Changes at GM With Exit of U.S. Treasury and Entrance of New CEO

The U.S. Treasury announced on Dec. 9 that it has sold all of its remaining common shares of  General Motors (GM), recouping about $39 billion of its roughly $50 billion loan to GM. We see this announcement as extremely good news for GM's stock--which reached a 52-week high of $41.17 on Monday--as the end of U.S. government ownership removes an overhang on the stock. While we look favorably on the changes happening at GM, we are not altering our fair value estimate or moat rating. A Canadian government entity still owns about 109.9 million common shares, or about 7.9% of actual shares outstanding on Oct. 25, as well as 16.1 million of GM's 9% Series A preferred shares. GM can redeem the Series A preferred at the end of 2014. The United Auto Workers' voluntary employee beneficiary association, or VEBA, owns another 140.4 million shares, a 10.1% stake, as well as 140 million Series A preferred shares. We expect the Canadians to exit in 2014, since we believe they won't want to own shares in a private company now that the U.S. government is out of GM. We think the VEBA will sell its shares more gradually but will indeed sell in order to diversify its asset base as well as meet retiree health-care claims.

We think GM will soon initiate a dividend on its common stock, as it has $26.8 billion of automotive cash as of Sept. 30, and management has indicated it intends to keep returning cash to shareholders. A dividend would open up GM's stock to a new institutional share base. We calculate that to match  Ford's (F) 2.4% dividend yield, GM would have to pay an annual dividend of about $0.98 a share. Based on the actual shares outstanding of roughly 1.39 billion, we calculate a cost of nearly $1.4 billion--a manageable figure, in our opinion.

New CEO Named
On Dec. 10, GM announced that CEO Dan Akerson will retire Jan. 15 and be succeeded by current head of product development, Mary Barra. We think Barra, 51, is a fine choice, and her promotion is not a surprise. GM's leadership has undergone tremendous change during the firm's restructuring, and Barra will be the fourth CEO since the company emerged from old GM's bankruptcy. The board also has changed dramatically from old GM, with about two thirds of its members new to the company, and we see only vice chairman Stephen Girsky having significant automotive experience.

Pulling Most of Chevrolet Out of Europe Should Make GM Europe More Efficient
GM announced on Dec. 5 that the Chevrolet brand will mostly be pulled out of Europe starting in 2016. The brand will still be sold in Russia and many former Soviet Bloc nations, but in Europe its presence will be limited to halo cars such as the Corvette. The move won't have a dramatic impact on GM's European capacity utilization because most Chevrolet vehicles sold in Europe are made in South Korea. GM expects to incur total net special charges of $700 million-$1 billion throughout the fourth quarter this year and the first half of 2014. Management estimates that about $300 million of this amount will be noncash, and also expects additional restructuring charges to be booked in the GMIO segment in 2014. Under GM policy, restructuring is not treated as a special item because it is considered a normal part of an automaker's operations.

According to data from the European Automobile Manufacturer's Association, Chevrolet had only 1.2% of EU27 registrations through October this year. We think GM Europe will become a more efficient segment by focusing its marketing efforts on Opel/Vauxhall and then gradually expanding Cadillac's presence in Europe.

Ally Sale Will Strengthen GM's Focus on Its Own Operations
In other GM news, media reports on Dec. 4 stated that GM intends to sell its remaining stake in Ally Financial for about $900 million. GM has held its stake of slightly less than 10% ownership in a trust since the government bailed Ally out during the financial crisis. A sale at this price would only be about a $0.50 per diluted share increase to our fair value estimate.

The Ally sale makes sense to us as the holding is a noncore asset for GM given that GM Financial is now the company's captive finance arm. Ally is undergoing an IPO that may be oversubscribed given high demand for a private placement sale earlier this year, so we think now is a good time for GM to sell this asset and focus on its own operations.

GM Exhibits Excellent Earnings Potential
We think GM's car models are of the best quality and design in decades. The company is already a leader in truck models, so a competitive lineup in all segments, combined with a much smaller cost base, leads us to think that GM will be printing money as vehicle demand recovers. Simply put, GM makes products that consumers are willing to pay more for than in the past. It no longer has to overproduce in an 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 and is about to see the upside to having a high degree of operating leverage.

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We think GM's earnings potential is excellent because it finally has a healthy North American unit and can focus its U.S. marketing efforts on just 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 saves GM about $3 billion a year; other benefit concessions and plant closings have drastically lowered GM North America's break-even point to U.S. industry sales of about 10.5 million vehicles, assuming 18%-19% share. The actual point varies based on mix and incentive levels. We think the normative demand for U.S. light vehicles is about 16.1 million-18.1 million units, so we expect GM to report excellent earnings growth as vehicle demand comes back during the next few years.

Dramatically better pricing has helped GM to be profitable at volume levels that would have meant billions in losses a few years ago. For example, the new Cadillac CTS will sell for as much as $8,000 more than the prior-generation CTS, and pricing will also be helped by the 2014 Chevrolet Impala receiving Consumer Reports' highest score of any sedan and being compared to a luxury vehicle.

Fair Value Estimate Is $56 per Share
Total-industry North American light-vehicle retail sales are a critical input to our valuation, and we have long believed that recent annual volumes were well below normative levels of demand. We model 2013 North American retail sales of 19.2 million units, 19.8 million in 2014, 20.0 million in 2015, 20.3 million in 2016, and 20.5 million in 2017 as the industry absorbs pent-up demand. Our compound annual revenue growth rate is just over 2%; we model about a point of declining market share due to continued strong competitive threats. We model the critical midcycle operating margin in the last year of our explicit forecast period at about 8%. Capital expenditure is modeled at just over 5% of automotive revenue on average.

Our weighted average cost of capital is 9.6%, and we are deducting about $3.9 billion for Series A preferred stock from our common stock valuation. Our diluted share count is 1.853 billion to reflect additional shares from warrants, restricted stock units, and equity issuances to fund the pension. We treat the Series B preferred shares as already converted because they are mandatory-convertible on Dec. 1, 2013.

Our fair value estimate, currently $56 per share, could change dramatically, given the extreme sensitivity of our discounted cash-flow model to key inputs such as North American light-vehicle sales, midcycle margin, and the weighted average cost of capital. For example, reducing our year-five midcycle margin by 100 basis points and lowering our year five North American industry sales by 1 million units, while holding all other assumptions constant, reduces our fair value estimate 13% to $49. Our fair value uncertainty is high to account for the wide possibilities in GM's fair value estimate, given its high degree of operating leverage.

Auto Industry Challenges Preclude a Moat
GM does not have a moat, and we do not expect that to change. Vehicle manufacturing is a very capital-intensive business, but barriers to entry are not as high as in the past. The industry is already full of strong competition, so it is nearly impossible for one firm to gain a sustainable advantage. Foreign automakers from China and India may soon enter developed markets such as the U.S., and South Korea's Hyundai has become a formidable competitor. Furthermore, the auto industry is so cyclical that in bad times even the best automakers cannot avoid large declines in return on invested capital and profit. Cost-cutting helps ease the pain, but it does not restore all lost profit.

We think most automakers have a negative moat trend. As the global vehicle market expands, a new firm needs to get only a small piece of the market to generate enough revenue to make the large investment in a factory worthwhile. This idea is supported by the entrance of emerging-market firms such as  Tata Motors  to the global market. Existing players will continue to find moat-building very challenging.

Risks Include Consumer Backlash to Bailout
The biggest risk to GM would be too many Americans refusing to buy its vehicles because of animosity over the taxpayer-financed bailout. If sales were to decline for many years, GM probably would go bankrupt. We consider the likelihood of this scenario 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. Another important risk is GM's underfunded pension. The plan was underfunded by $27.8 billion as of Dec. 31, 2012. In late 2010, GM contributed $4 billion in cash to the pension and an additional $2.2 billion in GM common stock in January 2011. Management does not expect to be forced to make any contributions to the U.S. qualified plan for at least five years, but that assertion is only an estimate. U.S. gas prices going well over $4 a gallon is also a risk because GM is unveiling a new generation of full-size pickup trucks and SUVs (its most profitable vehicles) in 2013 and 2014.