Wednesday, November 08, 2006

Delphi Corp. Bankruptcy: How Wise the Oracle?

Increasing competition from foreign suppliers; a reduced number of motor vehicles being produced by General Motors; U.S. labor legacy liabilities and noncompetitive wage and benefit levels; restrictive collectively bargained labor agreement provisions; and, increasing commodity prices, most notably steel, petroleum-based resin products and copper —all these variables compounded an already deteriorating financial picture at Delphi Corporation, the U.S. largest auto-parts maker. In October 2005, Delphi (and certain of its U.S. subsidiaries) threw in the proverbial towel, filing voluntary petitions for reorganization relief under chapter 11 of the Bankruptcy Code.

On October 11, 2005, the New York Stock Exchange (NYSE) announced the suspension of trading of Delphi’s common stock. The NYSE subsequently determined to suspend trading based on the trading price for the common stock, which closed at $0.33 on October 10, 2005, and completed de-listing procedures on November 11, 2005.

The Common Stock of Delphi (DPHAQ-$2.25) currently trades on the Pink Sheets, a quotation service for over the counter (OTC) securities, and is no longer subject to the regulations and controls imposed by the NYSE. Unlike securities traded on a stock exchange, such as the NYSE, issuers of securities traded on the Pink Sheets do not have to meet any specific quantitative and qualitative listing and maintenance standards.

“A speculator is a man who observes the future, and acts before it occurs.” –Bernard Baruch.

The share price of Delphi has gained an amazing 582 percent in value in the last year, as investors speculate that there will be material value left for shareholders when a solvent Delphi emerges from bankruptcy proceedings.
Scottish writer Thomas Carlyle (1795-1888) said, “Conviction is worthless unless it is converted into conduct. “ Given Delphi’s current obligations, the 10Q Detective does not subscribe to the optimistic conviction and believes that the Company’s course of conduct will prove the Common Stock to be declared worthless.

The plan of reorganization has a human face—
’early’ retirement for hourly workers and modified retiree benefits. Still, the Delphi bankruptcy remains a balance sheet event. Ultimately, it was the Company’s inability to effectively respond to a magnitude of financial challenges, including its U.S. legacy liabilities (such as debt-service levels, fixed labor costs, and prior pension and health care funding obligations) and dependence on GM for top-line growth (about 48% of 2005 net sales) that pushed the Company over the edge:
  • As of June 30, 2006, Delphi had total assets of $15.06 billion (less inventories and goodwill) and total liabilities of about $25.3 billion. Additionally, the Company owes about $1.27 billion in other financial contracts and obligations (such as IT purchase commitments and capital/operating leases) that come due in the next four years.
  • Management believes that the average rates at which it currently compensates its hourly workers, including employee and retiree benefits, is nearly three times the average hourly labor rates paid by its U.S. peer companies. Specifically, Delphi’s U.S. hourly pension and other post retirement benefits (OPEB)—mainly health and life insurance—exposed Delphi to approximately $10.7 billion in unfunded liabilities at December 31, 2005, of which approximately $2.3 billion was attributable to unfunded pension obligations and $8.4 billion was attributable to OPEB obligations. [Ed. note.The Company is only allowed to defer these contributions until it emerges from Chapter 11. As such, the projected future cash outflows for hourly pension contributions and OPEB payments will increase as Delphi’s U.S. workforce continues to age and the ratio of retirees to active employees increases.]
  • Delphi is currently operating as “debtors-in-possession” (DIP). Specifically, DIP is unique from other financing methods in that it provides the lenders with (a first lien) priority over existing obligations, including debt and equity (current shareholders are considered unsecured claimants).

J.P. MORGAN SECURITIES INC. and Citigroup Global Markets, Inc arranged the DIP. As of December 31, 2005, Delphi had $250 million in term loans and $7 million of letters of credit outstanding under its DIP credit facility. However, Delphi has the ability to borrow up to $2.0 billion from its lenders. [Ed. Note. Again—each additional dollar borrowed means one less potential dollar for shareholders.]

  • The Chapter 11 Filings triggered defaults on substantially all debt obligations, including 10.0 million shares of trust preferred securities [collectively known as Delphi Trust I and Delphi Trust II]. The property trustee of each Trust is in the process of liquidating each Trust’s assets and it is expected that the holders of the trust preferred securities will receive in exchange for their securities a pro rata share of the Trusts respective junior subordinated notes issued by Delphi (which leaves even less of the money pie for Common Stock holders).

As of June 30, 2006, Delphi had a total stockholder deficit of $(7.93) billion [understated!], or about $(14.12) per share.

Albeit Delphi will probably emerge from bankruptcy as a viable entity, the math suggests that it is the creditors and bondholders who will become the Company’s new owners—not the stockholders.

Despite the empirical evidence to the contrary—conventional wisdom—and the efficient market hypothesis—do little to explain why investors would invest $2.00 in a stock that is seemingly worthless. In our view, mob psychology might help to define why individual investors tend to ignore responsible judgment. Being part of a group—(in this stock example) the plethora of message boards (and related threads)—makes investors absorb the behavior of the collective (while also being able to mask their actual identities). Ergo, as the price [of Delphi] started to rise from pennies to quarters, the message boards started buzzing that the price was headed much higher.

"Friends, Romans, countrymen, lend me your ears;
I come to bury C├Žsar, not to praise him.
The evil that men do lives after them;
The good is oft interred with their bones."
–And in his stirring speech, Marc Antony incited the gathering mob to drive Julius Caesar’s assassins from the city of Rome. [William Shakespeare’s Julius Caesar.]

Editor David J Phillips does not own any of the stocks mentioned in this article. The 10Q Detective has a full disclosure policy.


Anonymous said...

One thing your analysis ignores is that the lion's share of Delphi's liabilities are in its pension plans and reitree health plans.

I think many speculators (including myself) picked up the shares because they realized that the unions would have to accept lower levels of retiree benefits and lower salaries if they wanted to keep Delphi afloat and keep their jobs. Lower retiree benefits means less liabilities and more money for bondholders and shareholders. Lower salaries means better margins. All the losses Delphi is racking up means better tax-loss write offs in the futrue and hence, better margins again for a number of years.

I also think that commodities, including oil, go through cycles and that eventually the cost of commodities will come down... thereby improving Delphi's margins again.

Also, GM is on the hook for a lot of these pension obligations... it has to be, because if Delphi were to stop production (from strikes or liquidation), GM would have to shut down many of its plants and it would be crippled.

Adding all this up, buying Delphi shares is much less a risk than it would appear on the surface. That does not mean there is no risk.... just that there is much less risk than most market participants believe. Now, having said that, the extremely cheap price that the market is asking for the shares combined with the high potential for reward... reduces the risk of loss. Investors could have put a small amount of money on Delphi shares during extended periods for the past year... and even if they lost it all, the amount would be neglible (unless of course, they put a huge portion of their portfolio into Delphi stock).

Now, if Delphi emerges Bankruptcy, with a substantially improved operational model, enormous amounts of money could be made by the shareholders who have bought in the past year. The risk-reward tradeoff makes sense for me, and probably, for many other buyers of the stock.

J. Bardt said...

I'm not sure if I agree with that.
The Nasdaq Composite was higher for much of the day, but ended down 8.93 points, or 0.37%, to 2376.01.

J. Bardt

Anonymous said...

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I'm 25yrs old, have zero credit card debt, no student loans just my house that has just received a notice of default. Which would have a greater impact on my credit score a foreclosure or chapter 7 bankruptcy filing? I know a bankruptcy lasts about 7 years but how long does a foreclosure last, or better yet how soon can I buy a house after foreclosure? I'm fairly certain that a bankruptcy would be worse but I'm concerned that my lender might try or has the option to get a deficiency judgment since I refinanced a year ago. From what I understand the lender has two options (California Law) a private sale or judicial proceeding. I'm hoping for a private sale which will pretty much keep me in the clear. How often do lenders go with a judicial proceeding?
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