Description

General Motors Co. (GM) common stock

Trade: long GM at $26.71/sh for potential ~6-up, 1-down risk reward (+160%/-27%) over 2-3 years.

Thesis: undervalued orphan stock due to long investor memories of “old GM,” European economic weakness and lack of inclusion in major equity indices.

Investment summary: Unlike the “old GM,” the "new GM" is cash flow generative at the trough of its cycle and poised to grow earnings from its significant product launches, unshackled union cost structure, expansion of GM financial and continued growth in emerging markets. Upside is that stock can credibly grow 2x-3x over next few years without any improvement in valuation as FCF ramp-up and capital structure transformation plays out. Credible downside protection offered by company’s recent share repurchase from the U.S. Treasury at ~$27.50/share. Beyond that, likely cyclical trough in US SAAR and recent credit facility expansion ($11bn available liquidity) protect GM stock from cratering below low $20s, which would require EPS decline of 30%. 

Investment rationale

1. Consensus valuation methods widely underestimate GM’s free cash flow generation potential

Sellside forecasts for GM and its peer group are primarily focused on non-cash valuation metrics such as price-to-earnings multiples and enterprise value-to-EBITDA. The problem with this approach is that it overlooks GM’s powerful free cash flow advantages over peers, namely the virtual lack of cash tax expense or pension cash contributions until 2019. Beginning in 2013, these combined measures will increase free cash flow by ~$5bn annually (~100% increase over 2012) and enable management to pay down debt, repurchase shares and re-invest in “smart” capex. However, sellside analysts remain anchored to target share prices within the mid-$30s by using non-cash earnings multiples rather than free cash flow generation used to pay down debt. 

2. Investors remain overly negative on GM’s European auto division

Market actors remain vocally worried about the ongoing slowdown in Europe and its effect on automakers broadly. Most recently, the fact that GM’s Opel/Vauxhall division continues to sustain operating losses and management didn’t forecast a return to breakeven until mid-decade has caused most investors to remain skeptical on GM’s overall growth potential. While valid to a certain degree, these concerns are overstated and overly punitive on the current share price. First, GM’s bankruptcy restructuring has made its European division vastly more competitive than peers. By cutting fixed-costs in capacity, headcount and selling expense, the Vauxhall/Opel group profit can breakeven at ~7mm SAAR versus 11-13mm SAAR needed for EMU peers. Second, GM Europe represents only ~14% of annual company sales and ~10% of annual earnings – a far lower figure than the percentage for Fiat, Ford, Toyota or Nissan. Finally, one could argue that markets have already priced in ongoing losses in GM’s European division and assume continued profit burn and ~20% sales declines for 5-10 years. This means European sales would need to be lower than 25% annually for over a decade for the stock to react more negatively from here; a reality which I believe positions risk – reward more for a positive surprise upward than negative. 

3. Investors are missing GM’s powerful earnings growth opportunities in trucks, EM and GM Financial

First, GM is benefitting from improving SAAR and average vehicle age jumping beyond 11 years. 2013 refresh cycle is growing, led by trucks, which are more profitable. New trucks are a ~$3.5B EBIT opportunity. Competitors don’t have as many new launches coming out in 2013, whereas about ~50% of GMs models are getting a refresh. Second, GM Financial, the company’s captive financing arm, is poised to open up attractive consumer finance opportunities and lower GM’s overall cost of funding following changes to the parent company’s credit facilities in November 2012. With GM Financial now able to tap $4bn in available liquidity across a variety of foreign currencies, GM can now provide consumer financing at attractive rates for ~80% of the company’s auto sales. Over time this should steadily boost non-automobile company earnings as consumers have the option of receiving GM at a more favorable rate. Third, in China and Latin America, GM has spent years developing a market presence there, expanding capacity and partnering with local brands. This should enable it to have a competitive advantage and maintain market share leadership over new entries by Ford, Toyota etc.

4. Structural catalysts should improve liquidity and transparency in GM’s capital structure

GM’s complex capital structure and lack of inclusion in major equity indices has prevented its natural buyer base from returning post-IPO in January 2010. As a result, GM continues to trade at a valuation discount to peers, returning -4% year-to-date while global automaker stocks are up 0-10% and trading at ~4x forward price-to-operating cash flow versus 6x-10x for peers. However, structural catalysts over the next 12-15 months, namely the remaining sell-down of the U.S. Treasury stake (~20% of market cap) and inclusion in the S&P 500 Index, should drive the share price materially higher as the stock’s natural buyer base returns and valuation discount to peers closes. Reviewing Standard and Poor’s criteria for index inclusion suggests that with its Q4 2012 earnings and initial Treasury buyback in December 2012, GM should be included in the index sometime in the coming months. Referencing stocks added post-bankruptcy in 2012 (e.g. LyondellBasell and Delphi Automotive) suggested GM could appreciate 20-25% in the months following index inclusion.

Valuation:

• Bull case:  ~$70/share (+160%) derived by forecasting FCF and debt paydown through 2015, then applying a 1x price-to-book multiple to 2015e book equity.
• Bear case: of ~$21/share (-22%) by assuming continual cash burn in European business through 2015, margin erosion, zero growth in GM’s financing unit and significant loss of market share in China and Latin America. This appears to be overly punitive given company fundamentals would have to crater ~25-40% for the stock to sink below this level.

Risks: worse-than-expected sharp downturn in European economic growth, production and cost overruns, delayed timeline of U.S. Treasury exit, inventory overhang persisting longer-than-expected, deterioration in U.S. SAAR and/or consumer spending, competitive entries in China and Latin America. 

Catalyst