The Tragedy of General Motors

The Detroit giant is a weird, scarred combination: a carmaker doing poorly, and an insurance company engulfed by its obligations. It's heading for a wreck -- which is why CEO Rick Wagoner has the toughest job in business.

By Carol Loomis

March 10, 2006

[Continued, page 2]

In all that GM is doing, there is a bleak awareness that no companies have ever turned around because of cost cutting alone. The essential partner is revenue growth--and as those losses in market share show, that has been the crucible for GM. In product design, it lost the magic long ago. "They need irresistibility and head-turners," says one car buff, "and they haven't had them." The man now on that case is product-development boss Bob Lutz, 74, who, after retiring from Chrysler, was hired by Wagoner in 2001. Tall, elegantly dressed, and outspoken, he is treated like a rock star at auto shows, often attracting more attention than his cars. At the Detroit show in January, touring GM's space with reporters, he was pleased to point out classy-looking car interiors--"some of GM's used to be grotesque," he said--and a level of fit and finishes that he judged superb. A reporter needled him: "Bob, I miss those bad fits, those gaps, that you had a while back. I used to store my quarters for tolls in those."

Lutz--and all at GM--are plainly battling the past, when many buyers gave up on its vehicles and turned to foreign cars. Today, GM has an enormous perception problem: a belief by too many U.S. consumers--particularly in the East, West, and some of the South, which pretty much leaves GM hugging the Midwest--that it doesn't make cars as reliable as those of foreign producers. That was indisputably true once. The current evidence, though, is mixed: Consumer Reports, a bible for many carbuyers, rates GM's improvements as "inconsistent" and ranks most of its cars as also-rans; J.D. Power, however, a leading arbiter of quality, gives many of its cars top grades. Meanwhile, GM people haul out comparison charts showing, for example, that a Chevrolet Malibu outdoes Toyota's Camry in just about every performance rating going, yet costs $2,640 less. Customers shrug their shoulders and keep on buying Camrys--their memories are long, and their motivation for returning to GM small.

The gist of GM's sales problem is summed up by Don Freda, a suburban New Yorker who has run an independent auto-repair shop for 52 years. What, he is asked, do you think about the quality of GM's cars these days? "They're very good," he answers. "They don't break like they used to." Then, immediately, "But nobody will buy them."

So it's no surprise that GM has been the impresario of incentives since 2001, when it immediately followed up 9/11 by launching the incentive program called Keep America Rolling. After that, the come-ons never ceased, so buyers quickly realized it would be idiotic to pay anything close to MSRP (manufacturer's suggested retail price). Last spring, when Wagoner personally took over the running of the North American business, he said that GM would reduce the use of incentives. But that pullback wasn't immediate: GM needed revenues in 2005, no matter their quality, and it kept on dishing the incentives out.

It was not until this January that GM officially announced a new pricing program, built on the thought of "selling the product, not the deal." The program cuts the MSRP on most of GM's cars, a change aimed at still giving the buyer an attractive price, but not by way of ballyhooed incentives. The price of a Tahoe SUV, for example, is dropping from a 2005 level of $36,790 to $32,990 (an amount that Wagoner says could still be reduced by ad hoc incentives). A big reason for the change is that about two-thirds of carbuyers these days do comparison shopping on the Internet, where GM feels it must show a "real" price, as opposed to the fictional prices--before incentives--that it was presenting before. As still another part of its new marketing program, GM is planning to cut back on its large-scale sales to rental-car companies, which not only buy at a sharp discount but also quickly flip their vehicles into the resale market and thereby hurt the residual values of GM cars. In all this, it is important to keep remembering that GM desperately needs to at least stabilize its market share and simultaneously to extract profits from what it sells. Whether this plan will do any better than the others now discarded is deeply uncertain.

Acknowledging the risk--"The jury's out," he says--Wagoner nonetheless expresses confidence because he believes there is "inherent goodness" in GM's products that the market will begin to recognize. But he also knows that every car manufacturer has a provincial view of its own prospects: "We're all guilty," he says. "We go through our design studio and go, 'Wow, we've got great products. They're so much better than what we had. This is going to turn things.' What you forget is that the same discussion is going on in every design studio around the world." That doesn't necessarily make you wrong in your expectations, he says. But in the end, it's "a bet." And you don't know--can't know--whether this time it's going to bring in the revenue.

That's a sweat-out matter for GM in 2006. As the year begins, the world is also focused on the company's "liquidity"--its store of ready assets that would allow it to withstand further operating blows, should they materialize. On the balance sheet of its auto business at year-end, GM had $20.5 billion in liquid assets, made up of cash, marketable securities, and short-term assets in a VEBA--a "voluntary employees beneficiary association" that holds money dedicated to the payment of health costs. GM calls this amount of liquidity "strong." But this is a company whose auto operations had a negative cash flow last year of nearly $6 billion. Suppose that repeats this year? Or suppose--Wagoner himself volunteers this--that the price of gas goes to $3 a gallon? Or that industry sales of autos drop by, say, 5%, or there's an outright recession? Besides, GM can't possibly spend itself down to its last dollar. Jerry York figures that GM needs at least $5 billion at any given moment just to operate, and others say the amount might be $10 billion.

Success by GM in selling just over half of its finance subsidiary, GMAC, would help GM's liquidity--though that really wasn't the impetus for putting it on the market. Here are GMAC's finer qualities: It is a well-run company; a good earner, with profits of $2.83 billion in 2005 (before a goodwill write-off of $440 million) on about $22 billion in book value; and a dutiful corporate child that paid $2.5 billion in 2005 dividends to its parent. So why would GM be unloading this treasure? Because GMAC's raw material is money, and--thanks to its scruffy parent--it is losing access to its raw material. The issue here is that GMAC's credit ratings are linked to GM's and therefore have been repeatedly lowered. That means GMAC is no longer welcome--as it devoutly wishes to be--in the commercial-paper market, which is in effect a deep-pocketed bank with good interest rates. So GMAC has been funding itself more expensively, by selling off its loans or borrowing against them.

A sale of, say, 51% of GMAC to a financially strong buyer would presumably raise its ratings and put it right back in the commercial-paper market. As to what the sale might deliver to GM, that's a mystery. A deal has dragged, partly because prospective buyers are leery of the financial consequences should they make a purchase and then see their co-owner, GM, go bankrupt. There's also a downbeat qualification about the money that GM might get: The company carries out intracompany transactions with GMAC that ordinarily leave GM a net debtor. It is very likely that any buyer of GMAC, not wanting to be owed by GM, would insist that those debts be paid off as part of any transaction. That would reduce GM's take.

Moody's has said unequivocally that "the sale proceeds are critical to GM maintaining adequate liquidity." Standard & Poor's wants this deal done too. But it questions just how much GM would benefit. Said S&P's Robert Schulz in January: "GM will be giving up half of an asset that's provided a lot of earnings. At the end of the day, it's hard for us to get excited about that."

Another boost to GM's liquidity could be gained by the company's embracing what Jerry York has labeled "equality of sacrifice"--that is, compensation cuts for most of its non-union constituencies. Such moves, for example, might cut the pay of GM's directors, who include such corporate folk as lead director George Fisher, retired CEO of Kodak, and Stanley O'Neal, CEO of Merrill Lynch. Base pay for a board member annually is $200,000, though each must put $140,000 of that into GM stock--an investment plan that hasn't worked out too well lately. Among the people escaping the entire GM flameout, it should be noted, is A.G. Lafley, CEO of Procter & Gamble, who exited as a director last spring. Given that a GM bankruptcy would no doubt put egg on the face of every board member, Lafley's departure possibly qualifies as Shrewdest Move by a Director in 2005.

York also wants GM's executives to cut their pay. Around headquarters in Detroit, there is muttering about this, since it would be a second blow: No bonuses were paid for 2005. In addition, the executives at the very top have definitely bled with the stock, because they are required by the board to hold multiples of their base salary in GM shares. The requirement for Wagoner works off his 2004 base salary, $2.2 million, and stipulates that he should own seven times that amount in stock, which is $15.4 million. Wagoner may have met that goal at one time; a precise answer about that has disappeared into proxy-statement fog. He for sure was still an optimist in March 2005, when he paid $1.5 million to buy 50,000 GM shares at about $30. Today, though, with the stock down closer to $20, he is way shy of the $15.4 million target.

What York sees as truly essential is a 50% cut in the dividend--pain for every shareholder, including himself and Kerkorian. Such a move may be symbolically important. It is not, though, an economic panacea. The dividend is only $1.1 billion annually--against a GM market value, in early February, of about $13 billion. Totally eliminating the dividend would, for example, not even cover one-fifth of GM's annual spending for health care (about $5.7 billion last year). There is another, quite unintuitive, point to be made about the dividend: With bankruptcy certainly a possibility, you could make a case that GM's directors might be doing their dead-level best for the shareholders by continuing to pay the dividend. That is, in a bankruptcy the shareholders are apt to reap nothing; for now, the dividend is something. A corollary to that thought is that any unsecured creditor of GM's who thinks bankruptcy will come should logically be protesting every penny paid to the shareholders, since any outflow of cash is money the bankruptcy estate won't be getting.

For GM, the problem of whether to cut the dividend is huge--in scale, way beyond the $1.1 billion. Were a reduction to be made, there would surely be national, and even global, headlines. That would agitate buyers who are already nervous about GM's viability--who worry, for example, about the company's ability to make good on its warranties. That's an unnecessary worry, but it still exists. It is probably not an overstatement to say that cutting the dividend would be a public relations disaster. On the other hand, not cutting the dividend gives the finger to the UAW, which has already agreed to a "giveback" of health-care benefits and from which GM needs many more concessions. "Why," the UAW is asking, "are we making sacrifices when the shareholders aren't?"

The GM board was scheduled to meet shortly after this issue went to press, and the betting here is that the dividend will be cut. That's because in these intense times, and in anticipation of a contract up for renewal in September 2007, GM desperately needs decent relations with the UAW. Keeping peace with the union right now almost has to outweigh a public relations problem.

The truth is that GM is essentially indentured to the UAW because of the union's power to strike. To that sign of bondage, add another: GM's hourly and salaried employees, present and past, essentially own this company, a fact we will prove by describing some bank accounts. At the end of 2004, the latest date for which figures are available, GM's pension funds (both inside the U.S. and out) had $100 billion in assets--which is wealth belonging to GM's employees, retirees, and dependents. To that you can add $19 billion that GM has put in a dedicated account for retiree health benefits. That makes $119 billion that GM has banked for its employees. In contrast, the shareholders of GM recently owned their grubby $13 billion in market value. That is a bizarre, Alice-in-Autoland result from 98 years in which capitalism supposedly reigned.

The union's leverage over GM affects everything that the company tries to do in cost cutting. The burning example is retiree health benefits, surely a competitive cost disadvantage if there ever was one. At various Berkshire Hathaway meetings, chairman Warren Buffett has envisioned what GM would do if it had contracted many years ago to buy steel at a premium price and had arrived at 2005 needing to get that cost back in line. "It would simply get out of the contract," Buffett has said. GM's retiree health benefits, arrayed against the benefits that the Japanese companies don't provide, are like paying extra for steel. But the odds against GM's breaking this contract are monumental.

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