Is GM’s Recall Scandal a Buying Opportunity?

Just as General Motors (NYSE:GM) shed the stigma of its reputation as “Government Motors” from its 2009 U.S.-led bankruptcy, the car company has become engulfed in a worldwide recall scandal.

GM is recalling more than three million vehicles worldwide due to faulty ignition switches that cut off engines and power to airbags as well as problems with brake parts. The number of recalled vehicles has grown from an initial 1.6 million to include three more recalls of some 1.7 million vans, SUVs and Cadillac luxury cars. But it took GM more than a decade to recall these vehicles even after the company knew about the faulty ignition switches as early as 2001 and failed to fix the problem.

Lawmakers are investigating why it took more than a decade to initiate the recalls. Under the Tread Act, automakers are required to report safety problems within five days or incur a penalty. Both the Senate Commerce Committee and the House Energy Commerce Committee plan to hold hearings on the automaker’s recall. The company will also have to answer to a criminal probe initiated by the Justice Department.

In short, just as GM shined up its reputation after rolling out a new lineup of refreshed models that won record quality marks with JD Power & Associates and Consumer Reports magazine, the carmaker has taken a turn for the worse.

History shows there’s a general sequence of events that occur with scandal-laden companies, like GM. After the initial event, follow-on information concerning the event generally ensues, according to Karl Mills, president and chief investment officer of Jurika, Mills and Keifer, a San-Francisco-based investment firm that specializes in investing in tarnished businesses.

Analysts lower their sales and earnings forecasts. Often the leadership of the company is brought before Congress for a fact-finding show-and-tell on national television, and then the class action lawsuits are filed.

In the first stages the stock generally plummets. After that, the stock’s appeal hinges on two factors: whether the problem is fixable and whether the share price has fallen far enough to compensate investors for the company’s problems. The art is qualifying how big the problem is relative to the stock-price decline. If the issues are temporary and the stock price has plunged, investors have likely found a good buying opportunity.

“The stock market is clearly saying this is a de minimis event for GM.”

- Marty Leclerc, CIO at Barrack Yard Advisors

In the case of GM, the company has cycled through most of the classic events – Congressional hearings will take place next month and lawsuits are being teed up. Yet despite continuous negative headlines, GM’s stock is roughly flat around $35 per share since February 13 when the first recall was announced. Granted price action hasn’t resembled a straight line since mid-February. Shares rallied to $37.69 on March 7 before falling back some 7% to around $35 by mid-March. Still, the muted reaction is surprising for a scandal of monumental proportions.

“The stock market is clearly saying this is a de minimis event for GM,” said Marty Leclerc, chief investment officer and portfolio manager for Barrack Yard Advisors.

Is the market right? To answer that question investors need to determine whether the scandal is something the car company can overcome or if it’s a harbinger of a permanent change in condition for the company that could harm its businesses.

Just Stalled Out or Totaled?

Perpetual negative news headlines could cost GM sales in the short term, but the impact of the recall on the company’s reputation and business longer term depends on actions the company takes over the next few months.

Thus far, GM is taking accountability. The company issued a public apology and says it will repair faulty auto parts in any recalled cars for free. It’s also offering a $500 voucher to customers hurt by the ignition switch recall who want to buy or lease a new GM car. The company will take a $300 million first-quarter charge to earnings to cover costs of the recall and to replace problematic ignition switches, brake parts and wiring for air bags. GM also just named a new vehicle safety chief to identify and resolve product safety issues.

“We expect GM will continue to take responsibility and admit fault in how it handled the process,” said Morningstar analyst David Whiston, who doesn’t see a major risk of lost sales due to a dented reputation. “The vehicles recalled are old and not indicative of the quality that GM currently produces.”

Although GM is taking action to diffuse the crisis and keep its reputation intact, the company is still on the hook for burgeoning liabilities. Toyota’s (NYSE:TM) record-setting settlement with the Justice Department over misleading consumers about safety problems with its cars should send a chill across GM.

Lawyers are already lining up to see if they can persuade U.S. bankruptcy judge Robert Gerber to reopen GM’s bankruptcy case and reverse the firm’s bankruptcy shield. Under the terms of the bankruptcy, GM isn’t legally required to compensate crash victims for accidents that took place before July 10, 2009. Meanwhile, civil lawsuits are stacking up and safety advocates are pushing GM to compensate victims.

GM vs. Toyota

Although we have no way of predicting GM’s fate -- and there are likely additional revelations that could trickle out -- it’s comforting to compare GM’s situation with Toyota’s scandalous vehicle recall a couple years ago. Toyota, which built its reputation on quality to capture a loyal customer base and historically some of the strongest sales in the automotive sector, was late in revealing quality problems with its vehicles to the public. The issues caused vehicles to accelerate out of control, killing 59 people. The problems required Toyota to make three separate recalls over two years totaling some 10 million vehicles and temporarily halted production.

The stock plunged from $91 per share in early 2010 to $62 in Nov 2011 only to rebound to around $110 per share today. Even better, Toyota’s sales rebounded a robust 31% to $266.6 billion last year from $204.2 billion in 2010. However, there can be aftershocks.

Just this week – four years after Toyota’s safety issues surfaced -- the Justice Department announced a settlement with the Japanese automaker for a record-setting $1.2 billion fine to resolve a criminal investigation into the company’s handling of sudden acceleration of its cars.

GM is in a somewhat better position than Toyota, analysts said. Unlike Toyota the GM models that suffered ignition issues are no longer being sold on the market. In Toyota’s case, those models affected were and are still in production.

“I don’t see consumers in the show room now looking at a 2014 Chevrolet Cruze – the successor to the Cobalt -- afraid that the residual value on a 2014 model will be hurt by the recall of a 2006 cobalt,” said Whiston.

What’s an Investor to Do?

At this point, the scandal hasn’t offered investors a lower entry point to GM stock. But, investors might do well to look past the recalls to the merits of GM’s business since exiting bankruptcy and its forecast future sales and earnings relative to the current stock price. At $35 per share, GM trades at 9.3 times forecast 2014 per-share earnings of $3.73, compared with Ford, which trades at 11.4 times and the auto sector, which trades at 14.4 times.

Chris Versace, editor at PowerTrend Profits Newsletter, is one money manager looking past the recall.

“It’s an easy reason for investors to sell the stock, but they are forgetting that GM is back to paying a dividend, introducing several new models that should ward off market share loss and positioning itself to tap growing automotive markets outside of the U.S., such as China,” he said.

S&P Capital IQ auto analyst Efraim Levy is also positive on the outlook for GM’s business. He likes that GM has cut product lines, closed dealerships and is focusing on fewer, more salient brands. Also alluring to Levy is that the company’s bankruptcy filing allowed it to shed billions of dollars in liabilities, sharply reducing its operating costs and its number of dealerships.

“We stay bullish due to underlying fundamental positives we see, even as it works through this,” he said. “If resolved soon, we see no long-term impact on GM.” Levy upgraded GM to a “strong buy” rating from “hold” in early March with a 12-month price target of $48 per share.

At $35 per share, Morningstar’s Whiston thinks the stock is “significantly undervalued” and could reach $57 some time in the next three years. But he cautions it could be a volatile ride to $57 per share if more bad headlines surface about GM’s recalls. Still the analyst said, “Any mass selloff of GM's stock on recall news would create an excellent buying opportunity.”

Given the way scandals play out – the dust hasn’t fully settled – but taking shares of GM for a spin now based on its business prospects could pay off for investors in a couple years.