South Korea has been General Motors' (NYSE:GM) Achilles' heel recently. GM Korea is one of the few pieces of the U.S. auto giant that is still losing money year after year; by early 2018, it was nearly bankrupt.
However, last month, General Motors reached a rescue deal for its Korean affiliate. Somewhat surprisingly, GM Korea was able to agree with its labor unions on cost-reduction measures and with the Korea Development Bank (KDB) to provide $750 million of funding. Yet the key stakeholders disagree on the timeline for turning around the business. Let's take a look at whether GM Korea has a reasonable chance of returning to profitability in 2019.
Since announcing the tentative rescue deal a few weeks ago, General Motors executives have repeatedly stated that they expect the company to return to profitability in South Korea next year.
The local labor union agreed to a deal that will freeze wages, cancel bonuses for this year, and cut benefits. Additionally, 2,500 workers accepted buyout packages. Meanwhile, GM Korea will close its Gunsan manufacturing plant later this month. The labor deal, staff reductions, and plant closure will reduce costs by $400 million to $500 million annually. GM's management says that these cost savings will return the Korean subsidiary to profitability.
However, the KDB recently contradicted this rosy forecast. Indeed, GM Korea lost more than $1 billion last year, so something about the General's math doesn't quite add up. The KDB's official projections call for GM Korea to return to profitability in 2022. That scenario isn't nearly as good for General Motors shareholders.
Here's what the government projections may be missing
At first glance, it appears that General Motors may have been overstating the likelihood of a quick turnaround for its South Korean subsidiary. That said, there may be some differences in how GM and the KDB are measuring GM Korea's profitability.
Last month, General Motors CEO Mary Barra stated that the restructuring "will enable GM to be profitable at an enterprise level from vehicles produced in Korea." That's not the same as earning a profit under standard accounting rules.
For example, Barra is likely excluding the cost of developing future vehicles, as GM would have to pay for those development costs regardless of whether the work was done in South Korea. GM Korea will develop two new products in the coming years -- a crossover and a small SUV -- so these costs could be significant.
Additionally, like other global automakers, General Motors has a number of core architectures or vehicle platforms that each support multiple models. For accounting purposes, GM Korea likely has to pay the parent company for the use of vehicle platforms developed elsewhere. In evaluating profitability at the enterprise level, management is presumably ignoring intercompany transactions that show up as costs for GM Korea but as revenue in other regions.
Lastly, as part of the restructuring, General Motors converted about $2.8 billion of intercompany debt into additional equity in GM Korea. This will reduce GM Korea's interest burden by roughly $140 million annually, providing additional savings (at least from an accounting standpoint) beyond the improvement in GM Korea's core operating performance.
Labor peace could be the key to long-term success
In the short run, it's possible that General Motors' management and the KDB are both right. GM Korea may improve its financial performance enough to make a slightly positive contribution to the full company's earnings -- including its support of GM's overhead costs -- while continuing to record losses each year.
However, investors ultimately want to see GM Korea earn consistent, meaningful profits. That could be feasible, despite the unit's recent losses. A big source of GM Korea's recent problems has been overreliance on small and midsize cars, which have fallen out of favor in most of the General's markets. The new crossover and small SUV being developed should lift factory utilization and dramatically improve profitability when they go into production a few years from now.
On the other hand, labor unrest could undermine this promising trajectory. Frequent strikes have been a major drag on GM Korea's profitability in recent years, and the company's recent drive to extract concessions has further aggravated management-labor relations.
Even if all goes well over the next few years, GM isn't going to be making money hand over fist in South Korea. As a result, it will have very little margin to absorb the costs of routine strikes. Unless GM Korea's management and employees can reach a consensus to avoid labor stoppages for the good of the company, GM Korea's turnaround may not last long.