GM Needs to Stay Together

Speculation surrounds General Motors’ GM stock following a call to spin off the company’s battery electric vehicle business. The idea sounds sexy, as many BEV startups are either going or about to go public this year. The stratospheric rise of Tesla’s stock, with a market capitalization recently approaching triple the value of Toyota, also makes the idea seem compelling. However, GM is a stock the market loves to hate, and we see no guarantee that a spin-off will get the same irrational (in our view) favorable valuation treatment that BEV startups are.

Branding would be an issue, as the spin-off would need to either pay GM a royalty to keep using brands such as Buick, Cadillac, Chevrolet, and GMC or create its own brands from scratch. Also, GM’s BEV business is not carved out internally from the rest of the company the way its Cruise autonomous vehicle business is. That can change, but it takes time, and we think it would be a distraction for management. We expect many BEV startups will fail as they struggle to get one or more vehicles to market at scale. Even Tesla has not reached the requisite scale to generate sustainable profitability without its lucrative sales of emission credits. Therefore, we believe GM’s BEV business will be better off under the protection of GM than out on its own constantly raising capital.

We think GM’s long-term plan is to spin off Cruise and over time transition to a BEV maker via the profits from the internal combustion engine business. We see ICE profits leading to annual free cash flow of at least $10 billion after the recession. If GM spins off the BEV business now, then the ICE business--also known as the stub in spin-off parlance--would eventually go bankrupt, in our opinion, assuming ICEs became obsolete long term. The stub could pay a lucrative dividend to entice ownership, but long term we think it’d be hard to justify owning it. Keeping the company together until a Cruise divestiture is the best way to preserve the long-term viability of all stakeholders, in our view. We hope the board does not decide to chase the hype of Wall Street financial engineering and place the future of many GM stakeholders in jeopardy.

We do see potential for large share price appreciation with a spin-off announcement, but it’s not guaranteed. The spin-off idea became public domain on July 29 when GM reported earnings. The stock fell 4.3% that day, suggesting the market does not like the idea or does not think it’s likely. GM’s stock has outperformed the S&P 500 since July 29, but it’s not skyrocketing like Tesla’s recent run. Also, if we are right that there is a bubble around BEV stocks now, a spin-off could see its stock come crashing back down within a year or two of the spin. That is a problem because GM does not have someone with the charisma of Tesla CEO Elon Musk to raise capital. By staying intact, GM can gradually wind down ICE operations as BEVs become a larger part of its sales mix while still having what we expect will be ample cash flow to resume its dividend and buy back stock.

GM as it exists today has the earnings power to support a higher valuation. Once the economy recovers, we think GM can generate $7-$8 in diluted earnings per share because 2019 earnings of $6.71 excluding the United Auto Workers strike show it’s already nearly there. At $7.50 EPS and an unlofty multiple of 7 times, GM’s stock would trade in the low $50s, offering over 60% upside from its current price.

There's Theoretical Upside in a Spin-Off, but We're Unconvinced In our sum-of-the-parts valuation of GM, we separate the Cruise AV business so investors can think about GM's BEV business stand-alone, but we think a spin-off would have to include Cruise because GM has made it clear repeatedly the past few years that all AVs are BEVs. We assume no change in Cruise's value since the $19 billion implied valuation from its last capital raise in May 2019 and use that figure to value GM's 82.7% ownership in Cruise.

We assume the legacy ICE business would keep GM Financial (this would be the so-called stub post spin), and we use what we consider to be a conservative multiple for the stub of 3 times $10 billion of free cash flow including GM Financial. This $10 billion may be conservative because we think the auto business alone can do $10 billion by the end of our five-year forecast period in our model, and GM Financial is not quite yet a fully mature captive finance arm. When it is mature around 2023-25, management has said to expect 100% of pretax income dividend back to the auto business, which would mean about $2.5 billion from the finance arm alone per GM’s 2020 outlook presentation on Feb. 5. In 2020, GM Financial paid a dividend of $800 million to the auto business, all in the first half of the year. We use a conservative multiple for the stub because the market seems to rarely like GM, and the stub without Cruise or BEVs could be seen as a long-term zero-value business by the market should the world fully move to BEVs several decades from now.

Finally, for the BEV spin-off, we use a price/sales multiple, including possible unconsolidated revenue from Chinese joint ventures, because even though GM guides for the vehicles using its new Ultium batteries to be profitable, we wanted to equate the spin-off to lofty valuations given to companies like Tesla or BEV startups, which are either unprofitable or, in Tesla’s case, often only profitable for now via selling emission credits. In a rosy scenario where the spin-off gets favorable sentiment from investors, we calculate that GM’s stock would trade between nearly $60 per share and $140 per share, a massive premium to its current trading levels.

This valuation to us is similar to a best-case scenario, but there are several reasons we don’t like the idea of a spin-off.

GM's Spun-Off BEV Business Might Not Achieve Startup Valuation Status First, there's no guarantee that a GM BEV spin-off gets treated like a startup or Tesla. The market may for once be practical about valuing a BEV maker and say its future is highly uncertain and capital-intensive. Then GM would have carved out its future growth story of BEVs and AVs with no benefit to shareholders. Related to this point, if BEV startups are presently in a bubble, which we think they are, then a GM spin-off could see its stock price eventually crash hard. Although we think well of GM's BEV leaders, we see no one who can garner Elon Musk levels of charisma and hype for constant capital-raising like Tesla has done for years. GM's BEV efforts and several future BEV products are not a secret; the market is not seeing these as sufficient to compensate for also being a combustion automaker, so why would a spun-off BEV business suddenly be worth many tens of billions right away? If the spin-off gets no lofty market valuation, then GM has cast off its future business and both the spin and the stub would be stuck in the mud, so to speak.

GM's ICE Business May Be Left for Dead The second reason we oppose the spin-off is that it may doom the stub long term. We expect that the stub would for years have strong free cash flow generation, but longer term, the ICE business would likely get smaller and smaller as BEVs and hybrids gain market penetration over several decades. The stub could use its free cash flow to pay a generous dividend, but the overhang of eventual ICE obsolescence would remain, in our opinion. We think that barring new business lines, there'd eventually be nothing left and the stub would go bankrupt and never exit bankruptcy, instead liquidating in a Chapter 7 filing.

Carving Out the BEV Business Is Easier Said Than Done Another reason we oppose the spin-off is that we believe the BEV business today is integrated into the rest of GM's design and product development. Separation, though not impossible, would be an administrative burden that we'd rather management not be distracted with. There is no separate BEV business the way GM has separated Cruise. A spin-off would have to pay GM to license its brands or take a risk creating new unknown brands to consumers, because GM's current plan is to have ICE and BEV vehicles for brands like Buick, Cadillac, Chevrolet, and GMC. In a Sept. 18 article, The Wall Street Journal cited an interview with GM CEO Mary Barra saying that engineering job cuts announced in late 2018 were to allow "GM to meld its electric vehicle team with the broader engineering enterprise." That to us supports our opinion that GM's BEV business is integrated into the rest of the company rather than running as its own siloed entity that can be quickly spun off.

Cruise Is a More Likely Spin-Off Candidate If GM is going to spin off or sell any business, we think it will be Cruise because the AV maker has its own leadership. Also, Cruise is its own segment within GM and geographically isolated from the rest of the company by operating in San Francisco and other locations in the Western United States. It does not have manufacturing operations. Cruise's Origin AV ride-hailing vehicle unveiled early this year will be made at GM's Hamtramck plant in Detroit, which could still easily happen if Cruise were divested. Hamtramck is receiving a $2.2 billion investment to become a dedicated BEV facility to make the Origin and Hummer BEV pickup. Also, the terms of the initial SoftBank investment in Cruise in May 2018 state that SoftBank can exchange its Cruise stake for GM common stock, or cash at GM's discretion, if Cruise has not completed an initial public offering, spin-off, sale, or dissolution within seven years. This clause does not guarantee a corporate action with Cruise, but it suggests some sort of divestiture no later than 2025, perhaps once Cruise's AV ride-hailing business is up and running.

Leaving GM Intact Is the Best Path for Long-Term Value Creation We think management's plan for a long time has been to build Cruise into a viable AV customer that it can then spin off. In the meantime, GM would be set up for the future by using free cash flow from selling its lucrative ICE light trucks to transition into a BEV maker. A BEV spin-off is trying to make that transition happen immediately, but it sets the stub up for having no future, in our opinion. Although it's not sexy financial engineering for GM to stay together versus a BEV spin-off, we think it's the right move to ensure that all areas of GM (ICE, GM Financial, Cruise, and BEVs) are set up to thrive for decades to come. We think the coming BEV portfolio with vehicles such as the Cadillac Lyriq crossover from GM will be far more appealing than the subcompact Bolt car (for now GM's only BEV in the U.S.) and will be competitive with Tesla's vehicles, which we think still lack interiors worthy of their price point. The cash flow from the ICE business enables GM to fund the BEV story without constantly having to raise capital like Tesla has over the years.

GM can use the ICE business as the underappreciated asset it is to fund its eventual transition to a dedicated BEV manufacturer, while many BEV startups we expect will likely struggle to get to market, reach scale, and survive. Look how many years and billions of dollars in capital raises, including a last-minute investment by Toyota and Daimler years ago, it’s taken Tesla to get to 2020, where it’s hoping to sell 500,000 units this year (first-half 2020 deliveries were about 180,000). Tesla has raised over $7 billion this year alone. Even Tesla still has a way to go to get meaningful volume, and we think it’s far ahead of startups such as Bollinger, Byton, Canoo, Faraday, Fisker, Karma, Li Auto, Lucid, Nikola (soon to be backed by GM), Nio, Rivian (backed by Amazon, Ford, and Saudi interests), Seres, Xpeng, and Lordstown Motors. GM is investing $75 million in Lordstown Motors, which plans to go public in late 2020 and sell a BEV pickup truck, the Endurance, next year with design and technology licensed from Workhorse Group targeting commercial fleet customers. GM’s throwing its BEV business into that fray may lead to a large valuation based on nothing but future potential, but we think it’s irresponsible to jeopardize the ICE business’ future, and there is no guarantee that the spin-off would receive startup treatment. A spin-off would likely have UAW labor and be the only BEV company, along with perhaps Lordstown, with that, which the market may not like. Keeping the two businesses together is the best path for long-term viability of all GM stakeholders, in our view, plus GM has the option value of Cruise’s AV story, which could still be spun off.

GM’s BEV business is not getting the credit it deserves, so a spin-off does have the potential to unlock value. However, even if the best case happens and a spin-off announcement causes the stock price to jump to nearly $60 or more, there’s no guarantee that the spin-off stays favorable to the market post spin; plus we believe the stub would be doomed long term, though highly free cash flow positive immediately post spin.

We believe keeping the ICE and BEV businesses together is the best course of action because it allows GM to fund the BEV business without constantly needing to access outside capital as a spin-off likely would. Staying together also allows GM to become a dedicated BEV maker as BEV demand gradually increases over the next couple of decades. If demand increases at an accelerating rate, GM will by then have ample BEV product in place and can just allocate more production resources to BEVs. A reduction in drive configurations via BEVs’ lower complexity (19 battery and drive unit combinations versus 550 ICE powertrain combinations now) and focus on highly profitable light-truck models are, in our view, the right moves to fight the impact of current lower volume from the downturn and set GM up to thrive after the recession. We think GM’s BEV portfolio will look far more enticing over the next two to three years, and we expect the market will eventually reward it for making vehicles competitive with Tesla while reducing costs. These actions will enable GM to do what BEV startups cannot do: make product at scale and generate large free cash flow.