There are a lot of things to like about General Motors Company (GM): It has reported 10 profitable quarters in a row, and trades at a P/E ratio of 4.4 compared to a ratio of 7.9 for its peers, and 14.7 for the S&P 500. Wall Street likes the future prospects for the company as well: The average five-year growth forecast is 10.7% (source: Morningstar.com).
However, there are a lot of problems with General Motors as well. For instance, its European market looks really bad. General Motors (unlike Ford Motor Company) did not receive investment grade status, so most of the profit comes from the North American region where limited earnings growth possibilities are expected. Furthermore, General Motors has $25 billion of unfunded pension liabilities.
So does this mean that General Motors should be bought? To quantify the combined effects of the above facts, I will value General Motors through a discounted cash flow model.
In this analysis, I will use a similar DCF approach that I used when I valued Intel. I estimate 5 factors:
- Average future revenue growth
- Operating margin
- Tax rate
- Sales/capital ratio
Capital is calculated as Equity + Debt - Cash + accumulated depreciation. This ratio helps us determine how much investment in capital we can expect the company to make.
After subtracting the investments from the after tax operating profit I obtain the free cash flow, which I discount (to get the present value). By adding the present value of the budget period and the terminal period, I can calculate the market value of the company. To get the value for shareholders, I subtract the book value of cash/short-term investments and the book value of debt.
General Motors North America (GMNA)
Revenue has increased by 31% from 2009-2011, and operating margin has gone from being negative in 2009 and 6.9% in 2010 to 8% in 2011. The primary drivers behind the positive growth are: (1) Successful vehicle launches, namely the Chevrolet Cruze, Chevrolet Equinox and GMC Terrain, (2) Favorable vehicle pricing, (3) A rise in CAD against the USD, and (4) Decreased amortization expenses.
Profitability has continued to improve in the first half of 2012, thanks to the good performance of the Chevrolet brand. Sales of GMC and Cadillac have been declining, but I expect the Cadillac brand to perform much better in the second half of 2012 with the introduction of the new Cadillac XTS, which performed extremely well in July (Cadillac sales in July were up by 20%).
For 2012, I expect revenue to increase by 2% with an operating margin of 9%. From 2013-2021, I predict revenues will grow modestly (3.5%), but I doubt that General Motors can maintain such a high margin; therefore I calculate with an operating margin of 7.5%.
General Motors Europe (GME)
The losses of GME were smaller in 2011 than 2010, but 2010 was artificially bad due to restructuring costs of $0.5 billion. Therefore, the "real" improvement was not as significant. Manufacturing costs decreased as well in 2011 due to the closing of the Antwerp, Belgium facility.
But if you thought 2011 was an indication of an improvement in Europe, you were completely wrong. Operating profit for the first half of 2012 was -$0.6 B and unit sales declined by 8%. The Opel/Vauxhaul car sales were the primary drivers of the negative growth, while Chevrolet sales increased slightly.
General Motors and Ford are very similar in the sense that both companies get the majority of their profits from North America, while losing quite a lot of money in Europe. But unlike Ford, General Motors has no history of earning money in Europe, and the economy of Europe is now worse than ever. However, if you believe CEO Daniel Akerson, GME has made a lot of progress on its restricting plan:
Turning to Europe. We have made progress on all of the key components of our restructuring plan: building a stronger team, investing in new products and addressing our cost and capacity. We have already reached competitive operating agreements with our Ellesmere Port complex in England and our Gliwice plant in Poland. We have also made good progress streamlining decision-making, reducing our material cost and managing our working capital and cash flow.
As we announced in June, Opel Management and German unions are continuing to discuss a broad range of issues that will help ensure the sustainability of the business, including productivity, cost and capacity. We expect to have a comprehensive agreement in place sometime this fall.
While I am not a believer of taking the rosy words of the CEO for granted, I do think that Europe will improve over a 10-year period.. It will not earn its cost of capital, but I expect an average operating margin of 1.5% and zero growth in revenues from 2013-2021, compared to an expected operating margin of -5% and a decline in revenues of 10 % in 2012.
General Motors South America (GMSA)
After a somewhat profitable second half of 2009, margins have been depressed in 2010 and 2011 with operating profits close to zero. The main explanations for this disappointing performance is the increased costs of material and freight ($0.7 B), and increased manufacturing costs ($0.3 B) in 2011. In the first half of 2012, the EBIT has been slightly positive, and according to Daniel Akerson, South America is starting to turn around (source: earnings transcript for the most recent quarter).
I think Daniel Akerson is probably right, and while South America will not obtain as high margins as GMNA, I think an average margin of 3.5% for 2013-2021 is realistic, compared to the expected margin of 2% in 2012.
General Motors International Operations (GMIO)
GMIO, along with GMNA, is the most profitable region for GM. Revenue has increased by 45% from 2009 to 2011, and I expect a further increase in revenues of 6% in 2012, primarily driven by better performance in Korea and an increase in joint ventures in China. It is especially sales of Wuling trucks in China and Chevrolet in Korea that are driving this positive growth.
I expect an average increase in revenues of 5 % from 2013-2021. Margins will decline slightly to an average of 7.5 % from an expected margin of 8% in 2011, due to an expectation of increased competition.
GM Financial is continuing to increase its revenues through a higher net margin (calculated as the difference between the finance charge income and interest expense) and increased lending. I expect GM Financial to continue to increase its lending. When determining the margin, I use the margin of Ford Financial Services as guidance, which is averaging close to a 45% margin over a 3-year period-similar to the margin in 2011 and first half of 2012 for GM Financial. Therefore, I calculate with a net margin of 45% from 2012-2021.
As can be seen in the below table, I estimate that General Motors is undervalued by around 25%.
The next question that arises is whether the margin of safety is high enough to justify a buy. To answer that, I'd like to change some of my assumptions to test whether GM still is undervalued under less rosy conditions:
The true beta is 2.5 instead of 2: This makes the fair share price of GM equal to $18.5.
- Europe will continue to lose money: Fair share price is $21.4
- South America will not turn around, and margins of International Operations will decline: Fair share price is $17.7
- The future sales to capital ratio is 0.9: Fair share price is 18.5
- GM Financial will not make money: Fair share price is 19.5
- Margins in GMNA will drop by 2 percentage points more than expected: Fair value is $21.7
Given the above variations in assumptions, I think the margin of safety is high enough to conclude that General Motors will be a great long-term investment.