General Motors: Not As Cheap As It Appears

April 20th, 2015

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This blog post was originally published on the blog by Jin Choi. The website no longer exists, but Jin has graciously allowed us to re-publish his research for the benefit of future investors forever.

On the third Monday of each month, Ill comment on the performance of the premium portfolios, and provide some additional analysis related to individual stocks.

Premium Portfolio News

In March, the premium portfolios had the following results:

  • Moderately Aggressive Portfolio: -4.6%
  • Very Aggressive: -7.4%
  • Extremely Aggressive: -11.2%

Because the premium portfolios consist of U.S. and Canadian stocks, it makes sense to compare the results against the S&P 500 and the TSX Composite, which are the most widely used U.S. and Canadian stock market benchmarks, respectively.

In March, the TSX Composite went down by 1.9%, while the S&P 500 went down by 0.2% in terms of Canadian dollars, which means that the premium portfolios far underperformed the market. (For what its worth, the portfolios have reclaimed most of those losses as of the time of this writing.)

We can attribute most of the underperformance to the two oil stocks in the premium portfolios - LRE.TO and BXE.TO. In March, LRE.TO went down by 35% while BXE.TO went down by 15%. Falling oil prices were to blame.

However, March also brought some positive news for BXE.TO in particular. In the last premium only article, I explained the significance of debt covenants. In short, a violation of the debt covenant can potentially bankrupt a company.

On March 11, BXE.TO announced that the banks chose to relax their debt covenants. Whereas the banks used to stipulate that the Total Debt to EBITDA ratio must not go above 3, theyve now relaxed it so that it must not go above 4.75. With the new debt covenant, my cash flow model shows that the company wont go bankrupt unless oil prices average below $45 a barrel for the whole of 2015.

With the newly relaxed covenants, I believe BXE.TO will almost certainly survive the current oil price environment. I also believe that when oil prices go back up, BXE.TO will likely double. Thats why I chose to buy more BXE.TO recently.

On the other hand, LRE.TO hasnt announced a similar deal with their banks yet, and that might partly explain why LRE.TOs stock has suffered more than BXE.TOs. However, Im optimistic that LRE.TO will reach a similar deal, given that its in a similar situation as BXE.TO. If it does reach such a deal, I expect LRE.TO to go up by more than BXE.TO.

Aside from the oil stocks, there isnt much to report on the premium portfolios. BKE released its earnings report mid March. While other companies stock prices typically move up or down by a lot, depending on their earnings, BKEs stock price doesnt fluctuate quite so much. This is because BKE releases sales reports every month, so its hard to catch analysts by surprise with an earnings report thats significantly different than anticipated.

Although BKEs sales havent grown very quickly as of late, the company continues to generate a healthy profit. Thats impressive, given the struggles that other teen retailers continue to experience.

Why I Researched GM

In past premium-only articles, Ive told you only about the stocks chosen for inclusion in the premium portfolios, but I havent told you about the ones I chose not to include. I thought it would be beneficial to explain my rationale behind some of the stocks Ive made a pass on, as that can also help explain my investment philosophy.

One such stock that I investigated and then passed on is General Motors (Ticker: GM). For the rest of this article, let me explain why I investigated it in the first place, and why I passed on it.

There are a few reasons why I chose to research GM. One reason is that superficially, the stock appeared cheap. In 2013, GM officially earned nearly $5 billion, yet the whole company traded at roughly $50 billion in 2014. This meant that GM had a price to earnings (P/E) ratio of just 10. Although I dont believe in basing investment decisions on the P/E ratio, Ive found that some stocks that have low P/E ratios do turn out to be genuinely cheap.

Another reason why I wanted to investigate GM was that it had a bad name. Most people Ive talked to felt that the Japanese and Germans made much better cars. In addition, GM went through bankruptcy during the financial crisis, and was struggling to contain the reputational damage caused by the ignition switch scandal. I figured that the average investor would have shied away from investing in GM because of the bad name. Fewer investors mean less demand for GMs stocks, which might result in a cheap stock.

Finally, I found out that the two money managers that work for Buffett were invested in GM. These money managers had good track records, so I felt that GM was at least worth looking into.

Unfortunately, when I analyzed the financials of GM, I was disappointed. The company didnt turn out to be as cheap as I had hoped.

GMs Liquidation Value

I typically break down the value of a company into two components - liquidation value and earnings potential. Liquidation value is the amount of cash that shareholders might receive if the company sold all its assets and distributed the proceeds. Earnings potential measures the value of future earnings that the company may generate if it doesnt sell its assets. If you want to get a deeper understanding of this valuation model, I would encourage you to Google residual income valuation.

The following link gets you to a spreadsheet that contains some of my analysis.

GM Financial Model

The first sheet details the liquidation value. Column B of the sheet shows the assets and liabilities of GM as presented in their 2014 financial statement. Column E of the sheet shows my approximation for GMs liquidation value.

The amount noted in the financial statements can be very different from their liquidation values. For example, GM recorded $13.6 billion as the value of its inventory, which means that the cars they havent sold yet have cost them $13.6 billion to build. If GM were to liquidate those unsold cars, they might have to sell at lower prices than their cost to build, so to be safe, I gave them a liquidation value of of $9.5 billion, which is 70% of the stated value.

When I adjust each item on GMs balance sheet this way and add them all up, I get a liquidation value of negative $20 billion. In other words, I project that if GM were to stop its operations and sell all its assets today, there wouldnt be enough cash to pay GMs shareholders at all. While this may sound alarming, its not a big deal. Many companies have negative liquidation values, but still have great value overall because of their earnings potential.

The negative liquidation value stands in stark contrast to GMs stated book value of positive $36 billion. By definition, book value is total assets minus total liabilities, and is supposed to indicate the value owned by shareholders. There are several reasons why book value doesnt equal liquidation value, but one of the main reasons is the treatment of deferred tax assets.

Im going to oversimplify here, but deferred tax assets are taxes that GM has paid early. Paying taxes early allows the company to pay less tax in the future, so the amount by which GM can pay less is recorded as an asset. At the end of 2014, GM stated that it had $35 billion worth of deferred tax assets.

While deferred tax assets can provide a real benefit, GM can only take advantage of the asset if it generates profits in the future. If it generates profits, then it has to pay taxes on those profits, and then GM can use some of the deferred tax assets to lessen the new tax burden. However, if GM doesnt generate profits, then it doesnt need to pay taxes anyway, and the deferred tax assets are worthless.

In fact, accountants will only allow a company to record deferred tax assets if they believe the company has a good chance of realizing the benefits of the assets. Indeed, the $35 billion worth of deferred tax assets didnt always exist on GMs financial statements. It only started to appear in 2012 when their accountants started to believe GM would make enough money to take advantage of the assets. Prior to 2012, GM had only recorded a total of $2 billion worth of deferred tax assets.

Because of these characteristics, I dont believe deferred tax assets will be worth anything in a liquidation scenario. Thats why I chose not to include it in my calculation of the liquidation value, and thats a big reason why GMs liquidation value is negative.

GMs Free Cash Flows

While GMs liquidation value is negative, the company can still be worth a lot if it has a big earnings potential. However, I was disappointed in this area as well.

The second sheet of my GM spreadsheet shows my approximation of the companys free cash flow. Free cash flow is different from net income in the sense that free cash flow only tries to measure the cash component of a companys net income.

For example, GM stated that it generated a net income of $6 billion in 2012. However, this figure included the gain of the previously mentioned deferred tax assets of $35 billion. But such gains dont affect GMs cash position right away. Excluding that gain and other non-cash items, GM would have earned much less in 2012. In fact, I believe its free cash flow would have been somewhere around $2 or 3 billion.

As my spreadsheet shows, I believe GM generated free cash flows of $2.3 billion in 2014, which is similar to how much it generated in 2012. This number is again lower than GMs stated earnings of $4 billion. There are several reasons for this, but let me state just one big one.

In the process of calculating GMs net income, GM expenses its employee pension costs, among other costs. However, calculating pension costs is not a straightforward process.

The stated pension costs dont represent how much GM contributed to its pension funds, but rather the increase in the companys pension obligations. For example, if GM employees promised pension benefits rise by $2 billion because of additional years of service, then GM will have to expense $2 billion, regardless of how much cash it contributes towards the pension.

Theres a lot more that I can say about the way pensions are accounted for, but let me save that for another day. For now, let me just say that many companies underestimate their pension expenses each year. Underestimating the expenses lead to inflated earnings, and thats partly why GMs free cash flow is lower than its earnings.

When I bring all this analysis together, I see a company that has negative liquidation value and annual free cash flows of around $2.3 billion. In the meantime, the whole company is trading at a value of nearly $60 billion today, which is more than 20 times its free cash flows. For me, this is too much, and thats why Ive taken a pass on GM.

This blog post was originally published on the blog by Jin Choi. The website no longer exists, but Jin has graciously allowed us to re-publish his research for the benefit of future investors forever.

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