How Safe Is General Motors' Dividend?

Auto stocks are the classic cyclical stocks: Profits swell during economic upswings, driving stock prices upward -- but when the economy turns down, profits can shrink, or even swing to losses.

That makes automakers like General Motors (GM 0.81%) a conundrum for dividend-minded investors. GM's dividend yield is quite good at the moment, but will GM's dividend get cut or disappear entirely during the next recession? 

Let's take a closer look at GM to see whether its dividend is one that we can rely on over the longer term. 

CEO Mary Barra has GM on course for profit growth -- and well-prepared for any economic downturn. Image source: General Motors.

General Motors' dividend: Key stats

Data sources: Thomson Reuters and General Motors. "Last increase" is the date the increase was officially declared, not the date it was first paid. 

Note that GM's dividend yield is 3.6%, well above average. Any time we see a dividend yield over 3%, it's important to dig deeper, as it raises a couple of important questions that need to be answered before we invest. 

How to tell whether a high yield is a buy signal -- or a warning

The first question that comes to mind when we see a high dividend yield is whether the yield is high because the stock's valuation is lower than it should be. When a company's valuation is low, it can be a sign of a value opportunity -- a good company that the market has overlooked for the moment. But it can also mean investors are shunning the stock for good reasons. It's important to understand why the valuation is low before buying the stock. 

Right now, General Motors' stock is trading at about 7.2 times earnings. Here's how that compares to the price-to-earnings ratios of GM's key competitors. 

Data source: Thomson Reuters.

GM's valuation is roughly in line with its old Detroit rivals', but it's well below those of several global peers. What's the story?

GM's valuation isn't low because the company in crisis: It's solidly profitable, with a strong balance sheet and a very good management team. It's low because investors were slow to catch on to GM's high-tech story: The company is emerging as a leader in two technologies that are key to the future of autos: self-driving and electric drivetrains. 

Wall Street has started to catch on to GM's story. The stock has risen about 21% this year. To my mind, its still-low valuation represents a buying opportunity, not a problem. 

Is General Motors' dividend sustainable?

The second question is whether the company will be able to sustain the dividend at the current level. Is the company paying out more money than it will be able to afford over time? 

In this case, we know that the yield is high because GM's stock has been somewhat out of favor with investors (though that's changing now). And we know that sustaining dividend payments through the next recession will be a priority for GM, up to a specific point -- because GM's chief financial officer told us so.

History teaches us that GM's profits are likely to be squeezed during a recession. Automakers have high fixed costs and require a fairly high level of sales just to break even. GM is running well above that level now, but when sales contract during a recession, its profits will almost certainly contract as well.

GM's all-new lineup of crossover SUVs is helping to generate the profits needed to fund future technologies -- and GM's dividend. Image source: General Motors.

In the past, such situations have led automakers to not only cut their dividends, but to also cut back spending on future-product programs. Nowadays, GM maintains a hefty cash reserve (around $18 billion) and a revolving line of credit (an additional $14 billion) to ensure that it doesn't have to cut future-product development during the next downturn. 

GM's chief financial officer, Chuck Stevens, has said repeatedly that GM expects to continue to pay dividends at the current rate through a recession until its cash reserve is exhausted. In other words, the point at which GM will eliminate its dividend in a downturn is the point at which it has to start tapping that line of credit. 

In a presentation in August, Stevens said that GM has modeled a typical moderate recession and concluded that it will use about $5 billion from its cash reserve in the first year of the downturn. Note that the over the last 45 years, peak-to-trough economic contractions in the U.S. have lasted an average of 12 months; the 2008-2009 recession, considered unusually severe, lasted 18 months. 

Summing up: How safe is GM's dividend?

To sum up: GM is in good health, it's out in front of technological changes coming to its business, and it's well-prepared for the next economic downturn, whenever that happens. Unless the next recession is unusually severe or protracted by historical standards, GM should be able to keep making its dividend payments at the current level.

Long story short: No company's dividend is ever 100% safe, but GM's is a pretty solid bet.