Any investor in General Motors (NYSE:GM) can tell you it seems like the recall headaches just won't go away. So long as the company continues to recall more vehicles, it is hard to imagine shares rallying much. However, the stock is cheap on just about any valuation metric, which makes it difficult to sell shares here. If GM can get through these recalls, I do think shares have significant upside and could get back over $40. If the recalls permanently stain the brand, profits may not materialize as the company loses market share. Thus far, the brand damage does seem limited, as monthly sales continue to be relatively strong. As such, I think the best trade is to be patiently long. Recalls will cap upside in the immediate term, but over the longer term, there is significant upside.
On Tuesday, General Motors announced another recall, impacting 2.42 million vehicles and costing $200 million (details available here). With this recall, GM has recalled over 13 million so far this year, a record for the company. GM has been working tirelessly to improve the quality of its cars to better compete with foreign manufacturers like Toyota (NYSE:TM), and the increasing recalls threaten this progress. The origin of GM's recall crisis is from cars being sold a decade ago. As a consequence, the real problem was the fact that GM covered up the problem, not that new models were flawed. Some of the recalls announced Tuesday include cars being sold over the past twelve months, with problems focused on the seat belt and air bags. This could threaten the view that newer cars are much safer.
Now, ever since GM came out and said it failed to recall cars impacted by a faulty ignition switch, the company has been under intense scrutiny. GM cannot afford to not recall vehicles, even if a problem falls in the "grey zone." The hit to the brand for failing to recall another vehicle would be serious, so management is going to recall vehicles it otherwise would only have sent a safety alert to dealers about. For the foreseeable future, we live in a world where GM, and to a lesser extent the other manufacturers, will be issuing more recalls to avoid another "failure to recall" crisis. In other words, these recalls are not a sign that GM cars are increasingly dangerous.
Still, these recalls are a headwind, and some consumers may just avoid GM cars for some time. Fortunately, we are not yet seeing this. In April, GM maintained its market share with sales jumping 6.9% (details available here). Retail sales improved an even stronger 8%. In other words, these recalls have not kept customers from buying GM cars. So long as consumers don't let past problems impact their buying decisions, GM can maintain market share and grow profitability. Thus far, GM has weathered the recall storm surprisingly well.
Excluding one-time recall expenses, GM has $4 in earnings power and carries $21 billion in net cash. Shares are only 8.3x earnings and do sport a solid 3.5% dividend yield. At this price, shares are pricing in a serious deterioration in fundamentals. This deterioration is simply not happening, as the recalls don't yet seem to be keeping customers out of the show room. Until we see a drop in monthly sales, there is no reason to be a seller of GM stock. At the moment, the dividend pays you to wait, and the valuation is especially attractive. I expect the recalls to cap the upside for the foreseeable future, but over time, I expect GM to return to a more normalized valuation, which would put shares past $40. Recalls are capping upside, but not overly burdening GM's business. Unless that changes, I would remain an owner of GM stock.
Disclosure: I am long GM. 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.