Ford: Have You Driven a Convertible Preferred Lately?

Patrick Kirts co-wrote this article.

The news is horrible for the auto industry. In October, J.D. Power and Associates published a study that suggested a potential collapse in the global auto industry in 2009. We love to buy panic, but this time it seems real. If you want to make money in such a dire situation, you will need to understand what you are putting up, what you could lose, and what is the payoff.

Part of our core portfolio includes a convertible preferred issued by Ford (F). But before we get too technical on how to play the global auto collapse, we need to see where Ford is in all of this and what could possibly cause it not to go broke. For those of you that don’t like reading, here is the punch line. The company has the cash to stay alive for a little while, it doesn’t have to be that great, and a little known version of the stock is selling cheap and pays well. For those that like to read, here you go.

Ford Motor Company’s stock is currently selling extremely cheaply and sentiment for the American auto industry as a whole hasn’t been worse in decades. GM is at sixty-year lows, and its bankruptcy has been rumored for a few years. Now we have October sales for GM down 45% and Ford off by 30%. If Ford, however, is able to get cash flow to continue to increase it may become profitable, and, when profitable, it has historically paid a dividend. We believe the company offers value if it merely improves today from a bad company to a less bad, somewhat profitable, one. Ford needs only to become mediocre to generate cash flow and make an improvement in the stock. Furthermore, America has an interest in keeping Ford solvent and Barack Obama has spoken of guarantees for auto loans, but we can’t count on them.

We first see that, following $1.44B profit in 2005, Ford suffered losses of $12.6B and $2.72B in 2006 and 2007, respectively. In the past four quarters, starting with the third quarter of 2007, Ford lost $380M, lost $2.8B, profited $100M, and then lost $8.67B in the second quarter of 2008. This last quarterly loss mostly resulted from a $6.61B automotive sector loss, for the most part confined to North America, and a $2.42B financial services loss resulting from a significant decline in used vehicle auction values during the quarter. On its balance sheet, Ford currently has $166B of long-term debt (it has been as high as $180B and $133B over the past ten years, seven of which were profitable), and a quarterly interest payment of $2.5B, for a debt-to-equity ratio of 0.62, which is healthy, given the problems facing the company. As of June 30, the company has $30B in cash, so it can afford to pay its debt for the next few years, barring catastrophe. It has had an even narrower range of total assets over the past ten years as well, and its 2007 cash flow of $17.1B is almost back to its 2005 level of $20.4B, after only $9.62B in 2006.

The question remains, will the financial services and automotive sectors continue to show significant losses, or is the worst behind Ford? Looking at the former first, we see that the past quarter’s loss of $2.1B has been accounted as a pre-tax impairment charge. Management notes that higher fuel costs and a weaker economy in Canada and the United States have contributed to a shift in consumer preferences toward more fuel-efficient vehicles, away from trucks and SUVs, and so predicted that lease values would be significantly lower than expected. Thus, the charge represents the difference between carrying value and the fair value of certain vehicle lines in Ford Credit’s lease portfolio. While this loss is significant, it shows that Ford is adjusting to new economic realities. This could be repeated if we see a much larger drop or shift in consumer demand.

Ford’s automotive loss also shows a similar adjustment in the company. The North American division actually showed a loss of $7.15B, but this was partially offset by profits abroad, particularly in Europe and South America. Again, the largest element of the loss is a fixed impairment charge, here of $5.3B. Management additionally attributes $1.3B to unfavorable volume and mix, about $300M of higher charges for increased benefits and personnel reduction, and several other smaller losses. The nature of these losses suggests that they result from a company reorienting itself to a changing market by writing down losses and cutting jobs.

If cash flow improves, we are willing to be long at even lower prices, but we would lower our stake on a price rise without a corresponding improvement in cash flow. Negative price action accompanied by continued deterioration could be a reason to sell, as well as more surprises or confusion from the financial services division. Negative cash flow would, of course, be a big warning sign. However, at the current valuation, we are prepared to be long for multiple years if Ford continues to pay its debt and halts losses.

This brings us back to how to play it. While the talking heads refer to the $2 price as a lotto ticket, we have a more intelligent way to speculate. In January of 2002, Ford issued 90 million convertible preferred shares (NYSE: F-S, F.PS, F-PS) paying a face value of 6.5%. The conversion rate is 2.8249 shares of Ford common stock. Recently, the premium above the value of common (common times 2.8249) is about 6 months worth of dividends. In basic terms, if you buy the convertible, you get the premium paid for in about 6 months. If you hold the convertible for 2 years, you get your money returned to you plus whatever Ford is selling for.

Now, remember in two years Ford could be bankrupt. It could also stop paying the dividend anytime it wants. So you can see why the market has priced the security cheap. This is not a free lunch, but it is a better way to get paid while you wait.

What are you waiting for? Simply the survival of the company is all. We don’t care about how well it does versus Toyota (TM) or if the new cars sell better than expected. We expect nothing except for Ford not to declare bankruptcy and pay its debt on time. It is a gamble we are willing to take and watch closely.

Full disclosure: Portfolio, LLC is long F-S (Ford Capital Trust II) at the time of this writing.

Comments

[rh13:]

Ford stopped paying a dividend some time ago.

2008 Nov 04 10:09 AM

[sumosama:]

not on the preferreds...

2008 Nov 04 10:18 AM

[NH LTI:]

The F-PS (Ford Capital Trust II) (or F.PR.S on some quote systems) has a 45% dividend yield today ($3.25 annual dividend paid quarterly)

What the author didn't say too is that there are only about 58 million shares outstanding after last summer's voluntary conversion offer (about 42 million shares converted if you check the SEC filings). This means that the quarterly cash outlay is about $47M. Not much for this company unless things get REALLY bad. So I don't think they will suspend the dividend because it just accrues anyway.

We'll know a lot more 11/7 when earnings come out....... but the Ford Preferred definitely looks like the best way to "play" Ford survival/turnaround.

2008 Nov 04 03:40 PM

[Wadhamite:]

This option sounds okay; but it doesn't do much for holders of Ford common stock, who have seen the value plummet over the past few years. An investor in common stock has little option but to hold on, since selling today would guarantee a loss. There are far more holders of common stock than this preferred. I would rather see Ford reward its common stockholders in some tangible manner -- granted, that could be tough when quarterly losses are so great.

2008 Nov 04 04:02 PM

[weiwentg:]

At this point, I can see a scenario where Ford survives but its equity and preferred holders get wiped out in a nationalization. I think this is way too speculative.

I think the convertibles for Chesapeake and Bank of America offer decent values with good downside protection. In BAC's case, though, I'd wait to see how things shake out with Citi - if they're forced to fire sale assets, BAC will be forced to take heavy writedowns on mark to market accounting. They will then have to raise extra capital.

2008 Nov 23 09:41 PM

[Lee Eugene ...:]

I agree! This is a speculation. However, at this point our real issue is not Ford getting nationalized, but how they will deal with the UAW when (yes, when) GM goes down.
However, Bank of America offers little downside protection other than the chances of BAC going to zero are less than Ford.


On Nov 23 09:41 PM weiwentg wrote:

> At this point, I can see a scenario where Ford survives but its equity
> and preferred holders get wiped out in a nationalization. I think
> this is way too speculative.
>
> I think the convertibles for Chesapeake and Bank of America offer
> decent values with good downside protection. In BAC's case, though,
> I'd wait to see how things shake out with Citi - if they're forced
> to fire sale assets, BAC will be forced to take heavy writedowns
> on mark to market accounting. They will then have to raise extra
> capital.

Jan 16 04:33 PM