The S&A Digest: The Bankruptcy of GM Part III - How to Profit

A new $10 dividend to grab… The $16 billion reason GM is bankrupt… How to buy into the new Wilbur Ross car-parts business… Who makes the X3…? A union man complains… I'm feeling better, thanks…

The bathroom is a wreck. Tissues are lying all around my bedside. And I haven't worn real clothes in two days. I need a shower... and a stiff drink. I haven't gotten the flu in years. The last time I remember being sick was the fall of 2000. Apparently I was due. It was horrible. Where's that drink?

Here's another dividend you should grab. Health Management Associates (HMA), which owns and operates hospitals in rural Southeast and Southwest markets (retirement havens), is paying a $10-per-share special dividend. Wall Street didn't like the move because the dividend ($2.4 billion) will be paid for with debt. HMA is launching a $3.2 billion bond offering to refinance existing debt and cover the dividend expense. Credit-rating agencies cut the company's debt rating to junk. The stock rose only 2.6% on the news – far less than you'd expect given the prospect of such a large dividend.

As you know, finance professors teach that the payment of a dividend should "net out" for investors. That is, the stock should fall by the same amount of the dividend, after it is paid to investors. However, in real life, managements only pay out capital they can't effectively use and don't need. As a result, we've found that almost every time a company pays a big one-time, special dividend, its share price returns to pre-dividend levels within six months.

What will happen with HMA? Will the stock bounce back after the dividend is paid? We think so. The company can easily afford the new debt and will still earn $100 million per year in free cash flow after the new debt's interest has been paid. Right now, it's earning 25% a year on net tangible assets – it's a good business. And the company owns $2.5 billion worth of community hospitals. It's simply refinancing its mortgages and paying out the cash windfall to investors. Finally, two investment outfits I greatly admire, Dodge & Cox and Private Capital, are large shareholders. I'm comfortable recommending this "dividend grab" even though it's being financed with debt. The dividend will be paid on March 1 to shareholders of record as of February 27.

I vividly remember sitting in the ballroom of the St. Regis Hotel in Aspen as Steve Sjuggerud told our Alliance subscribers that housing stocks had hit bottom and were now a "buy." He prefaced his prediction by saying, "This is probably too contrarian for you." After Steve's presentation, an Alliance member told me, "I've always made money with Steve, but I can't buy housing stocks now. They're going to fall a lot further."

But Steve was right. His two homebuilder picks are up 15% and 50% since the fall. News out of the industry today is shockingly bullish: Builders broke ground on new homes at an annual rate of 1.642 million in December, up 4.5% from November. Building permits increased 5.5% over last month, the most in four years.

Our 12% Letter editor, Tom Dyson, is a brilliant man with a whole barnyard of bad habits. He likes to steal rides on freight trains and has been apprehended by authorities in several countries for doing so. He likes to sneak onto exclusive country club golf courses. With his charm, upper-crust British accent, and scratch golf game, he gets away with it more often than not. He likes to dive into dumpsters and go through trash – he finds the most extraordinary things, including the clothes he wears.

Tom has even been nabbed by our border guards for sneaking across the Rio Grande. "Tom," I asked, "don't you have a green card?"

"I certainly do, Poor-tah. My father has lived in the States for decades. I've had a green card since I was a teenager. I told the border guards the same, though I can't blame them for apprehending me. They caught me square in the middle of the Rio Grande without any identification. I didn't really look like I was out for a jog, did I?" Tom wanted to know what it was like to be a Mexican sneaking into the United States. So, he drove to the border in Texas, snuck into Mexico, and then tried to walk back across the Rio Grande without any ID.

You might rightfully wonder… Porter, why do you employ people like this?

To excel in the investment game requires that you do what other "right thinking" people won't do, exactly when they least want to do it.

If you're sensitive to what other people think or if you naturally follow all the rules, it will be difficult for you to excel as an investor because you'll naturally be compelled to follow the herd. But coming from Tom Dyson's perspective… avoiding what's popular is second nature. In fact, Tom seems genuinely unaware of most conventional social norms. He's completely blind to fashion.

Since taking over at the 12% Letter, Tom has called the bottom in Canadian income trusts (picking three on their lowest closes of the year). He also put readers into McDonald's – not your typical income stock. It's up 10% since his November recommendation. And it hit a new high yesterday.

Other new S&A portfolio highs: Pope Resources (POPEZ), Disney (DIS), American Real Estate Partners (ACP), Anheuser-Busch (BUD), Telstra (TLS).

A special thanks to all of you who sent along your get-well messages. Send your comments here: feedback@stansberryresearch.com.

"If you ever lived in Texas you learn that when Boone Pickens talks about oil, you should listen. A few times he may be wrong in the short run, but he is never wrong in the long run. Oil bought my Mercedes, Porsche, an $800,000 house, and early retirement. It also gave me a fat portfolio (OK, S&A helped some in this area)." – Subscriber James Bennett

Porter Comment: I haven't lived in Texas. In 1996, as Pickens' first big company, Mesa Inc., spiraled towards bankruptcy, he had to offer Richard Rainwater a 25% discount to the publicly available price to buy a controlling stake and save the company. Doing so wiped out shareholders. Rainwater would fire Pickens a month after the takeover.

"If you believe Boone Pickens is wrong and the oil price will continue to decline, why does The 12% Letter recommend that we buy Enerplus, Penn West Energy, and Provident Energy?" – Subscriber Cheng-nan Weng

Porter Comment: For starters, I don't write the 12% Letter, and I don't tell my analysts what to think. That would defeat the purpose of hiring them, wouldn't it? Secondly, your list includes securities that were beaten up in the Canadian royalty trust debacle, which means they're attractive for reasons beyond the price of oil.

"[T]o all of you American auto manufacturer bashers, if I see you as an insurance agent, or doctor, or whatever, driving a foreign car, I won't do business with you, even if the car was 'made' in the U.S.A. As an outside contractor, a Union Ironworker, I have been in Japanese car plants in the U.S., and things aren't nearly so made in the U.S. as they would like you to believe. Economic patriots buy Union made in the U.S.A. Personally, I am looking to offshore my economic and market advisory service subscriptions to India or China, as I am certain to receive much more quality and less pompous advice, at a better price." – Subscriber Skip Dershem

Porter Comment: Skip, if you can find better research at a better price, buy it. And tell me about it. I'll subscribe, too, as long as it's written in English. I can't read Chinese.

"Next month I will be 80 and enjoyed the feedback from your 87-year old day-trader. I'm not officially a day-trader, but often engage in swing trading and short-term trading. Not only is the position my responsibility after I buy it, but the decision to buy or sell is my responsibility. If I don't agree with your recommendations or conclusions, then it's my choice to not act upon them. By the way, my reason for trading equities and options is simply because my 'retirement' won't support my lifestyle. Keep up the good work." – Anonymous subscriber

"I just started receiving your newsletter and I would like to comment on the items regarding GM. If you have'nt (sic) noticed they just won 'car and truck of the year' at the NAIAS. I retired last year from GM after almost 37 years. For the last 10 years I was assaigned (sic) to the Pre-Production Operations (PPO) which was involved with all the new design prototypes of new vehecles (sic). GM's vehicles as far a quality, affordability, is (sic) as good as or better than the foreign competition. They have cut operating expenses, won sefveral (sic) JDPowers awards and in my oppinion (sic) are on track. Perhaps its (sic) loyalty but when you weigh the facts it certainly means that GM is back." – Subscriber Ron Sherry

Porter Comment: That's great, Ron. It means those assets will soon make another company a lot of money. GM can't afford to pay $16 billion a year in financing costs, no matter how good its cars are now.

The Bankruptcy of GM Part III: How to Profit

Have you seen BMW's X3? What about the new Saab 9-3 convertible?

Since these models appeared in 2003, they've been popular with urban buyers of small cars. The X3 is an entry-level SUV, aimed at a young soccer mom. The Saab 9-3 convertible is a second car for a middle-aged professional.

Most buyers assume these "foreign" cars were built in Europe by BMW and Saab. Nope.

Both the BMW X3 and the Saab 9-3 convertible were completely assembled and shipped out to dealers from Magna International's plant in Canada. Thanks to NAFTA, not a penny was paid in tariffs.

Magna International is the world's most diversified auto-parts maker. Point to any part or system on a GM, Ford, Chrysler, BMW, Mercedes, or Saab car and, if it's a premium car, the chances are very good that the parts were made by Magna International. For example, at the auto show in Detroit last week, BMW made a splash by unveiling a new convertible hard top for its 3-series line. Magna International made that hard-top system.

Magna is so good at building car systems that in 2003 it began to assemble whole cars for foreign manufacturers for import into the United States. It's now doing the same for Mercedes, building E-series cars and G-series SUVs.

The company has an unusual charter that requires it to disburse 10% of all profits to employees and get shareholder approval before investing more than 20% of equity into ventures outside of its core business. Even more unusual for a big business, Magna doesn't manage its business as a single unit. Instead, like Johnson & Johnson and Koch, it manages its divisions as holding companies, allowing each of its 224 divisions to operate as a separate profit center. This makes it easy for Magna to buy new operations… and sell off underperforming assets.

The company's balance sheet is battle-ready. It has almost no long-term debt and net current assets exceed $2 billion. (Net current assets are total liabilities minus current assets – this is how much cash you'd have today if you paid off all of your liabilities.)

If the world's major carmakers go bust, Magna International will certainly be around to pick up the pieces. And it will have the cash to make big asset acquisitions.

I recommended the stock to Alliance members at our meeting in Aspen as a play on the troubled auto sector. The stock was trading around $74 then. It's up to about $80 now. And it's still very, very cheap, because sentiment in the sector could hardly be worse.

One other way to play the coming GM bankruptcy is Lear Corp. Lear, like Magna, is a diversified auto-parts maker. It was spiraling towards bankruptcy itself in 2005, because of a very unprofitable interiors unit. Lear spun this unit off, selling it to Wilbur Ross' new car-parts venture (International Auto Components) in exchange for a 34% stake in the new business. Thus, buying shares of Lear will get you exposure to the Ross car parts company.

Wilbur Ross, as you probably know, is the world's most accomplished "vulture" investor. Using the hedge funds he runs, he buys the assets of bankrupt companies and organizes new, profitable businesses. Most recently, he single-handedly re-organized the entire U.S. steel industry. He's been doing this kind of investing for 40 years, first for the Rothschilds and now on his own accounts. He reportedly has earned more than 40% a year for investors.

Just because GM is going bankrupt doesn't mean bad times ahead for the U.S. auto business. Quite the contrary, actually.

Regards,

Porter Stansberry

Cockeysville, Maryland

January 18, 2007

P.S. My prediction of GM's bankruptcy has motivated hundreds of subscriber e-mails. Before you send another angry e-mail, understand these three points. One, my prediction has nothing to do with the quality of GM's cars. Two, I believe the bankruptcy of GM is the fault of its managers, who for at least two decades have allowed the company to operate at a capital loss (meaning its profits were not enough to cover its capital needs). And three, regardless of what GM does now, it will still go bankrupt. GM's annual interest expense now exceeds $16 billion – which is more money that the company has ever made in an annual profit. In the last 20 years, the most GM ever made in one year (1992) was $7 billion. GM will go bankrupt, regardless of any increase in quality or productivity, because it has acquired far too much debt.

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