General Motors Company Is Still Headed Higher

By Adam

Last week, General Motors reported rapid growth in adjusted earnings and record operating income for Q3. In recent months, investors had shown increasing skepticism about the sustainability of GM's profitability. This strong earnings report has quickly helped to temper these worries -- General Motors stock has rallied more than 30% since late August.

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There's plenty of upside left, too. While the U.S. auto market has recovered from the Great Recession to near-record sales levels, these gains should be sustainable for quite some time. Additionally, GM's business in China remains stable, defying the bears' fears. Finally, the company is making good progress on turning around the rest of its business.

GM's strongest quarter yetDuring Q3, GM's profitability improved in most regions of the world. North America was the real standout, though. General Motors has benefited from strong demand for pricier trucks and SUVs in the U.S. in particular.

GM North America's adjusted operating margin hit a record 11.8%, up from 9.5% a year earlier. This will allow the company to achieve its goal of a 10% full-year adjusted operating margin in North America during 2015, one year ahead of its previously announced plan.

Looking at the rest of the world, GM's profit in China remained roughly steady at $0.5 billion. The company's loss in South America increased by nearly $200 million compared to Q3 2014 due to the weak Brazilian economy. On the flip side, GM reduced its loss in Europe by more than $150 million and also slightly reduced its loss in its other international operations. Profit from its fast-growing financing arm also increased modestly.

North America is still the profit driverAs I noted last month, while GM is a global business, the North America region is still by far the dominant driver of its profitability. In fact, through the first nine months of 2015, more than 93% of its segment profit came from that single region.

GM gets almost all of its profit from North America today. Photo: The Motley Fool.

GM is on pace to achieve its 10% margin target in North America this year despite some ongoing negative impacts from last year's ignition switch recall. That headwind is dissipating, though.

Furthermore, GM is launching updated (and significantly improved) versions of several key models in the U.S. this year, and will continue launching new vehicles at an accelerated pace in the next few years. These things should all support GM North America's profit margin going forward.

Meanwhile, the average age of cars on the road in the U.S. recently reached a record of 11.5 years. While improved reliability is allowing people to keep cars longer, they still don't last forever. Thus, replacement demand should continue to drive strong auto sales for years to come. With GM's annual revenue in North America already above $100 billion, this region should be a fairly steady source of $10 billion-$12 billion in annual operating income.

Incremental profit outside North America is just gravyEven after GM's recent rally, the company's market cap remains below $60 billion. This makes the stock look quite cheap just based on GM North America's pre-tax income (even after deducting about $1 billion in annual corporate overhead). If you include GM's relatively steady $2 billion in annual equity income from China, the stock looks like even more of a bargain.

This implies that the rest of GM's business is getting a negative valuation from investors. From this perspective, if GM can just get its other regions to breakeven, the stock could rise quite a bit.

The company's ambitions are much greater than that. Last week, GM reiterated its plan to be profitable in Europe in 2016, thanks to a few key vehicle launches in the past year. GM's International Operations segment is in the midst of a big restructuring. This process won't be completed until 2017, but the segment's performance should start improving before then.

South America is the biggest question mark today. GM has slashed its workforce by 20% in order to mitigate its losses there, but it won't return to profitability until the economy recovers. On the other hand, GM CFO Chuck Stevens predicted that margins would rise rapidly once the economy does improve.

Finally, GM Financial has dramatically expanded its operations in the past couple of years. That is already starting to produce earnings growth, but this should accelerate in the next few years as the business matures.

In short, GM is starting with strong businesses in the U.S. and China that should routinely post upward of $12 billion in annual operating income for the next few years. If it can eke out even modest profits from the rest of its operations -- which seems likely based on the company's progress thus far -- GM will prove itself worthy of a much higher valuation.

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Adam Levine-Weinberg owns shares of General Motors. 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.

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