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General Motors Company Earnings: Recall Costs Crushed a Good Quarter

By John Rosevear - Sep 10, 2014 at 12:33PM

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GM's recovery remained mostly on track during the quarter -- except for one huge problem.

Sales of GM's latest big SUVs, like this all-new 2015 Chevrolet Tahoe, helped boost earnings in North America during the quarter. Source: General Motors.

General Motors ( GM 2.82% ) reported on July 24 that it earned $278 million in the second quarter, an 80% drop from its year-ago result, as solid numbers in North America were more than offset by big charges related to GM's ongoing recall scandal.

GM earned $0.58 a share, not counting one-time items. That was just short of the consensus Wall Street estimate of $0.59 a share as reported by Bloomberg. 

It was also short of the $1.3 billion net profit reported by Ford, and far short of the $5.76 billion in net earnings reported by Toyota

GM's stock fell over 4% on the news. It has yet to recover.

A deeper dive into GM's numbers

Two key storylines tell the tale of GM's quarter. On one hand, the massive (and still mounting) costs of the automaker's various vehicle recalls eroded its profits for the second quarter in a row. On the other hand, GM's long-term recovery continued to play out fairly well around the world.

The best way to understand GM's quarterly earnings reports is to review the results from each of its regional business units. Note that the profits and losses reported for each individual unit are "operating" numbers; they don't include the effect of taxes. 

North America
Despite GM's success in China and elsewhere, North America remains far and away its most important unit in terms of profits, as you can see from this chart showing second-quarter results at each of GM's business units.

Source: General Motors.

GM North America earned $1.4 billion in the second quarter. That was down substantially from the nearly $2 billion it earned in the same period of 2013,  but it included the impact of about $1 billion in recall costs. 

The recall has been a costly mess for GM. But behind that mess, it was a very strong, very promising quarter for GM. Revenue in North America was up 9.3%, and GM officials said that without the recall costs, operating margin in North America would have been 9.2%.

That's a big sign that GM's turnaround remains on track. The automaker's plan in North America, in a nutshell, is to carefully control costs while improving the quality and competitiveness of its products. Better cars and trucks can be sold at higher prices, with fewer discounts; if costs are managed, profit margins should improve -- and they have.

GM's average transaction prices in the U.S. were up about $3,000 per vehicle in the second quarter. A lot of that is due to GM's new-for-2014 pickups, which are much improved and much more profitable over their predecessors. 

GM was also helped out by its new full-size SUVs. The all-new Chevy Tahoe and Suburban, GMC Yukon, and Cadillac Escalade are also much improved, and all sold well during the second quarter.

South America
GM South America lost $81 million in the second quarter, a substantial drop of $135 million from the profitable result it posted a year ago. As we saw with rival Ford, a slowing economy in Brazil and political challenges in Argentina and (especially) Venezuela have made South America a tough market for many automakers. 

GM was no exception. Revenue was down 26% in the quarter as sales declined sharply. One bright spot: Profits per sale improved thanks to the introduction of several new models.

GM Europe has posted massive losses over the last decade, as restructuring after restructuring failed to stop the red ink amid deteriorating economic conditions on the continent. But under former GM CEO Dan Akerson, a return to sustainable profitability in Europe became a top priority. Now, the company is finally making real progress toward that long-elusive goal.

New management, new models, and a closer integration with GM's global product-development teams have all helped a great deal. GM's losses in the region have narrowed considerably, and officials say the unit is still on track to be profitable by "mid-decade." 

But they have also warned that the decline in losses would not be "linear," and they haven't been: GM's second-quarter loss of $305 million was up from a $114 million loss in the second quarter of 2013. The increase was due to a series of one-time costs related to the closure of a GM factory in Bochum, Germany, CFO Chuck Stevens said.

The Opel Mokka, a twin of the U.S.-market Buick Encore, has become one of Europe's best-selling SUVs. It was the best-selling SUV in Germany in the second quarter of 2014. Source: General Motors.

The underlying metrics continue to improve, though. Revenue was up about 6.5% in the quarter, and GM's Opel and Vauxhall brands saw increased share in 11 key European markets on the strength of newer models like the hot-selling small Mokka SUV.

International Operations
GM International Operations, or "GMIO," include the company's equity stakes in its huge joint ventures in China, where GM's overall share of the world's largest auto market is second only to mighty Volkswagen's.

GMIO earned $315 million in the second quarter, an increase of about $83 million from the year-ago period. For the region as a whole, sales volume and revenue both fell -- in fact, revenue was off almost 25%, largely as a result of GM's decision to stop selling Asian-made Chevrolets in Europe, Stevens said.

But that revenue did not include GM's profits from China, which is reported separately as equity income. GMIO's total equity income -- net of taxes -- rose almost 24% to $516 million; nearly all of that is from China.

GM Financial
GM's in-house bank, built around a lender that GM acquired in 2010, made $258 million in the second quarter. That was up $4 million from the year-ago period. GM Financial's leasing business is on the rise, and credit losses remained unchanged from a year ago.

One thing to note is that the business GM acquired was a subprime auto-lending specialist. Its subprime lending and exposure remain somewhat higher than the industry average. But credit losses have held steady at a reasonable 1.4%; it's not a source of worry right now.

Special items and the recall charges
GM took a one-time charge of $400 million, its initial estimate of the cost of a fund GM is establishing to compensate victims of accidents (and surviving family members of victims who died) related to the defective ignition switches that touched off the recall scandal. 

That estimate ignited a bit of controversy, as many observers, including this Fool, expected the final cost of the fund to be substantially higher. GM emphasized in a statement that there is no cap on the fund; the amounts paid are up to Kenneth Feinberg, the outside attorney hired to administer the payouts, and the company noted that its estimate of the fund's cost "contains significant uncertainty."

GM also took a charge of $874 million to fund a change in the way in which it estimates and plans for future recall expenses. Going forward, the automaker will hold a reserve on its balance sheet for each vehicle it sells in North America; the idea is that the reserve will cover any future recall costs.

(Ford does something similar; it increased its reserves in the first quarter, likely in anticipation of heightened regulatory scrutiny of recalls in the wake of GM's scandal.)

The $874 million charge establishes a reserve for the 30 million GM vehicles currently on the road. 

The upshot: A complicated picture for GM investors

GM executives have said the seemingly endless string of recalls seen in the first half of 2014 is mostly over. Going forward, the company expects recall costs to run a little higher than in past years -- because of increased internal and external scrutiny -- but not a lot higher.

The recall scandal has already cost GM well over $1 billion, and could cost it billions more by the time all of the litigation and potential criminal penalties are resolved. It has also dented GM's reputation; but to a large extent, the reputation dented was that of "Old GM," the company as it existed before its 2009 bankruptcy and restructuring.

The evidence for that? GM's U.S. sales have mostly held up through the mess. It has lost some ground to Chrysler in the important full-size pickup market, but to some extent that's simply an effect of GM's strict price discipline, which has paid off in much-improved profit margins.

Meanwhile, GM's long-term story remains largely intact. Its newest vehicles are hugely improved; it is making progress in Europe; sales in China continue to grow; and while GM's luxury brand Cadillac has hit some bumps in the U.S., it continues to gain ground overseas.

Long story short, GM CEO Mary Barra and her team have done a solid job of keeping the underlying business on track through the recall storm. But the storm has yet to pass, and the damage to come could still be significant. Stay tuned.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis – even one of our own – helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.

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