One of General Motors' (GM 0.06%) most-appealing developments for investors is far less sexy than the highly profitable Chevrolet Silverado, the flashy new Camaro, or the newest bling available inside each Cadillac -- I'm talking about GM Financial. The business entity will play a crucial role for the company if Detroit's largest automaker is going to beat the market through the rest of the decade.
Many investors don't fully understand GM Financial. Here are some of the details, and why it's so important.
What's GMF exactly?
The business strategy behind GMF is simple: Provide automotive finance products to more than 16,000 dealers worldwide, and support GM vehicle sales while generating profitable growth. Sounds easy, right? It's certainly more complicated than that, but if you really want to dig in and learn about it, I recommend reading this brief explanation of securitization from GMF.
Long story short: When a consumer purchases a vehicle from GM using GMF, the latter will create a contract, and then pool multiple contracts together to form a special purpose entity (SPE). From there, the contracts are moved to an asset-backed securities (ABS) trust. That trust is used as collateral for corporate bonds that are sold to investors; when consumers pay their monthly bills, GMF essentially reaps the profit margin between the interest it earned from consumers and what it paid out to investors.
What investors might not know, however, is that GM was forced to sell off its former financial entity during its bailout amid the financial crisis. Then, in 2010, GM purchased another financial entity, and has since been slowly building out its business.
Image source: General Motors Financial Strategic and Operational Overview presentation.
It's certainly less sexy than selling the newest Cadillac for $60,000, but it's a very profitable business for General Motors. Already, it's one of GM's most important business segments for EBIT-adjusted earnings.
Image source: General Motors' third-quarter earnings presentation.
During this year's third quarter, GMF generated a quarterly record $1.7 billion in net revenue and $231 million EBIT-adjusted. That contribution is about to increase significantly in the near term, and will likely become GM's second-most-profitable business segment.
Image source: General Motors Global Business presentation.
Much of that growth will come from expanding GMF's presence in GM's retail sales. Consider that GMF represented only 10.5% of GM's total retail sales as of last year's third quarter compared to 33% in GM's third quarter 2015. Though GMF doesn't want to finance every single GM retail sale in the U.S., there should still be significant upside to the quality loans it can dish out. For additional context, consider that as a percentage of GM retail sales, GMF represents 35.5% in Europe and nearly 55% in Latin America.
For more proof that GMF can increase its bottom-line profitability, look at crosstown rival Ford Motor Company (F 1.17%). Because Ford wasn't forced into bankruptcy, it wasn't forced to sell off its finance arm. That means that Ford Credit is a much more mature financial business. While Ford Credit is much more profitable than GMF at the moment, it shows how much room for growth GMF has, since GM outsells Ford by more than 3 million vehicles globally per year.
For context, Ford Credit ended the third quarter with $122 billion of managed receivables compared to GMF's $53 billion. Ford's third-quarter pre-tax profit of $541 million and year-to-date pre-tax profit of roughly $1.4 billion are roughly three or so years ahead of GM's third-quarter EBIT-adjusted earnings of $231 million and year-to-date EBIT-adjusted earnings of $670 million.
Ultimately, while GMF is a business many investors overlook, it will play a big role in GM accelerating its earnings potential in the near term. It also offers investors more stability on the automaker's bottom line, as earnings from GMF will be less volatile in the event of -- albeit, not immune to -- an economic downturn. If GMF can generate around $1.8 billion annually in pre-tax profits by the end of 2018, it will be a big win for GM investors.
