David Einhorn of Greenlight Capital recently proposed that General Motors (NYSE:GM) divide its common equity into two parts, one that pays a dividend and another that captures the appreciation potential of the automaker. This is a demonstrably bad idea from one of the smarter people on Wall Street, thus we ask: What Is David’s game?
Einhorn, in case you’ve been trapped in cryofreeze over the past few years, is one of the more accomplished managers on Wall Street and is also a world-class poker player. Thus when he emerged from his bunker to put forward an idea that seems to be complete nonsense, we ask: why? What is the agenda of one of Wall Street’s smarties?
First and foremost, the idea of somehow bifurcating the equity component of a large automaker makes no sense at all. As we outline in “Ford Men: From Inspiration to Enterprise,” attempts to shed or divide the capital intensive portions of the business and/or cash flows of automakers have usually ended badly. Randal Forsyth gives a pretty thorough review of the past bad ideas in Barron’s this week, “What’s Good for Einhorn Isn’t Good for GM or U.S.”
But the more basic issue that Einhorn seems to ignore – we know he understands it – is that in the world of autos today’s excess cash flows are tomorrow’s operating losses. You cannot look at an automaker on an annual or even multi-year basis and make broad assumptions about future earnings and cash flow. Simply stated, those “excess” cash flows represent savings for future periods of sales drought and outright privation.
The auto manufacturers are hideously cyclical. When capacity utilization dips below 60-70%, they loose money and start to hemorrhage cash. Does anyone remember the spin-offs of Visteon and Delphi, two sad attempts to shed the “capital intensive” portions of the auto business that ultimately failed.
As we wrote in Ford Men: “Just as GM had separated itself from Delphi, Ford would sell Visteon to the public on the theory that the two remaining companies would will have higher profits and better returns for shareholders.” These new age ideas about dividing the capital intensive and capital light segments of the auto makers ultimately failed when GM and Ford had to support these supposedly separate businesses.
It was only a decade ago that both GM and Ford (NYSE:F) were on the ropes, bleeding cash and looking for alms in Washington. After years of debt induced recovery c/o Janet Yellen and the happy campers on the Federal Open Market Committee, autos look positively solid – except that they are not. Once the irrational exuberance of the subprime auto market cools, the heady estimates regarding auto sales volumes will also revert to the mean.
It is no accident that analysts at Wells Fargo & Co., one of the biggest underwriters of U.S. subprime auto debt, say investors in the bonds are well protected from rising loan losses in the securities, but that it is still a good time to take some risk off the table. The reason is that the residual credit risk in auto sales financing ultimately backs up to the automakers themselves in the form of losses on lease receivables, which account for more than 20 percent of total sales.
As the Yellen Bubble deflates, the appearance of aggregate demand created by extraordinary monetary policy will resolve into the familiar visage of unpayable debt. As UBS analysts Matthew Mish said in a report this week, the U.S. central bank’s quantitative easing and low interest-rate policies have exacerbated wealth inequality in the U.S. by fueling higher asset prices and wealth creation for some, while credit has made up the difference for everyone else.
Years ago, at a Ford annual meeting, we asked Bill Ford if, given a choice, he would put all of the family’s money into the auto market of today. He smiled and said “of course,” the answer you would expect since the Ford family today holds less than 4% of the economics of Ford Motor Co and 40% of the vote. But even with this extraordinary leverage, holding a stake in Ford is a marginal proposition in economic terms.
The global auto industry is comprised of a collection of large enterprises that engage in brutal competition for a fickle retail customer and only ever earn nominal profits on the most expensive units. The reality is that the global automakers like GM and Ford never really make money, even in good times, measured against their true cost of capital, which is well into the teens. So yes, GM and Ford are reporting profits today, but you must assess these results through the cycle to understand whether these business actually make money.
Of note, default rates in prime bank owned auto loans are also starting to rise, an indication that the credit cycle in auto finance is fully mature. We should expect that the credit fueled boom in auto sales volumes is over and those fat cash flows at GM and Ford will eventually disappear. The chart below shows net charge off rates for bank owned auto loans through year end 2016.
So when we assess the proposal of David Einhorn to divide the equity of GM into a debt-like piece that pays a set dividend and an equity component that reflects the appreciation of the firm’s business, we must respectfully disagree. The increase in defaults in below prime auto loans is the early warning of a sales correction in the auto sector. Those cash flows that today so attract Einhorn will eventually fade away and the auto makers will once again be marginal propositions for investors.