Market Musings - July 10, 2018
We continue our blog series: Market Musings, Volume 2, Edition 21, giving our (hopefully not too random) thoughts on recent goings-on in the markets. Today, we present "General Motors: Time for Activist Involvement".
THE ILLNESS: PERSISTENT SHARE PRICE UNDERPERFORMANCE
Common shares of General Motors (GM) (SEC filings here) have chronically underperformed the market since their November 2010 IPO, rising just ~16% plus dividends in almost 8 years versus the S&P 500 being up 130% plus dividends during same period, for a total underperformance of approximately 114% (the difference is even greater after dividends, or +155% for the S&P versus +33% for GM, since GM did not initiate a dividend until 2014). Shockingly, were GM shares to reach our $64 target price immediately (or 10X 2018E earnings), they would still have underperformed the S&P since their IPO, evidencing just how poorly the owners of the company have fared during the current bull market. Below is the tale of the disappointing tape from November 2010 to the present:
DIAGNOSING THE CAUSE
One might ascribe various reasons to explain this poor performance. Perhaps GM simply has a bad business model and thus value never compounds for its shareholders. We note, however, that competitors Toyota (TM) (SECs here) and Fiat Chrysler (FCAU) (SECs here) have not suffered despite having highly similar business models, as TM stock is up more than 60% since GM's IPO, while FCAU stock has more than tripled since late 2014, outgaining GM by 170% during that timeframe:
So GM's share price laggardness cannot be explained by the fact that it manufactures and sells autos. Nor can it rationally be explained by the threat of tariffs by the Trump administration or (in retaliation) by the Chinese government, since the vast majority of GM's GAAP profitability is generated within North America (and is therefore not dependent on vehicle exports). Moreover, GM China is composed of joint ventures with domestic Chinese companies such as SAIC Motors and Wuling Motors, which one would expect to be impacted minimally by any China-imposed retaliatory tariffs.
We also note that there are not even any headwinds evident in GM's 2018 financial performance that could logically explain the share price malaise. For example, GM recently reported domestic sales numbers for the April-June period, which showed an increase in deliveries of 5% year over year, resulting in a half percentage point uptick in market share (see here). In addition, the company announced last week that first half sales in China were up 4.4% (see here). So growth in GM's two largest and most profitable markets has been strong lately.
Could it be that GM has squandered massive amounts of money on unwise acquisitions since 2010? That does not seem to be the case either, as GM has not engaged in any large scale M&A transactions; rather, it has made apparently smart bolt-on deals. For example, in 2010 GM paid $3.5 billion for AmeriCredit (now GM Financial) (see here), in 2012 they paid $4.2 billion for Ally Financial's international operations (see here), and in 2015 they bought a 35% stake in Ally's China operations for $700 million (see here). All of these were logical additions to the core business model of selling vehicles to retail customers. In addition, GM paid $500 million for a stake in Lyft in early 2016 (see here) and paid around $1 billion for Cruise Automation in March 2016 (see here). Softbank recently committed to invest $2.25 billion in Cruise in exchange for 19.6% of the entity's equity, giving Cruise an implied valuation of $11.5 billion (see here). Concurrently, GM invested an additional $1.1 billion into Cruise. Thus if we assume that GM has sunk an aggregate of $2.1 billion into the company for its 80% stake (now valued at approximately $9.2 billion), on paper GM shareholders should be enjoying about $7 billion, or ~$5/share, in Cruise-related profits thus far. Meanwhile, Lyft's valuation has supposedly doubled over just the past year (see here), so GM's 2016 investment in the company should be firmly in the black. Yet GM's stock price is only up about $7/share since these investments were made, despite the company recording recording over $12/share in adjusted EPS since that time.
Could GM's share price doldrums be a result of stagnant earnings during this bull market? Again, no. Below are GM's 2009 through 2017 financial results, showing rising earnings from 2009 through 2016 and minimal 2017 earnings due solely to tax charges (without which earnings would have come in at $6.60/share) (sources here and here, respectively):
If we adjust for certain one-time tax charges and pencil in $6.60/share in earnings for 2017, below is a chart showing 2009-2018E earnings trends for GM:
This hardly resembles a company whose business model is collapsing or about to collapse, in fact just the opposite appears to be the case. Yet GM ranks close to the bottom of the entire S&P 500 with respect to P/E ratios. So we conclude that neither GM's business model nor its financial performance nor acquisition track record logically explains why the company's shares have massively underperformed peers as well as the overall market since late 2010.
So what is the real reason for the long-term underperformance? We believe that investors refuse to bid up GM shares because they believe that the interests of the board and management are not aligned with those of the shareholders and that therefore most of the economic benefits of GM's business model will never fully filter down to the true owners of the company. Why do we think shareholders believe this? Look at the following facts:
First, there is no true shareholder representative on the Board of Directors, so the owners of the company lack an advocate for their interests in the key decision-making body of the organization. Board members historically have bought only token quantities of stock on the open market and CEO Barra has only bought a minuscule 800 shares with her own money since 2010 (grand total spent: $26,400), despite receiving tens of millions of dollars in cash compensation (salary plus cash bonuses) since then. The following is the ONLY open market purchase of GM stock Barra has EVER made (source):
Barra is Chairman of the Board--by far the most important director--yet is not financially aligned with shareholders and in our opinion runs the board to benefit primarily the members of the C-suite, not the shareholders (see corporate governance section below). GM attempts to claim the contrary in its 2018 Proxy Statement, stating that "Your board holds management accountable" (see excerpt below); yet how can this possibly be when the board itself is chaired--and therefore basically controlled--by management (i.e., the CEO)???
The company further states above that "GM's performance under [Barra's] leadership demonstrates that [having her also serve as Board Chairman] is the most efficient way...to create value for shareholders". Does this statement make any sense at all given the fact that since Barra became chairman in early January 2016 (1) GM stock has vastly underperformed the S&P 500 and (2) the company has only raised the dividend by $0.02/share per quarter (with zero increases since shortly after Barra assumed the chairman's seat)?
In addition, below we can see that the non-executive directors on GM's board (who supposedly are looking out for the shareholders' interests and overseeing management's activities) collectively own just 107,088 shares outright, or about one-thirteen thousandth (1/13,000th) of all outstanding shares (source):
Second, GM's board and management have consistently refused to take actions to benefit shareholders except under the duress of a proxy fight:
1. FCAU merger proposal - Back in 2015 Fiat Chrysler chairman Sergio Marchionne proposed a potential merger between FCAU and GM. However, instead of pursuing a combination that could have brought with it many billions of dollars in synergies (most of which would flow to the shareholders of the respective companies), GM CEO Barra rejected the idea out of hand. According to contemporary news accounts (sources here and here):
"Marchionne sent an email to GM CEO Mary Barra in March [2015] suggesting that the two companies that a combination of the two automakers could cut billions of dollars in costs.... Barra discussed the pros and cons of a GM-FCA merger with her key staff and board members. However, in fairly short order, she sent Marchionne a rejection letter, denying his request for a face-to-face meeting on the matter."
So Barra would not even discuss the matter with Marchionne, indicating a close-minded attitude toward any outside influence that could potentially threaten her entrenched CEO/Chairman position (letting Marchionne get a foot in the GM door was clearly a threat). Since rejecting the FCAU proposal out-of-hand for no apparent reason, FCAU's share price has almost doubled, meaning Barra potentially left billions in value on the table that could have accrued to GM shareholders, assuming the two entities had combined in a stock-for-stock merger. No doubt Barra is not losing any sleep about such a missed opportunity, since her bureaucratic mentality naturally resists any external M&A advances, regardless of whether shareholders might prosper from them.
2. Proxy Fights - In addition, CEO & Chairman Barra et al. have now been the subject of two separate proxy fights in just the past 3 years. The first was in early 2015 when Harry Wilson acted on behalf of a group of hedge funds advocating for better capital allocation at GM, which contest GM settled by agreeing to a large buyback (source):
"General Motors agreed Monday to buy back $5 billion in stock and put forth a new capital allocation plan, which offers investors a more transparent view of GM's cash investment proposals than previously disclosed. In exchange, Wilson dropped his bid to get a seat on GM's board."
The second was waged by Greenlight Capital last year. Greenlight proposed an ingenious dual-share structure for GM that would likely have raised the share price significantly. GM, in its infinite bureaucratic wisdom, decided to sabotage any hope that the plan could come to fruition by trashing it with the rating agencies. We discussed this debacle in detail in a previous article (see here). However, the impending threat of Greenlight's proxy fight was sufficient to spur GM management into finally divesting GM Europe after $20 billion in losses over the previous 17 years, so at least it had one beneficial result for the owners of the company (note that the troubled European car market is once again stagnating).
WHY THE STOCK PRICE MATTERS: COST OF CAPITAL
Frankly, we are a bit tired of hearing apologists for Barra & Co. who insist the stock price doesn't matter, that it's all about the long term, etc. Firstly, if it's "all about the long term", why do the C-suite members get annual incentive bonuses based on achieving short-term (yearly) metrics (aka, the STIP)? If it's "all about the long term", why do GM's illustrious C-suite denizens constantly exercise and dump their shares on the open market as soon as they legally can (see, e.g., here, here, here and here)? But more than that, why the stock price matters is because the stock price determines what a company's cost of capital is--and the lower the cost of capital, the better able said company is to compete in the marketplace.
For example, what company would have a greater advantage in selling cars: Company A, whose stock trades at a P/E multiple of 5X (or an earnings yield of 20%), or Company B, whose stock trades at a P/E multiple of 200X (or an earnings yield of 0.5%)? Obviously, other things being equal, Company B will have a great advantage over Company A because it will be able to raise equity capital with a yield of just 0.5% (far below the yield on, say, 30-year Treasuries). Moreover, a company that can raise cheap equity capital will also likely be able to issue cheap debt, since debtholders will take comfort in the company's strong "equity cushion".
Or, to put it another way, a company generates value of its owners only if its ROIC exceeds its cost of capital. Thus, the lower the cost of capital, the more value accrues to the shareholders at any given ROIC. By permitting its cost of capital to be abnormally high (due to the conflicts of interest addressed herein), GM's board of directors are in effect robbing the true owners of the company of a portion of the economic gains that would otherwise flow to them. Simply because they can't be bothered to address the fact that the board is controlled by management instead of the shareholders. This is an obvious problem--but one that fortunately can be fixed.
THE REMEDY: ACTIVISM
Today an activist in GM has great opportunity to make billions in profits by forcing board of directors to act in the shareholders’ interests (rather than management’s). If GM's board of directors were chaired and/or represented by directors who actually prioritized the interests of the shareholders (as the true owners of the company) and took the steps we outline below to increase shareholder worth in GM, we believe that GM's stock could re-rate upwards to as high as $64/share, or 10X 2018's estimated EPS of $6.40 (indicating shares could have up to 60% upside). Thus, an activist who amassed a 10% stake in GM (meaning 140MM shares) could make up to a $3.36B profit on a $5.6B initial investment. To repeat, that is a profit of $3,360,000,000--not exactly chump change for large activist hedge funds or investors.
We note that in the past 6 months of trading, more than the entire share count has changed hands (see here). Thus, in order to acquire 140MM shares, an activist would only need to buy about 10% of the daily trading volume to build such a stake in half a year (or about 20% of the volume over a three-month period). Who could be potential activists? The following:
Greenlight Capital - as noted above, Greenlight ran a proxy contest against GM just last year and as of the end of Q1 2018 owned 22.6 million shares, or about 1.6% of the outstanding stock (source);
Elliott Management - probably the top activist hedge fund, Elliott has around $34 billion in AUM (source), so could easily amass a large enough GM stake to make a proxy contest worthwhile;
Appaloosa - Appaloosa Management, founded by David Tepper, is one of the most successful hedge funds of recent decades (source); Appaloosa was involved as an activist in the 2015 proxy contest and could potentially go for a second round of activism in light of GM's recent sagging stock performance since then;
Starboard Value - Starboard is a large and successful activist hedge fund with AUM of around $5 billion; they take concentrated positions and advocate aggressively for change at their investee companies. In addition, Starboard has experience in the auto / industrial manufacturing space, with recent positions in Advance Auto Parts and Cars.com (see here) and prior activist campaigns involving Wausau Paper Corp (see here) and ;
Pershing Square - Pershing Square is a well-know activist outfit which is now apparently on the rebound from several investment misfires; chief investment officer Bill Ackman tends to focus on alignment of incentives, which is clearly the biggest problem at GM. Note that Pershing held a significant position in GM as of the end of 2010, so they are familiar with the company (source);
Trian - Trian, headed by Nelson Peltz, has activist experience with industrial companies such as General Electric (currently holding over 70 million shares, source here), thus they could be a future activist with respect to GM;
Carl Icahn - Carl Icahn currently has an entire auto-related business segment under the aegis of his holding company Icahn Enterprises, consisting of the following (thus being an activist in GM could make logical sense for him) (source):
The following are steps we believe an activist must make GM's board take:
1. Increase the dividend - the current payout ratio, at ~25%, is far too low. The dividend should be increased to $2/share per year, representing a payout ratio of approximately 33% (which is still conservative). GM shares would yield a healthy 5% at current price levels.
1a. Buy back stock based on share price & P/E ratio (buy more when lower, less when higher) - we think it was a questionable decision in March of this year to buy $1.59 billion worth of shares owned by the UAW Retiree Medical Benefits Trust at nearly $40/share (see here), when GM could have bought a similar amount of stock 10% or so lower in price on the open market. As a general rule, however, when the company's forward P/E is under 8X, repurchasing shares makes a lot of sense.
2. Tracking Stocks - GM should issue tracking stocks for GM China and GM's New Ventures (Cruise Automation and its Lyft stake). If this were done, GM would be much more likely to trade according to the sum of its constituent parts, meaning the respective parts should accurately reflect their underlying cost of capital. Why, for example, should Cruise Automation, clearly a tech business, suffer from the suboptimal cost of capital attributed to an auto manufacturer, a capital-intensive industrial business? In addition, compensation of GM employees could be much better targeted, since individuals assigned to work for a tracking-stock entity could be paid with the currency of that entity instead of the overall company, while tracking-stock entities that need capital could raise the same via tracking stock issuances.
3. Fix GM's corporate governance - GM should allow for proxy access for holders of a 1.5% stake (which currently would amount to about $840 million worth) + 2 year hold period; in addition, the company must split the CEO and chairman roles and onboard as the new chairman a representative of a large shareholder.
4. Fix GM's senior executive compensation system - we outlined the flaws in GM's compensation system in our last GM Seeking Alpha article (see here). The current system is in dire need of reform, which changes an activist would be primed to effect.
5. Additional Items - an activist would be able to draw upon their own prior experience in proposing additional shareholder-friendly changes at GM. Perfection should always be the goal, therefore pressure constantly needs to be on the board and management to improve and perfect things over time.
Note that many activists operate behind the scenes as the most effective way to influence boards and management. Thus, just because a Greenlight or a Jana may not be attempting in public view to effect one or more of the above-outlined steps to increase shareholder value doesn't mean that they are not doing so privately.
DISCLOSURE: Long GM.
