By The Valuentum Team
Everyone knows the story about General Motors (NYSE:GM), and its struggles during the Great Recession that caused it to file for bankrutpcy protection. Many may not know, however, that the company reinstated its dividend in 2014, and now with a dividend yield approaching 5%, it's hard to ignore this investment "vehicle" as a consideration for income, especially with interest rates still near all-time lows and the yield on the S&P 500 at a meager 2%. For one, a mere 10%-20% "correction" in the S&P 500 could wipe out 5-10 years of dividend payments for an average-paying constituent. Is settling for average worth the risks? On the other hand, what about GM? Is the auto maker's lofty payout safe over the long haul?
Well, of course we can't possibly state with confidence that GM's dividend is completely safe over the long haul in light of its capital-intensive and cyclical business model. However, we're not seeing any immediate threats to it in the near term. The company has a portfolio of growth opportunities, including a very nice position in China. While a focus on reducing long-term capital spending may aid financial health, the company's bankruptcy filing in 2009 still speaks to an industry not conducive to long-term dividend growth ideas, unfortunately. Total automotive debt and net US pension + global OPEB stands at ~$9 billion and $18 billion, respectively.
And while there's a lot to like about GM's adjusted EBIT growth during economic upswings, operating performance of high-fixed-cost businesses tend to cut both ways, with painful profit drops during economic troughs. The next economic recession will be the biggest challenge to the sustainability of GM's dividend, in our view, and the question is not whether if one will come, but when. Adjusted automotive free cash flow will be solid in coming years, but we think management is being bold with its share buybacks, even if shares are trading at a bargain. GM is leaner today than it was in 2007, but it may not be lean enough to become a solid long-term dividend payer. Income investors should prefer a debt-free GM with US breakeven SAAR units below present levels.
All this said, however, GM's second-quarter results, released July 21, revealed that the company continues to execute well. The company registered records across the board during the period--record net revenue, record EBIT-adjusted, and record adjusted diluted earnings per share. CEO Mary Barra may have been right when she said that the second period "was an outstanding quarter for GM." After all, "strong retail sales in the US...record sales in China" are two dynamics worth being excited about. Looking to full-year 2016 performance, GM now expects adjusted earnings per share to be between $5.50-$6, up from $5.25-$5.75 previously. That means shares are trading at ~5 times forward earnings. We conservatively value shares north of $40 each, implying material upside potential.
General Motors's Investment Considerations
• General Motors makes cars, crossovers, trucks and parts. The firm's brand names include Buick, Cadillac, Chevrolet, and GMC, among others. Founded in 1908 in Detroit, General Motors has become synonymous with American manufacturing. A 'new' and leaner GM emerged from bankruptcy in July 2009.
• General Motors continues to improve. Its fixed costs have been reduced by roughly 25% since 2007, putting it on much more solid footing. Management is targeting a 20% ROIC, and we like the changes at GM.
• General Motors has significantly improved its breakeven point. On an EBIT-adjusted basis, break-even is roughly 10 million total US industry units (a level not reached in more than 20 years). During the past three years, the auto maker has posted an EBIT-adjusted margin of roughly 7%+. The company's North America EBIT-adjusted number has been the best in years.
• Though there will be hiccups along the way, we don't think GM is finished expanding operating margins. Its intermediate-term goal is for EBIT-adjusted margins to be greater than 10% as it continues to reduce fixed costs and improve efficiency. Recall costs have been more annoying than tragic.
• China will eventually become the world's largest vehicle market, and GM has used its first-mover advantage to become one of the dominant players in the highly-fragmented country. Its performance amid economic uncertainty in the country is worth watching.
Economic Profit Analysis
The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital. The gap or difference between ROIC and WACC is called the firm's economic profit spread.
General Motors' 3-year historical return on invested capital (without goodwill) is 1.2%, which is below the estimate of its cost of capital of 8.2%. As such, we assign the firm a ValueCreation™ rating of POOR.
In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.
During the second quarter of 2016, GM reported that its ROIC was 30.5%. Though it measures it in a slightly different fashion than we do, its performance is not inconsistent with our forecasts.
Cash Flow Analysis
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. General Motors' free cash flow margin has averaged about 2.6% during the past 3 years. As such, we think the firm's cash flow generation is relatively MEDIUM. The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. At General Motors, cash flow from operations decreased about 5% from levels registered two years ago, while capital expenditures expanded about 4% over the same time period.
We think General Motors is worth $43 per share with a fair value range of $30.00 - $56.00.
The margin of safety around our fair value estimate is driven by the firm's MEDIUM ValueRisk™ rating, which is derived from an evaluation of the historical volatility of key valuation drivers and a future assessment of them. Our near-term operating forecasts, including revenue and earnings, do not differ much from consensus estimates or management guidance. Our model reflects a compound annual revenue growth rate of 2.8% during the next five years, a pace that is higher than the firm's 3- year historical compound annual growth rate of 0%. Our model reflects a 5-year projected average operating margin of 6.5%, which is above General Motors' trailing 3- year average.
Beyond year 5, we assume free cash flow will grow at an annual rate of 1.7% for the next 15 years and 3% in perpetuity. For General Motors, we use a 8.2% weighted average cost of capital to discount future free cash flows.
Margin of Safety Analysis
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $43 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future were known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values. Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph above, we show this probable range of fair values for General Motors. We think the firm is attractive below $30 per share (the green line), but quite expensive above $56 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Future Path of Fair Value
We estimate General Motors' fair value at this point in time to be about $43 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart above compares the firm's current share price with the path of General Motors' expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change. The expected fair value of $53 per share in Year 3 represents our existing fair value per share of $43 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.
This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice.
Disclosure: I/we 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.