By David Whiston, CFA, CPA, CFE
What makes a great car company? At the big-picture level, we think the answer is simple: Great products made in the most cost-effective manner possible. So we are taking a deeper dive into General Motors Company (NYSE:GM), or New GM, to see what's really changed since it emerged from the bankruptcy of General Motors Corporation (Old GM). We find that in some ways GM still has work to do, but in other areas, such as labor costs, the new GM is a radically different company that is superior to Old GM.
The stock still seems extremely cheap to us on a discounted cash flow basis and at a P/E multiple of less than 5 times 2013 consensus, but not as cheap when looking at enterprise value, including GM's huge pension underfunding of $32.7 billion. Although Europe, legacy costs, and government ownership are likely to keep GM's P/E multiple depressed this year, we continue to believe the stock offers compelling value for the long-term investor.
Labor Costs Dramatically Different
GM is well on its way to making great cars, though it still has work to do against Toyota (NYSE:TM) in quality and dependability. Costs are the other side of a great car company, and this is an area where GM is now competitive with the transplant original-equipment manufacturers in the U.S., thanks most notably to implementing Voluntary Employee Beneficiary Association (VEBA) agreements with the United Auto Workers to move retiree healthcare risk to the union and away from GM. Drastic head-count reductions from several rounds of buyout programs and plant closings under Old GM also have improved GM's cost structure.
GM's U.S. hourly labor cost per North American vehicle produced has improved--down to $1,606 from $3,295 in 2005. Since the IPO, GM has disclosed that its break-even point for the all-important GM North America (GMNA) segment is now a U.S. industry sales rate of about 10.5 million units with 18%-19% share, compared with industry sales of 15.5 million and 25% share in third-quarter 2007. According to GM, retiree healthcare was about $4 billion of the $16 billion total U.S. hourly labor cost in 2005, so eliminating U.S. retiree healthcare obligations has helped immensely, as has reducing hourly head count by 57%. Also critical is that GM's U.S. all-in hourly labor cost is now about $56 per hour, compared with $78/hour under Old GM. For comparison, Toyota is about $55/hour. We think investors concerned with continued U.S. market share loss should consider that GM can break even at sales levels that occurred right after the collapse of Lehman Brothers and, as discussed in our report "Why U.S. Auto Sales are Still Too Low," we believe the U.S. is on its way back to normalized annual demand levels of between 16.1 million and 17.3 million units. GM has stated that it is able to run GMNA capacity at up to 150% utilization (three shifts with overtime) if U.S. industry demand reaches at least 16 million units.
Employee Incentives, Dealer Relations Are Far Improved
We also see incentives for both hourly and salaried U.S. employees as the best they have been for a long time, if not ever. As we discussed last fall after the new UAW contract was ratified, hourly workers now have a transparent and simple profit-sharing formula; the previous convoluted formula kept members from understanding how they were compensated. The new formula is based on GMNA's publicly reported adjusted earnings before interest and taxes (EBIT) and the contract explicitly lays out what the dollar bonus is for a given EBIT range. Essentially, it is an extra $250 for every additional $250 million of EBIT, with the payout capped at $12,000 per worker. GMNA must have adjusted EBIT of $1.25 billion for workers to get any profit-sharing. Also noteworthy is that the UAW and GM are working out the legal logistics of having 10% of profit-sharing diverted to the VEBA fund. We believe this more transparent bonus formula, along with an annual $250 bonus for meeting predetermined quality targets, gives workers more buy-in to the New GM since they get more money as GMNA's profits rise. Quality bonuses are also critical--GM must never return to the ways of Old GM of the late 20th century, when workers would knowingly let defective product continue down the assembly line.
Dealers also are benefiting from the New GM as the company no longer has to overproduce vehicles to bring in some cash to cover the ridiculously high $78/hour labor cost; instead, it can produce to meet demand. Dealers find the New GM much easier to work with, as they are no longer constantly pressured to buy cars they do not need just so a GM factory representative can meet a monthly volume target.
GM Still Cheap, but There's Baggage
We believe the U.S. auto market is on track to sell somewhere in the low to mid-14 million unit range this year, and eventually will rebound to our estimate of normal demand of between 16.1 million and 17.3 million vehicles. In per-capita terms based on the number of licensed drivers, the 2009 industry sales figure of 10.4 million was the lowest since at least 1951; the next lowest year was 1958, when the U.S. had 61% fewer drivers on the road. In 2009 and 2010, the U.S. scrapped more vehicles than it sold, which had not happened since the 1940s. We agree with the skeptics who believe the early 2000s were a time of artificially high auto sales, but nearly 60 years of per-capita data incorporating many boom-and-bust cycles shows recent sales to be far too low. At 10.8 years, the U.S. fleet is at its oldest since this data began to be collected in 1995, according to R.L. Polk.
Record-high used-vehicle prices also give consumers another reason to buy a new vehicle. The crash in new vehicle sales in 2008 and 2009 has severely reduced the supply of late-model used vehicles, which in turn has raised their price. With ample credit available in the market today and a less than optimal selection of used vehicles, consumers can either keep pouring money into repairs or buy a new vehicle and upgrade fuel economy in the process. Many compact cars today (such as the Chevrolet Cruze) now get close to, if not above, 40 mpg highway without being hybrids (which cost thousands of dollars more). In 2011, GM obtained $7.2 billion of its $8.3 billion adjusted EBIT from GMNA, and the U.S. accounted for 86% of GMNA's unit volume. This large profit contribution from a market that we believe still has tremendous upside suggests that GM will have positive earnings surprises in the future.
Europe's Forecast Gloomy, but China Looks Brighter
The storm clouds of the sovereign debt crisis loom large over the European auto industry as well as GM Europe. Opel and Vauxhall, GM's European brands, accounted for 16.7% of total 2011 revenue and 19% of GM's 9 million vehicles sold globally last year. We calculate that GM's European division, or GME, has lost money every year since 2000, with cumulative losses nearly reaching $15 billion. According to the European Automobile Manufacturers' Association (ACEA), GME's year-to-date unit volume at the end of June was down 10.8% as compared with an overall market decline of 6.8%. And it appears that GME will not improve by much, if at all, in the foreseeable future. GME's revenue in the first half of 2012 declined 20.4% year over year and we model its revenue to decline 20% this year and grow only 1% in 2013 and 4% on average each year between 2013 and 2016. If GME's revenue were to decline 5% each year from 2013-16, holding all else constant, our fair value estimate would drop to $41 per share from $48.
We do not see a bright future for Opel, at least not for a few more years. GM chairman and CEO Dan Akerson has said, "We have to fix Europe, or at least get it to where it doesn't drain the corporate coffers." However, we like Opel's turnaround plan approved by its supervisory board on June 28. The plan calls for 23 new models and 13 new powertrains through 2016. In addition, GM's recent acquisition of 7% of Peugeot is estimated to bring about $1 billion of annual cost savings to GM in five years' time. However, GM has admitted this alliance alone is not enough to save its European operations and GM may soon have to take an impairment charge on the investment.
GM China is a much more positive story than GME. GM's vehicle sales in China are carried on via three joint ventures and all earnings are accounted for via the equity method. The joint ventures are on GM's year-end balance sheet at $6.5 billion, while equity income net of tax in China was $1.5 billion in 2011, up from $1.3 billion in 2010 and $760 million in 2009, combining Old and New GM. GM has long been one of the top two players in China, along with Volkswagen (VOW), because management had the correct foresight to see the growth potential there. GM set up joint ventures with Shanghai Automotive Industry Corporation in 1997, Wuling in 2002, and FAW in 2009 that have combined to sell more than 2.5 million vehicles last year, up from 1.8 million in 2009. GM sells more than 5 times as many vehicles in China compared to Ford (NYSE:F). Through July, GM China continued to set record sales levels, with total vehicle volume up 11.7% year over year, though the FAW venture was down 2.9%.
There are issues at the industry level in China, however. Heavy pricing incentives in the luxury space this year have trickled down to lower prices for volume brands, and China's overall industry sales pace for the first four months of 2012 was the worst since 1998, according to the China Association of Automobile Manufacturers. Still, we think GM will continue to grow in China. Light-vehicle sales in China were 14.5 million last year, according to Automotive News. Many industry executives see this market growing to 30 million by 2020 as there is still excellent untapped growth potential. We calculate the U.S. currently has about 770 cars for every 1,000 people. According to LMC Automotive, Tier 1 cities in China have a rate of only 70 vehicles per 1,000 people and just 29 per 1,000 in Tier 2 cities. Even if China's rate never comes close to the U.S. level (which we estimate would put the Chinese fleet at more than 1 billion light-vehicles compared with 240.5 million in the U.S. today), there is ample evidence the country has a long growth trajectory ahead.
Government Ownership, Pension Obligations Loom Large
We calculate that the U.S. government's ownership of more than 500 million GM common shares is a 24.4% ownership stake (using our diluted share count of just more than 2 billion shares) and the Ontario and federal Canadian government's 140.1 million shares is a 6.8% diluted stake. The VEBA owns another 160.2 million shares for a 7.8% stake. We believe many investors understand the U.S. auto sales recovery story, but are afraid to enter a position in GM without knowing what the U.S. Treasury intends to do with its shares. We have long thought the Obama administration would want out of the position before re-election season, but that no longer appears to be the case as the campaign is using the auto job creation story. We calculate the Treasury would need to sell its shares at $52.79 apiece for taxpayers to break even, so we do not expect it to sell at a loss to avoid negative publicity during the campaign. While we do not think the Treasury will hold out to break even, we expect it to seek at least the $33 IPO price. We think if the Treasury would just announce plans for an orderly sale to avoid fears of dumping shares on the market, the stock's P/E multiple would increase. We don't think the Treasury even needs to actually sell a share to calm the market's fears; it just needs to have a stated plan.
Currently, there is no public plan so there is uncertainty, which leads to fear, a compressed multiple, and a depressed stock price. The ideal scenario would be for the government to announce its sale plans, concurrent with GM saying it will buy back a portion of the shares and retire them using its $33.6 billion cash hoard. Unfortunately, management continues to refrain from stating any preference for share repurchases as it seems more occupied with another one of its goals: de-risking the pension.
At year-end, GM's U.S. hourly worker plan had a projected benefit obligation (PBO) of $71 billion and assets of $61 billion, while the U.S. salaried plan had a PBO of $36 billion and assets of $33 billion. The international plan was underfunded by $12 billion, for a total underfunding of $25 billion. We calculate the overall funding percentage to be 81.1%, compared with 79.2% at Ford. On June 1, GM announced a groundbreaking way to de-risk part of its U.S. salaried pension plan obligation, which has 118,000 retirees. GM will offer participants a buyout if they retired between October 1997 and Dec. 1, 2011--this would apply to about 42,000 people. Those who do not take the buyout, as well as U.S. salaried plan participants who retired before October 1997, will have their obligations transferred to Prudential (NYSE:PRU) via a group annuity contract starting in January 2013. To compensate Prudential for assuming $26 billion of PBO, GM will transfer approximately $29 billion of plan assets to Prudential to purchase the annuity contract, funding $3.5 billion-$4.5 billion of this purchase from GM's existing cash rather than from the plan. The exact amount is uncertain as it depends on the take rate of the buy-out offers, which we expect to be low. The remaining $10 billion of U.S. salaried PBO will stay with GM and be underfunded by about $2 billion. GM will then freeze the U.S. salaried plan on Oct. 1, 2012, and workers will move into a 401(k) plan.
We See Tremendous Upside
We stress that New GM continues to transform itself into a global automaker. We see tremendous economies of scale yet to be realized, as the firm only builds about 50% of its production on global architectures--far short of its planned 90% by 2018 (Ford will be at 85% by 2013). The important U.S. market will see 70% of GM's nameplates new or refreshed in 2012 and 2013. Critical GMNA product holes from cutbacks during the crisis will be filled next year with the highly profitable new generation of full-size pickups and the next-generation Chevrolet Impala full-size sedan. Cadillac finally will return to the compact segment with the ATS out this fall, and the new full-size XTS replaces the STS and DTS. In China, GM's largest market at 28% of global unit volume, the company is expanding capacity by 25% through 2013 and will launch more than 60 new and refreshed vehicles in the next five years. Opel will unveil 23 new models through 2016. These product innovations are possible because New GM is investing $8 billion a year in capital expenditure regardless of the state of the economy. Old GM would cut back on capital expenditure in hard times, which caused it to fall further and further behind competitors. We model nearly $9 billion of annual capital expenditure in the outer years of our five-year forecast period.
GM is still learning to be a truly global enterprise as opposed to being run regionally, but we think Akerson and his team are moving the company in the right direction. A global accounting system due to be completed by the end of this year will be a welcome step on that path, and the firm projects its recent decision to consolidate Chevrolet's global advertising agencies from 70 to one will save $2 billion over five years. While we think Europe will weigh down shares for the rest of 2012, we expect the stock to increase considerably from today as these transformations unfold.
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