Unless it takes action soon,

General Motors

(GM) - Get Report

could end up looking like that beat-up old

Ford

(F) - Get Report

in the front yard.

The second quarter is always a big one for U.S. automakers, and GM's Tuesday morning report was impressive in many ways. Earnings came in way above market expectations, posting a massive gain from 2001 levels.

But the nation's largest car company could roll downhill from here if it doesn't put the brakes on problems that threaten to deplete cash flows and punish its balance sheet. Most pressingly, GM must prove that it can boost sales without offering costly cheap financing to consumers. Otherwise it faces the prospect of taking a beating like the one Wall Street has served up on Ford, once seen as the strongest of the Big Three automakers but now valued at half of year-ago levels.

Worrying

There's some evidence that investors already are worried about the big-picture trends playing out at GM. The company's stock dropped $2.08 Tuesday to $45.84, leaving it 33% below its 2002 high of $68. The stock reached that precipice just two months ago, when U.S. market share gains, buoyant sales and upward earnings revisions by analysts were creating a strong buzz around the company.

Since then, however, the stock has been hit by a growing belief that, despite the highly attractive loans and deals GM offers to consumers, demand for its products may start to fall. Perhaps recognizing that fear, GM executives Tuesday reiterated their view that 2003 U.S. vehicle sales would be in line with this year's target of just above 16 million units. They continue to believe the company can earn $6 a share this year (excluding its Hughes unit).

GM's price-to-earnings ratio is eight times Wall Street's 2002 forecast -- so low that other issues surely must lurk behind headline profits. (Detox

took a good look at GM in March.) Until GM clears these worries up, the shares will be hard-pressed to sustain a rally. Frustratingly for GM bulls, the company did little Tuesday to allay some of the main doubts.

Big Headaches

Two big areas of concern are GM's underfunded pension fund and the cost of paying for health care for current and past employees. The impact a pension fund has on earnings is complex, but the fear stems not so much from the effect on profits but the amount of hard cash GM will have to plow into the fund to bring assets in line with liabilities.

By the end of this year, GM said Tuesday, the company expects its pension to be underfunded to the tune of $13 billion. Now, it doesn't have to suddenly find all that straight away. However, the company does expect to contribute $2.5 billion by mid-2004, while some analysts model a much bigger contribution if the fund's assets show single-digit negative returns.

The nightmare scenario for GM is that it would have to borrow large sums to fund its pension scheme, damaging its balance sheet. And even if it doesn't raise its leverage to do this -- and uses cash from the pending sale of Hughes and other sources -- the pension outflows will hurt cash-flow indicators.

Another nonoperating worry comes from rising health care costs.¿ As an

earlier column pointed out, a sizable (and possibly dubious) reduction in expected growth of health care costs for 2002 will aid this year's earnings. On the call Tuesday, GM executives said they were on track to hit the health care costs target. If the company is successful, it'll be quite a feat, because the 6% health-costs growth it expects for this year is considerably lower than Ford's number. Expect bears to start pressing the company for its 2003 growth estimate.

King Cash

The other source of cash is operations. And GM executives were quick to boast of strong cash flows in the quarter. Automotive operations generated $5.2 billion in the year's first half, way up on the $3.5 billion for the same period in 2001. The company was quick to caution that cash flows wouldn't be so strong in the second half of 2002.

Yet in 2000 and 2001, cash flows from operations continued to rise in the third quarter. Why can't we expect the same this year? A GM spokesman says a lot has to do with a retooling of plants that make some of the company's top-selling SUVs and trucks.

GM also is staying mum about the number of vehicles sold using 0% financing and other very attractive deals. When asked about that Tuesday, the company answered by saying that 50% of sold units carried GM financing of some sort, compared with 40% in prior years. GM watchers have interpreted that as meaning the extra 10% used 0% and other special deals.

The company didn't provide a similar number for the first half of 2002. As in the past, the company Tuesday didn't break out the cost of the 0% loans, which is booked in GM's cost-of-goods-sold line. If it did divulge this -- and the number wasn't large -- GM would blow away a lot of its doubters. That it doesn't may say a lot.

The other key element to GM's success is the continued health of its financing arm, General Motors Acceptance Corp., or GMAC. Because GMAC has a higher credit rating from Moody's than the nonfinancial GM operations, it makes sense for GM to strive to preserve the health of GMAC's balance sheet. Efforts to do that are fine, but doing so may stop GM from taking a big cash dividend out of GMAC this year to help fund its cash needs. ¿

Notably, GM execs were extremely cagey Tuesday about how much GMAC will be able to pay to GM in 2002. But GM can't shore up GMAC forever. If GM's balance sheet deteriorates too much, Moody's may well decide that GMAC's is also at risk.

GM longs had better take a good look under the hood.