GM Earnings Annoucement Knocks $2.9 Billion from Market Cap

Two weeks ago, the Ross School of Business community heard Dr. Dieter Zetsche, President and CEO of the Chrysler Group, discuss the evolution of the auto industry and how DaimlerChrysler is coping with the change. From last week's revised earnings outlook, it appears that the General Motors Company is not coping with the change as well as some of its competitors. On March 16, 2005, GM shocked the investing community by slashing its earnings forecast. Prior to last Wednesday's announcement, GM predicted fiscal year 2005 sales would produce $4.00 to $5.00 per share. The announcement reduced the company's estimate to $1.00 to $2.00 per share, which in the best case scenario is a 50 percent reduction. Furthermore, GM reduced its operating cash flow projections by $4 billion to negative $2 billion, and that is before charges for the Fiat settlement and European restructuring.

Investors reacted swiftly, knocking $5.10, or 15.1 percent, from the share price by end-of-day trading on Friday. With 565.1 million shares outstanding, the drop equals a $2.88 billion loss from the company's market capitalization. As industry observers may know, GM has struggled with several problems over the past few years.



Healthcare and Pension Costs

According to the Financial Times, GM spent approximately $5.9 billion on healthcare costs last year, which translates to about $1,400 for every car produced for the U.S. market. Additionally, pension obligations contributed another $800 per car in 2004, which means that last year GM operated with $2,200 of fixed costs unrelated to its property, plant, and equipment.



Fat Inventories

By the end of February of this year, GM held inventories of more than 100 days, which is about 40 days more than its normal levels, according to a Wall Street Journal article. Inventory holdings are a particularly important data point in the auto industry because of the glut of supply in the industry, obsolescence due to model year roll-over, and its impact on incentives. Inventories are also a leading indicator of overall market share, which has declined in North America each of the past three years from 27.9 percent in 2002 to 26.7 percent in 2004, according to GM's 2004 10K report.



Lack of Model Turnover and Adoption

According to a Merrill Lynch report, GM has only replaced about 75 percent of its models since 1999, while Ford and Chrysler have replaced 85 and 91 percent respectively, and Japanese manufacturers have, on average, replaced 113 percent. And the new models that GM has released have not received a warm welcome. Most notably, the Pontiac G6 has faulted from the starting line. A Financial Times article cites the Automotive Lease Guide to explain the possible slow start, which predicts that after three years the G6 will retain only 38 percent of its value. By comparison, models from Japanese manufacturers are in the low 50s. Furthermore, the Financial Times article also claims that 10 percent of G6s are being sold to car rental companies at significant discounts, which means the company is dumping inventory.



Hefty Incentives

Another major factor in GM's lack of profitability is an aggressive discounting policy, which it launched after the September 11 attacks in 2001, but has been unable to shed since then. According to Autodata, a New Jersey consulting firm, GM increased its average discount by $474 last year bringing the total to $4,214 per vehicle. The company is therefore giving up $4,200 per vehicle off the top line and is incurring an additional $2,200 in fixed costs per vehicle. While most domestic competitors have followed suit, foreign competitors have used discount tactics much less.

While some of these problems may be new to the casual observer, the industry press has been aware of these issues for quite some time. This begs the question: if Wall Street has known about these issues for quite some time, why did GM take such a big hit when it announced its earnings downgrade, which could arguably have been expected?

It appears that investors see the announcement as a serious threat to both GM's $1 billion dividend payout and its financing arm, which generated $2.9 billion in net income in 2004. The threat to the financing arm stems from GM's current credit ratings, which hover just above junk status with negative outlooks from both Moody's and S&P. As the third largest corporate bond issuer in the U.S., a major downgrade to GM's credit rating could send the debt markets into a stir and limit GM's ability to source funds for its financing arm. As such, some investors have gone on record as saying that they expect GM to sacrifice its dividend payout to escape a major downgrade, but with this new earnings outlook, it may be too late to prevent such a downgrade.