Should Investors Test Drive the GM IPO?

As part of Morningstar's IPO Research Services, Morningstar auto analyst Dave Whiston recently released a company report and preliminary fair value estimate ahead of the firm's public offering later this month. 

Thesis
Although the "Government Motors" stigma is likely to hang over General Motors Company for years, we think GM's car models have their best quality and design in decades. The company is already a leader in truck models, so a fully competitive lineup, combined with a much smaller cost base, leads us to think that GM will be printing money as vehicle demand recovers.

We think GM's earnings potential is excellent because the firm finally has a healthy North American unit and can focus its U.S. marketing efforts on four brands instead of eight. The most critical cost-saving measure was setting up a voluntary employees' beneficiary association for the retiree health-care costs of the United Auto Workers. This move saves GM about $3 billion a year, and other wage and benefit concessions have drastically lowered GM's North American break-even point to about 10.5 million to 11 million vehicles. (The actual point varies based on mix and incentive levels.) We think normative demand for U.S. light vehicles is about 16 million to 17 million units, so we expect GM to report excellent earnings growth as vehicle demand comes back over the next few years.

Dramatically better pricing has helped GM be profitable at volume levels that would have meant billions in losses a few years ago. The new Buick LaCrosse, for example, sells for about $7,800 more per unit compared with 2009. Simply put, GM makes products that consumers are willing to pay more for than they once did. GM no longer has to overproduce to attempt to cover high labor costs, and then dump cars into rental fleets (which hurts residual values). It now operates in a demand-pull model, where it can produce only to meet demand, and is structured to break even at the bottom of an economic cycle. We think the largest threat to profitability is Europe, which has been losing money for a long time. The S-1 gives planned GM Europe capacity reduction and annual labor cost reduction targets of 20% and $323 million, respectively.

GM stockholders have to consider politics as long as the U.S. Treasury, Canadian and Ontario governments, and an affiliate of the UAW own large amounts of GM stock. We think this ownership will be an overhang on the stock for some time, since the U.S. government is likely to sell off its stake gradually in order to get the highest possible share price to get its money back. We also expect the VEBA to reduce its stake over time, since it needs to monetize its holdings to pay retiree health-care claims. Although these concerns are valid, we see them as short-term issues. We think the company is about to see the upside to having a high degree of operating leverage.

GM repaid all of its government loan obligations in April, so long-term debt, excluding preferred stock at June 30, was just $2.6 billion, mostly from balances on credit lines for international operations. In October, GM announced a new $5 billion secured credit line, but expects it will remain generally undrawn. It also said it paid off the $2.8 billion VEBA note obligation, which was in short-term debt. We like this move since it is a gesture of good faith with the UAW, and the new credit facility probably has a much lower interest rate than the implied 9% rate on the VEBA notes. Including short-term debt, we calculate annualized debt/EBITDA for the first half of 2010 to be 0.56 times, versus our calculation of 2.38 times for  Ford's (F) automotive segment. Preferred stock is now part of the capital structure, and including the nearly $7 billion of Series A preferred stock at June 30 gives a debt/equity ratio of 0.63. In October, GM announced that, after the IPO, it will redeem all of the $2.1 billion of the U.S. Treasury's Series A preferred shares. GM also has large underfunded pension and other postemployment benefits balances at June 30 of $26.4 billion and $9.3 billion, respectively. GM said that, after the IPO, it will fund the pension with $4 billion in cash and $2 billion in GM common stock. We have assumed this stock will be issued at $27.50 per share in our valuation model, which is about 72.7 million shares.

Share Structure
The share structure of GM is common stock and two series of preferred stock. The current ownership of the 1.5 billion shares of outstanding common stock is 60.8% to the U.S. Treasury, 17.5% to the VEBA, 11.7% to an entity controlled by the governments of Canada and Ontario, and 10% to Motors Liquidation Company.

Approximately another 318.2 million common shares can be issued via warrants to Motors Liquidation and the VEBA. Per GM's S-1, the warrant exercise breaks out as follows: Motors Liquidation can acquire about 136.36 million shares of GM common stock at a $10 per share strike price any time before July 10, 2016, and it can acquire another approximately 136.36 million shares at an $18.33 per share strike price any time before July 10, 2019. The VEBA can acquire about 45.45 million shares of GM common stock any time before Dec. 31, 2015, at a strike price of $42.31 per share. Motors Liquidation also may receive up to 30 million more common shares (the adjustment shares) depending on the amount of general unsecured claims against it exceeding $35 billion, as estimated by a bankruptcy judge. GM has already determined that at least 8.6 million more shares will probably be issued to Motors Liquidation under this arrangement, which is a purchase price adjustment for the 363 sale to allow GM to emerge from old GM's Chapter 11. We calculate that as many as 23 million shares may be issued to management to settle restricted stock units already awarded. Our calculations put the maximum number of common shares at about 1.944 billion. Before old GM became distressed, its diluted share count was 1.698 billion after adjusting for new GM's 3-for-1 common stock split announced in November 2010.

The 9.0% Series A preferred stock is recorded at just under $7 billion as of June 30, but is redeemable at $9 billion (360 million shares times $25 per share liquidation value). The value will be less shortly after the IPO, since GM plans to redeem all of the U.S. Treasury's Series A for $2.1 billion. Per the S-1, 260 million of the Series A shares are held by the VEBA, about 83.9 million by the U.S. Treasury, and about 16.1 million by an entity controlled by the Canadian and Ontario governments. The dividends are cumulative, and the preferred shares also prohibit a common share cash dividend unless all accrued and unpaid preferred dividends have been paid.

The IPO introduces a new class of mandatory convertible junior preferred shares (Series B). The Series B preferred shares are not redeemable, but will be convertible into GM common stock. The exact conversion rate and dividend has not been determined, and the S-1 indicates a mandatory conversion sometime in 2013. Neither class of preferred stock has voting rights except for issues relating to changes in the terms of the preferred share class.

 

Valuation
Our preliminary fair value estimate for General Motors Company is $44 per share after factoring in the 3-for-1 common stock split. The Series A preferred were not split. We are modeling $3 billion of Series B preferred stock to be issued.

Total industry North American light-vehicle production is a critical input to our valuation. We have long believed that 2009 volume was well below normative levels of demand. We model 2011 North American production of 13 million units, and then 18.5 million in 2012. We model operating margins peaking at 11% in 2012, with the critical midcycle operating margin in the last year of our explicit forecast period at 9.5%. We model capital expenditures at 5.5% of revenue, on average. We model GM Financial at AmeriCredit's June 30 book value, but have made no other adjustments for possible future captive finance expansion. Our weighted average cost of capital is 10%, and we are deducting $9.9 billion in preferred stock from our common stock valuation. Our diluted share count is about 1.944 billion to reflect additional shares from warrants, restricted stock units, and equity issuances to fund the pension.

Our base and upside scenarios model 2011 volume higher than 2010, as well as a dramatic increase in 2012, as the industry absorbs pent-up demand. The base case forecasts peak North American light-vehicle production of 18.5 million, while the upside ($69 fair value) models 20 million, and a midcycle margin of 11.5% compared with 9.5% in the base case. The base-case U.S. market share is forecast to gradually decline to 17.5% by year five of our forecast period. The downside fair value of $13 models a much slower rate of recovery in volume, market share falling below 17% by year five, and a midcycle operating margin of 7%.

Our fair value estimate could change dramatically because of the extreme sensitivity of our discounted cash-flow model to key inputs such as North American light-vehicle production, midcycle margin, and the WACC. Our fair value estimate declines 27.2% to $32 if we raise the WACC to 10.5%, lower the midcycle margin 100 basis points, and lower our year-five North American production figure by 1 million units. Our fair value uncertainty is high, to account for the wide possibilities in GM's fair value, given its high degree of operating leverage.

Risk
The biggest risk to GM would be a scenario where too many Americans refuse to buy its vehicles because of animosity over the taxpayer-financed bailout and the government's continued ownership of the company. If sales were to decline for many years, GM would probably go bankrupt. We consider the likelihood of this scenario occurring to be nearly zero. GM can break even at near-depression-like sales volume, and it is selling more units in the U.S. with four brands than old GM did with eight brands in 2009.

Another risk comes from GM disclosing it has a material weakness in its internal controls over financial reporting. This issue has been a problem for several years now. Although we think that GM is close to correcting the deficiency, poor internal controls raise the inherent risk for problems, such as a material restatement of results due to error or fraud.

Another important risk is GM's underfunded pension. The plan was underfunded by $26.4 billion as of June 30. Management does not expect to be forced to make a material contribution until 2014, but that assertion is only an estimate. On Oct. 28, GM announced that, after the IPO, it will contribute $4 billion in cash to the pension, and another $2 billion in GM stock.

This report is made available compliments of Morningstar IPO Research Services. For more information on Morningstar IPO Research, please contact Marc DeMoss at marc.demoss@morningstar.com or +1 312 384-4052.