The Thesis:
It is no secret that the history of these two automotive titans has mirrored that of the country’s industrial production history. They were once global economic standard-bearers who were eventually crippled by a combination of bloated overhead, unmanageable benefit obligations and intense foreign competition. However, after the pain of a strategic bankruptcy for GM and much-needed balance sheet and organizational reform at Ford, these two former heavyweights are clearly in shape for a comeback. To that end, we view both companies as core holdings. As we implied in our introductory piece, “man does not live by straight equity investments alone”, and this idea is no different. One of the secrets to successful professional investing is to review the balance sheets and options chains, for the most efficient way to take advantage of a solid concept. We will do that here. We will also follow up on this play in future pieces until we feel that the sector is fully valued. This is the way that investors like Buffett operate, why shouldn’t you? Take a core holding and extract as much value out of it as possible using a combination of income producing and equity investments focused on a theme. Our first step is considering these companies fundamentally, let’s have at it.

The Numbers:

Much has been written about the GM bankruptcy and the Ford restructuring. However, the bottom line is that these events created dramatically competitive valuations for both of these companies. This is due to a reduction of debt and more manageable benefit liabilities, combined with a focused and greener product lineup. Price-to-Earnings ratios for Ford and GM using reasonable 2012 forward-looking estimates come in the 6x to 7x range . That compares most favorably with about 14x for the S&P, and 11.85x for the Consumer Discretionary portion of the index, and therein lies the greatest rub: With any type of reasonable growth projections, the potential is here for significant profits as well as decent down-side protection. Without getting ahead of ourselves, the potential is here for at least a double.

A nagging concern for both companies’ has been significant debt woes. Consequently, it is also important to look at their EBITDA numbers versus their Enterprise Value. In Ford’s case, it is in the 3.5 range and for GM post-bankruptcy a scant 1.7 multiple. This gives both auto makers plenty of wiggle room for debt payments while providing for future growth. We cannot ignore Ford’s $20-plus billion in cash and the restatement of a 1.7% dividend. We expect the payout to grow given the Ford family’s previous penchant for a recurring and healthy dividend. GM’s cash position stands at a solid $30-plus billion and the company has given its investors more positive guidance on its unfunded pension liabilities which has always been a sore spot for it.

Given any type of important financial metric (Price-to-Book Value, Price-to-Sales or Price-to-Cash Flow) these producers are valued more like entities in a developing country rather than the U.S. Given their strong fundamental position we see them as solid long term plays. Yet, before we fall in love with these numbers, we need to keep in mind that they are in the business of selling cars. With that in mind, let us take a look under the proverbial hood.

The Skinny (A practical look):

Turnabout is fair play, and the domestic auto makers are retaliating with some of the same tactics that were effectively used against them over the last few decades. Granted, both Ford and GM created their own bloated overhead structures. It was their failure to respond to more product-concentrated, efficient competition that caused them to lose significant market share. To that end, both producers continue to bolster and market their formidable Truck and SUV platforms which have always been their strong suit. They now hold a commanding share of the market according to the latest statistics. However, it is in the family and luxury sedan segment that both players are poised for improvement. Collectively, they sold more than 1.5 million cars last year, lagging the combined efforts of Toyota and Honda. In order to increase that share, Ford is unveiling a newly re-designed Fusion at this week’s North American International Auto Show. The design has wowed critics, and is more along the lines of European-style luxury; it can be a game changer. Along with the rest of its lineup, its current version of Fusion and the Fiesta Ford are well positioned for worldwide reach. Reports are that these cars are responsive and fun to drive, perhaps finally passing the Accord and Camry.

GM for its part will introduce a Cadillac compact model that should compare favorably with the BMW 3-Series and Mercedes C-Class vehicles. In fact, Cadillac has seen resurgence with its more youthful profile and is ready to take aim at the foreign luxury producers. Cadillac has lost out over the last few years, ranking fourth in the U.S. behind BMW, Mercedes and Lexus. With the perception of an ultimate lower cost of ownership combined with better resale value, it may finally appeal to a sophisticated clientele looking for more value and not the 70’s “Dadillac”. Finally, offerings like the Malibu have won numerous awards for buyer satisfaction in its category. Chevy’s Volt, The 2011 Motor Trend Car of the Year is ready for a breakout. GM feels that the battery problems it faced are in check and the Volt is ready to roll. Another winner for GM has been its Cruze. On the whole, Detroit has decisively gotten back in the game.

Just as important is the Detroit automakers’ push in the developing BRIC countries. GM holds a leading market share in BRIC countries and sold 2 million vehicles in the rapidly developing Chinese market. If you are looking for future growth, this is where it will come from.

The reality is, that given GM’s and Ford’s reasonable valuations and stronger balance sheets, just remaining competitive could yield significant returns as their equities reach more normal Price-to-Earnings ratios. If in fact they become more dominant, this could turn into a home run. Keep in mind that global growth concerns and rising commodity prices are an issue that may delay growth. That is a good reason to seek yield from these investments, a subject we will now address.

The Play:

Let’s start with Ford. There are a number of Ford bonds outstanding with generous yields. For instance, you can take a laddered approach by combining investments on a shorter scale with longer ones. Take the Ford Motor Credits 8s of 2016 or the 6.625s of 2017. Both issues offer yields to maturity in the 4.375% range. Combine this with a longer maturity found in the 6.375s of 2029 which pay 6.175% and are a direct obligation of Ford. A 50% split in these durations will offer a 5.375% yield with an approximate 11-year life. It should also be noted that there are many Ford issues outstanding, so the professional buyer should look around the bond showroom.

Next, you can combine your Ford bonds with some common stock, thus creating your own homemade convertible security. For every dollar invested, you can split it 60% bond and 40% equity. In this instance, you will sport a yield close to 4 % [(5.375 in the bonds x .6) + (1.7% dividend yield in the common x .4)] with 40 % of the upside in Ford. Ultimately, you can adjust this position by adding or selling the common as you see fit. We would advocate using the stock to adjust your exposure, as the cost in the trading spread of the bonds would erode your potential profits.

As a finishing touch, calls or puts can be written against the position. An example would be the June of 2012 listed call options struck at 13 for 56 cents with the common at the 11.86 level. Do this twice in a year and you have added almost 10% to your common yield, allowing yourself to be called away at the 13.5 level. Again, we will follow up on this. Nevertheless, you have enough tools and fuel for thought to make a complete investment.

Now we turn to GM. For the present, we love the GM mandatory convertible preferred B trading at 38.25 versus approximately 23 in the common. This security pays an annual dividend of $2.375 yielding 6.2% as opposed to zero in GM. Mandatory means that you must convert to common by December1, 2013, at a rate to be determined at that time using the following formula:

If GM trades at $33 or less, you get 1.5152 shares of the GM per preferred share

If GM is $39.60 or above, you get 1.2626 shares of GM per preferred share

If GM is between $33 and $39.60, the number of GM shares you get is $50 divided by the price of the GM.

What we essentially have here is the common with a short call when GM hits 33 and a long call when it reaches 39.60 yielding over 6% until late next year. In other words, you will participate in GM’s gains until $33, hit a dead zone, and participate again past $39.60 until December 2013. In return, you receive a 6.2% yield.

To sum up, we would at this time combine the above investments in a 50/50 capital split giving the investor a static yield of around 5% with some decent upside. As a long-term play, you can adjust these positions accordingly or … for the meat and potatoes crowd … just trade the common stocks of each. Again, like any good trader we will update you as we move down the highway.

In Summary:

We view both Ford and General Motors as firmly undervalued ways to participate in the next phase of the domestic economy, a period that will emphasize efficiency and competitive technology. While it may take time for the markets to recognize the value presented here, the yields offered on these investments reward your patience.

One closing thought is that a smart financier kicks the tires, so to speak, when given the chance. Get out of your office, put down the HP12 and go visit a few dealerships this weekend. Even better, spend a few dollars and rent some of the vehicles mentioned. After all, this is a long term play on America’s and hopefully the world’s fascination with two storied brands.

Happy Motoring.

—The Thoughtful Arbitrageur

Prices quoted are as of mid-day, Jan. 9.

Edward Strafaci is not an investment adviser. Nothing he writes should be construed as investment advice or an endorsement of any particular security. From time to time, a family trust with which he is associated may have positions in the securities he writes about. When it does, he will tell you. What he writes is meant to inform and in some cases to entertain and amuse. HedgeWorld’s Alternative Reality is not an investment advisory site. As a general rule you should not take investment advice from blogs, anyway. Consult a financial professional for investment advice, not a blog.

This entry was posted on Wednesday, January 11th, 2012 at 3:16 pm and is filed under The Thoughtful Arbitrageur. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.