GM's Dividend Squeeze

This column was originally published on RealMoney on Jan. 6 at 11:11 a.m. EST. It's being republished as a bonus for TheStreet.com readers.

General Motors(GM Quote) is caught between a rock and a hard place.

On the one hand, GM's balance sheet would benefit from a dividend cut. On the other, the auto giant would alienate its shareholder base with a dramatic dividend cut. Since this dilemma is coupled with longer-term cost-structure woes, I believe investors clinging to hope and to the 10% dividend yield face a costly comeuppance.

First, let's look at the dividend. GM shares currently yield nearly five times the S&P 500, and the company paid out about 25% of its cash from operations to shareholders over the past 12 months. Most value and income-oriented funds and pension plans have rules in their charters that restrict them from holding stocks that don't pay dividends, so the elimination of the dividend would likely knock shares much lower.

With very few growth-oriented institutions playing the auto group, the last thing General Motors would want to do is alienate the one group of investors that remains willing to support its share price near the $20 level. According to my conversations with fund managers and investors over the past few months, General Motors will likely make a conscious effort to maintain an above-average dividend yield, likely in the 3% range; this would still save the company about $800 million a year in cash, on the basis of my calculation.

But regardless of the company's dividend policy, I believe General Motors faces such imposing financial threats that its equity may ultimately trade far lower than its already depressed $20.31. (Editor's note: Shares rallied Monday, Jan. 9, and were recently trading at $22.35.)

Of course, the fact is that none of this would matter if GM could manage to escape the noose of its post-retirement employee benefit cost structure.

The quickest fix is time, obviously.

As General Motors retirees age and ultimately die, the company's health care obligations will decline. Figuring out a way to make money on the cars it sells wouldn't hurt either, but that would require General Motors to outsource more of its labor and parts to countries such as South Korea. Such a move wouldn't sit well with the unions or with the U.S. politicians General Motors needs as friends when it lobbies to change or lay off its pension obligations to the Pension Benefit Guaranty Corp.

Although this bearish thesis may take a while to come to fruition, there is near-term upside potential in the stock. General Motors is reportedly working to complete a widely anticipated sale of 51% of GMAC, its profitable finance division, in an effort to create some financial breathing room. But after that, I wouldn't be surprised to see General Motors' share price work toward the single digits in 2006. Of course, the short trade can be painful in the near term as traders who borrow shares and sell them short are on the hook for the 10% dividend yield, so the move lower will likely be a steady grind and not a rapid fall.