Auto sector outlook brightens on GM production cuts

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Stalling U.S. auto sales, rising inflationary pressures and heftier borrowing costs have been weighing on the automotive sector this year. But the mood brightened considerably after General Motors Co. announced on Monday it would halt production at five North American factories.

GM shares surged 4.4 per cent on the news, and other car makers went along for the ride. Ford Motor Co. rose 3.1 per cent and Toyota Motor Corp. Ltd. rose 1.3 per cent (the shares trade as American depositary receipts in New York). Even Canadian auto-parts manufacturer Magna International Inc. rose 1.8 per cent.

Why did auto stocks rise after what is, on the surface, grim news?

Many investors tend to prefer brutal efficiency over warm hugs. GM’s decision to idle five plants, including one in Oshawa, Ont., will mean thousands of layoffs affecting some 15 per cent of the company’s salaried work force. The move has raised the ire of provincial and federal politicians in Canada, who expressed their disappointment in the company nearly a decade after governments bailed out the automaker during the financial crisis.

But the financial benefits of GM’s move are beguiling some investors who have been worried this year that slowing economic activity will hit economically sensitive companies, such as car makers, particularly hard. After all, the last economic downturn wiped out many stakeholders in North American car makers, which were caught off guard.

Perhaps this time around, auto makers will be more nimble. GM expects the changes announced on Monday will reduce its annual capital expenditures by about US$1.5-billion and reduce its annual costs by US$4.5-billion by 2020. That translates into a boost of US$6-billion to the company’s free cash flow, a measure of how much money a company generates for its stakeholders. According to Citigroup, this could increase free cash flow from an estimated US$4-billion in 2018 to US$10-billion by 2020.

Analysts liked what they heard.

“Today’s announcement shows that GM possesses unique turnaround levers that can drive meaningful savings over a relatively short period of time,” Itay Michaeli, an analyst at Citigroup Global Markets, said in a note.

Joseph Spak, an analyst at RBC Dominion Securities, said he was “positive on a plan to accelerate transformation.” He added he liked that GM was “transitioning to the future.”

GM had been performing well prior to Monday’s announcement, which raises questions about why the closings were deemed necessary.

In its third-quarter results, released at the end of October, the company beat expectations handily. It reported a net profit of US$2.53-billion – or US$1.87 a share after adjustments and a substantial 63 cents a share above the average forecast among analysts. Adjusted earnings before interest and taxes (or EBIT) was US$3.37-billion, or nearly US$1-billion above the consensus expectation among analysts.

But GM has faced considerable headwinds that sent its share price down 32 per cent from its highs in June to its lows in October. Other car makers and auto-parts manufacturers struggled, too, as some investors bet that the automotive sector’s best days in the current economic cycle had passed.

One problem the sector faced: U.S. auto sales, although robust, are set to decline to about 17 million units in 2018, down from 17.1 million in 2017, according to a recent report from Bank of Nova Scotia. To some investors, this suggests that rising borrowing costs are starting to dig into consumer spending.

The trend is likely to continue as the U.S. Federal Reserve battles inflationary pressures. Most economists expect the Fed will raise its key interest rate again in December.

Another problem: Rising steel and aluminum prices, largely the result of U.S. tariffs on imports, added US$400-million to GM’s costs in the third quarter, and are likely to add US$1-billion more in 2019 – a headwind facing the entire automotive sector.

Despite GM’s upbeat third-quarter performance, analysts expected earlier this month that the automaker would have to address these issues well before they began to drag on GM’s financial performance. And the stock market’s response on Monday suggests that investors like what the company is doing – and expect other companies will follow.