Sell General Motors On China Risk: Morgan Stanley

Investors who are closely following their positions that have exposure to China shouldn't overlook the auto industry, according to a new report by Morgan Stanley analysts.

Analyst Adam Jonas commented in a note on Monday that General Motors Company GM's earnings and cash flows are both "highly dependent" on China. In fact, earnings from the company's Chinese equity affiliates accounted for more than 32 percent of its net income for 2013 and 2014 combined and roughly half of its automotive cash flow.

"Outside of Germany, you'll struggle to find another original equipment manufacturer with greater exposure to China than GM," Jonas argued in his note.

Jonas said GM's exposure to China has worked "very much" in its favor in the past and represented a "steady and reliable" source of earnings growth and cash flow support. At its peak, GM's China operations was valued at $8 per GM share, but this is now changing. In recent months, GM has seen its sales slow "considerably" (-4.8 percent year-to-date) while overall sedan sales (in which GM has "outsized" exposure) have seen six consecutive months of decline.

With that said, Jonas is now making changes to his medium- and long-term forecasts for GM's growth in China. The analyst is now assuming a forward one-year average total China passenger vehicle growth of 4 percent while GM will see 2 percent growth. This implies a 300 basis point loss of share over the next 10 years to a "still-healthy" level of 13.5 percent.

Jonas is also assuming a drop in GM margins from a previously forecasted 11.7 percent pre-tax margin to 5.0 percent in 10 years. As such, the resulting 10-year growth rate forecast for GM in China now stands at negative 5.6 percent.

Bottom line, the China slowdown is "not just a GM issue" and affects all auto makers.

"Longer term, investors must consider the impact of China moving from a demand story to a supply story and the implications of exporting deflation to the rest of the world in the form of capacity and component supply," Jonas concluded. "These may be issues of earnings multiple rather than near-term earnings itself, but can equally impact near-term share performance."

Morgan Stanley resumed coverage of General Motors with an Underweight rating and $27 price target.