November 17, 2010

GM’s IPO: Uncle Sam’s Pump and Dump?

Filed under: Business Moves,Economy,Taxes & Government — Tom @ 8:53 am

Note: This post went up at the Washington Examiner’s OpinionZone Blog and was teased here at BizzyBlog on Monday.

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“We aim to increase our vehicle profitability by maintaining competitive incentive levels with our strengthened product portfolio and by actively managing our production levels through monitoring of our dealer inventory levels.”

– From Page 5 of General Motors’ S-1 Prospectus (bold is mine)

The initial public offering (IPO) of Government/General Motors is apparently ready to roll.

Why hasn’t anyone asked the company or its federal minders why they have from all appearances artificially created over $1 billion in U.S.-based EBIT (earnings before interest and taxes) through October by overstuffing its dealers with excessive levels of inventory?

According to the Wall Street Journal’s cheerleading Andrew Bary, the IPO is generating a great deal of fanfare. The Associated Press’s Sharon Silke Carty is decidedly less enthusiastic (“the world’s most charming used car salesman couldn’t cover up major concerns”), identifying four good reasons to for investors to sit the IPO out. One of them is that “Years of fuzzy math (are) still not fixed.”

From here, it seems that the company has created a unique category of fuzzy math: shipped-ahead profit.

The opportunity for manipulation arises in how vehicle manufacturers recognize sales. The related policy is identified in GM’s S-1 prospectus (a very large document accessible at the SEC’s web site), Page F-31:

Revenue Recognition … Vehicle sales are recorded when title and risks and rewards of ownership have passed, which is generally when a vehicle is released to the carrier responsible for transporting it to a dealer and when collectability is reasonably assured.

In other words, once a vehicle is on the truck and leaves the factory, it’s a sale. There’s nothing wrong with this; as noted, it’s common industry practice. But it also gives a company trying to make its books look better than the underlying reality an opportunity to do just that.

As of the end of October, GM dealers in the U.S. were sitting on inventories of almost three months’ worth of sales, up from the low-60s only five months earlier:

GMdealerInvsAndSales

The dealer inventory build-up has occurred despite at least two factors that would normally dictate lower inventory levels. First, after eliminating Saturn, Pontiac, and Hummer, GM is down to four brands (Chevy, GMAC, Buick, and Cadillac). Second, the company has substantially reduced its dealership roster. Yes, the company did offer to reinstate 661 dealers earlier this year. But while the rebound in the number of outlets could explain an increase in absolute inventory levels, it doesn’t explain why vehicles are sitting on dealers’ lots 23-24 days longer than they were in May.

Is 86 days of inventory an abnormally high level? In ordinary circumstances, I would say so. Guidance found at SafeCarGuide.com explains why (bold is mine):

Dealers must pay the manufacturers when they order a vehicle, not when it is sold. To provide adequate numbers of new vehicles whose options satisfy most customers, dealers finance this excess inventory through the financial arm of their manufacturer or through a local bank. This financing procedure is called a floor plan. To help their dealers keep up their inventory, manufacturers return the interest the dealer has to pay on those loans (floor plan) for the first 90 days by issuing them a “holdback” check every 90 days.

If a car has been sitting on the lot for 90 days or more, all of the potential holdback profits have been wasted on interest payments that the dealer makes to floor plan (finance) the vehicle. After 90 days, the dealership has to dip into its own profits to keep the car in inventory. So on vehicles that the dealer has had for over 90 days, holdback won’t help you at all.

Other guidance I have read indicates that dealers ordinarily try to keep their inventory levels at 45 or fewer days.

Thus, you would think that GM’s thousands of dealers would be squawking about holding so much inventory. But the circumstances of the company’s high-pressure, high-stakes IPO are certainly not ordinary.

You might be surprised at how much maximizing product shipped out the door — to heck with the long-term consequences — enhances reported profits. That’s because the variable costs associated with producing a vehicle are fairly low when compared to its selling price.

The only truly direct costs involved in vehicle production are materials, direct labor, and directly-consumed energy. Virtually everything else is at least in the short run essentially fixed, i.e., they are costs that will be incurred anyway regardless of the level of production. For example, you’re going to have a certain level of supervision no matter what; the costs of supervision don’t increase much, if at all, if production increases within a certain range. Pretty much the same number of workers will be involved with maintenance whether you’re producing 60 cars an hour or 80. Many fringe benefits, particularly health care costs, aren’t affected by production levels. You’re going to have to keep your factories’ lights on no matter how many cars they produce. Property taxes don’t change. Depreciation charges are fixed in the short run.

Companies justifiably guard the related cost data carefully, and you ordinarily won’t find information at the level necessary to nail down variable profit in a company’s financial statements or regulatory filings. Thus, specific data relating to variable profit is elusive.

But in 2007, Forbes Magazine carried this interesting tidbit:

Strategy consultant AlixPartners estimates a manufacturer earns $8,000 to $14,000 variable profit on each pickup it sells, but zero to $6,000 on each car.

Thanks to cost reductions achieved in its encounter with bankruptcy, GM’s variable profit is probably near the high end of both ranges; it wouldn’t surprise me if its variable profits are even higher. But to be conservative in the accounting sense, let’s assume that the variable profit numbers are $12,000 each for pickups (light trucks) and $5,000 for cars. If so, here is how GM benefited during the first three quarters of 2010 by putting 93,000 more vehicles onto dealer lots (478,000 minus 385,000 above).

  • Using sales data from the third quarter, GM’s domestic product mix is currently about 36% cars and 64% light trucks.
  • If dealer inventory is similarly proportioned, dealers had about 33,500 more domestic cars on hand on September 30 than they did on January 1, and about 59,500 more trucks.
  • That represents $167 million (33,500 x $5,000) in sent-ahead profits on cars and $714 million (59,500 x $12,000) for light trucks, for a total of $881 million.

That $881 million would represent about 18% of GM’s EBIT from its North American operations of $4.935 billion during the first three quarters of 2010 (from Page 75 of the Notes to Financial Statements in the company’s third-quarter 10-Q filing).

About $663 million of that sent-ahead profit has occurred since May’s trough in dealers’ days sales in inventory (70,000 of the 93,000 total increase x $881 million). Serious talk of the company going public began at about that time. Coincidence?

Early indications are that GM isn’t interested in taking chances on whether or not its closely-watched fourth quarter will be profitable. During October alone, it shipped ahead roughly $350 million in EBIT on a 37,000-unit dealer inventory increase that seems totally devoid of any ordinary business justification. That brings the company’s year-to-date shipped-ahead total to $1.23 billion ($881 mil + $350 mil), and the since-May total to just over $1 billion ($660 mil + $350 mil).

So is GM “actively managing its production levels” as described in the opening quote above by forcing its dealers to in essence give up their holdback profits as described in the name of a “successful” IPO? Or has the company made some kind of a special arrangement with its dealers — perhaps an extraordinarily long interest-free holding period — to make holding excessive inventories more palatable until the IPO is out of the way? Will it embark on a campaign to reduce dealer inventories — and reduce reported sales and profits — in 2011, after the hoopla surrounding the IPO and its immediate aftermath die down?

Has anyone involved in underwriting or promoting GM’s IPO even asked these questions, or about other potential “clever” profit enhancers the company might have employed?

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4 Comments

  1. Great work. Would love to see fly-over shots of dealer lots from May and November to add a visual to this.

    Comment by Jim — November 17, 2010 @ 9:28 am

  2. If this is a duplicate, sorry about that; it appears the commenting bug is still out there. That bit of data makes more likely the darker of the 2 reasons why the Treasury decided to take a mere $41 million premium now rather than a minimum of $755 million in dividends (9% for 4 years) on its $2.1 billion of preferred stock and allowed GM to buy it back now instead of waiting until the end of 2014.

    Comment by steveegg — November 17, 2010 @ 11:02 am

  3. [...] stock that should be hitting the open market in a few days, it is still junior to all debt. Tom Blumer noted that dealer inventories have been “gamed” in advance of the IPO to make GM appear to be [...]

    Pingback by No Runny Eggs » Blog Archive » New NRE poll – Why did the Treasury sell its GM preferred shares early? — November 18, 2010 @ 2:56 pm

  4. [...] g) was partially covered by yours truly earlier this week (“GM’s IPO: Uncle Sam’s Pump and [...]

    Pingback by BizzyBlog — November 20, 2010 @ 4:11 pm

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