EVT #5: Why smart investors are watching GM

General Motors' Chapter 11 bankruptcy is a classic turnaround case which could deliver us some seriously good returns.

Welcome back.

As you'll no doubt have read, US car giant General Motors filed for Chapter 11 bankruptcy a couple of weeks ago, and is expected to reorganize itself into a viable company in the next 12 months.

I think this story is worth following very closely. Because, although it may not look it right now, this is a classic turnaround case which could deliver us some seriously good returns.

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GM was a viable company, which was brought down largely by unionised labour and high legacy costs (in the form of healthcare and pensions for retired workers). But all of these issues should be resolved in this restructuring, and once the whole process is over the company should be able to become profitable again.

If you think I'm mad to even suggest this idea, then take a look at this graph.


This is the chart for Fiat (Italy: F). That particular car company nearly went bankrupt in 2004. But as you can see for yourself, once the restructuring started to work, the share price rose from €4.5 to €24 in two and a half years, giving a gain of roughly 550% over that period.

The story so far

Last Monday, GM filed for Chapter 11 after failing to come up with a viable reorganization plan, a condition of the bailout from the US government. The group had $184bn in liabilities. Of this, $27bn was in unsecured debt (bonds). Much of these obligations are legacy costs, relating to healthcare costs and retirement benefits, arising from the days when GM was a much bigger company in terms of staff.

It's been estimated that these costs added $2-$3,000 to the cost of each car produced by GM. This is a cost that rivals did not have to bear, as they were using factories in the US built with state subsidies and were using non-unionised labor. So it's perhaps little surprise that GM's share of the North American market has fallen to just 20%, after hitting 50% in the 1960s.

The recession dealt the final blow to GM, as the size of the North American car market plunged from 17 million cars a year, to below 10 million, as consumers were cut off from the credit most need to finance the purchase of a new vehicle.

However, there is hope. In the last few years GM's cars have started to climb the ranks of the customer satisfaction surveys, suggesting that the most fundamental issue dogging the company - poor product quality - was being resolved. That's good news, because Chapter 11 can help cure its other problems, as we'll see in a moment.

The plan

The restructuring plan involves GM selling all of its assets to a new entity, a government-sponsored company. GM will be then be split into two parts. There will be a "good" GM, with all the viable parts that are expected to form the core of the new profitable GM; and then there's the "bad" GM, where the rest will be placed and gradually wound down over time. The group is expected to emerge from Chapter 11 in two to three months' time as a private company and is expected to be relisted 12 to 18 months later.

In the course of the restructuring, debt will be brought down to $17bn. Ordinary shareholders will be wiped out. Bondholders are expected to be left with 10% of the new company. A further 15% will be issued in the form of warrants with various strike prices and maturity dates.

The rest will be owned by the US government (60.8%), the Canadian government (11.7%) and the Voluntary Employers Benefit Association (VEBA) on 17.5%. This is an entity created by the UAW united auto workers the main union. The US government is expected to offload its stakes once the restructuring is over (although no time frame has been given).

The restructuring process will hopefully deal with all the problems that have hurt GM's competitiveness - for example, labour costs are expected to fall to similar levels to other competitors. And importantly, the new GM is expected to break even with a 20% share of a North American car market totaling 10m units a year, so the fall in capacity is accounted for.

The opportunity

The opportunity lies in the fact that car companies (like airlines) have incredibly high operational gearing. In other words, their costs are pretty rigid. That's bad news in hard times, but it does mean that once break-even point is reached, any revenue on top is almost all pure profit.

As we've already noted, the new GM aims to be profitable with a 20% share of a North American market selling just 10m units a year. But that level was only reached in the past year, at a time when the economy was under a lot of stress. A more normal level for the market based on potential replacements and more normal' economic conditions is around 13-14m units a year.

So when GM emerges from Chapter 11 it should be a profitable company. I also think that people have overlooked the fact that GM owns some valuable foreign assets. The company is number three in the Brazilian market (a market that is keeping Fiat afloat in these difficult times) and is number two in China. To put that into perspective, GM's turnover in North America last year was $86bn. Brazil and Latin America chipped in $20 bn and China a further $18bn so those aren't insignificant markets by any means. In China, GM had already sold 680,000 cars in the first five months of 2009, and plans to sell two million cars in the next few years.

So the main problem for GM is very much North America once that is resolved, the rest of the group could prove very profitable.

The maths

At the moment you can only get exposure to the new GM by buying the defaulted bonds from the old GM, which are trading at around 12 to the par (12% of face value). These bonds will convert to a 10% stake in the company, plus warrants which will turn into another 15% at a price yet to be announced.

There's around $27bn of debt trading at 12% of face value. This will be converted into 10% of the new GM (plus warrant). So at these prices, the new GM has an implied market cap of $33bn (excluding warrants the strike price will determine how much these are worth and so at the moment are an unknown quantity) and an enterprise value of $50bn.

The main question is how much will the new GM actually be worth? This depends mainly on what the restructuring process achieves. Costs will be surely brought down but the reduction of the main legacy costs will depend on the willingness of the UAW union to make further concessions.

Of course, it will also depend on the car market. If the economy recovers and credit becomes more widely available, then expect to see the pent-up demand that has built over the last year (from people who wanted new cars but couldn't get any credit) to boost the car registration figures. This would have obvious positive repercussions on a GM that can break even with a total North American market of 10m vehicles a year.

If everything goes OK the new GM should be able to generate a lot of free cash flow. $1bn or $2bn per quarter (similar to what they were making five years ago) could be achievable, and so could support a valuation that is higher than the one currently implied by the bonds.

The strategy

My advice is this. If bond prices fall some more and go to 5% to 7% of par or roughly where they were trading 2-3 weeks ago (currently they are trading at 12% of face value) then it's worth buying some and waiting for the conversion into new stock. This could take a year. Remember that defaulted bonds do not pay interest.

With bonds trading at 5-7% of face value the implied market cap would be around $13-$17bn and you could have significant upside (remember I am excluding the warrants) once GM is relisted.

Otherwise follow the process very closely and see what kind of progress is made, then wait for the company to be relisted and get into the shares and warrants. I would love to be more specific and give out more precise figures, but so far the details of the plan are sketchy, and there are several variables that could affect the outcome of this strategy.

The bottom line

The bottom line is very simple. Once Chapter 11 is over, GM should come out lean and mean - hopefully leaner and meaner than its rivals. The break even point achieved with a market share of 20% in a North American market of 10m units gives great leverage if the company is able to capture a few more percentage points in market share, or if the market recovers to a more normal level of 13-14m units. Meanwhile, foreign subsidiaries have been almost forgotten but they can contribute significantly to earnings.

GM was not brought down because nobody wanted its cars, but because the prices of its cars were uncompetitive due to high costs. But car companies have high operational gearing, so once fixed costs are paid and break even is achieved the rest is almost pure profit. If GM's share price does anywhere near as well as Fiat's has after restructuring in 2004, you might even make enough money to buy a brand new car yourself!

I have deliberately omitted giving a target price and discussing the risks involved in this trading idea this week. Quite clearly the risk / reward profile is quite high (so you could end up losing 50% or making 150%, say) and too many things can still happen. So this is one to watch for now - I will revisit this situation once we have more information such as the strike price of the warrants, and we will discuss the risks once we have a clearer picture of the possible outcomes.

A worrying development

Onto something completely different. Last Tuesday, a government bond auction in Latvia failed (ie they did not manage to sell all the government bonds in issue). This pushed the Latvian currency, the lat, close to the lower end of its trading range against the euro (it's pegged to the European currency).

You might be thinking "Who cares?" Well, here's why you should.

Until 2007, this small Baltic state was in the midst of a huge bubble fueled by cheap credit provided in foreign currency by Swedish banks. Its economy was growing by more than 6% a year.

But now Latvia's GDP is shrinking at a rate of 18% a year. This news increases the likelihood that the peg against the euro will have to be abandoned and the currency will have to be devalued. If this happens, it will trigger a chain of negative consequences.

The first is that Latvians who took out loans in foreign currency (and most did) will find that their debt has risen massively. This will push up the default rate.

The second consequence is that the banks who lent to Latvia might have to write down assets held in lats (as they could be worth considerably less). As a result of these losses, their capital might be wiped out leading to the risk of more banks going bust. Swedish banks are the most exposed with 60% of the loans, while the other 40% has been loaned by other foreign lenders.

The third and most important consequence is that this could trigger a domino effect, forcing eastern European countries from Estonia to Hungary to Bulgaria to follow suit.

Just think of 1991 when the pound followed the Italian lira out of the Exchange Rate Mechanism. Or 1997 when the Thai baht was devalued and half a dozen South Eastern tigers followed suit, triggering the 1997 meltdown.

Needless to say, this could end the rally that started three months ago on hopes that the recession could be over. Also remember that markets are still not very liquid and this could make any downward move worse.

As the lat is almost impossible to trade I would advise to reduce any exposure you have to Swedish krona (which I doubt will be significant for most of you anyway!) In the mean time, I am exploring ways to take short positions on eastern European equities, which I'll report back on if things get any worse.

Of course, government bond auctions have already failed in Germany and the UK this year without any significant damage. But what set this apart is that Latvia is an emerging market with shallow capital markets and a bubble economy surrounded by similar economies.

As mentioned look out for the special trial and discounted offer for the Events Trader newsletter and I'd appreciete any feedback you have on the first five issues. As usual I am at your disposal, should you wish to contact me at my e-mail eventstrader@f-s-p.co.uk.

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