Friday Morning Comment: Congress & GM

July 10, 2009: Yesterday, a judge's order allowing General Motors to sell most of its assets to a new company went into effect clearing the way for the company to leave bankruptcy protection in just 39 days as a leaner entity that is better equipped to compete in the global auto market.

But the road ahead is fraught with potential perils for GM as well as U.S. taxpayers, who are now the majority owners of the once powerful auto maker.

Earlier this month, GM entered a government controlled bankruptcy proceeding in order to restructure the company and make it eligible for government aid. In exchange for $50 billion in public money to keep GM alive, taxpayers received 60% of the company's stock.

Given the fact that taxpayers are now at risk, Congress must learn from history and avoid the mistakes of the past...

....to maximize the possibility that one day taxpayers will be extricated from this risk and the U.S. Treasury will be paid back in full.

Sixty years ago GM was the pride of the free market. So large and so profitable, the company’s biggest concern was facing charges of anti-trust due to their sheer market dominance. Today, GM is a shell of its former self and would be out of business if not for being rescued by Uncle Sam.

The company's fall from grace was due to bad management decisions combined with a set of tin ears when it came to responding to changing market dynamics..

The beginning of the end started back in1950 when GM, in an attempt to bankrupt smaller competitors, offered up generous labor concessions to the United Auto Workers (UAW). By granting their employees annual cost of living increases, free health care coverage for life and generous pensions, GM hoped to squeeze Ford and Chrysler by forcing them to match the gold plated UAW benefit packages. Decades later, the costs associated with active and retiree benefits would grow to be unsustainable and eventually help drive the company bankrupt.

While poorly thought out benefit packages were part of General Motors structural financial problems, the company’s executive management contributed just as much to the demise of the once great auto maker. With GM’s heavily bureaucratic decision making process, the company consistently failed to produce innovative and quality vehicles all while ignoring growing competition from Japanese imports. 

As they began the bankruptcy process earlier this month, General Motors embarked upon a new advertising campaign to reassure Americans that the company and the products were solid. But even listening to the text of the ad shows just how critical understanding GM's history is, so the same mistakes won't be made again at taxpayer expense.

In the new GM television ad promoting the company’s rebirth, the announcer says “at one time, eight model lines made sense.”

GM offering eight model lines never made sense.

In the 1980’s when GM’s market share was in free fall in the face of Japanese imports, they were busy producing multiple models of the same poorly engineered vehicle. However no one at GM stopped long enough to realize that they were building the same lousy car only with different trim.

Meanwhile, consumers were flocking to Japanese imports due to better reliability and stronger resale values. To their credit,  Toyota and Honda were busy focusing on quality by offering just one model per car class like their Corolla and Civic, while steadily converting GM customers who grew tired of a lineup of lemons. 

In the 1990's, with GM's market share of domestic models steadily decreasing from a high of over 50% to less than 30% and their burdensome labor costs for both active and retired workers steadily increasing, the company faced a new threat; Toyota and Honda were opening factories in the United States.

Beginning in the mid-90's, both Toyota and Honda opened state of the art factories and began mass producing cars in the United States with labor costs at a fraction of GM. Comparing window stickers, GM had to include almost $900 more per vehicle than Toyota just to cover benefits for retired employees. And then came cheap gasoline.

With gas cheap and consumers driving demand for gas loving trucks and sport utility vehicles, GM began to depend too heavily on sales of their larger vehicles. Smaller vehicles in the GM lineup had razor thin profit margins and on some vehicles none at all, which made growing sales of their trucks and sport utility vehicles essential to maintaining profitability.

Then came a double whammy of skyrocketing fuel prices and the economic meltdown which finally sank the debt ridden GM. After months of unsuccessfully trying to secure private financing, GM had no where to turn other than the Federal Government.The company is now a ward of the government because its failure to make good business decisions.

Ideally, knowing the history of General Motors would hopefully motivate Congress to avoid repeating the same mistakes but that already seems unlikely.

Just last week on Capitol Hill, the Senate held hearings about the closure of GM and Chrysler dealerships as required as part of the bankruptcy reorganization. This smacks of micro managing and political meddling which if continues, will hamstring the companies attempt to return to profitability and repay taxpayers.

According to GM’s bankruptcy filing, the company will shed 14 factories, 21,000 hourly paid jobs, 8,000 white collar jobs and close 2,400 dealers. The temptation for Congress to get involved is high because factories and dealerships translate into jobs. Politicians don’t like to lose jobs in their home states.

However if taxpayers are going to recoup their investment, these cost reduction measures must be free from political grandstanding and interference. And if Congressional meddling wasn't enough to worry about, there have already been examples that the UAW will continue to command tremendous political influence to the detriment of GM's financial health.

The United Auto Workers, long the powerful political force, came out smelling like a rose compared to other creditors in the GM bankruptcy. Although they did give up some benefits as part of the agreement, they don't appear to be near enough to make the new GM profitable.

While they agreed to simplified work rules, there were no reductions for hourly pay, health care or pensions for active workers. Also, as part of the bankruptcy agreement, the UAW received $6.5 billion in preferred stock with a 9% dividend which will cost GM about $600 million a year.

In addition, the UAW flexed their political muscle with Congress and the White House during bail out negotiations by successfully killing a plan that would have allowed GM to import cheaper subcompact cars from China. Limiting GM’s ability to compete against less expensive competition does nothing to help the bottom line which is exactly what Congress should be watching.

From a shareholder’s perspective, this sets a troublesome precedent anytime GM management makes a business decision to allow the company to compete more effectively.  This is especially problematic given the fact that GM has been losing money on its smaller cars as the only financial sweet spot for the auto maker has been sport utility vehicles and trucks.

Combine the lack of profit with GM’s small car lineup and the recently announced government increase in CAFÉ standards and you can see some real challenges on the horizon for GM versus better positioned competitors.

As part of GM’s restructuring, a new management team is in place to run the company as it emerges leaner from a government forced organized bankruptcy. These people need to be left alone to run the company and make the hard decisions that should have been made decades ago. Eliminating unprofitable product lines, closing plants, reducing labor costs while streamlining their bloated network of dealers is critical.

If GM is going to succeed, it will need to be free from the back seat driving of Congress and the UAW.

Taxpayers so far have committed $50 billion to General Motors so far, making the U.S. government the largest shareholder of the new company. And while GM will emerge from bankruptcy smaller and with their structural costs shaved by about $7 billion annually, the road ahead is going to be long and uphill.

According to the Obama Administration, the goal is to be in a position to begin selling GM stock in 18 months and for taxpayers to be out of the auto business completely within five years. Assuming that the taxpayers aren’t required to sink another dime into GM, it would mean the company would have to be worth $100 billion dollars before taxpayers break even.

The problem with reaching the $100 billion benchmark is that at its peak, GM’s market cap was only $56 billion. Today with fewer lines, fewer dealerships and increased competition, repaying taxpayers and getting out of the auto business within five years looks unrealistic.

Furthermore, there is an emerging risk of Congress trying too hard to boost GM that will increase government debt and risk to shareholders while masking unprofitable business practices at GM.

In 2010, GM is scheduled to unveil its much vaunted compact electric car, the Chevy Volt. Already the Volt is at a disadvantage due to its $40,000 price tag which is 40% higher than Toyota’s Prius.

In order to help boost sales, Congress included a $7,500 tax rebate for Volt purchasers in the recent TARP legislation. But even with the hefty taxpayer funded rebate, the car still pencils out to lose money for GM because of its high production costs.

So not only is the taxpayer paying for GM to make an unprofitable product, but Congress is going to throw $7,500 of taxpayer money at buyers. Since the money is all coming out of the same U.S treasury, this raises the fear of Congress turning General Motors into Government Motors.

And speaking of money, Congress must realize the critical importance of protecting GM's financial health because the federal government will continue to be the lender of first and last resort if the company needs additional cash infusions in the future.

During the government forced bankruptcy of GM, the Obama administration ran roughshod over bondholders who held preferred positions.

Bankruptcy is typically a process of dividing up the pie according to laws that determine a creditors priority. In pushing bondholders to the back of the line, the Obama Administration tossed a hundred years of bankruptcy law out the window

In the forced settlement agreement, bond holders who were secured creditors were given just 10% stock in GM for their $27 billion in claims. Meanwhile, the UAW, which was an unsecured creditor, received $10 billion in cash, an annual yearly dividend of $600 million and 17.5% stock in the new company for their $20 billion in claims.

The problem for Congress is that investors tend to have long memories when they get burned. If GM faces financial pressures in the future, securing private funds will be difficult because the government has shown that respecting the rights of investors is optional. If GM hits a rough patch, they're only call is to the bank of Uncle Sam.

All of these factors mean that taxpayers need GM to get healthy quick.

Already the company has helped itself by finding buyers for its Hummer, Saab and Saturn product lines while Pontiac will be phased out. That leaves a slimmed down GM to emerge from bankruptcy with four brands to concentrate on marketing: Chevy, Buick, GMC and Cadillac.

The parts of the company not emerging from bankruptcy within the "new GM" will become part of "old GM," a collection of assets and liabilities that will be liquidated over the next few years and sold off to pay the company's various creditors including people with pending lawsuits.

And while GM's ability to shed itself of non-producing assets is critical, significant liabilities still exist, including potential environmental costs associated with plant shutdowns to disputes about the liquidation process.

The road back to black for General Motors and U.S. taxpayers will be long and difficult. A successful journey will at least be plausible if the White House and Congress allow the new company management the ability to run the company free from political meddling and the influence of the UAW.