General Motors Co (NYSE:GM) was once known for its high quality of standards but it is facing controversy regarding faulty ignition switches. As a result of the faulty ignition switches General Motors recalled 1.6 million vehicles out of which 1.4 million were from the US. The catastrophe became even more serious when it was revealed by the company that it was aware of the faults in the ignition switches since 2001. The bungled recall announced by General Motors drove its stock price down by almost 5.8% since the start of this month and -16.6% year to date. The situation has caused investigations initiated by government agencies, Congress and the company itself that are all in preliminary stages. The purpose of this article is to evaluate the current scenario from an investor's point of view.
What Does the Recall Mean For GM?
Although General Motors links 12 deaths in 34 car crashes to the faulty ignition switch problem, according to the Center for Auto Safety the number is as much as 303 deaths. General Motors however is not satisfied with the way the numbers are being calculated and calls it mere speculation. General Motors will not be badly affected by the costs it has to incur regarding the recall. Perhaps it is the goodwill impairment or distortion of brand image that may damage the company the most.
Fixing a recalled car will be an inexpensive procedure without any technicalities. Owners of the recalled cars can visit GM dealerships for a free fix where a mechanic will replace the faulty ignition switch with a new one. The key part that needs to be replaced costs about $2-$5 according to its manufacturer Delphi Automotive PLC. Combining the labor costs total expenditure for General Motors equals around $8 million. There exists the possibility that Delphi itself will bear some of the replacement costs since it was the manufacturer of the faulty ignition switches. Other than the free fix, owners of the recalled cars will be offered a discount of $500 for any purchase or lease of a new GM vehicle. If owners of all 1.6 million recalled cars apply for that discount this amounts up to $0.8 billion for the auto maker. Moreover, General Motors has been sued for $6 to $10 billion over the faulty ignition switches and the lawsuit deals with the fall in value of the vehicles.
General Motors is amid multiple investigations including a federal criminal probe, a hearing by Congress and investigations by the National Highway Traffic Safety Administration and the Justice Department. All of them revolve around the same question: why did GM take so long to announce a recall regarding a malfunction in cars that it was aware may lead to drastic car crashes and fatalities? According to a note from JPMorgan, General Motors may have to pay a fine of $35 million if it is found liable for failing to report a safety related defect to NHTSA. However, General Motors' 2009 bankruptcy shields it from liabilities as a result of accidents prior to July 2009 but many lawyers are up to challenge that shield in court. The possibilities of the shield being removed are very low but on the off-chance that it becomes reality the company will have to bear huge losses. If the Department of Justice rules against General Motors the costs for the company could be significant. Toyota Motors had been known for the biggest safety controversy in the past and recalled more than 6 million vehicles due to faulty brakes after 80 deaths. Toyota had to bear almost $2 billion in terms of fines, lost sales and litigation. If the death toll remains low then we can predict General Motors will be facing liabilities of far less than $2 billion. However, the criminal investigations against General Motors may bring more liabilities for the company accordingly.
The Road Ahead
As far as the impact of the recall dilemma on the sales volume of the company is concerned I do not believe it will be significant. The main reason is because the vehicles recalled are no longer sold in the USA such as the Chevrolet Cobalt, Saturn Ion, Pontiac G5, Chevrolet HHR and Saturn Sky. Some of these brands have already been discontinued. If the quality chaos continues for some time during this year General Motors may end up losing market share but it will be short term. All of the recalled models and brands were built under the old GM and the new GM is a transformed organization that has had high quality control standards after its bankruptcy. This is indicated by the fact that the company has initiated an internal probe regarding the ignition switch recall. A comprehensive internal safety review requested by the company's CEO has led the company to recall a further 1.55 million vehicles including Chevrolet Express, GMC Savana, Cadillac XDS, Buick Enclave, GMC Acadia, Chevrolet Traverse and Saturn Outlook. General Motors is expected to charge around $300 million in the first quarter regarding the costs of repairs in newly and previously recalled vehicles. The current dilemma has given General Motors a wake-up call and thus the auto maker is tightening its quality control standards. General Motors has seen a soft start to its sales in the US for 2014 due to the severity of the climate during these months. This has resulted in a huge inventory pile up and to sell off these vehicles the company is offering huge discounts. General Motors spent almost $3,204 per vehicle in incentives during February and intends to extend it to March that will act as a shrinking agent for its margins as illustrated in the graph below. In the last three months of 2013 GM's profit margin shrunk from more than 4% to less than 3%.
Although huge discounts will be shrinking the margins for the company it will also help to sell most of the piled up inventory and introduce the company's new products with a premium price tag. According to research General Motors earns around $5,000 per vehicle with respect to its redesigned Silverado and GMC Sierra pickups and that reflects huge gains for the company. The auto giant is going to discontinue the heavy duty versions of the Silverado and Sierra during the spring season and build up production of its redesigned editions due to their heavy demand. Moreover the company is expanding in the world's emerging markets as well as in China where the rising tension between China and Japan has also been a favorable catalyst for the company. It met 20% Y/Y growth to over 255,000 vehicles a month. The company has a bolstered its pipeline with nine new models to be served in China.
From the graph below one can easily determine that General Motors has enough cash resources to pay all its recall costs and other litigations and fines. The company's cash conversion ratio is also intact illustrating that the company is generating earnings of high quality since those are translated into cash flows at an accelerating pace.
Source: Yahoo Finance
In conclusion, the financial impact of the recall will not be very significant to General Motors. However the social impact may pressure stock prices for awhile. As the spring season approaches General Motors is poised to generate sales at an accelerating pace that will bode well for the company's future. Under the command of an outstanding leader, Mary Barra, the auto giant will eventually restore its tarnished reputation transforming it into a more reliable and well managed auto maker. According to Yahoo Finance the mean target for the stock price of General Motors stands at $46.60 which implies an upward potential of around 36%. Therefore, in my opinion, investors should hold the stock regardless of the current issues. In the long run, General Motors has the guts to deliver upside potential for its investors.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Business relationship disclosure: The article has been written by a Gemstone Equity Research research analyst. Gemstone Equity Research is not receiving compensation for it (other than from Seeking Alpha). Gemstone Equity Research has no business relationship with any company whose stock is mentioned in this article.