Although the headlines today all proclaim today as the day that General Motors declared bankruptcy, the company has actually been bankrupt for years. Much like a small private company, General Motors has been run for the benefit of the management and employees, not shareholders. Shareholders have not been the actual owners of the company for over a decade, as management and employees have staked claims to the companies future cash flows through pension and medical claims.
In 2005, I published a post about an "imminent" GM bankruptcy. I republish the post, not to congratulate my clairvoyance but rather to point out two key lessons that investors can use to analyze any situation. First, the markets are not "efficient". As late as October 2007, you could have sold short the stock of General Motors at over $40. Even in the past several weeks, when bankruptcy was all but certain after Chrysler's announcement, you could have bought puts on the stock (you couldn't have sold short because there was no more stock to borrow.) This opportunity arose because the market is made up of many investors who are hopeful, uninformed, conflicted, unsophisticated, or just plain lazy. Therefore, securities are often mispriced, not the other way around. It takes time for information to be disseminated and understood by the market. If you can get ahead of the mass of investors in your understanding of a company you already have a huge advantage.
Second, you didn't need any insider information to conclude that General Motors was bankrupt years ago. All you had to do was do some homework and read the footnotes of the financial statements. Understanding the company's pension and medical liabilities made it clear that equity holders had virtually no chance of seeing any of the company's cash flows return to them. Reading footnotes and listening to conference calls is tedious work and even most professional investors don't do it. However, that's how you can get an advantage over most participants in the market.
So with that, I bid adui to some great American classics – the Chevy Malibu, Buick Lucerne, and Pontiac G5 - three stupid cars with all the style, panache and innovation of a washing machine. You won't be missed.
From Contrahour, March 21, 2005 –
(Scene: At Play Now – in the bosses office)
Thomassoulo: George, I’ve realized we’ve signed a one-year contract with you, but at this point I think it’s best that we both go our separate ways.
George: I don’t understand.
Thomassoulo: We don’t like you. We want you to leave.
(Scene: At Monks Café)
Jerry: So you’re staying at Play Now?
George: Why not? Pay is good. I got dental, private access to one of the great handicapped toilets in the city.
Jerry: But they not you aren’t handicapped, aren’t you ashamed?
George: They’re the ones who should be ashamed. They signed me to a one-year contract. As long as I show up for work every day, they have to pay me.
(Scene: At Play Now – in the bosses office)
Thomassoulo: You win George. We’ve had it. If you leave right now, Play Now will give you six months pay. That’s half of your entire contract. Please…just go.
George: You see if I stay th e whole year, I get it all.
Thomassoulo: Want to play hand ball huh? Fine. (calls on intercom) Attention Play Now employees, George Costanza’s handicapped bathroom is now open on the sixteenth floor to all employees and their families.
George: Well played.
Thomassoulo: I’ll see you in hell Costanza.
— Seinfeld Episode 158 "The Voice"
General Motors CEO, Richard Wagoner, probably never watched Seinfeld regularly but if he had, he might have been able to save his company. His strategy of appeasing the union and waiting for employee attrition to reduce the company's payroll has backfired. As it stands, I believe that employees will be able to outlast GM's precarious liquidity position. The company is currently being run to fund current and former employee benefits, not for shareholders or creditors. Therefore, I believe GM will have to file for bankruptcy to restructure the company's crushing pension and healthcare obligations.
With the GM fiasco on the front pages, it's an opportune time to look at how I analyzed this situation. At first glance, GM might seem to be a reasonable speculative bet. The stock is trading at about 1x trailing EBITDA, 2x trailing cash flow, .09x sales, 4.5x trailing earnings and has a 7% yield.
In other words, the company's horrible fundamentals are probably priced into the stock at these levels. Among the well know problems are the company's short-sighted strategy of providing 0% financing and additional incentives for new car buyers. This pulled demand for the company's cars into the present, leaving future demand very low. The company's line up of brands and cars also gives you an insight into the company's problems. Aside from Cadillac and Hummer, none of the company's cars offer a distinctive marketing angle or economic benefit. If you want reliability you buy Japanese, and if you to show off, you buy German, if you want cool, you certainly don't buy a Pontiac. In fact, 4 of the company's 10 brands should probably be killed – Pontiac, Oldsmobile, Buick and Opel – because they are so tired and have no cache left.
These problems could be resolved by aggressively managing the company's operations. If the operational issues were all that plagued GM, I would probably be tempted to buy the stock rather than run for the hills.
The real problem is the company's onerous expense and liquidity position which is the result of the financial obligations owed to current and former employees. There are several aspects to this problem.
First, the company is not capable of cutting expenses aggressively because of its union contract. According to the Detroit Free Press, the big three U.S. auto makers and the largest auto-parts supplier are paying about 10,000 hourly workers in the U.S. and Canada full wages and benefits not to work, despite falling U.S. market shares, shuttered plants and production cutbacks. These workers are essentially in a holding tank for hourly employees who are off work a long time, a system devised by the auto makers and the United Auto Workers union.
While most of the companies refused to say how much they are spending to pay these workers, a Free Press survey suggests it is likely well over $1 billion this year, given the number of workers and typical union wage-and-benefit packages. Auto supplier Delphi has told Wall Street that it will spend $300 million in 2005 to pay the salaries and benefits for about 2,300 union workers who currently don't have jobs, and it says that cost is "as high as it has ever been for us." GM's 2004 10-K states that the average hourly wage for its employees is about $74/hour. I'm guessing few employees are actually getting paid that but once you add in the healthcare expense and "excess" workers, it's probably close.
Second, closer examination of the footnotes to the company's pension and other obligations, reveals that the company cannot survive with its current expense structure. The obligations due to current and former employees are a drain on the company's resources.
This table from the company's 2004 10-K from Footnote 16 reveals many of the issues. The colored items represent areas of interest:
Lets first analyze the pension plan, which is actually in reasonable shape. GM has historically had an underfunded pension plan but it is currently overfunded by $1.9 billion in the US. The plan is in good shape because the company funded it with a $10 billion contribution from the largest corporate debt offering ever in 2003. This essentially shifted the risk from employees (who might not get their pension), to creditors (who might not get full value of the bonds if GM goes into bankruptcy).
The foreign pension plan, which the company inherited when GM bought Saab, is in worse shape as it is underfunded by about $9 billion. This could cause a problem since GM will have to fund it from ongoing operations or existing cash on the balance sheet. And the company will probably be unable to raise capital at a reasonable price unless investors become more comfortable with the operations.
A minor side note is the company's assumption on the discount rate used to calculate its pension plan obligations. The company looks like it makes a slightly aggressive but still reasonable assumption that the pension plan will return 9% over the foreseeable future. That's down from 10% in the past year – which was clearly too aggressive. I think a more reasonable assumption would be 8%, and which would make the plan look underfunded again, but I can live with 9%.
The real problem for General Motors comes in the form of the Other Post Retirement Employee Benefits lines. These amounts refer to the retirement benefits provided by a company to its employees other than those from its pension plan – for the most part "healthcare expense". A look at the Other Post Retirement Employee Benefits from the table shows why this is the key issue for GM – the company's future obligations in this segment amount to $77 billion, while the company's plan to fund those obligations only contains $16 billion – leaving the company on the hook for about $61 billion in future healthcare expenses.
CSFB analyst David Zion, who has done an outstanding job analyzing retirement obligations, succinctly explains the problem with the Other Post Retirement Employee Benefits for existing and potential shareholders – "In many cases, in particular among large companies, the risk of rising benefit costs is absorbed directly by the company if the OPEB plan is self-insured. Investors need to take this risk into account when valuing a company with an OPEB plan, as they are not only investing in an operating company, but they may also be purchasing a healthcare insurance company, and, for those with pension plans, an asset manager, all rolled into one."
The Company paid out $3.8 billion in 2004 for expenses related to retiree healthcare. In addition, GM used $5 billion to fund the OPEB plan in the hopes that one day the plan will be fully funded and the company will no longer have to use cash from operations to pay for retiree expenses. I believe the $3.8 billion expense will probably rise at a faster rate as employees continue to retire and grow older. It seems unlikely that GM will be able to get the OPEB plan fully funded at any time in the near future.
The under-funded OPEB plan is essentially a cash flow problem. The $3.8 billion in expense and $5 billion in plan contribution is a high price to pay for a company that will only be breakeven on a "cash from operations" basis according to its own forecast. This is cash flow that could be used to pay down debt or pay a dividend is essentially diverted to paying for retiree healthcare.
There are two ways out of this predicament for GM – 1) fund the obligations with outside capital, as it did in 2003 when it issued $10 billion in debt or 2) renegotiate the extent of its obligations.
Given the state of GM’s balance sheet, I don’t believe the company will be able to float additional debt at reasonable rates to fund its obligations. The company’s balance sheet has deteriorated significantly in the past 15 years as the company has relied more on finance operations to boost the auto division’s results:
That’s right! Debt has tripled while stockholder’s equity has actually gone down over the past 15 years. Again, this is not a company being run for stockhoders – its being run for current and former employees. In addition, GM has $56 billion of debt coming due between now and 2007. It seems unlikely to me that the debt market will allow the company to issue additional debt on top of the existing amounts it already has to roll over. Therefore, it seems that the company could issue equity at these prices but I view that as unlikely given that the stock would collapse even further. I believe the only other choice for GM is to try to renegotiate its obligations.
However, I believe the company will be unable to negotiate with much leverage given that GM is locked into its current union contract until 2007. Therefore, the only way I see for GM to remain a competitive force in the auto industry is to enter into bankruptcy. From bankruptcy the union should feel pressure to come to a more reasonable compromise on healthcare obligations to help the company exit bankruptcy. Otherwise, neither the shareholders nor the employees will have anything – just like Play Now –
(Scene: At Monk’s Café)
Jerry: Gee, Play Now is filing for bankruptcy. I guess you’re not going in anymore.
Jerry: So they’re not paying you your…
Jerry: So you’re pretty much…