GM’s Rumored Stock Buyback Is Short-Term Thinking
General Motors (NYSE:GM) announced earlier this month that Harry Wilson, a treasury department official who helped with the automaker’s restructuring in 2009, has nominated himself for a position on the company’s Board of Directors. Wilson, who represents Tepper’s Appaloosa Management and three other Hedge Funds that own 2.1% of the company’s stock, plans to convince GM to buyback $8 billion worth of stock. [1] The move is consistent with the recent trend of a number of activist investors entering companies and pressuring them to buy back stock in order to profit from the potential rally in market price (by reducing the number of shares, there is an increased allocation of revenue and earnings to each outstanding share).
It can be argued that some companies, as they chase growth, do so inappropriately through ill-advised diversification and acquisitions, causing the Return on Invested Capital (ROIC) to decline. Some managers are incented to build empires even as ROIC suffers, implying a real agency problem, given that company managers are only agents acting on behalf of their principals, which are shareholders. As a result, there has been a trend in recent times, with activist investors going into companies and arguing that they should slash spending and return cash to shareholders, even if doing so requires them to increase leverage. This has also made it useful to support the argument that there are no profitable opportunities that they can profitably pursue, an argument given more credence by Larry Summers and the Secular Stagnation Hypothesis. Hence, S&P500 companies sitting with record piles of cash and record stock buybacks in 2014. It is projected that S&P500 companies will redistribute $1 trillion dollars in cash in stock buybacks and dividends to shareholders in 2015. [2]
However, the application of this trend to companies that do have productive investment opportunities can result in negative outcomes. Below, we take a look at whether GM fits the description of companies above or not.
We have a $40 price estimate for General Motors, which is about 10% more than the current market price.
GM Has A Strong Cash Position
As of the end of 2014, GM had $25 billion in cash and $12 billion in available credit lines. [3] The company has stated many times that its strong cash position is part of its “fortress balance sheet” strategy. By this the company means that the company wants to hold onto cash so that it can continue investing in new products even in times of economic distress. The automaker knows, following the 2008-2009 crisis, that having ample cash during a downturn can provide a huge boost to the company’s profits once the downturn subsides. For example, Ford and Hyundai, two companies that went into the recession with highly liquid balance sheets, had a slew of new products in showrooms when the recession ended and their sales picked up considerably. In contrast, GM had to scramble hard, even as competitors took market share from it. The company’s management does not want to make the same mistakes again. What’s more is that its competitors also have strong cash positions: Ford has around $32 billion in cash and credit lines and Fiat Chrysler has about $30 billion. [4]
Without the buyback, GM is likely to use the cash to invest in new products, factories, and hire additional workers. The company might use some of the cash to settle lawsuits related to car recalls. If the company uses $8 billion in a stock buyback and has to pay up to settle court cases with some of its remaining cash, it could end up incredibly thin on the amount of cash available for investment. For example, the company needs to invest in fuel-efficient vehicles in order to keep pace with companies like Toyota, Volkswagen, and Ford, which have been taking away market share from it in different markets. The company also needs to invest significantly in its luxury brand Cadillac, in order to increase its profitability and keep pace with German auto makers like Volkswagen, Daimler, and BMW. If the company uses up about $10 billion – $12 billion, it might need to wait another couple of years before it can build up the sort of cash balance that it needs in order to start investing. In 2014 and 2013, the net cash used by the company in investing activities exceeded the cash generated from operating activities by $5 billion and $2.5 billion, respectively. As a result, it had to rely on financing activities for liquidity. In case of a recession, the U.S. auto maker’s ability to raise cash through financing activities will be impaired and it might be hamstrung in terms of its ability to invest in potential productive opportunities. In the previous economic downturn, GM lost $18 billion and $12 billion in operating activities in 2009 and 2008, respectively, and as a result had to invest $21 billion in investing activities in 2009. The company had to be bailed out eventually by the Government. In fact, it raised $44 billion in financing activities, of which $16 billion came from a U.S. treasury loan facility, and another $33 billion from a debtor-in-possession facility. Additionally, the incentives driving Harry Wilson’s nomination may be focused on short-term gains and not on the long term. If he gets elected, and gets the company to buyback stock, the hedge funds that he represents may also sell their stock into any price rally. If this is the case, it might not be in the long-term best interest of the company’s management to approve his appointment.
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Notes:- David Tepper Uses Activist Tactics To Force GM Stock Buyback, Forbes, February 2015 [↩]
- S&P 500 Companies Have $2 Trillion To Spend In 2015, Valuewalk, February 2015 [↩]
- GM 10-K, SEC [↩]
- Ford 10-K, SEC [↩]