The record level of new car sales registered in the U.S. in 2015 certainly has many in the automotive industry celebrating. General Motors (GM) is even one of Warren Buffett’s top dividend stocks.
However, industry groups are predicting the auto production seasonally adjusted annual rate (SAAR) to decline over the next few years.
Given its tumultuous history, General Motors is nowhere close to becoming a dividend king, but can GM at least sustain its dividend during the next downturn in the auto cycle?
Overall, the automotive industry is not a great industry to invest. It is characterized by cyclicality, tense labor relations, and high levels of competition and capital intensity. Unlike many of the dividend aristocrats we follow and include in our Top 20 Dividend Stocks Portfolio, GM has historically been a very poor operator.
The company has a history of vehicle recalls, market share losses, out of control pension costs, and carrying a gigantic debt load. It is no wonder the company had to be bailed out by the federal government when vehicle sales collapsed during the financial crisis.
However, as we detailed in a previous article, the company has made a number of changes since the last peak of the auto cycle that gives us confidence that the company can perform during a downturn in the next auto cycle.
GM has closed one-third of its plants, reduced its dealer count by more than 2,300, and eliminated over 20,000 hourly jobs and almost 10,000 office jobs.
Labor cuts reduced the percentage of GM’s U.S. employees represented by unions from 67% in 2009 to 54% in 2015 which was down a further 2% year-over-year from 2014.
GM also shut down several vehicle brands (Hummer, Pontiac, Saturn, and Saab) to better focus its R&D, production, and marketing dollars. The combined effect of these actions is expected to let the company break even in a domestic market with annual sales of 10 million vehicles, close to the low point reached during the financial crisis.
Our goal is to never a own a company that cuts its dividend. Since GM is in our Conservative Retirees portfolio and operates in a cyclical, highly competitive industry, it is vitally important to analyze the safety of the dividend.
Dividend Safety Analysis: General Motors
We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend. General Motor’s dividend and fundamental data charts can all be seen by clicking here.
Our Dividend Safety Score answers the question, “Is the current dividend payment safe?” We look at factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more. A score of 50 is average, 75 or higher is considered excellent, and 25 or lower is considered weak.
General Motor’s Dividend Safety Score is 55, which suggests that the company’s dividend payment is about as secure as the average dividend-paying stock in the market.
General Motors currently pays annual dividends of $1.52 per share, including the 6% dividend increase announced earlier this year in January.
If the midpoint management’s earnings guidance of $5.50-$6.00 per share for 2016 proves accurate, it would imply a payout ratio of 26%. Furthermore, during 2015 the dividend consumed 55% of free cash flow.
These relatively low payout levels should provide some wiggle room if the company’s end markets were to quickly roll over.
However, given the cyclical nature of the auto industry and GM’s abysmal historical performance, let’s walk through how a declining SAAR could affect the company differently this time than in the prior cycle, which led to the company’s bankruptcy.
Peak to trough, sales have increased from $105 billion in 2009 to over $152 billion in 2015. During this time, net income increased from negative $23.3 billion (adjusting for the government bailout) to over $9.6 billion in profit in 2015.
Pre-crisis peak to potential 2015 peak, sales have gone from $180 billion in 2007 to $152 billion in 2015 while net income went from negative $39 billion to $9.6 billion. Remember, GM shut down numerous brands since the prior peak so the sales comparison is not like-to-like.
A major reason why GM went bankrupt during the financial crisis was because not only were they not generating any net income, but they were already in an extremely precarious financial situation.
In 2008, the company only had $14 billion in non-restricted cash on the balance sheet and around $46 billion in debt. Of the $46 billion in debt, nearly $17 billion of it was included in current liabilities, meaning it was due within a year. This does not even take into consideration over $58 billion in unfunded pension and post-retirement benefits entitled to the company’s employees.
This was an extremely aggressive way to finance a cyclical business and put the company in a very difficult situation if the capital markets were to ever freeze up and not allow GM to refinance their short term debt.
To sum up GM’s financial position heading into the financial crisis, the company was over levered, had huge unfunded pension liabilities, generated negative free cash flow, and only had a small amount of cash on the balance sheet relative to the company’s liabilities.
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Today, the company has around $23 billion in cash and marketable securities on the balance sheet and around $11 billion in debt related to its automotive segment. For every $1 of dividends paid last year, GM is holding over $10 in cash.
Since the company also owns GM Financial, which is the wholly owned captive finance subsidiary, GM reported over $54 billion in consolidated debt associated with this unit in 2015.
However, much of the debt is issued by Variable Interest Entities and is backed by finance receivables and leasing assets, lowering its risk profile.
Furthermore, the company has $27.1 billion in unfunded pension benefits – less than half the amount owed prior to the last recession.
In summary, the contrast in GM’s financial position today relative to the prior peak in the auto cycle is drastic. They have more cash, less debt and smaller unfunded pension obligations, a lower cost position, a more focused brand portfolio, improving market share, and are cash flow positive.
General Motors paid out approximately $2.2 billion dollars in dividends in 2015. Even with yearly pension contributions of around $1.6 billion, they could maintain the dividend for around 6 years from just current cash on hand (assuming that the company was able to refinance maturing loans and was at least cash flow neutral during the next downturn).
GM does finance the purchase of a lot of their car sales for customers, which could get the company into serious trouble if consumers cannot make their payments. However, the portfolio continues to perform very well with just 5.1% of receivables more than 30 days delinquent or in repossession as of the end of the second quarter.
Looking again at GM’s most important financial ratios we can see that while there are certainly risks to the earnings power of the business in a tough economic environment, there is flexibility to maintain the dividend if this scenario plays out. The EPS and Free Cash Flow Payout Ratios are within reason at 23% and 55%, respectively.
Commenting on dividend safety during the next potential downturn in auto sales, the company’s management team has also stated:
“Clearly, as we think about a moderate downturn and we think about our cash balance and everything else, what we would like to be able to do in a typical moderate downturn, maintain investment and maintain the dividend without drawing on the revolver…If those are the facts and circumstances at that point, I think that would be a guiding behavior or a guiding tenet that you can think about. But it really depends on the facts and circumstances of the downturn.”
GM defines a “moderate” downturn as down 20-25% – not as bad as the Great Recession but still painful. Management also commented they would be willing to use some of the cash on the balance sheet as necessary.
In other words, GM’s management team appears to have some confidence that the dividend should have good support, barring an extreme downturn in the auto cycle.
As long as the key drivers for auto sales (employment, fuel prices, average age of fleet) stay positive, there should not be a precipitous decline in SAAR. Thus, General Motor’s dividend should be safe for at least the next couple of years and potentially far into the future. Recent earnings results have certainly underscored today’s favorable conditions.
However, investing in a capital intensive, cyclical company with a captive finance business does entail very real risks. The dividend could be on the chopping block if the economic environment (and just as importantly the capital markets environment) quickly deteriorates and management needs to preserve financial flexibility at the company. We recently saw this scenario occur at many large oil and gas companies.
While we perceive this as a low probability event at this time, we need to closely monitor the developments over the coming years to make sure the dividend remains safe. Dividend investors should keep a close eye on the health of the financing business, trends in auto sales, how the management team handles the pension obligations, and payout ratios creeping higher.
Investors interested in other high yield auto stocks can review our recent dividend safety analysis of Ford here.
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