Tough Love Might Make GM Bonds Appealing

Even with likely concessions by the United Auto Workers, GM offers the most extreme example in U.S. business history of workers doing well at the expense of shareholders and creditors. While GM's equity and bond investors have been crushed, the employees, mostly unionized workers represented by the UAW, have a pension plan worth over $100 billion at the end of 2007. Overfunded by $20 billion back then, it was estimated to be underfunded by just $2 billion at the end of October, despite the global stock rout. GM also has earmarked $13.4 billion for a trust to fund retiree health care, mostly for UAW members.

The union argues that its wages aren't the root of GM's woes. But this ignores that much of GM's $43 billion of debt went to fund its employee benefit plans and that the bulk of GM's valuable non-core assets, including controlling stakes in Electronic Data Systems and DirectTV, ended up in the hands of GM employees. Yes, the car maker has an obligation to fund its pension plan, but for years, management refused to battle the UAW to meaningfully control or cut its obligations.

President Bush, eager to avoid a GM bankruptcy on his watch, essentially has kicked the problem to the incoming Obama administration by demanding as a condition of a $13.4 billion loan that General Motors formulate a broad restructuring plan by March 31, including a cut in unionized workers' compensation, now at about $60 an hour, toward the $45 that auto workers make at Toyota and Honda's U.S. factories.

The plan also requires GM to make progress on a plan to cut its $43 billion of debt by two-thirds, presumably through voluntary forgiveness by bondholders, as well as the issuance of new debt and equity.

THE BIG ISSUE IS WHETHER GM can come close to forging such a complex and difficult deal by March 31, or whether it will be forced into bankruptcy to do the necessary restructuring. The UAW has historically resisted givebacks, and it may be tough to get sufficient bondholder approval for a punitive exchange offer. Just look at the failure so far of GM's 49%-owned finance arm, General Motors Acceptance Corp., to get necessary bondholder support for a big exchange offer.

GM shares (ticker: GM) rose 83 cents Friday, to $4.49, valuing the company at $2.7 billion. Investors hope the company will be revived by the loan program, which will extend $4 billion to GM this month and $5.4 billion in January, plus some $4 billion in February (if Congress approves). Chrysler will get an immediate $4 billion, while Ford (F) says it doesn't need federal money now.

GM stock looks pricey at $4-plus because of the bankruptcy risk and the potential for significant equity dilution from a debt-reduction action. Then there are the warrants that GM is giving the government that likely will equal 20% of its shares outstanding. One reason GM shares may be holding at $4 is that they're tough to short.

Barron's has been wrongly bullish on GM common and debt in the past. Still, the best GM bet probably is its unsecured debt, which rallied Friday on the bailout news but which still trades below 20 cents on the dollar. GM's 6¼% convertible bonds due 2033 (GPM), which trade on the Big Board, rose 30 cents, to $3.78 -- about 15% of their $25 face value. The bonds yield 39%, but that's probably illusory, given the prospect that the convertible investors will have to participate in an unfavorable debt exchange or face the prospect of a GM bankruptcy. GM's 8 3/8% bonds due in 2033 were trading at 18 cents on the dollar. There could be value in GM bonds if the company restructures its debt and bondholders get 33 cents of real value (two-thirds of par). But if GM went into bankruptcy, the recovery value could be very low.

Bondholders, and shareholders, have a right to be upset about the massive wealth transfer from GM's owners to employees. Over the past 15 years, GM has put $103 billion in its benefit plans, hurting its competitiveness by "crowding out investment otherwise made in quality, safety, fuel efficiency and innovation," according to the restructuring plan it submitted this month to Congress. Reflecting this, GM's shareholder equity stood at a negative $60 billion on Sept. 30.

The giant auto maker's R&D and capital spending averaged 8.7% of sales from 2004 to 2007, the lowest level among its major global peers. Closing the gap with Toyota would require an additional $3 billion of annual outlays, enough to fund multiple projects like the plug-in Volt hybrid, which is expected to cost GM about $750 million to develop.

Under the gun of bankruptcy, GM may finally do the restructuring it should have done years ago. Too bad change is coming too late for shareholders and creditors.