GM And Ford: To The Junk Yard

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On May 5, 2005, Standard & Poor's Ratings Services lowered its long- and short-term corporate credit ratings on two of the Big Three U.S. auto makers -- General Motors (GM) and Ford Motor (F) -- below investment grade. Long-term ratings on GM, its General Motors Acceptance Corp. unit, and all related entities were lowered to BB from BBB-. Ford, its Ford Motor Credit subsidiaries, and all related entities -- except those of Hertz -- were reduced to BB+ from BBB-. The rating outlook for both Ford and GM is negative.



GM's consolidated debt outstanding totaled $291.8 billion as of Mar. 31, while Ford's totaled $161.3 billion at that date. The ratings on Hertz (BBB-/Watch Dev/A-3) remain on CreditWatch, where they were placed on Apr. 21, following Ford's disclosure that it was evaluating strategic options for the unit, including its potential sale.



The downgrade to noninvestment-grade for both automotive giants reflects our conclusion that management's strategies may be ineffective in addressing the mounting competitive challenges both face. Below is our analysis of the situation the companies face:



GENERAL MOTORS

It shouldn't have any difficulty accommodating near-term cash requirements. The effort by Kirk Kerkorian's Tracinda Corp. to increase its ownership stake in GM represents an additional uncertainty. However, this isn't a factor at all in the current rating action.



Of greatest immediate concern is that GM's sport-utility vehicles will no longer be as profitable as they have been in recent years. GM's financial performance has been heavily dependent on the SUVs' profit contribution. Recently, though, sales of GM's midsize and large SUVs have plummeted. Industrywide demand for these vehicles has evidently stalled, partly because of persistent high gasoline prices.



In addition, competition has intensified from a proliferation of new rival SUVs. GM has suffered from the aging of its SUV product line, which will be replaced by a family of new products during 2006 and 2007 -- when Ford will be doing the same.



POOR BRAND IMAGES. Moreover, competition could also increase in full-size pickups -- GM's only other major source of auto earnings. Although GM will be renewing its pickups in one-and-a-half to two years, Toyota Motor (TM) will introduce a new full-size pickup during this period, for which it's constructing expanded production capacity.



More broadly, GM suffers from a legacy of generally poor brand images. Even with extensive efforts to renew its products, GM continues to lose market share in North America, despite an aggressive pricing strategy over the past four years. At S&P, we believe its reliance on discounts has itself been detrimental to its brand equity. Although we assume some of GM's new products will be successful, we can't assume that overall improvement in GM's relative market position will result, given other carmakers' similar product initiatives.



In addition, it's questionable whether GM's relative competitive standing has improved as a result of extensive cost-cutting in its North American operations. The company has downsized operations through curtailing excess production capacity, but the boost to its efficiency has been undermined by market-share losses. GM has significantly reduced its workforce, but total personnel spending has risen, due in part to the soaring cost of its relatively generous health-insurance benefits. If GM were able to roll back such benefits, this could reduce a significant competitive disadvantage. However, we're skeptical about whether its principal labor union, the United Autoworkers (UAW), will cooperate with this.



MORTGAGE STRENGTH. In aggregate, GM's overseas automotive operations aren't mitigating for the difficulties in North America. GM has been unprofitable in Europe since 1999, and its losses there this year will likely be substantial, even before taking account of costs related to yet another round of restructuring. GM had until recently been highly profitable in China, but it's now suffering from weak demand in that region.



GM continues to derive significant earnings from its automotive sales finance activities, which are conducted through GMAC. (GMAC's financing volume and profitability are artificially bolstered in that automotive finance incentives require consumers to finance vehicle purchases through GMAC. GM then reimburses GMAC for the cost of the incentive.) GMAC has benefited in recent years from low credit losses and improving lease residual realizations. However, as interest rates have risen, GMAC's sales finance earnings have recently weakened markedly from the exceptional levels of 2003 and 2004.



Separately, GMAC's mortgage unit has been able to sustain impressive profitability, even with the decline in residential mortgage industry volume. This unit is benefiting from growing market share in the residential sector, a countercyclical increase in mortgage-servicing income, increased fee-based business, and expansion in overseas markets.



CASH OUTFLOW. GM's overall earnings have recently deteriorated precipitously. The carmaker incurred an alarming $1.1 billion net loss in the first quarter of 2005. We believe profitability could remain poor for the balance of this year, and prospects for a return to adequate profitability in the next few years are becoming increasingly uncertain.



Although GM has substantial cash reserves, its ability to withstand persistent poor financial performance is not unlimited. We now expect consolidated parent-level cash outflow to be in excess of $5 billion this year, taking account of substantially negative automotive operating cash flow, European restructuring costs, payments to Fiat totaling approximately $2 billion, capital spending budgeted at $8 billion, GM's common dividend payout ($1.1 billion in 2004), and $2 billion of dividends to be paid to the parent by GMAC.



Unless the auto operations' cash generating-ability improves, GM's burdensome postretirement benefit obligations could become even more onerous.



Outlook: The rating outlook is negative. GM's financial performance has proven to be volatile and unpredictable. Accelerating deterioration in the North American market mix, intensifying price competition, poor acceptance of GM's future new products, labor strife, and/or a weakening of the general economy could ultimately jeopardize the rating.



FORD

The greatest immediate concern is that Ford's overall SUV business may not be able to generate the profitability it has enjoyed historically. Ford's financial performance has been heavily dependent on SUV earnings. Recently, though, sales of its midsize and large SUVs have tumbled, due to the same conditions that are slowing GM's SUV sales.And Ford, too, has suffered from an aging SUV product line, which will be replaced by a family of new products starting late this year through 2007 -- the same time that GM will launch a similar effort.



In anticipation of the model changeover, Ford has been curtailing production capacity dedicated to these products while launching an array of smaller SUVs and so-called "crossover utility vehicles." Moreover, the same pickup-truck competition that's hitting GM is buffeting Ford as well. We believe pickups are Ford's only other major source of automotive earnings.



Even with extensive efforts to renew its lineup, Ford continues to lose significant market share in North America, particularly when excluding its sales to fleet customers. It has sought to be disciplined in its pricing strategy and selective in its discounting, but Ford cannot sustain market-share losses indefinitely.



REVISITING VISTEON? In addition, it's questionable whether Ford's relative competitive standing has improved as a result of extensive cost-cutting in its North American operations. The company has downsized operations through curtailing excess capacity, but efficiency increases have been undermined by market-share losses.



It has slashed its workforce, but also like GM, total personal costs keep rising, partly because of its relatively generous health-insurance benefits. Rolling back those benefits through negotiations with the UAW would greatly help. However, we're skeptical here, too, that the UAW would cooperate.



Among Ford's other challenges in North America is its relationship with Visteon (VC), Ford's ailing former affiliate and largest supplier. Ford continues to negotiate with Visteon regarding yet another restructuring of the agreements governing the two companies' relationship.



ACHIEVABLE TARGET. Altogether, Ford's other automotive operations aren't mitigating the difficulties it faces in North America. Although sweeping restructurings have recently returned the auto operations in Europe and Latin America to minimal profitability, it's questionable whether these units will contribute meaningfully to earnings in the next few years.



Ford continues to derive significant earnings from its automotive sales finance activities, which are conducted through Ford Credit. (Like GM, Ford Credit's financing volume and profitability are also artificially bolstered.) Ford Credit has benefited from lower credit losses, improved performance on lease residuals, and its still-low average funding cost.



Also, Ford Credit's reported results have benefited to an exaggerated extent from a significant reduction in accruals for credit losses and depreciation related to vehicles under operating leases. Ford Credit is unlikely to be able to sustain earnings at recent record levels. However, we believe management's targeted pretax earnings of more than $3 billion for 2005 (down from $4.4 billion in 2004) should be achievable, and that Ford Credit will be able to earn at least $2.5 billion per year on a sustainable basis.



MEDICAL ILLS. Ford's automotive cash flow (after capital expenditures, and before pension and other benefit contributions and dividends from Ford Credit) has been as mediocre as its earnings, totaling $1 billion in 2004. Although we now assume automotive cash flow will be lower in 2005 than in 2004, Ford Credit is expected to continue generating substantial cash, and dividends to the parent of approximately $1.5 billion to $2 billion a year should be sustainable (compared with $4.3 billion in 2004).



Ford has a large, unfunded pension liability that totaled $12.3 billion at yearend 2004. That figure has remained basically stable for the past year due to the measurement effect of a lower discount rate, despite contributions totaling $2.3 billion made during 2004 and favorable investment portfolio returns.



More troubling, though, is Ford's massive unfunded retiree medical liability --- $32.4 billion at yearend 2004 --- which has continued to grow, even with the benefit of the new Medicare prescription drug program and VEBA contributions of $2.8 billion made during 2004. Without modifications to its health-care benefits, containing growth in its retiree medical liability through prefunding actions could consume the bulk of Ford's surplus cash generated in the foreseeable future.



Outlook: S&P's rating outlook is negative. The rating reflects the assumption that Ford will have difficulty improving its automotive profitability from the roughly breakeven level anticipated for full-year 2005 (before special charges, which we assume will be substantial). However, Ford's financial performance has been extraordinarily volatile and unpredictable.



Accelerating deterioration in the North American market mix, intensifying price competition, poor acceptance of Ford's future new products, labor strife, and/or a weakening of the general economy could ultimately jeopardize the rating.



We assume that, even without an investment-grade rating, Ford Credit will have sufficient funding flexibility to carry on its vital role of providing sales financing support to Ford. Although S&P has decided not to notch down Ford Credit's senior unsecured issue ratings from its corporate credit rating at this juncture, we could do so in the future. We will continue to assess this matter.