General Motors bondholders have endured some tough times this year, and worse may lie ahead. Despite temporary reprieves, debt issued by the automaker continues to suffer from bearishness and volatility. Investors say that until Standard & Poor’s announces its outlook on the credit’s rating later this year, pressure will continue. Spreads on General Motors 8.375% bond due 2033 widened to around 380 basis points over Treasuries in February from a little over 300 basis points late last year.
Standard & Poor’s says it is reviewing the stable outlook on the company’s $291 billion debt and will announce its decision in the middle of the year. A negative outlook on General Motors’ debt, currently rated on the lowest investment-grade notch at BBB-, would give rise to the specter of a downgrade to junk. Investors fear this could throw a major wrench in the works of the bond market, as trading in General Motors makes up almost 8% of the total US trading in corporate bonds.
Meanwhile, the 97-year-old car company continues to face formidable profitability challenges and many investors complain it has no strategy to pull itself out of the ditch. Andrew Harding, director of taxable fixed-income securities at National City Investment Management in Cleveland which manages $7 billion, says his fund is underweight in General Motors because more losses are likely. “We don’t see the kind of leadership at General Motors that says ‘we’re going to dig our way out of this and this is how we’re going to do it.’ The difference between General Motors and Ford is that Ford knows it has issues and is taking measures to deal with them; General Motors seems a little more lethargic,” he says.
Others are even more pessimistic, arguing that although General Motors has always been a US economic giant, investors can no longer rely on the company’s long-term viability. “I own none of the American car makers,” says Steve Bohlin, a taxable bond fund manager who runs about $1 billion at Thornburg Investment Management in Santa Fe. “My fear is that in a couple of years they’ll be calling the Big Three Toyota, Honda and Nissan.”
This kind of sentiment has led many high-grade investors to sell their General Motors bonds while they can, fearing that more bad news from the company or grumblings from the rating agencies would batter prices beyond repair.
The main source of concern is General Motors’ poor profitability. Like rival US automakers, General Motors has suffered from eroding global market share and rising labor costs. Toyota, Honda and Nissan are already widely referred to as the Japanese Big Three, and Toyota is positioning itself to overtake General Motors as the biggest seller of automobiles in the world.
General Motors still earned a hefty $3.7 billion or $6.51 a share in 2004, but this was 63 cents less than a year earlier. Almost 80% of the earnings came from the company’s booming finance unit General Motors Acceptance Corp. (GMAC), while the auto operations scraped by with $800 million in profits. Meanwhile, the North American market share dropped to 26.7% from 27.4% the year before. The outlook for 2005 doesn’t look much brighter, with management predicting further declines in earnings per share and automotive-related cashflow.
General Motors has cut production and hopes that recently reintroduced rebates will spark buying, but investors say what General Motors really needs is a car that excites consumers. “General Motors needs to learn how to make money making cars,” says Harding. “I’d like to see a better designed car coming out of there.”
To make things worse, General Motors’ current product offering is about 25% older than that of its competitors, and the company is not due to refresh its sports utility vehicle and full-size pickup truck lines—which contribute the biggest profit margin—until 2006 and 2007.
There is a silver lining however. General Motors is due to renew some of its vehicles this fall and market participants say Standard & Poor’s is unlikely to change its ratings before it sees how the new products fare. Kip Penniman, auto and steel analyst at high-yield research firm KDP Investment Advisors, says new product launches this year will help shore up some of the market share losses. Penniman says he is optimistic about General Motors’ strategy, pointing out that the company is becoming more aggressive with new vehicle introductions, speeding up its product cycle, and pouring resources into its creative design team effort. Others argue that General Motors has already made some progress in its production, with higher-quality scores from consumers and better internal efficiency numbers.
B. Craig Hutson, senior bond analyst at independent research firm Gimme Credit, says while none of General Motors’ new products “blow you away” like the Chrysler 300, the new models are “significantly improved over what they were replacing.”
The question is whether these changes can give General Motors a lead over the competition. Even as it updates its product lines and speeds up its product cycle, other automakers are doing the same. Competitors are well ahead of the game, and European competitors in particular have an advantage with better design while Asian companies can benefit from lower labor costs.
Labor costs are a particularly sore issue. General Motors spent $4.3 billion in 2004 on health-care benefits, a figure which management expects will rise by another $1 billion this year. On a year-end conference call with analysts, chief financial officer John Devine complained about the “very substantial” burden of so-called legacy costs. “This is not to make an excuse,” he said, pointing out that the company is working hard to remedy the situation, but “frankly, the larger drag we’re getting on our profitability in North America comes from health-care costs and overall legacy costs.”
Health-care costs have been rising as much as 15% annually at companies across the country, and make up one of General Motors’ largest expenses. The company pays benefits to about 1.21 million workers, retirees and their dependents, shelling out about $1,400 for every car produced. Although the company last year plugged an $18.5 billion hole in its pension plan, many of General Motors’ future medical retiree benefit needs are as yet unfunded.
“This is a problem faced by all the US automakers, and I don’t think there’s going to be an easy solution,” says Penniman, arguing that Washington is unlikely to come to the rescue as some people hope. “It’s going to be a matter of the company doing what it can to educate its employees, so they make smart drug purchases, and trying to cut costs through its leverage and size.”
General Motors already tries to educate its workers about cutting health-care costs. Analysts point to Toyota’s example of setting up a pharmaceutical business that buys drugs in bulk for employees as one smart way of saving money.
Another drag on GM is its recent settlement with Italian automaker Fiat. In 2000, General Motors bought 20% of Fiat Auto from Italian conglomerate Fiat SpA in return for 6% of General Motors stock. The terms of the deal allowed Fiat to unload its entire stake in Fiat Auto onto GM by 2009, an option which Fiat insisted on exercising. General Motors balked at the prospect of acquiring another heavily indebted and unprofitable business, and instead bought itself out of the deal with a $2 billion cash payment to Fiat.
While investors said the size of the payment had been priced in, the announcement triggered more trouble: Moody’s cut its outlook on General Motors’ credit rating (two notches above junk at Baa2) to negative.
“The change in outlook follows the announcement that GM has agreed to pay Fiat SpA €1.55 billion to terminate the Master Agreement between the companies and to realign their industrial relationships,” said Moody’s. “Although the €1.55 billion payment does not represent a significant erosion in GM’s automotive liquidity position of $23 billion, this outflow comes as the company is facing increasing challenges in its competitive and operating environment.”
In the end, size and a strong balance sheet might save General Motors. Despite his gloomy outlook on General Motors’ automotive operations, Standard & Poor’s auto analyst Scott Sprinzen argues in a recent report that “General Motors’ liquidity and financial flexibility minimize any potential for near-term financial stress.” Sprinzen points out that General Motors has a large liquidity position of $23.3 billion in the form of cash, marketable securities and short-term funds in its Voluntary Employees’ Beneficiary Associated (VEBA) trust. General Motors’ short-term debt is moderate, and the long-term debt has a high maturity, he says, while General Motors also has access to $8 billion in various credit lines, the largest of which doesn’t expire until 2008.
As one Wall Street fixed-income strategist puts it, “I wouldn’t want to leave you with the impression that General Motors is going to roll over and die tomorrow. The company has tremendous financial resources at its disposal.”
Perhaps more importantly, General Motors has a trump card in the form of GMAC, its highly successful financing arm which contributed the bulk of earnings last year and holds $24.4 billion in cash. In order to preserve GMAC’s access to inexpensive capital and minimize the damage if Standard & Poor’s decides to downgrade the automaker, General Motors has said it might spin off two of GMAC’s residential mortgage businesses into a new holding company. That way, General Motors would still have a platform through which to borrow capital at investment-grade prices.
Some investors have criticized the plan, arguing that management seems to be throwing in the towel by trying to retain access to capital without addressing the underlying challenge of making cars that sell. “Psychologically it’s saying they’re considering the day they become high yield,” says Harding at National City, calling the planned spin-off a defensive strategy. “If you’re beginning to envision yourself as a high-yield company, you eventually will become a high-yield company.”
Analysts, however, feel the move will help protect General Motors’ financial position. “Desperate times call for desperate measures,” says the anonymous Wall Street strategist. “Is such a possibility the optimum solution from General Motors’ perspective? Maybe not. But this is a company which has to consider lots of alternatives which in past years it would have never dreamed of.”
Standard & Poor’s Sprinzen says in his report that the mortgage entity would probably receive a higher rating than General Motors or GMAC. “If this restructuring enables the existing, substantial intercompany advances extended by GMAC to the mortgage units to be refinanced externally, we believe it would represent a modest positive development for General Motors and GMAC because it would enhance funding flexibility,” he says.
The road to junk
In the end, however, a GMAC spin-off will not save General Motors from a ratings downgrade, as Standard & Poor’s has made clear its focus is on the automotive operations. A downgrade, were it to happen, is not expected before the end of the year. Market participants say the rating agency must first complete its outlook review, expected around mid-year, and then move to a negative credit watch before changing the rating.
In January, Lehman Brothers changed the inclusion rules for its benchmarks including the Lehman Aggregate by adding Fitch Ratings to its list of accepted credit raters along with Moody’s, stating that a credit must be rated junk by two rating agencies before it is kicked out. The move was interpreted by some as a safeguard against a potential downgrading of General Motors, and helped the bonds to recover.
Most analysts approved of the decision, saying it reduces the potential for significant volatility. Usually when a credit drops from investment grade to junk, its prices slide not only because of natural liquidation of long positions, but also because of forced selling by the numerous fund managers who model their portfolios after the Lehman Aggregate.
“This is new ground for US markets,” says KDP’s Penniman, adding that the rule revision provides an important backstop to extreme selling pressure. “We’ve never seen the potential for such a large fallen angel.”
However, some high-grade fund managers, including Thornburg’s Bohlin, consider the Lehman change to be only cosmetic and refuse to touch General Motors bonds regardless of their index status. Penniman says General Motors “smells and looks like a high-yield bond,” and he is recommending it to investors as good value compared with other junk bonds. Other high-yield experts agree, saying it’s a unique opportunity to own high-grade quality debt with very little risk of default, at junk prices.
“This security has been trading at high-yield levels, but the company is much more attractive than many credits that are rated single-B or lower, that are returning the same yield level,” says Harry Resis, director of US fixed income at Henderson Global Investors in Chicago, who mainly invests in junk. He says General Motors bonds represent good value when intermediate maturity spreads rise above 300 basis points over Treasuries, or long debt rises above 400.
High-yield managers might like General Motors these days because they have the opportunity to get their hands on an investment-grade bond at junk prices, but what about investment-grade managers? Many are sticking to General Motors until the outlook clears up because they don’t want to be caught on the wrong foot. Given how far General Motors debt has fallen, there is serious potential for a big rally. If a rally occurs and lifts the Lehman benchmark with it, a portfolio manager risks underperforming the market if he doesn’t own General Motors.
“It’s not a sure thing they’re going to high yield and that’s why we still own some,” says Harding at National City, who adds that despite his negative outlook his fund still holds a small underweight position in General Motors. “It’s an awful lot of income to give up. Especially if you’re wrong, some miracle happens and they do dig their way out.”
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