Over the past twelve months shares of Ford (NYSE:F) have rallied 15%. While a respectable performance, that rally lags the broader market as well as cross-town rival General Motors (NYSE:GM) (chart below). Ford's underperformance has worsened in the past six weeks after releasing guidance that underwhelmed investors and analysts, though shares have recovered some losses thanks to a dividend increase and Alan Mulally's announcement he will remain at Ford. Despite the recent underperformance, Ford is the favorite long in my portfolio as I believe it has over 20% of upside potential with minimal downside risk. Here are the seven reasons I feel this way.
1. The Bad News Is Already Priced In
While stocks in your portfolio may have significant upside potential, it is critical to consider what could send shares lower as downside risk can often outweigh upside potential. In Ford's case, much of the bad news is already known and priced into shares. In mid-December, management offered full year guidance that disappointed investors. In 2013, the company generated about $8.5 billion in pre-tax profits; however, the company is expecting a sequential decline to $7-$8 billion in pre-tax profits ($1.75-$2.05 per share). This declined stunned the street, and shares tumbled. Ford has set a low bar for 2014, and there is now minimal risk of disappointing operating performance.
Under Mulally, the company has tended to offer conservative financial guidance, preferring to positively surprise when earnings are released than vice versa. I believe that this guidance was another example of Ford taking a cautious approach and am looking for performance towards the upper end of the guided range. At the time of the announcement, speculation was still strong that Mulally could leave for Microsoft (NASDAQ:MSFT). He likely saw an opportunity to clear the deck and lower the bar in case he did leave. Moreover, it is important to recognize that lower profitability is due to calendar issues rather than operating performance.
2. 2014 Is a Transition Year Due to Product Launches.
Ford is not projecting a decline in profits because the end-market is softening as the U.S. remains robust while Europe is improving slowly. Nor are major market share declines to blame for weaker profitability. Rather, Ford has calendar issues. The company will be releasing a record 23 new or significantly updated vehicles this year. When a new product is launched, sales of its predecessor decline sharply ( who wants to buy the old model weeks before a new one comes out) and discounting is often necessary to move the inventory. Similarly, sales of the new model can take time to ramp up as plants try to add capacity. These launches will soften 2014 sales but will help to make 2015 a banner (and likely record) year.
Most importantly, Ford will be updating its F-Series of trucks, which have been the top selling trucks in America for 27 years and have been Ford's top selling vehicle for 32 years. These trucks are also higher margin than most of Ford's sedan offerings, so growing sales of this line is critical to Ford's future. Ford unveiled an aluminum F-150 at the Detroit Auto Show , which will cut a reported 500-700 pounds from the body, making the vehicle extremely fuel efficient compared to peers.
The updates to the F-Series will likely dampen first half 2014 sales, which will have a significant impact on profits due to their outsized margins. However, with better fuel efficiency and new designs, these initiatives will ensure the vehicle remains the top selling in its class. Ford has become an innovative leader in the auto space, which will power growth and robust market share for several years. Due to product launches that will impact Ford's most profitable vehicles, 2014 will be a transition year. That Ford will likely keep profits within 10% of 2013's level is a testament to the popularity of its cars and lean manufacturing cost structure. Investors are best served looking at Ford over a two year time frame as any lost sales are really just being deferred into 2015 when Ford should grow sales by 10% and earn towards $2.00 per share.
3. Europe Is Bottoming
Ford has successfully been cutting capacity throughout Europe to ensure it can be profitable at lower volumes. Thanks to high-cost plant closures, Ford has cut its capacity by 18% on the continent, which will ensure the company is solidly profitable in 2015. Moreover thanks to financial problems at Peugeot and confused brand strategy at General Motors (transitioning from Opel to Chevy back to Opel), Ford has been gaining market share.
Moreover after years of decline, it looks like the European market is starting to stabilize thanks to a bottoming in many European economies, though France still has a muddled outlook. Many debt-riddled countries have already seen their worst days, while countries in the North should have decent years. While Europe will continue to lag the United States, the European market should start to firm up. Thanks to its capacity cuts, Ford should outperform competitors on the continent, and I expect it to break even or turn a slight profit on a continuing basis. Due to closures, there will be some one-time items that could total $900 million, which will make the results rather messy. Still, Ford is about two years ahead of the curve on cutting capacity, and this will translate to the end of losses this year and noticeable profitability in 2015.
4. Emerging Markets Show Tremendous Growth
While Ford has been leading competitors in Europe, the company has been lagging in emerging markets, particularly China. These markets still have significant untapped potential that Ford will benefit from in 2014 and beyond. Thanks to One Ford, the company has been expanding margins in South America, and I expect some volume growth in 2014. Unfortunately, some country-specific issues will make the results weaker when translated back to dollar terms. The Brazilian economy has been underperforming of late and is growing more like a developed than emerging economy. At the same time, Ford is forecasting a nearly 50% devaluation in Venezuela's currency. Due to these factors, Ford will probably remain at the breakeven level despite volume growth. As these nations mature, Ford will be a prime beneficiary, but unfortunately, that appears to be several years away.
Importantly, Ford is starting to perform well in China where it had been struggling for years. Ford's China sales jumped by 50% in 2013 to over 900,000 vehicles compared to the 2.5 million it sells in the U.S. For comparison, GM actually sells more cars in China than the United States (3.1 million vs. 2.8 million). Ford has been late to China but is finally seeing some sales traction, and years of significant growth maintain as the market matures. Ford has been investing heavily throughout Asia to add capacity to meet China's demand. As a consequence, the unit has been running near the breakeven level. At this point, investors should be happy with this approach as it is important to build capacity and establish a foothold in these long-term growth markets. By 2016-2017 when the company is where it should be sales-wise in Asia, the company will start to see profitability that can propel earnings growth as the U.S. market starts to slow down.
5. Mulally Is Staying
I was never as concerned about Alan Mulally's departure as other investors, but I am glad to have him. He has built a strong team, primarily lead by Mark Fields, that can continue Mulally's work when he decides to step aside. Mulally has transformed Ford's culture into a collaborative one and has installed managers who have bought into this philosophy. Investors do need to recognize that Mulally will not be around forever (he will turn 70 in August 2015).
At some point, Mulally will retire; I suspect sometime in 2015. At that point, Fields is the clear frontrunner to take over as CEO. Still, it is a positive to have Mulally for another 12-18 months. With 23 product launches, it is important to maintain the schedule, an area where Mulally has excelled. With smooth launches, Mulally can position Ford for an exceptionally strong 2015 and 2016, which will make the management transition easy. As the company plans for major roll-outs and continues to implement One Ford to boost margins, it will be helpful to have Mulally at the helm. In 2006-2008, he saved the company, and in 2014, he will position it for years of profitable growth.
6. A Growing Dividend
Ford showed the world it was no longer in crisis mode when it reinstated its dividend with a $0.05 quarterly payout in the beginning of 2012. Management has made a priority of growing the dividend while improving its credit rating. Moody's and S&P rate Ford's debt "investment grade" after years with junk status. At the same time, Ford has grown the dividend and just announced a 25% hike to $0.125, which translates to a 3.11% yield.
Suddenly, Ford stock is attractive as an income vehicle, and I expect continued annual dividend hikes. Ford has repaired its balance sheet since mortgaging everything to survive in 2006, and the company has over $30 billion in cash and untapped credit facilities. With debt issues fading, Ford is in the position to better reward shareholders. Even with 2014 being a transition year that will depress earnings, analysts are expecting $1.50 in earnings. This means that Ford's payout ratio is still a low 33%. With earnings growth likely to resume in 2015 and the capacity to raise the payout ratio into the 40-50% range, I expect a 10+% annual dividend growth rate through 2018.
7. Reasonable Valuation
Despite all of these tailwinds, Ford shares are extremely cheap as investors worried too much about 2014's results. Analysts are looking for $1.50 in 2014 earnings, which would give shares a 10.7x multiple. Given the company's growth prospects, European improvement, and catch-up in China, that is a very attractive valuation. I am expecting a better year in 2014 as I believe management sand-bagged a bit to hedge against product roll-out related issues and am looking for $1.60-$1.65, which would translate to a 10x multiple. Moreover, any lost sales in 2014 are being deferred into 2015 when earnings should reach $2.00, barring an unforeseen recession in the United States. At these prices, Ford is very attractively valued. Shares could rally 25% to $20 and still trade at a respectable 13.3x analyst consensus earnings.
With its dividend providing some support and a very low valuation, I see limited downside risk for shares of Ford while the company should growing profitability significantly in 2015-2017 as product launches, leaner capacity in Europe, and growing sales in emerging markets start to pay dividends. At $16, I believe investors with a multi-year time frame will do extremely well while the low valuation provides ample margin of safety. These is no stock I own that I feel as comfortable with and optimistic about as Ford.