General Motors (NYSE:GM) is a classic case of a “value trap or value play?” argument. The market knows GM stock trades at 6x-plus forward earnings and offers a 4%-plus dividend yield. The question, then, is not whether General Motors stock is cheap — but whether it should be cheap.
After all, there are plenty of risks here, both short term and long term. In the near-term, tariffs are starting to have an impact on GM earnings. U.S. auto sales for 2018 still are expected to be below 2016 levels – and could come down further, particularly if higher interest rates impact borrowing costs. Longer-term, fears of “peak auto” persist amid likely seismic changes in the industry.
That 6x-plus earnings is cheap — if those earnings are stable or growing. Quite clearly, that’s not guaranteed for GM, or rival U.S. automakers Ford (NYSE:F) and Fiat Chrysler (NYSE:FCAU). Even with strong earnings this week, Luke Lango argued that the rally in General Motors stock would fade — and I see his point.
But I actually like GM stock here – for reasons that go beyond cheap headline valuation measures. Notably, the Q3 report this week showed significant progress toward key goals for the company. There’s enough here between a still-moderate valuation and the potential for cash flow growth to move General Motors stock higher. GM did jump nicely after earnings — but I don’t believe the rally is finished just yet.
Why GM Stock Is a Value Trap
The bear case for GM stock is rather easy to make. In fact, it might be easier to make than the bull case.
Yes, General Motors stock trades at 6x-plus next year’s earnings. But there are plenty of reasons why. Free cash flow has lagged adjusted net income, and continues to do so. The figure is guided to roughly $4 billion this year, even excluding a prepayment on the company’s pension obligations. That in turn suggests a P/FCF multiple closer to 13x — not nearly as attractive as earnings-based valuations appear.
At the same time, auto manufacturing is a notably cyclical and capital-intensive business. Auto sales easily could drop for years to come, and if the economy hits a rough patch, drop rather substantially. GM hasn’t been as aggressive as Ford in moving away from sedans and compacts, but its mix still is moving heavily toward trucks and SUVs. Higher gas prices could move more consumers to smaller cars … and to foreign manufacturers like Toyota (NYSE:TM) and Honda (NYSE:HMC).
Longer-term, the risks are obvious. Electric vehicle development, led by Tesla (NASDAQ:TSLA), could undercut GM’s dominance in ICE (internal combustion engine) vehicles. Autonomous driving in theory should lead car sales to plunge.
In sum, then, the worry about GM stock essentially is that it’s never going to be this good again. Earnings — and cash flow — will drop over time. The balance sheet is improved coming out of the 2009 bankruptcy, but GM still has a fair amount of debt (notably in its financial services division) and $6 billion in pension liabilities on the books. As earnings fall, the value of the business should as well, and the value of General Motors stock could, in that scenario, fall even further.
Good News in the Quarter
Those risks can’t be ignored. But the good news in the Q3 report, beyond the headline beat, is that General Motors made progress toward a number of goals that strengthen the bull case here.
Free cash flow has lagged earnings, but that should change. CFO Dhivya Suryadevara said on the Q3 call that capital spending should see a “meaningful decline” after upcoming launches. Lower capex dollars will in turn boost free cash flow – and help support the GM dividend and repurchases of General Motors stock.
GM Financial will help as well. That business is paying the corporate parent a $375 million dividend in the fourth quarter. That figure is going to rise as the equity base in the subsidiary strengthens. Suryadevara projected that by next decade, all of GM Financial’s profits would be dividends for GM Corporate.
Even the pension liability should come down, thanks to higher interest rates (and thus, discount rates). That liability, on a cash basis, is getting close to immaterial against the $50 billion-plus value of General Motors stock.
So Q3 looks helpful to the bull case for reasons that go beyond a huge earnings beat. The long-term case for GM stock, too, seems strengthened here.
Can General Motors Stock Be a Value Play?
With those tailwinds, then, GM stock basically just needs to keep profits reasonably stable. And I don’t think that’s too much to ask. Self-driving cars, as recent developments at Tesla and Alphabet (NASDAQ:GOOGL, NASDAQ:GOOG) unit Waymo have shown, are further off than initially believed. I’ve long argued that the problem beyond the technology will be convincing human drivers to give up control.
Mix issues are a larger risk, particularly if gas prices rise, but GM continues to back its Bolt, and as noted it hasn’t fled the sedan space to the extent that Ford has. International performance has been choppy — but there, too, GM seems ahead of Ford from an overall standpoint (particularly in China, where Ford has struggled so far this year).
It’s naive to call the bottom in a cyclical stock with billions in annual capital spending. And, again, GM stock isn’t protected just because it’s “cheap.” But there’s also a reasonable path for General Motors stock to keep earnings reasonable stable — which is more than enough for General Motors to grind back into the $40s, at least. Add in a 4% dividend, and that’s double-digit annual appreciation easily. Should GM finally drive real success with the Bolt, or see investments in its Cruise technology pay off, the upside is much larger.
Q3 earnings strengthen that case. And they add to the sense that (perhaps somewhat quietly), there’s actually a really attractive story here. GM very well may be able to grow cash flow for years to come. Right now, GM stock isn’t priced for that outcome — or anything close.
As of this writing, Vince Martin owns a bearish out-of-the-money options position on Tesla. He has no positions in any other securities mentioned.