Friday, May 18, 2007

How Cerberus Makes Its Money on Chrysler

The private equity giant may be sincere in its desire to revive the U.S auto industry, but its real interest is making a lot of money

The early rhetoric about Chrysler's sale to private equity firm Cerberus Capital Management tugs at the heartstrings.

Cerberus Chairman John Snow said in an interview that American manufacturing is vital and that Cerberus would like to play a role in saving it. Sources close to Cerberus founder and CEO Stephen Feinberg, who gives few interviews, say he owns a Ford (F) pickup and has a vision to restore America's prominence in the auto industry. "Speaking as an American, [Feinberg] and I wouldn't be alone in being delighted to see this icon of American industry return to American ownership and thrive," says Snow.

That probably is part of their motivation. But this is Cerberus we're talking about. Its logo isn't a three-headed dog for nothing. Its shareholders are big pension funds that expect returns of 15% or more. So Cerberus will do what it takes to make a lot of money.

That doesn't necessarily mean Cerberus will pull what United Auto Workers President Ronald Gettelfinger weeks ago called a "strip and flip," slashing costs to make quick money and then selling the company.

No CEO Shuffle

In fact, Cerberus could conceivably fetch a fat return on its money by doing very little. Consider Cerberus' low purchase price of $7.4 billion. Lehman Brothers (LEH) analyst Brian Johnson said in a research note that at most $2.2 billion of the purchase price was for Chrysler's carmaking operations. The other $5.2 billion or so bought Chrysler Financial Services, which made about $720 million last year and remains solidly in the black, according to Johnson.

If the restructuring moves that parent Daimler announced in February work, and Chrysler makes $1.5 billion to $2 billion in 2009 like the company said, then Cerberus makes a 68% profit on its investment over about a two-and-a-half-year period. That's at least 27% a year from the car business.

The fact that Cerberus has kept Chrysler's management team on board, including CEO Thomas LaSorda,, suggests that Cerberus thinks the company's current restructuring is enough. "That suggests to me they pretty well buy into LaSorda's turnaround plan," says investor Wilbur Ross, who has successfully bought other industrials like steelmakers and auto parts firms and turned them around. "LaSorda believes that in 2009 they could make $2 billion. If they do, that's already a pretty good return on Cerberus' investment," he adds. (To read more of Ross' thoughts on the Cerberus/Chrysler deal, see, 5/15/07, "Wilbur Ross: 'No Chapter 11 Here.'")

Unloading Liabilities

And that's just on the earnings. Like every private equity firm, Cerberus will eventually sell Chrysler either to the public markets with an initial public offering or perhaps to another automaker. That's where Cerberus may really have something else going for it. When the Big Three sit down this summer to craft a new four-year labor deal, the big item will be walling off Detroit's massive health-care liabilities into a separate fund managed by the union. By the end of the year, the three carmakers will have a collective health-care liability of $120 billion that burns billion in cash and profits every year.

The basic premise is that Chrysler, Ford, and General Motors (GM) would each give the UAW a massive coffer of cash and securities worth, say, 60% to 70% of the liabilities.

If the union agrees, accepts the fund, and takes over management of health care for workers and retirees, that would wipe most of the liabilities off the books of each company. It also would greatly reduce the cash and profit burn. The union can invest the funds so the workers have uninterrupted health-care coverage.

Bad Times for Gas-Guzzlers

This would be a huge boon for Cerberus. They bought Chrysler at a massive discount and might be able to sell it in a few years without the health-care issues that have been a bane for investors. "I'm not suggesting that this would fix these companies, but it's step No. 1," says JPMorgan (JPM) analyst Himanshu Patel. "If you remove health-care liabilities, you remove a cancer within the system that kept a lot of investors away."

There are plenty of things that could trip Cerberus up on its way to making billions off Chrysler. First, Chrysler's business could easily deteriorate further. Gasoline prices have topped $3 a gallon nationally, and about 70% of Chrysler sales come from fuel-hungry pickups, sport-utility vehicles, and minivans. That means market share could continue to slide, and profits from the bulk of Chrysler's lineup could keep slipping.

If that happens, Chrysler may need to do more than just cut one assembly plant and 13,000 jobs, as LaSorda announced in February. It might mean that Chrysler would have to buy out more workers, which could end up costing Cerberus even more for restructuring.

Network Disconnection

Cerberus also wants to spend more on new models, both to get into segments like passenger cars, where Chrysler is weak, and to improve the models they're already selling. Right now, Chrysler spends about $3 billion a year on new products. Cerberus wants to spend more.

Cerberus may also have to spend lots of cash to buy out car dealers and thin Chrysler's bloated network. Cerberus has a credit line of $12 billion and may have to take on debt to truly fix the company.

No one said it would be risk-free. "We believe Chrysler is poised for better results," Snow said, but he conceded that "it won't be easy." No, it won't. But if Cerberus and Chrysler play it right, the deal might work, and there could be big rewards.

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