Today's stock buyers "hope for" a second-half recovery that will drive a robust earnings recovery, and they rely on the conviction that paying 30 times earnings for stocks will prove to be a rewarding proposition. We do not share the hopes or convictions of the bulls.
The recent rally on Wall Street has been a classic triumph of faith over fact...of hope over substance. No stock better exemplifies misguided faith at work than Dow component General Motors. GM's frightening investment profile should inspire far more fear than greed. And yet, the automaker's shares have rallied a sparkling 18% since early March, contributing handsomely to the Dow's 1,000-point rally over the same time frame.
Apogee Research took a peek under the hood of this struggling automaker early last month and recommended that subscribers sell the stock short. Mr. Market had other ideas. The stock rallied sharply over the ensuing weeks, eventually hitting Apogee's stop-loss limit and forcing the research firm to advise exiting the trade...for now.
For the time being, the bulls are "right" about GM; their faith is serving them well. By contrast, Apogee's well-reasoned, skeptical analysis of the automaker has produced little more than weeping and gnashing of teeth, thus far.
What do the bulls know - or what do they think they know? Are the automaker's operations firing on all eight? Hardly. GM's "earnings growth" relies upon one lone cylinder: its credit operations...and that cylinder, too, is beginning to sputter. Meanwhile, GM's mounting pension and benefit obligation is an ominous drag on shareholder equity.
Most folks think of GM as a car company. But it's really a finance company in disguise. Of GM's three primary businesses, only GMAC - also known as the Financial and Insurance Operations unit (FIO) - has been the consistent leader in providing net income. As we noted in the Daily Reckoning last week, "Of the $1 billion that the company earned during the [first] quarter, $700 million came from its finance unit. Meanwhile, profits at the automotive division tumbled 16%. Hmmm...some banks give away toasters to attract new customers. General Motors, apparently, gives away cars."
GMAC's contribution to overall net income has nearly doubled since 1996 - from about 16% of net in 1996 to about 31% in 2002. But recent trends suggest that GM's shining star may be losing its lustre. Credit quality has deteriorated markedly over the past year, while less-reliable mortgage banking income has become increasingly important to the operations of GMAC. The percentage of GMAC's net income that comes from mortgage operations rocketed 64% higher in 2002, which means that mortgage lending contributed a whopping 29% of the entire company's net income. Not bad for a car company! What's more, this surprising trend accelerated in the first quarter of this year, when mortgage lending kicked in a breathtaking 38% of GM's overall net income.
Clearly, GM's booming mortgage banking business is masking the difficulties plaguing its auto operations. The buyer of GM shares must believe that the mortgage boom will hang on long enough for GM's struggling auto operations to produce a "hoped for" turnaround. Unfortunately, there are already some troubling clouds gathering on GMAC's credit-quality horizon. The provision for credit losses as a percentage of finance revenues has doubled over the past three years.
Meanwhile, charge-offs are accelerating. The $1.395 billion in credit charge-offs for 2002 is 160% higher than the $532 million in 1999, even though the $27 billion of FIO revenues in 2002 were only 32% higher than the $20.45 billion booked in 1999. In other words, change-offs are growing five times faster than revenues!
Another challenge for GMAC arises from its lowered credit rating, which S&P downgraded last October to triple-B from triple-B-plus. Although the rating is still in the investment-grade category, the downgrade has increased the cost of financing GMAC's credit operations, thereby squeezing its interest margin. The impact of the credit downgrade on GMAC's operations is described in GMAC's 2002 10-K as having "increased the Company's unsecured borrowing spreads to unprecedented levels".
Meanwhile, GM's operating margin has been contracting, due in large part to the company's aggressive sales incentive programs - 0% financing seems to be "standard equipment" on most new car models rolling out of Detroit these days. GM expects to continue its aggressive sales incentive program, according to CEO Richard Wagoner. "We'd obviously like to scale back on the incentives somewhat, because, frankly, it would help our bottom line," Wagoner candidly admitted earlier this year, "but when we've tried to do that over the past 12-18 months, we've found that the market shrinks and we lose share. And so we've actually decided we're going to stay aggressive in the marketplace."
Last, but certainly not least, GM's pension and benefits obligation is an ominous drag on shareholder equity. All told, GM's underfunded pension and other post-retirement and employee (OPEB) benefit obligation increased a whopping 27.6% last year, to $76.8 billion from $60.2 billion at year-end 2001.
For perspective, the shortfall is nearly 20 times GM's average annual net income of $3.9 billion for the past seven years. The rapidly worsening pension and OPEB underfunding led GM to take a $13.6 billion charge to shareholders' equity last year, which amounts to a staggering 70% bite out of the $19.7 billion in such equity listed as of Dec. 31, 2001. Last year's charge came on top of a $9.5 billion charge to shareholder equity that GM took in 2001. Because of the torturous complexity of the Financial Accounting Standards Board (FASB) rules that govern a company's accounting for pension and OPEB obligations, both charges bypassed the income statement and were charged directly to shareholder equity. As a result, many shareholders probably didn't realize the sheer enormity of the combined $23.1 billion charge, which decimated book value from more than $30 billion in 2000 to only about $7 billion at year-end 2002.
In effect, GM is selling the family silver to satisfy retiree benefits.
The growth in the OPEB obligation is being driven by escalating health care costs, which is more than a little ominous given the seeming intractability of these continually rising costs. The ever-increasing cost of providing health care, especially for the vast family of company retirees, is an obvious worry for GM's management, and it related as much in the September 2002 edition of GM Encore, a publication directed specifically at the retired employees. "GM spends $1.3 billion a year on prescriptions," the magazine said, "while annual costs are increasing 15% to 20%."
We can't help but note the incongruity of a company telling its retiree base that prescription drug costs are increasing at a 15% to 20% clip, while continuing to estimate far lower growth in its own OPEB obligation. In calculating its OPEB obligation, GM assumes only a 7.2% increase in health care costs for 2003, less than half the rate of increase in prescription drug costs that it laid out to retirees. Of course, while GM is cautious in not overestimating the rate of increase in health care costs, it throws caution to the wind when it comes to estimating future returns on pension assets.
Like other members of the S&P 500, GM has used a more than generous 10% expected rate of return on its assets. (GM will moderate its expected rate of return for 2003 to...9%.) Such exceedingly optimistic assumptions served to increase GM's operating income line by $8.7 billion in 2001 and $8.1 billion in 2002, even though the pension assets actually showed losses of $5.3 billion in 2001 and $5.4 billion in 2002.
How does GM get away with this sleight of hand? you may wonder.
It's all perfectly legit under generally accepted accounting principles. GAAP rules allow a company to book its expected return on pension assets, instead of its actual return, as part of its operating earnings.
Even more worrisome than GM's questionably favorable assumptions about future health care costs and asset returns, we think, is that most of the benefits are payable to people who no longer work for GM. The projected obligation is calculated on the costs for current employees as well as on the increasing costs for current retirees, who account for about two-thirds of the people covered by the OPEB obligation. According to GM's 2000-2001 "Corporate Responsibility and Sustainability Report," the company is "the largest private purchaser of health care in the United States and in 2001 provided health care coverage to 1.2 million employees, retirees and their dependents at a cost of $4.2 billion".
Given that GM's current employee head count is 349,000 (down from 362,000 in 2001), it doesn't take a mathematical genius to figure out that health-care coverage for 1.2 million means that a substantial portion of the costs are attributable to GM's aging retiree base. As of September 2001, GM's hourly employee pension plan had more than 520,000 participants, and its salaried employee pension plan supported 199,392, for a total of nearly 720,000 beneficiaries, both working and retired, or more than double the 349,000 people working at GM as of last December 31.
Unfortunately, there is probably little that GM could do to trim benefits for the current population of retirees. As Robert S. Miller, Bethlehem Steel's chairman and chief executive officer, told Bloomberg News: "I hope other companies are ready for this, because many of them, including some automakers, aren't going to be able to outrun their pension liabilities. At some point, the great sucking sound of pension and health-care liabilities just overwhelms your ability to raise capital or invest in new plants and equipment."
Over time - a very long time - GM may be able to overcome its myriad difficulties. But success is far from assured. We suspect that investors will require the faith of Moses and the patience of Job to reap a long-term profit from GM shares.
The Daily Reckoning
Editor's note: Robert Tracy, a top analyst at Apogee Research, provided critical insights and expertise to this exposé. In the face of the biggest market sell-off in 70 years, Fry and Tracy helped readers of Apogee Research's weekly communiqué make profits of 100% or more buying overlooked stocks like John H. Harland, H&R Block and ShopKo. If you'd like access to brutally honest investment research from the heart of Wall Street, click below:
This essay was originally broadcast in The Daily Reckoning