In my last Seeking Alpha column, I mentioned as a very speculative investment GM exchange traded or “retail” notes that trade on the NYSE. Thus far, this has not been a good investment. I mentioned XGM in particular, then trading at $4.90, and now trading at $1.56, with this loss partially cushioned by two dividend payments totaling 90 cents.
Despite these losses, I decided to not only hold, but buy in a little more around these prices. I certainly have been proven wrong in thinking that the Obama administration would not let GM file for bankruptcy, and this talk was mostly bluffing to get the bondholders to agree to concessions, which was the strategy with GMAC.
Even under bankruptcy I still see value in the bonds, but again as only a very speculative part of one’s portfolio. This is not an investment for the kids’ college fund.
My thesis has two major assumptions. First is that in an eventual bankruptcy senior debt holders will come away with a substantial chunk of the equity of the new GM. Second is that this new GM will be profitable. In this article I will discuss the reasoning behind these assumptions, and try to figure out how much GM senior debt, now trading for about 6 cents on the dollar (around 1.5 for notes with a face value of 25) is actually worth.
The first issue is how much of the new GM senior note holders will end up with. The most recent offer, which almost certainly will not reach the 90% tender rate needed to be accepted, is for 10% of the company. I consider this the lower bound of what we'll end up with in bankruptcy. The higher bound I believe is around 30%, which is a conservative estimate of the percentage of GM’s $27 billion securitized debt, represents a percentage of all senior liabilities, and what we’d get if contract and bankruptcy law are scrupulously observed, since these instruments are pari passu with other senior liabilities.
So if the $27 billion in face value securitized debt will be converted into 10% to 30% of the new GM, the next question to value these notes is how much the new GM will be worth.
Normally I'd start by looking at the balance sheet, but it is an opaque and dishonest mess. Like the banks I have often written about, their accounting is untrustworthy.
Instead I look at (1) GM's solid financial performance during happier times earlier this decade and what it might be shorn of its legacy liabilities after it emerges from bankruptcy (2) the market capitalization of other automakers.
In FYs 2002, 2003, and 2004 GM earned an average of $2.77 billion per year, or $3.58 billion per year “excluding Hughes Electronics and special items.” Those days of cheap gas, cheap credit, and free-spending consumers buying HUMMERS with HELOCS are long past, and I do not expect them to return. But what’s notable is that GM made this money despite the bloated dealer network, high labor costs, legacy healthcare and pension costs, worldwide over-capacity and all the other factors dragging it into bankruptcy today. What's also important is that Americans still love their full size trucks and truck-based SUVs, and these markets are protected in the US by a 25% tariff. Only Toyota (NYSE:TM) has full size light truck operations in the US to avoid this tall trade barrier.
How much might GM make when the U.S. economy recovers, but with cheaper labor, no unprofitable dealers, Chrysler essentially gone, Ford (NYSE:F) much smaller than before, and its huge securitized senior debt converted into equity? Well, in 2007 GM paid in cash $3.751 billion in post-retirement benefits and contributed $937 million to its pensions. Its 2007 AR estimated that in 2010 it would be paying about $6.5 billion in interest on its debt. That debt will soon be wiped away, and so will those interest payments, which amount to over twice GM’s profits in the earlier part of the decade. Without these liabilities in its salad years in the first half of this decade, GM would have made well in excess of $7 billion a year.
Perhaps you can see where I am headed here. Allowing for a few years of inflation, with its legacy debt done, with its legacy contractual liabilities (the three big ones being its unprofitable franchise agreements, union contracts, and retiree obligations) all resolved in bankruptcy, and with the backing of the U.S. and Canadian governments as major shareholders and providers of cheap financing, in two years I see GM with a clean balance sheet easily and making $5+ billion a year in profits. At a P/E of 10, that would value the company at $50+ billion. If bondholders end up with 10% of that, that’s $5 billion, suggesting that GM’s $27 billion face value bonds eventually will be worth at least $5 billion, or about 18.5 cents on the dollar. Or if GM bondholders manage to get 30% of the reconstructed GM, that’s 55.6 cents on the dollar. Given they now trade around 6 cents on the dollar, this suggests that an optimistic but reasonable medium-term forecast is a three-fold gain, with a 9-fold gain not completely outside the realm of possibility.
Buried beneath the layers of debt and legacy liabilities lies a company that still has a very strong market share of not only the U.S. market, but also many other world markets, including Brazil, China, Mexico, Canada, Australia. I know there are quite a few dollar bears here who predict the collapse of the U.S. currency. I don’t share this view, but I do agree with the consensus that it has long been overvalued against the major Asian currencies. If the dollar does drift downward, GM bondholders (soon to be stockholders) will benefit as Asian imports become less competitive in the U.S. market, and profits earned in foreign currencies in GM’s overseas operations will be worth more in U.S. dollars.
Another way to see if my $50 billion estimate is reasonable is to look at the market capitalizations of other automakers.
Given that all of these companies have legacy liability issues of their own, and except for Toyota all of them are smaller than GM, I don’t think my $50 billion market cap estimate for a new and healthy GM is at all unreasonable.
Disclosure: Long BGM and GRM