The S&A Digest: GM's Impending Bankruptcy

Hugo Chavez moves on oil… China's stock market tops $1 trillion… Another Thai reversal… More comments on our track record… The numbers behind GM's coming bankruptcy…

We're putting the final touches on our new S&A 16. It will be sent to all S&A Alliance members tomorrow. (For those of you who are new to us, the S&A 16 is a model portfolio made up of the best 16 stocks to buy right now from all the companies we have under coverage. We choose four stocks in these four categories: value, growth, income, and macro.)

So how did the January 2006 S&A 16 perform? According to yesterday's closing prices, we're up 21%. I'm pleased to say that the two best-performing stocks in last year's January S&A 16 (Convergys, up 59%, and Lexmark, up 53%) were both PSIA recommendations. Goldsmith reminds me that the worst performing stock in the portfolio (RadioShack, down 16%) was a PSIA pick, too.

Hugo Chavez is now trying to nationalize the Orinoco oil belt in eastern Venezuela. The projects in the region are worth an estimated $33 billion and are believed to hold up to 235 billion barrels of oil. Chevron, ConocoPhillips, ExxonMobil, Total, Statoil, and BP all own significant assets in the area.

KHD Humboldt Wedag, an Extreme Value recommendation, was awarded a $50 million contract to supply a new cement production line to a Russian company. The contract is worth nearly half of the company's total sales last year.

Evil Wal-Mart is at it again… 47.4% of Wal-Mart's 1.3 million workers are now covered by its health plans, after announcing an 8% increase today. About 76.3% of its employees are eligible for the company's plan, beating the average of 59% for workers in the retail sector.

As of yesterday's close, China's stock market has topped $1 trillion for the first time. Since China was opened to international investment in 1978, its economy has grown 10-fold.

The Thai government has made its second policy reversal in less than a month. Now, the new rules limiting foreign ownership in Thai companies will not affect the telecommunications industry. The Thai finance minister said that he mistakenly included telecom among off-limits businesses… oops. The market is even cheaper now, trading at a P/E of 5.6.

Cisco is suing Apple over the use of the term "iPhone." Cisco is claiming that it owns the trademark on the term since its purchase of InfoGear Technology and the release of its own iPhone, which makes calls over the Internet. Apple called the lawsuit "silly" and is ready to take the matter to court.

We're light on mail today. The phone lines are open, drop us a line: feedback@stansberryresearch.com.

"I must take issue… with your prediction on the Apple iPhone. I am not an early adopter of anything, but I want an iPhone so badly I can taste it… My prediction – Apple will sell every iPhone they can make, and they can name their own price for it. All the other cell phone manufacturers now have to play Apple's game, or fight it out for the lower end of the market." – Paid-up subscriber Billy T.

"In a recent issue you rated S&A newsletters. Most got an 'A' or and 'A+'. In the beginning of that issue you stated that you expected your editors to exceed the market by at least 6%. But only 2 or 3 of the dozen or so newsletters you rated did so. Most didn't even meet the market, but fell behind. So how did they end up with 'A' or 'A+' ratings if they didn't even meet the market, let alone exceed it by 6%?" – Paid-up subscriber Frederick M.

Porter Comment: You must be thinking of someone else. I wrote in the S&A 2006 Report Card that I expect our analysts to beat inflation (which I judge to be running at about 6% a year) by 10%. So this year, our baseline for an "A" was 16%. Ironically, I explicitly rejected any notion of returns relative to the market, which is flawed in many ways. Also, you should know great investors will beat the market, over the very long term, by a few percentage points. Beating the market by six percentage points a year, every year, is extremely unlikely. And finally, most of our letters got As or A+s because, on an annualized basis, they far surpassed the market's return and our baseline return. Many even did so without a single losing recommendation.

"With all the criticism of your picks, I wonder what other letters people think have better track records than yours. I would love to hear from others what newsletters have matched or exceeded your track record… I bet the list is very small." – Paid-up subscriber Jay S.

"Red wine and football are both wonderful things, and they both have their place… but not together, you pussy. There had better have been some beer there for the game as well (BUD, of course)." – Paid-up subscriber Brian T.

"You must have started your celebrating early because the Florida Gators football team won the national championship bowl game in Glendale, Arizona, not Tempe. As a former Glendale resident (now living in the mountains in Cottonwood, AZ), I suppose I should be offended, but I'll forgive the slip as a carryover from your extended 'celebration.' Besides, I'm glad the Gators won. Congratulations! Hope you're fully recovered." – Paid-up subscriber Erv M.

GM's Impending Bankruptcy

How could GM, one of the world's largest businesses – and a market share leader for decades – find itself on the brink of bankruptcy? In the usual way: Its managers have long disregarded the impact of growing liabilities upon the company's asset base.

The same thing happened to WorldCom and to Enron.

In WorldCom's case, billions in debt were added over a period of 10 years to a company with a declining return on assets. Near the end, in 1998, the company paid $38 billion in cash for British Telecom's stake in MCI. At the time of the deal, MCI's assets were only earning 2.1% annually. WorldCom's average cost of capital was in the 8% to 10% range. It was buying assets that couldn't possibly produce a profit, given their funding costs. Shockingly, WorldCom steadily increased its investments in new assets after the MCI deal, spending more than $10 billion on capital investments in 2000. The result was inevitable.

Why did Bernie Ebbers drive full speed into bankruptcy? Because he believed the company's accounting, which showed the costs of these acquisitions and their maintenance expenses spread across 40 years. In an accounting sense, that was accurate – these were long-lived assets. But the economic reality for WorldCom was totally different. You don't get to live in your house for 40 years if you can't pay your mortgage. The company kept reporting "earnings," while quarter after quarter, its cash deficit worsened and its liabilities grew.

Professional investors should have recognized what was happening. Wall Street's banks should have limited the company's access to more debt, which couldn't possibly have been repaid. Instead, everyone's bonus depended on pushing the stock higher and getting the company more capital.

Essentially, the same thing happened at Enron.

The company's investments were measured with "mark to market" accounting, which allowed the company to claim a lifetime of estimated profits from any deal, whether or not any money materialized. And, because Enron's managers were rewarded for producing "phantom" profits, that's what the company produced. The result was the same as at WorldCom: a steady accumulation of low-quality assets and high-cost liabilities.

How does all of this compare to General Motors?

According to the company, its troubles are the fault of bad labor negotiations that have saddled it with terrible legacy costs. It's certainly true that these burdens are substantial. GM owes post-retirement health benefits to union employees estimated to be worth $85 billion. Last year, this cost the company $5 billion in actual expenses.

But the company's financing costs have increased by more than twice that amount in the last three years. The real problem at GM, just as at WorldCom and at Enron, is the company's exploding debt burden and its low-quality assets. Let me show you the numbers:

The numbers above are in billions and have been rounded to the nearest billion.

Over the last 10 years, GM's gross profits have declined 46% – a number that does not factor in legacy costs. GM's cars have become increasingly uncompetitive because GM has not kept pace with its peers in several key areas, most notably styling, performance, handling, and interiors. To sell these cars, GM has been forced to rely on deep discounting, frequently selling cars for less than their total production costs.

That's why its gross profits have fallen in half.

A business of this size, with a slim return on assets even in good years, cannot afford such a material decline in gross profits. You should notice that GM's corporate overhead (SG&A) has grown by 89% during this period. Its corporate overhead alone now exceeds its gross profits.

That's why GM has seen its total debt more than double in the last 10 years. Worse, its interest expenses have skyrocketed because not only have total debts grown by more than $200 billion, its credit rating has fallen below investment grade.

GM is already bankrupt… shareholders just haven't realized it yet.

In 2007, GM's corporate overhead and its interest expense will likely exceed gross profits again. In addition to these losses, the company faces its legacy obligations, restructuring expenses, and capital investments, which are constantly needed to keep its plants operational. Quite simply, GM cannot possibly afford its overhead, its upkeep, and its interest expense. This company is upside-down. Its asset base cannot support its overhead – never mind any legacy costs.

On top of this unpleasant financial reality, there are a host of other problems, each of which could destroy the company. GM's collective bargaining agreement with the UAW will expire in September 2007. Any UAW strikes would bankrupt GM in a matter of days. A federal grand jury is investigating the company's accounting with suppliers. Separately, SEC and federal grand jury subpoenas have been served on GMAC insurance entities. Any federal indictment would trigger defaults on all of the company's senior debt, forcing bankruptcy.

When it's all over, you can be sure that Congress will demand an investigation. That CNBC will say that no one saw it coming. And that GM's leaders will be hauled into the courts, charged with all types of fraud and "looting the company."

The truth is more banal. GM has done a terrible job of designing, building, and selling cars – for a long, long time.

There is, however, a silver lining. Inside GM's enormous pile of assets, there are more than a few gems. Investors who position themselves correctly now will be able to grab those assets for pennies on the dollar, after they become unencumbered by GM's legacy costs, debts, and inept managers. For these investors, GM's impending bankruptcy looks more like a rainbow leading to a pot of gold than just a thunderstorm.

I'll tell you more about this next week.

Good investing,

Porter Stansberry

Cockeysville, Maryland

January 11, 2007