Ford and GM on the Chopping Block?

For years now, the demise of the Big 3 has seemed like only a matter of time. None of the companies, Chrystler, Ford or GM, has been profitable for years. On top of that, all 3 have significant debt burdens. As a result, all three have taken a pounding from the credit rating agencies. Of the three, Ford leads the pack with a B credit rating from S&P, while GM and Chrystler hold B- ratings, all firmly in junk territory. Remember, there was a time when GM had a AAA credit rating. So here's the question: could the current credit crisis spell the end for the big 3? In the following rant, I chose to focus solely on GM and Ford, ignoring Chrystler, because it is now privately held and its financial statements are no longer available to the public, but just trust me that the same holds more or less true for them.

Right now, both Ford and GM are literally bankrupt. Both companies' liabilities are greater than their assets, resulting in negative equity. For GM, this has been the case since 2006. Ford only joined the club following their huge 1H loss earlier this year. Both of these companies would have filed for Chapter 11 long ago if they were not considered to be so vital to the American economy. As far as I can tell, creditors are only willing to lend them money, based on the perception that the US government will be forced to intervene. In 2007 GM and Ford generated $182 Billion and $172 Billion in revenues, respectively, placing them in the 3rd and 7th places in the Fortune 500, respectively. Additionally, Ford employess about 87,700 people, whereas GM employees a whopping 266,000. These are truely huge companies. Additionally, for every direct job created, approximately 6 indirect jobs are created. Therefore if these companies were to simply close their doors tomorrow (Not going to happen, but I will get to that later), it could result in a loss of approximately 2.1 Million jobs.

Why are Ford and GM in such bad shape? Well, for starters, they have been losing money for years, but that is actually not the most serious. As I stated above, both Ford and GM are actually bankrupt. Looking at the companies' most recent balance sheets, both of them have negative equity. Ford's deficit stands at -$1.7 Billion. This means, that Ford owes 1.7 Billion more dollars than the total worth of the firm's assets. GM's equity deficit amounts to a gragantuan -$57 Billion. There is no way in hell they can dig themselves out of this hole. To get back in the black, GM would have to make $19 Billion a year, a 14% ROA, with capital expenditures never exceding depreciation and no dividends paid. Mind you, the company has lost $39 Billion, $2 Billion and $10 Billion in 2007, 2006 and 2005, respectively, and they are well on their way to another record loss this year, already posting a $15.5 Billion loss in the first half of 2008, with an 18% drop in revenue.

The worsening economy is going to pose two distinct problems for GM and Ford: greater losses and a more difficult time refinancing. As everyone knows by now, during the height of the age of gluttony, Americans were buying bigger and bigger cars, trying to keep up with the Joneses, as the bigger the car, the more powerful the status symbol. Naturally, Ford and GM shifted their production lines to fill the SUV niche. However, as oil prices have risen and the economy has tanked, Americans have shunned their hummers, excursions and suburbans. Naturally, it takes time and money to retool an assembly line and introduce new vehicles, two things GM and Ford are short on. As a result, both companies are stuck with a vehicle fleet that few want to buy. The rise in oil prices has already reaked havoc on Ford's and GM's income statements, now they are going to have to contend with a massive economic slowdown, consumer defaults and a lack of banks willing to give out auto loans. Ford also has about $106 Billion in consumer loans to auto owners - through their financial subsidiary - on their books. It'll be interesting to see what happens when those start going up in smoke.

Despite the fact that both Ford and GM will likely take enormous losses over the next few years, as long as they have a steady supply of credit, they will be in business. Ford is already so desperate for loans needed to keep going that they have pledged their logo as collterall. Nevertheless, the recent credit crisis has spooked investors, who have been shying away from just about everything except for government bonds. The TED Spread, the difference between 3-Month US Treasuries and 3-Month Libor (London Interbank Offering Rate), an average of at what percent the biggest American and European Banks, all firmly in investment grade territory, are willing to lend to each other, stood at 3.31%. If A/AA-rated banks are only willing to lend to each other at 3.31% more than treasuries, how willing are they to lend to bankrupt B/B- rated companies? For the sake of accuracy, that is an extremely large TED spread, and may only be temporary, as the short term credit market could signficantly unlock if the bailout gets passed.

Interestingly enough, while Ford's balance sheet is divided between two sections, Ford Automotive and Ford Financial, seemingly independent subisidaries of the same parent company. Of Ford's $166 Billion in debt about $140 Billion is on Ford Financial's books, while the remaining $26 Billion lies with Ford Automotive. More about the implications of this later, Now on to the interesting part. On Ford's consolidated Balance Sheet, there is seperation between short-term debt and current portion of long term debt and plain old long term debt. Analysts often like to have these things seperated out, so they can evaluate things like working capital and a number of credit ratios relating to short term debt (Debt Service Coverage Ratio, Short term debt/EBITDA, etc.). Why did Ford leave it out? A quick look on Yahoo finance reveals that Ford has quite a few bond issues coming to maturity in the coming year. Additionally, in their 2007 annual report, Ford had $41.1 Billion in debt coming to maturity and needing to be refinanced in 2008, $40.2 Billion from Ford Finance and $920 Million from Ford Auto. I somehow doubt that over the course of this year, Ford completely and radically restructured their debt, and that there is no debt coming to maturity, especially given the fact that according to Yahoo finance there is quite a bit. Why wouldn't Ford want its investors to know that it has a significant portion of its debt load coming up for refinancing when it is in effect bankrupt, stuck with a junk rating in the midst of the worst financial crisis since 1929?

GM is at least slightly more transparent, the company has a total of $40.5 Billion in debt outstanding, of which $8 Billion is short term, not all that different from Ford without its finance unit. This is largely due to the fact that they sold off 51% of their finance arm, GMAC, to a private equity fund in 2006. Nevertheless, it doesn't change the fact that they are going have trouble refinancing the debt.

Both Ford and GM are trying to resist bankruptcy filings by keeping mountains of cash on hand, in case their credit lines get pulled and they can't refinance their loans. At the end of 2Q, GM had $19.4 Billion on hand, while Ford had $30 Billion. This may work in the short term, but in the long term their losses will eventually deplete their cash stockpiles.

So what is going to happen to these two giants of the automotive industry? For GM the case is more clear cut. The company will likely file for Chapter 11 Bankruptcy Protection sometime in 2009. The company will likely sell off some brands, discontinue other unprofitable brands and renegotiate some of it's other liabilities, leaving bondholders more or less whole. All told, GM has $192 Billion of liabilities on $136 Billion worth of assets, however only about 21% of their liabilities are debt. The rest of the company's liabilities stem from things like the company's retirement plan, deffered taxes and accounts payable. In fact, if the company were to eliminate it's pension plan and other post-retirement benefits, it would once again be solvent.

Ford's case is a bit more tricky, given the division of their business lines. Ford Finance was actually solvent at the end of 2Q 2008, although it had about a 15-to-1 assets to equity ratio. This is likely to decrease in the coming months as consumer defaults increase. If 10% of the company's $110 Billion auto loan book were to default, the company would become insolvent. Additionally, unlike repossessed houses, repossessed cars have very little salvage value. Like GM, Ford could spin off Ford Financial to try and plug the $11 Billion hole in their balance sheet. However, financial services companies are not exactly in vogue right now and it is unlikely that Ford Financial would be able to fetch much on the market today, especially given Ford Financials's 1H $2 Billion loss. Alternatively, Ford could try to load up Ford Financial with some of Ford Automotive's liabilities and sink Ford Financial into Chapter 11, while Ford Automotive would remain a going concern. However, I am sure the investment bankers, who arranged Ford Financial's debt offerings wrote restrictive covenants into the bonds against such activity. Therefore, in the next year, Chapter 11, brand sales, brand discontinuations, liability renegotiation and possibly the sale of Ford Financial probably await Ford as well.