Why Ford's Equity Is 'Built Ford Tough'

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 |  About: Ford Motor Company (F)
by: Valuentum

Summary

Ford has come a long way since the depths of the Great Recession where it witnessed its peers fail.

We think the market is mis-pricing the operating leverage inherent to Ford's business beyond 2014.

The company is our favorite automaker and a holding in the Best Ideas portfolio.

Ford (NYSE:F) will never be able to completely shake off the financial and operating leverage inherent to its business model, but the firm is doing a great job of improving its credit quality as it better positions itself to capture earnings leverage from pent-up auto demand. The automaker is also making strides in China, and we think it will be the biggest upside surprise in market share in the country in coming years. Though its dividend isn't as healthy as some of the stronger dividend payers in the market today, we like management's focus on returning cash to shareholders. Let's calculate Ford's intrinsic value and run shares through the Valuentum process.

But first, a little background to help with the understanding of some of the terminology in this piece. At our boutique research firm, we think a comprehensive analysis of a firm's discounted cash flow valuation, relative valuation versus industry peers, as well as an assessment of technical and momentum indicators is the best way to identify the most attractive stocks at the best time to buy. We think stocks that are cheap (undervalued) and just starting to go up (momentum) are some of the best ones to evaluate for addition to the portfolios. These stocks have both strong valuation and pricing support. This process culminates in what we call our Valuentum Buying Index, which ranks stocks on a scale from 1 to 10, with 10 being the best.

Most stocks that are cheap and just starting to go up are also adored by value, growth, GARP, and momentum investors, all the same and across the board. Though we are purely fundamentally-based investors, we find that the stocks we like (underpriced stocks with strong momentum) are the ones that are soon to be liked by a large variety of money managers. We think this characteristic is partly responsible for the outperformance of our ideas - as they are soon to experience heavy buying interest. Regardless of a money manager's focus, the Valuentum process covers the bases.

We liken stock selection to a modern-day beauty contest. In order to pick the winner of a beauty contest, one must know the preferences of the judges of a beauty contest. The contestant that is liked by the most judges will win, and in a similar respect, the stock that is liked by the most money managers will win. We may have our own views on which companies we like or which contestant we like, but it doesn't matter much if the money managers or judges disagree. That's why we focus on the DCF - that's why we focus on relative value - and that's why we use technical and momentum indicators. We think a comprehensive and systematic analysis applied across a coverage universe is the key to outperformance. We are tuned into what drives stocks higher and lower. Some investors know no other way to invest than the Valuentum process. They call this way of thinking common sense.

At the methodology's core, if a company is undervalued both on a discounted cash flow basis and on a relative valuation basis, and is showing improvement in technical and momentum indicators, it scores high on our scale. Ford posts a Valuentum Buying Index score of 6, reflecting our "fairly valued" DCF assessment of the firm, its neutral relative valuation versus peers, and bullish technical. Ford is a holding in the portfolio of our Best Ideas Newsletter. We'd only consider removing shares from the portfolio if/when they register a 1 or 2 on the Valuentum Buying Index (or the equivalent of a "we'd consider selling" rating). A 1 or 2 on the index signals that shares are significantly overpriced with deteriorating technicals. Ford is still a long way from that, in our view.

Ford's Investment Considerations

Investment Highlights

• Ford has been around since the turn of last century and produces and sells automobiles. The company also engages in other businesses, including financing vehicles. 2013 represented its best sales year since 2006, setting records for Fiesta, Fusion and Escape.

• Though Ford's earnings outlook for 2014 was muted due to expected product investments, the automaker continues to please investors who not only have seen increased dividends but also have witnessed the firm effectively capture pent-up demand caused by the Great Recession.

• Ford continues to implement its 'ONE FORD' plan successfully and accelerate development of new vehicles customers want. The company continues to have success driving operating margin improvement and has reduced North America's structural costs by more than $9 billion since 2005.

• Though Ford will see current CEO Alan Mulally leave at the end of this year, we think COO Mark Fields is highly capable of running the automaker as the next chief executive. The middle of the decade is looking quite bright for Ford Motor.

• We like the firm's ability to generate strong automotive cash flow while reducing pension obligations. Ford now boasts an investment-grade credit rating and expects to maintain it through the course of the economic cycle.

Business Quality

Economic Profit Analysis

The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital. The gap or difference between ROIC and WACC is called the firm's economic profit spread. Ford's 3-year historical return on invested capital (without goodwill) is 3.7%, which is below the estimate of its cost of capital of 10.4%. As such, we assign the firm a ValueCreation™ rating of POOR. However, we think Ford will be generating economic value by the end of our forecast horizon. In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.

Cash Flow Analysis

Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Ford's free cash flow margin has averaged about 3.3% during the past 3 years. As such, we think the firm's cash flow generation is relatively MEDIUM. The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. For more information on the differences between these two measures, please visit our website at Valuentum.com. At Ford, cash flow from operations decreased about 34% from levels registered two years ago, while capital expenditures expanded about 54% over the same time period.

Valuation Analysis

Our discounted cash flow model indicates that Ford's shares are worth between $15-$27 each. We think investors should view this range of probable fair value outcomes in the context of a risk-reward assessment. For example, with shares just shy of $17 each at the time of this writing, we think there is significantly more upside than downside - upside to the high $20s. The margin of safety around our fair value estimate is driven by the firm's MEDIUM ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers.

The estimated fair value of $21 per share represents a price-to-earnings (P/E) ratio of about 12 times last year's earnings and an implied EV/EBITDA multiple of about 11 times last year's EBITDA. We think these a very reasonable multiples. Our valuation model reflects a compound annual revenue growth rate of 4.3% during the next five years, a pace that is in-line than the firm's 3-year historical compound annual growth rate of 4.4%. Most of the expansion will be driven by continued unit growth in the US, a recovery in Europe, and strong expansion in China. Our model reflects a 5-year projected average operating margin of 8.1%, which is above Ford's trailing 3-year average. Though promotional activity could impact Ford's margins to a degree, we think operating leverage will help drive profit-margin expansion in coming years as unit volumes increase.

Beyond year 5, we assume free cash flow will grow at an annual rate of 3.6% for the next 15 years and 3% in perpetuity. For Ford, we use a 10.4% weighted average cost of capital to discount future free cash flows. We think the relatively higher-than-average discount rate is appropriate to account for its cyclical operations.

We understand the critical importance of assessing firms on a relative value basis, versus both their industry and peers. Many institutional money managers - those that drive stock prices - pay attention to a company's price-to-earnings ratio and price-earnings-to-growth ratio in making buy/sell decisions. With this in mind, we have included a forward-looking relative value assessment in our process to further augment our rigorous discounted cash flow process. If a company is undervalued on both a price-to-earnings ratio and a price-earnings-to-growth ratio versus industry peers, we would consider the firm to be attractive from a relative value standpoint. For relative valuation purposes, we compare Ford to peers General Motors (NYSE:GM) and Toyota (NYSE:TM), among others. Though automakers, in general, don't garner significantly elevated multiples, Ford's PEG ratio (which considers earnings expansion over a 5-year period) is very attractive. Its normalized earnings multiple is also lower than the industry and peer medians. It is priced slightly higher than peers on a forward PE basis, but we think a normalized perspective is more important in valuation.

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Margin of Safety Analysis

Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $21 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values. Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph below, we show this probable range of fair values for Ford. We think the firm is attractive below $15 per share (the green line), but quite expensive above $27 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.

Future Path of Fair Value

We estimate Ford's fair value at this point in time to be about $21 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart below compares the firm's current share price with the path of Ford's expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change. The expected fair value of $26 per share in Year 3 represents our existing fair value per share of $21 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.

Pro Forma Financial Statements

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In the spirit of transparency, we show how the performance of the Valuentum Buying Index has stacked up per underlying score as it relates to firms in the Best Ideas portfolio. Past results are not a guarantee of future performance.

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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: F is included in the Best Ideas portfolio.