A Second Bite at GM - Looking Even Better After Ford's Results

Includes: F, GM
by: Adnan Zaman
It's not every day you get a second bite at an investment opportunity that looks even better than the first. If you were disappointed about missing out on GM's IPO, now is your opportunity to buy the shares at a discount to the IPO price.
After quickly climbing to near $40 from the IPO price of $33, GM shares retreated all the way down below $30 when a confluence of negative news and events pressured the shares. First came the messy Q4 results suggesting profitability was not as sure as people thought, then came the unrelated departure of the CFO, followed by higher incentive payouts, higher oil prices affecting sales of trucks, and, ultimately, fears that supply disruptions from the Japan earthquake and tsunami would affect the American automakers as well. Though each of these are concerns, even in aggregate, they don't warrant GM's current valuation.
Both GM and Ford (NYSE:F) are on the path of a multi-year recovery from the nadir of the recession, when GM was begging for bailout dollars. They've both come a long way from those embarrassing days of being questioned about how the CEO traveled from Detroit to D.C. and so forth. At the time, it seemed that these companies could never compete with the Asians or the Europeans, and that they could never turn a profit.

Both companies have been posting impressive sales and production figures as they've refreshed their line-ups and removed a number of underperforming models and brands from their portfolio. In addition, they both boast healthy balance sheets and an improving pension liability situation. GM, having accepted bailout funds, is in a much better position, both from a balance sheet point of view and from a dealer network point of view. In addition to these advantages, I prefer GM for a number of other factors I discuss below.

Though I've felt that GM is a compelling investment story for weeks, Ford's results on Tuesday confirm my assumptions. Investors had been spooked since last quarter's disappointing results, when both companies posted weak profits despite decent sales. However, last quarter included a number of launch costs as well as higher incentives than this quarter.

Ford dispelled these fears, posting net profit of $0.62 versus consensus estimates of $0.50 on automotive revenue of $31 billion, about a billion above forecasts. Pre-tax margin of 6.9% easily outstripped last quarter's 2.4% margin, and the all-important North American margin came in at over 10%. Though pricing was partially boosted by an adjustment to incentive accruals on existing dealer stock inventory, the results were solid across the board.

Possibly even more important than the Q1 numbers was Ford's forecast for scheduled production of 710k vehicles in North America and nearly 1.5 million vehicles worlwide. The North America production estimate represents a 10% y/y increase and an 8% q/q increase. Though Ford expects a reduction of about 6-7% in European and APAC production, its worldwide figures are still up 1% y/y and q/q. There have been many fears that the problems faced by Japan's big three will spread to American manufacturers, but Ford's robust production schedule should allay those fears. Ford's estimated EBITDA of $3 billion shows the company is on track to acheive analysts' expectations of approximately $12 billion of EBITDA this year, suggesting a current valuation of just over 4x 2011 EBITDA and ~8x 2011 P/E.

With Ford's results out before GM's, investors should feel more comfortable that last quarter's messy results were an anomaly and that both companies are on track for an impressive rebound this year and, most likely, next year. With Japan's big three feeling devastating reprecussions from the earthquake and tsunami, Ford and GM have an unprecedented opportunity to take share from their Japanese counterparts.

Analysts have cut profit forecasts among the Japanese automakers from 50-80% as supply disruptions are likely to persist for most of the remainder of the year. As evident from Ford's release, the American automakers are not feeling these effects to nearly the same degree. GM had to slow some Opel production and production of a small truck plant in Louisiana manufacturing trucks that are not even due out until later this year. Both companies are scrambling about what to do about the black paint shortage, but that problem is being faced ubiquitously by all auto manufacturers.

The only concern raised on Ford's earnings call was the impact of rising commodities prices. Ford believes the impact of inflation could be as much as $2 billion, higher than what most analysts were expecting. Obviously, this will impact GM as well. However, GM had already stated that production efficiency, likely from higher plant utilization and other cost savings, will outweigh most of the inflation. There has been further inflation since then, but both companies are in a position to increase pricing and reduce incentives going forward as supplies tighten.

Automakers have already announced price increases ranging from $100 to over $200. A $2 billlion increase in costs represents less than 2% of revenue, which can be offset by an average increase in prices by about $300. Both GM and Ford should be able to offset the commodities inflation with some combination of higher prices and increased output.

We've spent a lot of time discussing Ford, so why would I rather invest in GM? First of all, though Ford shares are trading at 4x 2011 EBITDA looks like a good value, it's generally in line with its global peers. Both GM and Ford have roughly the same equity value; however, Ford has $12 billion more debt on its balance sheet and $10 billion less cash. Not accounting for pension liabilities and value of their respective investments, Ford's enterprise value is over $20 billion higher than GM, even though both companies are expected to generate approximately $12 billion of EBITDA this year; in fact, Ford is expected to come in just shy of $12 billion while GM exceeds that figure.

Including pension and OPEB liabilities offset by the value of investments in unconsolidated businesses and potential value of NOLs, Ford trades at 4x 2011 EBITDA, while GM trades at a paltry 2.5x EBITDA. Furthermore, GM's revenues are expected to grow faster this year and next year, which is expected to result in a 20% increase in EBITDA and a 25% increase in EPS versus Ford's sub-10% increase in profits.

All this doesn't even take into acccount the benefits of having all the excess cash that GM enjoys on its balance sheet. The extra $10 billion of cash could serve a variety of purposes, including dividend increases, share repurchases, investment in new technology or even investment in marketing and dealer enhancements. GM's positioning in China with important strategic partnerships, a dealer network far vaster than Ford's, and better brand recognition, provide a much better growth engine in Asia compared to Ford's. Also, GM's lead in electric cars not only has publicity benefits, but could also translate into a long-term advantage as did a lead in hybrid technology for Toyota (NYSE:TM).

The only potential overhang on the GM investment is the upcoming share sales planned by the US government. Whereas investors initially thought the sales would be more gradual and would contemplate a break-even on the investment, it appears that the majority of the share sales are expected to be completed this summer.

I still think the time to get in is before GM reports next week, but price appreciation is likely to stall this summer. One potential options strategy is to purchase January 2013 calls and, if share prices increase post-earnings, sell September 2011 or January 2012 out-of-the-money calls.

Disclosure: I am long GM.