1 Thing to Watch Closely at General Motors

General Motors (NYSE: GM) has posted a series of record profits in North America this year. But it may have an inventory problem brewing.

GM's dealer stocks in the U.S. have risen significantly during 2016, with much of the increase coming in the past few months. While crosstown rival Ford Motor (NYSE: F) has been cutting production to clamp down on dealer inventory, the General continues to churn out vehicles at a high rate. This raises the risk that it will have to make even sharper cuts next year.

Dealer stocks for GM vehicles are rising rapidly. Image source: The Motley Fool.

GM rebuilds its inventory

General Motors ended 2015 with lean inventories in the U.S. Its inventory totaled 630,950 vehicles, equivalent to 61 days of supply. Most automakers would consider that an appropriate level.

However, GM sells a large number of pickup trucks. (Year to date, pickups account for more than 30% of GM's U.S. vehicle deliveries.) Due to the vast number of configuration options available for pickups, it's usually prudent to carry more inventory to increase the chances that prospective buyers will find what they are looking for. Yet GM had only 60 days of inventory for pickups at the end of 2015, well below historical levels.

As a result, General Motors made a conscious choice to increase its inventory this year. Its U.S. vehicle stocks bottomed out just below 630,000 units at the end of January and then rose at a moderate pace over the next six months. By the end of July, GM's U.S. inventory had reached 682,170 units, or roughly 66 days of supply.

Inventory soars

The increase in GM's dealer stocks was relatively modest through July. However, in the last three months, inventory has soared.

General Motors recently reported that it ended October with vehicle inventory of 834,201 units in the U.S. This means that production has outpaced sales by an average of 50,000 units per month over the past three months. GM now has 84 days of supply in inventory, compared to 75 days of supply a year earlier.

To be fair, there are always seasonal ebbs and flows in production and sales. Vehicle inventories usually decline during the last two months of the year. Last year, the drawdown in GM's U.S. inventory during November and December totaled 75,770 vehicles. The General needs to reduce its inventory by at least this amount in the next two months to enter 2017 in a good position.

Ford is reducing production. What about GM?

General Motors isn't the only automaker facing rising inventory as U.S. auto sales growth grinds to a halt. Ford has also built up too much inventory for multiple product lines in 2016. As of the end of June, Ford's U.S. dealer stocks had reached approximately 728,000 vehicles, up from 611,000 units a year earlier.

Some of that increase was planned, as inventory of the new 2015 Ford F-150 was still very tight in mid-2015. However, some of the increase was unexpected, and so Ford moved quickly to reverse the buildup. During Q3, Ford reduced its U.S. vehicle inventory by 70,000 units, to a much more reasonable 658,000 units.

Ford has been slashing production and reducing its inventory lately. Image source: Ford Motor Company.

More recently, Ford has announced plans to idle several plants across North America for a week or two. This will allow it to burn off some inventory of models for which sales have missed expectations. By contrast, GM has kept production running full tilt in recent months, despite its rising inventory.

Overproduction in 2016 could hurt GM in 2017

Automakers book revenue (and earnings) based on when they ship vehicles to dealers -- not when the vehicles are actually sold to end users. Thus, GM's production increases this year have contributed to its strong earnings growth, even though many of the extra vehicles it has built are now sitting on dealer's lots rather than in customers' driveways.

If GM finishes the year strong, it may be able to get inventory in line with demand and thus hold U.S. production roughly flat next year. However, if it ends the year with an inventory glut, it will be faced with an unpleasant choice between offering massive incentives to stimulate sales and reducing production to balance supply with demand.

Ultimately, GM would probably choose the latter course of action in order to maintain its pricing integrity. However, production cuts could drive a sharp decline in its U.S. earnings -- just like what Ford has experienced recently.

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Adam Levine-Weinberg owns shares of General Motors. The Motley Fool owns shares of and recommends Ford. 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.