Investing

How We'll Know If GM Is Really Fixed


General Motors (GM) is back. Right?

Having survived its tumble into bankruptcy and clawed its way back to the stock market, GM is unquestionably in its best shape in decades. Debt has been drastically reduced, labor costs cut sharply, and new management put in charge that has little attachment to the old culture. But GM has been on top of the auto industry as recently as 2000—when it earned $4.5 billion, more than any other car company—and somehow managed to nearly lose it all. So what exactly would tell investors the new GM is on a path to long-lasting success, especially of the sort that would allow U.S. taxpayers and new shareholders to cash out at a profit?

Businessweek.com posed that question to one of the key architects of the new GM, as well as other auto industry insiders, investors, and analysts. Here are the six key metrics they pointed to.

1. Keep debt from growing

When General Motors declared bankruptcy on June 1, 2009, it reported total debt of $172.8 billion. The bankruptcy cleared away all but $8.6 billion in outstanding debt as of Sept. 30, 2010, according to GM's IPO prospectus.

Debt is "absolutely a disaster" for a company like General Motors, says Harry Wilson, a former senior adviser to the U.S. government's auto task force, which reorganized the automaker. In his new book Overhaul, Steven Rattner, who headed the task force, describes Wilson's aggressive efforts to tear up the old GM and remake it as a profitable company. "Too much debt [and GM] doesn't have the financial dexterity to invest in the future," Wilson tells Businessweek.com.

Like all public companies, General Motors reports the state of its balance sheet every quarter. However, Tony Boase, an analyst at First American Funds, warns that a proper total of GM's financial obligations is made difficult by the company's complex financial structure, which includes joint ventures, pension liabilities, and other arrangements. When GM refinanced some debt on Oct. 26, it said it has "no significant contractual debt maturities" until 2015. Since bankruptcy, the debt load "seems much more manageable," says Boase, whose funds include the new GM shares. In its prospectus, GM says its goals are to continue paying down debt and eventually to achieve a high-quality "investment grade" credit rating. GM now has a "junk," or high-risk, rating on its bonds from the major rating agencies.

2. Steadily increase earnings

The old GM was too focused on maintaining market share, and not enough on profits, Wilson says. In the past two years, GM has slashed costs and, as a result, the company has been profitable for the last three quarters despite a big drop in sales. Last quarter's revenues were $34.1 billion, down 22 percent from the comparable quarter's $43.7 billion three years earlier. Some of the deepest cuts have occurred in North America, where GM produced 707,000 vehicles last quarter, down from 1.02 million three years earlier.

In earnings releases, GM emphasizes its earnings before interest and taxes, or EBIT, saying the metric is a useful way of describing cash profits after deducting all the costs of doing business each quarter. Wilson says this measure, also known as operating profits, is the top metric he is watching. "As long as they're profitable, they'll have the cash flow to reinvest and continue to improve their product portfolio," he says. Operating profits were $2.3 billion last quarter, up 12 percent from the previous quarter.

3. Reverse losses in Europe

GM's North American operations have gotten a radical overhaul, and operating profits at home have rebounded to $2.1 billion last quarter. That's not the case in Europe, where a loss last quarter drained $600 million from the company's cash. GM chose to hang on to its Opel unit, rather than sell it to a group headed by Magna International (MGA), partly so it could retain European engineers central to the development of innovative new models, including the Chevrolet Cruze sedan. But the European market is perhaps even more competitive than that of the U.S. "They have to engineer a pretty significant turnaround in GM Europe in 2011," Boase says. "It's going to come down to cost containment." GM said Oct. 4 it would shut a factory in Antwerp by the end of the year, part of an effort to trim European capacity by 20 percent and labor costs by $323 million.

The operating loss for GM's Europe operations last quarter was triple its loss in the previous quarter. "The European car market is brutal," Wilson says. "They still haven't unlocked the keys to success in Europe. It's a work in progress." Morningstar (MORN) analyst David Whiston estimates GM can be successful if it merely stabilizes European losses in 2011, laying the groundwork for a profit in 2012.

4. Hold down sales incentives

In the midst of the recession, General Motors was using deep discounts to get customers into dealerships. In the past year, GM has slashed those sales incentives. According to GM, last month its U.S. retail incentives totaled 9.5 percent of a vehicle's average sale price, down from 14 percent in July 2009. Incentives have also dropped compared with the rest of the industry. In October 2009, GM was offering incentives 40 percent higher than competitors; last month they were 1 percent higher.

Ideally, incentives will fall below the industry average, says Morningstar's Whiston—signaling that the vehicles, and not bargains, are attracting customers. Incentives—which could total $4,000 or more per vehicle in the depths of the recession—are "a pure hit to profitability," Wilson says. He suggests watching closely the average transaction price, which is the average sale price per vehicle. So far, so good: On Nov. 3, GM said its average transaction price is up $3,100 year-to-date, vs. a $1,500 average increase for the auto industry as a whole.

Customers are willing to pay more because General Motors is putting out better cars than it used to, experts say. "You're putting product on the street that people want to buy, so you're not putting $3,000 or $4,000 [in incentives] on the hood to get people to buy them," says James E. Harbour. The veteran auto industry consultant and former Chrysler and Ford executive founded The Harbour Report, an annual study of the industry's manufacturing efficiency.

5. Continue to impress car critics

Consumer Reports on Oct. 26 gave 83 percent of Chevrolets, GM's largest U.S. brand, a "predicted reliability" rating of average or better. That is up from 50 percent last year. The Chevrolet Volt, GM's new electric car, was named 2011 Car of the Year by both Motor Trend and Automobile magazines. Wilson says the old GM would try to cut costs "in dumb ways" that could make its cars much less attractive. The new GM has spent an extra $300 to $600 per car on interiors "and it's a dramatically better-looking car," he says. "The old GM was so saddled with excess costs—retiree costs, health-care costs—that they couldn't afford to do that."

Still, it could take five years or more before consumers fully recognize the improvements that are going into GM's latest vehicles, says Doug Scott, senior vice-president of consulting firm GfK's automotive division, which studies consumer behavior. "There is a major lag time between getting a 'check rating' [from Consumer Reports] and getting consumers to agree that your quality has changed," he says. Watch to see if GM continues to win accolades when the new 2012 models are reviewed a year from now.

6. Hope U.S. consumers return to old habits

General Motors can put better cars and trucks on the sales lot, pinch pennies here and abroad, and churn out a reasonable profit at the current depressed levels of car sales. But to really kick this turnaround into gear, U.S. consumers will have to replace their vehicles at a faster pace. North America still accounts for a full third of GM's total vehicle production and 80 percent of its operating profits. So the company was hit hard when total U.S. auto sales fell to 10.4 million vehicles in 2009, 35 percent below

2007 and the lowest total since 1982. From 2000 to 2007, sales averaged 16.8 million per year, according to Commerce Dept. data.

The upshot is that Americans are hanging on to their vehicles longer—which helps whittle down their personal debt but hurts carmakers. Research firm R.L. Polk estimated on Nov. 3 that Americans are driving new cars for 63.9 months on average, 4.5 months longer than a year earlier.

Sales have been turning up recently; in October, cars and light trucks sold at a seasonally adjusted rate of 12.25 million. But consumers need to buy 13.5 million cars a year just to replace all the vehicles they send to the scrap yard, Whiston estimates. If consumer spending fully rebounds, a "sustainable level of demand" could be 16 million to 17 million cars per year, he says.

GM has cut its fixed costs so deeply that a big lift in auto demand is likely to go straight to the company's bottom line. "If [U.S. auto sales] ever get back to 15 or 16 million, you're going to have GM minting money," Harbour says.

Steverman is a reporter for Bloomberg News in New York.

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