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GM INVESTMENT SUMMARY

 

General Motors has received considerable attention this year and is up 20% ytd, but the stock is still significantly undervalued. I will layout a roadmap for GM’s stock to double over the next 24 months. It is a combination of higher earnings, multiple expansion and potential monetization of emerging technology assets. Also, it is important to acknowledge that this is a new management team with new ROC priorities. They have taken steps to prove that they are paying more than lip service to shareholder priorities—and have validated through asset sales and buybacks that this is not your “mother’s GM”.

 

First, anyone who’s covered the auto sector for a while may be skeptical of investing in auto OEMs. GM’s stock has not exactly been a steady compounder. But a lot has changed, and it is worth highlighting a few of these items: a pristine balance sheet, an improved cost structure, technology that could be spun out and monetized, 2+ years of beating Street estimates, conservative consensus estimates looking forward and a new management team that is focused on enhancing shareholder value. Applying a 10x multiple on $7 in core earnings and adding $10 for emerging technologies gets to an $80 price target.

 

AUTO SALES ARE NOT ROLLING OVER

 

One of the biggest criticisms with respect to investing in GM is that we are late in the US auto cycle and several analysts expect an imminent downturn. Yes, the current economic expansion is long in duration based on historical cycles, but the strength of the cycle has been relatively subdued. Note that the last trough was unusually deep and it would not be surprising to see an extended upcycle (or at worst flat sales). This is due to a healthy economy, robust employment, low interest rates and a pro-business government. In fact, recent trends are strengthening as October auto sales came in above expectations at 18.0m SAAR v 17.5m for consensus. Also, the hurricanes in August and September should play a supporting role in lifting replacement demand for the next several months.

 

Further supporting an extended cycle is the fact that the average age of both passenger cars and light trucks in the US have hit a new high. The average vehicle age is now 11.6 years up from 8.5 years in 2006. This is the highest recorded figure since IHS started tracking this data back in 2002.

 

Everyone can have their own view of the auto cycle but if either of green lines above are accurate then GM will be posting strong earnings growth for the next several years. Just for fun, let’s assume the bear case scenario comes to fruition (red line). Well, we just had a mini-test of what results might look like because volumes in N. America were down -26% y/y in 3Q17. This was a result of GM cutting production to clear inventory, which is actually a good thing with respect to 2018. During this difficult production qtr, GM still generated $5b of ebitda and $1.32 eps. If annualized, that is $20b of ebitda and $5.28 of eps—not bad. In a recession, GM claims they have reduced costs to the point where their break-even levels are half of what they used to be. They believe the N. America segment will earn money all the way down to a 10-11m SAAR. Only a true recession will prove or disprove this notion, but if management is even half correct, GM stock should re-rate higher.

 

INTERNATIONAL MARKETS ARE IN EARLY INNINGS

 

Recent results are without much contribution from international markets. South America has been losing money and just turned profitable this last qtr. This division will either improve substantially or be monetized. GM management sold their European business (Opel and Vauxhall) on Aug 1, 2017 for $2.3b. minus associated future pension liabilities. This transaction eliminated a money losing division and frees up ~$2b in cash for GM to redeploy. Also, GM invested $4.4 billion into this division over the past 3 years and that spending will no longer continue. This deal proves that management is more focused on bottom line results than in the past.

 

With respect to China, GM generated $500m of ebit 3Q17 here and this is not likely to slow down. Sales in China were +10.7% in October for GM, which supports a continuation of healthy growth and share gains. GM’s expanded electric vehicle offerings (20 new products by 2020) should support strong growth there in the years to come. GM has already demonstrated it can be successful in China with its 14% market share.

 

VALUATION – GM IS VERY CHEAP

 

GM is trading at 6.6x ’17 eps and 4x ebitda. How can this be viewed as anything but dirt cheap? The S&P 500 index is trading at 18x ’18 earnings. In looking at all stocks within the S&P 500, only 1 stock has a p/e below 6 on current year earnings. Examining GM relative to its own historical trading range, it is still on the low end (see chart below). GM’s p/e multiple has gone up over the past 2 months, but it is still well below the trading range for the past 5 years.

 

 

What if GM were to trade at 15x earnings? The stock would be at $105 on my $7 eps estimate.

 

This is not unreasonable for the following reasons:

1) GM would still be trading at a discount (~16%) to the S&P 500.

2) GM has an above average dividend yield of 3.6%

3) GM has bought back 20% of its market cap in the past 4 years.

4) GM has a 10% free cash flow yield on this year or last year. There are only 3 stocks in the S&P 500 of similar or greater market cap that have double digit free cash flow yields. At 15x, the free cash flow yield would still be 5%.

5) GM has beaten consensus eps estimates in each of the past 10 quarters.

6) GM has more cash than debt on the balance sheet (note this excludes pension and postretirement liabilities).

7) GM sold its money losing European business and took in $2.3b for it.

8) GM’s South American division has been losing money and just turned positive this past qtr. So it has been a drag on earnings and cash flow until now.

9) GM has been gaining market share across the world (see table below).

10) GM has been heavily investing in autonomous driving and electric vehicles, in addition to OnStar, Lyft and Maven. They have the ability to separate and monetize these businesses.

 

While I believe a 15x multiple is reasonable, a more conservative 10x multiple yields a $70 price target and assigns no value to their emerging technologies. Historically, GM has traded at 10x – it happened in 2011 as well as in 2013 and 2014 (see previous chart), and this was with a less shareholder friendly management team and without emerging technologies.

 

Many analysts say GM trades at 6-7x earnings because it is cyclical. Well, CAT is also cyclical and trades 18x ’18. Other cyclicals include DE at 19x ’18, CMI at 15x ’18, TEX at 20x ‘18.  Even super-cyclical airlines trade at a premium to GM at 9x ’18 eps.

 

My base case price target is $80 (+94% upside).This is made up of 10x $7 eps in ’18 plus $10 for emerging technologies and a 3.6% dividend yld.

 

GM DOWNGRADES AND SPECIFIC RISKS

 

There were 2 noteworthy downgrades since GM reported 3Q earnings. On 10/25, Morgan Stanley downgraded GM stock from overweight to equal weight with a $43 price target. The main reasons cited were general bearishness on the US auto cycle into 2019, valuation and execution risk on the autonomous strategy. Then on 10/30, Goldman Sachs downgraded GM stock to sell with a $32 price target. He is bearish on the US auto cycle, sees the pick-up truck product refresh leading to share loss in 2018 and sees more competition in crossover utility vehicles (CUVs). This has led him to project GM’s ebit to decline 22% y/y in ’18.

 

I’ve already addressed the cycle concerns, but it is worth addressing the GM pick-up truck refresh in 2018. This could dampen results, but this is a myopic view, and overall it is a good thing. GM has been taking share over the past 12 months even without their product refresh (see table below). This refresh improves the 2-3 year outlook. The company’s response to this concern is that GM has planned for this for a while and there are cost take-outs that should dampen any short-term interruption. Also, on 11/15, CEO Barra emphasized that by better utilizing their Oshawa plant they will be able to build 60,000 more trucks than last year.  Therefore, the impact of the new truck launch, which is estimated to cause 70,000 units of downtime, may not be as much of a drag on a net basis as most expect.

 

GM MARKET SHARE
		3Q16	3Q17	Chg
N. America		16.5%	16.7%	0.2%
International		9.0%	9.3%	0.3%
China		13.3%	14.2%	0.9%
S. America		15.9%	16.1%	0.2%
Brazil		16.9%	17.8%	0.9%
Source: GM 3Q17 presentation.

 

Another criticism is that there is growing competition in crossover utility vehicles. There has been and there will continue to be. When asked directly about this risk, the company said GM’s products are being well received and, in fact, they expect to continue to win share and  not lose share. GM expects to further enhance their position with the new GMC Terrain, GMC Traverse and Buick Enclave models. Just because this is a bigger portion of the market than it used to be doesn’t mean it won’t continue to grow.

 

AUTONOMOUS SPIN & VALUE

 

Right now AV (Autonomous Vehicles) are contributing zero to revenue, but adding to costs. Last conference call GM said they are spending about $600-700m a year on AV. Separating this business out will benefit GM on many levels: it will remove costs associated with ramping this business, and the market will likely assign it a high valuation. Even if it is not a “high valuation” it will definitely be higher than GM’s 6-7x p/e. Auto equities with high technology content like VC, DLPH, ALV trade 14-20x eps and of course TSLA is in a league of its own. GM management has hinted that this will be a large scale commercial operation by 2020.  Deutsche Bank assumes this division could be valued at $15b, which could mean $10 to GM’s  stock price. The Citicorp analyst has a price target with long-term upside potential to $134 and a large part of that is emerging technology.

 

EARNINGS

 

GM has beat consensus estimates every quarter for the past 10 quarters. It would not be surprising to see that trend continue. Consensus estimates have earnings declining slightly in ’18 & ’19. This conservatism sets the bar low for GM to jump over. First, analysts see  declining revenue in N. America. This may or may not happen, but remember GM is coming into ’18 with lower inventory than last year. Furthermore, on 11/15, CEO Barra reiterated her conviction in double digit N. American margins in ‘18. This is above current consensus. Also, S. American, Asia and the Finance Unit should all have higher revenue in ’18. GM is taking an additional $1-1.5b of costs out. Investments in Europe are over, so that will no longer be a drag (that was >$1b/yr). I expect ~4% of free cash flow to go toward buybacks. So when I add this all together, I see earnings growing 10% each of the next 2 years. Consensus is at $5.85 eps for ’18 and I am at $7 eps.

 

GENERAL RISKS

 

US Recession, labor strikes, rapid acceleration in material costs, a weakening dollar, execution.

 

Catalyst

1)    November 30 analyst day available on webcast.  GM will showcase some of its autonomous technology.  Unclear how detailed management will be, but they believe it will be a market moving event.   Any details that allow analysts to model this business would be a major positive.

2)    2018 guidance in January at Detroit auto show.  I think it is unlikely that GM guides below current consensus of a decline in earnings next year.

3)    Any word of monetization or separation of emerging technology assets.  This is difficult to quantify today, but could be where the real upside in this stock comes from.

4)    Additional redeployment of cash into the buyback would be positive.  GM sits on $21b of cash (33% of current market cap).  It’s good to have a cash cushion, but that is excessive.  I believe $5b could be used to reduce the share count 8% without having an adverse impact on their business.