The Detroit Death Pool

[doh]

http://www.forbes.com/2007/05/23/det...rtner=yahootix

Anyone who has spent any time in Detroit recently will tell you it is by all apparent indications a dying city. Crumbling buildings, widespread decay and a population in flight make for a depressing landscape. Detroit's fortunes have always been tied intimately to the fortunes of the U.S. auto industry. So it's hardly surprising that a look at Ford's and General Motors' balance sheets will show just as much decay and devastation as a trip through Detroit's worst slums. The only real question is, Which automaker will declare bankruptcy first?

Let's start with GM (nyse: GM - news - people ). Instead of talking about its autos, I'll just focus on the numbers. Over the past decade, GM's gross profits have declined from $40 billion to $22 billion, while its debt has increased from $199 billion to over $450 billion, all during a period of historically low interest rates.

The low rates won't last forever, though. Just over the past three years, GM's interest expenses have risen 77% from $9 billion to $16 billion and are projected to rise to $18 billion this year. Rates are still very low by historical standards.

One of the reasons the Federal Reserve cuts interest rates is to make it easier for companies to get the cash they need to finance growth. Unfortunately, free-flowing cash also makes it easy to dig yourself into a hole. GM supposedly took on all that debt to get its profits back on track, but as you can see, the opposite has occurred.

The simple truth is that GM can't make enough money selling cars to pay for its overhead, upkeep, salaries and dividend payments. Its solution has been to take on more and more debt, rather than spending its cash reserves, so that it can show a "profit" on quarterly income statements. In other words, GM is kiting checks all over town, using its MasterCard to pay off its Visa, burying itself ever deeper under a crushing mountain of debt.

At present margin levels and interest rates, it will take more than 20 years to pay down its debt load. Imagine what will happen when rates return to their long-term average level, as they inevitably will. With inflation looming, the Fed will have no choice but to raise interest rates at some point. It's only a matter of time.

Plus, GM's credit rating has been downgraded, meaning future rate hikes will hit it even harder. GM couldn't get its act together during an era of cheap, easy money. What reason is there to believe it will be able to do so when the ocean of capital dries up?

Ironically, GM's recent divestiture of GMAC relieved it of its only hedge against rising rates, while leaving it on the hook for any and all default risk. It's a no-win deal for GM, the sort only a desperate company would agree to. The fact that this deal went through at all is enough to show that GM is a company in crisis, but it's only one indicator among many.

GM can try closing plants, renegotiating its union contracts, laying off workers and asking for a government bailout of its staggering employee medical care expenses. In fact, I predict it will try all of the above. Doubtless it will be watching Chrysler's private-capital transformation like hawks. If Chrysler squeezes any concessions out of the unions, you can bet your bottom dollar GM will demand the same. But none of this will erase GM's massive and ever-growing debt burden.

GM has had its chance to save itself. It has taken liberal advantage of plentiful cheap, easy capital, and matters have only gotten worse.

The bottom line is, in order for GM to survive, it needs to make rapid, substantial gains in profitability. Of course, this was just as true three years ago as it is today, and the results speak for themselves. Whatever its massive PR machine may say, GM is already effectively bankrupt. All that remains is for the company to admit it.

A visit across town to Ford (nyse: F - news - people )will do little to improve the gloomy atmosphere. The situation is dire indeed for GM, but Ford is no better off. Ford's balance sheet is overflowing with red ink from unfunded pension and health care obligations. According to The Wall Street Journal, even assuming Ford somehow manages to negotiate with unions a 25% decrease in its health care costs, it will still face a $58 billion deficit, which adds up to well over three times its total market capitalization. The book value of Ford's non-car assets including cash and equity holdings comes in at about $52 billion.

Ford predicts it will burn through $17 billion of its cash over the next three years. Assuming Ford's predictions are correct, that leaves $35 billion in assets apart from the car business. Subtract $48 billion in liabilities, and you are left with a value of negative $23 billion for everything Ford owns except the car business. In other words, Ford's car business would have to be worth $23 billion simply for the stock to have zero value. In order to justify Ford's current market cap of $16 billion, its car business would have to be worth close to $40 billion.

Is Ford's automobile business worth that much? Not likely. For a number of years, Ford sold cars at a loss in order to subsidize its more profitable SUV and truck models. Now, just like in the '70s, the big gas guzzlers are falling out of favor with consumers, who are turning to more efficient Asian models, like those sold by Nissan (nasdaq: NSANY - news - people ). The results have not been pretty. SUV sales are down in excess of 30%. Ford can no longer rely on high-end models to prop up its profits. It will have to learn to make money selling cars again if it is to survive, and as of yet there are no promising new models with the potential to fulfill this need.

According to the same article in the Journal, Ford can only realistically hope for about a 2% pretax margin on its car sales. 2006 sales were $132 billion, but Goldman Sachs predicts Ford's sales will decline for 2.5% annually for at least the next three years. Frankly, I believe even this estimate is optimistic, but let's go with it. That leaves sales of $122 billion. A 2% margin on this gives $2.44 billion in pretax income.

[Bornfromparents]

wow this article is filled with hope for the future, great read!

[Buickman]

Excellent article. Where is the blame for management's repeated failure? Without accountability, no sustainable progress will ever truly develop.

[Cabana Boy]

All BS.

I live near Detroit (30 miles North) and I am downtown all the time. The city is really starting to come to life. As the Big-3 become great again, it will only help the city.

Total BS read.

[BrickTamland]

Detroit has been losing population for 50 years. Its population hit its peak with the 1950 census, and has declined ever since. I do not think that is a very good analogy to draw. Detroit has been deteriorating even when the automakers were healthy.

[smk4565]

Toyota is worth $385 billion. I suspect Toyota one day buys one of the Detroit automakers, even if just to close them down, and resurrect a nameplate later down the line. Although a few American brands will probably go out of business on their own, so Toyota might not even bother.

[jon21]

Not many good news for Ford lately.

[VCDJ]

This is true. This is why i keep screaming here that Rick and Lutz need to go right now. Those two are idiots. GM will be out of business if two of them stay. What good did they do for gm nothing. Rick just complains about unions and lutz about fuel standards. Those two idiots just keep investing money into wrong product. Because of GMT 900 they delaied zeta and epsilon 2. Imagine if we had those two platforms now with two mode hybrids. How about if every gm had 6 speed. Do you think that gm would be losing market share? Or how about if they made Fuel economy and quality #1 priority. Most people would like to see 40 mpg impala hybrid then then 25 mpg tahoe, or how about 60 mpg cobalt? I do not know how can anybody support rick and lutz anymore they need to go.

[Masospaghetti]

GM can try closing plants, renegotiating its union contracts, laying off workers and asking for a government bailout of its staggering employee medical care expenses. In fact, I predict it will try all of the above.

He really predicts "all of the above", eh? That's impressive, considering the three former he listed have already happened. So he's predicting GM will need a government bailout. Possibly, but there seems to be hope with the UAW healthcare pool they are talking about, to avoid this.

[mikesright]

Where is this guy's sources?!! GM itself (car operations, not finance operations) has about $30 billion in actual corporate debt and has large pension and heathcare obligations that amount to about $12 billion a year and will never all come up at once and that we all know about. With the new accounting regs, yes, the companies have technically negative value.

Buickman, you're best friends, the Smith's, are responsible for this enormous burden, not Wagoner. And they are gone.

[01cavalier]

Here we go again with the doom and gloom. GM starts showing signs of a turnaround and they get attacked, forget about any positive signs of progress.

[K-1]

Originally Posted by Cabana Boy

All BS.

I live near Detroit (30 miles North) and I am downtown all the time. The city is really starting to come to life. As the Big-3 become great again, it will only help the city.

Total BS read.

I agree. Those who live here aren't seeing the massive degradation of the economy.

[tgagneguam]

Originally Posted by smk4565

Toyota is worth $385 billion. I suspect Toyota one day buys one of the Detroit automakers, even if just to close them down, and resurrect a nameplate later down the line. Although a few American brands will probably go out of business on their own, so Toyota might not even bother.

You haven't been paying as close attention to Toyota and the reasons for its success as I thought you have been, smk4565. It would benefit Toyota more to slowly bleed Detroit-a position in which Detroit seems frustratingly comfortable with occupying-than to deliver a knock-out punch. Much of Toyota's growth has been internal, and with the rise first of Lexus and then Scion, it's obvious Toyota is capable of sustaining that growth. It serves no purpose to buy someone else's headaches.

Of course, in terms of more nebulous assets like people talent and brand equity, I believe Detroit possesses what it needs to succeed. But that makes it all the more annoying that Detroit doesn't capitalize on its strengths.

[espo19047]

This story is GMI at its worst. Can we start a gloom and doom section so it can easily be avoided? I read this junk everyday in the paper and other websites. I thought this site was for "inside news." I don't come here to read people taking pot shots at GM.

[Dynamo]

Originally Posted by Cabana Boy

All BS.

I live near Detroit (30 miles North) and I am downtown all the time. The city is really starting to come to life. As the Big-3 become great again, it will only help the city.

Total BS read.

I agree, I live about 10 miles from downtown and anybody who lives here would know that it's actually getting better. It's still recovering from the days of C. Young and riding the momentum of D. Archer. As for the suburbs, there's no way you could apply the term crumbling.