GM's Rolling, but Road to $10 EPS Won't Be Smooth

General Motors is putting the pedal to the metal just as its engine is starting to overheat.

The nation's leading automaker audaciously claimed last week that it expects to triple earnings by 2005. If GM achieves this goal, it will have pulled off a remarkable U-turn. Already, investors have begun to take note.

Based on GM's forecast that it will earn $10 a share by 2005, the stock looks like a juicy bargain. No wonder, then, that the market is beginning to fall in love with GM and its recently energized management team, led by CEO Richard Wagoner, Chairman John Smith and CFO John Devine.

GM stock is up 30% since the September introduction of 0% auto loans sparked stronger sales. And the bulls are finding plenty of other reasons the stock's climb still has a way to go: the strengthening economy, GM's continued market share gains in key product areas, and, of course, the internally distracting remake at cross-town rival Ford(F Quote).

But a few good numbers and some impressive buzz shouldn't fool investors.

In the car market, GM faces unremitting competition from foreign automakers and a punishing pricing environment. Looking inside GM itself, the Detroit giant has internal weaknesses that stretch far beyond widely discussed negatives like its burdensome pension fund liability.

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Take its finance subsidiary, General Motors Acceptance Corp., or GMAC. GM's auto sales rely heavily on GMAC, which finances customers' car purchases and sells warranties and insurance. Though it has a higher rating than GM, GMAC's true strength is almost impossible for outsiders to gauge. A good chunk of GMAC's revenue -- and perhaps its earnings -- comes from large internal payments made by GM to GMAC. And for a finance company with $100 billion of loans on its balance sheet, GMAC's financial disclosure is extremely patchy.

Nor should GM's accounts escape scrutiny. Investors need to take a much closer look at a recent change in health care cost assumptions that stand to aid 2002 earnings, for example.

GM execs strongly reject these criticisms. They deny that GMAC disclosure is poor, and they stand by the health care accounting. As for the $10 earnings target, the company asserts that is not as gaudy a target as it looks.

Demi Moore

First, disclosure. Last week, GM execs aimed to boost financial disclosure by making a special filing that contained extra detail on things like off-balance-sheet financing structures. This decision was viewed as a smart move in the post-Enron environment. However, the filing contained nothing that could fill in the many gaps that exist in GMAC's quarterly financial statements. Though a subsidiary, GMAC's numbers are critical because the unit's loans drive many GM sales.

Perhaps most striking is the lack of credit quality data at GMAC. One of the most important parts of analyzing a finance company is checking the strength of loan loss reserve, which is the capital cushion lenders keep to protect against bad loans. If the cushion is too small, additions have to be made to the reserve. The additions, also called provisions, are an expense in the income statement. Since 1994, GMAC has just about doubled the size of its on-balance-sheet loan book to $95 billion, most of which are auto loans.

At that size, even the smallest addition to the provision can have a huge impact on earnings. A provision equivalent to 1% of the loans could cost nearly $1 billion. And in the first nine months of 2001, GMAC provisions cost the company $816 million, equivalent to 40% of pretax income in the period.

Hit the Pedal GM expects to make $10 a share by 2005

*All years till 2001 are actual earnings. Earnings for 2002 and 2003 are analyst forecasts. 2005's $10 per share is the company's forecast. Source: Detox.

To be sure, the reserve has been boosted by a lot over the past year or so, and GM's earnings haven't been at all bad. This apparently shows a laudatory caution on GMAC's part. But amid strong portfolio growth and a lurching economy, investors need to keep tabs on credit quality; that requires extensive quarterly disclosure that can be used to check the reserve. (The company provides better disclosure in its 10-K annual reports, which come out once a year and are due by the end of this month.)

Two methods are frequently used to measure the solidity of a reserve: comparing it with charge-offs, which are loans that are considered to be losses because they can't be recovered; and with past-due loans, loans that the borrower is late paying, but which haven't been charged off yet. A loss number is given in GMAC 10-Q filings, but it isn't straightforward. Something called the "annualized net retail loss rate" is given as a percentage of "total average serviced automotive receivables." This rate was 0.69% in the third quarter, and no dollar figures were provided for two numbers used to arrive at that ratio.

Call In the Reserves

Normally, the dollar losses would be compared with the dollar size of the reserve, $1.6 billion in the third quarter at GMAC. But because no dollar number for losses is given in quarterly statements, this is impossible. Also, one can't be backed out by taking 0.69% of "average serviced automotive receivables," as no dollar number is given for that. A number for something called total finance receivables is provided quarterly, and auto loans make up about 85% of that. But what are the other 15%, and what sort of quality are they?

As for past-due loans, or delinquencies, GMAC doesn't provide those quarterly either. This is an incredibly anomalous shortcoming. Nearly all stand-alone publicly traded finance companies do so. Delinquencies give guidance of what losses will be. If they spike, losses normally do later, and provisions have to be jacked up.

GM spokeswoman Toni Simonetti responds: "We have more than adequate disclosure for all aspects of the company." And Bill Muir, GMAC's finance chief, asserts that the lack of delinquency data isn't a big deal. "I don't see what the need is on a quarterly basis," he says. "The adequacy of our disclosure is in the eye of the beholder."

Muir also insists that GMAC's reserve is strong enough. "There is no basis in history or in current expectations to say that we aren't adequately reserved." And he firmly rejects the argument that the recent loan growth, achieved mostly by offering attractive terms, will have brought on less creditworthy borrowers. "The credit quality of the 0% loans is absolutely cream of the crop," says Muir.

Also, it'd be very useful to know how much gains from selling mortgages have added to profits. Like many other mortgage lenders, GMAC sells the mortgages by bundling them into bonds. The loans are no longer on GM's balance sheet, but when they are sold, a specially calculated gain is booked to income partly based on estimates about the future profitability of these loans. This method is called "gain-on-sale" accounting.

In times of fast growth, the gains can stack up and make lenders look more profitable than they really are. Later, if the loans don't do as well as expected, losses have to be booked. In its annual report, GMAC does say that it recognized $682 million of pretax gains from selling mortgages in 2000, though it's not clear whether those gains are synonymous with gain-on-sale profits. By comparison, the mortgage business made net income of $327 million in 2000.

Payment Streams

And no analysis of GM is complete without a close look at how GM itself contributes to GMAC's revenue and earnings. Investors particularly have to watch the large amount of internal payments GM makes to GMAC for a range of services. These are broken out only in the annual report and amounted to more than $2 billion in 2000. The cynical view is that these payments make GMAC look more profitable than it really is to ensure that its rating, one notch higher than GM's, is maintained and keeps the cost of its borrowing down.

Do the transfer payments matter? At first blush, it would seem not. If GM didn't make the payments, its expenses would be lower and it'd be more profitable. Also, GM can always be relied on to shore up GMAC's rating.

However, there are potential snags to these arguments. GM needs GMAC to sell cars. Without it, sales would almost certainly be a lot lower. A good chunk of transfer payments is the result of GM making GMAC whole for seemingly uneconomic deals. In 2000, GM made a payment of $739 million to GMAC for leases that were priced too low. GM execs see these sorts of payments as marketing costs. That may be so, but how long can they continue? At some point, investors are going to want to see that GM can sell cars with less assistance from GMAC's incentivized financing.

There are two ways in which that financing would have to slow sharply: first, if GMAC profits are hurt by higher interest rates -- lower rates have been a massive boost to recent earnings -- or by a spike in credit losses; and, second, if GM's car sales deteriorate even with the low-cost financing.

GM's got a long drive ahead if it wants to get to $10 a share.