Friday, March 27, 2015

The GM Buyback: Beyond the Hysteria!

Here is a script for a movie about the evils of stock buybacks, with the following players. The victim is an well-managed company in a business with significant growth opportunities and profit potential. The company has delivered products that its customers love, while paying its workers top-notch wages & benefits and invested heavily and prudently in its future. The villain is an activist investor, and for added color, let's make him greedy, short term and a speculator. In the story, he forces the  company to redirect money it would have spent on more great investments to buy back stock. The white knight can be a regulator, the government or a noble investor (make him/her successful, wealthy and socially conscious, i.e., Buffett-like) who rides in and saves the hapless company from the villain and stops the buyback. The story ends happily, with the defeat and humiliation of the activist investor, and the moral  is that stock buybacks are evil (and need to be stopped). As you read some of the over-the-top responses to GM's buyback, such as this one, you would not be alone in thinking that you were reading about the mythical company in the movie. But given GM's history and current standing, do you really want to make it the basis for your case against buybacks? 

GM is not well managed now, and has not been so, for a long time
Is GM a well managed firm? The answer might have been yes in 1925, when GM was the auto industry's disruptor, challenging Ford, the established leader in the business at the time. It would have definitely been affirmative in 1945, when Alfred Sloan’s strategy of letting GM's many brands operate independently won the automobile market race for GM, and it was the largest and most profitable automobile company in the world. It may have still been positive in 1965, when GM was on top of the world, a key driver of the US economy and US equity markets. 

By 1985, the bloom was off the rose, as GM (and other US auto makers) were late to respond to the oil crisis and had let Japanese car makers not only take market share but also the mantle of reliability and innovation. In 2005, GM remained the largest car maker in the world, but it was in serious financial trouble, with an ageing customer base and huge legacy costs, from promises made to employees in good times. In 2008, the problems came to a head during the financial crisis, as GM had trouble  making its debt payments, attracted government attention and a bailout. As part of the bargain, equity investors in GM were wiped out and lenders had to accept significantly less than they had been promised. If the objective of the bailout was GM's survival, it worked, as the company was able to reverse a steep drop in revenues (in 2008) and start making profits again. That recovery came at a significant cost to taxpayers, who lost $11.2 billion in the bailout.

GM was able to go public again in 2010 and since it is the new version of the company that is buying back stock and it would be unfair to burden the incumbents with the mistakes of prior managers, I focus the bulk of my attention on how well the management of this new incarnation has done in its stewardship of the company. The picture below captures the new GM's evolution as a company over the last five years:
The New GM: Investment, Revenues and Profits from 2010-2014
GM has been reinvesting actively since it went public again in 2010, adding almost $25.5 billion in investments (in plant, equipment and working capital) to it base. The good news is that revenues have gone up, albeit at an anemic rate (3.56% a year between 2010 and 2014) but the bad news is that these increasing revenues have been accompanied by declining profitability. Even in 2011, the best of the five years in terms of profitability, GM's return on capital of 6.86% lagged its cost of capital.

Does this imply that the existing management of GM is not up to the task? Not necessarily, since they were dealt a bad hand to begin with. They were saddled with brand names that evoke nothing but nostalgia, a cost structure that put them at a disadvantage (still) relative to other automobile companies and a legacy of past mistakes. At the same time, there is little that this management has done that can be viewed as visionary or exciting in the years since the IPO (in 2010). In fact, the end game for the new GM seems to be the same one that doomed the older version of the company: a fixation on market share (and number of cars sold), a desire to be all things to all people and an inability to admit mistakes. In the last two years, GM’s fumbling response to its "ignition switch" problem seem to have pushed GM back into the  “troubled automobile company” category again. The bottom line is that the best case that you can make for GM's current management is that it is a "blah" management,  keeping the company alive and mildly profitable. The worst case is that this is still a management stuck in a time warp and in denial over how much the automobile business has changed in the last few decades and that it is only a matter of time before the government is faced again with the question of whether GM is too "big to fail".

The auto business a bad one, with disruption around the corner
My measure of the quality of a business is simple and perhaps even simplistic. In a good business, the companies collectively in that business should be able to generate a return on capital that exceeds the cost of capital (based on the risk in the business) and the “best” companies in the business should earn significantly more than their costs of capital. The auto business fails both tests. In my most recent data update in January 2015, I computed the aggregated return on capital at auto companies globally (about 125+) in the trailing 12 months leading into January and arrived at 6.47%, a little more than 1% below the collective cost of capital of 7.53% that I computed for auto companies. Lest this be viewed as an outlier, the table below summarizes the aggregated return on capital and cost of capital for companies in the global automobile business each year for the last ten years:

If you are wondering whether this collective miasma is caused by the laggards in the group, I isolated the twenty largest automobile companies in the world in 2015 and estimated profitability and leverage numbers for them in March 2015:


Note that, if anything, the return on capital (which is based on operating income and invested book capital) is biased towards making a company look better than it really is (largely because accountants are quick to write off mistakes), but even on this measure, only one of the ten largest companies (Audi) earned a return on capital that is higher than its cost of capital in 2014. In fact, mass-market auto companies like Volkswagen, Toyota and Ford have abysmal returns on capital, suggesting that the club that GM is trying to rejoin is not an attractive one. The typically large automobile company in 2015 is a highly levered behemoth, which struggles to earn enough to cover its cost of capital in a market with anemic revenue growth. 

Given that the business model for automobile companies seems to have broken down, it should come as no surprise that the business is being targeted for disruption. While I have argued against the pricing premiums that the market is paying for Tesla, it is undeniable that it's entry into the market has speeded up the investments that other auto makers are making in electric cars. Given their track record of poor profitability, I would not be surprised if the next big disruption of this market comes from companies in healthier businesses and that will bring more pressures on existing automobile companies. If there is a light at the end of this tunnel for incumbent automobile companies, I don't see it.

A GM Buyback: Value Effects?
In an earlier post on buybacks, I used a picture to illustrate how a buyback may affect value and I think that picture can help in assessing the GM buyback:


Looking at the picture, I can see why activist investors were pushing GM to return more cash. It is a middling company in a bad business, where even the very best companies struggle to earn their costs of capital. Since it is possible that I am blinded by my stockholder-focus, I considered what GM could have done with the $5 billion, instead of buying back stock.
  1. Invest the cash: GM could have invested the cash back into the auto business, but given the state of the business and the returns generated by players in it, this effectively throws good money after bad. In fact, looking at how little the $25.5 billion in reinvestment has done for GM in the last five years, I think a stronger argument can be made that they would perhaps have been better off not investing that money and returning it to stockholders as well. 
  2. Hold the cash or pay down debt: Auto companies are natural cash hoarders, arguing that as cyclical companies, they need the cash to survive the next recession or downturn. In fact, that argument seems to have added resonance at a company like GM, which has just come out of a near-death experience with default. At the risk of sounding heartless, I would counter that survival for the sake of survival makes little sense. A corporation is a legal entity and there is a corporate life cycle, a time to be born, a time to grow, a time to harvest and finally a time to shut down. If your response is that you cannot let that happen to an American icon like GM, there was a time when Xerox was so dominant in its business that it's corporate name  became synonymous with its product (copies) and Eastman Kodak was the 'camera' company, but pining for those days will not bring them back. The actions driven by the "too big to fail" ethos have cost the taxpayers $11 billion already. Do you really want to do this a second time around with GM?
  3. Return the cash to other stakeholders (labor, the government): You can argue that my view of buybacks fails to take into account the interests of other stakeholders in the firm, its workers, its suppliers and perhaps even the government. It is true that GM could use the $5 billion to give its workers raises and replenish their pensions. That will be good news for those workers, but doing so will only push down the measly return on capital that GM is currently earning, make future access to capital (debt or equity) even more difficult, and set the company on the pathway to financial devastation.
The Root of the Disagreement
There are "corporate finance" reasons for arguing against buybacks in some companies and they include concerns about damaging growth potential (where buybacks come at the expensive of good investments), about timing (when companies buy back shares when prices are high, rather than low) , or managerial self-interest (if buybacks are being used to push up stock prices ahead of option exercises). Since it is almost impossible to use any of these with GM, those arguing against a GM buyback are really against all stock buybacks, no matter who does them. While I don't agree with these critics, I think that there is a simple way to understand the vehemence of their opposition and it is rooted in ideology and philosophy, not finance.  If you believe, as I do, that as a publicly traded automobile company, GM's mission is to take capital from investors and generate higher returns for them that they could have made elsewhere, in investments of equivalent risk, with that money, you can justify the buyback and perhaps even argue that it should be more. If you believe that GM's mission as a car company is to build more auto plants and produce more cars, hire more workers and pay them premium wages and save the cities of Flint and Detroit from bankruptcy (as a side benefit), this or any buyback is a bad idea. In fact, it is not just buybacks that you should have a problem with but any cash returned (including dividends) to investors, since that cash could have been used more productively (with your definition of productivity) by the company. It is also extremely unlikely that you will find anything that I have to say about buybacks to be persuasive since we have a philosophical divide that cannot be bridged. So, its best that we agree to disagree!

Past posts on buybacks

  1. Stock Buybacks: What is happening and why (January 25, 2011)
  2. Buybacks and Stock Prices: Good news or bad news (January 25, 2011)
  3. The Shift to Buybacks: Implications for Investors (February 1, 2011)
  4. Stock Buybacks: They are big, they are back and they scare some people (September 22, 2014)



17 comments:

CB said...

How do you balance GM's need to reinvest capital just to maintain their anemic return on capital? Arguably, if they didn't reinvest at least a portion of the $25Bn they risk going from a positive return on capital to a negative return on capital and a situation that spirals downward.

memyselfandi007 said...

Dear professor,

thank you as always for your insightfull posts.

One quick remark: I think one should strip out financing subsidiaries from car companies when calculating ROCE/ROIC.

The number for BMW for instance looks like you have included the financial arm.

Audi for instance looks pretty good because the financing arm is consolidated at Volkswagen level wheres subsidiary Audi only has "car assets". Without financing, BMW for instance would achieve roughly the same ROIC.

regards,
mmi

Glenn Mercer said...

Superb. The good professor's website and blog are the best sources on the internet I have ever found, for unbiased and thorough examination of issues of finance and valuation, all of it supported by extensive and freely-distributed data sets. Bravo! And thank you!

Tangentoverview said...

Does this mean that GM has a good management stuck with a lethargic old company within a poor industry? It seems circular when you say GMs new management is lack lustre, then point out how every single auto company struggles to meet its hurdle rate & the entire article is GMs share repurchase program initiated by the same management.

Anonymous said...

I noticed that the share price at which the buyback occurs was not included in your picture. Does the price at which the buyback occur not have a very important impact on the value created or destroyed?

Aswath Damodaran said...

Tangentoverview,
I am sorry if I confused you but GM is doubly damned. It's management is not visionary or exciting but it is also in a bad business. In effect, for stockholders, there is little hope that the capital will be deployed efficiently. If the business had been a good one, you could have at least hoped for redemption.

Aswath Damodaran said...

Anonymous,
The price at which the buyback happens is neither value adding nor destroying. It is value transferring from those who hold the shares to those who sell back. If you are a stockholder and believe that the company is overpaying, sell your shares back.

Corpraider said...

Thanks for this post professor. Always enjoy your blog.

Neenyi Ayirebi-Acquah said...


Thanks Prof. Your blog is a great place for intellectual stimulation and continuous learning and re-learning.

Just wondering though, how about the case of GM selling its laggard brands and investing behind those brands that have great potential and have better margins.

Would that change your conclusions?

Anonymous said...

Interesting read.

I cannot agree more with memyselfandi007. You are here using ROIC on both an industrial (the auto part) and a bank (the financial arm). Therefore, your ROIC are not correct if you are trying to assess the auto business. .

Aswath Damodaran said...

It is true that GM and some of the other auto companies in this sample have a financial arm, but there are three things to note about these appendages:
1. They are captive financing arms, which effectively gives them the business risk characteristics of the underlying business (rather than financial service firms).
2. These financial arms do have lower returns on capital than the operating arms, which lowers the return on capital at firms that have financing subsidiaries.
3. However, these financial subs also borrow large amounts of money and that debt lowers the cost of capital at the parent company.
Consequently, while I agree that having a financing arm affects ROIC and cost of capital, I am not sure that removing them will have any effect on the ROIC vs Cost of capital spread.

Tim Liu said...

Professor Damodaran, I think your data on the ROE of GM may be flawed because it is using an aggregate of both the financing business and the operating car business. If you strip out the financing side or value it separately as two businesses your evaluation may be more meaningful.

Aswath Damodaran said...

Tim,
Let's say we strip them out and find that GM Auto earns a ROIC higher than its cost of capital and GMAC does not. I am not sure how to read this and what to do next. As a captive financing arm, GMAC's job is to provide financing at below-market rates to auto buyers who are buying GM cars, thus making both returns questionable. I think that if you buy GM, you get GMAC as part of the package, and breaking this company into independent companies will almost impossible to do.

Tim Liu said...

@professor damodaran

I agree with your assessment largely that GM Financial is essentially subsidizing car sales but I think of the cost of capital issue is probably significant when evaluating a mixed business like GM, the trend in the securitization market post-GFC have brought down the cost of vehicle financing significantly, to the point I think the real cost of capital is probably under 2% for the financing arm (especially given the asset backed nature), which would be significantly lower than cost of capital for the operating business. I think these factors are pretty material. I may be wrong though.

Jim said...

Professor,
I am a big fan of yours but I would appreciate some more clarity surrounding your invested capital calculation? Are you including matched asset-liabilites of finance arm that earn positive spread? This makes no sense. I think your comments are too generalized. The bulk (70% of revenue) of their business is running a healthy EBIT( high 8s) and revenue growth rate. Unfortunately they have used this wonderful North American business and burned it in Europe. To have nearly 15% market share in China is an impressive feat which you don't value here. You also don't mention the DTA they have on the books. Tough to argue they only care about share a month after they departed Russia which is 15% of Europe. As mismanaged as its been, the brand and franchise is still intact. I think you are jumping to conclusions by A. comparing the stock to Tesla (the Volt was profitable) which is a grossly overvalued security and B. suggesting some healthy company entering a crappy business will be a threat to their future(it will be a threat to Apple not GM). obviously the buyback was positive who needs 25 billion of cash lying around except WEB and your time horizon is infinity. long and strong since 30

Sometimes, incidentally, it's much easier in these transforming events to figure out the losers. You could have grasped the importance of the auto when it came along but still found it hard to pick companies that would make you money."-WEB

Michael Spacey said...

If I were an investor in a weak company in an awful industry, I would prefer special dividends over buybacks

Unless the company is obviously undervalued, I'd rather get a dollar now then a greater share of an uncertain (and possibly declining) stream of cash flows in the future

Anonymous said...

Dear Mr. Damodaran,

To get back to your updated valuation of Lukoil in your Valucation class. Are you planning to sell shares since the stock price is 49.33 (April 2nd 2015) while your Value per share is 42.53.

Thanks,
Tim