Future cash flow, that will grow substantially when pent-up demand materializes in full, make Ford Motor Co. (F) a stock with an interesting upside. For the time being, the company has a strong product portfolio and is well positioned to profit from any uptick in demand. At the same time, the company doesn't have a sustainable competitive advantage and is not a great long-term buy & hold.
Fellow Seeking Alpha contributor David Zanoni recently published an interesting article called Ford's High Return On Equity Is A Competitive Advantage. It's title attracted my attention because in my article published on October 14 I argued the exact opposite:
The auto business isn't really a great business to be in. There are no barriers of entry to the auto market except capital requirements. That is not a real competitive advantage and so whenever there are substantial profits to be had, new entrants come into the market.
This is a curse that afflicts all automakers. Some notable competitors are: Toyota Motor Corp ADR, Daimler AG ADR (OTCPK:DDAIY), General Motors Co (GM) and Volkswagen AG ADR (OTCQX:VLKPY). Because of this competitive dynamic where it's very hard to gain a real sustainable competitive advantage, auto companies are not something you want to buy and hold for eternity.
However, Ford is well positioned in a market characterized by pent-up demand and a wide generation of competitive products early in their product cycles. The most important thing when looking at Ford is that its future cash flow possibilities are undervalued.
I agree with David that:
overall, Ford looks attractively valued, pays a dividend, has an above average ROE, and has above average expected earnings growth. These factors should allow Ford to continue to beat the performance of the market and perhaps continue to outperform the other automakers.
What I don't agree with, is his interpretation of Ford's recent ROE numbers. David gathers from this number that the company has a competitive advantage. Although a company posting above average ROEs over a long period of time is likely to have a competitive advantage, it is not one in itself. Most likely Ford doesn't have one.
Although Ford's recent ROEs are attractive numbers, looking at the numbers in 2006 and 2007 makes you second guess how useful a few years of data really is. Morningstar shows ROEs for those years of -265% and -251%.
Over a ten-year period, Ford has performed excellent when compared to U.S automakers. Outside of the U.S, there have been better performers over the last ten years. The returns over this time period also might give you pause whether to invest in the sector at all.
The reason I don't consider capital requirements a sustainable competitive advantage is because whenever there is a period of above average returns being realized in such a market, the capital will find its way. Subsequently, excess returns will be driven down. Competition Demystified has been incredibly helpful to me in thinking about competitive advantage. The authors Bruce Greenwald and Judd Kahn only identify three real base competitive advantages: supply, demand and economies of scale. These are extremely strict categories in their work. For example, demand includes "switching costs" but not "branding" as that is in most cases so expensive to sustain - its cost eats up excess return on equity.
The reason I'm addressing David's article, even though our thoughts on the valuation of the company are ultimately similar, is because a discussion about competitive advantages can be helpful to readers with many future investment decisions.
Like I wrote earlier, I'm not a huge fan of the auto sector. Yet throughout the year, my writing has been overweight the sector. The one factor that captured my interest in the auto sector is that of pent-up demand. The deleveraging story is widely known and it has caused significant pent-up demand.
If economists looking at the housing sector are generally optimistic, those who follow the auto industry are practically brimming with glee. Right now, the average age of cars on the road is the oldest ever recorded, at 11-and-a-half years, which means at some time, people will have to buy newer ones. As NPR's Sonari Glinton reports, that time may be now.
There are also voices that counter the pent-up demand story. For example, with arguments that people invested in maintaining their cars and that they don't feel the need to own a new car. There is also a valid argument that even though the car fleet aged, cars last longer because their overall quality and thus lifespans have been improved.
Both are valid arguments and there is most likely some truth to them. Still I think the record age of the fleet indicates there are better sales numbers to come. Perhaps not equal to peak demand before the crisis but better then they are currently.
Something I wholeheartedly agree on with David Zanoni is that Ford has a wide portfolio of competitive products at this point. I didn't test drive any myself, but quoting a U.S. News Report.
The Best Cars for the Money Awards cover 21 different automotive categories with one winner in each. With six wins, Ford took home the most awards of any brand, followed by Toyota, which took home five awards across its Toyota, Scion and Lexus brands. As a whole, domestic automakers won nine awards and import brands won 12. Some cars are long-time award winners. The Lexus RX 350 has won Best Luxury Midsize SUV five years in a row, and the Ford Taurus has won Best Large Car for the Money for the past four years. However, there are some newcomers such as the BMW X1, Scion FR-S and Buick Verano.
Does this make Ford a superb automaker? A stock to own for the ages? No. Does it mean they are likely to do well if the pent-up demand story plays out? Yes.
It's just that at the present time, the potential upside outweighs the downside. The potential upside being powered by pent-up demand, a recovering economy and a generation of strong models.
Discounted Cash Flow
After performing two DCF calculations, taking into account the above views on the development of future cash flow, I arrive at a Net Present Value estimate of either $15 or $28. To arrive at the lower number, I estimated current cash flow growing at a rate matching inflation for a few years into the future. When assuming significant growth of cash flow, which would materialize when the pent-up demand story would play out, Ford's net present value is $28. In that case, Ford would generate significantly higher profits for five years into the future. However the pent-up demand story is up for debate.
Given future cash flow considerations, the stock is undervalued. Mainly because of a strong product portfolio and demand dynamics in the market.
Huge cyclicals are far from my favorite investments. Smaller plays that can possibly become the target of a buyout or M&A offer are much more attractive to me. If you are looking for major cyclicals to add to your portfolio, I think this is a solid choice at $17.