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General Motors Can Be Sustainable During The Entire Business Cycle

Summary

  • General Motors is returning cash to shareholders via generous dividends and buybacks.
  • Hedge fund managers are lining up to take advantage of undervalued shares.
  • Investors remain reluctant to invest in a cyclical business that couldn't survive the bottom of the last cycle.
  • There are clues GM can survive an economic downturn; profits and margins are improving in two key markets near the bottom of their automotive cycles.

The value of a company is the total sum of cash that be extracted from it over the course of decades, after accounting for inflation. This article will explain why General Motors is only being valued at $50.6B despite its recent success enriching shareholders.

General Motors (NYSE:GM) is generating cash and returning it to shareholders. The company made $4.5B in total income over the past 12 months and returned over $4.0B of it to shareholders through dividends ($2.0B) and buybacks ($2.0B). This extracted cash represents an 8% return when compared to the market cap. Owners should be happy; however, share prices are retreating.

As the general market ignores General Motors, several famous investors and hedge fund managers are lining up to purchase shares. The following funds (manager) have substantial holding in the company.

  • Appaloosa Management's (David Tepper) largest stock holding is GM, consuming about 10% of their capital.
  • Greenlight Capital (David Einhorn) initiated a position in GM in Q1 and it accounts for about 5% of their portfolio value.
  • Berkshire Hathaway holds 41 million shares.
  • George Soros added over 700,000 shares in Q1 too. His fund now holds close to 5 million shares.
  • Hayman Parties (Kyle Bass) has over 20% of their capital tied up in GM. Kyle Bass was one of the strongest advocates of the buyback plan.

So far, these managers have watched their shares lose value. It's difficult to understand why when one looks at all the facts. Several Seeking Alpha authors are making strong bull cases:

  • Daniel Radakovich recently reported GM is outselling Ford (NYSE:F) in the high-margin truck category. The GMC Sierra and Chevrolet Silverado are overtaking the F-series for the first time in decades. If GM can retake the truck-sales crown, it could provide an additional marketing tool to further propel sales.
  • KBC Research highlighted GM's $34B in deferred tax assets. As GM continues piling up earnings, these deferred taxes will help ease the tax bill.
  • Achilles Research notes increasing operating margins in the latest quarter. Mary Barra announced a strategic plan in 2014 to achieve EBIT-adjusted margins in North America and China of 10% by 2016. Things are look good so far. More importantly, Barra has a firm grasp on the operational capabilities of the company.
  • The current trailing P/E ratio is below 12, signifying a company with flat earnings. However, GM is actually accelerating earnings.
  • Almost all authors agree a forward P/E in the neighborhood of 6.0 represents tremendous value and good growth. I'd be remiss to not reiterate this point. GM is undervalued!

The real problem with General Motors and why share prices lag is sustainability. The automotive industry is notoriously cyclical. Any OEM can flourish at the peak but companies need to prove they can remain profitable during the busts as well. At the bottom of the last cycle, GM went bankrupt (do I need to remind you?).

Toyota (NYSE:TM) trades with a trailing P/E of 11 and a forward P/E of 21. The reason Toyota trades at a premium to GM, F, or other American carmakers is resiliency. Toyota has proven they can generate and return cash to shareholders in any economy. While the Big 3 received a $25B federal loan to avoid bankruptcy in 2008, Toyota paid out $3.7B in dividends. As domestic automakers struggled or died during the Great Recession, Toyota continued returning cash; they paid out $4.3B, $1.9B, and $1.6B in dividends in 2009, 2010, and 2011 respectively. Today, Toyota's dividend yield and buyback rate is less than GM's and they still trade at a premium. Ravi Parikh believes Toyota's discipline in retaining more earnings makes them a safer bet over GM going forward. The market agrees.

Many investors think GM is overleveraged. Their debt to equity ratio is higher than industry average and it has been increasing every year since 2011. If GM can't be profitable during a trough, this overleveraging can come back to kill them. The hedge fund managers I listed above think GM can be profitable during a downturn. I agree. There are two case studies to support the thesis.

First, we should look at China. China is undergoing a scare right now. Their stock market is crashing and their currency is being devalued to discourage imports. There are signs the Chinese consumers are already starting to cut their discretionary spending; for example, GM announced July sales were down 4% Y/Y.

Unlike the United States, China's auto cycle has already passed its peak. Monthly sales are the lowest in 17 months. Therefore, if I can prove that GM can still thrive in China during a trough, I can feel safe they can handle the bottom of cycles in other markets as well. So, how is GM China doing from a financial viewpoint as vehicle sales crumble?

It's difficult to see exactly how GM China is doing because it doesn't get its own reporting segment. Instead, it's clumped with GM International Operations (doesn't include Europe or South America). However, China is the main component of GMIO, so we can induce how they're performing by extrapolating from GMIO.

As expected, sales from GMIO decreased in Q2 from a year ago. Revenue dropped 15% from $3.6B to $3.1B. However, EBIT increased 11% from $315M to $349. The ability to increase profits and margins during an economic downturn is a huge bullish indicator. For the next earnings report, keep an eye on GMIO's Q3 revenues and EBIT. Compare it with the same period last year. Expect revenues to continue decreasing. If EBIT continues increasing, this supports my thesis that GM is sustainable during the entire business cycle.

Second, we can look across the pond. Europe continues to be a bane for the Big Three. The automotive cycle in Europe is near a bottom and GM is still losing cash there. However, GM plans on returning to profitability in Europe by 2017. In the first six months of 2014, GM Europe recorded revenue of $11.6B. In 2015, revenues decreased almost 20% to $9.4B. Yikes. However, investors should look to see how GM is managing their operations there and take a look at the margins. GME lost $589M in the first half of 2014, for a net margin of -5.1%. In 2015, GME has only lost $284M, representing an operating margin of -3.0%.

It's difficult to improve margins as sales are falling due to fix costs. However, GM has managed to do so. Again, I ask investors to keep an eye on this region during the next earnings call. Look for revenues to decrease again but EBIT to increase. This is the path to profitability and will again reinforce by belief that GM can be sustainable during the entire business cycle.

I understand investors' reluctance to invest in a cyclical company that bellied up during the last trough. I believe the bad taste left in the "Old GM" shareholders mouth after bankruptcy is still haunting today's share price. Going forward, GM will need to prove they can return cash even when times are tough. I believe the business is already proving its resiliency by improving margins in China and Europe. I think the big hedge fund managers see this as well and explains why they're lining up to accumulate shares. Each quarter, I will investigate the company's operations in its "down" markets to see if they continue improving profitability. For now, I'm holding my shares and enjoying the excess cash being returned to me.


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