GM’s Sensible Strategy

This deal is aimed at the two segments where GM is at a greatest competitive disadvantage: lease and subprime (ACF’s base is FICO
500-700, half homeowners with $60K-65K gross incomes, not “buy-here-pay-here”
customers). It’s not clear from ACF’s current business how they will handle
leases, but GM does not claim they will expand rapidly in that segment.

For that matter, ACF already handles a large share of GM’s subprime business (no details provided, but the numbers suggest that). Now
ACF intends to gradually grow their business (17% of their portfolio is from the
past 2 years, 37% from CY2007 at lower spreads and higher default rates, for
obvious reasons). The GM tie is clearly intended to facilitate their
originations. I don’t now GM’s credit rating — if I read the documents
correctly, ACF is “B” and so does not have low funding costs without
access to the ABS market. Does the acquisition let ACF knock down the cost of
its warehouse line of credit? But the current ABS market gives ACF a 6.4% pretax
return and the loan loss rate on their recent originations is very low (their
cohort analysis shows by far the best performance in the 10 years covered).

One key question is whether the financial regulation overhaul that prevents including ratings in ABS prospectuses will kill that
market. That appears not to be the intent of the legislation, and may be reversed
fairly quickly. However, ACF has a $1.3 bil warehouse line of credit that they
have not touched (as of their last financial statements), which they state is
sufficient for 6 months of operations. It’s not (yet) time to lose sleep over
that issue, at least for ACF.

Now in the background is the late GMAC, transmogrified via subprime mortgages into Ally Bank. Given their huge problems as a bank (a
lot of human capital in doing subprime mortgages), they are currently relying
on the government. I’ve talked a staffer of the TARP Congressional Oversight
Panel, and I don’t see that they have a strategy other than to “hang in
there.” Depending on what’s happened, Ally may have maintained the humanware
to do “prime” car loans and floorplan but they have to build up other
business more or less from scratch if they’re to be viable. There are a lot of
established banks out there for a new wholesale bank to make a go of it. The
pressure will be to expand many lines of business where they have little
experience. My own belief is that they should be shut down, perhaps with the
auto business sold off to someone else.

So to me GM is doing something sensible, getting a well-run loan origination operation that has an overhang of bubble-era loans
but has preserved their core capabilities and is expanding in a measured
manner. That will provide a supplement in the 40% of the market that is the potential
ACF client base.

However, ACF is not suited to floorplan and has no particular strengths in prime where the cost of funding (credit rating) is key.
And Ally is not likely to be reliable for that. Are other banks picking up
those businesses? My sense is that dealers still worry about funding, but that
conditions are far better at present. I’m not close enough to the market to
know whether the banks that remained in that market are expanding; I assume so.
Nevertheless, as banks worry about their capitalization, access to the ABS
market is important to maintain volume. But that’s even more true for Ally.

GMAC went back to the 1920s, and was a key component of GM’s overtaking of Ford (Henry didn’t believe people should borrow …
though he showed no compunction about asking his dealers for cash up front).
GMAC developed the car loan business. But it’s a mature business now, at
least at the “prime” end
of things. Ally isn’t a particularly reliable partner for GM right now, and in
my opinion Ally’s position is likely to deteriorate.

So the ACF acquisition will address a gap left by Ally’s difficulties in financing any but the best loans. It would be nice to
hear what GM is doing about floorplan and prime. But my guess is that days when
a captive finance operation was needed for that business are past. Leases? —
we’ll see, but the projection from GM is of incremental growth, they’re at 4%
now (industry average 21%) and are aiming at 7% or so.

Finally, what is GM doing with an M&A at this time? First, I don’t know how to evaluate the price, as I’ve no experience with
acquisitions (16x earnings doesn’t sound particularly high, given that loan
originations are still low and the margins / expenses / loan loss experience to
me all suggest more upside than downside risk). So it may be a good purchase
that will earn GM money. Nothing wrong with that. Second, it makes GM look
“complete” prior to its IPO. Is there anyone (besides Chrysler) who
does not have a captive finance arm? [See the latest news from Chrysler,
they’re also moving on that front.] Third, my guess is that profitability at
ACF is less volatile than GM’s vehicle businesses. Again, that’s good for an
IPO because (sensibly or not) Wall Street seems to like steady profits (even
if, as we know, insurance carries a price — higher lows come at the cost of
lower highs and lower overall profitability).

The average M&A is bad for the acquiring side, but this is one that complements an existing business, is not done in the midst
of an M&A boom (much less a bidding war), and does not involve (from ACF’s
side at least) a turnaround situation. While all of this is educated guesswork,
backed by going through a bunch of numbers, I see no yellow flags, much less a
red one.