The New GM

Analysis of the Revenue-Profits data for the five consecutive quarters ending Q1 2011 by Dr. V. Laxmanan Email: vlaxmanan@hotmail.com
____________________________________________________________ The new General Motors, after emerging from bankruptcy, has just reported it highest quarterly profits to date for the first quarter of 2011. Profits have more than tripled, from $0.9 billion to $3.2 billion compared to the same quarter in 2010. Also, revenues went up, to $36.2 billion from $31.5 billion last year. Analysts had expected $35.59 billion; see link below for the news release. http://www.msnbc.msn.com/id/42896143/ns/business-autos The following describes a simple approach to analyzing this financial data using a somewhat unconventional methodology. For a household, the simplest type of a financial entity, Income Expenses = Savings. The higher the income, or the lower the expenses, the higher will be the savings. As income increases, expenses also increase but we also expect the savings to increase. Likewise, the basic law that governs the operation of any other financial entity, such as a corporation, can also be written quite simply as follows: Profits = Revenues Costs If revenues increase and/or costs go down, profits will increase. This is supported by the quarterly earnings released by the new GM. Quarterly profits tripled in 2011, compared to the same quarter in 2010, but revenues
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also increased. This is also obvious from the revenues-profits data for the last five quarters, starting with first quarter of 2010, see Table 1. Notice that revenues increased as profits increased in each of the quarters for which data is available, the only exception being the fourth quarter of 2010 when revenues increased without a concomitant increase in profits.

Table 1: Profits-Revenues data for GM for the five most recent quarters
Quarter Q1 2011 Q1 2010 Q2 2010 Q3 2010 Q4 2010 Revenues, $ billions 36.2 31.5 33.2 34.1 36.9 Profits, $ billions 3.2 0.9 1.3 2.0 0.5

Thus, it appears that the road to higher profits is paved by both revenue enhancement and cost cutting strategies. Exclusive and/or excessive focus on cost cutting will not grow a company since it means that the company is not paying attention to enhancing its revenues, which is often accompanied by increased market share. The higher the market share, the higher the number of vehicles sold (as in the case of an automotive company such as GM, see the GM annual reports), or other goods and services sold, and the higher will be the profits. Is there a simple and thus far unrecognized relationship between revenues enhancements and increased profits? This can be explored by preparing a x-y scatter graph, see Figure 1. As we see here, there is a remarkable upward trend which can be described mathematically using a simple linear equation y = hx + c, where x = revenues, y = profits, h = slope of the straight line and c is the intercept made by the straight line on the y-axis. When revenues increase, profits do not increase immediately. Revenues must exceed a certain minimum value before any company can report a
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profit, since there are fixed costs associated with all operations. The linear relation revealed here can be shown to be a consequence of the classical breakeven analysis for determining the profitability of any operation. This equivalence is shown in Appendix 1.

Figure 1: Graphical representation of the Profits-Revenues data for GM for the five consecutive quarters ending first quarter of 2011. A remarkably linear relationship is revealed here, if we take the Q4 2010 data as an outlier. The regression coefficient r2 = 0.959 which indicates a high and positive correlation between profits and revenues.

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Appendix 1 Linear Profit-Revenue Relationship and Classical Breakeven analysis Let N denote the number of units sold and/or manufactured. The total cost of producing these units, C = Fixed cost + Variable cost = a + bN. This is the simplest mathematical relationship between C and N. If k is the unit price, the revenue R generated by selling N units is R = kN. Here a, b, and k are constants that depend on the type of units being sold/manufactured. The breakeven quantity is the value of N for which R = C. The profits P will increase as the number of units sold increases beyond this point. P = R C = kN a bN = (k b)N a But, N = R/k. Therefore equation A1 can also be written as P = [ (k b)/k ] R a .A2 ... A1

Equation A2 is a linear relation between profits P and revenues R and can be rewritten as y = hx + c where y is profits and x is revenues and where and, h = (k b)/k c=-a

The simple linear relationship between profits and revenue, as revealed here, by the GM financial data for five consecutive quarters is simply a consequence of the classical breakeven analysis in a much more complex situation (with more than one product stream each with its own value of the constants a, b, and k, and with different N values). The significance of the nonzero intercept c (which is the negative of the constant a in the breakeven analysis) must also be appreciated. This is the reason why profits more than tripled between Q1 2010 and Q1 2011 but revenues went up only by about 15%. From equation A2, we can see that the ratio P/R = [(k b)/k] a/R is not constant and keeps changing as revenues increase or decrease. The ratio P/R is a constant if and only if
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a = 0 or c = 0, i.e., if the P-R graph passes through the origin. This is impossible because of the nonzero fixed costs. Hence, a tripling or doubling of revenues does not lead to a tripling or doubling of profits, or vice versa. Figures 2 and 3 illustrate the graphs of these relations for predetermined values of the constants k, a, and b. In the real world, the constants h and c can be deduced using a simple linear regression analysis as shown here.

Figure 2: Classical breakeven analysis. Revenues increase as units sold N increases. Costs also increases as N increases. The breakeven quantity N0 (denoting zero profit) is obtained by setting R = C or kN = a + bN; thus N0 = a/(k b). For the values chosen here N0 = 1/(0.5 0.25) = 4, as seen from the graph above. The minimum revenue for profitability R0 = ak/(k b) = kN0 and is deduced from equation A2 by setting profit P = 0.

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The classical breakeven analysis also implies a simple linear relationship between profits and revenues, as illustrated in Figure 3. The slope h = (k b)/k = (0.5 0.25)/0.5 = 0.25/0.5 = 0.5 Intercept c = - a = - 1 These numerical values are confirmed by the graph prepared in Figure 3.

Figure 3: Linear relationship between profits and revenues implied by the classical model for breakeven analysis. Profits increase linearly with increasing revenue, beyond the breakeven value.

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Appendix 2 An example of forward predictions based on this methodology Consider the profits-revenues data for the first and second quarters of 2010. Both revenues and profits increased. A straight line can obviously be drawn between these two data points. The slope h of the straight line can be readily calculated as follows. The slope h = (1.3 0.9)/(33.2 31.5) = 0.235 Q12010 and Q22010

It is important to remember that this straight line does not pass through the origin (0, 0). There is a finite intercept c, the significance of which has already been discussed (it is related to the fixed costs). If the linear relationship holds, the data point for the third quarter should fall on this same straight line. Nonetheless, lets recalculate the slope using the third data point. The slope h = (2 1.3)/(34.1 33.2) = 0.7/0.9 = 0.777 Q2 and Q3 data The slope h = (2 0.9)/(34.1 31.5) = 1.1/2.6 = 0.423 Q1 and Q3 data The average of the two slopes 0.235 and 0.777 equals 0.506 and the average of the three slopes is 0.479. The slope of the best-fit line through many (x, y) pairs, using standard statistical methods, is merely a statistical average value of the slope when many data points are accumulated over several quarters. Thus, if future revenues can be predicted (using other market analysis tools), the future profits can be predicted using the best-fit line and the profits-revenues data for the immediate past quarters. As an aside, this method, also known as the least squares method, or simple linear regression analysis, was popularized by the French mathematician Adrien Marie Legendre, in a famous paper published in 1805. For than 200 years, an incorrect side view portrait of this famous mathematician has been used, as noted in a recent Wikipedia article.
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http://en.wikipedia.org/wiki/Adrien-Marie_Legendre Legendre was interested in discovering methods to curve fit astronomical data (the orbits of comets, notably). In the praise of his method, Legendre noted that of all the principles that can be proposed, there is none more general, none more exact, and none more simple and easy to apply than the method of minimizing the sum of the square of the errors. The error that Legendre is referring to is the vertical deviation of an individual data point from the best-fit line. The slope h of the best-fit line is fixed by minimizing the squares of the vertical deviations, since some data points will fall above the best-fit line (positive deviation) and some data points will fall below the best-fit line (negative deviation). If there is no error all the data points will fall exactly on the best-fit line. The formulae for determining the slope h and intercept c, along with a worked example, may be found in the link given below. http://phoenix.phys.clemson.edu/tutorials/excel/regression.html Unfortunately, although the method of least squares is well known to financial analysts it is rarely employed, as done here, to analyze financial data accumulated each quarter for literally hundreds and thousands of companies all over the world, operating in different sectors, and in different economic, political, and social (read tax ! ) environments. Instead, it is common to use % changes and various ratios, such as the profit margin (ratio of profits to revenues), or earnings per share (ratio of earnings to total number of shares), etc. to assess the financial performance of various companies and rank them, for example, in the annual Fortune and Forbes magazine lists. The significance of the non-zero intercept c and its fundamental and far-reaching implications for the validity of various ratio analyses cannot be overlooked and will be discussed separately.
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Finally, in addition to considering quarterly data for the individual quarters, we can create additional (x, y) pairs by considering 6-month, 9-month, and annual profits and revenues data to refine the estimates of the slope h and the intercept c. The best-fit line determined in this fashion becomes the operating line for GM, at least for the near future. GMs future performance can thus be assessed on the basis of its immediate performance in the last few quarters. Over the last nearly 10+ years, the author has studied the financial data for several companies, in several sectors of the economy, using exactly similar methodology. It is sufficient to note that the simple linear relation observed here holds for all companies. Indeed, it appears that the linear law y = hx + c can be elevated to the status of a universal law that describes the behavior of all companies, in any given sector of the economy, each with slightly different values of the constants h and c. Analysis across sectors and between companies within a single sector can therefore be performed using this remarkably simple approach going back more than 200+ years to Legendres most famous contribution to statistics. Finally, heres an interesting example of what Legendres least squares method, or linear regression analysis, or best-fit line can do. A few years ago, when the present author was discussing the efficacy of such an analysis, he was posed the following question by a clearly skeptical golf enthusiast. Ok, in my last three rounds, I posted 72, 66, 74. Tell me what I scored in my final round? These are not the exact numbers given to the author, but the general nature of the question should be appreciated. Yes, one can use the least squares method to determine the best-fit line through these three data points (1, 72), (2, 66), (3, 74) and get the value (4, y). Or the analysis can be done differently, and more accurately, as (1, 72), (2, 138), (3, 212), or even as (18, 72), (36, 138), (54, 212), since 18 holes are played during

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each round of golf. The y values for the second and third sets are obtained by adding the scores for all the previous rounds. Indeed, the prediction made for the fourth round using this method proved to be resoundingly correct and was so acknowledged by the (honest) golfer! Of course, true golf enthusiasts know that this method might not apply to the fourth round of star golfers like Rory McIlroy, Phil Mickelson, or even the new Tiger Woods of the year 2011! As we see in Figure 1, there are always outliers.

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About the author: The author obtained his Masters (S. M.) and Doctoral (Sc. D.) degrees in Materials Engineering from the Massachusetts Institute of Technology, Cambridge, USA. He then spent his entire professional career at leading US research institutions (MIT, NASA, Case Western Reserve University, and General Motors R & D Center, in Warren, MI). He holds four patents in advanced materials processing, has co-authored two books, and has published several scientific papers in leading peer-reviewed international journals. His expertise includes developing simple mathematical models to explain the behavior of complex systems. He can be reached by email at vlaxmanan@hotmail.com

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Appendix 3 Some comments and discussion The following are some comments received from some friends and colleagues with whom I shared this analysis prior to uploading it as a public document. Impressive analysis. We are still not back to even a recession level of sales. We are about 2 million units below what would be a recession sales level. Dave Thanks for the encouragement. The remarkable thing about the new GM, which comes out of this analysis, and the linear law y = hx + c, is that once the breakeven revenue level is achieved, nearly 50% of the additional revenue (from the increased sales, once we reach higher post-recession levels) is turning into profits. The slope h is like the marginal tax rate in economics, the tax paid on each additional dollar earned. Likewise, the slope h = dy/dx is the derivative of the profits-revenue curve and is different from the familiar profit margin, which is the ratio y/x. The slope h tells us about the profit made on each additional dollar of revenue, past the breakeven revenue level. In my earlier analysis of the financial data for the old GM, the slope h had a much smaller value. It definitely is an interesting angle to the whole earnings game. Thought provoking, to say the least. Please publish it and let's see what kind of response you get. Ramesh Thanks. What is new is that the slope h is now very high for GM, which means that almost 50% of the additional revenues will translate into profits, once the breakeven revenue has been achieved. But, this will not last for very long. As the new GM gets older, the slope will change (actually reduce) and the intercept c will go from the negative value today to a positive value. This is what happens with what I call "mature" companies. There is another universal mathematical curve that can be fitted to such a situation. Hopefully, we will discuss this in a later write up.
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Your analysis is correct, though I see the following 2 issues affecting profitability in near future: 1) Part production from Japan is reduced, so finding alternate sources may be expensive in the short term or even not possible. This will reduce the revenue very soon. So, dont know when $40 billion level will be reached. 2) With less no. of vehicles produced and good demand, incentives will be lower, so higher profit will be made. So, we may get same/relatively more profit without increase in revenue in the near future. Lets see how it goes. Sudhir The above response was prompted by the following message from the author. Here's a problem for you. The following is taken from the news on GM quarterly profits this morning. It has more than tripled according to the report - from 0.9 B to 3.2 B. Also says revenues went up, see below what I have pasted from the article. http://www.msnbc.msn.com/id/42896143/ns/business-autos Net income in the first quarter rose to $3.2 billion, or $1.77 a share, compared with $900 million, or 55 cents a share, in the year earlier quarter. Revenue rose to $36.2 billion from $31.5 billion last year. Analysts had expected $35.59 billion. Now, I have a problem for you to think about. Lets say, in the near future, the quarterly revenues increase to $40.2 billion from the current value of $36.2 billion. What will be the profit in that quarter? I predict a profit of $5.16 Billion in that quarter based on the info currently available. Do you agree? Anyway, if GM gets to $5 billion in quarterly profits, it would be a mind boggling quarterly profit by an auto company. Before the bankruptcy, they could not show $5 billion profit annually with more than $200 billion in revenues.

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Sounds good. But here we are only talking about P&L (profit and loss). Where is the analysis on the B/S (balance of sheet), pipeline of cars, international growth and all that. Also, create an account on blogspot and post it there as well. LN. Hi LN: To me their detailed balance sheet per se is NOT important. The bottom line is their profits and revenues. Everything else follows. Hence, what I have done. We cannot look at the trees and forget the forest. That is what everyone seems to do. Then they dont get the BIG picture. (Some analysts have already stated that GM is nowhere doing as well as Ford. Give me a break, that is stating the obvious and that is really not the issue. The issue is how well GM is doing.) We can do a similar analysis for Ford and only then compare GM and Ford but even then it would be comparing two very different situations. One company is emerging from bankruptcy while the other has avoided it in the worst crisis faced by the US economy and the automotive industry since the days of Henry Ford. A mature company cannot be fairly compared to an emerging and nascent company.

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