Taunter Media

I guess the Administration just has a blind spot in the financial sector; elsewhere in the world they are able to recognize reality and make the best of a bad situation.  With the auto companies, for example, they are able to admit that the current business models and plans simply do not work, and they are even able to utter the word “bankruptcy” without stating categorical opposition.

To get a sense of how bad the situation needs to be to scare the administration into action, think of the challenges facing GM:

Revenue
A healthy industrial business needs to grow its revenue.  GM cannot grow its revenue until it has a compelling product line that is sold through an efficient distribution network to the maximum addressable market.

Product Development
The published GM turnaround plan starves product development.  One of the key changes between the December and February plans is the reduction of 2012 launches from twelve to five.  The “fewer, better” strategy is hard to square with a consumer-facing business that, at least in part, is taste-driven; GM no longer has the power to force customers to accept particular designs.  A more successful business would have more flexible manufacturing that could launch several visually distinct models off of common chassis/powertrains.  Think of the Volkswagen Touareg / Audi Q7 / Porsche Cayenne – the same guts, but different styles for very different customers.  Incidentally, GM has the same manufacturing complexity without the benefit, since they are pulled by their dealers into offering a massive number of options per vehicle.

Brand Management
A successful GM will have brands that stand for something.  This is the most thought-through element of their turnaround plan; for once they are going through the discipline of asking “what is a Chevy?”  It is a shame this exercise was not carried out before Saturn and SAAB got into their current situation; one or both could easily have been the US name for Opel cars instead of odd plastic cars and cars for Vermont liberals, respectively.  GM still does not have a clear sense of what Buick stands for (it means something very different in China), and this will need to be resolved if it is to avoid becoming Oldsmobile.

Distribution

In a steady state GM should have a dealer network that both reflects the current size of its operations and brings its products to market in the best light.  Ideally, the revenue footprint would match a map of America by purchasing power; Southern California, for example, should be a meaningful contributor.  Instead, today’s GM derives a high and growing share of its revenue from the Midwest.  It gives away too much of the strike zone.  Furthermore, the Buick/Pontiac/GMC combination seems completely opposed to the brand images of these entities.  Pontiac is a sporty niche brand; it should be with mass market Chevy: “looking to kick it up a notch, sir – why don’t you try our Pontiac here?”  GMC is all about “professional grade;” why would it be sold in the same place as Buick, which is dedicated to ease and comfort?

It is also unclear that today’s model of full-service dealerships makes the most sense.  Especially in the large metro areas, distinct retail environments supported by fewer, common service areas would probably make the network more profitable.  No need to build more bank branches to serve more customers; build more ATMs and let people with complicated transactions come to a few full-service banks.

Quality
GM needs to be a quality leader.  GM knows this.  Unfortunately, they have the wrong definition of “quality.”  GM produces to a low ppm error rate, and often seems genuinely confused by the persistence of customer doubts.  However, the error rate is only a measure of how far an output deviates from specification.  If my specification is +/- 10mm, my error rate should be lower than someone whose specification is +/- 2mm, but I am not necessarily producing at higher quality.

In addition, these are measures of production reliability, not customer quality.  McDonalds produces a much more consistent hamburger than Smith & Wollensky, but that does not make it better.  Compare Audi and Cadillac; both occupy the same brand space of “clever alternatives to BMW/Mercedes.”  If you see wood or leather in the Audi, it is wood or leather.  If you see wood or leather in the Cadillac, it is likely a synthetic.  Which will a customer think has higher quality?  The JDPower survey GM values so dearly is an exercise in conditional probability: given that you have purchased Cadillac, what defects have you encountered?  But the picky customer is driving an Audi!  If a customer could get comfortable with the look and feel of a Cadillac, he is not likely to be disappointed when he owns one.  GM needs the customer to get comfortable in the first place, and it needs to respect that these are rational perceptions of real problems.

Costs
GM is far better at managing its costs than growing its revenues.  The UAW has already agreed in principle to provide GM cost parity with the transplants and, more importantly, parity of work rules.  The purchasing organization is already world-class; go to any supplier and look for the customer that pays the least for a given product and you will surely find GM (it also receives the lowest-quality product, which goes to its quality challenges).

A successful GM, however, will need to generate positive free cash flow.  Therefore, it has to cover its operating costs, plus the capital expenditure associated with an exciting new vehicle program, plus service its financing needs and long-term benefit obligations.  And that brings us to the capital structure.

Liabilities
GM’s current out of bankruptcy negotiation deals solely with the $27bn of unsecured bonds and $20bn of VEBA obligations.  Even if both vanished, the company would still have significantly negative book equity.  The $39bn of OPEB obligations – likely more, as they are calculated using an 8.5% investment return – would haunt the company.  The cost of actually restructuring the dealer network, instead of relying on attrition and the simple disappearance of HUMMER, Saturn, and SAAB, is not even on the books, but it would remain an cash impediment to getting to a clean business.  In essence, the restructuring would be unfinished.

Bankruptcy
GM has made the threat that it could get stuck in bankruptcy; revenue would fall away so quickly no amount of liability unloading could salvage the operation.  Part of the answer hinges on the uncertain nature of customer reaction.  Depending on whether it was portrayed as a government-sponsored restructuring or a liquidation (a common connotation of “bankrupt”), it could be seen as a positive – “the government is finally stepping in” – or a negative – “how will they honor my warranty”.  In the event, we are essentially providing it with DIP financing one way or another; the company loses cash and we are keeping it alive.  In a meaningful way, the business is already bankrupt, but is leaking cash to an arbitrary group of stakeholders.  Bankruptcy allows for a prioritization of outflows.

More broadly, though, I would suggest we are in a process of discovery of the true value of GM.  Whatever it is worth, it is worth more without historical liabilities than with them.  If stripped of all of its historical liabilities it still has negative value, it should probably be shut down; we would be better off transitioning to something that does not destroy resources.  But I don’t believe this to be the case.  There are significant assets at GM; assets that are not worth the liabilities it took to acquire them, but assets all the same.  It will take a major restructuring with the full power of the court to abrogate contracts to undo two entire generations of unrealistic promises to stakeholders left and right.  But it can be done.