What We Should Do With Detroit

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The following post is being reprinted from our discussion boards. Posts are usually a part of an ongoing thread, and are out of context when presented here. The material should be read in that light. Click here for the latest on the $17.4 billion bailout announced today.

Re: UAW = Idiots
Board: Investment Analysis Clubs/Macro Economic Trends and Risks
Author: TMFSlydo
Date: December 13, 2008

Hi Folks,

Lots of emotion on display here. Certainly understandable given all the issues involved-labor, management, government, taxes, personal experiences, perhaps even a bit of nostalgia (first cars, first loves, old lemons and whatnot). Lord knows I have my own personal biases, given that my dad's a retired [General Motors (NYSE: GM)] exec.

Anyway, here are my thoughts.

1) The current crisis is a direct result of the credit meltdown. That is not a problem of the automakers' making

2) The fact the credit meltdown became a crisis for the automakers IS a problem of their own making.

3) It became a problem because of cars, agreements and decisions made 10, 20, 30 and even 40 years ago (stretching back before the 1973 Arab oil embargo).

4) Current management and union leadership have made more progress in working toward fixing the problems in the past five years than was made in the previous thirty.

5) That progress is still nowhere near enough.

So where are we today from an operational/business model standpoint?

The cars are far superior to what was being turned out even a few years ago, and continue to improve with each passing year. The most recent UAW agreement promises to eliminate the cost differential between domestic and transplant automakers, putting them on a level competitive playing field. [sidenote-my dad, no fan of the union, was saying long before this mess that current UAW head Ron Goettelfinger is the first union leader who "gets it"]. Top management has agreed to aggressive pay cuts. The dividend was cut in half. Retired executive health insurance has been completely eliminated. Bondholders have been asked to exchange debt for equity.

In other words, all stakeholders, except perhaps retired UAW members who are contractually protected, have taken or been asked to take a hit.

But that's still not enough. As a result, GM and Chrysler face imminent bankruptcy. Ford (NYSE: F) has a bit more time, but they are leveraged to the hilt and will quite likely face a similar crisis in 12 to 18 months if sales do not turn around.

Now, I would clearly appear to have a bias in wanting to see GM survive for my dad's sake, but at this point I believe his fate is sealed, no matter what happens. His basic pension is secure even in bankruptcy, but his health insurance is gone for good, ditto the value of his stock holdings. The remaining dividend is as good as gone, as is his supplemental executive pension. So whatever happens from here on out really has no bearing on the personal situation.

That said, we first must decide if saving the domestic auto industry is not just a worthwhile goal, but an imperative one. First, we should keep in mind that despite all the talk of the domestics not making cars Americans want to buy, GM, Ford and Chrysler still rank 1, 3 and 4 respectively in total vehicles sales (and they retained those ranks in November). The prospect of their failure carries heavy economic, social, national security and global competitiveness implications. 

The economic factors have been discussed at length-some 2.5 million jobs at risk, with all the attendant impact that would have on our precariously positioned economy. Simply from a timing standpoint, failure of one or more of the automakers could cause an economic tailspin that could take many, many years from which to recover.

But the intangible losses could be far worse. The auto industry, including ancillary industries, is the nation's largest R&D spender. Those dollars employ engineers and scientists of all stripes, researching and designing everything from power plant technologies that include electric, hydrogen fuel cell and biofuels to metal alloys, plastics, safety, navigation, pollution control and a range of technologies that have benefits that go far beyond the automotive world. 

Beyond the fruits of that R&D, the demand for those scientists and engineers (automakers are the single largest employers of mechanical engineers) provides a market that encourages students to pursue studies in those fields. The industry is also a rich source for instructors in those fields. We must consider the impact the loss of such a vital skill set could have on our long-range ability to innovate and compete globally, not to mention what life-improving innovations may be lost to posterity.

That is a point that should not be taken lightly. Anecdotally, I own a business that helps source parts and components for companies. A while back we were asked to find a part for an old piece of equipment. I scoured the U.S. trying to find it, but was finally told I'd have to go to China. The reason was haunting. It wasn't just that it wasn't made in the U.S. anymore, but that-and I quote-"You won't find anyone here that knows how to make it." A skill we had lost forever, ceding it to our greatest upcoming competitor. How many more such stories will we encounter if we lose our domestic automakers? I'd rather not find out.

The loss of skills does not just pertain to college-educated professionals. Despite all the comments about bumper-hanging, hubcap-attaching autoworkers, the truth is that today's line workers have become highly skilled technicians. The equipment in today's auto plants are technical marvels that require a great deal of training and expertise to operate and maintain. Whether they are overpaid or not in today's environment may be a point of debate, but the value of those jobs and the skills they require are precious. We should not dismiss them quite so cavalierly. 

Even more frightening might be the impact on our social fabric, especially in Midwestern states. The city of Detroit already provides a blueprint for what happens when good jobs leave. Crime, poverty and desperation are sure to rise. We've seen how intractable those problems are once they become a routine part of life. The financial and social cost of dealing with the fallout of failure is almost certain to far outweigh whatever cost we're considering today.

All that said, it still makes no sense to bail the automakers out if the business model remains broken. So can it be fixed? I believe it can. First, we have to separate current operations from legacy costs. A sizable, perhaps insurmountable, portion of their problems stem not from operations today, but the costs imposed by decisions made decades ago. If current operations can be freed from those costs, a thriving domestic industry can emerge. And if we believe a thriving domestic industry is important-which is what the argument above is all about-then finding a way to deal with those costs are the basis for a revival.

So how do we go about it?

To date, the argument has largely centered on one of two options: Give them the money or let them fail. Many believe Chapter 11 bankruptcy is the best option. In a way, I agree. But I don't believe a standard filing could work for several reasons. First, consumers are sure to be scared off from buying vehicles if they fear warranties won't be honored, parts and service may not be available and that resale values will plummet. That would make emerging from any Chapter 11 filing almost impossible. Second, the industry is extraordinarily dependent upon credit to finance operations, including dealer floor plans, parts and raw materials, finished inventories and capital investment. It's the nature of the business, whether we're talking GM or Toyota (NYSE: TM). Even if one wiped their current debt off the books, they'd need to secure new debt immediately to finance the business. This debt is not a bad thing, but it would be very difficult to secure it while in a Chapter 11 situation.

Therefore, I believe the best option is a pre-brokered, government-backed bankruptcy. The government would infuse cash in exchange for future consideration, whether it's in the form of warrants, preferred stock or some other form of temporary equity position. The government would then guarantee both the new debt needed to finance operations and customer warranties, thereby putting a floor to the downside of consumer expectations.

Meanwhile, the Chapter 11 filing would open the door to the draconian cuts that must take place. Current shareholders (which include my dad) would largely be wiped out. Bondholders would exchange debt for equity in the new shares. Management would take across-the-board pay cuts. The union would accelerate concessions scheduled to take effect in 2010 and accept health care plans that are more in line with what most working Americans have. They would also have to open the door to retiree concessions, particularly with regard to health insurance. It need not be eliminated, but it certainly needs to be restructured. Dealerships would be pared and product lines cut, thereby reducing overhead, redundancies and managerial jobs. No one would like it, but that's the point-everyone must sacrifice.

The result would be a far different, but very competitive, American auto industry. Analysts estimate that such cuts would make GM cash flow neutral at an industry sales volume of 13 million or fewer units annually. That's a level that has been exceeded every year since 1993 (including this year), and has been missed only twice since 1983 (12.3M in 1991, 12.9M in 1992). In other words, GM would be breaking even to slightly cash flow positive today and profitable in almost any other circumstance. That's a successful business model.

It would not be painless-not by a long shot. But it would be far better than what we're facing. I know it won't satisfy the visceral need some seem to have to see the union or management "get theirs." But it would also mean we're not going to cut off our nose to spite our face. I've never been one to care what someone else is getting. It just doesn't matter. Nor do I have much stomach for government getting involved in private industry. Still, it happens all the time, from state and local tax breaks that encourage companies to relocate to publicly funded stadiums. None of those would appear to be nearly as important as a strong, competitive domestic auto industry. 

I'll close with a well-known, though often misquoted, line from former GM president Charles Wilson, made during his 1953 confirmation hearing to become Secretary of Defense. In response to how he'd handle a situation where there was a conflict between what was in the nation's and GM's best interest, he replied "For years I thought that what was good for our country was good for General Motors, and vice versa."

I think that line captures today's situation perfectly. We're all part of one interwoven community. We should not look at this as helping the automakers-and we absolutely should not see it as helping them maintain the status quo. Instead, we should see this as helping us all. For what's good for the automakers, in this case, really is good for the country.

Sorry this turned into more than a snappy soundbite. 

Paul