Recommending GM: No, I'm Not Kidding

I hope when you've finished this recommendation, you'll feel astonished. We're boldly going where angels sometimes fear to tread: Yes, that's right... the Automotive Sector.

We'll probably hear arguments that what we're buying into with our recommendation this week for a call spread on General Motors (GM) is a "value trap". That's where the stock is incredibly valuable on paper, and looks like it should be worth billions, yet it continues to flounder in the market. There is merit to that argument, yet we have taken a cold, hard look at the fundamentals and we think that the stock isn't worthless, and that American Ingenuity wins out over the long haul. We want to be positioned here for a turn, because when (okay... if) it happens, this stock will be off to the races. There is an incredible valuation gap here between GM - currently selling at 0.05 times sales - and its competitors, both foreign and domestic.

What do we mean by valuation gap? GM's entire market cap right now is just over $9 billion dollars. That's all. There are mutual funds that have probably lost that much on it since it's in the S&P 500 and has been for years. Add on the economic value of GM's debtload and you get a total enterprise value of $30 billion. On a metric of $180 billion in annual sales, that's a price-to-sales ratio (P/S) of 0.05x (on the $9 billion for market cap). Ford, which remains publicly traded, currently has a P/S ratio of 0.08, which isn't much better, although Toyota (TM) (apples and oranges, I know) has a P/S ratio of 0.67.

I can hear the naysayers now -"Toyota MAKES MONEY, that's why they get valued so much higher". GM hasn't been exactly printing money lately - they've actually been losing it nearly every quarter for the last few years. The exception has been December 2007, when they posted a surprise profit of $0.08 per share. This Winter should be the "Winter of their discontent." They probably will lose something on the order of $4 to $5 a share, as they continue to downsize and sell off remaining assets in order to be profitable.

So today GM's stock is back at valuations last seen in the depths of 1991. Yes, the good old days. I think Barry Sanders played for the Detroit Lions back then, didn't he?

The axiom we're pulling out today is "Buy when blood runs in the streets." Well, folks, look at the chart, look at the fundamentals, look wherever you want. Blood is gushing. Where's the turnaround? We don't know - honest answer - but we still believe that American ingenuity comes to the fore when the chips are down. GM has to - absolutely HAS TO - in order to survive - do something dramatic and they need to do it now. We're voting with Rick Wagoner and Bob Lutz and their team of Detroit managers to come through.

The chart above shows GM for the last six months. The stock has come down to levels last seen in 1991.  The Relative Strength Index [RSI] and Moving Average Convergence / Divergence [MACD] stochastic lines are both bottoming out right now, giving us an opportunity to buy shares in an American icon at a great price.  Hold your nose and buy.    

Fundamental Data

• Current Price:  $16.18
• Shares Outstanding: 566.1 million
• Market Cap: $9.2 billion
• Forward Price / Earnings (avg. Est): N/A
• PEG Ratio (5 Year Expected):  N/A
• Price / Book:  N/A

GM estimates for earnings are all over the place.  The current quarter has an average of a loss of $1.97 per share, although the 12 analysts covering the company are presently seeing a high estimate of a $0.24 per share profit all the way to a loss of $3.37 per share.  So much for an efficient market, yes?

For the year 2008, estimates are also pretty scattered across the spectrum.  From a "high" of a loss of $0.49 per share for the year ending Dec 31, 2008, to a low of a nearly $9.00 per share loss.  2009's outlook is even murkier, so just throw the analyst "guesses" out the window.  Don't look back either to the $74 per share GM wrote off last year in total per share losses.  You'll only give yourself a headache.

Revenue per GM share is $318, which is a total of $180 billion annually.  If GM could make the industry average profit margin of 5.53% on that amount (skewed, of course, by Toyota's 8% profit margins), well, the company would see some amazingly significant profits.  GM shareholders would probably be very happy with a 1% profit margin - which would translate to $3 per share?  Too much to ask?  Maybe.  But those are economies of scale we're talking here.

The GM balance sheet is another enigma.  They have over $41 per share in cash on the books, a total of $23 billion right now.  Offsetting that is a $44 billion debt load, which gives the company a negative $74 per share book value right now.  Ouch.  Look past that into the spin-cycle of free cash flow.  There's $4.7 billion in operating free cash flow here over the last 12 months, or over $8 per share.  The heartbeat underneath this zombie exterior is still working, doctor.  Thump, thump.  Thump, thump.

Our recommendation this week is to buy a GM call spread at its present $16.18 level.  We are recommending buying a GM January 2009 $15.00 call for $3.75, and writing the January 2009 $25 calls for $0.80, for a net cost of $2.95 to this spread.  We would look to sell this call spread over the next few months at a level of $6.50 or higher, giving us a return of just over double the money.  We'll re-evaluate based on announcements from the company of a change in strategic direction, so stay tuned to Detroit.

On a longer-term basis, we would consider a position in the January 2010 $20 LEAPS on GM at the $3.50 level, although we would definitely sell the Jan 2010 $30 LEAPs short against that position.  Those are presently bid about $1.45.  The 2010 options are higher strike prices with longer term expirations and higher risks, but should the company make its move, you will benefit by a higher return on your investment.

Please note: Options trades all involve a high degree of risk and the potential to lose some or all of your investment. These recommendations are general in nature, and you should consult your own financial professional who is familiar with your situation as to the appropriateness of these trade ideas.

Disclosure: Analyst has no position in GM stock or GM options.

Comments

[fxtrader07]

the key sentences of this article:
'Where's the turnaround? We don't know - honest answer - but we still believe that American ingenuity comes to the fore when the chips are down. GM has to - absolutely HAS TO - in order to survive - do something dramatic and they need to do it now.'

so actually, you are just trading on hope and wishful thinking.
GM resembles many of the USA's problems and the ugly message is: you have to do a lot about it, radical steps. but they may not be taken, still and even if, success is far from certain.
the giveaways and burdens from the past are weighing heavier by the day - you see, they can't fix it with imprroving GM's operations. because even if they are successful at it, it is too little, too late to make a dent in the bigger picture.
frankly, i see alot far better call-spread plays and more compelling stories out there than just trading on the hope that someone might stop the bleeding at GM. There are cases, where all medications and all surgical operations in the world will not save the patient. GM is as perfect as an example for that as it gets. touch this zombie at your own peril

[lakeside]

Due to price of oil, every who pays for their gasoline is delaying purchase of new car by at least one year. By delaying new payments ($400/month) or higher payments ($100/month more each month) folks in the market for a new car will be able to pay for gas on money saved (and higher insurance costs) by delaying new car just one year. The difference in gas mileage is not that great by extending car purchase one year. So, all auto makers are going to have tough time. I agree 100% with previous poster -- "so actually, yoiu are just trading on hope and wishful thinking." Your time would be better spent analyzing energy stocks.

[Donald E.L. Johnson]

Last week I blogged on why I bought a GM July covered call. The dividend yield is about 6.32% now. Add the income from selling a call and you have a pretty nice income, assuming the stock doesn't tank even more. Morningstar.com rates the stock a four-star with an estimated fair value of $27. When I did the CC, the return was 63%; the next day it fell to 45%. Haven't checked where it is now. My plan is to roll over each month on out of the money calls so the stock is unlikely to be called and I can collect the dividend, assuming it isn't cut, which it could be.

This is a highly speculative trade and should be a tiny part of any portfolio, imo.

What's wrong with this strategy?

[seeker2012]

I work for GM, and the turnaround is coming and will hit like a tidal wave, this company is going to kick Toyota's butt! If you want to talk about good ole American Ingenuity, remember WW2 and who changed to win the war - GM! Keep your eyes open, it's coming!

[Mac'em X]

Seeker 2012, any more detail you can give us about what's in store???

[seeker2012]

The Chevy Volt is in overdrive right now! And, do you remember the platform GM had for new cars, many designs can be built on this platform. GM is all about saving money now - more than ever before, I know, I've been here 31 years. They are cutting wages to most of the jobs here to save money too. Look at the opinion that the stock should be at $27 right now. What does that tell you? It is going to make a comeback.

[blahargoue]

I haven't read very much about the auto industries version of the housing credit mess: The excess inventory of lease return vehicles, especially trucks and SUV's that are being turned back in at values far less then the stated residuals in the closed end lease contracts. Expect to see the used vehicle market flooded with these vehicles at major discounts over the next couple of years. The financial divisions of the major auto manufactures such as GMAC, Ford Motor Credit and the others will be having to deal with these lease returns and sell them for far less than what they had calculated their resale values to be when the original leases were written. The excess inventory of relatively inexpensive lease return vehicles will also cut into new car sales. Anybody have any thoughts on the issue?

[BioInvestor]

seeker2012, I wished I shared your confidence; I don't. I don't see a trend within GM that suggests this company is going to make any kind of comeback. I think that the best prescription for GM is to clear out the top management. I am actually surprised that, with such poor performance, the top layer of GM hasn't been culled years ago. I hope GM makes a turnaround; I don't expect it to happen.

[Daniel Jones]

I agree with the first two posters who kind of took me to the woodshed for trading on hope. Honestly, it is a wing and prayer type of a long call play, but I do believe that underneath the zombie exterior here is a car company that can be profitable. Seeker2012 has some unique insight that I'm glad he shared, and this company will turn around. Sometimes the contrarian play is the right one. We also did a put spread in Mid-May on UPS and FDX. Those stocks actually went UP the day after FDX warned on earnings. Today after releasing earnings, the stock is down big - down a total of 15% since mid May and those puts are flying. It's a business of going against the grain sometimes - that's where we are with GM.

Onward,
Daniel

[User 212262]

Current management have demonstrated that they haven't a clue. Just this month, they finally noticed that at current gas prices, gas guzzlers don't sell well. HELLO! Which pile of sand have their heads been in for the past year?
And you expect these bozos to perform the most heroic turnaround in history?
Hedge your bet: buy puts. Or, forget about the "strategy" in the article and just buy the puts. Not only is GM's total book value negative, as you point out, but also its current assets are less than its current liabilities. It just takes one supplier to sue GM for payment, and it will have to go into Chapter 11.

[lsuavecito]

I agree with those above that likened, once proud, Gm's future to the Dionne Warwick song, "Wishin' & Hopin'"; however, for the contrarian types, instead of buying the common which is strictly a crapshoot, why not buy GPM, the 6.25% conv. pfd., callable, 7/10, currently yielding 9.75%? I know, conversion is off the map, but if GM does perform a miracle, these will move faster than the common - AND U R getting paid handsomely to wait . Aside from this, GPM has a put option down the road(2018).

[previse]

Yes, GM is doing all the right things, but I think they are doomed. I’ll invest when they emerge from Chapter 11. Take a look at their balance sheet. We’ve got 5.4 billion in GMAC – auto, real estate, consumer loans etc.. To their credit, they’ve been writing that down, but with $4.00 gasoline, I’d value GMAC at approximately zero. Accounts receivable, 10 billion. Inventories 17 billion. Good luck with that. Equipment on operating leases is another 10 billion “asset”. How much of that is used to build trucks and SUV’s ?

GM kept making large pieces of junk because they had to feed the unions or go bankrupt. It can’t do that any more, and the union will suck it dry. If GM had a credible plan for producing lithium batteries in the quantities required and if the Volt was being produced by non-union labor, there might be hope. As it is, zippo. Beaten up as it is, GM is a short.

[elroy]

The market is in panic mode right now and doesn't make sense. Ten year old Geo Metros are selling at original MSRP. Automotive News -- the industry publication -- had a report from a Honda dealer trying to buy vehicles at auction that used 2007 Civics were selling at $1000 more than the sticker price of brand new 2008's!!!! This panic will hurt the big 3 the most in the short run since Toyota et al just bring more cars in from overseas.

Longer term, iwhen (if?) the American economy improves, the dollar will get stronger and the price of oil will decrease too....oil is sold on the basis of US dollars, but it is really the buying power of what these US dollar buys that's important.

The glory days of the pickup trucks and SUV's may behind us, but if you can stomach the extra 30% in gas costs, there are some great deals out there!!! If you look at total cost of ownership over a five year horizon, including vehicle price and gas, the costs of owning a pickup or SUV has gone down year over year -- the deals far outweigh the increase gas costs unless you drive a ton of miles a year!

[mextex]

Wishfull thinking! Assumes that foreign technology will stand still.
The mindset at GM is quantity over quality. I have long given up on US made cars because they are not as reliable as foreign made ones. our newest generation of consumers are learning rapidly that value is in reliability and safety of cars, not names! They are learning from the housing fiasco!

[Whisper OnThe Wind]

GM could actually have 10 times last year's profit and I still wouldn't buy it, wouldn't buy the cars, don't want anything to do with it. For about 8 years, I held some GM stock and lost money constantly. They can go fly a kite, for all I care. Automotive is not going anywhere for a while.

[Be Oh Be]

GM quality is way up - the statistics are all over the place. New products like the Malibu, CTS and even some of the Saturns are actually really nice cars. The problem is perception - if GM can get some better ads and get more people into their showrooms, I'll think they'll begin to start selling more cars profitable. The Volt may be big, I'm on the edge of my seat. Import only buyers should give many of the new GM models a look - you may be very pleasantly surprised.

I don't work for them nor do own any stock in them.

[BioInvestor]

Be Oh Be, welcome to Seeking Alpha; it's good to see first time posters.

I don't think that the problem is perception: at least, I wouldn't call perception a problem.

GM, like Ford and Chrysler, has a history. There's no getting away from it. Ads aren't the solution. Ads work when, among other things, there's a lack of information, or a company wants to keep its brand out there. For the case of GM, perception is reality: GM has made poor quality products in the past; things have improved, but the company still lags its competitors. In this case, ads would only work if consumers were dumb!

For me one of the better sources of objective information is the surveys conducted by Consumers Union. Here you have the raw feedback from the people that matter to any company: those who buy the product. What such people say matters. The surveys show, consistently, that GM doesn’t make good products when compared to its competitors.

Saturn, which you mentioned, is a great example in another context. Saturn is an example of where GM got it right, but, sadly, didn't capitalize on the shockingly successful product--in fact movement--that it created. I am sympathetic to the argument that the corporation invested too much money into Saturn; I also believe that it didn't exploit its success. It has always surprised me the company didn't have a product beyond the SL2. It was such an obvious next move. You had loyal, fanatic customers, but you didn’t have higher end products for them! It slapped the Saturn name on another car, but it wasn't a Saturn. I can only surmise that GM didn't appreciate what it created in that brand.
GM discovered something important in Saturn: Americans are proud to own a quality American car. The American consumer wants a safe, reliable car at a reasonable price. Price is last. I would brand Saturn, sadly as a failed success story.


If you really want to test GM cars, rent. I do. GM is still making an inferior product; it's still behind its competitors. I have said it for years, but it's time for the senior management at GM to go.

[fxtrader07]

most posters here don't get the point obviously: Even if GM were as successful and smart as Toyota they faced an uphill task due to the ever rising burdens from the past. Those obligations along with billions and billions in recurring interest payments simply kill the company. Reorganizing under ch11 will come at some point. the longer they wait, the deeper the hole they have to come out of.
the bonds trade waayy to high - they are as 'junk' as it gets.
recession hasn't even really started in the u.s. when it will, over the coming 6-8 months, GM will be gone. if things don't improve fast, GM will have burnt through their cash one or two years from now. but how can things improve given the dire economic picture for the usa and even for europe for the coming months and years?
and no, it is NOT a coverd call candidate at all. reliable, stable businesses are. not zombies that can collapse any day.

[User 25255]

it's all about china....

[Akron]

As a huge gear head I just want to say that the GM car line has made a huge improvements. Honda and BMW may be the best, but GM is a very close second and often in front of Toyota, and as for reliability Toyota isn't what it used to be. I there's a lot of factors, but good products are probably the most important step to making profits. GM's been hitting the target.

[WolfDog]

The comments about miniscule P/revenue and betting on American ingenuity are valid. The counter balance is that the company's cash burn rate is ferocious, and so it is a race against time. I have a long postion in the 2010 Leaps so I hope they win the race, but it is by no means a layup bet.

[oops!]

Hope no one followed this recommendation. With GM under 10, the likelihood of it climbing back to 20 by year's end is quite low.

[CoverIsBetter]

What about making this same trade at lower strike price points now?