Tuesday, November 11, 2008

The future for US Auto Stocks

There have been some pretty negative news surrounding the big three US auto manufacturers this year. Recently GM and Ford reported continuing large losses, triggered by a decrease in the demand for cars nationwide. The demand for cars, which typically is highly cyclical in nature, is lower because of the low consumer confidence in the economy as well as the difficulty that car buyers have in obtaining credit financing to purchase new vehicles.

As a result of these events Detroit manufacturers’ stock prices have taken a large hit this year with GM losing 82% in 2008 while Ford stock lost only 70% during the same period of time. GM eliminated its dividend payment in July 2008 in order to boost its liquidity. The company has taken other measures to bolster its cash situation by selling off assets. Ford eliminated its dividend payments back in 2006. These two stocks should have been out of any dividend portfolio after the cuts, as every dividend investor knows that dividend cutters and eliminators have underperformed the stock market over the past 30 years on average.

The future of the US car companies is definitely getting bleaker every day. The executives of GM, Ford and Chrysler are in talks to get money from the US government in order to keep the industry afloat until the current downturn ends. This could be the only thing that could save several million jobs in the auto industry, since selling off assets might be difficult to achieve in the current tough credit environment.

With GM and Ford stocks trading at multi-decade lows, it seems that investors could potentially make large gains once GM and F overcome the crisis and return to profitability. I see three scenarios for the future of car companies:

1. Car companies receive a loan guarantee from the US government, similar to the one received by Chrysler in the early 1980s. Millions of jobs will be saved; new energy and cost efficient models will be unveiled and after the economy recovers the auto manufacturers will make advance loan repayments and start paying out distributions to their shareholders. Furthermore, as long as the stock base isn’t diluted, long term investors could easily see large capital gains from current levels. Back in the late 1970’s Chrysler stock was trading at under $2 a share before the government loan guarantees. After the company turned around, the stock traded as high as $50 before the 1987 crash. No dividends paid for several years after the bailout. If this scenario were to occur owning stock would be a very good strategy.

2. The other scenario assumes that the US government entities does provide a bailout similar to FNM, FRE and AIG, where common and preferred stock ownership is diluted as the government takes majority stakes in the auto companies. This could lead to more losses for Ford and GM shareholders. The best strategy for this scenario would be to purchase GM and F debt at current levels.

3. A third scenario could occur if the government lets Ford and GM file for Chapter 11 reorganization. Shareholders will be completely wiped out, while bond holders would end up owning the companies after their interests are converted into equity into a newly formed corporate entity.

There could definitely be more scenarios involving a potential purchase of US assets by foreign auto manufacturers. The main point is that at this point owning GM or F stock is highly speculative, and should not be looked upon as an investment. In the meantime we could see short squeezes as short positions amount to 13% and 16% respectively of Ford and General Motors share float.
That being said if investors want to speculate on the auto industry, I believe that GM or Ford bonds could be the best vehicle for such operations. There are several retail bonds issued by GM, whose nominal value is $25. These bonds and notes are traded on the NYSE just like any other instrument. You could find more information in the table below (Source: GM Investor Relations Website):

Each of those bonds is trading currently at about 25% of face value.

Full Disclosure: None

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