GM & Chrysler With Flu Symptoms

The two top stories in the news today are the Swine Flu and the Auto restructurings. At first blush they sound totally unrelated, but I think the Flu is a good metaphor for the situation that GM (GM) and Chrysler find themselves in.

Every year there is an outbreak of flu, with some years having a much more dangerous strain than others. Most of the time (the recent outbreak in Mexico seems somewhat different in this regard) if you are an otherwise healthy adult, the flu simply means a few days with frequent trips to the bathroom and a bit of a fever. However, for the very young and the elderly, and those with compromised immune systems (such as people with AIDS or on chemotherapy), the flu can be deadly. (If a 75-year-old person gets the flu and dies, what is the cause of death — the flu or did they simply die of old age?)

The credit crisis was like a very nasty outbreak of the flu. Since autos are big-ticket items that almost always require financing for sales to occur, the entire industry was affected. However, Toyota (TM) and Honda (HMC) are spending a lot of time in bed - they, too, have been posting losses. Aside for the current outbreak of flu, however, they are generally healthy.

General Motors and Chrysler were more analogous to a person with a compromised immune system. The most important measure of a company’s “immune system” is its balance sheet. Equity is the equivalent of the white blood cells that allow the company to fight off an infection. They have been gradually losing market share for decades. As such, they have been shrinking their active workforce relative to the number of retirees they have. This has led to built-up debt on the balance sheet.

It also led the companies to need to make the most money possible during the recent strong auto market. This meant tilting the production to the most profitable models at the time - namely full-sized SUV’s and pick-up trucks. It also meant that there was less money available for new product development, particularly for smaller and more fuel-efficient cars. This meant that Detroit was hit with a double whammy (secondary infection) when the price of gasoline skyrocketed last year. The government decided to provide an emergency transfusion of new loans.

The UAW long ago (back when the U.S. firms had a de facto oligopoly controlling the U.S. market) decided to forgo some of their current income in favor of pensions and good health care for its members when they retired. In effect, the workers were lending money to the company (in the broad economic sense of providing money now in return for benefits in the future). However, since those promises were first made, the cost of health care relative to just about everything else has skyrocketed. This has greatly weakened the firms’ financial immune system.

The firms recognized this and tried surgery, in the form of amputating the health care cost into a separately administered trust, the VEBA. The new restructuring plan will turn half of the debt owed to the VEBA and the Government into equity, and as a result together they will own 89% of the company.

Senior bondholders will own most of the remainder of the firm, and the existing shareholders will all be be diluted out of the picture, owning only about 1% of the restructured firm. This should significantly strengthen the firm’s immune system. Current equity holders are not the only ones who will feel the pain, as about one third of the existing UAW workers and one third of the existing plants will be closed.

Pontiac, Saturn, Hummer and SAAB are destined to join Oldsmobile on the scrapheap of history. Absent the debt-for-equity swap, this would have simply exacerbated the problem of a shrinking active work force supporting a growing retiree population. According to the company, after the restructuring it should be profitable in a domestic market of just 10 million units a year. While that is above where the market is now, it is well below the normal size of the market.

While being diluted almost out of existence is not good news for current U.S. shareholders, this restructuring does have the potential to keep GM out of bankruptcy. The net effect is pretty much the same as one might see on the other side of a bankruptcy, but it avoids a long debilitating stay under court supervision. Overall, that is good news for the economy.

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