General Motors (GM)

Background

GM (post bankruptcy) has been written up before on VIC (JRSteelers, Dogstar, Stanley339, Ragnar0307).  Since its restructured IPO in 2010 it is up less than 6% while the S&P has climbed 60 plus percent.  Most of the catalysts/drivers for GM in the previous write-ups have come to fruition with the US government selling its stake, a healthy dividend and strong financial performance.  However, GM has managed to get itself involved in a complex product liability litigation that casts a shadow over the stock and the company’s public reputation. 

At its current price of $35, Mr. Market is significantly overpricing the litigation liability and the franchise damage caused by faulty ignition switches.  The stock trades at valuation of under 2.5 times forward EBITDA and is trading at multiples that are more inline with an S&P at 666 and not at 2000.   This long investment is premised on a multiple expansion thesis.  At a 4 EV/EBITDA multiple where F is trading, GM should be worth $45-$50.   I see 30%-40% upside with minimal downside risk in GM.  The news tape has been brutal but taking a 2-3 year forward looking perspective GM is one of the better risk adjusted trades in a market that is up over 300% from its 2009 lows. 

GM Valuation

GM is a large complicated company with a lot of operational levers.  The sell side is good in forecasting the top line for the auto companies.  Top line forecasting is aided by monthly sales numbers and channel checks.  But GM (and other large auto companies) are large complex global business bigger than the GDP of most of the countries in the world.  There are a lot of moving pieces in trying to forecast bottom line earnings and cash flows on a quarterly basis.  However, at the valuations where GM is trading I think financial performance is secondary to litigation overhang and the negative sentiment in the market.  When you are trading at 2.5 times forward EV/EBITDA on a $160-$170 bil revenue company (the size of New Zealand’s GDP) the only real way for the stock price to appreciate is the multiple to expand. 

GM long term has many financial drivers.  The main one being Europe getting to breakeven and starting to make some profits in 2016-2018 time frame.   The Bloomberg consensus for forward EBITDA is $15.6 bil. and $15.9 bil. for 2015 and 2016.  If GM can attain at 9% EBITDA margin (its goal is 10%) it should generate $15 bil plus in EBITDA and over $3 in FCF per share.  Looking forward GM should have a FCF yield 9%-10% for next 2-3 years.   So you have a sub 10 forward P/E stock, with 9-10% fcf yield, at a 2.5 EV/EBITDA multiple that has a pristine balance sheet. 

GM reporting for this year will have a lot of one off charges related to the recalls.  There is a fair bit of noise in any GM financial reporting, it is a big complex company.  But from a valuation and capital structure perspective GM today is not the company it was in 2006 – it is much cleaner leaner and financially healthier.  It is also a lot cheaper on nearly any valuation metric. 

Value Catalyst

Litigation Settlement

The scope of the GM litigation and settlement is between $3-$6 bil.  Three parts of the litigation liability; claimants, class action and US Government.   SIG on the sell side does a good job of following GM litigation.  

The claimants are parties directly injured as a result of GM's unsafe ignition parts.  GM has said there are 13 fatalities due to ignition parts.  GM management did a good move in hiring Kenneth Feinberg to set up a process to compensate these victims.  To date there have been over 100 claims.  Kenneth Feinberg handled compensation for 9/11 victims.  He is the best mediator for victim compensation.  http://en.wikipedia.org/wiki/Kenneth_Feinberg

The approach by GM to settle these claims is the right approach.  GM can litigate and try and limit these liabilities to “Old GM – the bankruptcy estate.”  But GM not paying fatalities would seriously damage its public reputation and its brands.  There is a lot of media noise and political noise around GM but there has been little consumer reaction.  GM product line is strong and sales have not been impacted by the media and political stories around the ignition issues.  It also helps that the cars impacted are old discontinued models. 

Having Feinberg sends a very strong message to claimants.  There will be a fair settlement.  GM assumes the personal injury settlement could be 400-800 mil.  I assume it will be $1 bil.  GM selection of Feinberg was the single best decision undertaken by GM management.  This issue needs to be resolved and fair compensation paid.  I expect Feinberg to settle this in 2015.

Class Action – Economic Damages.  GM is facing 90 plus class action for economic damage caused by the ignition recall.   GM is using the bankruptcy process to shield these claims.  This is going to be an overhang over GM.  Bluntly GM is in a better spot than Toyota was.  GM has the ability to use the threat of dragging this back into bankruptcy and it will till the issue eventually settled.  By the time it is settled most of these cars will be scrapped (they are already long in the tooth) and lawyers will do okay.  Settlement of $1-$1.5 bil.  using Toyota settlement ($100 per car) as a bench mark.

US Government  - this is the wild card.  Fines could be $1-$3 bil if you use Toyota as a benchmark ($110 per car) plus additional penalties for GM concealing the issue.  In reality the US government was the majority owner of GM for a good portion of 2008-20012.  The US government sold to private buyers while these issues were not disclosed.  Strangely no one in US government or Congress has asked about governance at GM when it was under US government control or disclosures to the market as its stake was sold.  I am working under the assumption GM settles with US government. 

The key point is the liability is limited, is defined and should be settled for less than 1/5 of GM’s current cash balance.  The brands have not been damaged as shown by the monthly sales data.   The negative for investors and the market is the overhang of litigation and taste of “old GM” in the “new GM”. 

Auto Cycle

I am bullish on the auto cycle.  The 2007-2008 great recession transformed US auto demand and the US auto industry.  The reduction in SARS from 17 mil. to 12 mil. was unprecedented.  This was partially driven by improved quality of autos that allowed stretched US households to extended time duration between replacement sales.    I don’t see US households as continuing a trend of driving cars/trucks till the wheels fall off.  Average age of US cars on the road will decline as US households purchase newer cars and will return to the norm of 8-9 years.  The assumption is the US consumer with improving employment, wage growth and household balance sheet will buy newer cars.  This creates demand and floor for SARs between 15-17 mil. for next 4-5 years.  Also financing has gotten much cheaper – subprime lending is back in the auto space. 

Creative Destruction from TSLA

Another large fear factor in the market compressing multiples for GM and also F is TSLA.  TSLA boasts a market valuation of $30 bil. TSLA sells fewer Model S cars than Chevy sells corvettes.  There is also a longer wait period for the new stingray corvette than the Tesla Model S.  There is a very informative thread on TSLA on VIC.

TSLA matters because there is sell side coverage overlap and TSLA also has some institutional ownership.  For sell side valuation models on TSLA to fit into any consistent valuation framework an assumption has to be made on electric cars transforming the automotive sector.  In other words, the only way to get TSLA to appear to not be a bubble stock for sell side analysts and buy side portfolio managers is by assuming TSLA is going to change the auto industry and destroy GM and F.   I am surprised the TSLA sell side analysts have not convinced their oil and gas analysts to lower the price of oil in the long term as we will be living in a world transformed by electric cars. 

TSLA by licensing its technology appears to betting that the auto industry is not going to be transformed by TLSA somehow manufacturing millions of cars.  If Google comes up with a driverless car it is going to license the technology.  The deep complex manufacturing base that GM and F (and other auto makers) matters – they are not going away.  Whatever transformation in auto space takes place will have to be evolutionary to the existing manufacturing base.  This is not the consumer electronics sector. 

Capital Structure Engineering 

GM holds too much cash and over the next 3-5 years will generate a lot of cash ($4-$5 bil. a year).  Given its current valuation there could be shareholder pressure to return that cash via a Dutch tender, special dividend or a large buyback.  The litigation overhang provides cover for GM management to wait till it is resolved.   The flip side of the litigation is that GM Board and managements behavior thru the whole ignition issue takes away their ability to do “the old GM” we know best policy.  GM with it stock trading flat in a bull market will have to address it capital structure.  GM management and Board will not have the luxury to hoard cash on balance sheet or treat GM shareholders as irrelevant. 

Conclusion

GM at $35 price fits the classic definition of an orphaned value equity – it is cheap on nearly all historic metrics.  It is cheap relative to current market metrics.  There is a litigation overhang but it is quantifiable and not open ended.  This investment requires patience and a long-term investment horizon.  But the upside is 30%-40% and with the current dividend you get paid to wait for the upside.