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How General Motors Company's Profits Could Get Crushed

General Motors  (NYSE: GM  ) seems to be in trouble with its current bout of vehicle recalls. Recently, the company had to recall 1.2 million vehicles due to an airbag issue. While this certainly appears to be a big deal, it's likely just a drop in the bucket compared to the issues that are being raised about the "ignition switch conspiracy," and how the company tried to sweep this fatal issue under the rug. 

The recall
In February, General Motors recalled just over 1.6 million vehicles. The reason for the recall was simple: The ignition switch has the potential to automatically turn on "accessory mode," causing the vehicle to lose power (including to the airbag), which can have lethal consequences. 

To public knowledge, GM first became aware of the issue in 2004. At least 13 deaths associated with the problem have been reported since then. 

For investors, it's not just a case of, "Oh, it's another recall. It'll blow over."

This is a big issue now that the U.S. Attorney General has launched a criminal investigation into how the company handled -- or failed to handle -- this issue. The Attorney General's criminal investigation joins a similar investigation by the National Highway Traffic and Safety Administration.

The stock's reaction
I write the nightly recaps on CNBC's "Fast Money" TV show for, and every one of the traders on that show, night after night, has continued to say that shares of General Motors are at good levels to buy. 

Based on the price action of the shares, perhaps they are right. Perhaps everyone who is calling GM a buy right now is right. Whatever the case may be, new CEO Mary Barra is doing an excellent job handling the situation. She's being honest, straightforward, and cooperative. Barra has no reason to lie and every reason not to. The last thing she needs to do is start off her tenure with a huge scandal. 

Upcoming headwinds
There are two potential major headwinds for the company: Toyota Motors (NYSE: TM  )  recent $1.2 billion settlement,, and the recent lawsuit filed against General Motors for up to $10 billion in damages.

Toyota experienced a similar issue when it recalled roughly 10 million vehicles due to unintended acceleration, a malfunction that resulted in five deaths. Like GM, Toyota also tried to cover up the problem and was subsequently investigated by the U.S. Attorney General. 

On Wednesday, it was announced that Toyota would agree to pay a whopping $1.2 billion to the U.S. Justice Department. The settlement comes four years after the criminal investigation began. 

The case against Toyota Motors could likely act as a template for how the Attorney General will handle the current situation with General Motors. However, my thought is that the settlement could be for more than the $1.2 billion that Toyota had to pay. 

What if the fine is north of $2 billion? While that amount may seem minimal to a company that reported revenues of $155.4 billion in fiscal 2013, consider that it only pulled home $3.8 billion in net income. A $2 billion fine would reduce the company's annual profit by more than 50%. 

Even in fiscal 2011, when GM reported a record profit of $7.58 billion, a $2 billion fine would cost the company more than 25% of its total annual profits. Heaven forbid that the fine is greater than $2 billion. 

Concerning the potential $10 billion lawsuit, a group of lawyers from Corpus Christi, Texas, are seeking compensation for the diminished value of their clients' vehicles. The lawsuit is not in connection with the reported deaths of the ignition switch recall, but rather the value lost in the vehicles due to the issue. 

Investors have to ask themselves what will happen if GM does have to pay even half of that amount?

A lawsuit settlement of $3 billion-$5 billion, coupled with another potential 10-digit settlement with the U.S. Attorney General, and suddenly the company could have two years' worth of profits completely wiped out!

The bottom line
While GM indeed has many great things going for it -- strong demand for its autos in the U.S. and China, an attractive dividend, and great new products -- there are some nasty headwinds looming over the company. Even if those headwinds take years to play out, much like Toyota's four-year investigation, it's still something investors should at least consider before buying shares.

As a long-term investor, it's fairly safe to say that the company will weather this storm. But if there are better entry points for an investor considering the stock, or even better places to put one's money to work in the meantime, then it may be worth considering those alternatives.

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Comments from our Foolish Readers

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  • Report this Comment On April 02, 2014, at 12:06 PM, TMFMarlowe wrote:

    Just a reminder to everyone that GM has over $30B in cash and short-term lines available. This is a crisis, but not a crisis that threatens the company's financial viability.

    I don't see GM getting "crushed" here. My semi-wild-guess is that this whole thing will cost them maybe $3-4B, about what Toyota spent. I think it's likely that GM will spend somewhat more in settlements and somewhat less in fines than TM did -- I don't see the USAG pursuing a criminal case against GM's current management team as long as they continue to be forthright.

    John Rosevear

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Bret Kenwell

At The Motley Fool I cover consumer goods and industrial companies, and mainly the automakers. I am a long-term investor looking for companies with sustainable and above average growth. I also like to uncover value, dividend-paying companies. Follow me on Twitter @BretKenwell

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