GM’s Capital Allocation Framework case

Harry Wilson disclosed plans to nominate himself to GM’s board of directors

 Acting in conjunction with 4 investment funds
 Wanted GM to repurchase $8 billion in stock
 Found significant opportunities for GM to grow its profit margins (not increased much
since 2010

GM’s new capital allocation framework:

1. Invest with the goal of obtaining a 20% or higher return on invested capital (ROIC)
(recent efforts to enhance capabilities to measure profitability levels with a full allocation of costs
 track returns + impose greater discipline when considering opportunities)
2. Maintain an investment-grade balance sheet with a target cash balance of $20 billion 
ensure a minimum level of cash that could be used in the event of a recession
3. Once investment and balance sheet needs were met  return all available FCF in the form
of dividends or share repurchases  Plan to repurchase $5 billion of GM shares by the
end of 2016

Following the announcements, Wilson withdrew his plan to become a GM director;

Questions that arose right after:
 Would the capital allocation framework help GM managers deploy capital in a more
efficient manner?
 How would analysts and investors respond to it?
 Would it drive increased returns to shareholders?
 What implications did the framework have for strategic choices that GM faced?

The choices implied in the above questions were related with how much GM should invest in its
European operations:
 Focus in Russia  recent lackluster performance  weak macroeconomic conditions and
significant devaluation of the rouble dragged down performance;
 To keep with new regulations and to continue manufacturing activities in Russia  Spend
approximately $1 billion;
 Had been spending $9 billion a year on capital investments to ensure it launched leading
products at the right cadence  New framework highlighted the required returns
associated with these investments;

Innovations with large potential consequences on the horizon:

 Industry projections for the rapid growth of electric vehicles
 Technologic assistance advances  some manufactures already testing fully autonomous
cars in public;
 Emerging business models for ridesharing and carsharing
CHANGES WITH THE ABILITY TO DISRUPT THE NATURE OF THE AUTO INDUSTRY

COMPANY BACKGROUND
History
 Founded in 1908  combination of several motorcar companies in a single conglomerate;
  1920  restructuration of the company into 5 main automobile divisions: Cadillac, Buick,
Pontiac, Oldsmobile and Chevrolet;
 1950s/1960s  world’s largest automaker in unit sales and accounted for 40% of
US automobile sales
 Later part of the 20th century  Increased competition (Japanese automakers)
 2008: Surpassed by Toyota after being the world’s sales volume leader for 77 years;

Financial crisis in 2008  Sharp decline in auto sales

 Emergency financial rescue plan
 GM received $13.4 billion in emergency aid at the end of 2008
 Rising debt forced the company to file for chapter 11 reorganization

Reorganization: GM split into two entities

1. New GM: included 4 major brands;
2. Motors Liquidation Company: Other parts that were sequentially sold off or closed;
To support GM  US Treasury provided GM with an additional $36,1 billion in funding and
obtained 61% of GM equity

GM reported healthy profitability in the following years;

November 2010  listed on the NYSE and the Toronto SE (one of the largest IPOs)
2013  federal government exited GM by selling off its remaining shares and recovered
roughly $39 billion.

Management:
 Many of GM’s corporate officers had recently taken on their roles;

Operations, Products and Services:

Automotive operations organized into 4 regional segments:
1. GM North America (GMNA)
2. GM Europe (GME)
3. GM International Operations (GMIO)
4. GM South Africa (GMSA)

At the end of 2014, GM held a 16,9% retail vehicle market share in North America;
 Outside of North America, Buick, Cadillac, Chevrolet… brands were predominant;
 GM was a part of many joint ventures (largest: Shanghai general motors)

Wide variety of cars, trucks, crossovers and SUVs;

2010: GM began selling the hybrid Chevrolet Volt
2015: announced an all-electric Chevrolet Bolt headed for production

 Component of retail sales: sales to fleet customers (rental car companies, commercial
fleet customers, leasing companies, and governments)  19,2% of global sales in 2014
 Network of 20000 dealerships around the world; Independent from GM;
GM sold off its ownership interest (GM Acceptance Corporation)  between 2006 and 2013,
continued to provide financial services through GM Financial (provided retail loans, offered lease
programs to automotive customers)
 To finance these loans and leased equipment: relied on secured and unsecured credit
facilities;
Owner of Onstar  subsidiary that provided security and mobility solutions;

INDUSTRY CONTEXT:
 Highly cyclical industry
 Increased sales and production volume following the 2008 crisis
 Total US motor vehicle sales grew from 10.6M in 2009 to 16.8M in 2014
o Passenger car sales: 5.4M  7,7M (13,5%)
o Light Truck Sales: 5M 8.7M (20,6%)
o Medium and heavy truck sales: 200000 407000
*GM, US market, in 2014

 Rise in global automobile demand  global new passenger car registrations grew from
51.4M to 70.1M (2009 2014) (more in North America and Asia)
 Main sources of projected increase on sales: outside North America and Western Europe

Potential disruptions faced by the industry:

 Shift to electric vehicles: environmental concerns, tightening CO2 emissions regulations,
high fuel prices;
o Sales increased from 45000 to 307000 (2011  2014)
o Regulations expected to become more stringent
o Projections that electric vehicles would become 10-15% of global auto market in
2020.
 Growth of shared mobility
o Ridesharing (Lyft and Uber) + carsharing (Zipcar)  exploit the fact that, on
average, cars sat idle 96% of the time
 Development of autonomous vehicles
o Technologies are still under development, but Google believed that car utilization
rates could increase to 75%

 The demand of shared mobility, and especially autonomous shared mobility, could have a
big impact on the demand for vehicles and the profitability of original equipment
manufacturers.
 Many industry experts believed that vehicle sales would fall
 Morgan Stanley: worldwide growth in vehicle production would fall to 0% by 2025 and
remain there until 2030 (fraction of shared cars grew to 15%)
 Barclays: US auto falls by 40% by 2040
 Deutsche Bank: cars would be driven more miles  need to be replaced more often

Not clear which firms would capture the value associated with these changes
(returns could go to whoever produced the software, owned the data, and provided the
coordination services)
THE CAPITAL ALLOCATION FRAMEWORK:
 Efforts to enhance measures of profitability and new perspectives about leverage:

 Concerns that the P&Ls of each GM entity were not precise enough because they were a
function of transfer prices negotiated within the firm
o Risk that some parts appeared to perform well because managers had been
successful in negotiating favorable terms;
STRENGTHEN FINANCE FUNCTION: GM developed point of sale reporting capabilities  allowed
managers to measure profitability in a manner that fully allocated corporate costs;  more clarity
about profitability at the country and product level  possibility of conducting deeper analysis if
the firm was generating enough returns for the capital employed in different locations;

 Concerns with Liquidity:

o Capital intensive nature of GM’s activities generated significant operating leverage;
o Decrease in sales generated large cash needs
Low margins + cyclical industry  Need of a BS capable of withstanding a downturn

3 TENETS OF THE GM CAPITAL ALLOCATION FRAMEWORK

1. Boost the ROIC to 20% or more (place GM in the top quartile of automakers)
a. Numerator is adjusted EBIT (used as a performance metric); Measure of net assets
that excluded the value of deferred income taxes and goodwill
b. Compute ROIC using the trailing 4 quarters of data  communicate it widely 
present it on quarterly earnings releases
c. Possible to measure ROIC at the country, regional, global level + product programs
Target had different implications in different investments:
 GM was spending $9B a year in capital expenditures
o 70% on product programs  goal for these = 20/25%
o Luxury and full-size trucks tended to have higher margins
o Gross margins in the automobile industry varied with production volume (many
production costs were fixed)
o Capital intensive process and union contracts constrained to cut salaries
o Early stage product lines had not yet reached significant scale  difficult to achieve
high ROIC
o 30% used to close to equal amounts on asset sustainment (don’t generate marginal
returns for GM) and business model improvements (were assigned a relatively high
ROIC target)

2. Maintain an investment-grade balance sheet (target cash balance of $20B)

 Allow GM to continue to meet operational and non-operational obligations during an
average recession
 Minimum cash required in a steady state: $8B (meet needs generated from seasonality &
includes $3B in cash held overseas that could be costly to access)
 During average recession: additional $10 to $11B + 5$ to $6 working capital needs +
interest payment/dividend of $5B
 Pension obligations (see better)

 3. Increase the return on capital to shareholders
 Cash not needed to the 1st or 2nd  returned to shareholders through dividends and
repurchases
 Senior management analysis current/forecasted cash generation + investment needs
 make recommendation concerning payouts
 Strong dividends = disciplinary device
 GM shares were undervalued, making repurchases particularly attractive; Initial $5B
share buyback is good for our owners  cannot earn better returns by investing that
cash in the business at this time

 Quarterly dividend of $0.30 per share in the 1st quarter of 2014

 Plans to increase to $0.36 in the 2nd quarter of 2015
 Authorization to repurchase $5B  begin after the announcement and conclude
before the end of 2016

Praises to the Capital Allocation Framework:

1. GM is returning more capital to shareholders, sooner than expected (immediate buyback);
2. GM will be returning more capital to shareholders on an ongoing basis;
3. GM targets a more efficient capital structure ($20B gross automotive cash)
4. GM is increasing transparency with respect to near-term targets (20% ROIC)

RELATED GM MANAGEMENT PROCESSES:

(Implementation of CAF required changes in several management practices)

Capital Budgeting: product program business cases that included projected volumes, prices and
material costs over the life of the product program; Risk that projections have involved  risk of
excessive optimist on volume or pricing was significant for new products
Performance of product programs was evaluated and monitored at many points in time;
Cases also carefully studied after the program was concluded  regular reporting of results
among managers;
 Recent efforts had enhanced GMs ability to consider product programs in a more integrated
way  the Vehicle Execution Group brought together chief engineers and regional
presidents to make trade-offs and look for efficiency gains across product programs  The
group rationalized product lines and optimized manufacturing plans

Incentive Compensation (for GM executives): executives participated in a ST and LT incentive

program;
STIP  include targets based on (adjusted EBIT, FCF, market share and quality) and executives
received a payout depending on performance
LTIP  2 components:
 Restricted Stock Units (RSUs)  time based, and individual received grants with 3-year
vesting periods
 Performance Stock Units (PSUs)  granted on a rolling basis and tied to performance over
specific 3-year periods (see ROIC and payouts)
LOOKING FOR THE FUTURE
 Over the last years, performance with a consistent improvement and indications to
continue;
 April 2015: EBIT adjusted for the 1st quarter of 2015: 2.1B (+0.3B from the same period of
2014)
 Stock price: $36
 Key decisions regarding its operations in Russia and Europe
 Changes in the industry

1. Analyze the recent evolution of GM. Do shareholders have reasons to be happy with the
recent performance?
2. What do you think about GM’s capital structure? Is it reasonable, considering the special
characteristics of the firm and the industry in which it operates?
3. Why is the firm targeting a ROIC of 20%? Is this target reasonable or too ambitious? What
does the firm try to achieve by publicly announcing it?
4. Please make a critical analysis of GM’s ROIC calculation methodology (Exhibit 8)
5. How, in the context of your previous analysis, can you explain the objective to repurchase
$8bn of common stock? And what about the stated policy of use of future cash flows?
6. In between, the company has announced the objective to retain $20bn in cash balances.
What are the objectives of such cash policy
7. What are the consequences of the new policies in terms of the approval of capital
investments on the achievement of long-term survivability of the firm? Could such policies
have negative strategic effects?
8. Explain the new management incentive compensation scheme. Is it aligned with
shareholders’ interests? What are the dangers?
9. Putting everything together, what do you believe GM is trying to achieve with this new
capital allocation framework and associated initiatives?