General Motors: How ICE Business Is Funding The Future And Reducing Financial Risk

Nov. 13, 2019 10:16 AM ETGeneral Motors Company (GM)F, STLA, TM41 Comments

Summary

  • GM management has transformed its legacy business from loss making to one of the most efficient and profitable auto manufacturers.
  • Why selling at book value does not make sense for GM and how the company is making the right steps to prepare for the future.
  • Financial health matters a great deal when recession might be just around the corner and GM seems to be better prepared than its peers.

Investment Thesis

The new General Motors (NYSE:GM) management managed to do the impossible over a very short period. Over just a few years, the company has turned into profitability by focusing on the high margin segments of the automotive industry, while allocating the proceeds into building successful future mobility platforms - autonomous driving, BEVs and fuel cells.

Although being labeled as "soon to be extinct", the strong standing of the automotive business serves as a bedrock for GM future. Not only is the strong automotive business of GM serving as a cash flow cow for investments in Electric Vehicles, Fuel Cell technologies and Autonomous Driving through Cruise, but it also contributed to the GM's current strong financial standing which would be crucial when next recession hits.

Source: gmauthority.com

GM Automotive - high and stable returns

As a starting point I will review GM within the light of its main peers in the U.S. with the highest market share - Ford (F), Fiat Chrysler Group (FCAU) and Toyota Motors (TM). For the time being I will skip Tesla (TSLA) as it's more comparable for review in the light of EVs only and perhaps autonomous driving.

Source: FCA 20-F Filing 2018, page 25

Source: author's calculations based on 10-K and 10-Q SEC filings

GM has been the underdog after it emerged from bankruptcy, lagging behind its major peers in terms of return on equity.

In just a few years however this trend has reversed and for the past 5-years GM has now been leading the pack, with the exception of FY2017 when the sale of European division to PSA and abnormal tax expense had one time effect. It should also be mentioned that FCAU ROE in TTM 2019 should be adjusted for the $6.5bn received from the sale of Magneti Marelli business.

Source: author's calculations based on 10-K and 10-Q SEC filings

*Excluding GM Financial, Ford & Toyota Credit

Since 2012 GM has significantly improved its gross margin by focusing on high margin Trucks, SUV and Crossover sales in the U.S. and scaling down low margin operations in Europe. Back in 2012 GM sold 1.3m cars in North America and 2.0m Trucks. In comparison in the last twelve months the share of cars was just 17%. By becoming a much leaner and profitable organization GM has become much better prepared for the current disruptions in the automotive industry.

Ford's (F) story on the other hand has been very different over the same period. The company has been slower than GM to restructure its operations in international markets and as a result is still struggling to improve its profitability at a time when investments in future mobility platforms are crucial.

Although low profit margin cars segment is about the same at Ford, the company's automotive gross margin profitability is much lower due to its international exposure and inefficient operations.

Source: author's calculations based on Ford and GM 2018 10-K SEC filings

Similarly to gross, operating profitability follows a similar trend. However, it is worth noting that after excluding GM Financial, Ford & Toyota Credit from operating profits, the divergence of automotive profitability between Ford and GM is even larger, with Ford's automotive operating profit turning negative in 2019.

Source: author's calculations based on 10-K and 10-Q SEC filings

*Excluding GM Financial, Ford & Toyota Credit

Asset turnover is very similar across the reviewed peer group, with the exception of FCAU which is the only company out of the four that doesn't have a financing arm. As expected Total Asset Turnover has been declining over the past years as vehicles sold on operating leases and through financing has increased significantly.

Source: author's calculations based on 10-K and 10-Q SEC filings

In spite of its very high leverage ratio, Ford is still not able to match its peers Return on Equity, while GM has managed to keep leverage constant over the past 5-years at around x5.0.

Source: author's calculations based on 10-K and 10-Q SEC filings

As expected F and GM have much higher leverage ratio than FCAU due to their financing arms - GM Financial and Ford Credit. Also FCAU has managed to significantly deleverage over the past few years. In the case of Toyota, the lower leverage ratio is due to the much lower size of the company's financing arm when compared to GM Financial and Ford Credit and the lower size of pension liabilities.

In a nutshell, GM's management efforts have paid off and the company is now leading its peers as far as return on equity is concerned. The company has managed to achieve that by focusing on high margin segments thus improving gross profitability, increasing operating efficiency and leveraging its operations through GM Financial. Ford on the other hand, with its global footprint is still struggling to match GM's profitability in spite of its higher leverage through Ford Credit. Fiat Chrysler, although seemingly doing very well on most metrics listed above, has been busy deleveraging its business and has failed to catch up with peers on the development of autonomous driving platform and electric vehicles. That is why it comes as no surprise that FCAU has been so desperate in finding new partner to merge with after the failed merger talks with Renault.

Investments in future mobility platforms

Although, some companies are doing a much better job than others at allocating shareholders capital by focusing on the most profitable ICE vehicle segments and allocating proceeds to future mobility platforms, all four companies reviewed above trade at around book value.

So why is this happening then? Well, if we ascribe to the popular belief that the traditional ICE vehicles industry is dying and giving way to EV or fuel cells platforms while at the same time the facing peak auto and a high probability of recession, then perhaps the safest bet is that all these auto manufacturers are worth the liquidation value of their assets, i.e. companies would trade at book value of equity.

However, there are a couple of problems with the assumptions made above. Firstly, clearly some traditional auto manufacturers are doing a much better job at transforming their businesses. Although not being profitable business models at the moment, BEVs, FCEVs and AVs will at one point in time generate high returns and being able to acquire leaders within this space at book value today seems like a bargain. Secondly, it is not entirely clear when exactly will rates of return on old ICE vehicles drop and when will future mobility platforms become profitable. In a sense we have a gap in profitability from expectations for falling returns on legacy businesses on one hand and expectations for increasing returns from future mobility platforms on the other. The smaller this gap is, the higher the premium over book value of assets should be.

Having said that, GM seems to be among the leaders not only within its legacy business, but within the field of future mobility platforms as well.

When it comes to BEV sales in the U.S., GM took the second place after Tesla in 2018, despite the company using the Chevy Bolt more as a compliance vehicle. GM is now planning to use its premium brand Cadillac for offering all electric and hybrid vehicles. The premium Cadillac brand would offer another high end feature which will help it differentiate from most competitors - improved Super Crusie.

As far autonomous driving is concerned, GM is also leading in the space alongside Google's Waymo project. I covered that in much more detail in my previous article on GM.

Finally, companies like Toyota for example, does not see 100% BEV future. According to Toyota, hybrids and fuel cell technologies all have a place in the car of tomorrow.

Source: Toyota Motors 2018 Annual Report

Not only that, but according to Toyota's vision for the future, hybrids and fuel cell vehicles will have a considerably higher market share within the longer-distance and larger vehicle size part of the transportation industry.

Source: Toyota Motors 2018 Annual Report

Fuel Cells - so many "mind-bogglingly stupid" people

According to the Tesla CEO, the idea of using fuel cells technology is:

mind-bogglingly stupid

Well then, if we all listen to Elon Musk then it seems there are many "mind-bogglingly stupid" people out there, or is it?

Of course, if you ascribe to the simple logic of why do we need to use electricity to produce hydrogen and then use that as a fuel as opposed to just using this electricity to charge our cars in the first place, then yes the idea does seem stupid. There are however numerous problems with such simplistic conclusions and the world we live in is not as simple as some people may say.

Similarly to Toyota, Honda and Nissan are also building their strategies around a mix of battery and fuel cell powered vehicles.

Experts from H2 mobility on the other hand claim that fuel cells technology has an environmental advantage when it comes to longer distances. This seems to back up Toyota strategy that when it comes to heavier and longer range commercial vehicles, fuel cells seem to be the better choice.

U.S. military is also interested in developing military vehicles based on the fuel cell technology, while Honda is investing alongside GM to bring production to scale and reduce costs. As a matter of fact, GM's SURUS project might offer a much better solution to commercial transportation than any battery based alternative.

Source: gmauthority.com

To sum up, the top of the line ICE vehicle business of GM is used to invest in a wide range of future mobility platforms - from all electric vehicles to fuel cells technology and self driving cars. Similarly to the ICE business, GM is also among the leaders in each of these fields.

Financial Health

The best in class automotive business that GM is using to invest in platforms of future mobility has also allowed the company to remain financially stable and better prepared for an upcoming recession than its peers.

The strong financial standing is absolute necessity in my opinion as the sector is facing so many disruptions at the same time when the risk of recession is at its highest levels it has been.

Despite the increase in total amount of automotive debt from $8.8bn in FY 2015 to $15.3bn in Q3 2019, GM still has the lowest Debt/Equity ratio from its peers.

Source: author's calculations based on 10-K and 10-Q SEC filings

When put into perspective the decision to increase leverage actually makes sense as the capital structure has not been optimal and GM is trying to fully capitalize on the auto cycle in order to fund its future ventures.

Just for comparison Tesla has a debt to equity ratio of x1.6 which could easily bring the company down to its knees should liquidity in the market start deteriorating or a severe recession hits. Of course, a direct comparison is not that relevant as supposedly Tesla is growing rapidly and is not in a mature stage as the companies listed above, but is indicative of the overall financial risk.

Source: author's calculations based on 10-K and 10-Q SEC filings

*Note: operating income includes profit from GM Financial and Ford Credit

GM's debt service coverage ratio (total automotive debt / operating income) is significantly better than that of its peers.

As a matter of fact GM's total automotive debt stands at $15.3bn as of Q3 2019, while cash and cash equivalents is at $20.1bn which results in a negative net debt figure. But even if one uses gross debt figure, GM's operating income for the last twelve months is covering 0.45 of total automotive debt outstanding.

No doubt, should the U.S. economy face a recession in the coming months, operating profitability of all auto manufacturers could quickly dry up. That is why debt maturities are crucial.

In the case of GM, 75% of total automotive debt is due beyond FY2023, which gives the company plenty of breathing room as far as automotive debt is concerned.

Source: GM 2018 10-K SEC Filing

For Ford, the share of automotive debt due after FY2023 is 66% with most of the short term due in this fiscal year which after looking at the Q3 2019 results seems to have been renegotiated for a later period.

Source: Ford 2018 10-K SEC Filing

Finally, the situation for FCAU is much worse with almost all debt due within the next 5-years and $5,861m due over the course of FY2019 which after looking at the Q3 report is still showing on the balance sheet.

Source: FCA 2018 10-K SEC Filing

Conclusion

To conclude, one should not forget all the risks associated with investing within the automotive industry, whether it is GM, F, FCAU, TM or even TSLA. It is a highly cyclical industry, facing a long list of challenges - disruption from a wide array of technologies and new deep pocket entrants, high risk of recession and very high customer indebtedness associated with peak auto.

Nevertheless, in my opinion it is this long list of risks that could easily cover up well-performing assets, skilled managements and investments future technologies.

In my view, GM has one of the best in class ICE vehicle assets. The company has become one of the most efficient auto manufacturers which positions it well for the upcoming disruptions in the industry. Its efficiency and profitability has allowed the management to improve on key financial risk metrics while at the same time investing heavily into the technologies of tomorrow.

This article was written by

Vladimir Dimitrov, CFA profile picture
4.14K Followers
Investment strategy for those seeking steady and above-market returns

Vladimir Dimitrov is a former strategy consultant with a professional focus on business and intangible assets valuation. His professional background lies in solving complex business problems through the lens of overall business strategy and various valuation and financial modelling techniques.

Vladimir has also been exploring the concept of value investing and in particular finding companies with sustainable competitive advantages that also trade below their intrinsic value. He supplements his bottom-up approach with a more holistic view of the markets through factor investing techniques.

Vladimir made his first investment in farmland right out of high school in 2007 and consequently started investing through mutual funds at the bottom of the market in 2009. In the years that followed he has been focused on developing his own investment philosophy and has been managing a concentrated equity portfolio since 2016. Vladimir is LSE Alumni and a CFA charterholder . 

All of Vladimir's content published on Seeking Alpha is for informational purposes only and should not be construed as investment advice. Always consult a licensed investment professional before making investment decisions.

Disclosure: I am/we are long GM. 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.

Additional disclosure: Please do your own due diligence and consult with your financial advisor, if you have one, before making any investment decisions. The author is not acting in an investment adviser capacity. The author's opinions expressed herein address only select aspects of potential investment in securities of the companies mentioned and cannot be a substitute for comprehensive investment analysis. The author recommends that potential and existing investors conduct thorough investment research of their own, including detailed review of the companies' SEC filings. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice.

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