GM Is Turning The Recall Into A Big Opportunity

| About: General Motors (GM)


Shares of GM are relatively undervalued on an enterprise to sales basis and strong earnings growth should drive price gains.

Shares have lagged on uncertainty around the recall but customers do not appear to be leaving the brand.

Strong incentives could get customers to use their recalled cars to trade into newer brands and drive sales this year.

Shares of General Motors (NYSE:GM) have lagged rival Ford Motor Company (NYSE:F) since the beginning of the year on uncertainty over the vehicle recall. GM continues to improve on sales and it does not appear that customers are fleeing for other automakers. The company may actually be able to use the recall to its advantage by bringing customers into the showroom for new models and could surprise on sales figures for this year. Investors able to wait out the uncertainty could see strong returns over the next couple of years.

First the bailout, then the recall

Investors in General Motors were just beginning to see some light at the end of the tunnel last year when the U.S. Treasury finished selling its stake in the company. Shares had jumped more than 21% from October to the end of the year as the company shed the stigma of the bailout and sales forecasts were strong for 2014.

Then the nightmare over the recalls began. The company issued a recall of 800,000 Chevrolet Cobalt and Pontiac G5 vehicles in February and have added to the number ever since. To date, 15.8 million cars and trucks made between 2008 and 2011 have been recalled in the North American market alone. While earlier weakness in the shares, compared to Ford Motor below, were attributed to weakness ahead of earnings the weakness since February is all about the recall.

GM stock performance on recalls

At the heart of the recall is the ignition switches in the Chevrolet Cobalt, Saturn Ion and others made by the company that could turn off the engine and power if bumped. The loss of power has prevented airbags from deploying in crashes. The company recently released the result of an internal investigation which CEO Barra said showed a, "fundamental failure of the company," and resulted in the firing of 15 employees.

CEO Barra is being called back to Washington to detail the result of the internal investigation to Congress. She is sure to face a grilling by politicians eager to voice their opinions ahead of this year's elections and the media coverage may hit the shares briefly. I doubt that the 15 fired after the investigation will be the last though CEO Barra will likely keep her job.

GM won a decision on Monday against more than 85 federal lawsuits filed on behalf of owners claiming their cars lost value as a result of the recalls. The lawsuits will be bundled and pretrial proceedings will take place in the federal Judicial Panel on Multidistrict Litigation in New York.

Can the recall actually improve sales?

GM reported last week that sales were up 13% from the same month last year to nearly 285,000 vehicles, its best month since August 2008 and well above Ford's sales gain of 3% over the same period. Recent performance has come on consistently stronger sales each year with 2.8 million in U.S. vehicle sales and 9.7 million global vehicles sold last year.

LMC Automotive expects light vehicle sales in the United States to increase 3% this year to 16.1 million units. May was the eight-consecutive month that consumer spending increased on new vehicles on a year-over-year basis and the trend should continue on an improving economy and low interest rates.

Many of the recalled models are not even being made anymore. Both the Cobalt and the Ion have been discontinued and replaced with different brands. That means the stigma of the recall may not hurt the brand as badly as investors fear. The company's strongest performer last month was the Chevrolet Cruze, the brand that replaced the Cobalt. This tells me that customers are coming into the showrooms with open-minds and are driving the new models. As the new cars far exceed their expectations, admittedly from a low bar set by models like the Cobalt and Ion, they are sticking with the company.

Customers coming in for the recalls are being offered employee discounts on new cars and loans up to 90 months. That is a pretty attractive offer considering the extremely low rate environment and I think GM could continue to surprise on the upside for sales.

While CEO Barra and other executives will find it difficult to shed the animosity over the incident, car sales are much more about local dealer interactions. Dealers are a part of the local community and should be able to maintain the trust of their communities.


Shares of GM trade for 20.8 times earnings, well above Ford's price multiple of 10.6 times, but earnings are artificially low on ongoing restructuring charges and other costs. Earnings are expected 52% higher next year as the company continues its sales momentum and improves margins. On an enterprise value, shares are relatively cheap at just 0.45 times trailing sales compared to a 1.09 enterprise multiple for shares of Ford.

The company just reinstated its dividend policy in March at $0.30 per share on a quarterly basis. Increasing free cash flow, even after high spending on capital expenditures, should allow the company to increase its dividend and share repurchase programs.

Sales grew at 2.1% last year and I am estimating an increase of 2.75% this year to $160 billion with capital expenditures of $8 billion and a net margin of 3.35% on an improvement in operating expenses. This would lead to net income of $3.37 per share on a slight reduction in shares due to the repurchase program. Free cash flow greater than $5 billion should also drive an increase in the dividend and continued buyback of shares.

I am estimating between $5 billion and $6 billion for the ignition recall, including any fines from the Justice Department, victims fund and any other charges. This could prove a conservative estimate but I would rather estimate on the high side than be surprised when a larger reserve charge causes the shares to drop.

With a price multiple of 14 times 2014 earnings, I have a price target of $47 on the shares and might expect the stock to go even higher on 2015 expected earnings. GM shares are still trading on a discount due to the stigma of the bailout and are now being held back by uncertainty over the recalls. Sales do not seem to be getting hit by the recalls and the company may be able to turn it to their advantage by getting people to come back to the dealerships. Investors willing to wait out the uncertainty could see a nice upside over the next year or two.

Disclosure: I 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.

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