Ford Is Cheap, But Should You Buy It Now?

March 17, 2018

Ford Is Cheap, But Should You Buy It Now?

  • Today, we’ll discuss what’s most important when analyzing a company like Ford: fundamentals, the economy, sales, intrinsic values, cars, and the stock price.
  • When investing in Ford, you have to think about what the stock price will be when the earnings turn negative. They always do.
  • I’ll show you 3 models that will explain the current price for Ford.

Why Is Ford So Cheap?

Many see Ford (NYSE: F) with a price to earnings ratio of just 5.6 and a dividend yield of 5.66% as an extreme bargain. That might be true at first glance, but those who think so haven’t seen economic cycles.

The automotive industry is extremely cyclical and that has a huge impact on car manufacturers. In a speech, Martin B. Zimmerman, a former vice president at Ford, discussed how the industry is extremely cyclical and how a typical recession lowers sales by 15% at Ford, and that makes the difference between strong earnings and big losses.

Figure 1: The former Ford vice president’s FED speech. Source: FED.

So when analyzing a car manufacturer, one must always think about the business cycle and that’s exactly why the stock might look cheap now. Further, Zimmerman explained how a rise in interest rates (higher interest rates make car financing more expensive) and economic shocks (like pricier oil) make cars a less attractive means of transportation.

Right now, we are seeing rising interest rates, anyone who wanted to buy a new car has already bought one, and tariffs might be a small economic shock. What’s important is that car sales in the U.S., Ford’s core profit market, have already started to decline even though we are still in an expanding economy.

Figure 2: U.S. light vehicle sales have been stable for 3 years now. Source: FRED.

The two things to look for when analyzing a cyclical is the long term balance value and the discount at which such a stock could be bought in a panic sale or market crash. Given that lots of fund managers focus on the latter, you will never see Ford valued at market rates, it will always be cheap because everyone expects a big, sharp decline in the next recession just as has been the case in the past.

Figure 3: Ford’s historical stock price. Source: Yahoo Finance.

So from 1999 to 2003, the stock went from $31 to $7. From 2004, it went from $14 to below $2 and during the 2012 European recession, it went from $16 to $9. As U.S. car sales have flattened, Ford’s stock has been in a negative trend for the past 3 years even though earnings are strong. Let’s look at the business to see what we can expect.

How Can The Business Be Impacted?

The management sees no growth in 2018 and a declining bottom line.

Figure 4: Ford’s global sales and sales guidance. Source: Ford.

Stable sales are good, but one has to ask how Ford’s cash flows and earnings will evolve during the next recession. As we are in the late part of the economic cycle, this is the main worry investors have when discussing Ford.

The problem is that the management already forecasts lower earnings even though there are no signs of a recession and the global economy is expanding synchronously.

Figure 5: Ford’s guidance for 2018 isn’t a growth one. Source: Ford.

What’s very important for Ford is the economic situation in the U.S. because practically all of its profits are from there.

Figure 6: Ford’s global profits. Source: Ford.

As practically all profits come from the U.S. and no improvements are expected elsewhere, a recession in the U.S. would be extremely detrimental to Ford’s bottom line.

Higher commodity prices won’t help the company, but thankfully tariffs aren’t expected to make a big impact.

Figure 7: Higher commodity prices take billions of the table. Source: Ford.

When looking at a cyclical, it’s very important to look at inventories and those have been increasing in Europe lately which might mean nothing but it isn’t a good sign.

Figure 8: Ford’s global dealership inventory. Source: Ford.

Even if Ford doesn’t see growth in 2018, the management expects to increase dividend payments.

Figure 9: Past and expected shareholder distributions. Source: Ford.

The dividend may look sustainable as Ford spends $3.1 on dividends per year and its net income was $7.6 billion in 2017. However, $7.6 billion on $156 billion in revenue shows how tight the margins are in the industry and how quickly things can change. Therefore, I wouldn’t be surprised to see Ford cut the dividend when the cycle turns. The key is to see what will happen then, when earnings turn negative.

Another risk that few think about when analyzing Ford are pension contributions. The company has been lucky that returns on assets were 13.4% which is an excellent result. But this also means that most pension funds are invested in stocks which makes it a very risky endeavor that might be very costly later.

Figure 10: Returns on assets won’t be this positive in the future. Source: Ford.

So the risks with Ford are that a recession lowers sales by 15% which would lower revenue by 15%. Thus, from $156 billion to $132 billion. If commodity prices increase and interest rates increase, there will be more pressure on earnings and it would also eliminate profitability and perhaps even push earnings into negative territory. If return on pension funds turns negative too, the situation would get very ugly.

Now, to be a bit more optimistic I’ve made three models for what could happen to Ford. The first model assumes volatile earnings over time, but two U.S. recessions in the next 10 years. I also put a final value of $10 for the stock in 2028. The present value at an 8% discount rate is $9.93 in such a scenario, which is close to the current price.

Figure 11: The value calculations for Ford. Source: Author’s calculations.

In case there is no recession in the next 10 years, and Ford manages to reach the top of its 2018 earnings guidance in every year up to 2028 with a final stock price of $17, then the present value goes to $18. Given the low likelihood that Ford achieves constant earnings over time and there isn’t U.S. or global recession in the next 10 years shows why a price of $11 for Ford might look cheap, but a 5.66% dividend yield and a PE of 5.6 aren’t.

The third model uses the average earnings for the past 10 years and a current price for 2028. The present value isn’t far from the current price in this scenario either.

Now, the key to investing in Ford is to estimate what the stock price will be when the next recession cancels the dividend and earnings turn negative. Will the market understand the cyclicality or will people panic?

People will probably panic as no one likes a dividend cut and many will expect to buy in at a lower price. Such pressure will deliver great opportunities to those who patiently wait for cyclicals to come to them.

I’ll finish here by quoting Peter Lynch on how to invest in automotive stocks:

“If you know your cyclical, you have an advantage in figuring out the cycles. (For instance, everyone knows there are cycles in the auto industry. Eventually there are going to be three or four up years to follow three or four down years. There always are. Cars get older and they have to be replaced. People can put off replacing cars a year or two longer than expected, but sooner or later they are back in the dealerships. The worse the slump in the auto industry, the better the recovery.”