Can Ford Keep Its Motor Running?

Apr. 8.14 | About: Ford Motor (F)

Summary

Ford Motor screens as undervalued according to YCharts quantitative valuation metric, the Value Score.

This article—an excerpt of YCharts Research recently-published full report on Ford—examines the demand environment for Ford and other U.S. car makers.

We find a mixed picture on both the willingness and ability fronts as well as uncertainties to Ford’s valuation, based on demand factors, a high degree of operating leverage, and.

This article-an excerpt of YCharts Research recently-published full report on Ford (NYSE:F) - examines the demand environment for Ford and other U.S. car makers, and attempts to answer the question "Are American consumers willing and able to buy cars?"

Willingness

States of mind-willingness included-are difficult things to measure and project. To get a proxy for willingness of consumers to buy cars, we observe three sets of data representing 1) product saturation, 2) likely replacement demand, and 3) demographics.

Saturation

There are different ways of looking at the degree to which the US automobile market is saturated and most of these seem to be pointing to roughly the same conclusion. The below chart displays the number of cars per 1,000 people in the US.

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From looking at this chart, it is not hard to tell that Ford and the other American car manufacturers' glory days were in the long postwar period until the mid-1970s oil shock. During this period, Ford and its domestic competitors enjoyed not only the fruits of a growing population, but of a growing population that was underserved for vehicles. Eight hundred some odd cars per 1,000 people implies roughly 2.0 cars for every American household and 1.3 cars for every licensed driver. Various academic studies and common sense indicates that this level of ownership would qualify as a saturated market. However, cars wear out, so clearly there will be replacement demand such that ownership rates stay roughly where they are right now, all other things held equal.

Replacement Demand

Below is a chart representing the age of vehicles on US roads.

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While the long flattish period for trucks for the 15-year period from the mid-1980s to the early 2000s might be ascribed to small business demand related to the construction industry, the line for passenger cars has monotonically increased during this time period. This likely reflects the growing saturation of the market and also an improvement in quality of vehicles as international competitors began to make an entrance into the US market.

In a previous job, I reviewed and (unfortunately) bought into a complex thesis regarding automobile replacement demand and learned a hard lesson. To wit, no matter how complex and well thought out the argument, all investment arguments boil down to one of two theses: reversion to the mean and fundamental change. The gist of the complex argument (which took the author roughly 60 pages to spell out) was that "natural" replacement demand would eventually force the average age of cars on the road down to the 8-9 year level from the level that existed then-roughly 10.5 years. This reversion to the mean argument demonstrably failed to pan out.

Clearly, there exists a maximum useful life for any mechanical object, but it is difficult, considering demographic shifts and other factors to know what this maximum useful life will be for automobiles in an investment context. Anecdotally, my household has two cars with an average age of 12.5 years and I can see this age increasing to about 15 before we will likely get rid of the older car and drive the remaining one for a few more years. And while it is never a good idea to make investment conclusions based on anecdotal evidence, it is hard for me to imagine that my case is so much different from other people in my demographic and income bracket.

Demographic Changes

The last observable piece of willingness has to do with demographic changes. Clearly, there is pressure for people starting a family to move to the suburbs, at which point one cannot reasonably function without eventually getting two cars-one for each parent. While this suburban migration trend has held true in the past, however, there is some question whether it will continue into the future.

The Department of Transportation publishes statistics showing the total number of drivers at different age brackets. The blue line on the following graph shows the difference between the number of licensed drivers as a percentage of the overall population, comparing the 2012 survey to the 2000 one. The green line shows the percentage change of population in each age cohort between the two time periods according to the Census Department.

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The way to read this chart is that, for instance, there are 7 percentage points fewer drivers in the 15-19 year-old age bracket in 2012 than there were in 2000 and at the same time, 5% more people in that age bracket in 2012 than in 2000. The interesting thing to note from this chart is that until we reach the Baby Boomer cohort (marked by the enormous green peak in the above chart), the proportion of licensed drivers to population is lower for all age groups in 2012 versus 2000.

There is a bullish and bearish way to analyze these data. On the bullish side, if spending on autos among the 15-29 year-old cohort has been restrained due to cyclical factors (e.g., the Great Recession, student debt repayment, etc.), the difference between the green line and the blue in those cohorts represents pent up demand that will spring back as soon as the cyclical factors work themselves out.

On the bearish side, the fact that the number of drivers as a percentage of the population is lower in those age groups represents a secular, cultural shift away from such an emphasis on automobiles for transportation.

The growth of New Urbanism, an increased tendency to take ecological impact into consideration when making purchase decisions, and increased availability of mass transit, urban bikes for rent, etc., may be fundamentally influencing the way Americans interact with automobiles.

All of these factors might have marginal impact on willingness of Americans to make car purchases if economic considerations were not taken into account. However, to understand the demand environment, one must also understand the ability of American consumers to buy these relatively expensive items.

Ability

At Ford's heart lies its founder's insight into mass production assembly lines and his belief that the American middle class should enjoy the fruits of what had heretofore been a luxury item-the automobile.

The strategy of targeting American middle classes worked to the extent that the American middle class was able to purchase the company's products. Henry Ford believed in a capitalistic noblesse oblige by which a good manager would offer generous enough pay to workers for them to be able to buy the product they were manufacturing. In a real sense, Ford's founder bootstrapped the American middle class and created a market into which his company could sell its own products.

Even today-more than a century after the founding of the firm-roughly two-thirds of Ford's sales are generated in its North American division. Another mid-teens percentage of sales is generated in markets in developed Europe (UK and Germany), leaving 20%-25% of revenues to be generated elsewhere. Operating margins are typically much higher for the North American business than for its other geographical segments, meaning that, from a profit perspective, even more of Ford's value is supported by its position in its home geography.

The Twentieth Century belonged to the U.S., with the country transforming from a vast, isolationist, and rural nation to become the world's preeminent superpower; as such, the strategy of selling means of transportation to its increasingly affluent citizens was a good one (recall the chart showing the number of automobiles per 1,000 people above). However, the effects of globalization and a trend toward shifting manufacturing offshore has altered the economic equation in the US.

All consumers base purchase decisions upon a combination of two quantities: flow (income) and stock (savings). Below is a graph of the purchase price of a vehicle versus the median income of a U.S. citizen over time:

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This chart shows that for a household generating the median income, the relative price of a car has increased from under two-fifths of that income to three fifths of it within less than a generation. If flow was the only consideration, it is clear that a company targeting the middle class ("median" is the statistical middle) would be in trouble.

But flow is not the only consideration; (some) consumers have savings that is another source of purchasing power. Below is a graph showing the price of a car versus median net worth in the U.S.[1]

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More bad news for a company targeting the middle class. The Great Recession of 2008 slashed the wealth of the middle class-most of which had been held in the form of real estate-to such an extent that, in "stock" terms, the price of a car nearly doubled for a median household over a period of three years (2007-2010).

American consumers-or at least the ones in the middle-are having a hard time paying the increasing price for convenience and mobility. This is not good news for an auto company built to serve the middle class.

Uncertainties

The auto business is a complex one with a great number of moving parts (literally and figuratively). Let's look first at uncertainties surrounding valuation drivers-revenues, profits, and balance sheet effects.

Growth of future revenues will largely depend upon the willingness and ability of the U.S. middle class to purchase automobiles (as discussed above) and to a lesser extent, to bettering conditions in Europe and Asia. Changes in wealth are fairly hard to predict since they largely depend upon the vagaries of markets. The trend regarding median income change does not look good for Ford, but there may be surprises-either positive or negative-here as well.

Considering the huge operational leverage in Ford's manufacturing business, profitability fluctuates based upon production and sales volumes, so an improvement or worsening of the macro environment has knock-on effects on profits as well. We discuss the effect of operational leverage more in the data commentary later in the report.

In addition to these uncertainties that directly affect cash flow, there is also a large "balance sheet effect" in the form of Ford's pension liabilities. Ford presently has unfunded pension obligations on the order of $10 billion; this underfunding implies a claim on cash that would otherwise flow to owners. If the equity market falls, the portion of Ford's pension exposed to equities (around 30% of the fund) will cause a further pension shortfall, and this will cause an increasingly large claim on owners' cash flows. Ford, thanks to actuarial adjustments, structural changes to its compensation package and pension investments, and increased funding to the tune of around $5 billion, has made a good deal of progress on shrinking its obligation, but owners should understand that the potential for uncertainty surrounding these obligations still exist.

Another uncertainty not directly related to valuation drivers, but which bears mentioning nonetheless is Ford's ownership structure. There are two classes of Ford stock, one of which exists to allow descendants of Henry Ford control of the company. Different analysts have different interpretations of the relative import of this type of ownership structure, and we believe it is difficult to say that dual-class shareholding is universally good or bad, but keep in mind that investing in Ford means that one will be basically investing in a closely-held family-run business.


[1] Net worth figures are quoted from a paper by Professor Edward Wolff of New York University entitled "The Asset Price Meltdown and the Wealth of the Middle Class" (August 26, 2012). Wolff draws his data from the Federal Reserve's Survey of Consumer Finances.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.