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Morningstar | Steel Costs Hit GM's 2018 Guidance and We See Too Many Factors Beyond Management's Control. See Updated Analyst Note from 25 Jul 2018

Although GM beat consensus in its second-quarter results with adjusted diluted EPS excluding GM Korea restructuring charges of $1.81 versus $1.78 market expectations, the stock fell about 7% the morning of July 25 due to management reducing its 2018 adjusted EPS guidance to a range of $5.80-$6.20 from $6.30-$6.60. This was driven by an additional $1 billion in steel and aluminum (mostly steel) headwinds than management previously expected and currency devaluations in Argentina and Brazil against the dollar.

We are reducing our fair value estimate to $45 from $56. The change comes from raising our weighted average cost of capital to 10% from 8.5% to reflect what we see as higher external factor risk than at the start of 2018 that we think is mostly beyond management's control. Tariff risk from the Trump administration is increasing not only with the already levied steel and aluminum tariffs that have caused commodity prices to escalate more than management expected but also from increased rhetoric from President Trump on tariffs of 25% on foreign autos. Even if NAFTA remains in place, tariffs on autos outside NAFTA are not necessarily positive for GM. We do not think that many high-end German sedan customers will instead buy a Cadillac for example. If auto sales fall due to tariffs outside of NAFTA, we don't think GM's stock would be immune from the market risk. There is much uncertainty as to whether or not the tariffs will go into effect, in what form, and how long will they last so we are raising our WACC. Other issues working against management is that we think U.S. auto sales already peaked and this is likely to give investors hesitation to buy GM stock now, more vehicles are coming off-lease which draws some consumers to a used vehicle over a new one, and there is risk of anti-U.S. sentiment in China impacting GM's business there. Management is not seeing these pressures in China, but if protests happen we think it would likely hurt the stock.

GM China is actually doing quite well and is insulated from the recent Chinese tariff hike to 40% because almost everything GM sells there is made in China, as are the parts. GM China had record second-quarter equity income of $592 million but management did warn of second-half 2018 headwinds due to launch costs for 10 new models and pricing pressure. Management now guides for full-year total company equity income of about $2 billion from slightly over $2 billion previously. We are not terribly concerned about this change, however, because we were already modeling $2 billion and Chinese demand for GM vehicles looks strong to us. Cadillac continues to thrive in China with unit sales up 29.2% versus the first half of 2017 and momentum should continue with the new XT4 crossover launch this year.

Commodity costs are causing GM North America's streak of adjusted-EBIT margin of 10% or more for three straight years to be in jeopardy. Guidance for 2018 had been for another year of at least 10% but is now for 9% to 10%. Management expressed willingness to pass cost increases along to customers when able, but we think the auto industry is too competitive for GM to pass along all tariff costs to consumers and dealers. Management has mitigated about $1 billion of a $2 billion total headwind from commodities and currency but cost-cutting measures and some pass throughs to customers cannot alleviate all the problem, hence the guidance cut. For the quarter, GMNA margins declined by 280 basis points to 9.4% mostly due to a $1.3 billion mix and cost headwind from pickup truck mix favoring less profitable trims and $700 million in materials and commodity costs. The new generation full-size pickup will begin shipments in early August and will be high content crew cab trims but meaningful new generation truck volume will probably not be until at least the fourth quarter.

Although GM is seeing increased macroeconomic pressure, we still think that if the U.S. does not enter a recession, 2019 could be a good year for the company. There's more new crossovers in 2018-19 coming such as the Cadillac XT4, XT6, and Chevrolet Blazer, the new generation pickups, and GM International will have a full year of about $400 million of annual cost savings from the recent Korean restructuring actions including a plant closure.

Also interesting is that GM Cruise is expected to launch its autonomous ride hailing service in 2019. We think this will initially be in San Francisco and perhaps Phoenix and New York where GM is, or in New York's case, will be testing soon, but we think GM is a leading player in AVs and the market may not be giving the firm enough credit for that yet. The recent SoftBank investment in Cruise (see our May 31 note) values the business at $11.5 billion. GM began reporting Cruise as its own segment for the second quarter and the segment has no revenue yet and has lost $320 million in the first half of 2018, with full-year 2018 losses guided to be about $1 billion.