Breathing Room for GM's Wagoner

Strong operating profits suggest the CEO's promised turnaround could happenbut it will need more than one solid quarter to convince critics

After a tough 18 months, General Motors Chairman and CEO G. Richard Wagoner Jr. is getting some much-needed breathing room.

Wagoner has faced intense pressure since early 2005, a year in which General Motors (GM) lost $10.6 billion. Market share continues to fall in the key North American business. And he has billionaire Kirk Kerkorian, who owns 9.9% of the stock, looking over his shoulder and pressuring for such radical moves as a proposed equity tie-up with Renault-Nissan (NSANY).

But give Wagoner and his team some credit. The company reported its first automotive operating profit since 2004, earning $1.2 billion if you don't count the costs of buying out or retiring almost 35,000 workers. Add those costs in and GM lost $3.2 billion.

Perhaps the biggest sign of hope came in North America. Sure, GM lost $85 million, but that's a rounding error next to the $1.1 billion loss the company put up in the second quarter of last year. "We can't be satisfied at all with these results," says Vice-Chairman and CFO Frederick A. "Fritz" Henderson. "But a quarter of solid progress."


  Indeed, the drive toward breaking even at home shows that Wagoner's cost cuts, concessions made by the United Auto Workers, and GM's pricing strategy—which emphasizes lower prices rather than rebates—are bearing some fruit.

However, plenty of questions and challenges remain. Higher oil prices continue to threaten GM's profitable trucks. The company continues to lose market share at home. And some analysts still question whether GM can sustain its improved profitability.

Of GM's $1.2 billion profit, almost half isn't sustainable. Here's why: GM booked a $300 million earnings improvement due to lower warranty costs. That's a fine sign that quality is better, but it's still a one-time help to the bottom line. Also, the company's GMAC financial-services arm added $259 million to its profits by selling off a regional home builder it used to own.

Without those one-time windfalls, the quarter wouldn't look nearly as good. Plus, GM's large SUVs—which were launched early this year—stand to lose momentum in the market as the buzz of an all-new vehicle wears off, writes Goldman Sachs (GS) analyst Robert Barry. So they may not be as big a contribution going forward.


  GM could also keep burning cash this year. The company was cash-flow positive in the quarter, generating $700 million. But GM only spent $3.1 billion of its budgeted $8.7 billion in capital expenditures. Of the $6 billion in cost cuts this year, only $2 billion worth will save cash. UBS analyst Robert Hinchliffe estimates GM could burn as much as $3 billion this year.

That's not to say GM's suddenly rosy numbers are a mirage. The North American business is healthier. As is GM's long-suffering European business, which posted a tidy $124 million profit in the quarter—four times what it did the same quarter last year. GM's Latin American business made $174 million and GM-Asia Pacific brought in $167 million, helped by a 47% increase in sales in China this year.

Even at home, there are reasons for optimism. Wagoner has bought out 35,000 workers and, with them, taken out a lot of factory capacity that wasn't being used. That means GM will be paying fewer workers who are on furlough and can build inventory closer to real market demand. That could eventually translate to better pricing since GM won't have to bribe consumers to buy excess production.

In total, Wagoner's cuts have taken $1.5 billion in costs out in the first half, but will really hit in the second half. GM will drop $4.5 billion in costs in the next two quarters, Henderson says. That has one analyst, David Healy of Burnham Securities, forecasting a profit of $5 billion for the year. GM says it will take another $3 billion in costs out in 2007.


  Longer term, there is evidence in GM's design studios that Vice-Chairman Robert A. "Bob" Lutz's push for better styling will finally bring some hits. GM has a trio of crossover SUVs for Saturn, GMC, and Buick on the way. The next-generation Chevrolet Malibu and Impala sedans could be breakthroughs for the company. So could the next Cadillac CTS sedan. All of those cars boast tasteful styling, yet a radical departure from the "good enough" execution that has become synonymous with most GM brands.

GM will need all of that if the company expects to break the cycle it has been in. Even though the second quarter is much improved, it only gets GM back to where it was just before the crisis. For years, GM has made most of its money from its GMAC finance arm—which made $900 million in the quarter. Even before last year's fiasco, GM made anywhere from 60% to 90% of earnings from GMAC in any given quarter.

That's problematic since by year's end GM should complete the sale of 51% of GMAC to Cerberus Capital Management. When that goes through, Cerberus will pocket half of the lending profits that have traditionally kept GM afloat.

If Wagoner can deliver the kind of "robust profitability" he has been talking about—even without half of GMAC—he may finally have an iron-clad case to get Kerkorian off his back.

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