The second quarter was a rough period for traditional automakers like General Motors (NYSE:GM). The COVID-19 pandemic disrupted production, particularly in North America. Meanwhile, many dealers were forced to shift to virtual operations for a lengthy period, adding to the sales headwinds from low inventory and weak economic conditions.
That said, austerity measures and strong demand for GM's recently upgraded full-size truck lineup mitigated the pressure on earnings more than Wall Street analysts had expected. Barring any further pandemic-related setbacks, the company is set to deliver surprisingly solid business performance in 2020 and beyond.
Overcoming production shutdowns
Like most of its fellow U.S. automakers, General Motors halted production in North America, its main market, in mid-March to slow the spread of the novel coronavirus. Production remained suspended for more than half of the second quarter. Furthermore, while production resumed on May 18, all plants initially operated with a single shift. GM's U.S. truck plants didn't return to normal three-shift operations until the beginning of June.
Given that GM books revenue when it delivers vehicles, these production constraints had a big negative impact on earnings. North American vehicle wholesales plummeted 62% year over year. Management estimated that this volume decline reduced operating income in North America by $4.4 billion.
However, General Motors was able to offset some of the earnings pressure it faced in North America through austerity measures like slashing marketing spending. It also benefited from improved pricing, thanks to strong demand for its newer models and less need to discount due to inventory constraints. As a result, GM posted an extremely modest operating loss of $101 million in North America last quarter.
Unsurprisingly, GM's international operations reported a bigger operating loss of $270 million. (In recent years, GM has struggled to remain profitable in international markets even when industry conditions have been relatively favorable.) It also spent $195 million on its Cruise autonomous vehicle subsidiary and earned $226 million from its GM Financial subsidiary. After accounting for corporate expenses, GM posted an adjusted operating loss of $536 million and an adjusted net loss of $0.50 per share. This was much better than the average analyst estimate, which called for a loss of $1.77 per share.
Don't worry about cash burn
The one detail in GM's Q2 earnings report that might seem worrisome to investors was the company's cash burn. Adjusted automotive free cash flow was negative to the tune of $9 billion last quarter -- at the unfavorable end of management's initial expectations. On a year-to-date basis, GM has burned through nearly $10 billion.
That said, the vast majority of GM's Q2 cash burn related to working capital pressure, which is a temporary phenomenon associated with the sharp drop in production last quarter, particularly in the first half of the period. Changes in working capital (including sales allowances) had an $8 billion negative impact on free cash flow.
Looking ahead, CFO Dhivya Suryadevara indicated that General Motors may be able to recapture about $5 billion of the working capital pressure experienced last quarter by year-end. While the company isn't providing formal guidance, this would be consistent with automotive free cash flow of $7 billion to $9 billion in the second half of 2020.
The recovery could be quicker than many expect
In the second quarter, GM's domestic vehicle deliveries plunged 34% year over year. Even in May and June -- when sales trends improved relative to April -- GM's retail sales fell nearly 20% year over year.
However, these weak results shouldn't concern investors. Low inventory has likely been a significant contributor to GM's recent sales declines. At one point in early June, GM had just 87,000 pickups on dealer lots: down 68% year over year. Inventory recovered to 120,000 units by July 25, supporting sequential sales growth. Sales of high-margin pickups should continue to build as inventory increases over the next few months.
The impact of the pandemic on GM Financial also appears to be muted thus far. Credit losses for loans are trending toward the low end of GM's official forecast, and resale values for vehicles coming off leases have been remarkably strong following a brief dip in April.
It's reasonable to expect U.S. auto sales to remain depressed in the near term relative to the highs of the past five years. That said, the average age of vehicles registered in the U.S. recently hit an all-time high of 11.9 years, up from 10.6 years a decade ago. As the economy recovers from the pandemic over the next two to three years, U.S. auto sales will likely rocket higher due to pent-up demand, enabling General Motors' earnings and free cash flow to reach new highs.