A Labor-Led Lift for GM?

Goldman Sachs figures the UAW will likely agree to concessions on retiree benefits -- and that could boost the automaker's stock

by David Bogoslaw

Auto workers, and their union representatives, may be ready to concede to wage and benefit cuts in their negotiations with General Motors (GM) later this year, Goldman Sachs (GS) says in a new research report. And the investment bank figures that will likely give the stock a boost.

Goldman upgraded its rating on shares of the auto manufacturer to buy from neutral on June 25, saying that the market is pricing into the stock a 20% reduction in GM's healthcare obligations for retirees. A cut in benefits of that magnitude is a "highly probable" outcome of labor negotiations slated for the Fall, according to the report.

Goldman described the upgrade as a "tactical trading call that in coming months expectations will grow that significant concessions will come out of this year's UAW talks, which is likely to engender significant upside in GM shares." The market will pay more attention to near-term cost cutting than to the more thorny longer-term revenue and cost trends, the report added. Goldman Sachs even went so far as to say that it sees United Auto Workers' members and retirees as "increasingly amenable" to substantial wage and/or benefit cuts.

Goldman Sachs also raised its target price on the shares to $42 from $29, explaining that the higher valuation is based more on a shift of emphasis to short-term measures such as earnings before interest, taxes, depreciation and amortization, adjusted for pension and other post-employment benefits, rather than on discounted cash flow and sum-of-the-parts, which guide longer-term valuations.

At $35, which is just below the closing price on June 22, the market is pricing in only moderate concessions by the UAW, and those concessions could end up being much more substantial, Goldman said. The report cited a 60% probability that retirement benefits would be cut by 20% and a 40% probability that they would be slashed by 40%. The former translates to a share value of $35 and the latter to a share value of $52. The weighted average of the two is $42, Goldman's new target price

What's likely to persuade the UAW to agree to such a significant cut in retiree benefits is growing recognition among union leaders that unwieldy healthcare and other costs, together with continuing shrinking of market share, could push the Big Three automakers into bankruptcy unless these costs are reined in, the Goldman report said. Given how important membership numbers are to the UAW leadership, GM's ability to limit layoffs under a revised wage structure in exchange for reduced benefits may serve as an incentive for the UAW to consent to cuts.

Having Ford Motor Co.'s (F) new chief executive, Alan Mulally, at the table could also work in the Big Three's favor in the contract talks, according to Goldman. In his years heading Boeing Co. (BA), Mulally proved proficient at explaining why employees and retirees must take an active part in ensuring a company's long-term viability. Other supporting factors are a potentially aggressive stance by Cerberus, Chrysler's soon-to-be new owner and the union's realization that regulatory trends toward mandating improved fuel efficiency and lower emissions are working against the automakers, whose profits rely heavily on truck sales.

If a healthcare deal with the UAW doesn't materialize this year, another route for GM and other automakers might be to use the Medicare Advantage private-fee-for-service offered by managed care providers, beginning in 2008, according to Bear Stearns (BSC) analysts. The PFFS plans would take some of the responsibility of healthcare benefits for retirees who have reached age 65 off the shoulders of original equipment manufacturers, Bear Stearns said in a research note on June 7.

The automakers currently pay the extra costs of additional benefits they provide to retirees above and beyond those covered by Medicare. But if they moved to a PFFS plan, "funding economics would provide incremental benefits above those standardized by Medicare," the note said.

Bear Stearns estimated 10% to 15% in healthcare savings for retirees over 65 as a result of moving to PFFS. If GM's obligation to these retirees is around $2 billion a year, a switch could boost earnings by 25 to 35 cents a share a year. Bear Stearns said it sees no reason that the UAW wouldn't want to approve such a move and added that potential healthcare savings in the contract that emerges from labor talks this fall wouldn't be limited to that option.

There are also some risks tied to elimination of the retiree-benefits liability for GM, Goldman warned in its June 25 report. For one, the uncertainty around how to value the projected benefit obligation and of its impact on the stock's valuation would be removed after lowering the liability and converting it into debt, cash and possible equity. Making the stock's valuation more transparent after retiree benefits deal with the UAW wouldn't necessarily be positive for the company.

Goldman's options experts recommend buying call spreads, which entail buying a call and selling a call based on a much higher price. Calls give the holder the right, but not the obligation, to buy shares if the price rises beyond a designated level.

Goldman Sachs has an investment banking relationship with General Motors and has either managed or co-managed a public offering of its shares in the past 12 months. Bear, Stearns does and seeks to do banking business with the companies it covers and the bank or one of its affiliates owns a significant financial interest in the company's outstanding debt obligations.

Bogoslaw is a reporter for BusinessWeek's Investing channel.