Detroit after the Bailout

With President Bush's Dec. 19 announcement to loan up to $17.4 billion to  General Motors (GM) and Chrysler LLC with funds from the Troubled Asset Relief Program (TARP), we thought now would be a good time follow up on our Dec. 9 Stock Strategist industry report on the current state of the U.S. auto industry. It appears 2009 will be the most uncertain year in the industry's history and one that will likely see the demise of many suppliers and dealerships. The Detroit 3 could liquidate as well, but we think the possibility is remote with the Democrats in power in Washington, D.C.

We will know more about GM and Chrysler's fate in the next few months, but we will focus most of our discussion on GM because Chrysler is a private company. GM's Dec. 19 loan term sheet says that by Feb. 17, 2009, GM must submit a restructuring plan that will enable it to "achieve and sustain the long-term viability, international competitiveness and energy efficiency of the Company." Provisions of such a plan include repaying the government loan and complying with federal fuel regulations. There are three critical provisions to GM avoiding bankruptcy and the company must submit signed agreements to the government by Feb. 17 from all parties for these three conditions. First, GM must reduce its unsecured public indebtedness by "not less than two-thirds through conversion of existing public debt into equity or debt." Per its 2007 labor agreement with the United Auto Workers (UAW), retiree health-care costs are transferred to a VEBA account run by the UAW on Jan. 1, 2010. GM was to fund this VEBA through cash and convertible GM debt, but now the government says the UAW must accept at least half of all future GM VEBA contributions be made in the form of GM stock. Finally, the UAW must also amend its 2007 labor agreement (rather than wait until it expires in fall 2011) so that GM has complete labor cost parity with the U.S. employees of  Toyota (TM),  Honda (HMC), and  Nissan (NSANY). GM must then submit a progress report by March 31, 2009, at which time the government must decide if GM's plan allows it to be viable. If not, the government could call its loans due by the end of April, which would force a bankruptcy filing.

There are many issues with these terms. The most important is that the UAW has already said it will work with the Obama administration to "ensure that these unfair conditions are removed." The UAW feels they already made significant concessions in their 2007 labor agreement, which we agree with, and that they should not have to give up more beyond the suspension of the jobs bank. If the government does not allow the UAW to revise the "unfair conditions" and the UAW fails to cooperate as a result, GM could have to file for bankruptcy. The same possibility applies if unsecured creditors refuse to materially reduce GM's debt by replacing their bonds with GM stock. It's likely the Obama administration and a Democrat-controlled Congress will amend the Bush loan package or replace the entire package with new terms that are more favorable to the UAW. We think the labor cost parity requirement will be pushed back until the labor agreement's expiration in 2011, but it's also possible Obama will be very generous to the UAW and eliminate the requirement altogether. We believe the current requirements on the UAW should stay in place because complete labor cost parity would allow GM to compete on an equal cost basis with foreign automakers. While the current terms ask the UAW to make more concessions, the reality is that GM is a dying company and further restructuring and sacrifice by all stakeholders is needed now.

Assuming the Obama administration does not let the automakers file for an unorganized bankruptcy, another set of loans will be coming in the spring and will likely be for far more than $17.4 billion. Despite Obama's opposition to bankruptcy, we believe that GM's stock is a terrible investment right now. Any government aid will have warrants attached to it. These warrants are currently not very dilutive under the Bush loan package, but Obama could decide to give taxpayers a greater stake in the company and eliminate the ceiling on how many warrants can be issued or make the warrants equal to far more than 20% of the loan amount. We think it's unlikely the warrants will be very dilutive, however, as most of the dilution is going to come from unsecured creditors exchanging their bonds for equity. If the requirement to fund the VEBA partly via GM stock remains, then the government does not want its warrants to dilute the stock and impair the VEBA's ability to pay UAW retiree health-care costs. As for the unsecured creditors, we estimate that their debt for equity exchange would amount to them owning about 95% of GM's stock. Based on these issues, we think buying GM stock now is an incredibly speculative and risky investment and one we would not do under any circumstances. One could obtain equity exposure by buying GM's unsecured debt, but even that option is very risky and not one we would pursue. Even if it avoids liquidation, GM has too many other risks including potential prepackaged bankruptcy, poor brand equity in the U.S., and far healthier competitors in the U.S. Furthermore, key suppliers such as Delphi  remain in financial distress, which could cause supply chain disruptions for GM.

Although a prepackaged bankruptcy is a risk, we do not think the Obama administration will pursue this path. Such an event would mean UAW pensions would be subject to the whim of a bankruptcy judge and would likely cost far more in debtor-in-possession (DIP) financing by the taxpayers than anyone believes. Even a prepackaged bankruptcy could take years due to the size and complexity of GM. We argued against a prepackaged bankruptcy previously and we maintain that position. Since our Dec. 9 article, CNW Marketing Research released a new study that showed 48% of consumers would consider buying a vehicle from a bankrupt automaker if the consumer knew the government was guaranteeing obligations such as a warranty. This percentage is an improvement from prior research that said 20% would buy a vehicle (with no mention of government backing). Some media outlets have said this new study suggests the Detroit 3 would survive in bankruptcy, but we think 48% is still not a great number to decide the fate of a firm whose collapse would lead to the loss of millions of American jobs. Proponents of the bankruptcy option point to the ability of some airlines to emerge from Chapter 11, but buying a vehicle is a much larger purchase than taking a flight on a bankrupt airline. A vehicle is a good that the owner uses every day and will need to be serviced whereas a flight is a service that has no attachment to the consumer once completed. Unless a consumer is determined to buy American (and fewer and fewer are), we think there is little incentive for a consumer to take the risk of buying a vehicle from a bankrupt automaker when there are many other brands from automakers not in distress to choose from. The risk of liquidation of the Detroit 3 also stifles American ingenuity. If the Detroit 3 disappeared, it is likely that more American assembly jobs would be created over time as foreign automakers expanded U.S. capacity to make up for Detroit's collapse. However, many of the engineering jobs would remain in Asia and Europe and the jobs we have here to create products such as the Chevrolet Volt and lithium-ion batteries would disappear.

Even with a very generous lifeline from the government, Detroit's survival still comes down to having a top product and getting customers into a showroom. A bailout cannot make that happen in and of itself, it just gives Detroit more time to get smaller and produce more well designed cars such as the Chevrolet Malibu, Cadillac CTS, and Ford Focus. GM and  Ford (F) need to convince Americans to pay as much if not more for their cars than a foreign car. Detroit manufacturers currently rely far more on incentives than import manufacturers so they cannot get as much revenue per vehicle. In manufacturing, declining revenues with a bloated cost structure is a recipe for disaster, the end game of which we are seeing now with a bailout.

Chrysler faces the same challenges as GM and Ford, but we do not think Chrysler will be a stand-alone entity much longer. Chrysler is undergoing a severe restructuring with numerous senior management departures, a complete shutdown of production for one month, and a recent announcement of a "massive reduction" of fixed costs coming to show the government Chrysler deserves more loans. We think Chrysler's private equity owner, Cerberus, wants to keep the company alive long enough for market conditions to improve so another firm will buy the company. This purchase could come in whole or in parts for platforms such as the Dodge Ram, the Town & Country minivan, and Jeep. We think Cerberus is more interested in Chrysler Financial and would love to dump its now failed investment in the auto business. With no other automaker looking to make acquisitions right now, another possibility is the government facilitating a GM-Chrysler merger as part of an Obama aid package in early 2009. However, as we argued in our Oct. 13 Stock Analyst Note, we see little value from putting two failing companies together. Although at least this would put Chrysler out of its misery.

Another critical issue with GM and Chrysler that is not getting much attention is the plight of their captive financing arms, GMAC and Chrysler Financial. GMAC is 51% owned by Cerberus, which also owns all of Chrysler Financial. These captive financing companies are essential to their automaker parents because the financing arms provide floorplan financing to dealers so the dealer can purchase inventory as well as provide loans for consumers to purchase vehicles. Both GMAC and Chrysler Financial are in dire straits and their collapse would likely force the automaker parent to file for bankruptcy as the automaker would not be able to sell many vehicles. GMAC alleviated its distress by obtaining bank holding company status from the Federal Reserve on Christmas Eve, which will allow it access to TARP funds. Chrysler Financial has yet to receive such approval or access to TARP money and in a Dec. 12 letter to dealers it even mentioned the possibility of suspending wholesale funding, which would mean no low-cost floorplan financing for dealers. The government will likely need to make a decision soon as to whether it will be as generous with Chrysler Financial as it was with GMAC. If the government demands more capital from Cerberus, Cerberus could refuse. This would force the government to choose between bailing out Chrysler automotive again, letting it fail, or facilitating a merger with another automaker. One related note on GMAC is that under the terms set forth by the Fed, GM must reduce its GMAC equity and voting stake to under 10% and Cerberus must reduce its equity stake to 33% with no more than 14.9% of the voting rights.

Even with President Bush's bailout package, there is still much uncertainty in the auto industry going into 2009. Many dealers and suppliers will still go out of business due to lower production and lower sales, which could cause supply chain problems for the stronger parts suppliers. With less production coming from the Detroit 3, parts suppliers will have to consolidate because there will not be enough volume to support the supply chain in its current form. Parts suppliers that have highly leveraged balance sheets and/or derive the vast majority of their revenue from Detroit 3 firms are likely to liquidate in 2009, as their revenue will fall too hard and too fast to remain profitable (and in compliance with debt covenants). Over time, foreign automakers will add capacity in the U.S., but that will not happen fast enough for some parts suppliers to offset their losses from Detroit automakers. We still think healthy dealer firms are great businesses that are good places to wait out an auto industry recovery (see our Dec. 9 Stock Strategist article for a list of our favorite supplier and dealer firms) and that current sales levels are too low on a per-capita basis. If we are right, then there is a massive amount of pent-up demand for vehicles that continues to build. When consumers start spending again, patient investors will reap the reward of looking at a sector currently way out of favor on Wall Street.