News Analysis date published New: 
Tuesday, April 5, 2011 - 07:00

Why GM Can Rally 50% or More

Analysts love to grab headlines. And to do this, they often resort to their favorite ploy: The super-sized price target. So when analysts at Morgan Stanley predicted that GM (NYSE: GM) might eventually soar to $100, I and others sat up and took notice.

Morgan Stanley's analysts predicted that shares would start to build higher right away on the heels of yet-to-be-released fourth quarter results. To be fair, their $100 target was predicated on results several years into the future. But so far, this bold prediction looks like a dud. The stock is off 18% since we looked at this investment thesis, trading right around its 52-week low.

Were the analysts flat wrong? Or were they simply premature? Let's take a look...

In hindsight, the analysts overlooked one major point of concern: rising oil prices. GM, along with Ford (NYSE: F), remains highly dependent on pick-up trucks and SUVs for the bulk of profits. Generally speaking, the bigger the vehicle, the fatter the profit margin. Crisis in the Middle East has helped fuel an oil price spike, leading many to conclude that truck sales, which had recently been more robust, were about to take a big hit. That conclusion is likely premature, especially if the U.S. economy builds a head of steam.

A confusing quarter
GM's shares started to slide when the automaker released fourth-quarter 2010 results on Feb. 24. GM's profits came in ahead of forecasts, but some questioned how GM can turn around its unprofitable European operations. Management did no favors to short-term focused investors by detailing plans to ramp up engineering expenses to help beef up a thin slate of scheduled new vehicle releases. The $510 million quarterly profit was also below the profit earned in prior quarters, though much of that is attributable to expenses associated with the recent IPO (initial public offering).

Most analysts were fairly surprised that the stock sold off. Citigroup raised its target from $47 to $50 (roughly 50% above current levels), noting that higher-than-expected cash-flow projections in coming years were the real take-away from the quarter. Although Goldman Sachs dropped its price target from $45 to $42 (due to a possible shift away from high-margin trucks), its analysts "still see the shares presenting one of the best values in the space."

What about Morgan Stanley? Its analysts have come to realize they have underestimated some of the potential headwinds when they came up with that lofty price target. Instead of looking several years out with a $100 target, they now speak of a $50 target during the next 12 months. Nevertheless, that's far above the current $32 price.

Not timely
One of the reasons many institutional investors have dumped the stock is that few timely catalysts exist: the first quarter may show signs of a slowdown in truck sales; the crisis in Japan is leading to shutdowns at some of GM's U.S. auto plants because key components such as hybrid transmissions have been sourced in Japan; and a recent sudden departure of GM's Chief Financial Officer has led to questions of leadership.

Yet these are all short-term factors. If you assume oil prices will cool off once Middle East tensions abate, then the whole institutional crowd will swing right back around and start buying GM again.

This all obscures a much larger picture. The whole point of the GM restructuring, and all the enthusiasm around the company at the time of the November 2010 IPO, was about the really bright long-term picture for the "new GM."

This is a company so vastly different from the old GM in terms of a far cleaner balance sheet, a much improved line-up of vehicles, belated-but-real momentum in emerging economies such as China and perhaps newfound respect among American car buyers. So to quibble with how the next few quarters will be impacted by rising engineering expenses, or to write off truck sales even though many work trucks have been in the field for quite some time, or to question why the CFO is departing is simply myopic.

Action to Take --> Morgan Stanley was likely a bit reckless with that lofty $100 price target. But the sentiment was correct. GM is on the road to far higher profits as the new vehicle cycle plays out, and shares should be getting more respect after the IPO. If you have a time-frame that extends past one or two quarters, then this still looks a great name to own.

David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.

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