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by Eric Englund and Karen De Coster
As punctuated
by General Motors’ second quarter (6/30/08) loss of $15.5
billion, General Motors is a company in financial distress.
In its attempt to survive the current economic milieu, management
has been looking to throw excess weight overboard to keep
the company afloat. GM is trying to ditch its declining Hummer
brand, and it has been rumored that Pontiac and Buick may
be fire-sale material.
[1] The company has been offering massive rebates on
its trucks, along with 72-month, 0% financing in an attempt
to unload its weighty inventory. In spite of this, along with
sagging car sales, [2] a tightening credit market, junk-rated bonds,
a doomed balance sheet, massive production cuts, [3] substantial layoffs, zooming gas prices, and eroding cash flow,
Merrill Lynch analyst John Murphy had maintained a “buy” on
GM with a target of $28 per share.
Let’s
step backwards a bit. On June 25, 2007, Wall Street powerhouse
Morgan Stanley put
out a “buy” recommendation with respect to General Motors’
common stock. Robert Barry, Morgan Stanley’s star analyst,
proclaimed
a 52-week target price of $42 per share. Less than five months
later, on November 7, 2007, Wall Street analysts were stunned
by General Motors’ staggering third-quarter (9/30/07) loss
of $39 billion – one of the largest bookkeeping losses in
history, which was mostly related to the writedown of deferred
tax assets.
Fifty-three
weeks after Morgan Stanley’s buy recommendation, GM’s stock
hit a 54-year
low of $9.98 per share – on July 2, 2008, after Merrill
Lynch’s recommendation had gone from a “buy” to “underperform”
(i.e., sell) on that day. In one sweeping move overnight,
Merrill Lynch analyst John Murphy cut
his target price on GM by a whopping 75%, reducing the
target price from $28 to $7. So how is it that GM suddenly
went from respectability to mediocrity – in one analyst’s
mind – overnight? In fact, why did it take until July 2008
to concede that GM was on life support? Wall Street, belatedly,
is willing to acknowledge the fact that General Motors is
teetering on the verge of bankruptcy.
Accordingly,
key questions come to the forefront. How did any stock analyst,
worth his salt, get blindsided by the aforementioned $38.3
billion writedown of deferred tax assets? Are Wall Street’s
Ivy League-educated MBAs able to comprehend advanced accounting
and finance? Has rigorous security analysis, on Wall Street,
been supplanted by self-serving cheerleading and inane platitudes
with the objective of transferring wealth from the masses
to the Wall Street elites?
As Benjamin
Graham and David L. Dodd so eloquently stated in their classic
1934 book Security
Analysis, “The correct calculation of the asset values
and their relationship to securities or creditors claims depends
on the purposes of the analyst.” Therefore, to answer the
above-posed questions is simple. Wall Street has little to
do with disseminating competent securities analysis and advice
to average “investors,” and has much to do with transferring
wealth from Main Street to Wall Street – and, for the most
powerful Wall Street brokerage houses, doing the bidding of
the government’s Plunge Protection
Team.
For Wall
Street analysts to claim “surprise” at GM’s massive deferred
tax asset writedown, during fiscal year 2007, and to finally
discuss (in mid-2008) General Motors’ financial condition
in terms of a possible bankruptcy, indicate that low-level
fluff is easily passed on to Main Street “investors” under
the guise of serious analysis. At the very least, earnest
auto industry analysts should have been sounding the negative-outlook
alarm after General Motors published its December 31, 2006
annual report – yet Wall Street was shouting “buy, buy, buy.”
One must wonder, again, if any of Wall Street’s analysts are
even capable of reading a financial statement. If the answer
is affirmative, then honest analysts would have drawn the
same conclusion as Eric Englund did in his July 9, 2007 essay.
Here is an excerpt:
To
analyze General Motors’ 12/31/06 FYE financial statement
is to understand that this once great company is likely
heading towards bankruptcy. Here are the gruesome details:
- GM’s
"as stated" net worth is negative $5.4
billion
- By
fully discounting intangible assets, which includes deferred
tax assets, GM’s net worth is arguably negative
$48.5 billion (refer to Note 13 of GM’s 12/31/06 financial
statement)
- GM’s
as stated working capital is negative $3.7 billion
- By
fully discounting current deferred tax assets,
GM’s working capital drops to negative $14 billion
- General
Motors’ total liabilities amount to a staggering $190.4
billion
- GM’s
net loss, in 2006, was nearly $2 billion
With
GM’s September 30, 2007 third-quarter writedown of $38.3 billion
in deferred tax assets, GM’s financial
condition – at fiscal year-end December 31, 2007 – validates
Eric’s above-shown analysis. Accordingly, GM’s 12/31/07 as
stated working capital and net worth positions stood at negative
$10.2 billion and negative $37.1 billion, respectively.
Then, at March 31, 2008 (GM’s most recent filing), the company’s
financials reveal a negative net worth of $41 billion. To
compound this company’s downward spiral, with the latest quarterly
loss of $15.5 billion, GM’s net worth arguably stands at negative
$56.5 billion. These are the financial indices of a company
on the verge of bankruptcy. To put things into perspective,
GM’s market capitalization stands at under $7.5 billion, which
is among the lowest of the 30 firms in the Dow Jones Industrial
Average.
On the
surface, it appears that Graham and Dodd’s invaluable book
Security Analysis is unfamiliar to most securities
analysts. If a financial analyst understood the nature of
a deferred tax asset, and that such an asset is properly deemed
an “intangible” asset, then the course of action to take is
quite elementary. As Graham and Dodd stated, “It is customary
to eliminate intangibles in the computation of the net asset
value, or equity, per share of common stock.”
In the
case of General Motors, a competent analyst would not have
been surprised by the massive writedown of deferred tax assets.
After all, such an analyst would have already fully discounted
the intangibles in order to derive a conservative financial
condition. The fact that General Motors eventually wrote down
these intangible assets merely reflects the financial picture
that a principled financial analyst previously would have
drawn.
The point
here is that GM is so unprofitable that its top-level management
realized they had to come clean and write down the value of
its deferred tax assets because it became completely unpredictable
as to when the company would actually return to making a profit,
and thus use that tax asset against any future tax liability
it incurs. Essentially, GM is uncertain about its ability
to generate profits in the near future, and correspondingly,
its use of its tax shield is in doubt. According to accounting
rules, GM must recognize the impairment of the tax asset,
hence the write-off. This is a huge indicator of management's
pessimism about the coming years. GM, in writing down its
tax assets as it did, made a negative judgment about the uncertainty
of future economic events and their outcome. In view of that,
this is a company heading toward bankruptcy, and executive
management is fully aware of how close they are to being unable
to prolong the dog-and-pony show.
So, just
how savvy are some of Wall Street’s best and brightest analysts?
Nine days before GM’s deferred tax asset writedown bombshell,
UBS upgraded its rating of GM to a “buy.” On September 13,
2007, Citigroup initiated coverage and issued a buy recommendation.
Other Wall Street heavyweights, in 2007, that had weighed
in with “upgraded” opinions of GM included Banc of America
Securities, Goldman
Sachs, J.P. Morgan, Lehman Brothers, and Deutsche Securities.
One must heed Graham and Dodd’s words as to what purpose is
behind a securities analyst’s recommendation. But then again,
Wall Street analysts long ago abandoned their roles of providing
independent expertise, and instead turned to selling their
firm’s investment banking services. Mark Reutter writes:
Stock
analysts have long been fixtures at investment banks that
both broker (that is, sell) stocks and bonds to the public
and underwrite new security issues for companies. With deregulation
of brokerage commissions in 1975, which ended the practice
of fixed-rate minimum commissions, investment banks found
their brokerage business drying up, undercut by Charles
Schwab & Co. and other discount brokerages.
Trading
fees plummeted and analyst reports no longer paid for themselves.
As a result, the role of the analyst shifted from providing
relatively impartial information for brokers and their clients
to boosterish tie-ins with corporate clients, such as using
the research reports to hype a company’s prospects and promoting
initial public offerings (IPOs) on investor "road shows."
So now,
with the two services – investment banking and stock analysis
– conveniently commingled, and thus creating a huge conflict
of interest, a dealmaker’s sales literature is passed off
as serious and useful analysis of the financial markets, leading
Main Street investors – who tend to follow these recommendations
– seriously astray.
Also
ignored by Wall Street analysts was the banking community’s
loss of confidence in General Motors. A strong indicator as
to how nervous GM’s bankers were, pertaining to this automaker’s
viability, emerged when General Motors’ banking syndicate
amended GM’s line of credit on July 20, 2006. This borrowing
facility went from a $5.6 billion unsecured line of credit
down to a $4.6 billion line of credit, of which $4.48 billion
was secured. This 97%-secured bank line had a termination
date of 2011. This arrangement was described as being a "positive
action toward additional financial flexibility."
Positive for whom? This meant that the holders of the new
loans, which were secured by collateral, had priority over
GM’s unsecured bonds. A default on the loans before the bonds
are paid off would mean that bondholders would be left high
and dry. This caused another credit-rating cut to GM’s bonds,
which were already junk. As of March 31, 2008, GM’s borrowing
facility remained substantially the same. Nonetheless, this
still begs the question as to whether or not Wall Street analysts
read 10-Qs anymore?
But the
agony does not end there. Adding to GM’s plentiful wounds,
S&P announced that effective after the close of trading
on July 17, 2008, General Motors would
be dropped from its flagship S&P 100 index. A vital
component of the Index of Leading Indicators, there has been
no comment from S&P as to why the purge occurred. Though
a drop from the S&P is not unique, in an historical sense,
the most important index of large-cap US stocks must not see
an enduring future for General Motors. In addition to that
news, market participants have little confidence in General
Motors. The credit derivatives market has priced in a
75% probability that GM will default on its loans within
the next five years, and a 25% chance that it will default
within one year.
Perhaps
the next buzzword that journalists and Wall Street prophets
of profit will swoon over will be "going concern."
In financial accounting, "going concern" means that
a company must be financially sound enough to continue operating
as a business entity. A company's value, as conveyed by its
balance sheet, must reflect the value of the company in the
long-term (beyond one year). Management has a duty to act
on the principles of going concern when preparing financial
statements. They must assess whether or not there are any
material items that create uncertainty about an entity’s ability
to continue as a going concern for and beyond the foreseeable
future. Material items that bring forth doubt about an entity’s
viability must be disclosed in the financial statements. A
company facing bankruptcy due to financial items that give
rise to material uncertainties is not a going concern. Auditors
who form an opinion on financial statements are not required
to devise and conduct specific audit procedures to validate
the going concern assumption. However, they are required to
evaluate conditions and events that indicate the potential
for going-concern problems.
In 2001,
when 257 publicly-traded companies went bankrupt, a survey
of 202 of these companies revealed that only 48% of them
had audit reports that included the auditor's explanatory
paragraph expressing doubts about the company being a "going
concern." This must be considered a mammoth failure for
the audit-accounting industry as a whole. Considering all
the significant factors driving GM’s financial deterioration,
the buzz on the Internet contains occasional references about
whether or not a “going concern” qualification should
or will be issued to General Motors. Certainly, that
is highly unlikely, since no public accounting firm is likely
to accelerate the downfall of its premier client.
[4]
Considering
GM’s shrinking profit margins, mounting debt load, and onerous
legacy obligations, [5] there is not enough cash from operations [6] to pay the rising cost of its debt expense
or invest in future operations. Thus we have continued to
write about General Motors and the fact that it operates on
the verge of insolvency. The trend for GM has been the build-up
of negative equity, negative working capital, insurmountable
losses, and previously, its only profits were coming from
its finance arm until it sold a majority stake in GMAC. In
a world of $4 + gasoline, GM is now caught with an impractical
product mix dominated by pickup trucks and SUVs.
A well-capitalized
automaker could see its way through these difficult economic
conditions and take the appropriate time and steps to develop
a more suitable lineup of automobiles. However, General Motors’
fragile balance sheet will not see this automaker through
to better times. GM will have to declare bankruptcy and Wall
Street, as usual, will absolve itself of such a self-serving
clustering of buy recommendations pertaining to General Motors’
common stock. You can be certain that the big brokerage houses
were offloading their own GM stock (and for those well-connected
clients) to the poor saps on Main Street who trusted Wall
Street’s analysts. And thus the deception and the wealth transfer
continue.
References
Notes
Past
articles on GM (by Karen DeCoster and Eric Englund) are here and here.
[1] GM CEO Rick Wagoner claims (as of July 25, 2008)
that only Hummer is on the block, and no other brands will
be eliminated or sold.
[2] Auto sales in the US are at a 16-year low.
GM’s sales fell
26% in July. The devaluation of the US dollar makes GM’s
Saab brand costly to import and sell here in the US. Sales of Saab were
down 29% in the first half of 2008.
[3] For Q2 2008 (2nd quarter), GM’s
vehicle production dropped to 835,000, down 27% from the
previous year.
[4] A public accounting firm is unlikely to want to
be responsible for lowering stockholders’ and creditors’ confidence
in a company, especially a venerated giant like General Motors. The New
York State Society of CPAs states, “The fear is that a
going-concern opinion can hasten the demise of an already
troubled company, reduce a loan officer’s willingness to grant
a line of credit to that troubled company, or increase the
point spread that would be charged if that company were granted
a loan. Auditors are placed at the center of a moral and ethical
dilemma: whether to issue a going-concern opinion and risk
escalating the financial distress of their client, or not
issue a going-concern opinion and risk not informing interested
parties of the possible failure of the company.” But the purpose of a financial audit
is to add credibility to management’s implied assertions that
its financial statements fairly represent its financial performance
and position to its shareholders. Thus the code of
silence on “going concern” issues is both contradictory and
dishonest.
[5] Roger
Lowenstein writes, “After falling $20 billion behind on
its pension earlier this decade, G.M. doggedly put money into
its plan to catch up. It has also agreed to invest more than
$30 billion in a fund to cover future health-care expenses.
But these efforts have starved its business.” Unfortunately,
he follows that comment with a call for the government to
take care of social insurance so that the automakers can concentrate
on manufacturing cars.
[6] Where this really hurts GM is in the emerging
markets, where GM is doing better than in North America. While
Volkswagen and Toyota have robust operations in China, GM
is lacking the capital to quickly expand its market in
China.
August
5, 2008
Karen
De Coster, CPA, is a Certified Public Accountant and has an
MA in Economics. She works in the securities industry. See
her website and blog at www.karendecoster.com.
Send her mail.
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