Shared Sacrifice

Automotive Industries,  July, 2001  by Maryann Keller

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GM, Ford and Chrysler have spent billions to buy back their stock while product programs suffer. Is this what you thought Shareholder Value was all about?

Improving shareholder value has been the mantra of U.S. auto companies during the last decade. Frustrated by what was seen as low stock valuations, management made decisions through the shareholder value prism. The reasoning was simple and logical: A higher stock price and price-earnings ratio would result from a higher return on assets and higher profit margins.

Boosting stock valuation is desirable because equity financing can be undertaken at a lower cost of capital. Rising stock price becomes a powerful instrument for acquisition and investment and provides opportunity for incentive compensation for employees.

In retrospect, the influence of shareholder value as a determinant or excuse for management decisions has had mixed results on the competitiveness of the domestic auto industry. That, of course, is the only real measure of shareholder value.

The ongoing rearrangement of assets at General Motors Corp. and Ford Motor Co. has been generally beneficial in terms of value creation for shareholders. Because of the overwhelming dominance of auto operations, the investments made in consumer finance, electronics and computer services had negligible impact on the valuations of auto company shares, despite their faster growth and often more attractive financial measures. Selling them, spinning them out to shareholders, or otherwise monetizing these assets to pay down pension or other liabilities -- or simply give shareholders cash or shares in a separate company -- were smart decisions from operating and shareholder points of view.

Restructuring and then spinning off parts and services businesses also made sense. These operations will ultimately be better off as independent, having to compete for contracts instead of being awarded them because of common ownership. High vertical integration didn't make strategic or financial sense and the actions enabled GM and Ford to eliminate low margin, low return divisions.

However, getting rid of assets is easier than investing a company's cash. There are only two possible decisions related to an owned asset: keep it or sell it. If the decision is to jettison an asset, then the only issue for management is how to get the most money for the business. But spending or investing choices are virtually unlimited and it is in the use of cash that mistakes were made.

GM and Ford, convinced of better opportunities beyond their historic brands, spent billions on global auto diversification, which has yet to bear fruit for shareholders. Nevertheless, both companies believe that scale and brand breadth will provide a competitive advantage over the long term. It might, but investing in Hummer (GM) and Range Rover (Ford) for the top of the SUV market, or adding another fixer-upper international brand like Daewoo, may not raise returns over a reasonable investment period. Investments in e-commerce, whether it's GM's stake in NetZero, Ford's equity stake in the now defunct CarClub, or both companies' investment in Covisint, may provide insights into how the technology should be used in their operations. But they have failed as investment vehicles that were supposed to enhance the image or earnings of their owners. It should be noted that these diversification efforts not only took cash away, but also management time and talent.

An Unwise Use of Cash

By far the largest cash use, apart from capital investment, has been share repurchase programs. Insititutional investors always clamor for stock buyback initiatives because their focus is often mechanical factors that support the share price in the short term. Chrysler, GM and Ford spent billions of dollars to buy their stock in the open market since the mid-1990s, though Ford suspended its buyback program recently, as it has to spend so much on the Firestone tire recall.

The idea behind share buybacks is simple enough. When a company generates cash beyond the anticipated needs of the business, purchasing stock could be a more appropriate use of surplus cash than low-yielding investments. Buying in shares allows management to use stock options for incentive compensation without diluting pershare profits. It represents management's conviction that the stock is undervalued and the best possible use of cash. It has the effect of reducing the number of shares outstanding, which would result in higher earnings per share as the number of shares outstanding falls.

Mathematically, the calculation makes sense because the shareholder return is higher than the loss of interest income on the cash spent on the buyback. The common stock of companies with large continuing repurchase programs is sometimes boosted by the announcement while the program is in effect. A repurchase program provides liquidity in the market, giving large investors the ability to dispose of large blocks at predictable prices. There is, however, little long-term evidence that stock buyback programs raise valuation and share price beyond the period when they are in effect.