David Einhorn’s Bullish GM Case Explained

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David Einhorn of Greenlight Capital presented his bullish case for Generate Motors (GM) yesterday. Let’s break down the two major themes of this presentation in more detail.

 

Earnings will increase

GM already trades at a cheap valuation compared to its peers. It trades at over 7 times estimated fiscal 2012 earnings and less than 6 times estimated fiscal 2013 earnings based on yesterday’s closing price of $23.68. Einhorn believes earnings can rise up to $6/share by 2014. 

GM’s earnings will be decided on two factors:

  • How its car models stack up to its competitors.
  • The overall state of the auto industry.

Although, Einhorn called the new Cadillac “outstading”, it is out of our circle of competence to make a judgment on their models.

On the other hand, there are lots of statistics that suggest that the auto industry is in a cyclical upturn. The sagging economy pushed U.S. vehicle sales down to just over 10 million in 2009 from an average of over 17 million from 2000-2006 (See chart below).

Annual U.S. Vehicle SalesFigure 1 U.S. Annual Vehicle Sales (data from Wards Auto)

In 2011, U.S. vehicle sales were around 13 million. This year sales are on target to be over 14 million. If sales reach anywhere near the pre financial crisis of 17 million, GM’s earnings will get a big boost.

Although, U.S. sales are going back up, sales in Europe are plummeting. Revenue in the first 2 quarters of 2012 for General Motors Europe (GME) is down over 20%. This has had a huge impact on overall profitability. According to Einhorn, “it will take time and there will be more losses but GM could expect Europe to break-even within 3 years.” Any type of European recovery will be a big boon to GM.

If the aforementioned things happen, most of the earnings will go straight to the bottom line. At the end of fiscal 2011, GM had over $47 billion of deferred tax assets of which over $21 billion were carryforward tax assets. This means that GM will not pay very much in taxes for a long time.

Earnings could also increase if GM starts buying back the government’s stake with the $33 billion it has in cash and marketable securities.

Pension risks overblown

At the end of fiscal 2011, GM had over $138 billion of pension and other postretirement benefit obligations. The pension and postretirement benefit plans were underfunded by $32.3 billion.

However, GM, with its cash, marketable securities, and abundant cash flow has the means to cover the shortage.

Besides being underfunded, the obligations are scary to investors because their calculations are based on such factors as mortality rates, discount rates and market returns. A slight increase or decrease in any of these rates could increase or decrease the obligations by billions of dollars. For example, a 25 basis point decrease in the discount rate could increase the obligations by $2 billion.

To reduce this risk, GM is getting out of the business of managing pensions. In June of this year, it announced that Prudential would administer and pay $26 billion of the aforementioned obligations. “GM’s anticipated cash contribution to its U.S. salaried pension plans to effect these actions will be in the range of $3.5 to $4.5 billion to help fund the purchase of the group annuity contract and to improve the funded status of the pension plan for active salaried employees.”

GM also ceased the accrual of additional benefits to its U.S salaried pension plans this September.

So, hopefully in a couple of years the pension risks will be mitigated.

Conclusion

David Einhorn’s case for GM makes a lot of sense. We are long GM shares and will look to add to our position. 

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Disclosure: I am long GM.

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