On Monday, top U.S. automaker General Motors (NYSE:GM) rolled out a major update to its capital allocation strategy.
The highlight of the announcement was that GM will immediately begin repurchasing $5 billion in stock, with the full buyback scheduled for completion by the end of next year. This is part of a broader goal of returning all free cash flow to shareholders going forward.
To some extent, GM was forced into announcing the buyback by pressure from activist investors led by Harry Wilson, one of the masterminds of the 2008-2009 auto industry bailout. However, that doesn't mean it's a bad idea. The stock is extremely cheap -- it trades for a little more than eight times GM's projected 2015 earnings per share -- and the buyback will accelerate EPS growth.
Spoiling for a fight
Last month, Wilson announced that he planned to nominate himself for a board seat at GM, supported by a coalition of four hedge funds. The cornerstone of his "platform" was a call for GM to complete an $8 billion buyback by mid-2016. He also wanted improved transparency about the company's medium-term plans.
Wilson's proposed stock repurchase would have been dangerous for GM. The combination of a big, rapid buyback, a potentially massive fine related to GM's botched ignition-switch recall from last year, and increasing capital spending would have jeopardized the company's credit ratings. This, in turn, could have sabotaged its plans to grow the GM Financial auto financing business.
However, Wilson and his backers have called off their fight in light of GM's new capital allocation plan. While GM's buyback will be somewhat smaller and somewhat slower than they had sought, the activists were ultimately willing to compromise.
A reasonable deal
Some GM investors and analysts worry that even a $5 billion buyback is too much. They point to the company's bankruptcy and government bailout just a few years ago, arguing GM needs to maintain a massive cash hoard to protect against another crisis.
However, GM has concluded that a $20 billion cash target provides plenty of protection against unforeseen events, due to the company's efforts to reduce its breakeven point. Based on that cash balance target, GM expects to have at least $5 billion available for buybacks, factoring in planned capex, dividends, and other potential one-time costs.
In fact, GM's management indicated on a conference call Monday that additional cash could be available for share buybacks in 2015 and 2016 beyond the $5 billion committed so far. If GM's cash balance is tracking above $20 billion despite the buybacks, the company will presumably increase the stock repurchase authorization.
GM is performing well
Buying back shares is a good move for GM because the stock's low multiple does not reflect the strength of the business. Through the first two months of 2015, GM's U.S. deliveries rose 10% year over year, and the sales mix moved sharply toward more-profitable vehicles.
The company is on track for another strong year in China and is likely to reduce its losses in other international markets by more than $1 billion from 2014. The net result will be a big increase in companywide profitability this year.
This improving earnings trend will ensure GM generates enough free cash flow to support a $5 billion stock repurchase over the next two years. The buyback will help the automaker turn its net income growth into even faster earnings growth. That's a good outcome for both shareholders and other GM stakeholders.
Adam Levine-Weinberg owns shares of General Motors. The Motley Fool recommends General Motors. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.