Thursday, May 12, 2005

Kerkorian shifts to OverDrive.

On May 4, 2005, shares of the world’s largest automaker, General Motors (NYSE: GM), were boosted by 18% with the announcement that Kirk Kerkorian’s Tracinda Corp. was making an offer that would give the multi-billionaire casino mogul and financier an approximately 9% stake in GM. Kerkorian has taken big stakes and has exerted various degrees of control over automakers, casinos, movie studios, and airlines. This led Wall Street to think that General Motors would be Kerkorian’s next victim, but Tracinda officially communicated that the offer was made for “investment purposes”. Given Kerkorian’s investment track record, we have reasons to believe that he is probably contemplating to exert influence on the company and force some major restructurings. On the other hand, we also believe that GM is currently a bad investment to make in light of the company’s failure to devise and apply a sound strategy to respond to fierce competition and changing market dynamics. Should Kerkorian pursue control over GM, he should carefully review the company’s strategy as a guide to any restructuring alternatives.

Analysts have been pessimistic about the true nature of the tender offer issued by Mr. Kerkorian’s Tracinda Corporation. Moreover, they believe GM to be in borderline financial distress; S&P downgraded the company’s credit ratings to junk status arguing GM’s inability to address its competitive disadvantages. GM’s 1Q 05 results were weak, stating increasing healthcare and pension benefit costs. Morgan Stanley argues that GM is diminishing the importance of other key factors such as weak market share and volume, weaker product mix, and excess capacity. Despite the slump in earnings, the company seems to be undervalued according to Citigroup, which values the company at 4.2x 2005E EBITDA, versus a higher median of 4.9x for the automaker comparable universe. JPMorgan anticipates more upside potential than downside risk due to GM’s prudent approach to bloated inventory levels. The bet that some analysts perceive in Tracinda’s tender offer is that the financing division in General Motors will be able to provide more than enough cash flows to increase the current stock price to the mid thirties range, making Kerkorian’s investment in GM similar to the one he did in Chrysler a few years ago.

In sum, the research community depicts an underperforming company with some potentially better outlook in the short term, but a bleak one in the longer term. Moreover, Citigroup’s analysis, and perhaps Kerkorian’s as well, point out a possible undervaluation by the market. If all of this is true, then Kerkorian should aggressively rectify GM’s strategy to focus on some key factors to ensure a better valuation in the longer term. First, GM should focus on better addressing consumers’ needs. For instance, in Europe, where GM has been unprofitable since 1999, the company has made an extremely late move into using diesel engines in its cars. In the US, Japanese car makers adapt as much as possible to the American market by changing sizes and specifications of cars. GM, on the contrary, has been criticized to simply have converted some key Saab and Cadillac models in Europe to right-hand drive. Second, GM should diversify from too much focus on larger vehicles. Oil prices are at all-time highs and research has demonstrated that consumers will tend to smaller cars, a segment in which Japanese cars are dominant. In addition, GM’s performance has been heavily dependent on the profits from SUVs, the sales of which have softened due to a possible shift to smaller cars and the incursion of Japanese automakers in the segment. Third, GM should focus on maintaining its brand strength and not pursue abysmal price reductions to regain market share. Fourth, GM should pursue innovation more aggressively. The company has become stagnant in diversifying product offerings and has failed to catch up with alternative technologies such as hybrid engines.

Kerkorian’s move with GM is strikingly similar to what he did with MGM. Recently, Mr. Kerkorian failed to take over Chrysler and has just lost a 10-month battle with the company’s management over the merger with Diamler; situation that is parallel to that of his unpleasant exit form the International Hotel. At the same time, he has been quietly buying GM’s stock and could become the company’s third largest stockholder if the announced transaction takes place; very much like his approach when he took over MGM right after his hotel venture. It seems a déjà vu to hear his spokesperson state that the GM transaction is purely for “investment purposes,” when it was much more than that for MGM. Given everything Kerkorian has done in the past, we don’t believe he will stand on the sidelines, but it is yet to be seen what he has in mind for the automaker. Whatever the outcome, he will definitely be in for a winding drive to extract value from ailing GM.

Gomez, Hiriart and Lozano


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