As a result of its bankruptcy and subsequent restructuring, GM has been radically transformed into a business with structurally higher margins and a fortress balance sheet. In coming years GM will benefit from a cyclical recovery in the US auto market, a strong new product cycle, growth in emerging markets, and growth in financial services.
GM has significant excess cash which provides good downside protection and may be used for accretive share repurchases. As memories of the “Old GM” fade and the market adjusts to the reality of “New GM”, the stock will appreciate significantly over the next 1-2 years to my estimated intrinsic value of $50 per share. This report discusses the following key reasons why GM is a long:
1. New GM is a vastly improved business
2. Tailwind from a cyclical recovery in the US auto market
3. Tailwind from GM’s product cycle
4. Strong balance sheet with excess cash
5. Growth in China
6. Growth in financial services
7. New management
New GM is a vastly improved business:
GMNA’s fixed costs have been reduced from $34bn pre-crisis to $25bn currently, and capacity utilization is now near 100%. Therefore Old GM’s vicious cycle (The constant overproduction of shoddy cars resulted in rampant price discounting and depressed resale values. This hurt GM’s brand value and sales leading to yet lower market share, and perpetuated a vicious cycle) is being replaced by New GM’s virtuous cycle. Rightsizing supply has enabled GMNA to increase base prices and reduce discounts (average unit price has increased by $2.6k since early 2010). The chart below shows the trajectory of discounts (aka incentive spending) in the all-important light truck category. Lower supply is driving improved resale value and brand perception for GM. Higher profits are being reinvested into product development which should improve product quality. Ultimately this could partially reverse GM’s market share losses (although my base case doesn’t assume large gains).
Tailwind from a cyclical recovery in the US auto market:
GM will benefit from a strong cyclical rebound in US auto sales, particularly in high margin light trucks. US auto sales in 2012 were 14.4mm. This leaves considerable upside to my normalized demand level of >17mm based on replacement demand and population growth. I assume replacement demand of 15mm annually (6% scrap rate on 250mm US auto fleet). Note that a 6% scrap rate is lower than historical levels and implies a 17 year vehicle life.
US replacement demand could exceed expectations in coming years given that the average age of cars is at a record high of >11 years (table below). While there is a long-term trend of increasing car age, the recent acceleration is likely caused by economically stressed consumers postponing the replacement of old cars. This pent up demand could be released as the economy recovers.
Pickup sales have an 80% correlation to housing starts which have been rapidly growing. Note that pickup sales have recently lagged housing starts suggesting pent up demand. Housing appears to be in the early stages of a cyclical rebound, with an annualized rate of 890k starts as of Jan. 2013, well below the longer-term average of 1.5mm (chart below). Morgan Stanley estimates that based on historical correlations, each 100k increase in starts could increase US auto sales by 200k. In addition to housing, the booming shale gas/oil industry is supportive of pickup demand.
Tailwind from GM’s product cycle:
In addition to a favorable macro backdrop, GM also has stock-specific tailwinds related to its product cycle. GM will refresh 80% of its model lineup by 2014 (40% in 2013 alone), more than any other OEM. Most significantly, GM is rolling out a new light truck platform (replacing its seven year old GMT900 platform with its fully redesigned K2XX platform). K2XX will close a competitive gap with Ford’s newer light trucks particularly in fuel efficiency (~20% improvement) and interior trim quality. Based on past experience the launch of K2XX is likely to boost GM’s market share. Although less significant to the bottom line, some of GM’s smaller car rollouts are encouraging and could help to resuscitate the brand. For example, the new Cadillac ATS (recent winner of Car of the Year award at the Detroit auto show) emulates the BMW 3 Series and represents a notable departure from the clunky Cadillacs of years past.
Strong balance sheet with excess cash:
GM has a rock solid balance sheet with substantial excess liquidity. As of Dec. 2012, GM had net auto cash and marketable securities of $14.7bn ($8.90 per share on a fully diluted basis). A large and growing cash cushion provides significant downside protection. However, GM also has a large underfunded pension/OPEB liability. As of Dec. 2012, the total deficit was $25.2bn net of tax benefits (table below). GM is working to “de-risk” its pension liability and recently completed a large transaction whereby Prudential Financial assumed $28.7bn of pension liabilities in exchange for $30.8bn of plan assets. This deficit amounts to $15.25 per fully diluted share which more than offsets GM’s net cash balance. However, it is important to note that GM’s pensions are a long-term liability with no funding requirements projected until 2017, and GM will generate substantial free cash flow in the interim.
Growth in China:
Chinese auto sales have grown rapidly from 6.7mm in 2007 to 15.5mm in 2012 (currently the largest auto market in the world). There remains considerable room for growth given that the market is still under-penetrated at 85 cars per 1000 people (vs. 812 per 1000 in the US). This gap will close as Chinese income levels rise. In 2013 the Chinese auto market is expected to grow 10% vs. 8% for the US market and a decline of 4% in Western Europe.
Growth in financial services:
Following its emergence from bankruptcy GM had no captive finance subsidiary. GM began to rebuild a financial services business through the acquisition of Americredit in Oct. 2010, and recently announced the acquisition of Ally Financial’s international operations. Pro-forma this acquisition GM Financial will have assets of $33bn and a pre-tax earnings run-rate of $1bn. When GM regains its investment grade credit rating (which management hopes will happen this year), it will be able to re-enter the prime lending market and could potentially double its finance business in coming years. Expanding GM Financial organically or through acquisitions would be a great use of excess cash, not only because of the attractive returns on auto loans, but because GM believes in-house lending services will expand auto market share.
New management is much improved. Current CEO, Dan Akerson, is an auto industry outsider willing to challenge the dysfunctional status quo. GM is executing a plan to reduce its vehicle platforms from 20 in 2010 to 14 by 2018. While old management chased market share at the expense of profitability, new management has emphasized profitability and demonstrated admirable restraint on incentives.
My $50 intrinsic value estimate is based on a simple average of P/E and EV/EBITDAP based valuation approaches. I arrive at a P/E based valuation of $46 by applying an 11x multiple to fully diluted 2014E EPS of $4.19. I use 2014E because by this year projected US auto demand is more normalized (16mm), and K2XX will be fully rolled out. My EPS estimate assumes little improvement in GME ($1.3bn EBIT loss). There is upside to my EPS estimate if the US market returns to my fully normalized assumption of ≥17mm units (each additional1mm adds $0.60 to EPS). Each 100mm of share repurchases adds $0.27 of EPS. If GM Financial doubles EBIT by expanding into prime lending ($1bn increase) this adds $0.40 to EPS. 11x is a reasonable multiple of sustainable mid-cycle earnings for a business with good downside protection. GM currently trades at a discount to most comps.
I arrive at my EV/EBITDAP based valuation of $55 by applying a 4.0x multiple to my 2014E core auto EBITDAP of $17.1bn. To this I add projected net auto cash, GM Financial at book value, foreign JVs at 10x equity income, and the present value of NOLs using a 14% discount rate. I deduct pension/OPEB liabilities net of tax. 4.0x is a reasonable EBITDAP multiple for a solidly profitable auto business, and is a discount to most comps.