Delphi Revs the Bulls' Motors

Hedge funds join sell-side analysts in betting on a restructuring deal with GM and the UAW.
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Normally, a company with squeezed margins, an overleveraged balance sheet and huge pension and health care obligations would be a perfect short-sale candidate. But not in the case of

Delphi

(DPH)

, which has become a favorite of not just the upbeat sell-side community but of hedge fund managers as well.

"Delphi is an event-driven restructuring story, and it is not surprising if it is attracting interest from event-driven hedge funds," says Brian Johnson, an auto analyst at Bernstein & Co., who has a market-perform rating on the stock.

Shares of the Troy, Mich.-based auto-parts maker have risen by 25% since June 23, when Robert Miller was named chairman and CEO. In the past month, Delphi received upgrades from analysts at Lehman Brothers, J.P. Morgan and Goldman Sachs, and from Robert W. Baird on Tuesday. But those betting on Delphi say the main event is yet to come.

Specifically, Delphi bulls are counting on ongoing talks between former parent

General Motors

(GM) - Get Report

and the United Auto Workers to result in a restructuring of existing labor and perhaps supply contracts to ensure Delphi avoids bankruptcy. And the time-line for a deal is presumably limited: Oct. 17 is the milestone for new and tougher bankruptcy laws to take effect.

Part of the talks would include the possible sale of factories that have not been competitive for Delphi. Such a scenario would benefit GM, allowing it to outsource the production of some of its parts to countries with cheaper labor costs. (GM's stock rose 2.2% Wednesday on

hopes for concessions from the UAW; Delphi shares dipped 0.1%.)

When it was spun off from GM in 1999, Delphi negotiated a contract with the UAW that guarantees workers' job security. The very stringent contract mimics those seen in France and Germany, and it is part of the problem, says Johnson. For instance, Delphi cannot downsize. It currently keeps on its payroll 4,000 workers who are not working. In addition, if Delphi were to terminate its pension and health care benefits because of a bankruptcy, GM would have to pick up the cost of paying benefits for 24,000 workers. Such obligations amount to almost $14 billion, with $4.3 billion payable in pensions and $9.6 billion in health care, according to the company's regulatory filing.

Another deterrent is that Delphi remains GM's main supplier in auto parts, so any bankruptcy would deeply disrupt production for the Dearborn, Mich.-based auto giant.

UAW spokesman Paul Krell said that the bankruptcy issue was discussed at Wednesday's meeting, with GM and Delphi counsels present, but that no action had been taken. He declined to comment further.

"We are pleased with the upgrades, and our management continues to focus on the discussions," says Claudia Baucus, a Delphi spokeswoman.

The bulls assume that GM is not going to put the benefits liabilities on its balance sheet, and that's why so many predict that GM is going to bail out Delphi. After all, the main reason Delphi faces a bankruptcy threat is its high fixed cost of labor. Delphi workers receive a $35 hourly salary or $65 including benefits, vs. a $25 salary paid to workers at independent parts suppliers, says Johnson. And since the auto-parts maker sells mostly to GM, a company that has been losing revenue and market share because of competitive price pressures, Delphi's bottom line has been harmed. With rising steel prices making matters worse, the company lost $660 million in net income in the year to date.

A hedge fund analyst whose firm has a position in Delphi said there are basically two types of plays for hedge funds, depending on whether they invest in stocks or in bonds:

A common hedge for those who believe the company will avoid bankruptcy is to be long the stock and short Delphi's debt. If bankruptcy is avoided, the loss on the short fixed-income position will be limited to a known factor, the discount price as the bond can only move up to par, or the price at which the bonds were issued. Discounts are in the 87-93 price range, for respectively the 2009 and the 2006 maturities. (Bond quotes are percentages of the bond's face value of $1,000.)

For funds that primarily trade the debt -- Delphi's senior unsecured debt is rated triple-C-minus by Standard & Poor's -- the bullish arbitrage is to take on a long credit position hedged by the purchase of puts on the stock. If the restructuring does not happen, investors lose on the bond side but presumably will make up for it with the puts.

"These types of trades appeal to hedge funds," says this hedge fund analyst. "It's an absolute return strategy, not a directional bet but a risk-neutral bet." He adds that "every major hedge fund is in this name because it's pretty large and liquid."

But with such consensus on the Street and a relative absence of short-sellers -- Delphi sports a 4% short ratio and a days-to-cover ratio of 3.84 -- one wonders if there is really any event to be anticipated, or whether a positive outcome is already built into the stock.

Event-driven trades have been rewarding this year, spurred by merger activity. The strategy returned 2.18% in July and is up 3.95% for the year, according to HedgeFund.net. It is not great, but it still beats the

S&P 500

, which is up about 0.5% year to date.

But usually, those event-driven strategies are based on uncertainty leading to price discrepancies between the stock's real value and the market price. With everyone placing bullish bets, can we really talk about an event-driven opportunity in the case of Delphi? Investors in the event-driven arbitrage for that name say "yes," because no matter what the consensus is, it is not clear what GM will do.

What remains clear is that "if the restructuring doesn't happen, Delphi is in a lot of trouble," says Michael Hawthorne, managing director at Mellon HBV Alternative Strategies, Mellon's alternative investment arm.

His reasoning is that GM may see the pension liability as a pending problem, because if it does not happen now, the bankruptcy looms as a future potential scenario. "They may think they'll be responsible for it anyway, and they may want to get the filing done before October and get the cost-cutting out of the system," he says. "We are thinking of the trade, and within two weeks we are going to take positions." He declined to elaborate.

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In short, nobody wants to take the risk of being short the stock with a potential deal coming as the bulls keep running. "If there is good news, the stock could run up big time and maybe double; if you short it, you can lose your shirt," says the hedge fund analyst.