General Motors Keeps Proving Doubters Wrong

We think

A stock with a strong balance sheet, good brands, and the potential to improve margins and cash flow should not be trading for 6-7 times forward earnings as GM often does. We expect price/earnings multiple expansion into the high single or very low double digits if the company delivers on its turnaround plan. Guidance for 2017 is for adjusted diluted EPS of $6.00-$6.50, about double from 2010, the year of GM’s initial public offering. For now, investors are paid to wait with what we see as an attractive and safe dividend yielding about 4.5% on shares that offer significant upside. We think GM can boost margins via cost-efficiency measures rather than relying on high top-line growth. Our valuation model actually assumes that by 2021, GM will have lost 70 basis points of retail market share in its key North America segment relative to 2016.

More Scale Is Possible Because Transformation Is Not Complete GM's move to common platforms is slow because of the firm's size and because of the time needed to develop a new vehicle, but it has been progressing since New GM's formation in July 2009. The company started its platform consolidation several years after Ford F, because GM did not think it was necessary until the U.S. government cleaned out senior management during Old GM's bankruptcy. Having one platform generate millions of units a year instead of hundreds of thousands in only one region will help GM spread its development costs over far more units. GM plans to move nearly all volume onto 13 platforms and 2 vehicle sets by 2020. By 2025, GM plans to have all of its volume on just 4 vehicle sets: front-wheel drive, rear-wheel drive, SUV, and truck. This modular production strategy will give GM maximum flexibility in shifting production among various car and light-truck segments to meet consumer tastes.

In our opinion, manufacturing costs are one of the most critical factors in GM’s turnaround, along with making great products. Primarily because of engine, transmission, and safety-related components, the front of the vehicle is 45% of GM’s material costs. For a long time, GM had treated the powertrain as a separate entity from the rest of the vehicle. Little up-front integration in GM’s development process meant a standardized approach to what it calls a cylinder set strategy. This method resulted in wasted materials because engines were developed based on having the same spacing between the cylinders, for say, a 2.5-liter and a 2.0L engine. The process resulted in a 2.0L with the engine block mass of a 2.5L, which prevented GM from getting the fuel economy it should on a small vehicle with a small-displacement engine even though it invested in research and development. GM is now starting to vary its cylinder spacing depending on the displacement size, which enables smaller engines with reduced mass.

Weight savings come not just from the engine but also from a smaller front end, which requires less steel. This change facilitates the placement of the engine to best optimize the cabin and exterior design. The transformation of the development process is also set up with the goal of zero defects. GM has done validation work on its new processes with the help of Boeing and the nuclear engineering group of the U.S. Navy. To us, this type of effort does not sound like the same old GM that never changes. These cost-cutting efforts, along with moving more parts plants closer to assembly plants, have allowed GM to reduce annual materials and logistics costs by as much as $2 billion in recent years. Including these savings, management expects to achieve $6.5 billion of gross cost reductions through 2018 relative to year-end 2014 via further material and logistics savings, platform reductions, insourcing IT, and more-efficient overhead. In January, management reported cumulative savings achieved under the plan of $4 billion relative to 2014 and expects to be at $5.5 billion by the end of 2017.

Product Also Enables Scale and Profit Growth The company's CFO pointed out in April 2015 that a turnaround is possible in its car lineup similar to what GM has achieved with its new-generation full-size pickup and SUV platform, which contributes about $1,000 more per unit in profit than the trucks it replaced. He said this is because at the time, GM's U.S. car and crossover portfolio was the oldest in the U.S. industry. That gap narrowed with the launch of the new-generation Chevrolet Malibu midsize sedan in late 2015. In 2016, the Malibu had its best retail channel sales (nonfleet sales) since 1980. The current Malibu has even won praise from Consumer Reports with the head of automotive testing saying Toyota could learn something from GM. GM's product portfolio age gap will improve considerably over the next few years thanks to GM's global launch rate accelerating after being slowed by Old GM's distress.

More-efficient manufacturing on new car platforms, such as the Malibu on the E2XX platform, along with appealing design has helped increase Malibu’s per-unit incremental variable profit by about $1,500 compared with the previous generation, and the same with the Cruze compact sedan. A longer version of E2XX supports the new-generation Buick LaCrosse sedan launched in late 2016. Cost efficiencies and a favorable mix shift to light-truck models have helped GM’s crucial North American segment increase its profit in 2016 by about $1 billion year over year. Other key vehicles to watch in 2017 are the new-generation Chevrolet Equinox, Chevrolet Traverse, and GMC Terrain crossovers to complement the new GMC Acadia launched in 2016, a new-generation Buick Enclave crossover, and a re-engineered Cadillac Escalade. In 2017, GM will go from having by far the oldest crossovers in the industry to the newest. The Escalade is also important despite low volume because these vehicle types produce profit per unit of more than $10,000 based on our estimates. GM dominates the full-size SUV segment, which includes vehicles such as the Escalade, Chevrolet Tahoe, Ford Expedition, GMC Yukon, Lexus LX, Lincoln Navigator, Nissan Armada, and Toyota Sequoia.

In our opinion, important launches beyond 2017 in Automotive News' product pipeline report are the new generation of full-size pickups in 2018 and heavy-duty versions in 2019, the possible return of the Chevrolet Blazer as a midsize crossover in 2018, a refreshed Buick Envision crossover in 2018, a new Cadillac XT3 small crossover in 2018, a new large XT7 crossover in 2019, and a smaller XT2 crossover in 2020. Management said in 2015 that full-size trucks and luxury vehicles make up about 14% of the industry's global volume but contribute about 60% of its profit. So more Cadillac offerings are critical to profitability, especially in crossovers, where Cadillac is currently severely lacking with just one vehicle overall, the XT5 released in 2016. More crossovers in both volume and luxury brands for GM is also well timed, with gas prices so low and light trucks making up 70.7% of GM's U.S. mix in 2016. In 2016, crossovers increased their share of the U.S. industry by 220 basis points, more than any other vehicle segment, to 32.2%. Profitability improvements from new products suggest to us that the increase in GM's profits and its stock is not finished.

Great Product Matters, and GM Is Getting Noticed The outgoing version of the Malibu beat the Toyota Camry in the 2015 J.D. Power U.S. Vehicle Dependability study. Malibu won the midsize sedan segment, while the sales-leading Camry finished behind Malibu and the Nissan Altima. The 2015 J.D. Power study was the first time all four of GM's brands made the top 10. For many decades, GM made rather unappealing, cheap sedans while relying on pickups and SUVs to drive earnings, a strategy that led to disaster when gas prices skyrocketed in the first half of 2008.

This product momentum continued in 2016, with accolades and sales data that many critics of American carmakers would be surprised to hear. The J.D. Power Vehicle Dependability Study released in late February 2016 saw GM post another data point indicating that its vehicles are no longer low-quality. This study focused on 2013 model year vehicles and the problems experienced per 100 vehicles. It placed vehicles into 19 possible segment categories, and GM won 8 of them, the most of any automaker. Toyota was second with six wins. All four of GM’s U.S. brands finished above the industry average, and three of the four brands (Buick, Chevrolet, and GMC) finished in the top 10. Buick finished highest among GM’s brands, coming in behind Lexus and Porsche. The 2013 Malibu won the midsize car category, while the Buick Verano won the compact car segment, beating Toyotas such as the Camry, Corolla, and Prius to do it. Toyota did come back fierce in the 2017 VDS that was released in February 2017 by winning 10 of the 18 segments versus 4 for GM. All four of GM’s U.S. brands finished above the industry average, however, with Buick fourth overall behind Lexus, Porsche, and Toyota and Chevrolet finishing eighth, besting Honda, which came in ninth, and Audi in 16th place.

In June 2016, J.D. Power released its annual Initial Quality Study, which tracks problems per 100 vehicles that owners have in the first 90 days of ownership. For only the second time in the IQS’ 30-year history, the Detroit Three had a combined lower problem level than all of their import competition combined. GM led the IQS with seven vehicles winning their segment (Buick Cascada, Chevrolet Equinox, Chevrolet Silverado light duty and heavy duty, Chevrolet Spark, Chevrolet Tahoe, and GMC Terrain), followed by Toyota with six and Hyundai and Volkswagen each with four. Kia led the overall survey with 83 problems per 100 vehicles, and Porsche was second at 84. GM’s four U.S. brands did well for the most part, with all but Cadillac better than the industry average of 105 problems (Cadillac had 112). Chevrolet finished sixth overall at 95 problems and Buick seventh at 96, tied with Lexus.

In July 2016, J.D. Power published its annual APEAL (automotive performance, execution, and layout) study, which measures “owners’ emotional attachment and level of excitement across 77 attributes,” such as power felt when accelerating and luxury feel. The attributes are then combined into an index on a 1,000-point scale, with the industry average at 801. Porsche has won the APEAL study 12 years in a row and posted an 877 in 2016. Premium brands such as Audi, BMW, Cadillac, and Mercedes occupied the first 11 spots of the results, but among nonpremium brands, all three of GM’s volume brands--Buick, Chevrolet, and GMC--finished at or above the nonpremium brand average of 794. Cadillac finished 10th overall at 836. GM won the most vehicle segments, with six (Buick Cascada, Chevrolet Camaro, Chevrolet Colorado, Chevrolet Sonic, Chevrolet Tahoe, and GMC Sierra heavy duty), while Toyota won only two for the Lexus RC sedan and the Toyota RAV4 crossover. Results like these give credence to our long-held belief that GM makes vehicles that are equal to or better than Japanese vehicles, which we think have been revered by Americans for too long for their quality, and that the quality gap between American and transplant automakers is largely only perception.

Study results are good barometers, but they do not directly bring in profit. Another data point we stressed throughout 2016 comes from actual sales, specifically retail sales over fleet sales. We prefer profits over market share, so we are encouraged that GM reduced its U.S. rental fleet sales by 18% year over year in 2016. Rental sales can hurt residual values, which in turn hurts retail sales, so we are not worried that GM’s overall 2016 market share fell 30 basis points year over year to 17.3% while its retail (nonfleet) share increased 50 basis points to 16.8%, making GM the fastest-growing automaker, according to a Jan. 4 sales release. GM’s year-to-date November 2016 incentives as a percentage of average transaction price were 11.7% versus 11.4% for the industry, so we do not see evidence of the company overdiscounting to buy market share. Only GM, Honda, and Hyundai-Kia increased retail channel volume in 2016 as the industry leveled off, which shows to us the appeal of products from Chevrolet and Buick, the two GM brands increasing retail channel volume in 2016. Buick had its best retail year since 2005, up 4.6% year over year, while Chevrolet increased 3.2%. These examples explain why we are not troubled by GM’s overall U.S. market share declining. Profits matter more than share, and GM’s share dropped because its fleet business fell 12%. New GM does not have to overproduce and overdiscount its inventory as it did under Old GM. This pricing dynamic, along with competitive products, levels the playing field from what we believe many investors are used to thinking about GM versus Japanese and German brands.

Capital-Allocation Policy Looks Favorable for Shareholders GM finished 2016 with $21.6 billion of automotive cash and $35.6 billion in total automotive liquidity. This liquidity should easily keep GM healthy in a recession and currently enables shareholders to receive a lucrative dividend and a large share buyback. We think the dividend is safe in a recession, but we do not expect GM to increase it in a downturn, since cash is king in a recession. Ever since GM announced its straightforward capital-allocation policy in March 2015, we have seen the frequent questions directed to management about hoarding cash and plans for deploying cash fall to nearly zero.

The capital allocation plan has three components: reinvesting in the business at a target return on invested capital of at least 20%, with an ROIC calculation given each quarter; maintaining an investment-grade balance sheet, with a target automotive cash balance of $18 billion outside of a recession; and returning all free cash flow above what is needed to meet these first two objectives to shareholders via buybacks and dividends.

GM defines an average recession as about a 25% decline in U.S. industry sales over two years. For perspective, U.S. new light-vehicle sales declined about 35% in total over the two years ending in 2009, when sales bottomed out at 10.43 million vehicles. That was the worst absolute number since 1982’s 10.36 million and the worst since at least 1951 in per capita terms of the number of licensed drivers. The next worst per capita year was 1958, so we think the most recent recession is not a typical delta and GM’s number is reasonable. During the recession of the early 1990s, for example, the U.S. industry declined 15% over the two-year period ending in 1991’s 12.31 million vehicles sold.

The day GM announced its capital-allocation policy in March 2015, it also announced a buyback program to initially purchase $5 billion starting immediately and ending before year-end 2016. GM completed this $5 billion buyback in the third quarter of 2016, but in January 2016, management announced an additional $4 billion buyback through 2017 for a total of $9 billion across 2015-17. At year-end 2016, $6 billion in shares had been repurchased. These buybacks, along with the annualized dividend currently at $1.52 per share, mean GM returned over $9 billion to shareholders combined in 2015-16. We think GM is more likely to buy back stock during good economic times in the United States, because cash is of critical importance in a recession. We were pleased in January 2017 to see management announce an additional $5 billion buyback authorization with no expiration, and the recently announced sale of the Opel and Vauxhall brands to Peugeot means buybacks should accelerate once that deal closes by the end of the year.

We continue to think that GM buying back shares now is a good use of its excess cash because we like to see companies buy back their shares when the stock is trading well below our fair value estimate. We think shareholders win because the buyback reduces an asset that is earning a near-zero return sitting on GM’s balance sheet while not drastically raising the risk profile. We say that because management intends to keep the balance sheet strong at all times. The company also has $14 billion of automotive credit lines it can tap in an emergency, so we think that buying back what we see as a very undervalued stock makes sense. Furthermore, returning all free cash flow to shareholders after reinvesting in the business and keeping a strong balance sheet is tough to argue against, even for activist shareholders. We would still like to see GM fund more of its pension obligations (underfunded by $18.3 billion at year-end 2016), but that does not appear to be on the table beyond the $2 billion discretionary contribution funded via bond issuances in spring 2016. Nonetheless, we think a buyback is still an excellent use of GM’s cash now.

We increased our fair value estimate by a dollar after GM’s March 6 announcement that it will sell Opel/Vauxhall to PSA Group. The increase came from the net impact of our capital expenditure spending for 2018-21 declining 4.5% from our prior model, removing an unprofitable business, cash proceeds of about $1.9 billion, selling part of GM Financial, and GM contributing $400 million (beyond issuing $2.8 billion in new debt) to fund the active employees’ pensions that will be transferred to PSA. GM will retain the retirees’ pensions, which were underfunded by about $6.5 billion at year-end.

We think it would have taken GM well into next decade to possibly bring GM Europe to meaningful profitability, so we do not mind that GM becomes less of a global automaker by selling a business that made up about 12% of its 2016 unit volume. GME has never been profitable on an annual basis in this century and has lost over $22 billion. Exchange headwinds from Brexit were going to make GME’s turnaround effort more difficult, and we can’t blame management for saying the risks of keeping Opel/Vauxhall outweigh the benefits. Once Cadillac has a more complete lineup and more cachet, GM could still re-enter Europe beyond the Cadillac and high-priced Chevrolet models it sells there now. To give GM some way to benefit should PSA succeed in turning around Opel/Vauxhall, GM receives nine-year warrants in PSA exercisable starting five years after the deal closes (by the end of 2017) with a strike price of EUR 1. The warrants equate to 4.2% of PSA shares (39.7 million shares) and are valued for deal purposes at about $700 million. GM must sell shares received via exercising the warrants within 35 days of exercise.

GM receives about $1.9 billion in cash: $900 million for the auto business and about $1 billion for the captive finance arm valued at 0.8 times book value. Add about $700 million for the PSA warrants and deduct $400 million for the pension, and total consideration is about $2.2 billion.

The pension settlement ended up being expensive for GM, but it was necessary to get the deal done and probably meant that in exchange, GM could demand PSA warrants to capture possible upside to a combined PSA/Opel/Vauxhall. The active employees’ pensions had net underfunding at year-end of $2.8 billion. GM must give PSA $3.2 billion, a 14.3% premium, to compensate PSA for assuming this liability. Most of this balance was not required to be fully funded, but PSA did not want to pay for this pension liability, which is understandable. GM will issue new debt of about $2.8 billion to fund the transfer and pay $400 million in cash on top of the debt issued. Total pension underfunding for Opel/Vauxhall was $9.3 billion but will be $6.5 billion after the deal closes.

GM expects to take a special item charge of $4.0 billion-$4.5 billion for the Opel/Vauxhall deal. Almost all of this will be noncash and mostly consists of $2.7 billion for writing off deferred tax assets, recognizing a $1.2 billion deferred pension loss, and a $400 million cash charge for the premium paid for the pension transfer. Management reduced its target automotive cash required from about $20 billion to about $18 billion due to the sale and is accelerating buybacks because of this change. We now model 2017 buybacks of $5 billion instead of $3 billion earlier this year, based on the Opel sale and management saying in late March that it expects to return about $7 billion in 2017 to shareholders, including $2.2 billion in dividends.

Things to Look for in 2017 In early April, Neil Gorsuch was confirmed to fill the Supreme Court vacancy left after Antonin Scalia died in February 2016. This may be relevant to GM because in late 2016, GM filed with the court to appeal a July 2016 appellate panel ruling that overturned a bankruptcy judge's decision that New GM is not liable for economic loss claims on ignition switch recall vehicles manufactured by Old GM. Nearly all of these vehicles were made by Old GM, so allowing New GM to be sued for this would make what we expect to be an eventual settlement much larger. A final amount is hard to estimate, but we continue to model a $7 billion reserve--about a $4 per share deduction to our fair value estimate--for future ignition recall matters. We think a Republican judge such as Gorsuch would be inclined to reinstate the bankruptcy court's ruling, although the Supreme Court has not yet said whether it will hear GM's appeal.

Something else to watch will be customers’ reaction to the Chevrolet Bolt battery electric vehicle with 238 miles of range. The car just started deliveries in California in December and will be rolled out to other U.S. markets in the first half of 2017. The car’s success or failure will give a useful data point as to whether a manufacturer other than Tesla can sell long-range BEVs in the U.S. Mobility services are also important for the next decade, and GM’s Maven car-sharing brand, which launched in January 2016, is likely to increase U.S. penetration from 17 cities presently. We expect Maven to eventually develop into an autonomous ride-hailing service for cities, so we will be looking for more news regarding Maven as well as autonomous vehicle work such as the testing program ongoing in San Francisco and Scottsdale, Arizona, and just added in Michigan. In early 2016, GM invested $500 million to acquire about 9% of Lyft, so we do not think GM is ignoring the threat of startups such as Tesla and Uber. We have been impressed by how aggressive GM management has been with investments such as Lyft and the acquisition of Cruise Automation. Old GM management would have considered investing in a startup tech firm to be beneath the automaker, or it would have killed the decision in a series of PowerPoint meetings.

New GM is more efficient and leaner than Old GM, and we think the stock is undervalued. Shareholders are paid to wait via a large dividend yield and buybacks while the company continues to generate more scale via platform and cost reductions. We think GM can continue to improve even as the U.S. market slides downward. In a downturn, it is also important to remember that over 25% of GMNA’s hourly workforce is variable, so a lower break-even point, labor flexibility, and far more competitive products across all vehicle segments than under Old GM say to us that it really is different this time. We see upside to the stock even though the U.S. market is peaking for this cycle.