Merrill analysts prefer Ford, General Motors convertibles, debt over equity

By Ronda Fears

Nashville, Nov. 5 - The auto sector is prime for capital structure trades and analysts at Merrill Lynch & Co. Inc. make several suggestions in a new report, including switching into the convertibles of Ford Motor Co. and General Motors Corp. from the stock.

Recommendations across the entire capital structure of Ford, GM and Fiat SpA include these companies' convertibles, although the analysts suggest an underweight position in the Fiat converts. DaimlerChrysler AG also appears in the report, with some suggested capital structure trades.

The report is a collaboration between Merrill's global research groups - equity, fixed income, convertibles, derivatives, asset-backed securities, pensions, foreign exchange and strategy. Some 22 analysts contributed to it.

"With the automotive sector having some of the most complicated capital structures around, we believe a capital structure investment approach is particularly relevant in the auto industry," the analysts said in the report.

"The Big Three autos [Ford, GM and Chrysler] earn on aggregate just shy of 2% operating margin at the current trend level of demand, and not much better than breakeven at the net income level, leading our equity analysts to remain neutral to negative on the stocks.

"However, ample liquidity and attractive debt valuations drive our preference for bonds in the capital structures as opposed to stocks."

In general, the report provides relative value recommendations across the capital structure, a detailed fundamental and credit review of each company and their captive finance units, an overview of industry fundamentals in the United States and Europe, the ABS market, pension funding and the effects of a weaker dollar.

"A significant correlation has developed between share prices, credit spreads and option volatility," it was noted in the report.

Also, from an issuance point of view, the auto industry is very capital intensive, so the interrelationship of securities in the capital structure is very important. And with globalization becoming a larger reality - reflected in the creation of DaimlerChrysler - there are other factors at work such as currencies and regulation.

"The automotive companies themselves take a capital structure approach to issuance," the analysts pointed out.

"Equity, convertible bond and ordinary bondholders should be no different in their approach to investment in this dynamic sector."

The stock market has become acutely aware of how dramatic an impact declining credit quality and credit ratings can have on a company's ability to fund itself and survive. For example, about two weeks ago, Standard & Poor's downgraded DaimlerChrysler to BBB and placed Ford's BBB rating on a negative watch that could take it to the brink of junk territory.

"In the case of the auto sector, the high dividend paying auto stocks share similar characteristics with bonds [so] ... presumably investors holding on to the equities of these companies are largely holding them for the stream of cash flows being generated by their high dividend yields," the analysts said.

However, they added: "The willingness or ability of the companies to continue to pay these large dividends is the basis of credit analysis."

In the auto sector, the analysts prefer the bonds over the stocks.

First, limited earnings growth is unlikely to propel share prices higher in the near future. Second, the dividend yield on auto stocks is typically about one-half the yield on the most comparable bond. And, third, historical bond and stock returns in the auto sector suggest better value in the former.

In the bond universe, the analysts prefer bonds issued by the captive finance companies - Ford Motor Credit Co. and General Motors Acceptance Corp. - over the parent bonds, in part because those entities hold the most liquid, highest quality assets.

However, the analysts specifically recommended the Ford and GM convertibles over the stock.

Regarding Ford, Merrill suggests investors swap out of the equity into the convertible for high current yield, an attractive risk/reward profile and more than four years of call protection. Ford's convert is a 6.5% trust preferred that has more debt characteristics than stock.

As for GM, Merrill recommended that investors swap out of the equity into the convertible for increased yield and downside protection. Also, the converts are higher in the capital structure and have a favorable risk/reward profile. GM's convertible bonds - 4.5% due 2032, 5.25% due 2032 and 6.25% due 2033 - were all issued at par of 25 and are listed on the New York Stock Exchange.

Under the Fiat Group, the analysts recommend underweighting the convertibles as they are likely to be put in July 2004 and the yield-to-put is unattractive. Fiat has a 3.25% exchangeable bond due 2007, which converts into GM shares.

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