General Motors: Negative Recall Reaction Is Overdone, Presents A Good Entry Point

Mar.17.14 | About: General Motors (GM)

Summary

Financial impact of the recall is unlikely to be huge.

Reputation risk is the main concern.

The market share losses from such recalls in the past have been minimal.

Shares of the Detroit, Michigan based General Motors Company (NYSE:GM) have come under pressure after the Department of Justice (DOJ) announced that it would examine GM's recent ignition recall. The company recalled around 1.6 million vehicles last month due to a defect in some models' ignition switch. The investigation relates to select Saturn/Pontiac/Chevy/Opel models sold between 2003 and 2007, and GM's decision not to issue a recall until February 13 of this year. What seems to have triggered an investigation by the DOJ was the company's negligence regarding consumer safety as the issue dates back more than a decade and has resulted in more than 12 known casualties and numerous injuries.

Although the amount of the fines or the extent to which the company is liable is still not known, we do not think there will be any significant long-term financial impacts of the recall. However, the company faces reputational headline risks that could threaten to impact GM's shares and pricing, even if temporarily.

Fixing Recalled Vehicles An Inexpensive Procedure

According to the basic cost parameters given recently by Delphi management, fixing the recalled vehicles should not cost GM much. It is an inexpensive procedure, requiring just the replacement of the ignition switch with a new one. The new parts would be available by April at GM dealerships for a free repair. In the meantime, the owners of the existing faulty models are advised to use the key alone to the ignition mechanism to prevent the sudden stopping of the vehicle as the key moves from the "on" to the "off" position. GM is also offering a discount of $500 to recalled cars' owners on the lease or buy of a new GM vehicle.

Reputation Risk The Key Negative

As mentioned earlier, the financial impacts of the recall are unlikely to be large. However, the key negative for GM is not the cost of the recall, which could be $100 million (assuming $50 per vehicle for parts, labor and associated costs for 1.6 million vehicles). In fact, the costs in reality would be less given not all the 1.6 million vehicles would be brought for repair and also the warranty provisions already recorded in the income statement would decrease the actual amount of recall costs. Likewise the fines levied by NHTSA for similar issues have been fairly small in the past [Toyota (NYSE:TM) paid $17 million for its accelerator issues].

The key negative impact is the overhang from the DOJ criminal investigation, which could take years to close and for which there is little visibility in terms of financial or other impact. The high profile house panel investigation is also negative for the company but its impacts are short term.

Although the company has offered fixes, the fact that the company knew about the major safety hazards of its vehicles and resulting fatalities, and yet waited for so long to recall its vehicles presents a significant reputational risk. The company no longer sells the recalled models but the customers might raise concerns regarding its ability to address similar problems that might occur in its current models and therefore hampering the company's future sales. The company's management needs to satisfy customers that internal issues that led to the delay in resolving the issue on hand is resolved.

Not Another Toyota

The market share losses from such recalls in the past have been minimal. Similar examples of recalls in the past include Ford (NYSE:F)/Firestone recall in 2000 (largest recall, approx. 14 million vehicles) and the Toyota recall of faulty throttle pedals, both implied DOJ and congressional investigations.

GM's apparent reaction to the initial ignition problems may have reminded the investors of the controversy that surrounded the Toyota recall. However, there aren't many similarities between the two cases. Toyota's recall was much bigger and involved vehicles that were in production, whereas GM's recalled vehicles are no longer in production. While Toyota and Audi did lose noticeable market share during their respective unintended accelerator recalls, the nature of these two recalls was different from GM's current recall. While the situation is far from an easy call, the risk of a large share loss would only come to play if the headline situation worsens or persists for many weeks to come.

Conclusion

GM's stock is overly beaten by the negative news. Although the company faces a significant reputational risk due to a decade-long delay in resolving the issue, the negative reaction was overdone. Even if we assume a huge $2.0 billion federal fine, it would still be less than the initial hit that the stock took. Following the news of the investigation, GM fell more than 5%, equal to $3.2 billion of the company's market cap. In the last three days the stock is down 8%. The reaction is simply not justified, keeping in mind all the facts discussed in the article. It provides a very attractive long-term entry point especially keeping in mind GM's cheap valuation and excessive liquidity. However, the company needs to address the all-important concern that internal issues that caused the delay in recall have been resolved.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.