GM Releases Its Crown Jewel

Updated from 8:40 a.m. EDT

General Motors ( GM) announced a long-awaited deal Monday to selloff a majority stake in GMAC, the finance subsidiary that has recently been the automaker's only profitable business, in return for $14 billion in cash over the next three years.

Despite its profitability, GMAC's credit ratings have suffered over the last year at the hands of its parent's dismal financial condition. Its sale has the potential to restore investment-grade ratings for the business and prevent spiraling borrowing costs from wiping out its profitability. But initial commentary circulated through the credit market suggests the buyer, a private equity consortium led by Cerberus Capital Management, may not be able to immediately improve GMAC's ratings.

For its part, GM unloaded its crown jewel out of a pressing need for cash as it juggles dwindling market share, a burgeoning cost structure, dicey consumer spending and heated bankruptcy proceedings at Delphi ( DPHIQ), its largest auto parts supplier and former subsidiary. Even with its current cash cushion of around $30.1 billion, GM's willingness to sell the finance business reflects, in part, the potential for its reserves to be eaten up quickly should events take a turn for the worse.

"GM needs to liquefy its balance sheet in order to have the cash on hand to fund its pension problems, its facility close-down problems, its Delphi problems and all its other problems," says Paul H. Ross, managing director with ING Investment Management.

GM agreed to sell a 51% stake in GMAC in the deal, which is expected to close in the fourth quarter. GM will receive $7.4 billion in cash at that time, along with an estimated $2.7 billion cash distribution from GMAC. It will receive an additional $4 billion over the next three years related to the monetization of some assets over time and other adjustments. The company also will record a pretax charge related to the sale of $1.1 billion to $1.3 billion in the second quarter.

Citigroup ( C) will provide $25 billion in a syndicated loan to support GMAC's continuing business, in addition to an initial equity investment in GMAC.

GM shares recently were down 56 cents, or 2.6%, to $20.71.

Ratings in Question

Comments from the major ratings agencies Monday indicated that GMAC's credit would continue to be rated as junk status, at least in the near term. Moody's Investors Service said "the best-case rating outcome will be a confirmation of the current GMAC ratings at Ba1," the agency's highest junk rating. Moody's also said it could move the company's rating one notch lower to Ba2.

Meanwhile, Fitch Ratings put GMAC's rating on watch with positive implications. Fitch currently rates GMAC two notches below investment grade.

Standard & Poor's Ratings Group said it anticipates GMAC's rating would be boosted to BB+, the highest noninvestment grade rating.

"We've been saying since October that if a 51% stake in GMAC was sold to a highly rated financial institution, we could see GMAC at investment grade," says S&P analyst Robert Schulz. "If it was something different than that, we probably wouldn't view it as favorably. In the end, they didn't sell to a highly rated financial institution, but we're evaluating the deal now as it stands."

Developments at GMAC last week suggest that the underlying value of its business could have been contested by the buyers. GM's finance business said it would restate its financial results for 2005, reclassifying some portion of the cash flows from its residential mortgage business to cash from investing activities rather than cash from operations. While it said the changes won't affect its bottom line or cash reserves, analysts says the revision may have lowered the company's price tag, since cash from operations is widely viewed as a better gauge of a company's value.

"Investment income is usually looked at as more of a one-time benefit," says Argus Research analyst Kevin Tynan. "If you're a buyer, you're going to place more value on the operating cash flow than the investing cash flow. So, if you reduce cash from operations, the company is probably worth less."

Tynan said the process of doing due diligence in order to complete the sale of GMAC may have brought these issues to light.

"This might not be as beautiful a rose as it looked like when it was hidden under the GM umbrella with everything that's gone on," he says.

GMAC's plan to restate its earnings came after its parent was forced to acknowledge that its losses for 2005 were worse than it had originally reported. In mid-March, GM widened its loss for the year to $10.6 billion from its previously reported $8.6 billion, due to larger-than-expected charges for its sweeping restructuring in North America and a host of other issues. The company's financials remain under scrutiny from federal regulators for a number of issues, including supplier credits and raw materials contracts.

Mortgage Lending Cools

In addition to accounting issues, GMAC's business prospects face considerable risks as interest rates rise, the housing market cools and consumers see higher borrowing costs. GMAC has benefited from years of being able to offer cheap credit with interest rates at low levels. With the Federal Reserve ratcheting back on the money supply, GMAC's earnings declined last year to $2.4 billion from $2.9 billion in 2004.

"Mortgage lending has been an extremely hot area the past few years," says Morningstar analyst John Novak. "Originations have started to cool off now, and they're likely to continue to cool off. In addition, you've got rising interest rates, and that's going to crimp profitability for GMAC. This all probably explains why this sale has taken so long to complete. These are complicating factors, and trying to figure out what the normalized business looks like is difficult."

In 2005, GMAC reported that 62% of its income before special charges came from its mortgage and insurance unit.

"It's quite clear that a topping off of the momentum of being able to raise prices in housing in such markets as Connecticut, Washington, D.C., or southern California is what is slowing some of the momentum in the market," Ross says. "It's causing a number of the large builders to offer houses with lower price points in order to attract first-time and move-up buyers. It's quite clear that if the pace of new home sales, or if the pace of second-home sales, were to deteriorate by 10% or 15%, than all the mortgage providers would suffer accordingly."

Ross, who holds positions in GMAC and GM bonds, added that he doesn't believe a secular change in the rate of demand for housing in the U.S. is underway. He believes residential mortgage financing will remain a positive business for GMAC. He also said he believes that GMAC's principal business, financing and leasing vehicles sold to consumers, remains favorable.

The deal also raises questions about how GM's relationship to GMAC will play out now that it's not a majority owner of the finance business.

"A private equity shop does not make investments forever," Ross says. "If they're going to own 51% of GMAC, and GM is going to own 49% of GMAC, what is going to happen years down the road? How does Cerberus calculate their earned return if they don't at some point have an exit? And, what is the relationship between GM and the buyer as it relates to the continuing relationship between the two and what the goals of each party is? In the past, we've only had to worry about the goals of one party -- GM. Now, things will be different."

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