Even with the relentless bid to U.S. stocks in the past month, General Motors, an iconic American brand name, has badly lagged the advance. GM is down 21% year-to-date, and is trading near the same place it was on its IPO in late 2010:
A Bloomberg article this morning essentially laid out the bull case for GM, hinging on a cheap valuation, the recall headlines behind it, and new management focused on better products and higher margins going forward. Here was the conclusion:
Barra said she’s trying to get GM to shake off a sense that doing well is good enough. “It’s a healthy impatience that I’m driving into the organization, pressing the business to do more, faster and have a greater sense of urgency,” she told reporters after an Oct. 13 speech in Detroit.
The bankruptcy broke GM out of “a spiral of doom” that forced it to over-produce vehicles to cover legacy costs such as union benefits and debt, Moningstar’s Whiston said. With its new balance sheet, GM can be profitable when U.S. auto sales are as low as 10 million cars and trucks, he said. Sales this year are on track for 16.3 million.
“There’s a lot more economies of scale that they could still realize,” Whiston said. “Investors can be impatient and understandably some don’t want to wait many years for this all to play out.”
Since GM is one of the most widely followed stocks in the whole market, it’s presumptuous to simply write off the market’s view of the stock as misguided. The sellers clearly have some significant concerns with regards to the future profitability of GM. How salient are those concerns relative to the current valuation?
First off, margins and the overall management of the business operations are crucial for GM’s earnings power. Sales have actually held up quite well in the past few years, with around $150 billion in sales in 2011, $152 billion in 2012, $155.50 billion in 2013, and an expected $155 billion in 2014. However, 2011 EPS was $5.28, vs. $3.24 in 2012, $3.18 in 2013, and $2.65 expected in 2014. That is not exactly the picture of a well run company.
The recall situation has hurt 2014 results, but margins have also been hit by significant increases in operating expenses. Even though sales have only increased 3.5% since 2011, operating expenses have increased around 25% (especially hurt by operations in Europe and South America). While analysts have modeled in much better gross margins and higher sales in 2015 and 2016, and forecast a jump in EPS to $4.37 and $4.68, respectively, investors have good reason to be skeptical based on the results of the recent past.
Finally, GM gets about 45% of its revenues from outside the U.S. International growth concerns have not helped sentiment on GM. In addition, the rising dollar also acts as a potential headwind if it continues to appreciate.
Even so, GM’s valuation might indicate an overly pessimistic outlook. Even if GM misses those EPS estimates by 10-20% over the next 2 years, a 2015 result around $3.50-$4 and a 2016 result around $3.75-$4.25 would mean an earnings yield of around 11-13% with the stock where it is today. That’s much cheaper than the vast majority of large cap stocks in the U.S. market, whatever their business line.
GM is a good value in most scenarios. Given its high operating leverage, though, it could get hit quite hard in a major global growth crunch in the next year. Rather than simply buying the stock, I’d rather look to take advantage of the relatively cheap implied volatility in GM, and use an options structure for possible upside over the next 6 months:
TRADE – Buy the GM ($32.10) June 33/38 call spread for 1.25
– Buy 1 June 33 call for 1.75
– Sell 1 June 38 call at .50
Breakeven on June Expiration: Losses of up to 1.25 below 34.25 with total loss below 33. Gains of up to 3.75 above 34.25 with max gain at $38.
Rationale: That trade offers much better risk/reward than simply stepping up to buy GM here in my view. GM in the high 30’s or near 40 is much more fairly priced, so capping the upside to cheapen the structure makes sense to me.