GM has been nothing short of an extremely disappointing business (and investment) for more than a decade. Market share losses, chronically unprofitable operations, ballooning pension and healthcare obligations, safety issues, vehicle recalls, a massive government bailout during the financial crisis, and more have left investors’ skeptical of GM since its relisting in late 2010. More recently, uncertainty in China (GM’s second largest market) and a potentially peaking automotive market have created additional anxiety about making an investment in the company. We think the new GM is a much healthier, structurally more competitive company that is attractively priced with a 4.6% dividend yield and a 2016 forward earnings multiple of about 6x. GM was added to our Top 20 Dividend Stocks list on 7/21/15 at a price of $30.39. It never hurts to know that Berkshire Hathaway moderately increased its stake in the company over the past year either (see Warren Buffett’s dividend stock holdings here).
Business Overview
GM is one of the largest manufacturers of cars and trucks in the world, racking up total retail vehicle sales of 9.9 million in 2014. Its North American brands are Buick, Cadillac, Chevrolet, and GMC, and the company’s vehicle mix in the U.S. is 37% cars, 38% trucks, and 25% crossovers. Customers outside North America are also served by GM’s Holden, Opel, and Vauxhall brands, as well as brands owned by Asian entities GM has equity ownership stakes in. By geography, North America accounts for 55% of sales, Europe 19%, South America 15%, and Other International Markets 11%. China is GM’s second largest market (#1 by volume). In 2014, GM estimates it had the largest market share in North America and South America, the number six market share in Europe, and the number two market share in the Asia, Middle East, and Africa region.
GM’s dark past remains relatively fresh in the minds of most investors. The U.S. government spent about $50 billion to bail out GM during the financial crisis. During GM’s bankruptcy in 2009, the government’s investment was converted to a 61% equity stake in the company, plus preferred shares and a loan. The government started exiting its stake in late 2010 when GM was relisted and was completely out of the company by the end of 2013.
What led to the company’s bankruptcy? Essentially, GM’s union-driven labor costs kept it uncompetitive with foreign competitors and chronically unprofitable, the company’s debt load was out of control (GM had more than $2 of liabilities for every $1 of assets prior to going bust), it was selling too many brands to too many dealers, and the frozen credit markets after Lehman Brothers collapsed made it impossible for GM to raise money or sell non-core assets to stay afloat. The company had been restructuring its operations for more than four years before the crash, racking up over $80 billion in losses, but it didn’t help enough.
In reality, GM’s demise started long before the years leading up to the financial crisis. This history is important to understand because it provides perspective on the significance of the new GM’s improved operations, which we will discuss later on. If you rewind the clock back to the 1940s and 1950s, there was actually very little foreign auto competition in the United States. During these golden years, GM actually held over 50% of the light vehicle market compared to less than 20% today. With such dominance, the company was able to comfortably maintain labor peace by handing over big pensions, free health care coverage for life, annual cost-of-living pay hikes, and more to its workers. One of the more ridiculous benefits was the Jobs Bank, a concession made in the 1980s that entitled any laid off workers to be paid 95% of their salary until a new job could be found for them.
At the time, GM could still get away with this because of its massive scale compared to peers. However, it was starting to feel the effects. According to The Center for Automotive Research, GM was spending 50% more per hour on each worker compared to its Japanese counterparts, and the cost of retired works’ health benefits added more than $1,200 to the cost of each car compared to vehicles produced overseas. Higher labor costs made the production of lower-ticket, smaller vehicles basically unprofitable, yet GM needed to maintain high production levels to avoid layoffs (it still had to pay laid off workers 95% of their salary until they found a new job, remember?) and continue pumping its massive dealer network with inventory that had to be deeply discounted to sell. Not surprisingly, GM’s quality deteriorated and the company’s market share was steadily eroded for more than 30 years. The rise of lean manufacturing in Japan further exacerbated GM’s inefficiencies and lower quality products. The following chart shows GM’s share of the US light-vehicle market from the early 1980s through 2008.
Source: The Economist
GM wasn’t alone. Chrysler was also bailed out during the financial crisis, and Ford requested a multi-billion dollar government credit line. Let’s take a closer look at the industry.
Business Analysis
The financial crisis forced the big US automakers to seriously rework their costly labor deals. Leading up to the financial crisis, automakers actually rid themselves of their health care obligations with a $50+ billion payment to a union-run trust fund and negotiated a two-tiered pay scale to pay new workers similar rates to those working for overseas competitors. It wasn’t enough when the crisis hit, but it was a start. After the crisis, the Jobs Bank act was phased out, significant labor cuts were made, factories became increasingly automated, and the mix of unionized workforce was decreased.
Altogether, GM closed about one-third of its plants, pulled back more than 2,300 dealers, and eliminated over 20,000 hourly jobs, almost 10,000 office jobs, and nearly $80 billion in debt. Labor cuts reduced the percentage of GM’s US employees represented by unions from 67% in 2009 to 56% in 2014. GM also shut down several vehicle brands (Hummer, Pontiac, Saturn, and Saab) to better focus its R&D, production, and marketing dollars. The combined effect of these actions is expected to let the company break even in a domestic market with annual sales of 10 million vehicles, close to the low point reached during the financial crisis. From a labor cost perspective, a recent study by the Center for Automotive Research reported that GM still paid $10 per hour more for labor than Toyota in 2014, the equivalent to about $250 a car in higher labor costs. While not at parity, we think enough of the gap has now closed for GM to be a viable competitor for years to come.
Cost is one thing, but quality is another. Japanese cars dominated on quality for many decades, particularly in the small and midsize car markets where efficiency matters most. However, GM’s new vehicles are showing glimmers of hope. Buick and Cadillac captured two of the top four spots in J.D. Power and Associates’ annual vehicle dependability study. This study is a big deal because it monitors complaints from owners of three-year-old vehicles. Buick also became the first domestic name to make Consumer Reports list of top 10 auto brands in the three years it has been published. Perhaps the company’s new designs and advertising are starting to pay off. Compared to Toyota, both companies received seven of 19 “best in segment” awards from J.D. Power and Associates, and all of GM’s brands outperformed the industry average of problems per vehicles.
Just this week, GM reported that its retail market share increased for a sixth consecutive month. GM’s US market share had been steadily eroding, falling from 15.7% in 2011 to 14.1% in 2014, and incremental share gains will not be a piece of cake. GM is still working to rebuild its reputation and brand with consumers, and recent events like the costly 2014 ignition switch recall certainly don’t help. Other brands are strong and come with much less baggage than GM, possibly keeping their customers more loyal. However, with the stock trading at a very low multiple of earnings, we believe the market is not expecting GM to gain any market share.
While the auto industry has fragmented over the last 50 years with increased foreign competition, the top four companies still account for nearly 50% of the industry’s output. The auto manufacturing industry is very unforgiving, requiring high levels of capital intensity, consistent technological innovation, extremely robust supply chains and efficient manufacturing facilities, big marketing budgets, and strict adherence to safety and environmental regulations. Last year alone GM spent $7 billion on R&D, $5 billion on advertising, and $7 billion on property. These factors keep barriers to entry high but have also made it difficult for existing players to earn a consistent profit, especially considering the cyclical nature of auto sales.
Looking ahead, GM’s strategies should lead to higher margins over time. The company seeks to cut $5.5 billion in costs over the next three years, more than offsetting increased investments in autonomous cars (it will start testing a fleet of self-driving Chevrolet Volt plug-in hybrid cars late next year) and ride-sharing services (7 million of its cars are connected to the internet already through OnStar) the company is making. These strategic investment position GM for various directions the auto industry could head over the next decade while still allowing the company to reinvest in its brands, including a $12 billion multi-year investment in new products and marketing for its Cadillac brand. Fewer brands, production discipline, less dealer incentives, and more concentrated marketing and R&D efforts form a foundation for structural margin improvement. GM hopes to boost its pretax profit margins from 6.8% last year to about 10% over the next five years and believes global auto sales will rise from 85 million to 130 million by 2030. Time will tell, but we like the direction GM is headed in.
Key Risks
The financial crisis highlighted some of the major risks faced by the industry. Vehicle sales are notoriously cyclical and have ranged from a low of 10 million in 2009 to more than 17 million in excellent years. Designing and manufacturing vehicles is very capital intensive, requiring large debt loads. If auto manufacturers are not careful, they can be caught with too much leverage and not enough cash when the cycle unpredictably turns. GM is in the best financial position it has been in for quite some time, holding over $25 billion in cash on hand. With its reduced factory footprint and more reasonable labor agreements, the company should operate near break even in the event of another downturn with much quicker response times to take out cost.
Timing the end of a cycle is next to impossible, but some investors are concerned we are near the end of the current one since vehicle sales have been very strong for six years and are near prior peak levels. China’s slowdown is also causing some agitation. GM wouldn’t perform well in either of those environments, but its downside risk seems much more limited to us than in past cycles given the current valuation and investor sentiment. For all we know, the record age of vehicles on the road (11.5 years vs 9.6 years in 2002), low gas prices, rock bottom interest rates, and underpenetrated international markets could prolong the current cycle. It’s too hard to predict.
Beyond cycles and global growth, union negotiations, fuel costs, and vehicle recalls are issues that come and go. In 2014 GM was challenged by significant ignition switch safety issues related to vehicles produced 10 years ago. The company recalled more than 25 million cars and trucks last year but still grew its North American business by more than 5%. The ignition switch issues has since been resolved, with most of the liabilities attributed to the bankrupt “Old GM” entity, saving GM billions of dollars.
A final risk to keep an eye on is much longer term in nature. As electronics, sensors, and technology continue ingraining themselves more into cars, the importance of Google and Apple’s expertise grows. Google has been developing self-driving cars for many years, but it’s difficult to understand its ultimate intentions and how they could impact GM and the rest of the auto industry. Regardless, their deep pockets and innovation make the issue one to watch.
Dividend Analysis
We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend. GM’s long-term dividend and fundamental data charts can all be seen here and support the following analysis.
Dividend Safety Score
Our Safety Score answers the question, “Is the current dividend payment safe?” We look at factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.
GM recorded a solid Safety Score of 35, suggesting its current dividend payment is safer than 35% of all other dividends available in the market. While it’s not a bad score, it is a reminder of the volatility in GM’s business, its capital intensity, and still meaningful debt load.
Over the trailing twelve months, GM’s dividend has consumed 49% of its GAAP earnings and 63% of its free cash flow. These levels provide some cushion if GM can indeed break even at trough level vehicle sales figures like it expects. However, the company’s restructured operations have yet to be tested. Looking ahead to next year, GM thinks it can earn $5.00 to $5.50 in adjusted earnings per share. This would imply an EPS payout ratio of 30%, a healthy measure for a cyclical business.
The balance sheet is an extremely important indicator of dividend safety as well. When times get tough, a healthy balance sheet can continue funding a company’s dividend. We can see that GM has a significant amount of debt on its balance sheet, including its financial arm. Its pension is also underfunded by about $30 billion. However, its $26 billion in cash and $12 billion of unused credit lines have it much better prepared for disappointing economic conditions, particularly if it can operate at break even.
The rise in debt to capital largely reflects the expansion of GM’s financial lending arm, including its acquisition of Ally Financial’s international auto operations in 2013. This business will provide better support and service to its dealers under GM.
Dividend Growth Score
Our Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.
GM’s Growth Score is 65, meaning its dividend’s growth potential ranks higher than 65% of all other dividend stocks we monitor. GM boosted its dividend by 20% earlier this year, and its profitability metrics are set to improve with the ignition switch issue behind it and continued strength in industry demand. The company’s $25+ billion of cash on hand provides cushion and opportunity for continued dividend growth. Since the company initiated its dividend in early 2014, longer-term dividend growth metrics are unavailable.
Valuation
As a cyclical stock, P/E multiples usually expand during recessions when earnings are lower and contract during healthier times, anticipating a future drop in profits. While industry conditions have been strong since 2010, GM trades at an exceptionally low multiple of forward earnings – about 6x. GM expects to earn between $5 and $5.50 per share before items next year, an increase of 11% to 22% compared to 2015 earnings estimates.
GM’s 4.6% dividend yield is good for a Yield Score of 76, meaning its yield is higher than 76% of all other dividend stocks. Unless the auto cycle crashes or China falls into a recession (both seem like very low probability events), we believe GM’s stock offers considerable value for long-term dividend investors at today’s price, which remains below the $33 per share IPO price from late 2010.
Conclusion
The pain caused during the financial crisis built up over numerous decades but finally allowed GM and the rest of the domestic auto manufacturers to form more sustainable business models. Despite the black eye caused by the ignition switch recall last year, today’s GM is much more cost competitive, better financed, and pointed in the right direction with market share gains and profitability improvements. At 6x forward earnings and a 4.6% dividend yield, GM looks appealing for long-term dividend investors.
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