structure consists of base salary, STIP (Short-Term Incentive Plan), long-term PSUs (Performance Stock Units), long-term RSUs (Restricted Stock Units) and one-time option grant. The STIP is based on achievement of a few operational targets such as EBIT-adjusted and automotive FCF-adjusted. The PSUs are based on performance against ROIC and global market share (modifier) over a three-year period. In 2015, over 80% of total executive compensation was pay-at-risk, namely based on performance of operational metrics and share price. Over 70% of the CEO’s and around 60% of other Named Executive Officers’ total compensation was in the form of equity. A one-time option grant was also issued in 2015, of which 40% was time-based vesting and 60% was based on share price performance against peers. Moreover, under the stock ownership requirements, about 300 senior leaders in GM are required to hold company stock at a multiple of base salary for over five years, and non-employee directors are required to own company stock or DSUs (Deferred Share Units) with market value over $400k and are prohibited from selling while being members of the Board.

3, Growth potential in the long run

Investors don’t seem to be optimistic about the growth outlook of global auto industry, as suggested by the low valuation multiples of many auto makers’ stocks. However, I think despite the concerns and problems in the short term, the long-term growth potential of the industry looks promising.

In US market, the light vehicle SAAR is at ~17.5mn units, close to my estimate of the cyclically adjusted normal demand level. On per-capita basis, the vehicle sales per thousand people was 54 in 2016, close to the long-term average of the past fifty years or so. This suggests that, contrary to what many investors think, current level of demand is sustainable, and should gradually grow in long term as population grows. Moreover, the light vehicle expenditure to GDP ratio of ~3.0% in 2016 was below long-term average of ~3.5% over the past fifty years or so. The average light vehicle age of ~11.5 is at historical high and the scrappage rate of ~4.2% is at historical low over the past decade. These suggest that there may be sizable pent-up demand for new cars, which could be unleashed when economy is good and consumer confidence is strong.

Chart 1: US light vehicle sales per thousand people

Source: Bureau of Economic Analysis, International Monetary Fund

In China, while it is already the largest auto market in the world on volume sales basis, the potential of future growth remains huge. As of end 2014, China’s car ownership per thousand people was 88, which was way below the levels in developed markets and even lower than global average of 122. As a comparison, the number in US was 379, which was actually on the lower end among developed markets. While the large cities like Beijing and Shanghai are suffering traffic jam issues, many people in lower tier cities and the vast rural areas have yet to buy their first cars. The stock market’s concern about a near-term sales decline driven by the tapering of government stimulus policies may be fair, but in long term China’s market size should continue growing to much higher levels in 5, 10, or 20 years. And GM is well positioned to benefit from such secular growth as its JVs have the second largest market share in China.

Besides China, other emerging markets such as South America, India, ASEAN, Africa also offer long-term growth opportunities. GM’s leading market shares in some of these markets make them well positioned to benefit from future secular growth. 

4, Investing with gurus

It is quite reassuring to find names of investment gurus on GM’s shareholders list. Berkshire Hathaway started investing in GM in 2012, and has since raised its share to 3.3%, becoming the sixth largest shareholder. Other renowned top-class value investors who are shareholders of GM include Harris Associates (GM is its second largest holding) and Gotham Asset Management. Also, the names like Greenlight Capital (GM is its third largest holding) and Renaissance Technologies, although being different type of investors, are encouraging, too.

 

Valuation

GM’s share price is now trading at ~6x FY16 EPS (on both adjusted and unadjusted basis), below 5x FY16 FCF (= net income + depreciation & amortization - maintenance capex, assuming maintenance capex is $8bn) and below 6x if deducting pension & OPEB contributions from FCF, and ~1.3x FY16 book value despite of more than 20% ROE. This looks quite cheap on a standalone basis, as well as compared to historical mean and global peers. The average and median PER of the past five years was 8x and 9x, respectively, and current PER of major global OEMs range from 5x to 15x (excluding outliers) with an average at around 10x. These suggest significant upside of current valuation of GM by simply reverting to its historical mean or average level of its peers.

Chart 2: GM’s historical P/E

Of course there are reasons for the cheapness. In a word, investors are concerned that earnings peaked in 2016 and will fall in 2017, despite of the management’s optimistic 2017 guidance. Specifically, 1) Investors are concerned about a cyclical decline of US industry SAAR, after it reached historical high of 17.5mn unit in 2016. 2) Related to this, investors are concerned about intensifying competition in US as industry growth slows down. The recent fast rise of incentives has only exacerbated such concern. 3) Investors are concerned about a simultaneous slowdown in China, as the government’s car purchase tax cut is downsized from 5% cut in 2016 to 2.5% cut in 2017. 4) Investors are concerned about the decline of used vehicle values, which may result in residual loss on sale of off-lease vehicles. 5) Investors are concerned about policy risks, due to the protectionist tone of the new US administration.

My argument is as follows. 1) While US industry SAAR is at historical high, as discussed in previous chapter, vehicle sales per capita has just returned to long-term average level and the light vehicle expenditure to GDP ratio is below long-term average. Especially, as the average light vehicle age is at historical high and the scrappage rate is at historical low over the past decade, there may be sizable pent-up demand for new cars, which could be unleashed when economy is good and consumer confidence is strong. 2) In Feb 2017, industry incentives rose by 18% yoy, but Average Transaction Prices, which are calculated after impact of incentives, did not fall. GM’s ATP actually rose to a new Feb record. Also, the rise of incentives is nothing new. Incentives rose every year since 2013, and were up strongly by 15% in 2016, which was partly due to shift in sales mix towards larger vehicles. Despite of this, GMNA’s EBIT in 2016 was up by 9% oya and almost double of 2012 level. Looking at the big picture, the auto industry is always competitive, but in US the Top 10 makers have combined market share of over 90% and GM is the largest with 17% share. As such, it is not a very fragmented market, hence the risk of a destructive price war is limited, and GM is in good position to defend its profitability. 3) The sales fluctuation caused by change in stimulus policy is short lived in nature and shouldn’t impact long-term normalized trend. Even in short-term, the market’s concern seems overdone as China’s car sales in Jan-Feb 2017 was up yoy, supported by replacement demand from stricter emission control. 4) Despite of rising lease take rate post GFC, used vehicle value has actually been flattish. While this may change in future, I expect potential negative impact on GM to be limited. As of 2016Q4, US industry average residual realization was already in ~5% loss for cars, but still over 5% gains for CUVs/SUVs/Trucks. GM has stronger competitiveness in and higher sales exposure to the latter than the former. In 2016, US industry residual value gains fell, but GM Financial’s leased vehicle expense, which includes residual sale gains/losses, declined as a percentage of leased vehicles asset value. GM’s estimated end-2016 residual value of leased assets was $23.6bn, so a 1% drop of it will increase annual costs by less than $236mn, or 1.9% of 2016 EBIT-adjusted. While not negligible, such impact is manageable and may reverse when market conditions improve. 5) I will explain why policy risk is limited in the next chapter ‘Key risks’.

Overall, the stock market’s concerns are near-term focused and overdone. I believe GM’s 2016 operating earnings are sustainable and will continue growing in long term, as global automobile market size expands, and the company continues improving profitability and competitiveness under the shareholder-minded management.

My estimate of GM’s intrinsic equity value is $86bn, or $58 per share, implying about 60% upside of current share price. This is based on intrinsic EV of $100bn, added by end-2016 automotive net cash of $10bn and deducted by unfunded pension and OPEB liability of $24bn. The intrinsic EV of $100bn is based on normalized FCF of $10bn and a discount rate of 10%, which I think is conservative. The normalized FCF of $10bn is based on normalized net income of $9bn, depreciation & amortization of $9bn, and maintenance capex of $8bn. The fair P/E implied by my intrinsic equity value estimate is ~9.5x, which is within the range of GM’s historical P/E. If we look at it from a sum-of-the-parts perspective (although I don’t prefer sum-of-the-parts as the value of GM Financial is highly dependent on the value of the automotive business), the implied fair P/E of the automotive business and of the financial service business is ~9x and ~12x, respectively, which still look undemanding compared to their peers.

Moreover, the above estimate of GM’s intrinsic equity value is just the company’s current value based on current normalized earning power, and is likely to grow going forward. Considering the company’s high returns on capital, shareholder minded management and the long-term growth potential of global auto market, I am confident that the company’s intrinsic value will continue growing in future.

Key risks

Government policy

The protectionist tone of the new US administration has spurred concerns in the stock market. In particular, investors are worried about impact of potential adoption of the Border Adjustment Tax (BAT) and renegotiation of NAFTA. I think although there is possibility that the impact of US policies on GM will end up being net negative, such risk is to some extent priced in, and won’t significantly reduce the attractiveness of GM stock in the long run.

The probability of hardline protectionism is low in the first place. About the BAT, considering the opposition from business lobbyists, legislators including some Republican congressmen, and the reluctant attitude of President Trump, the likelihood of current proposal being adopted without significant revision looks quite low. About the NAFTA, President Trump has shown much more flexible stance towards NAFTA than TPP. While TPP was withdrawn completely, NAFTA is likely to be revised via negotiation rather than abolished.

If BAT is adopted and NAFTA is renegotiated, the impact on the auto sector including GM could be negative (over 30% of GM’s NA production is outside US). However, given the depressed valuation multiples GM’s is trading at despite strong earnings performance, such risk seems partially priced in already.

If the new US administration is indeed protectionist, then literally they should protect American businesses like GM. The GOP is said to be pro-business, and the President has also shown a generally business friendly attitude, too. So it is hard to imagine they will push through policies that will devastate companies like GM. What is likely to happen, then, is that even if some policies may hurt GM, they will reward GM’s ‘sacrifice’ with other policies. For example, US government may help domestic automakers gain market shares vs Japanese makers by being tough on Japan, such as forcing appreciation of JPY vs USD or renegotiating trade terms.  

Other Trump policies being planned, such as corporate tax cut, infrastructure spending increase, relaxation of environmental regulations, will likely benefit GM. As such, the Trump policies as a whole package may well have net positive impact. After all, be it protectionist or not, if new policies do make American economy stronger, it should benefit not hurt GM.

Interest rate

Interest rate in US has bottomed out and may continue rising for a long time. While the stock market seems to be concerned about the impact of interest rate increase on the auto industry, for GM, who has significant pension liability, such impact may be net positive.

According to GM’s annual report, a 25bps increase in discount rate will reduce GM’s end-2016 US PBO by $1.65bn and non-US PBO by $0.75bn. This is significant as total end-2016 unfunded PBO was $18bn. On the other hand, the potential impact of a 25bps increase of average interest rate on GM’s net automotive interest expense should be less than $25mn, not to say that GM’s automotive debt is fully covered by its liquidity in the first place, and also GM Financial is likely to benefit from a rise of interest rate.

The rise of interest rate will likely increase purchase cost and lower purchase power of consumers. However, if interest rate rise comes along with improving economy and sentiment, it will unlikely stop people from buying cars. Rather, rise of consumer confidence, inflation expectation and actual wages may help unleash the pent-up demand discussed above. Looking at the relation between US interest rate and light vehicle sales over the past fifty years, we can see the rise of the former didn’t have significant, long-lasting impact on the latter. For GM, its share price actually had positive correlation with US treasury yield in the past.

Oil price

Rise of oil price could lead to lower demand for automobile, especially for larger vehicles like SUVs and CUVs which GM has high exposure to. However, I think the probability of significant rise in oil price is low in the first place, considering the global shift towards cleaner energy, the abundant reserves and production capacity, and the breakeven points of oil producers. Rather, the oil price may drop further due to policies under the new US administration. Secondly, auto makers including GM have improved fuel efficiency over the years, hence the negative impact of oil price hike should be less than before. Even in the past, when oil price surged from $20 to over $100 in the ten years before the GFC, US SAAR only dropped by a few percentage. Over the past fifty years, the rise of oil price didn’t have significant, long-lasting impact on US auto sales. Finally, the risk from oil price increase can be reduced by portfolio diversification.

 

*Notes: All share price related data are dated Mar 17, 2017.

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