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Investors Are Still Underestimating General Motors

By Adam Levine-Weinberg - Updated Feb 9, 2018 at 3:12PM

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General Motors achieved record earnings per share last year, with further earnings growth likely in 2019 and 2020. Free cash flow is also primed to rise. Yet GM stock continues to trade at an absurdly low valuation.

During 2017, U.S. auto sales declined year over year for the first time since the Great Recession. That didn't slow down top U.S. automaker General Motors (GM 1.35%), though. Earlier this week, the General reported record adjusted earnings per share (EPS) for the full year.

GM delivered these strong results despite its growing investments in autonomous and electric vehicles and a major effort to reduce dealer inventory in the U.S. Nevertheless, General Motors stock trades for less than seven times earnings. This represents a huge opportunity for long-term investors to bet on a company with a burgeoning track record of outperformance.

Solid 2017 results

The biggest highlight of 2017 for General Motors was its decision to exit numerous unprofitable markets, including most of Europe and Africa. This immediately helped to improve the company's international profitability. Meanwhile, GM posted steady results in its two main markets: North America and China.

In North America, GM's adjusted operating profit slipped to $11.9 billion from $12.4 billion a year earlier. This was extremely impressive given that wholesale volume declined 11% year over year. The vast majority of this decline in wholesales related to U.S. inventory fluctuations: GM reduced its domestic inventory by more than 90,000 units last year compared to an increase of more than 200,000 units during 2016.

Two Chevy Malibu midsize sedans parked in a desert setting

General Motors reduced its domestic inventory significantly last year. Image source: General Motors.

Meanwhile, equity income from China stayed roughly flat at $2 billion during 2017, as higher sales offset ongoing pricing pressure. GM's other international operations reduced their losses, primarily due to improving market conditions in South America. Finally, the growing GM Financial unit posted a strong 50% increase in its segment earnings last year.

The improved results from South America and GM Financial fully offset the modest profit decline in North America and higher investments in autonomous vehicle development. As a result, adjusted operating profit stayed flat at $12.4 billion (excluding discontinued operations in both 2016 and 2017). Adjusted EPS reached a new record of $6.62 -- up from $6.12 in 2016 -- driven by a lower effective tax rate and a lower share count.

Results should stay strong in 2018

In 2018, General Motors is likely to get a huge lift in the U.S. from having launched all-new versions of several key crossover models last year. However, it will have to reduce production of its lucrative full-size trucks by at least 60,000 units in order to retool its factories for next-generation models that will be launched over the next couple of years. The net impact on North American profits will probably be roughly neutral.

GM expects further improvement in its international markets and its financing business in 2018, which will offset another spending increase for its autonomous-vehicle program.

All in all, management projects that adjusted operating profit and EPS will be roughly flat year over year in 2018. However, GM has been fairly conservative with its guidance recently. For example, just a few months ago, the General had forecast that adjusted EPS would come in around $6.25 for 2017 -- 6% below its actual full-year result.

Big opportunities coming in 2019 -- and beyond

Looking ahead to 2019 and 2020, the outlook for General Motors gets even brighter. First, the company will benefit from its new full-size truck platform. The high-volume light-duty pickups will be updated first, with new models arriving later this year. The lower-volume (but extremely profitable) heavy-duty pickups and full-size SUVs will be updated in 2019. GM expects to realize significantly higher profits from these models next year, with additional gains coming in 2020.

In its international markets, General Motors' new low-cost GEM vehicle platform will be ready next year. This will enable the company to build affordable vehicles for emerging markets more profitably.

Additionally, GM is preparing to take drastic action to end a long-running string of losses in its South Korean operations. This could enhance its profitability beginning in 2019.

Lastly, free cash flow is set to surge after 2019. Right now, GM's capital expenditures (capex) remain elevated due to the upcoming launches of the new full-size trucks and the GEM architecture. After 2019, annual capex could fall to $7 billion compared to around $8.5 billion now. Additionally, GM Financial should be ready to start paying dividends to the parent company on a routine basis within the next few years. Improvements in GM's underlying profitability could offer further upside.

Even with the heavy investments it's making today, General Motors expects to produce about $5 billion of free cash flow in 2018. As these investments wind down -- and start to pay off -- free cash flow could rise to $8 billion, or more, by 2020. GM plans to return the vast majority of this cash to its shareholders. This makes the stock look like a steal based on the company's current market cap of approximately $60 billion.

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