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Friday, January 12, 2007

GM’s Impending Bankruptcy

By Porter Stansberry, Stansberry & Associates
Cockeysville, Maryland

How could GM, one of the world’s largest businesses – and a market share leader for decades – find itself on the brink of bankruptcy? In the usual way: Its managers have long disregarded the impact of growing liabilities upon the company’s asset base.

The same thing happened to WorldCom and to Enron.

In WorldCom’s case, billions in debt were added over a period of 10 years to a company with a declining return on assets. Near the end, in 1998, the company paid $38 billion in cash for British Telecom’s stake in MCI. At the time of the deal, MCI’s assets were only earning 2.1% annually. WorldCom’s average cost of capital was in the 8% to 10% range. It was buying assets that couldn’t possibly produce a profit, given their funding costs. Shockingly, WorldCom steadily increased its investments in new assets after the MCI deal, spending more than $10 billion on capital investments in 2000. The result was inevitable.

Why did Bernie Ebbers drive full speed into bankruptcy? Because he believed the company’s accounting, which showed the costs of these acquisitions and their maintenance expenses spread across 40 years. In an accounting sense, that was accurate – these were long-lived assets. But the economic reality for WorldCom was totally different. You don’t get to live in your house for 40 years if you can’t pay your mortgage. The company kept reporting “earnings,” while quarter after quarter, its cash deficit worsened and its liabilities grew.

Professional investors should have recognized what was happening. Wall Street’s banks should have limited the company’s access to more debt, which couldn’t possibly have been repaid. Instead, everyone’s bonus depended on pushing the stock higher and getting the company more capital.

Essentially, the same thing happened at Enron.

The company’s investments were measured with “mark to market” accounting, which allowed the company to claim a lifetime of estimated profits from any deal, whether or not any money materialized. And, because Enron’s managers were rewarded for producing “phantom” profits, that’s what the company produced. The result was the same as at WorldCom: a steady accumulation of low-quality assets and high-cost liabilities.

How does all of this compare to General Motors?

According to the company, its troubles are the fault of bad labor negotiations that have saddled it with terrible legacy costs. It’s certainly true that these burdens are substantial. GM owes post-retirement health benefits to union employees estimated to be worth $85 billion. Last year, this cost the company $5 billion in actual expenses.

But the company’s financing costs have increased by more than twice that amount in the last three years. The real problem at GM, just as at WorldCom and at Enron, is the company’s exploding debt burden and its low-quality assets. Let me show you the numbers:

GM 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005
$158 $166 $148 $167 $185 $177 $177 $186 $194 $193
Gross Profit $40 $48 $43 $50 $39 $33 $33 $33 $34 $22
SG&A $17 $33 $27 $31 $22 $23 $29 $30 $30 $32
Interest Exp $6 $6 $7 $8 $10 $8 $8 $9 $12 $16
ROA 2.2% 2.9% 1.2% 2.3% 1.5% 0.2% 0.5% 0.9% 0.6% -2.2%
Total Liab. $199 $213 $231 $253 $272 $304 $363 $425 $455 $465

The numbers above are in billions and have been rounded to the nearest billion.

Over the last 10 years, GM’s gross profits have declined 46% – a number that does not factor in legacy costs. GM’s cars have become increasingly uncompetitive because GM has not kept pace with its peers in several key areas, most notably styling, performance, handling, and interiors. To sell these cars, GM has been forced to rely on deep discounting, frequently selling cars for less than their total production costs.

That’s why its gross profits have fallen in half.

A business of this size, with a slim return on assets even in good years, cannot afford such a material decline in gross profits. You should notice that GM’s corporate overhead (SG&A) has grown by 89% during this period. Its corporate overhead alone now exceeds its gross profits.

That’s why GM has seen its total debt more than double in the last 10 years. Worse, its interest expenses have skyrocketed because not only have total debts grown by more than $200 billion, its credit rating has fallen below investment grade.

GM is already bankrupt… shareholders just haven’t realized it yet.

In 2007, GM’s corporate overhead and its interest expense will likely exceed gross profits again. In addition to these losses, the company faces its legacy obligations, restructuring expenses, and capital investments, which are constantly needed to keep its plants operational.

Quite simply, GM cannot possibly afford its overhead, its upkeep, and its interest expense. This company is upside-down. Its asset base cannot support its overhead – never mind any legacy costs.

On top of this unpleasant financial reality, there are a host of other problems, each of which could destroy the company. GM’s collective bargaining agreement with the UAW will expire in September 2007. Any UAW strikes would bankrupt GM in a matter of days. A federal grand jury is investigating the company’s accounting with suppliers. Separately, SEC and federal grand jury subpoenas have been served on GMAC insurance entities. Any federal indictment would trigger defaults on all of the company’s senior debt, forcing bankruptcy.

When it’s all over, you can be sure that Congress will demand an investigation. That CNBC will say that no one saw it coming. And that GM’s leaders will be hauled into the courts, charged with all types of fraud and “looting the company.”

The truth is more banal. GM has done a terrible job of designing, building, and selling cars – for a long, long time.

There is, however, a silver lining. Inside GM’s enormous pile of assets, there are more than a few gems. Investors who position themselves correctly now will be able to grab those assets for pennies on the dollar, after they become unencumbered by GM’s legacy costs, debts, and inept managers. For these investors, GM’s impending bankruptcy looks more like a rainbow leading to a pot of gold than just a thunderstorm.

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