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GM Is Losing Traction


A couple of years ago, General Motors Corp. (GM) finally seemed to be getting its act together. Profits were strong and the company had recorded back-to-back annual gains in auto market share -- something that had not happened since the 1970s. Cadillac and Hummer were genuine hits -- and, more important, big moneymakers. Former Chrysler Group (DCX) star Robert A. Lutz was leading a renaissance in styling, stealing the spotlight at auto shows.

But today, despite billions invested in new cars, GM is once again losing ground. And suddenly its slide seems to be picking up speed. That point was driven home on Jan. 13, when Chairman and Chief Executive G. Richard Wagoner Jr. announced that he was moving to wall off his most reliable profit machine -- the mortgage-lending portion of General Motors Acceptance Co. (GM) -- bowing to the real possibility that his flailing auto business will be downgraded to junk status. Carving out the mortgage lending unit, which contributed a cool $1.1 billion to GM's bottom line last year, as a separate entity should preserve its credit rating. But finance profits are already shrinking, and could fall further in years ahead. And GM's scramble shows just how dramatically its options are shrinking. With fewer dollars to squeeze out of finance, the pressure is on to begin delivering significant profits from new cars and trucks.

HEALTH-COST SPIKE

The gathering fears about GM's tenuous turnaround were crystallized when Vice-Chairman and Chief Financial Officer John M. Devine told analysts, also on Jan. 13, that auto profits in GM's vital home market will fall by more than half this year, to $500 million, from $1.2 billion in 2004. The news knocked more than 3%, or $1, off GM's stock price. The biggest culprit: GM's retiree health-care costs are expected to spike by $1 billion this year, to $5.3 billion. Total 2005 earnings should tumble at least 20%, from $3.6 billion to between $2.3 billion and $2.9 billion.

GM has struggled for years with its legacy of costly worker and retiree benefits. Indeed, it's easy to view the company as a huge medical and pension provider with a side business in manufacturing. Each vehicle GM sells carries a crippling penalty of nearly $2,000 for benefits paid to retirees. Its Japanese rivals, which began manufacturing here within the past 20 years, have far fewer U.S. retirees to worry about. A national pension system in Japan leaves them with much lower fixed costs in their home market. Not so GM. The company made only $213 on average on each of the 5.4 million cars and trucks it sold in North America last year. That compares with $1,472 for Toyota a year earlier. With lackluster models, its U.S. car and truck market share fell from 28% in 2003 to 27.2% in 2004. It could hit 25% by the end of the decade, says CSM Forecasting. Soon after, Toyota Motor Co. (TM) could supplant GM in worldwide sales leadership. GM says its ranks of retirees will begin to thin in five years, gradually easing at least that burden.

For now, though, GM heavily relies on its finance arm, which kicked in 80% of total profits last year. And that explains why a reassessment of GM's creditworthiness is such a threat. After Devine's heads-up about profits, the Standard & Poor's rating agency (which, like BusinessWeek, is owned by The McGraw-Hill Companies (MHP)) issued a warning about GM's outlook, which it said was "stable" after a downgrade to BBB- in October. Investors took that as a hint that a downgrade to junk status may be in the offing. A junk rating would limit GM's access to capital, since many fund managers cannot buy junk bonds, and would raise the cost of any unsecured debt GM or GMAC tried to issue.

Any downgrade could raise GM's borrowing costs, cutting into profits on its lending business. To get around that, GM is already selling more loans to investors. But that will cut into long-term profits. Without a boost in auto earnings, that jeopardizes the parent company's goal of earning $10 a share, or $5.7 billion, in the next few years.

How bad could things get? GM's big retiree handicap and lower-cost competition has prompted some speculation that its only solution would be to follow steelmakers and airlines into bankruptcy. No one who seriously follows GM's finances sees that as an option, though. GM is solidly profitable, has too much cash -- $24 billion -- and has more liquid assets that could be sold in a crunch than do, say, airlines.

But it's also clear that Wagoner's strategy of buying market share with steep discount pricing -- while making up the difference on the finance side -- has GM treading water. "GMAC will make money, but not as much," says Morgan Stanley (MWD) analyst Stephen Girsky. "In the long run, the auto company has to make money."

GM is counting on new models of its big sport-utility vehicles and trucks to pick up the slack. They're going on their seventh year without a total redesign, which is why some models needed $5,000 rebates at the end of last year. New Chevrolet Tahoe and GMC Yukon SUVs won't arrive until early 2006. New pickups come later. If the trucks sell well enough to cut $1,000 in rebates, it is worth $1.4 billion in pretax income.

But in the meantime GM still has too much factory capacity. It faces sharp new truck competition from Toyota, Nissan (NSANY), and Hyundai. Costs of raw materials are soaring -- its steel bill could rise by $500 million this year, says UBS (UBS) analyst Robert Hinchliffe. And GM may have to cough up more than $1 billion to wriggle free of its ill-fated investment in Italian carmaker Fiat (FIA). GM's auto business still generates cash, but it has slowed dramatically, from $10.2 billion in 2003 to $4.2 billion in 2004. This year, Devine says, cash flow will be just $2 billion.

What worries investors is that any improvement on the auto side may not arrive in time to head off a credit downgrade. That's why GM executives are working feverishly to safeguard finance. A separate mortgage subsidiary would likely get its own credit rating, since its business is not related to autos. And it would feed profits back to GM in the form of dividends, just like GMAC does now. Separating the mortgage business from GM should give it a higher credit rating. But GMAC Chairman Eric Feldstein argues that even if it kept GM's current BBB- rating, the mortgage unit would probably get lower borrowing rates. That's because GMAC already carries a sort of GM penalty -- its borrowing costs are actually one percentage point higher than those paid by companies with similarly rated debt.

THERE'S A CATCH

Feldstein is also changing GMAC's auto-lending business -- which backs 45% of all GM car sales -- to shield it against the risk of higher borrowing costs. The lender has begun selling more loans shortly after it originates them, to other lenders with better credit ratings. GMAC charges the banks origination and servicing fees. That fee income is predictable and it gives GMAC steady, cheap capital to keep writing auto loans.

There's a catch, though. In the near term, profits could rise, since having fewer loans on the books means GMAC can free up some reserves and book them as profit. But in the long run, GM's car-finance business could be less profitable. Lenders make less money from service and origination fees than they do on interest income. On any given loan, a lender typically makes a 1% profit. About three-quarters of that comes from interest and the other quarter comes from fees, says Thomas K. Brown, CEO of Connecticut-based Second Curve Capital. By selling off loans quickly, GM gives up interest income.

The strategy has a precedent: Ford Motor Credit Co. (F) has been shrinking its balance sheet since 2001. A windfall from loan-loss reserves helped Ford Credit (F) profits skyrocket to a record $2.9 billion in 2003. But Ford execs admit that the gains aren't sustainable. They wouldn't be for GMAC, either.

Already, GM's finance profits are tightening as rising interest rates cut consumer demand. Total U.S. mortgage volume dropped 30% last year, to $2.7 trillion, as interest rates jumped close to 1 percentage point in the summer. This is particularly bad news for GMAC, which benefited from a boom in home refinancing. Its mortgage profits fell 10% in 2004, to $1.1 billion. Feldstein says GMAC earnings will hit at least $2.5 billion this year, guaranteeing a dividend to GM in excess of $2 billion. That's down from $2.9 billion in 2004.

Still, GM is a long way from the worst-case scenarios floated by some critics. Before it could qualify for bankruptcy, GM would have to tip into serious cash-negative territory. United Airlines Inc. (UALAQ) lost $5.4 billion in the two years before it went bankrupt in 2002, and it has avoided paying hundreds of millions in pension payments since. GM, by contrast, now has a $3 billion surplus in its pension fund and won't have to make any contributions this year or next. Says Devine: "Anyone who thinks that bankruptcy is an answer is nuts."

Wagoner tried to make the same point on Jan. 13. He never mentioned the "B" word but offered up a short history lesson. He referred back to 1992, when GM's pension plan was underfunded by $21 billion. The company was bleeding red ink; cash flow was a negative $2 billion. Many investors figured that GM was doomed. Today, Wagoner said, GM is in the black, is cash-positive, and has $23.5 billion in its coffers. His message: "The situation today is dramatically different, and dramatically better."

But Wagoner can't wait another 12 years to show results. His only hope is to do something that GM hasn't accomplished for three decades: generate lots of excitement with its cars. Until GM proves it can do that, Wagoner will have a very tough time quieting skeptics.

By David Welch in Detroit, with Nanette Byrnes in New York


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