Why This Analyst Raised General Motors' Price Target

By Daniel Miller Markets Fool.com

Detroit skyline. Image source: Getty Images.

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There hasn't been a long list of analysts posting bullish notes on major automakers over the past year, due to the inevitable peaking of the U.S. new-vehicle cycle after the industry set sales records each of the past seven years. That's why yesterday's upgrade from Morgan Stanley analyst Adam Jonas, a highly respected analyst and longtime Tesla Motors bull, was a pleasant surprise for investors. Here's what Jonas had to say as he raised General Motors' (NYSE: GM) price target from $40 to $42.

What Jonas said

Roughly three quarters of the increase to our target is based on removing the 25% discount we had applied to our valuation of GM's deferred tax assets [DTAs] which we value on a DCF [discounted cash flow basis] at $7.2bn ($5/share) at a 9% WACC [weighted average cost of capital]. While we see GM and its OEM [original equipment manufacturer] peers producing substantially lower margins over time in the US market, we expect they can remain profitable long enough to fully utilize its DTAs this cycle. The remaining increase in our target is driven by our modestly higher earnings expectations, offset by slightly lower expectations in our China JV [joint venture] forecast.

Deferred tax assets are used to offset the taxes General Motors will pay on its earnings. Thus, a lower effective tax rate will increase the company's adjusted automotive free cash flow. As of Sept. 30, 2016, GM had $34.4 billion of net deferred tax assets, which will help Detroit's largest automaker drastically offset tax liabilities on future earnings.

More positives for GM

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Sure, GM's mountain-like pile of DTAs is a good thing, but there's more to like about the automaker. While total new-vehicle sales may be peaking, some upside could remain as consumers continue to park their sedans in favor of more expensive SUVs and full-size trucks. Due to that trend, GM's average transaction prices have moved from $35,300 in 2013 up to an estimated $42,200 in 2016. With sales peaking in the U.S., GM will face increasing pricing pressure, but it at least has a little more wiggle room now than it did even a few years ago.

Another positive for GM's top line, bottom line, and overall brand image is that the cadence of its new-product launches is going to improve through 2020, as you can see below.

Image source: GM's Deutsche Bank Global Auto Industry Conference presentation.

In addition to raising its average transaction prices and offering a fresher product portfolio, GM has been diligent about trimming costs and creating synergies. In 2015 GM set forth a plan to create $5.5 billion in cost efficiencies by the end of 2018, and it's progressed so well that it's bumped that estimate up to $6.5 billion. Only about $3 billion of that would be net savings, due to GM pouring some of the proceeds into investments in brand-building, engineering, and technology as the race for electrified and autonomous vehicles heats up.

A lot to like

GM's balance sheet is now investment-grade. In addition, the company keeps a constant cash-pile target of $20 billion for rainy days and has made tough decisions to pull out of certain markets and focus on others to help drive return on invested capital above 20% consistently. While most of Jonas' bullish note was based on the value of DTAs, there's a lot to like about GM, even as sales peak in the U.S. market.

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Daniel Miller owns shares of General Motors. The Motley Fool owns shares of and recommends Tesla Motors. The Motley Fool recommends General Motors. The Motley Fool has a disclosure policy.