GM, Ford in the Hot Seat

Includes: F, GM
by: Mike Stathis

The recent Merrill (MER) research report on General Motors (NYSE:GM) should not be treated with any urgency, although I agree with the overall assessment of a potential bankruptcy. But I would also add Ford (NYSE:F) into that picture. As you will recall, we heard the same thing from analysts less than three years ago only to see GM's share price more than double over the ensuing two years.

However, much like a sustained bear market, both GM and Ford continue to make lower highs and lower lows, both in their business performance and stock price, increasing the probabilities of a permanent meltdown unless radical changes are made soon. Due to the difficulty and timeliness of needed changes, I am doubtful that each of the Big 3 players will be around in eight years without government assistance, which appears likely. I stated some of the most critical issues faced by this industry in a May 12 article, "Industries to Avoid, Industries to Buy."

Part of the problem is that US auto makers no longer rely much on sales driven by real consumer demand. A very large portion of sales from the Big 3 come from the combined orders made by police departments, other government entities, corporations (drug reps and other sales reps), and car rental companies. These are virtually guaranteed sales so there is not much pressure to make the best, most desired autos possible, as defined by consumers. In response to diminished quality, rather than promoting the appeal of their auto lines as the main selling point, they emphasize "lucrative" financing deals to exploit the consumption epidemic that has infected most US consumers. As a result, the Big 3 now resemble financial companies more than auto makers.

This focus on consumer financing helped keep the Big 3 afloat for many years. But now the effects of the credit crunch are causing much of the stress on performance. While this recession is still in the early stages, we already see cost-cutting measures for government entities at all levels. Corporations are keeping cars for longer periods. And consumers who have the money (or available credit) for auto purchases are seeking out more reliable and more fuel-efficient Japanese autos. The Big 3 continue offering cheap gimmicks to lure customers โ€“ hybrid SUVs, $2.99/gallon gas for three years, $0 down, 0% interest, etc. In contrast, Japanese auto makers surge forward to address consumer demand. They continue to give consumers what they want. That is precisely why there are waiting lists for the Prius and other fuel-efficient autos. When you view the prospects of the Big 3 from these considerations alone, the picture looks frightening. Of course, labor costs are another, much bigger issue.

Early in the decline of the US auto industry, ridiculous demands of the UAW set up cost issues that would haunt the Big 3 for many years to come. Over the past several years, as the globalization trend has strengthened, the effects of UAW demands have magnified โ€“ US auto workers want and expect too much, while the overseas labor market does same job for less money with very few if any company-sponsored benefits. This represents the core disconnect found within US manufacturing. Current free trade policies, by necessity force manufacturing overseas due to the much lower labor costs offered by foreign competition. US companies are simply unable to compete with foreign competitors who do not bear the high costs of healthcare and pensions. In most nations, the government pays for healthcare and pensions. Until healthcare is made universal and free trade is made fair trade, America will continue to lose what little manufacturing jobs that remain. Otherwise, US companies will have no choice but to send jobs and entire manufacturing facilities overseas to escape the enormous costs of healthcare.

This is not a political issue. It is an economic issue. If America wants to stop its gradual and permanent economic decline, these issues must be addressed with real solutions. America must produce more of what it consumes rather than sending money overseas, creating huge trade deficits.

Ultimately, leveling the playing field through some type of real healthcare and free trade reform will not ensure long-term viability of the US auto industry. The Big 3 have faced a tremendous amount of brand name destruction for many years, and deservedly so. Among many of the changes needed, a radical management shakedown must occur if the Big 3 expects to survive. And I mean radical. The management and board of these companies must be replaced, not by some insiders who are accustomed to bureaucratic waste and phony inspiration. The industry needs younger, motivated, experienced and creative minds with a track record of REAL success in virtually any industry. These would be business leaders willing to take the majority of payout in stock rather than cash; guys who are willing to hold the stock for at least 10 years instead of dumping it in 2. They should seek out sharp, entrepreneurial visionaries, similar to Lee Iacocca, Steve Jobs and Michael Dell.

While private equity firms might look to purchase GM and/or Ford, I cannot see this happening under the current credit crisis unless they are sold very cheap. Even then, these deals would be difficult to consummate. Investors are shying away from the hidden risks of the highly leveraged credit bubble. Very few institutions would have interest in a buyout because the risk exposure is in the tens of billions and expected to worsen as the economy weakens. We already see a meltdown of private equity and leveraged buyout deals over the past two quarters.

I could only see a potential sale to foreign companies (or US firms looking to broker the deal) willing to take on these risks in exchange for immediate positioning in the auto market. Such risks could be justified by a trade-off resulting from the cost savings realized by a cheaper labor market and the desire to elevate their market position overnight (such as Tata Motors (NYSE:TTM) or a Chinese auto maker). While some type of foreign carve out is possible, I would say the more likely outcome will be a government bail out. A bailout could also occur once GM or F was taken private as well, but only if manufacturing jobs were guaranteed to remain on American soil. The US auto industry is, has been, and will continue to be one of the worst industries to invest as long as America continues to support policies that result in unfair trade.

For those of you who feel prices for GM and F look like a great deal at current levels, I'd like to remind you of the tremendous liabilities faced by each company. Remember, they resemble banks more than auto makers, with huge amounts of unknown liabilities. High oil prices, high inflation, muted median wage growth, and consumer stagnation are certain realities over the next few years, at minimum.

That said, do GM and F represent any short-term trading opportunities? That is certainly a possibility. But I for one would not want exposure trading fundamentally miserable companies with potentially huge liabilities, especially during the high market risk that remains. We must remember that analyst downgrades typically come in masses just prior to capitulation. At the very least, I would need to see a few more Wall Street analysts issue Sell signals before I would even consider GM or F for a trade. Given the latest sales figures from June, we just might see more downgrades soon.

Disclosure: None