Ford Revs Higher As GM Falters: How To Think About Their Investment Prospects

Jul.25.14 | About: Ford Motor (F)

Summary

The most important determinant to financial outperformance in the auto space is not based on which type of car or truck you drive (or like).

It is based on understanding and capitalizing on the factors that drive stock prices.

Stock prices are driven, of course, by the buying and selling of shares, and the buying and selling of shares is primarily influenced by a company’s cash-flow-derived intrinsic value.

Let's take a look at Ford's and GM's recent quarterly earnings and offer our perspective on their respective investment opportunities.

Sometimes it's easy to fall in love with a company and its products. This, unfortunately, can become a behavioral and psychological barrier to financial outperformance. Whether you are a Ford or Chevy guy or gal determines little about how successful you will be as an investor in auto stocks. The most important determinant to financial outperformance in the auto space is not based on which type of car or truck you drive (or like), but instead, it is based on understanding and capitalizing on the factors that drive stock prices.

To this point, stock prices are driven, of course, by the buying and selling of shares, and the buying and selling of shares is primarily influenced by a company's intrinsic value - or the present value of the company's expected future free cash flows, adjusted for items on the balance sheet. Financial outperformance is driven by identifying a mismatch between a firm's share price and its intrinsic value, and gaining conviction in one's investment thesis such that there is a high degree of confidence that price-to-fair value convergence will eventually occur.

This is a shorthand explanation of the Valuentum process - where we look to identify underpriced stocks that are just starting or continuing to go up (experiencing price-to-fair value convergence). Though a firm's product portfolio is certainly an important investment consideration as it relates to determining a company's expected future free cash flow stream, even companies with the worst of products can often make for good investments if their shares are significantly underpriced ("on sale") and the likelihood of price-to-fair value convergence is high.

As investors, we're looking for bargains-stocks that are trading at a discount to their cash-flow-derived intrinsic value - where outsize risk-adjusted returns can be had. In this article about Ford and GM, we're not interested in talking about the divide between consumers that like the Mustang versus the Camaro and vice-versa, but instead, we're interested in talking about the investment prospects of each company. This is an entirely different conversation altogether.

Ford's (NYSE:F) shares continue to be "on sale," and the company's second quarter results reminded us why it is included in the Best Ideas portfolio. The second quarter marked the automaker's 20th consecutive one of profitability, with pre-tax profit in the period of $2.6 billion increasing $44 million compared with a year ago. Second quarter net income of $1.3 billion and automotive operating-related cash flow of $2.6 billion marked the 17th consecutive quarter of positive performance, and both were better than expected. The automaker ended the second quarter with a healthy balance sheet. Automotive gross cash of $25.8 billion exceeds debt by $10.4 billion.

Ford affirmed its 2014 pre-tax profit guidance of $7-$8 billion, and management was quick to note that such performance comes in a period with an unprecedented number of global product launches. The firm expects the payoff from such investments to result in a strong product lineup with higher volumes, revenue and margins in 2015 and beyond. We can't say we disagree, and we maintain our view that Ford's shares are worth north of $20 each. The company has been a Best Ideas portfolio holding since September 2011.

On the other hand, GM's (NYSE:GM) second quarter performance was disappointing. Adjusted operating income came in at $1.4 billion and included the impact of $1.2 billion in recall-related costs and $0.2 billion in restructuring expenses. This compares to the second quarter of 2013, when the company recorded adjusted EBIT of $2.3 billion, which included a charge of $0.2 billion for recalls and $0.1 billion in restructuring costs. Both cash flow from operations and free cash flow fell from the year-ago period.

GM is clearly having quality issues, and its recalls are having a direct impact on profit levels and management's ability to execute effectively across the globe. Still, new vehicle launches have been successful, and the US and China remain key sources of strength at the firm. Free cash flow also continues to be positive, despite weaker year-over-year performance, and the firm ended the quarter with $38.8 billion in automotive liquidity. Though the second quarter was troubling, particularly as it relates to recalls, GM is far healthier than the days of the Financial Crisis.

It doesn't matter if you drive a Ford truck or a Chevy Corvette, the key factor driving buying and selling decisions - and by extension, stock prices - is the present value of expected future free cash flows. Our thesis on Ford rests on continued execution of its strong recovery in the US, and we think the automaker will demonstrate the largest share gains in China over the next several years. Since we can only include one automaker in the Best Ideas portfolio (due to diversification considerations), Ford makes the cut.

That said, we think readers should also keep a close eye on GM. If it can work through the recall issues with minimal damage, the firm's operating leverage would translate into explosive earnings growth as pent-up demand from the depths of the Great Recession is realized. We think GM's fair value is in the mid-$40s, though we point to Ford as a better risk-adjusted opportunity.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

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