GM tests the limits of financial engineering

COPYING AND DISTRIBUTING ARE PROHIBITED WITHOUT PERMISSION OF THE PUBLISHER: CHUNT@EUROMONEY.COM

By:
Kathryn Tully
Published on:

A top-notch pension scheme and subsidized healthcare ensure employees love working for General Motors. But the costs place a huge strain on the finances of one of the world's biggest bond issuers. Smart financial engineering has eased investors' fears over these liabilities. But GM must now address weak profitability in the car business. Its financing arm can't bail it out for ever. Kathryn Tully reports.

Jonn Devine, GM's CFO, is described as a visionary thinker and a risk-adverse manager.
IT IS ONE of the world's top three bond issuers. In terms of assets, it's among America's largest banks and makes most of its money from mortgages. It has 340,000 employees worldwide and vast purchasing power. It is second to only the government as the largest purchaser of Viagra in the US and is the world's biggest buyer of golf balls. Yet neither banking, executive sports or performance-enhancing pharmaceuticals are its main line of business and it isn't a conglomerate. It likes to think of itself as the world's biggest automotive company.

There are many baffling things about General Motors but the fact that it buys so much Viagra to pass on at subsidized rates to its employees under its healthcare scheme is surely not run-of-the-mill corporate practice. "People seem really very happy to work there," says one analyst.

We can see why. What with the Viagra flood, one of the best employee pension schemes in the industry and more golf balls than you can shake a five iron at, it sounds like a great place to work.

But GM's pension and healthcare burden, legacies of a time before merciless competition eroded its market share and left it with vast overcapacity, have also become big threats to profitability and the balance sheet.

GM's $19 billion under-funded pension liability, a product of low interest rates and poor returns on investment, was one reason why Moody's decided to downgrade the company from A3 to Baa1 last year and put it on negative outlook. The shortfall at the end of 2002 was the highest for a decade, prompting GM's finance team, led by CFO John Devine, to take drastic action.

Filling the hole

In the space of a year, GM has managed to plug the deficit. It ended 2003 with $300 million in surplus in its US hourly and salaried pension plans. But this wasn't funded by profits. GM only ended up making consolidated net income of $3.8 billion in 2003. It is debt issues and asset sales that did most of the job, and the balance sheet is feeling the strain.

On top of that, the company now concedes that addressing its intimidating $60 billion healthcare bill is a top priority for 2004. It is also facing negative net pricing, loss of market share, profitability and fierce competition in its US automotive business.

With no dramatic upturn in profitability likely soon, GM still has its back to the wall. It supports about 2.5 pensioners for every employee. The number of GM pensioners that are members of the all-powerful United Automotive Workers union is more than twice Ford's. GM has 228,550 retired members and 63,480 surviving spouses, compared with Ford's 77,460 retired members and 24,220 surviving spouses.

While GM's foreign competitors are adding to their pension liabilities all the time they are expanding US capacity, GM is trying to decrease its own burden. But the gap between GM and foreign rivals in particular isn't going to go away in a hurry. In fact, the pension burden is not going to go away while retired workers are still alive. "There's a very slow ramp-down when it comes to our US hourly and salaried pension costs," says Devine. "When people leave their roles they retire, they live for a long time, bless them. Their spouses live even longer."

GM also has twice Ford's healthcare liabilities. Because of high US healthcare inflation its VEBA healthcare plan for pensioners has liabilities of $60 billion and only $10 billion set aside to meet them.

Healthcare is not a legally enforceable liability like pensions, but it has to go on the balance sheet and so rating agencies take note of it.

GM injected $5.7 billion into its VEBA trust last year. But with national healthcare inflation predicted to rise to 8.5%, the company's retirees healthcare costs will be even higher in 2004 – up to $4.6 billion from $4.3 billion last year. Devine points out that this will be over $1,000 of healthcare cost per vehicle produced in 2004. "Our healthcare costs are still going up, we need more help [from the government] and we need to help ourselves," he says.

On the bright side, Devine says the rise in healthcare expense has particularly come from prescription drugs, something that the federal government has tackled with recent legislation and which GM will no longer subsidize to the same extent following the latest round of UAW negotiations. According to analysts, scaling back subsidies on brand name drugs - including all that Viagra - could save billions.

The company is now considering diverting more operating cash into its VEBA fund, although how and when this will be done hasn't been decided yet. A relatively small cash injection is only the tip of the iceberg, though. "It will take several initiatives over the next few years to address this," Devine says wearily.

GM's employee expenses
($bn)
Source: Company reports and DrKW Debt research
A visionary straight talker

Devine is not scared of tackling a problem head-on. Formerly a product professional at Ford, he's described as a visionary thinker who is nevertheless a straight talker and risk-averse manager. The day he left his job as CFO of Ford in October 1999 after 32 years at the firm, the share price slumped. "For Rick Wagoner [GM's chairman since last May] to hire Devine was a great move," says someone who knows him well. "He knows the business but he also knows how to make money."

It was he who decided GM should tackle up-front the negative market sentiment surrounding the pension problem by launching last year's multi-tranche, multi-currency, straight debt and equity-linked $17.6 billion bond for GM and GMAC.

Devine, with GMAC chairman Eric Feldstein, hosted 45 conference calls with investors in two-and-a-half days. It was unusual for a CFO to get so involved in a bond issue; that Devine did showed its strategic importance. It also showed he was willing to put his credibility on the line.

It was certainly an audacious deal, launched when auto spreads had been very volatile and negative market sentiment about the sector abounded. GM leaned heavily on the funding expertise of GMAC to make it work, particularly the banking relationships of Cynthia Ranzilla, GMAC's head of funding.

The company made secretive preparations for months with long-standing relationship banks and lead bookrunners, Merrill Lynch and Morgan Stanley, about how they should address the pension issue – whether or not to go for a jumbo offering, what currencies they should tap in what maturities and how to set up the underwriting group. "Sanjev Khattri [assistant treasurer] wanted to get two independent reads on the market before they decided to go ahead," says Hugh Sullivan, managing director in global industries and communications and GM relationship manager at Merrill Lynch. Finally GM had 16 bookrunners, with 41 banks involved overall.

Morgan Stanley and Merrill Lynch didn't know they were working together as lead bookrunners until GM brought them together in a meeting, with Citigroup joining as third lead just a few days before.

The rest of the bookrunners on the deal didn't know what their involvement would be until they were summoned to GM's New York headquarters at 6.30pm on Thursday, June 19. The deal was launched the next morning. By Monday afternoon, one of the leads was beginning to panic as it had no orders. Then they came piling in and the deal size was increased from a planned $13 billion.

It wasn't the cheapest deal GM could have done at the time but then that was never going to be the priority. "We couldn't be sure that the transaction would raise in excess of $17 billion," says Raj Dhanda, co-head of global debt syndicate at Morgan Stanley. "When we added together the different pockets of demand, we weren't even sure that we could get to $15 billion."

The deal has performed well in the secondary market, supported partly because nothing comparable could be issued before it. "In the end, size almost worked to its advantage because nothing was going to come out in the face of that," says Tom Ostrander, managing director and chairman for global industrial and North American investment banking and GM's relationship manager at Citigroup.

It had the desired effect on the credit market's perception of GM. Investors saw the pension issue as shelved after the bond, when GM said it would not have to make required pension fund contributions for four years, freeing up $10.5 billion in cash. "We may have replaced our pension liability with real debt, but we've replaced a short-term funding requirement with debt with an average of 19 to 20 years in maturity, which has a huge impact on liquidity," says Walter Borst, GM's treasurer.

To some analysts, though, the fact that GM has $10.5 billion more funding flexibility as a result of not having to pay into US pension plans for four years is misleading. "GM claims it 'strengthened' its balance sheet by $10 billion in 2003. As this came about primarily through an increase in automotive debt of $15 billion, it's tough for a bond investor to buy into this definition of 'strengthened'," wrote Gimme Credit analyst Carol Levenson after GM's full-year 2003 results appeared last month.

However, other commentators defend the decision to substitute a variable future pension liability that could lessen over time for a concrete debt now because the repayment schedule is predictable on a bond, whereas the top-up cash contributions GM has to pay into its pension plans under US Erisa and PBGC regulations are uncertain. "You don't know what could hit you when you can least afford it," says Mike Ward, auto analyst at CreditSights.

In fact, the bond issue was only one part of GM's $18.5 billion contribution to its pension deficit in 2003. The defence business Hughes Electronics was sold in the first quarter for $1 billion. The cash and stock sale to NewsCorp, a transaction that had been on and off for several years, fortuitously closed just a few days before Christmas 2003, allowing the company to put the $4.1 billion proceeds into the pension fund before the year-end. And after the pension plan produced a respectable 9% return on investment in the first six months of the year, it closed 2003 with a 22% return, which also reduced the pension shortfall.

"We knew that with the bond issue and the asset returns we were getting in the first half that we could make a decent contribution to the pension," says Borst. "But our asset returns were stronger in the second half and we were looking to see when the Hughes deal would close so we could put in another $4 billion. It was partly good planning, partly overperforming."

Hitting targets

Ford versus GM
Industrial net cash development ($bn)
 Source: Company reports and DrKW Debt research
Although GM failed to grow market share in North America and in fact lost a bit, it managed this in the rest of the world, and, excluding Hughes, generated $32 billion in cash, up from $17.3 billion in 2002. It delivered annual earnings per share of $5.62.

In the end it turned in $10 billion of operating cashflow alone. "Analysts took note of our strong cashflow from operations, which must be a record in difficult market conditions," says Borst "It's extremely strong compared with earnings."

But it should be noted that GM counts the $1 billion dividend it received in 2004 from GMAC, its asset sales and its jumbo bond issue within its overall $32 billion cashflow generation number. So investors should be wary – after all, GM is not going to do the biggest bond deal in the capital markets or raise $5 billion in asset disposals every year.

In other ways the balance sheet is looking even less rosy, even despite a strong automotive cash position, with cash and VEBA assets (which GM counts as cash because they can be removed from the fund) of $26.9 billion at the end of 2003.

Because of its increased debt levels through the bond issue, the reclassification of a funding agreement with GECC and adverse foreign exchange movements, auto net debt increased to $5.5 billion, from a positive position of $300 million at the end of 2002. The plugging of the pension issue and putting more funding into Veba has not done any favours to net liquidity, despite a monster year of asset sales.

CreditSights' Ward found surprising the higher than expected net debt level at GM's auto operations announced with the full-year results. "Given that Hughes had $2 billion of net debt that GM is no longer carrying, we though it would be more like $2 billion to $3 billion," he says.

Analysts reckon that getting back this net cash position will be challenging, given that GM has halved its operating cashflow generation target for 2004 to $5 billion because of higher capex, lower car rental volumes, no predicted asset disposals and production cuts. "We estimate that it could take at best around one year of automotive free cash flow to fully absorb existing net debt, should a sustained economic recovery emerge" said Christophe Boulanger, auto credit analyst at Dresdner Kleinwort Wasserstein, in a January report.

Borst accepts that this is important. "From a competitive and downturn perspective we think we're fine because of our cash balance but obviously we want to get back to net cash as soon as possible and that's a challenge for my team now," he says. "But you need to look at it a lot more broadly than cash minus debt, because we've taken our pension shortfall from $18 billion to zero."

It's not just the increase in net debt at the automotive division that funding the pension deficit has produced, it has also brought $1 billion extra interest expense that GM will be carrying each year. One of the benefits of doing the jumbo bond deal was that under US accounting, the assumed asset return on GM's pension fund will be 9%, whereas the cost of GM's new borrowing comes to just 7%. This is obviously good news for shareholders, who are making positive noises in any case. In fact, GM's share price has risen 35% since last November. Most of the projected $600 million saving this year should start to show up in the first quarter as the company actually paid the proceeds of the bond into its pension fund in the fourth quarter. 

But although the likely earnings gain is an accounting construct, from a credit perspective the extra interest expense is a cash outlay that GM has already had to swallow, with $700 million in interest expense dragging down fourth-quarter global automotive earnings and helping to bring net income from its global auto business to just $1.1 billion – half of what it made last year and well below its full-year target of $1.7 billion to $1.9 billion. 

GM does not like to draw too close a comparison with Ford, even though they operate in each other's backyard. For example, GM has now taken over Ford's Renaissance Center in Detroit to use as its executive headquarters. Unfortunately, GM forgot to check if the car park came with the building and ended up red-faced when it had to buy it separately afterwards.

Investors, though, have been more worried about Ford recently, particularly since Standard & Poor's downgraded it in November. From a credit point of view, GM and Ford's respective auto businesses are looking remarkably similar, despite the fact that S&P now rates Ford Motor one notch below GM at BBB- and GM's credit curve trades consistently inside Ford's.

With cashflow generated at the auto business set to halve and net debt to remain high, doesn't that make the credit profile of GM and Ford closer than ever? Have investors been so preoccupied by the fear of Ford, itself a huge issuer, being downgraded to junk that they have not devoted sufficient attention to what's going on at GM?

CreditSights' Ward says: "Contrary to common perception in some pockets of the market, Ford's balance sheet profile is actually better (arguably much better) than GM's, even if its flexibility to navigate the debt markets is not." Whereas at the year-end GM had clocked up net debt, for example, Ford had $10.9 billion net cash.

Some analysts are going as far as predicting a downgrade of GM too. This is not, though, the majority view. Ford's balance sheet may be more liquid and its structural costs far less onerous but, as Paul Griffith, executive director of investment-grade research at Goldman Sachs points out, GM is more profitable. Ford has only just managed to report a first full-year net profit since 2000 – of only $495 million.

Griffith adds that GM's cost structure is lower and productivity better and that the rating differential is there for a reason: "One of the drivers for the rating differential between Ford and General Motors is the difference in free cashflow generation," he says. "GM has stated it expects to generate $5 billion of free cashflow in 2004 versus Ford's guidance of $1.2 billion."

Another analyst suggests that because GM's management anticipates situations more quickly and is more aggressive, it should quickly be able to catch up with Ford in terms of balance sheet strength.

The trouble is that GM will have to achieve this when it is not generating anywhere near enough profit in its key automotive business. The $1.1 billion it made from autos globally last year is tiny since the revenue base was $160 billion, implying an operating margin of 0.1%. And that margin was heavily bolstered by Asia Pacific and the high-margin China business, where full-year income rose to $577 million from $188 million.

In Latin America, net losses rose from $7 million at the end of 2002 to $112 million at the end of 2003 because of weak economic conditions coupled with asset write-downs. In Europe, GM made a full-year loss of $286 million.

GM's biggest automotive business headache is in North America, where it produces 75% of its sales but where it went backwards from a profitability point of view in 2003. It made $1.2 billion of net income, down from $3.1 billion in 2002.

Fierce competition has led to aggressive incentive spending by the big three auto makers in the past two years. GM started the battle with its "Keep America Rolling" 0% financing initiative after September 11 and has always been the most aggressive on price. According to CreditSights, GM spent $3,785 per unit on average in 2003 compared with Ford's $3,233. This has not delivered bigger market share. In fact, GM's US market share was slightly down year on year, to 28%. Incentives can also make a big dent in profitability. CreditSights notes that a $500 swing in per-unit incentive costs accounts for $2.3 billion gross profit.

The good news is that GM's revenue per unit was up to $294 in 2003 on strong US sales in its higher-margin truck business.

Yet GM had to rely heavily on GMAC last year to bump up income. GMAC, with over $275 billion of assets in 41 countries and financing, mortgages and insurance divisions, made a record net income of $2.8 billion in 2003, up from $1.9 billion.

Low interest rates, record high mortgage volume and favourable refinancing at rich profit margins helped GMAC to make more money from its mortgage division alone, at $1.25 billion, than GM did from the whole of its global autos business.

Worryingly, the company now expects GMAC's profits to fall in 2004 to around $2 billion because of a decline in net interest margins and much lower mortgage volumes. Some analysts wonder whether even a $2 billion target can be reached.

Mortgage mitigation

However, GMAC says its mortgage profit will decline less than the slump in volume the mortgage industry as a whole is likely to suffer, partly because of deferred gains on sales in securitization activity from previous years, partly because mortgage servicing assets will appreciate in a rising rate environment and also because its growing fee-based mortgage businesses is less sensitive to mortgage volume.

It also expects profitability at its insurance division to improve because of increased underwriting income and the appreciation of its investment portfolio.

Yet even if GMAC continues to perform, will the auto business be able to contribute to the hefty overall increase GM wants in earnings per share of between $6 and $6.50 in 2004? GM also wants to grow market share in all its key regions and thinks it will break even or be slightly up in Europe, reduce losses in Latin America and see a further 40% growth in Asia.

GM is hoping that a stronger US economy will bolster auto unit sales in the US, helping it to get to $1 billion to $1.4 billion in net income. It thinks US industry sales will be up 2% to 17.3 million units, and 60 million globally, up 3% over 2003. "We've seen the economy picking up in the last few months of 2003, confidence is improving," says Devine. "It's early days for 2004 but things are looking better in Europe and China is looking very good. In the US market, we hope the economic recovery will translate into higher sales volumes and possibly better pricing, but we'll have to wait and see."

He concedes that incentives offered in the last couple of years may have already used up some of the expected recovery in US sales. "Volumes are not going to rebound so much because of incentives but we're seeing a bit of improvement," he says.

There are bright spots. Borst describes the reversal of fortunes at Cadillac, GM's luxury car division, which has rapidly increased sales in the past year, as phenomenal. However, it's not just volume growth that Devine is looking out for in the crucial North American market. He has to improve profits as well – "walk and shoot at the same time" as he puts it. That will be tough. GM has already signalled this year that it is going to carry on an aggressive incentives strategy. A company as big as this with such low margins has to keep its volumes up unless it wants its profitability to slide.

GM is rolling out an impressive list of 17 new models in North America alone in 2004 and is offering 24-hour test drives to encourage buyers to bite. However, the fact that this year GM is renewing its efforts in the small passenger car market where margins are low compared with trucks and pick-ups (which make up most of its sales), doesn't bode too well for bolstering profits.

GM has made better-than-expected material cost reductions and the strategy is that this, volume growth and performance improvements will more than off-set any impact of negative pricing on 2004 profits.

Outsiders are not so sure. "There's a positive sentiment coming from GM because they now have a better cost structure along with product momentum," says Barclays Capital's auto analyst, Juan Carrion. "But this is not translating into improved profits in their automotive business.You can't cost-cut your way to prosperity."

Nothing more to sell

GM has already divested most of its non-core businesses and further asset sales seem unlikely. It looked set to sell GMAC's commercial mortgage division to Deutsche Bank last October for $1 billion but couldn't secure a price it was happy with. Borst says: "I think that's off the agenda now, but because the commercial mortgage division has tended to use a significant amount of cash from the parent company to fund operations, I think we will do some more work on restructuring its balance sheet."

A couple of years ago GM set itself a mid-decade financial target of $10 earnings per share. Devine says this will now be a lot more challenging to reach as pension and healthcare costs have risen since it was set. He says for that to be achieved, the economy will have to behave and the company will also need a minimum net margin of 2.5% in North America and 1% in Europe. "We'd be more than pleased to earn more than that in both markets but it's a minimum measure for us," he says.

Others see the problem as even simpler – GM just has to turn around profitability in the North American market.

According to commentators, GM's executive line-up is the one you'd choose to pull it off and the all-star team of Wagoner, Devine, Bob Lutz, GM's product tsar, Gary Cowger, head of north American operations and Feldstein are the best since Alfred Sloan stepped down in 1956. Those in its New York treasury office headed by Borst are also "a gutsy team", say bankers.

But the exceptional balance sheet re-engineering that Devine and his colleagues pulled off last year cannot be relied on to ease the burden of GM's continuing structural costs, make the company more competitive once again or indeed fulfil the ambitious mid-decade EPS target.

It won't be financial re-engineering but a turnround in GM's ability to make more money selling cars and trucks that will have to see to that.