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|  | MAY 5, 2005
 S&P RATINGS NEWS GM and Ford: To the Junk YardS&P lays out its case for cutting the two American auto giants' credit ratings to "noninvestment grade"On May 5, 2005, Standard & Poor's Ratings Services lowered its long- and short-term corporate credit ratings on two of the Big Three U.S. auto makers -- General Motors (GM ) and Ford Motor (F ) -- below investment grade. Long-term ratings on GM, its General Motors Acceptance Corp. unit, and all related entities were lowered to BB from BBB-. Ford, its Ford Motor Credit subsidiaries, and all related entities -- except those of Hertz -- were reduced to BB+ from BBB-. The rating outlook for both Ford and GM is negative. GM's consolidated debt outstanding totaled $291.8 billion as of Mar. 31, while Ford's totaled $161.3 billion at that date. The ratings on Hertz (BBB-/Watch Dev/A-3) remain on CreditWatch, where they were placed on Apr. 21, following Ford's disclosure that it was evaluating strategic options for the unit, including its potential sale. The downgrade to noninvestment-grade for both automotive giants reflects our conclusion that management's strategies may be ineffective in addressing the mounting competitive challenges both face. Below is our analysis of the situation the companies face: GENERAL MOTORS It shouldn't have any difficulty accommodating near-term cash requirements. The effort by Kirk Kerkorian's Tracinda Corp. to increase its ownership stake in GM represents an additional uncertainty. However, this isn't a factor at all in the current rating action. Of greatest immediate concern is that GM's sport-utility vehicles will no longer be as profitable as they have been in recent years. GM's financial performance has been heavily dependent on the SUVs' profit contribution. Recently, though, sales of GM's midsize and large SUVs have plummeted. Industrywide demand for these vehicles has evidently stalled, partly because of persistent high gasoline prices. In addition, competition has intensified from a proliferation of new rival SUVs. GM has suffered from the aging of its SUV product line, which will be replaced by a family of new products during 2006 and 2007 -- when Ford will be doing the same. POOR BRAND IMAGES. Moreover, competition could also increase in full-size pickups -- GM's only other major source of auto earnings. Although GM will be renewing its pickups in one-and-a-half to two years, Toyota Motor (TM ) will introduce a new full-size pickup during this period, for which it's constructing expanded production capacity. More broadly, GM suffers from a legacy of generally poor brand images. Even with extensive efforts to renew its products, GM continues to lose market share in North America, despite an aggressive pricing strategy over the past four years. At S&P, we believe its reliance on discounts has itself been detrimental to its brand equity. Although we assume some of GM's new products will be successful, we can't assume that overall improvement in GM's relative market position will result, given other carmakers' similar product initiatives. In addition, it's questionable whether GM's relative competitive standing has improved as a result of extensive cost-cutting in its North American operations. The company has downsized operations through curtailing excess production capacity, but the boost to its efficiency has been undermined by market-share losses. GM has significantly reduced its workforce, but total personnel spending has risen, due in part to the soaring cost of its relatively generous health-insurance benefits. If GM were able to roll back such benefits, this could reduce a significant competitive disadvantage. However, we're skeptical about whether its principal labor union, the United Autoworkers (UAW), will cooperate with this. MORTGAGE STRENGTH. In aggregate, GM's overseas automotive operations aren't mitigating for the difficulties in North America. GM has been unprofitable in Europe since 1999, and its losses there this year will likely be substantial, even before taking account of costs related to yet another round of restructuring. GM had until recently been highly profitable in China, but it's now suffering from weak demand in that region. GM continues to derive significant earnings from its automotive sales finance activities, which are conducted through GMAC. (GMAC's financing volume and profitability are artificially bolstered in that automotive finance incentives require consumers to finance vehicle purchases through GMAC. GM then reimburses GMAC for the cost of the incentive.) GMAC has benefited in recent years from low credit losses and improving lease residual realizations. However, as interest rates have risen, GMAC's sales finance earnings have recently weakened markedly from the exceptional levels of 2003 and 2004. Separately, GMAC's mortgage unit has been able to sustain impressive profitability, even with the decline in residential mortgage industry volume. This unit is benefiting from growing market share in the residential sector, a countercyclical increase in mortgage-servicing income, increased fee-based business, and expansion in overseas markets. CASH OUTFLOW. GM's overall earnings have recently deteriorated precipitously. The carmaker incurred an alarming $1.1 billion net loss in the first quarter of 2005. We believe profitability could remain poor for the balance of this year, and prospects for a return to adequate profitability in the next few years are becoming increasingly uncertain. Although GM has substantial cash reserves, its ability to withstand persistent poor financial performance is not unlimited. We now expect consolidated parent-level cash outflow to be in excess of $5 billion this year, taking account of substantially negative automotive operating cash flow, European restructuring costs, payments to Fiat totaling approximately $2 billion, capital spending budgeted at $8 billion, GM's common dividend payout ($1.1 billion in 2004), and $2 billion of dividends to be paid to the parent by GMAC. Unless the auto operations' cash generating-ability improves, GM's burdensome postretirement benefit obligations could become even more onerous. Outlook: The rating outlook is negative. GM's financial performance has proven to be volatile and unpredictable. Accelerating deterioration in the North American market mix, intensifying price competition, poor acceptance of GM's future new products, labor strife, and/or a weakening of the general economy could ultimately jeopardize the rating.
BW MALL
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