- Drama around GM's major vehicle recall continues to unfold, which substantially raises the stock's headline risk.
- Empirical evidence (Toyota's recall in 2010) points to slim probability of a long-term reputation damage.
- GM is now valued as a "structurally challenged company" (below 10x 2014 P/E).
- This is clearly unjustified, in my view, given 1) the US auto industry recovery and 2) GM being a true multinational company.
The big news impacting General Motors (NYSE:GM) recently (and still ongoing) is the big vehicle recall. In mid-February, GM announced a recall of only 778,562 Chevrolet Cobalts and Pontiac G5s in North America because of an ignition switch problem. By late February, the ignition switch recall expanded to 1.6 mn vehicles worldwide. Last week (Mar 17), GM recalled an additional 1.7 mn vans, SUVs and Cadillac luxury cars to fix a variety of problems. Hence, 3.3 mn vehicles have been recalled since mid-February, with most of them produced in the US market. Moreover, other negative headline news came such as Congress investigating the GM recall, GM detecting ignition switch problems dating back to 2001, and rival Toyota Motors (NYSE:TM) paying $1.2 bn to settle the US probe due to its big vehicle recall in 2010. This all pretty much explained in GM's 14% share price decline YTD (vs. S&P 500's 1% gain) or 16% decline from its all-time high ($41.53/share on Dec. 17, 2013). In this article, I would like to examine 1) the impact of big vehicle recalls from an empirical data point perspective and 2) GM's valuation as what I call a "structurally challenged company" valuation.
Let the data speak
First of all, to examine the impact of big vehicle recalls from a data point perspective, I conducted data on two major vehicle recall events in the auto industry. This would serve as a good analogy to GM's recall. The first one (more similar to GM's recall) was Toyota's pedal entrapment and sticking accelerator pedals recall in late 2009 to early 2010. As of the end of January 2010, Toyota recalled approximately 9 mn vehicles worldwide, with most of them produced for the North American market. The second analogy was Ford's Firestone tire recall (US market only) happening in August 2000. Approximately 6.5 mn Firestone tires used in Ford (NYSE:F) vehicles were recalled. As a precaution, Ford also replaced an additional 13 mn Firestone tires on Ford vehicles in May 2001.
In short, my key finding is that the impact of major vehicle recalls is primarily short term (no long-term reputational damage). As an illustration, Toyota's vehicle sales volume in North America in 4Q09 and 1Q10 were 642K and 551K units, respectively. Assuming 597K units (average 4Q09 and 1Q10) as normalized sales volume prior to the big recall, it took 8 quarters (1Q12) for Toyota to reach back its normalized volume. After 1Q12, Toyota's sales volume hit a minimum 600K units/quarter in North America. Worth mentioning is that during 1Q10-1Q12, there were 2 quarters of production disruption (2Q11 and 3Q11) owing to March 2011's big earthquake in Japan. As a matter of fact, 4Q11 volume (579K units) was close to normalized volume. Net-net, I could infer that it would've taken Toyota a shorter time (6 quarters) to reach back normalized volume, adjusting for the earthquake's impact.
(Source: Toyota Motor's 10-K and 10-Q forms in 1Q08-4Q13)
As for Ford's recall case, I got to look at yearly data due to lack of reliable quarterly data disclosures back in early 2000s. (Note Ford changed the way it classified its vehicle sales volume breakdown per region basis a couple of times. This resulted in me not being able to reconcile it on a quarterly basis). The yearly number here appears to support a view that Ford's recall was the big reason for a plunge in its vehicle sales volume in the US, from 4.2 mn units in 2000 to 3 mn units in 2005 (7% CAGR contraction). Even after a strong recovery from the 2008-09 Great Recession under CEO Alan Mulally (who engineered the turnaround), Ford's US sales volume stood at only 2.5 mn units in 2013. But, what had really transpired in the first half of the 2000s decade, which accounted for Ford's volume nose-dive, was that Ford misread the consumer trend (moving toward fuel efficient and cheaper cars). In early 2000s, Ford made a strategic decision to continue its focus on producing big vehicles at higher-than-peers prices.
(Source: Ford's 10-K forms in 1998-2013)
"Structurally challenged company" valuation justified?
Largely as a result of negative headline news adversely impacting its share price, GM now trades at 9.3x 2014 P/E (note: GM's earnings are based on Bloomberg consensus estimates), a 19% discount to rival Ford. 10x P/E valuation or below is what I consider "a structurally challenged company" valuation. Examples of well-known companies with below 10x P/E are Hewlett-Packard (HPQ, 8.6x 2014 P/E), American Airlines (AAL, 7.7x), Staples (SPLS, 9.4x) and Xerox Corp. (XRX, 9.9x). I think we can agree on these companies operating in a structurally challenged environment/industry.
The big question, of course, is whether GM operates in a structurally challenged industry, thereby deserving a structurally challenged company valuation as it trades now. The threat of long-term reputational damage due to the big vehicle recall described above may be the icing on the cake. But, Toyota's and Ford's experience with major recall events reveal a slim probability of long-term reputational damage on an auto company.
Looking at the US auto industry, its three-year vehicle sales volume CAGR in 2010-13 was a strong 10.4% (partly helped by low base effect) due to the continued recovery from the 2008-09 Great Recession. Looking further back, I could see industry volume stabilize at the 17-17.5 mn range (which happened in 1999-2005). Hence, 2013's 15.9mn vehicle sales in the US remains 7-10% lower than the 17-17.5 mn range, indicating low single digit CAGR potential the next few years. This is certainly not an industry in a structural decline phase. Even at its peak years (1999-2005), it is a flattish industry (replacement demand sustaining flat volume).
(Source: GM's and Ford's 10-K forms in 1999-2013)
To play devil's advocate, let's assume I agree on the bearish argument the US auto industry is in a structural decline beyond 2016, which justifies the below 10x P/E valuation for GM. What's overlooked in this argument, in my opinion, is that GM is much more than a US play only. In fact, the US accounted for only 29% of GM's total vehicle sales volume in 2013. The developing world (mainly Asia and S. America) has contributed 51% of GM's total vehicle sales volume. Moreover, this proportion has risen from the 33% level in 2008, indicating GM's greater clout in the developing markets. I believe we all could agree that the developing markets are far from saturation points. In 2010-13, GM's vehicle sales volume in developing markets rose by a 7% CAGR (note: this was achieved without a low-base effect). Hence, a conclusion that GM operates as a structurally challenged company is far-fetched, in my view, especially considering that GM is a real multi-national company, just like Coca Cola (KO, 18.3x FY14 P/E), Procter & Gamble (PG, 18.4x), McDonald's (MCD, 16.4x), Apple (AAPL, 12.4) and the likes.
(Source: GM's 10-K forms in 2008-13)
GM's ongoing debacle of major vehicle recalls has substantially raised headline risk on the stock. However, looking closer from an empirical data perspective (particularly Toyota's big recall in 2010 as analogy), I draw comfort that major vehicle recalls do not bring about long-term reputational damage when appropriate responses are undertaken. More often than not, a big strategic decision, not recall events, would determine the long-term fate of an auto company. For example, Ford misread consumer trends in early 2000s as a reason for its volume plunge. Moreover, GM's 9.3x 2014 P/E valuation (partly owing to rising headline risk) indicates that the market has classified the company as a structurally challenged company. I believe this is unjustified on two counts: 1) US auto industry is on the path of low-single digit CAGR the next few years and 2) GM is a true multi-national company, with rising developing market sales opportunities.
Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in GM over 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.