What GM’s $5 Billion Stock Buyback Means For The Company’s Strategy In The Next Few Years
General Motors (NYSE:GM) announced on Monday that it had come to an agreement with a group of activist shareholders seeking to force the company into an $8 billion stock buyback. The group, led by Harry Wilson, a former member of President Obama’s auto industry task force, and the U.S. auto maker have settled on a $5 billion share buyback that will commence immediately and wrap up by the end of next year. [1] Additionally, the company agreed on other changes in management to return more cash to shareholders over time. Wilson had announced that he planned to nominate himself to the Board of Directors of the company on behalf of a group of hedge funds which own about 2% of the company’s common stock, and if elected put pressure on the company’s management to spend $8 billion in buying back its own shares. The agreement represents a shift in GM’s handling of cash, which has been extremely conservative since it emerged from bankruptcy in 2009. Under the agreement, Wilson will withdraw his nomination for the Board of Directors and the proposed buyback plan. [2]
Two questions arise immediately from this: 1) can the company continue to invest aggressively in growth opportunities despite the use of $5 billion in cash to repurchase stock, and 2) does it bode well for the company’s long-term stability? The first question is easy to answer: the company has stated that it plans to invest around $9 billion in new products and facilities this year, roughly the same level as its competitors. It seems unlikely that the cash buyback program will affect the auto maker’s investing plans. The second is harder. While the $20 billion in cash on hand is enough to sustain the company’s investment activities for around two years, but in case the company accrues fines related to car recalls related to a faulty ignition switch defect, that might not remain the case. It is hard to estimate just how much the company might pick up in fines. However, it seems safe to argue that the company will need to access the capital markets in case that happens. If the company can maintain an investment grade balance sheet, that should not be a problem.
We have a $40 price estimate for General Motors, which is about 10% more than the current market price.
New Capital Allocation Framework
According to Wilson, the group and the company agreed on a new framework for capital allocation, which includes three core principles:
1) Company to Target Higher ROIC: General Motors management said that it will reinvest in its business with the objective of achieving a 20% or higher Return on Invested Capital (ROIC). [2] Last year, the company announced a new compensation measure that is tied to ROIC, in the hopes of incentivizing its management to drive the ROIC figure higher. [2] The U.S. auto maker also stated that it will start reporting its ROIC performance quarterly, starting from the next quarter. [2] According to our calculations, the company achieved a return of 18.6% on its invested capital in fiscal 2014. It’ll be interesting to see how the company plans on raising that figure. It could hypothetically do this by raising its average unit price per vehicle sold or by selling a mix of vehicles that is weighted more heavily towards the side of higher priced cars and retail sales than wholesale or corporate fleets. This would mean that the company will have to focus on making its cars more fuel-efficient as consumers are unlikely to pay more upfront for GM’s cars if they do not see a net gain in the long term. This would also mean a greater focus on the company’s Cadillac brand, whose revival is extremely important for the company’s profitability.
2) An Investment Grade Balance Sheet: The company has stated that it is targeting an investment grade balance sheet that includes a target cash balance of $20 billion. 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.
In order to get an estimate of the amount of cash the company might require in the case of a downturn, it is helpful to compare its use of cash in 2014 and 2013, two relatively stable years, with 2008 and 2009. 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.
3) Returning Cash to Shareholders: GM stated that it plans to return all available free cash flow to shareholders. The company will adopt an annual capital return program at the beginning of each fiscal year, starting from next year. [2] The company also reiterated that it plans to increase its quarterly dividend rate to $0.36 a share, from the current $0.30, starting the second quarter of 2015. [2]
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