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Greenlight And Einhorn Are Right About General Motors

May 30, 2017

Summary

  • Greenlight's dual share plan optimizes the company's capital structure without creating any real operational risk and should lower the company's cost of capital.

  • GM's dismissive reaction towards, and apparent misrepresentation of, Greenlight's plan is sadly bureaucratic, emblematic of a dangerous 'Day 2' Corporate Culture.

  • Shareholders should vote for Greenlight's GREEN Proxy and send a clear message to GM's management and board that 'enough is enough'.

Greenlight Capital and David Einhorn have proposed a dual-share structure for General Motors (NYSE:GM) consisting of a dividend paying share and a capital appreciation share, to be voted on at GM's annual meeting on June 6th. Greenlight's presentation regarding their plan can be found here; and management's response can be found here. We believe that the proposed dual-share structure for GM makes obvious sense and would likely result in its shareholders being 30-80% wealthier. While GM's management has perjoratively described the plan as 'financial engineering', we think it is actually good financial engineering that will force the market to correct the severe undervaluation of GM's stock and lower the company's cost of capital, while at the same time doing nothing to harm the company's long-term prospects.

 

According to the proxy statement filed by Greenlight on April 28th [see document here], however, GM's response to Greenlight's plan has been totally unacceptable. Rather than attempting to work cooperatively with Greenlight to remedy any possible defects in their plan in order to achieve a solution that would benefit holders of GM stock, GM's management has instead apparently deliberately attempted from the outset to sabotage the plan by mischaracterizing it to stakeholders and the ratings agencies, displaying a disturbing 'same old GM' bureaucratic mentality that mindlessly resists any outside attempt to influence governance at the company. Nor has management proactively offered any plan of their own that would correct the persistent undervaluation in GM's stock price.

 

After seven years of suffering from a languishing stock price, during which time the overall market has doubled, resulting in GM currently ranking dead last in the entire S&P 500 in terms of P/E ratio, enough is enough. Shareholders should vote for the GREEN proxy in favor of Greenlight's non-binding proposal and send a message to GM's management and board that its apathetic 'just do more of the same' approach is no longer acceptable.

 

OPTIMIZING GM'S CAPITAL STRUCTURE DOES NOT CONSTITUTE HARMFUL FINANCIAL ENGINEERING

 

When an activist hedge fund comes along and makes capital structure recommendations for a target company, people both inside and outside the company typically react dismissively. It is automatically assumed that hedge funds are quick-buck artists who pursue 'financial engineering' schemes for short-term gains at the expense of long-term stakeholders. Certainly this is true in some cases. Financial engineering, though, is like many things in life--there's a good kind and a bad kind. The good form benefits both medium and long-term shareholders, as well as other stakeholders in the company, and does nothing to compromise the long-term health of the company; the bad form benefits only short-term traders and penalizes medium and long-term holders, as well as other stakeholders.

 

For example, a reckless debt-fueled buyback program by an already highly levered company at a high P/E multiple would be an example of the bad form of financial engineering, since the aim of such a program would serve to artificially prop up shares so that favored exiting holders could dump their overpriced stock on the market, at a substantial cost to the long-term financial health of the company. Conversely, the good form of financial engineering aims to fix a sub-optimal capital structure so that shares are properly valued by the market and the company's cost of capital is lowered, which is in the interests of all stakeholders. And make no mistake about it, in addition to running business operations efficiently and intelligently, a key job of any company's management and board of directors is to ensure that the company has an optimal capital structure so that its shares are appropriately valued by the market.

 

We believe that Greenlight's dual share proposal is clearly a good form of 'financial engineering'--if one insists on using that term--since it does nothing to harm the company's or management's ability to operate, while simultaneously creating an optimal share structure likely to appeal to all types of holders. The dual-share structure, by separating the dividend from reinvested earnings and buybacks, also acts as a forcing mechanism to cause GM's common equity to be properly valued by the market. The resulting higher valuation would thus reduce GM's cost of equity and, hence, its cost of capital, which makes GM more able to compete in the marketplace and, again, benefits all stakeholders.

 

VOTING FOR THE PLAN HAS NO DOWNSIDE RISK AND SIGNIFICANT UPSIDE POTENTIAL

 

Shareholders should note that Greenlight's proposal is non-binding--it doesn't force management or the board to do anything, let alone do something that could potentially harm the company. If the company can come up with a better solution than Greenlight has offered to correct its stock undervaluation, it is perfectly free to do so. Thus, voting for Greenlight's proposal has absolutely zero downside risk, but significant upside potential, representing the prototypical 'no brainer' decision.

 

If properly implemented, the dual-share structure should result in the company's common equity being valued by the market appropriately, or 30-80% higher than the current market price. In creating separate classes of common equity, it would force the market to value the dividend and the company's significant retained earnings as follows:

 

1. The dividend shares should be worth $17 to $22. Holders of the dividend shares would receive the same $1.52 per year dividend that GM holders currently receive. The dividend would be safe because [1] the company is currently paying out just 25% of its earnings in dividends, so even in a cyclical downturn it should be able to continue to cover the dividend, and [2] the company has approximately nine years worth of dividends in cash on its balance sheet. This safety should result in the dividend shares conservatively yielding in the 7-9% range, resulting in a valuation of $17 to $22. The company could also structure the security to increase the dividend over time in line with inflation, to protect its purchasing power.

 

2. The capital appreciation shares should be worth $26 to $38. Holders of the capital appreciation shares would enjoy the benefit of the reinvestment of retained earnings in excess of the dividend; in addition, they would benefit from any share repurchases by the company, since repurchases would be concentrated in the capital appreciation shares rather than the dividend shares. As the company is currently earning approximately $4.50/share per year in excess of the dividend, even a low P/E multiple of 5.8X to 8.4X would result in the capital appreciation shares being worth $26 to $38.

 

Combined, the dividend shares and the capital appreciation shares would thus be expected to be worth $43 to $60, or 30-80% higher than the current market price. Even if one were to assume that GM's earnings would temporarily fall to $3/share in a cyclical downturn scenario, however, the dividend shares would likely retain their $17-$22 valuation, since the dividend would remain safe, while the capital appreciation shares would likely be worth 12-15X the $1.50/share of earnings in excess of the dividend, or $18-$22.50 [note that P/E multiples for cyclical companies typically expand near the bottom of the cycle, as the market anticipates the next cyclical upturn in earnings]. Together, even at bare minimum the combined valuation of the dual class structure at the bottom of the cycle should still be higher than today's stock price.

 

GM'S MANAGEMENT APPARENTLY DELIBERATELY TRIED TO SABOTAGE GREENLIGHT'S PROPOSAL WITHOUT MAKING A GOOD-FAITH ATTEMPT TO COMPROMISE IN A WAY THAT WOULD BENEFIT SHAREHOLDERS

 

According to Greenlight, GM's management has inexplicably tried to block Greenlight's plan at every step of the way without making a genuine good faith effort to reach an agreement that would benefit the company's shareholders. Greenlight has laid out in its proxy statement linked above exactly how this has occurred, and we would strongly encourage all shareholders to read the section beginning on page 5 therein entitled 'Our Recent Interactions with GM's Management Team and Board'. Frankly, we believe that shareholders should be outraged at GM's management's intransigence, which if successful will leave shareholders much worse off than if they had taken an iterative and cooperative approach with Greenlight instead of a hostile one.

 

For the sake of brevity, we include the following summary bullet points of just some of the actions GM's management and advisors have taken to torpedo Greenlight's proposal, as described in Greenlight's proxy statement:

  • Announced at the outset that they believed that changing the capital structure cannot unlock much value for shareholders, exhibiting a shocking lack of urgency and open-mindedness when it comes to correcting the valuation discount in GM's stock

  • Spent shareholder money on hired-gun investment bankers to discredit the plan by using spurious assumptions. Such assumptions included lowballing the dual share class valuation by [1] assigning a miniscule 3.4-4.2X P/E multiple for the capital appreciation shares, even though such a multiple would represent a 50% discount to the lowest current P/E multiple in the entire S&P 500, and [2] assuming that the dividend shares would trade at a ridiculously high double-digit yield, even though the dividend should be amply covered by the company's earnings even in a stress scenario

  • Misrepresented Greenlight's proposal and omitted key financial information in presenting it to the rating agencies, so as to all but guarantee that the rating agencies would reach an unfavorable conclusion regarding the plan's effect on the company's investment grade rating

  • Refused to allow Greenlight to speak with the ratings agencies regarding the effect of the plan on GM's ratings, even though Greenlight offered to pay all costs in connection therewith

  • Failed to provide Greenlight with the company's valuation analysis of the dual-share plan, despite repeatedly promising to produce it to them

  • Raising supposed 'conflict of interest' governance concerns, when in reality many companies have different classes of equity stock, typically preferred and common, and such companies have no trouble managing conflicts

  • Generally displayed a surprising lack of sophistication in either understanding the plan or how to optimize the company's capital structure

GM'S MANAGEMENT SADLY CONTINUES TO DISPLAY A 'DAY 2' BUREAUCRATIC MENTALITY

 

A key to understanding GM's seemingly knee-jerk rejection of Greenlight's dual-share plan can be found in the following quote from Amazon CEO Jeff Bezos:

 

As companies get larger and more complex, there's a tendency to manage to proxies. This comes in many shapes and sizes, and it's dangerous, subtle, and very Day 2. A common example is process as proxy. Good process serves you so you can serve customers. But if you're not watchful, the process can become the thing. This can happen very easily in large organizations. The process becomes the proxy for the result you want. You stop looking at outcomes and just make sure you're doing the process right. Gulp. It's not that rare to hear a junior leader defend a bad outcome with something like, "Well, we followed the process."

--Jeff Bezos, 2016 Amazon Shareholder Letter [see full document here]

 

GM's response to Greenlight's dual-share proposal exhibits all of the hallmarks of this affliction, which Bezos calls a 'Day 2' problem ['Day 1' being a company's vibrant entrepreneurial phase and 'Day 2' being in his words a period of 'stasis; followed by irrelevance; followed by excruciating, painful decline; followed by death']. When presented with Greenlight's proposal, instead doing the logical, shareholder-friendly thing and engaging with Greenlight to attempt to work out some acceptable solution to GM's sub-optimal capital structure and languishing share price, GM's management instead decided to attack the messenger and message. Because the dual-share proposal did not emanate from GM's normal governance process, it immediately became anathema to the organization, much in the way that a person's immune system's immediate response to an outside pathogen is to attack it. 'Not invented here, not wanted here' becomes the mantra, which is very Day 2. No management team with a 'Day 1' approach to governance would ever react to Greenlight's non-binding proposal in such a close-minded and dismissive manner, including apparently deliberately bastardizing the proposal in presenting it to the ratings agencies in order to produce the expected negative response.

 

It appears that GM's management, with their power and authority threatened by the appearance of a dreaded 'activist investor', would rather leave its shareholders poorer than adopt a plan formulated outside of their normal process, which admittedly would necessitate some outside-the-box thinking and a bit of explaining to the rating agencies. But even this modest amount of effort, it seems, is too much to ask from those occupying GM's C-suite.

 

CONCLUSION

 

It is often remarked that doing the same thing over and over and expecting a different result is insanity. Nearly seven years have passed since GM's IPO, the overall stock market has doubled and GM's stock price has gone absolutely nowhere despite company earnings doubling during the period. When presented with a proposal to rectify this problem by optimizing GM's capital structure and thus force the market to properly value GM's common shares, a 'Day 1' management team would have embraced such an opportunity with open arms and tried to make it a reality. Instead GM's 'Day 2' management has dropped the ball completely, attacking and misrepresenting Greenlight's plan as risky 'financial engineering', while proposing nothing but a 'just do more of the same, even though it hasn't worked' approach. In reality, when facing an intolerable situation, true risk lies in doing nothing and expecting a different outcome.

 

GM's management has squandered a chance to be heroes to shareholders by proactively and collaboratively engaging with Greenlight in order to cure the valuation discount in the company's stock; instead, they have opted to be zeros. When management refuses to do the right thing for shareholders, then shareholders must act and send a message to management that the status quo is simply not good enough. Voting for Greenlight's non-binding proposal sends just such a message.

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