Star hedge fund manager David Einhorn thinks that shares of General Motors (NYSE: GM) are deeply undervalued. He notes that GM has the lowest earnings multiple in the S&P 500 while also having one of the highest dividend yields.
I agree that GM stock is a bargain (and has been for years). However, Einhorn's plan to fix this low valuation -- splitting GM stock into separate "dividend shares" and "capital appreciation shares" -- wouldn't be nearly as effective as he suggests. Moreover, this kind of financial engineering isn't necessary for getting the stock on track in the coming years.
Since their public market debut in late 2010, shares of GM have dramatically underperformed the S&P 500, even though the company has grown its operating profit by more than 50%. Einhorn believes that GM stock has performed poorly because it is held by a "suboptimal combination of yield-oriented and value-focused shareholders" with divergent objectives.
GM's profit has surged in recent years, but its stock price hasn't kept up. Image source: General Motors.
Yield-oriented investors want to maximize their dividend income. However, GM's dividend payout ratio is around 25%. These investors aren't willing to pay full value for the other 75% of GM's earnings that are not being paid out. Meanwhile, value-focused shareholders care less about the dividend and would like to see higher buybacks to drive faster EPS growth.
To address this issue, Einhorn has recommended splitting GM stock into two separate share classes. The GM Dividend Shares would be entitled to the current annual dividend of $1.52/share. The Capital Appreciation Shares would initially receive no dividend, but would be entitled to all future earnings growth.
Einhorn believes that the dividend shares would be valued at $17 to $22, attracting income investors with a 7% to 9% yield, while the capital appreciation shares could be worth $26 to $38. This would imply a combined value of $43 to $60: well above GM stock's recent $33 to $38 trading range.
There could be real consequences
In his investor presentation, Einhorn argued that there is no downside to his scheme. Yet General Motors' executive team and board of directors found otherwise, leading them to reject the proposal.
Most importantly, GM noted that there is a high risk that the dual-class share proposal would cause it to lose its investment-grade credit rating. (Sure enough, the two largest credit rating agencies stated this week that Einhorn's proposal represented a "credit negative" for GM.)
Losing the investment-grade credit rating would raise borrowing costs at GM Financial, the company's in-house financing arm. It would also constrain GM Financial's ability to grow its balance sheet and to offer lease financing during economic downturns. In total, this could negatively impact GM's annual operating profit by around $2 billion.
Additionally, without an investment-grade rating, GM would need to hold more cash on its balance sheet. This would prevent it from executing share buybacks for some time.
Here's the real problem
Ultimately, concerns about the future of the auto industry are at the root of General Motors' low valuation. Indeed, top rival Ford Motor Company (NYSE: F) is also one of the cheapest stocks in the S&P 500.
U.S. auto demand has more or less peaked. A glut of used cars is forcing GM, Ford, and their competitors to offer better discounts to keep sales steady. Falling resale values could also negatively impact their financing arms, GM Financial and Ford Credit. Just last week, Ford confirmed that it expects its pre-tax profit to decline in 2017 and it offered a particularly weak earnings forecast for Q1.
Clearly, investors don't trust General Motors' bullish forecast for 2017. And they certainly don't think the company can sustain its current level of profitability in the long run.
What is to be done?
At best, complex financial engineering might provide a partial solution to low auto sector earnings multiples. But the real solution is for General Motors (and other automakers like Ford) to continue posting strong results.
Frustrated GM shareholders need to remember that during the last auto industry downturn, General Motors went bankrupt. The company has shown decisively that it can make a lot of money when industry conditions are favorable. It still has to prove that it can remain profitable through a recession.
Ironically, a recession might be the cure for GM stock's recent woes. The stock would probably decline during the recession itself, but once it became clear that GM had made it through unscathed, its earnings multiple would be likely to soar to a more normal level.
In the meantime, General Motors continues to return tons of cash to investors. In 2017, the company plans to buy back about $5 billion of stock, which would allow it to shrink its share count by nearly 10%. It will also continue paying a hefty dividend. These actions will make GM stock even more valuable in the long run.
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