Dark Clouds Shadow GM-Ford Financing Parade

Accelerating out of a skid is a risky tactic for any driver. But a particularly nasty crunch could await Ford (F Quote) and General Motors (GM Quote) when the two automakers ease off the gas and let sales slow.

Over the past year, the auto giants have ridden out the economic slowdown with aggressive demand-boosting tactics made possible by low interest rates. These widely applauded efforts have included making 0% loans, which were started soon after the Sept. 11 attacks, and giving hefty rebates.

Most investors and analysts don't seem overly concerned that the companies' lending arms have embarked on this credit splurge, which Detox examined earlier this year. Rather, Wall Street has chosen to worry about other problems, such as enormous pension liabilities, burdensome cost structures and foreign competition.

But the companies' free pass on financing may be about to expire. In a recent report, Goldman Sachs auto analyst Gary Lapidus focuses on the finance subs, raising plausible-sounding questions about the sustainability of their lending programs. The analyst contends that the finance arms will require billions of dollars of capital injections if the auto companies are "to maintain their existing market share and growth trajectories."

The rub is that if the companies cut back on lending, auto sales could fall sharply. And Lapidus highlights a key accounting issue at Ford. Cash in hand and cash flow would both be markedly lower if the Ford automotive division made subsidy payments to the finance company in the same way as GM and DaimlerChrysler (DCX Quote) do to their finance units, the analyst argues. "We find it odd that the Big Three's approaches differ on such a material manner," Lapidus writes in his note.

Ford didn't respond to a request for comment. GM spokesman Jerry Dubrowski said: "The assumptions contained in the Goldman Sachs research report are highly speculative and GM does not agree with the scenarios described in the report." Lapidus didn't respond to a request to expand on points in his note. He rates Ford market perform¿and¿has no¿rating General Motors; Goldman has done recent investment banking for both companies.

Ratings Risk

The key to understanding what Ford and GM are doing is to track how the cost of incentives like the 0% loans is booked.

A finance subsidiary can't lend at 0% or it could be unprofitable and its equity would be diminished, leading to a credit downgrade. And lenders need strong credit ratings to keep their own cost of borrowing down.

For that reason, it's the auto divisions at the Big Three that pay the extra cost of doing a 0% loan. They then book it as an expense in their income statement. Ford breaks this amount out -- it was $4 billion in 2001 -- but GM doesn't. Of course, the cost of doing this saps profitability of the auto segment and can contribute to declines in automotive equity.

This has been happening in a big way. The auto divisions of GM and Ford will have tangible equity (equity minus intangible assets) of negative $6 billion and negative $9 billion, respectively, at the end of this year, Lapidus estimates.

However, it's unlikely that the finance companies will be able to pay big dividends to the automotive segments -- one way of restoring auto equity -- if loan growth continues at current rates. In fact, the finance divisions will need capital injections if they are to keep debt-to-equity ratios at current levels, says Lapidus. Over the next two years, those injections could total $4.4 billion at GM and $2 billion at Ford.

And it's not that the companies are free of other large cash needs looming on the horizon. Both companies could end up adding billions of dollars into their pension funds, a problem that is far worse for GM.

"General Motors has no plans to inject additional capital into GMAC at this time," says GM's Dubrowski. "In fact, GM still expects to receive a dividend from GMAC this year."

Tracking Flows

Tracking cash flows between auto and finance divisions is also critical, and Lapidus claims Ford's method could mean that numbers for cash flows and cash at the auto division are "less robust than they appear."

When GM books a GMAC subsidy as a cost, it passes the cash to GMAC immediately, according to Dubrowski. However, Ford does not pay cash immediately to Ford Credit, even though it books the expense up front. If Ford did things GM's way, Lapidus estimates that Ford auto's cash balance would've been $12.5 billion, and not $22.5 billion, at the end of 2001, and cash flow would've been $1.5 billion less in 2001. Under certain trends, Ford auto's cash balance could actually go negative by 2004, if the cash payable to Ford Credit were factored in, the analyst concludes.

But company manuevers are only part of the equation. People's demand for auto loans, even attractively priced ones, may start to wane. At some point, interest rates will rise and cut off demand, and a slowdown could mean people cutting back on big-ticket items like cars. What's more, even in a relatively benign economic environment, demand could soften because recent incentives have done no more than bring forward demand. That could deepen the recent sinking spell for these stocks: Ford stock is down two-thirds this year, and while GM's is off only 6% it trades well below its 2002 high.

Ford and GM have to make some unenviable choices. The easiest way out would hurt current stock and bond holders, and that would be to raise billions of dollars through equity and bond issues. Or they could take on the unions to get costs down. The conspiracy theory is that Ford and GM may allow a dire-seeming situation to develop so that the unions are more pliable. Who knows, if they play that game to the extreme, they may even get a handout from the Bush administration, as 2004 draws closer. Could this be why Lee Iacocca is granting more interviews these days?