Other Editorials

Detroit Death Pool

Jack Brynaur
Wednesday, May 23, 2007


Anyone who has spent any time in Detroit recently will tell you it is by all apparent indications a dying city. Crumbling buildings, widespread decay and a population in flight make for a depressing landscape. Detroit's fortunes have always been tied intimately to the fortunes of the U.S. auto industry. So it's hardly surprising that a look at Ford's and General Motors' balance sheets will show just as much decay and devastation as a trip through Detroit's worst slums. The only real question is, Which automaker will declare bankruptcy first?

Let's start with GM (nyse: GM - news - people ). Instead of talking about its autos, I'll just focus on the numbers. Over the past decade, GM's gross profits have declined from $40 billion to $22 billion, while its debt has increased from $199 billion to over $450 billion, all during a period of historically low interest rates.

The low rates won't last forever, though. Just over the past three years, GM's interest expenses have risen 77% from $9 billion to $16 billion and are projected to rise to $18 billion this year. Rates are still very low by historical standards.

One of the reasons the Federal Reserve cuts interest rates is to make it easier for companies to get the cash they need to finance growth. Unfortunately, free-flowing cash also makes it easy to dig yourself into a hole. GM supposedly took on all that debt to get its profits back on track, but as you can see, the opposite has occurred.

The simple truth is that GM can't make enough money selling cars to pay for its overhead, upkeep, salaries and dividend payments. Its solution has been to take on more and more debt, rather than spending its cash reserves, so that it can show a "profit" on quarterly income statements. In other words, GM is kiting checks all over town, using its MasterCard to pay off its Visa, burying itself ever deeper under a crushing mountain of debt.

At present margin levels and interest rates, it will take more than 20 years to pay down its debt load. Imagine what will happen when rates return to their long-term average level, as they inevitably will. With inflation looming, the Fed will have no choice but to raise interest rates at some point. It's only a matter of time.

Plus, GM's credit rating has been downgraded, meaning future rate hikes will hit it even harder. GM couldn't get its act together during an era of cheap, easy money. What reason is there to believe it will be able to do so when the ocean of capital dries up?

Ironically, GM's recent divestiture of GMAC relieved it of its only hedge against rising rates, while leaving it on the hook for any and all default risk. It's a no-win deal for GM, the sort only a desperate company would agree to. The fact that this deal went through at all is enough to show that GM is a company in crisis, but it's only one indicator among many.

GM can try closing plants, renegotiating its union contracts, laying off workers and asking for a government bailout of its staggering employee medical care expenses. In fact, I predict it will try all of the above. Doubtless it will be watching Chrysler's private-capital transformation like hawks. If Chrysler squeezes any concessions out of the unions, you can bet your bottom dollar GM will demand the same. But none of this will erase GM's massive and ever-growing debt burden.

GM has had its chance to save itself. It has taken liberal advantage of plentiful cheap, easy capital, and matters have only gotten worse.

The bottom line is, in order for GM to survive, it needs to make rapid, substantial gains in profitability. Of course, this was just as true three years ago as it is today, and the results speak for themselves. Whatever its massive PR machine may say, GM is already effectively bankrupt. All that remains is for the company to admit it.

A visit across town to Ford (nyse: F - news - people )will do little to improve the gloomy atmosphere. The situation is dire indeed for GM, but Ford is no better off. Ford's balance sheet is overflowing with red ink from unfunded pension and health care obligations. According to The Wall Street Journal, even assuming Ford somehow manages to negotiate with unions a 25% decrease in its health care costs, it will still face a $58 billion deficit, which adds up to well over three times its total market capitalization. The book value of Ford's non-car assets including cash and equity holdings comes in at about $52 billion.

Ford predicts it will burn through $17 billion of its cash over the next three years. Assuming Ford's predictions are correct, that leaves $35 billion in assets apart from the car business. Subtract $48 billion in liabilities, and you are left with a value of negative $23 billion for everything Ford owns except the car business. In other words, Ford's car business would have to be worth $23 billion simply for the stock to have zero value. In order to justify Ford's current market cap of $16 billion, its car business would have to be worth close to $40 billion.

Is Ford's automobile business worth that much? Not likely. For a number of years, Ford sold cars at a loss in order to subsidize its more profitable SUV and truck models. Now, just like in the '70s, the big gas guzzlers are falling out of favor with consumers, who are turning to more efficient Asian models, like those sold by Nissan (nasdaq: NSANY - news - people ). The results have not been pretty. SUV sales are down in excess of 30%. Ford can no longer rely on high-end models to prop up its profits. It will have to learn to make money selling cars again if it is to survive, and as of yet there are no promising new models with the potential to fulfill this need.

According to the same article in the Journal, Ford can only realistically hope for about a 2% pretax margin on its car sales. 2006 sales were $132 billion, but Goldman Sachs predicts Ford's sales will decline for 2.5% annually for at least the next three years. Frankly, I believe even this estimate is optimistic, but let's go with it. That leaves sales of $122 billion. A 2% margin on this gives $2.44 billion in pretax income.

If I value the business at 10 times its annual pretax income, that means Ford's car business is worth about $24.4 billion based on pretax earnings. Subtract the $23 billion deficit from the rest of Ford's balance sheet, and you're left with a valuation of $1.4 billion. Subtract taxes, and Ford is worth less than zero. It's difficult to imagine how Wall Street justifies a $16 billion market cap for this company.

Perhaps the most telling sign, however, is Wall Street's reaction to recent rumors that the Ford family was considering selling some or all of its stake in the company. The family now controls about 40% of the outstanding shares. When rumors of a possible sale began circulating, the shares went up 4.8%, the biggest jump in over six months. This despite repeated statements by the Ford family that the rumors were false. That kind of a reaction to a potential unloading of 40% of the Ford family's voting power speaks volumes about the confidence level of the investing public in the the company's current owners and managers. The sum total amounts to roughly the same as Ford's true valuation: less than zero.

In sum, Ford and GM are both effectively bankrupt. Whether they end up declaring Chapter 11, or undergo a massive "restructuring" that amounts to the same thing, is hardly material. The only real question is Which will go first?

Attorney Jack Brynaur writes the Contrarian Perspective, available at his Web site, Quite Contrarian.