MOODY'S LOWERS GM LONG-TERM RATING TO Baa1; GMAC LONG-TERM AND SHORT-TERM RATINGS LOWERED TO A3 AND PRIME-2 RESPECTIVELY
Moody’s Investors Service lowered General Motors Corporation’s (GM) long-term rating to Baa1 from A3, and also lowered General Motors Acceptance Corp’s (GMAC) long-term rating to A3 from A2 and its short-term rating to Prime-2 from Prime-1. The existing Prime-2 short-term rating of GM is confirmed. The Rating outlook for both GM and GMAC is negative.
The downgrade of GM reflects Moody’s expectation that the intensifying competitive environment in North America, in combination with large pension and OPEB funding obligations, will result in the company’s automotive earnings, cash generation, and debt protection measures remaining weak through 2003. Moreover, despite the likelihood of continued progress by GM in reducing its variable cost structure and maintaining a competitive new product cycle, we expect that these two challenges (greater competition and large legacy obligations) will severely restrain the degree to which the company’s performance will rebound as the US economy and automotive demand recover during 2004 and beyond. However, as GM contends with this more difficult long-term operating and financial environment, it will benefit from a strong gross liquidity position of over $20 billion, an average maturity of approximately 16 years for its $15 billion in industrial debt, and considerable cash proceeds that should be generated from asset dispositions. Moody’s believes that these favorable balance sheet and liquidity enhancing characteristics afford GM a critical near-term financial cushion. This cushion should provide the company with the flexibility to demonstrate ample evidence, over the next six to twelve months, that it will be able to address critical business challenges. These challenges include: 1) continuing to reduce costs; 2) preserving product momentum; 3) maintaining market share at 2002’s levels; and, 4) achieving a UAW contract that contains wage/benefit increases that are no greater than those granted during the 1999 contract but provides greater work rule flexibility.
The downgrade of GMAC’s ratings reflect the substantial linkages that exist between it and GM. These ties are both operational and financial. GMAC provides financing for GM dealers and their customers, and the quality of its portfolio is influenced by its parent. For instance, the financial and operating health of GM dealers, and the collateral and residual value of GM vehicles directly and significantly affect GMAC’s performance. Therefore, GMAC’s ratings are tied to its parent’s.
The negative outlook reflects Moody’s concerns that the competitive environment in the US could become even more intense, that the weakness in the US economy and consumer sentiment could extend well into 2004, and that GM might fall short of achieving various operating and financial objectives. Adverse developments in any of these three areas could contribute to further downward pressure on the rating. As a result, during the next six to twelve months, Moody’s will closely monitor both the competitive conditions in the US market, and GM’s ability to successfully achieve key elements of its strategic and operating plan. Key benchmark indicators for the US market would include:
- 2003 unit shipments remaining above 16.0 million units
- 2004 unit shipments looking on track to approximate 16.5 million units
- Average vehicle incentives not materially exceeding current levels.
Key benchmark indicators for GM’s operating performance and competitive position would include:
- Maintaining U.S. market share that approximates 28%.
- Further closing the product quality and consumer survey gap relative to Japanese products.
- Remaining on target to substantially improve the operating earnings of GM North America for 2004.
- Achieve trouble-free launches and solid consumer acceptance for key product launches.
- Completing the planned sale of Hughes Electronics shares.
- Achieving a reasonable UAW contract.
- Significantly strengthen free cash flow generation from core automotive operations.
Despite the possibility of further intermediate-term pressure on the GM rating, the company’s liquidity position and operating fundamentals should enable it to remain well positioned within the Baa rating category during the next 24 months.
GM’s key North American market will remain characterized by increasingly intense competitive conditions as Japanese, Korean and German manufacturers all look to grow their transplant manufacturing operations in this region, expand their presence in higher-margin truck, SUV and luxury categories, and increase their market share. As a result, the high level of incentives and the negative price realization that the North American automotive market has exhibited during the past two years will likely continue.
As GM contends with this more difficult pricing environment, it will be burdened by the growing funding costs associated with its pension and OPEB liabilities. With a year-end 2002 US unfunded pension liability of $19 billion, GM faces the prospect of intermediate-term annual pension funding requirements of approximately $3 billion based on its current estimates of a 6.75% discount rate and a 9% return on pension plan assets. Although the actual funding requirement could vary considerably based on future interest rate levels and equity market returns, the intermediate-term funding requirement will remain large. In addition, GM’s annual OPEB expense is approximately $4 billion. Due to the continuing rise in US health care costs we expect that this expense will continue to rise.
GM’s sizable pension and OPEB funding obligations are largely the result of the company’s large retired work force - it has approximately 2.5 retired workers for every active worker. This retiree base, and the related pension and OPEB funding requirements, result in GM having a very high fixed cost structure. GM’s need to cover this large imbedded expense base, and the limited flexibility it has to manage these costs down, are the key drivers of many of the company’s most important operating and strategic decisions. For example, it has embraced aggressive incentives in order to maintain unit shipment levels above its break even level, and it may be unlikely to pursue any large employment reductions for the unionized work force because this would further exacerbate its legacy burden.
Key components of GM’s strategy for addressing these challenges – negative net pricing, high pension and OPEB expenditures, and a large fixed cost structure – have been to diligently reduce variable costs and to maintain an aggressive new product initiative. As a result of its cost cutting initiatives, GM is the most efficient operator among the Big-3, and it has considerably narrowed the productivity gap that had existed between its North American manufacturing and assembly operations and those of Japanese transplant facilities. These operating efficiencies and a low variable cost position have enabled GM to maintain a relatively high degree of profitability, compared with the other Big-3 manufacturers, despite the intense incentive environment.
GM has also undertaken an aggressive and relatively successful new product initiative over the past four years. This effort has strengthened its position in the US truck and SUV markets, and will begin to cover the company’s domestic car franchise. This is an important long-term undertaking to broaden the company’s base of domestic profitability beyond the trucks and SUV sectors, which are becoming much more competitive and less profitable.
In order for GM to preserve an adequately competitive position in North America, the company must demonstrate that it will be able to continue to reduce its variable cost position, and maintain a broad-based and successful new product initiative in the US.
As GM faces these competitive and structural cost challenges, and as it continues to implement its cost reduction and new product strategies, the company’s intermediate-term liquidity position and cash generation should remain sound. At March 2003, GM’s manufacturing operations benefited from a gross cash, marketable securities and short-term VEBA position of approximately $20.6 billion. This compares with total debt of about $15.0 billion. Importantly, the average maturity of this debt is about 16 years.
During 2002, GM’s strong cash flow from operations enabled it to make $4.8 billion in contributions to its US pension (considerably more than the level required to avoid VRP payments) and $1.0 billion to its VEBA. The company is now undertaking a number of transactions that should provide for additional sizable contributions to the pension during 2003. It has sold its defense business for $1.1 billion, contributed $1.2 billion in Hughes Electronics shares to the pension and VEBA plans during early 2003, and reached an agreement to sell its remaining Hughes shares for approximately $4.0 billion. In addition, a possible sale of GMAC’s commercial mortgage business could yield proceeds in excess of $1.0 billion. These initiatives should enable it to make pension plan contributions of $6.0 billion or more in 2003 - a level that for the second consecutive year would significantly exceed contributions required to avoid VRP payments.
GM’s ability to generate cash flow from operations has been strong through 2002. However, the pricing pressure it faces in North America will dampen the level of cash that can be generated from earnings. For instance, during 2002 increases in various operating liabilities and accrued expenses (such as dealer sales allowances, policy and warranty payments, and employee befits) contributed a significant $5.2 billion to cash from operations. As earnings decline, this type of working capital contribution could become an even larger portion of the company’s total cash generation. Although important and sizable, this source of cash generation can be vulnerable to reversal in subsequent years depending on the level of business activity. Consequently, our assessment of GM future cash generating ability will focus on the company’s longer-term ability to generate cash from earnings - the most reliable and highest quality source of cash flow generation.
GMAC’s ratings were downgraded as a result of the downgrades of GM’s obligations. GMAC’s operating performance has held up quite well through a difficult economic environment. The company has recorded successive periods of record absolute profitability as a result of growth in its auto financing portfolio, and most of its other businesses have proved to be solid earnings contributors. The auto financing business’ profit margins have come under some pressure, primarily as a result of higher losses and tighter financing margins. Losses in the auto portfolio have been most affected by loss severity versus default frequency, as the used car market remains very weak. Profits in the mortgage business, on the other hand, have improved as the company enjoys the benefits of the continuing strong mortgage refinancing market after having written off a significant amount of mortgage servicing rights in recent years. GMAC leverage position has become pressured as asset growth has exceeded capital formation. We expect that GMAC will manage its financial profile and operations prudently, thus preserving the one rating notch differential between it and GM.
General Motors Corporation, headquartered in Detroit, Michigan, is the world's largest producer of cars and light trucks. GMAC, a wholly-owned subsidiary of GM, provides retail and wholesale financing in support of GM's automotive operations and is one of the worlds largest non-bank financial institutions.
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