Why GM's Earnings Could Be Down

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What can we expect when General Motors (NYS: GM) reports third-quarter earnings Wednesday?

Certainly a solid profit seems likely -- GM's sales are up around the world. But while the underpinnings of the General's businesses remain strong, and the company's upward post-bankruptcy trajectory looks set to continue as its product renaissance gathers steam, some costly headwinds could put a damper on profits this time around.

Strong revenues likely to get stronger
GM earned $2 billion in the third quarter of 2010, a result reported just before the November IPO that returned its stock to the NYSE. That profit came on revenues of $34 billion, a number that is likely to be higher this time around thanks to strength in GM's two key markets:

  • U.S. sales were up 16% through September versus the year-ago period, thanks to a slowly improving economy, a few strong new models, and tsunami-related shortages of key products from rivals Toyota (NYS: TM) and Honda (NYS: HMC) . And like Ford (NYS: F) , GM is earning more per sale as it continues to reduce incentives and offer more competitive products with premium features, so margins could be up as well.
  • China sales were up 7% through September. While the white-hot growth of China's auto market has cooled considerably, the forces behind that cooling have arguably played to GM's advantage to some extent. The end of a government subsidy program that effectively incentivized low-end Chinese-brand products reduced the relative price disadvantage of Shanghai GM's offerings, and Chinese consumers have continued to find the quality and value of locally made Buicks and Chevys compelling.

GM sells more vehicles in China than it does here, but the joint-venture arrangements required in China mean that its per-vehicle profits are split with local partners. U.S. sales remain the key driver of GM's revenues, and strong results here bode well for strength in its upcoming earnings report.

But as noted above, an increase in revenues might not lead to a big jump in earnings this time around, because of a market disruption that has already put a dent in rival Ford's earnings.

A headwind on earnings
A paper loss on derivative securities put a damper on Ford's third-quarter earnings (and its share price), and at least one analyst has raised the possibility that GM could report a similar loss. In a nutshell, Ford's CFO explained that the company holds derivatives that will rise in value if certain commodities prices rise, helping to offset the increased price that Ford would have to pay for parts and materials in such a scenario. This is a standard practice at industrial firms, including GM, and it's a prudent, sensible risk-control measure -- not at all like the derivatives that led to the banking crisis.

But a steep drop in the prices of some commodities (particularly aluminum and copper) in September led to an on-paper drop in the value of Ford's derivatives, and accounting rules required that Ford count that drop as a loss in its quarterly earnings report. That was a $350 million hit, and worries about further (again, on-paper) losses led Ford's CFO to warn that the company's margins were likely to show a decline for the year. That news led to a big drop in the price of Ford shares.

Barclays Capital's Brian Johnson has raised the possibility that GM could report a similar loss, and I think it's something that GM shareholders should keep in mind. As I said when Ford reported, this is no big deal in the long run -- Ford executives were at pains to point out that lower commodity prices would be a solid net gain for the company if they persisted, though it might take a few quarters to be visible, and GM should be in a similar position to benefit.

But while GM's underlying businesses appear strong, notwithstanding concerns about sales growth in 2012, even a passing headwind that results in a year-over-year drop in profits could lead some investors to turn away. That could hit the share price hard. But depending on what else GM reports on Wednesday, that could mean nothing more than a nice buying opportunity. Stay tuned.

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At the time this article was published Fool contributor John Rosevear owns shares of Ford and General Motors. You can follow his auto-related musings on Twitter, where he goes by @jrosevear. The Motley Fool owns shares of Ford. Motley Fool newsletter services have recommended buying shares of Ford and General Motors. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. 

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