The Resurrection of General Motors

 | Aug 06, 2012 | 2:25 PM EDT
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Mention the American auto industry and most people will still respond with pessimism about its future. Any time the majority takes a singular position with respect to business, my natural tendency as a value-oriented investor is to look closer. After all, when investors are optimists they have a habit of paying too much for assets. When pessimism exists, odds are good that you can find an attractive price.

While I've yet to invest in General Motors (GM), the shares sit trading at $20 a share and less than 8x earnings. And if you believe that the American auto companies are embarking on a slow resurrection of sorts, GM is an even more attractive opportunity than valuation ratios suggest. GM recently reported second-quarter earnings of $1.5 billion, or 90 cents a share. Profits declined 41% from the year-ago quarter. Unsurprisingly, the decline was a result of weak performance from Europe and South America. Yet even under this scenario GM made a tidy profit relative to its valuation.

GM sits on a market cap of $31 billion while the balance sheet holds more than $35 billion in cash against $15 billion in debt. If that were it, the balance sheet would be among the best of any large industrial conglomerate. GM's anchor, or rather what analysts are zeroed in on, are the pension obligations. Currently GM has $134 billion in pension obligations, but what really matters is the underfunded portion of that obligation, about $25 billion. That's clearly a big number, but given GM's balance sheet, pension obligations are no longer the kryptonite they once were. Furthermore, GM currently plans to transfer a portion of its pension liabilities and obligations over to insurer Prudential.

The cloud created by the pension liabilities masks the earnings power of the new GM. Furthermore, in the years ahead U.S. new car sales are poised to improve. The average age of the U.S. passenger vehicle is currently 11 years, the oldest fleet ever. At some point those cars will have to be replaced. Of course, many people will probably trade for newer used vehicles, but that newly-used inventory has to come from somewhere. Auto makers like GM will be in line to sell plenty of gently used vehicles. And many of those vehicles will come from new cars that GM leases today further driving the revenue stream. Either way you slice it, odds are quite favorable that the average age of vehicles on the road will decline.

Both analysts and the market are giving signals that this age decline will occur. Shares in auto parts retailers, which perform well when cars are getting older, have retreated over the past several months in expectation that sales growth may take a breather. Both Advance Auto (AAP) and O'Reilly (ORLY), two of the three largest auto parts retailers, are down over 30% from their 52-week highs.

Another plus for General Motors is the recent purchase of shares by Berkshire Hathaway and David Einhorn, darn good company to keep. GM has shut down many lackluster brands and the cars are starting to look a lot better. Clearly the anchor today is the underfunded pension obligations, but GM's balance sheet is significantly better today than it was before the reorganization. Mr. Market always wants certainty and GM's pension is a cloud, but its likely a cloud that is covering up a powerful growth engine.



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