General Motors is facing a new threat to the company and it isn’t from Toyota or Volkswagen. It’s from activist shareholders, who have launched a proxy fight aimed at returning some or all of the company’s estimated $24 billion dollar cash reserve to shareholders. Leading the fight is investment group leader Harry Wilson, formerly member of President Obama’s auto task force, who were instrumental in GM’s bankruptcy restructuring in 2009.
The company has reached a deal which will keep Wilson off the board of directors, but at considerable cost. GM will buy back $5 billion of stock and will boost its quarterly dividend to 36 cents a share from 30 cents previously. The total cost to the company will be about $10 billion through 2016. GM shares were up 2.4 percent at $37.42 within hours of the announcement.
More for GM shareholders, less value for GM
The return of something like 40 percent of GM’s cash reserves to shareholders would seem to be normal market behavior….if markets were normal. Instead, GM’s defensive buyback has the effect of draining about 40 percent of a capital pool which is now not available to build the critical value proposition for any auto maker: new product. Why? Because new platform development in the auto industry is extremely expensive. An all new vehicle on a new platform can easily cost 5-billion dollars and is expected to spawn at least a half a dozen nameplates in the 6-7 years before major redesign. And those models will require “freshening” on a 2-3 year cycle in between at a cost of several hundred million dollars.
It’s a lot of money, but it’s easy to see where it goes. A good “back of the envelope” estimate on wages alone goes like this: about 1000 engineers with a total per employee wages and benefits package of $100,000 per annum spend 4-5 years of effort to bring the new platform to market. The half billion is simply labor costs. On top of this, testing, retooling and sourcing parts and assemblies from hundreds of Tier Ones gets Job One out the door, after which the full run must be manufactured, distributed, marketed and serviced. The astronomical cost is one of the reasons why Detroit Three automakers became masters of the “reskin” in the 50’s, 60’s and 70’s, while retaining similar core architectures. Engines, transmissions and axles, for example, had lifespans in decades. GM’s own small Chevrolet V-8 which debuted in 1955 was finally retired in 2003 after production of over 100,000,000 units. That’s efficient capital utilization, but it’s strictly history. Consider its successor.
If you bought a Malibu in 2004, it shipped with the then –new “High Value” V-6 which was a significantly better engine…and lasted until only 2011 in production. That engine, like all that followed it required more tooling, tighter tolerances, higher part count and more plastics and light alloy materials. Like all modern engines, it’s more expensive to design and build than similar previous generation engines. In effect, it’s harder and more expensive to engineer key auto assemblies now, yet total product life is much shorter.
Warren Buffet isn't impressed
There’s really no option for the GM or any other automaker….all the world’s big automakers can and do raise the bar every year with new platforms spawning multiple new models. Put simply, 20-25 billion dollars in the GM war chest is a shareholder windfall to institutional investors, but it’s in fact the seed capital for the next generation of product that GM desperately needs to stay current with Toyota, Volkswagen, Ford and other competitors. If this pool is depleted, GM can go to the market; current interest rates do look attractive. The challenge is to prevent the same activist shareholders from applying similar logic to the share buyback strategy. In fact, US corporations are borrowing money to buy back stock in record amounts, a practice not without controversy.
For General Motors, however, the plan to put Wilson on GM’s board was criticised by none other than Warren Buffet, who noted that Wilson’s deal with his hedge fund partners was to pay him two to four percent of any gains in GM shares over the next two years: Commenting on CNBC he said he was wary of accepting “somebody on the board who has an option on some other people's stock which is only good for two years.”
Trouble ahead for GM?
Taken by itself, five to eight billion dollars of cash distributed to shareholders will not affect GM operations, but the real cost must consider what could have been done with the money, what economists call “opportunity cost”. The windfall for shareholders could have bought an entirely new platform with five or six models. That platform could have been a lower cost Tesla competitor for example, or a new light alloy Silverado to challenge Ford’s profitable aluminum F-150 light truck series. It could also have been used for advanced robotics, new lightweight composite materials technology or other high-impact research and development efforts. And GM has other significant cost on the horizon: recalls. Potentially the most expensive is the 2014 ignition switch issue involving nearly 28 million cars worldwide. In the second quarter of 2014 alone, GM announced a $1.2 billion charge against earnings, with more to come as lawsuits continued.
What about R&D?
This investment model is a stark contrast to many of GM’s competitors. An example is Honda. Honda invests 5 to 6% of revenues in R&D and in 1986 began a project to build small jet aircraft. The resulting HondaJet took 26 years to get to full production status and is expected to receive full certification sometime in 2015. How could a Japanese carmaker convince its shareholders to invest in a project that will take over a quarter of a century to generate a return for shareholders? As Honda Aircraft Company CEO Michimasa Fujino told The Wall Street Journal in 2012, “we often get asked, why is Honda building airplanes? I mean, it’s inconceivable that another automaker like General Motors would start selling jets. At Honda, we take a multi-faceted approach to business focussed not just on short-term quarterly or annual earnings reports, but longer-term objectives over a five or 10 year time horizon”.
With Wall Street piloting General Motors and other major American manufacturers, short-term gain may equal long term pain in a highly competitive retail world.