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GM Decline to Junk Yields Shows Waning Confidence in Automaker
March 8 (Bloomberg) -- General Motors Corp., struggling with declining market share and ballooning health costs, faces a growing menace that`s making all its challenges more dangerous: rising interest expense on its debt.

Besides spending $5,349 per vehicle on consumer incentives last month, or 49 percent more than Toyota Motor Corp., GM Chief Executive Rick Wagoner, 52, must pay more to lure investors to GM`s bonds.

Interest expense at GM and its finance unit rose 26 percent to $11.9 billion last year, more than double the 11 percent gain in combined debt. By demanding higher yields, bond investors are signaling waning confidence in GM, the world`s No. 2 corporate borrower outside the finance industry. Rising interest payments damage Wagoner`s ability to invest in the redesigned cars, trucks and sport-utility vehicles he needs to stimulate sales and lift his credit rating, says Scott Colbert, who helps manage $7 billion in debt at Commerce Bank in St. Louis.

``We`re not willing to think past five years with this company until we see a turnaround in their products, profit margins and sales,`` Colbert says. He`s avoiding maturities on GM and Ford Motor Co. debt beyond 2009.

GM bonds already are trading at levels similar to companies whose debt is rated junk, the high-risk, high-yield category of corporate debt. Standard & Poor`s rates GM bonds BBB-, one level above junk, because of stiffer automotive competition and rising medical costs for retirees. Bondholders like Colbert are watching for signs of a rating cut that would officially drop GM, the world`s largest automaker, into junk status.

GM`s U.S. market share will fall to 24.3 percent in 2009, according to Joe Barker, an analyst at CSM Worldwide, an automotive consulting firm based in Farmington Hills, Michigan. Its share was about 44 percent in 1980.

Pace of Change

Colbert and other bond investors say they don`t foresee a bankruptcy at GM. If borrowing-cost increases and market-share losses are gradual, Wagoner won`t have to scale back investment in new products and equipment anytime soon, says Merrill Lynch & Co. analyst John Casesa. Wagoner has said he expects capital expenditures of $8 billion in 2005.

``If their borrowing costs rise very quickly and they can`t generate the cash they need for new products, then it becomes a vicious cycle,`` says Casesa, who has a ``neutral`` rating on the shares.

While not predicting a cut to junk status for GM, Andrew Harding, who oversees $6 billion in fixed-income assets at National City Investment Management in Cleveland, says it`s a ``real possibility.`` He also says the U.S. government is likely to provide assistance should GM`s finances deteriorate too far.

Toyota`s Edge

Shares of Detroit-based General Motors rose 8 cents to $34.92 in New York Stock Exchange trading yesterday and have fallen 13 percent this year, compared with a 0.8 percent decline in the 17-member Bloomberg World Auto Manufacturers Index.

Among analysts rating the stock, there are three ``buys,`` seven ``holds`` and four ``sells.``

Toyota`s cost advantage over GM in the credit markets was on display last week. Toyota, with a rating of AAA from S&P, sold $1 billion of five-year notes with a 4.25 percent coupon, offering investors a yield of 37 basis points over U.S. Treasuries with a comparable maturity. A basis point is 0.01 percentage point.

General Motors` comparable security, a 5.625-percent note maturing in 2009, traded yesterday at an extra yield, or spread, over Treasuries of 242 basis points.

The difference in the two companies` spreads means that if GM had sold $1 billion of notes yesterday, it would have needed to offer investors $20.5 million more in annual yield than Toyota offered last week.

`Cutting Into Profit`

``Interest expense is cutting into profit,`` says Joseph Balestrino, who helps manage $7 billion of fixed-income investments at Federated Investors Inc. in Pittsburgh. ``They continue to lose market share. Toyota`s goal is to overtake GM, and they will be aggressive.``

In February, Toyota, based in Toyota City, Japan, spent $3,601 per vehicle in rebates and other incentives in the U.S. The $5,349 offered by GM was a 6.4 percent increase from January, the biggest month-to-month rise since Wagoner unveiled zero percent loans just after the Sept. 11, 2001, terrorist attacks, according to Art Spinella, president of CNW Marketing Research in Bandon, Oregon.

Even so, GM`s U.S. sales fell 13 percent to 305,550 cars and light trucks in February as sales of compact SUVs like the Chevrolet TrailBlazer fell 23 percent, and as new car models like the Chevrolet Cobalt showed slower-than-expected gains.

During the same month, Toyota`s U.S. sales rose 11 percent to 163,059 units. Ford`s fell 2.9 percent to 254,134.

Financing`s Role

As its U.S. market share declines, GM remains profitable. Net income fell in 2004 to $3.69 billion from $3.82 billion in 2003. In each year since 2002, more profit has come from the finance unit, General Motors Acceptance Corp., than from the automotive unit. Last year, GMAC earned $2.91 billion for GM, the auto unit earned $1.47 billion, and other units reported a loss of $695 million.

The automotive unit had an operating profit margin of 0.5 percent in the fourth quarter, compared with 9.1 percent at Toyota, according to Merrill Lynch.

Two years ago, General Motors made a $10,000 pretax profit per unit from a family of 11 vehicles, including the Silverado full-size pickup truck and the Tahoe SUV, and lost money on virtually every other car and truck it built worldwide, according to David Healy, an analyst at New York-based Burnham Securities. Now, pretax profit may drop to $7,000 per unit as Toyota, Nissan Motor Co. and Honda Motor Co. introduce full-size pickups and SUVs, Healy says.

GM`s predicament has been building for years.

Ten years ago, when S&P upgraded Ford to A+ and Chrysler Corp. to A-, General Motors` debt rating was left at BBB+. S&P`s concern then was GM`s lackluster sales in North America.

Japan`s Challenge

``A turnaround there is not something that can be assumed to go smoothly,`` S&P Managing Director Scott Sprinzen said on a Jan. 24, 1995, conference call. He also predicted a ``strong resurgence`` by Japanese automakers. He was right on both counts.

GM`s U.S. market share eroded to 27.3 percent last year from 32.8 percent in 1995 and 40.7 percent in 1985, according to Woodcliff Lake, New Jersey-based Autodata Corp. During the same period, Toyota`s share has risen to 12.2 percent from 7.3 percent in 1995 and 6.2 percent in 1985.

The trajectory of GM`s bond ratings is similar.

S&P rated the debt AA+ in 1985. By 1993, the rating had slipped five times and settled at BBB+, partly because of GM`s obligations to retirees and an industry decline that took U.S. sales by all automakers from 15.4 million units in 1988 down to 12.3 million by 1991. In 1993, when he was GM`s chief financial officer, Wagoner vowed to quickly ``restore`` GM`s credit rating.

Competition, Costs

Better auto sales and profit helped push the rating up to A by 1998, the year Wagoner became GM`s president. It didn`t last. As market share continued its slide, the rating was cut to BBB+ in October 2001, BBB a year later and BBB- in October 2004. S&P is reviewing its current ``stable`` outlook on the debt.

Moody`s Investors Service rates GM`s debt Baa2, and Fitch Ratings has GM at BBB. Both are two levels above junk. Fitch cites rising competition in SUVs and pickup trucks, weak car sales, European losses, high fixed costs, and retiree health expenses. Moody`s cites falling market share and burdensome health costs.

Moody`s cut its outlook to negative from stable after GM said Feb. 13 that it`s spending $2 billion to scrap an alliance with Italy`s Fiat SpA.

General Motors ended 2004 with $19.8 billion in cash and marketable securities in the automotive unit, down from $23.5 billion in the prior year. Wagoner had said he expected $2 billion in surplus cash flow at his automotive unit this year. That amount was wiped out when he agreed to pay $2 billion to disengage from Fiat.

Balance Sheet

During the last four years, Wagoner has worked to reduce the impact of increased costs on the company`s financial standing, GM spokesman Jerry Dubrowski says.

Wagoner is overhauling the balance sheet of GMAC. In 2001, GM derived two-thirds of the finance unit`s funding in the U.S. from unsecured corporate bonds, or debt backed only by GM`s creditworthiness, not collateral. As credit ratings decline, unsecured debt is more expensive to roll over because bondholders must be paid a higher annual yield.

Today, unsecured bonds account for one-third of GMAC`s U.S. funding.

GMAC should earn at least $2.5 billion this year, even if a ratings cut occurs, Dubrowski says. That compares with $2.9 billion in 2004. At the same time, Wagoner is spending at least $2 billion to redesign the Silverado and Tahoe family of vehicles. He also named a new sales chief for North America on March 1.

China Earnings

The company`s China unit, which had net income of $417 million last year, is one example of GM`s ability to build cars and trucks that people want to buy, Dubrowski says.

``We know we have to improve our automotive profitability,`` he says.

Still, costs continue to mount. Combined interest payments at GM`s auto unit and GMAC increased by $2.4 billion last year. At the end of 2004, combined debt outstanding at the two units totaled $301.2 billion. The added interest, rising more than twice as fast as total debt, cramps profit and may hurt Wagoner`s ability to invest in new products.

The rising interest expense partly reflects tactical decisions by GM management, Dubrowski says. GMAC is agreeing to higher coupon payments as it shifts to bonds with long-term maturities, and it`s borrowing money now in case its funding sources dry up after a rating cut, he says.

Inefficiencies

In total, Wagoner spends $2,500 more than his Japanese rivals to build each car and truck in the U.S., says Sean McAlinden, an analyst at the Center for Automotive Research in Ann Arbor, Michigan. About half of the difference comes from inefficient factories and the other half from the fact that General Motors has 2 1/2 retirees getting pensions and health benefits for every active worker.

Health-care costs are set to hit a record $5.6 billion this year. The retiree portion of GM`s cost disadvantage against rivals will peak in 2007 and disappear in 2015, McAlinden estimates.

So far this year, the extra interest GM must offer to debt holders is widening.

In its most recent bond sale, in November, GM sold $1.75 billion of 6.75 percent notes maturing in 2014. The yield paid to buyers was 270 basis points more than comparable Treasuries.

Trading Like Junk

Yesterday, that spread had widened to 304 basis points, according to Trace, the bond-price reporting system of NASD, formerly the National Association of Securities Dealers.

The spread on GM`s 8.375 bond maturing in 2033, which is among the company`s more actively traded bonds, was 402 basis points more than comparable Treasuries.

Yield spreads for junk bonds in general are about 282 basis points, according to Merrill Lynch. So, GM bonds are trading as if they were junk even though they`re rated above that level.

If GM borrowed the same $1.75 billion today that it borrowed in November, the company would have to pay bond buyers about $6 million more per year over the 10-year life of the debt. GM last year sold about $13 billion of unsecured corporate bonds in the U.S.

Fed Action

Borrowing costs may rise further this year if S&P cuts GM to junk, or if the Federal Reserve continues boosting rates. Eventually, the debt that`s sustaining GM may become prohibitively expensive.

``Unless the Fed slows down the rate increases, it`s going to become a dangerous situation for General Motors, probably more so than any other company in the country, because they`re so dependent on discounted loans for consumers,`` says Colbert at Commerce Bank.

The Fed is forecast to raise its benchmark overnight lending rate a quarter-point to 2.75 percent on March 22, the seventh straight increase. Fed Chairman Alan Greenspan told Congress last week the economy is proceeding at a ``reasonably good pace.`` The Fed started raising the rate in June from 1 percent, which was the lowest since 1958.

Outstanding debt at GM`s automotive unit totaled $32.5 billion on Dec. 31, an increase of 0.4 percent during 2004. Debt at GMAC rose 12.2 percent to $268.7 billion.

Excluding purely financial companies, the combined debt of GM and GMAC ranks General Motors second globally among corporate borrowers behind Fairfield, Connecticut-based General Electric Co., according to data compiled by Bloomberg.

General Electric has the best rating from Moody`s, Aaa, and from S&P, AAA.

Bond Markets

Harding, at National City Investment Management, calls the threat of a GM ratings cut the primary focus for bond markets generally during the next 12 months.

Shaky finances at GM will be noticed in Washington, he says.

``This isn`t like an airline going out of business,`` Harding says. ``There`re plenty of airlines around. There are three domestic automakers, and it`s the core of the manufacturing that`s left in this country.``

In the past year, General Motors has run ads in the Washington Post and Congressional Quarterly reminding lawmakers that it has 154,000 employees and 500,000 retirees and that it made $20 billion in capital investments in the U.S. in the past five years.

Federated Investors` Balestrino says GM can survive.

``They`re making a lot of money,`` he says. ``The problem is they`re spending a lot of money.``

In December, General Motors` unfunded health-care liability totaled $53.8 billion.

Lehman Index

A cut to junk status would push General Motors` bonds one step closer to being dropped from Lehman Brothers Holdings Inc.`s Credit Index, which many fund managers use as a benchmark for bond performance. Investors unwilling to hold anything other than investment-grade bonds would sell.

``It would be horrific,`` says John Weaver, who manages $800 million of bonds, including GM debt, at McGlinn Capital Management in Wyomissing, Pennsylvania.

A selloff might depress prices and rattle bond investors worldwide. After the WorldCom Inc. and Enron Corp. bankruptcies in 2002, GMAC couldn`t sell an unsecured bond in the U.S. for weeks, GMAC Chairman Eric Feldstein, 45, said in an interview last year.

Mark Kiesel, an executive vice president at Pacific Investment Management Co. in Newport Beach, California, says he doesn`t expect a rating cut this year for automakers, including Ford and GM.

`Good` Liquidity

``The liquidity of a lot of these companies is in good shape,`` says Kiesel, who helps manage $400 billion at Pimco, with runs the world`s biggest bond fund.

With about $20 billion in cash and marketable securities at its automotive unit, plus $5 billion in credit lines, General Motors can meet expenses without additional borrowing, spokesman Dubrowski says. Much of the auto unit`s $32.5 billion in debt has long-term maturities, so the principal on the bonds won`t need to be paid in the near term, he says.

Lehman last month made it less likely that GM would be dropped from the index. The firm added evaluations from Fitch to its measures of creditworthiness starting July 1. Now that Moody`s, S&P and Fitch are included, two of three must rate a company at junk before it is dropped.

Changes within GMAC may help.

Market Value

GMAC itself, with $311.8 billion in assets on Sept. 30, would have ranked as the sixth-largest U.S. bank last year, according to Fed data. Alone, GMAC is worth more than General Motors` $19.7 billion market value, according to the 2004 annual report of Memphis, Tennessee-based Southeastern Asset Management Inc., which owned 26 million General Motors shares in December.

As GMAC has reduced its dependence on unsecured corporate bonds under Wagoner, it`s relying instead on the sale of bundles of loans and leases, favored by investors because they`re secured by consumers` car payments. To find new ways to attract capital at a reasonable cost, Wagoner`s also selling bonds directly to individuals and portions of his GMAC loan holdings directly to banks.

S&P grades GMAC debt with the parent`s rating because an industrial company in financial ``distress`` may be prone to take steps that harm the credit quality of its captive finance unit, according to the rating company.

GMAC`s borrowing costs increased as the Fed boosted its overnight bank-lending rate six times since June. The company offset part of this increase and achieved record net income because some assets benefit from rising rates. These include investments on insurance policies.

Buying Time

Casesa, the Merrill Lynch analyst, says GMAC`s shift to securitization of loans rather than retaining them on the balance sheet may sacrifice some future earnings. Still, he praises Wagoner for making financial adjustments to try to buy time to fix the automotive unit.

``They can borrow so much money that they can probably muddle along like this for several years,`` Casesa says. ``In the long run, they must stop the market-share slide and start growing revenue.``

For now, Casesa says, Wagoner`s reliance on debt tends to favor bondholders over shareholders. At 7.29 percent, the yield on GMAC`s 6.875 percent bond due Aug. 28, 2012, exceeds the 5.7 percent dividend yield on GM shares over the last 12 months.

General Motors may be resigned to the possibility that Toyota will pass it to become the world`s largest automaker by volume. General Motors sold 8.2 million cars and trucks last year, up 1.8 percent from 2003, compared with 7.52 million for Toyota, up 11 percent.

`They`re After You`

``I hear all these things about how `they`re after you, they`re after you,``` General Motors Vice Chairman Robert Lutz said in a December interview. ``I can`t let myself get distracted by that. If they overtake us, they overtake us.``

Wagoner says he hopes to reverse the market-share slide partly through higher quality and improved design. He plans to introduce the redesigned Tahoe SUVs in 2006 and Silverado pickups in 2007.

``The new trucks and SUVs will be critical in determining whether or not General Motors can keep its investment-grade credit rating,`` says Sasha Kamper, who helps manage $65 billion, including GM debt, at Principal Global Investors in Des Moines, Iowa.

`Crossover` Vehicles

Even more critical may be SUVs derived from cars instead of trucks for a smoother ride and better gas mileage, says Casesa at Merrill Lynch. These ``crossover`` vehicles were the fastest- growing U.S. market segment last year, and Japanese automakers captured half the market while General Motors captured 14 percent, Casesa says.

Balestrino, of Federated Investors, says he`s more impressed by GM`s ability to generate cash than he is alarmed by its interest-payment burden. Still, he`s wary.

``It`s reasonable to expect that GM will grind lower in market share,`` Balestrino says. ``It all depends on their new- product launches. The key to sales has been incentives, and that`s not a healthy model.``
 
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