Wednesday, June 03, 2009

The Nationalization of General Motors

The bankruptcy of General Motors is the tangible result of the capitalist free-enterprise system functioning exactly as it should.  This did not come about because of a slowdown in automobile sales as part of the “Great Recession”; that is just the straw that broke the camel’s back.  It came about because of the long-term destruction of capital investment in this company, both debt and equity, that was provided by investors throughout its history.  GM (as well as Chrysler) has destroyed so much capital that private investment capital is no longer available, thereby necessitating an unprecedented government nationalization of the company, outside of the capitalist system, to save thousands of jobs.

The value of capital is destroyed when a company in which it is invested does not generate an internal rate of return on invested capital (ROIC) to cover the capital’s cost (This is simply net operating profits after tax divided by the total capital invested in the company).  Conversely, when a company generates an ROIC that exceeds its cost of capital, then value is created.  This is called economic value added, or EVA, and is one of the primary considerations in our investment analysis.

The weighted average cost of debt and equity capital (WACC) deployed in the automobile industry has historically been about 10 percent, and no company in the auto industry has consistently generated ROIC that even came close to meeting that cost.  GM’s return on capital (when they had any at all) hovered around 4-5%, so they have always been capital value destroyers.  Ultimately, when capital destruction reaches a crescendo, as it has in the vast losses posted by GM in the last several years, all capital is finally destroyed.  And that’s what just happened.  If anyone has any doubts about the cost of equity capital (some naively believe it has no cost) ask the “former” shareholders of GM what it just cost them.  This, of course, is equally true of Chrysler, whose most recent shareholders, Cerberus and Daimler, have been wiped out over the last several years.

More than three years ago I posted a blog entitled “Generous Motors”, calling for the bankruptcy of GM.  Here is an excerpt:

 I am often asked if I believe GM can avoid bankruptcy. My answer is always: “They shouldn’t”. In my view, Chapter 11 is the only way to save GM from themselves and the union. Like the airlines, management in bankruptcy can eliminate ponderous salary and benefit provisions (and the jobs bank!) once and for all. Also, it presents a once in a lifetime opportunity to bring fresh management thinking to an industry that has always been run by people who grew up in the business; usually in the same company…. People in Detroit really don’t get it about product, and that isn’t something new. So, if the bankruptcy court is wise, they will cede management of a bankrupt GM to outside professionals, who could care less about “how we have always done it around here”. Also, that ultimate old boys club, the dealer network, needs to be changed drastically, but no one in Detroit has ever been strong enough to tackle it…. In the world of the internet, cars should not be sold from vast inventories held by dealers and floor-planned by captive auto finance companies. This is a huge misuse of capital, but very convenient for keeping assembly lines cranking when cars aren’t selling. Cars should be ordered on-line and delivered “just-in-time”, and dealers should be delivery and servicing agents; obviously very different from today and probably only achievable “in extremis” of bankruptcy. By the way, I’m waiting for the Japanese to figure this one out…. Frankly, I have very little hope that much of this is going to happen. I’m pessimistic about Detroit and I do not believe the U.S. auto industry is too big to fail. However, we have no way of knowing when the band-aids will fall off.

If you would like to read the rest of this posting, click on 2006 in the box at the right and scroll down to March 31, 2006.

Unfortunately, the “band-aids” have really fallen off now and I don’t like what I’m seeing.  Things have gotten a lot worse in the last three years than I had imagined.  The usual means of providing financing in a Chapter 11 bankruptcy filing is called “Debtor in Possession” (DIP), which is usually provided by the nation’s largest banks, secured by the restructuring assets of the bankrupt company.  This is how the steel and airline bankruptcies were done in the last several years, with the DIP loans being paid off as the companies emerged from bankruptcy.  However, with the nation’s banks themselves in-extremis and being propped up by the Federal Reserve, they are not candidates to loan GM $50 billion plus in DIP financing, especially since there is no probability of GM paying off these loans anytime in the near future.  So, with the $20 billion already lent by the federal government it would be natural for them to become the lender of last resort for DIP financing.  That, along with guaranteeing warranties, would seem to be the right solution, but that isn’t what’s happening.  The U.S. government is nationalizing GM by taking a 60% ownership/equity position, while Canada will own 12.5%.  This is the exact opposite of what the government did with the banks, because the concept of nationalization is anathema in a capitalist system.  And, as I see it, there is no reasonable probability of the government being taken out by private capital for a very long time to come.  Remember that vast amounts of private debt and equity capital have just been lost by GM investors and no reasonable capitalist is likely to make an equity investment until they can see an ROIC which would meet their opportunity cost.  Since that has never happened in the auto industry, why would anyone believe it will happen anytime soon?  We will no doubt hear about the new GM becoming profitable.  But when will it become profitable enough to provide the ROIC necessary to attract private capital?  Not soon in my opinion, so only taxpayer capital, which has little or no return expectation, will remain.

As the talking heads keep repeating, the “new” GM will emerge from bankruptcy very quickly. And why shouldn’t they?  They are now majority-owned by the U.S. and Canadian governments.  This is historic, because for the first time in our free-enterprise, capitalist system, government is taking ownership of the means of production, primarily to save the jobs of thousands of Americans.  It would be different if private capital was waiting in the wings but it isn’t, for all the reasons mentioned above.  So what we now have is not free enterprise capitalism; it is benign socialism and a giant WPA-like jobs program necessitated by the failure of the automotive industry to provide the investment returns necessary for capital investment to flow.

David Brooks of the New York Times described the effects of government control of GM in a June 1, 2009, op-ed entitled “Quagmire Ahead”:

“The end result is that G.M. will not become more like successful car companies. It will become less like them. The federal merger will not accelerate the company’s viability. It will impede it. We’ve seen this before, albeit in different context: An overconfident government throws itself into a dysfunctional culture it doesn’t really understand. The result is quagmire. The costs escalate. There is no exit strategy.”


To read the rest of David Brooks’ op-ed click here:

The emergence of Chrysler from bankruptcy is potentially even worse, since Fiat, its new minority owner whose own track record is very shaky, is making no financial investment for 20-35% of the company, the UAW gets 55% for its health-care trust, and the federal government is providing all the DIP capital to save the jobs.  This is socialism thinly masquerading as capitalism and, in my opinion, only delays the ultimate Chapter 7 bankruptcy liquidation of Chrysler, which ultimately makes it worse for Detroit and those whose jobs are temporarily saved.

Unfortunately, this is just one of the major problems facing our economic system and we are likely to remain in potentially dangerous financial waters for years to come.  For our part, we continue to focus wholly on equity and fixed income investments in EVA producing companies, which are very unlike the auto industry.  This has always been our investment strategy and we believe it is more important today than ever before.

Let us know what you think.

Jack Falker

June 3, 2009

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