Ford (NYSE:F) recently caught my attention after I realised that I had been unfairly overlooking it due to its total debt levels (more on this later, but read my previous article for more detail). Getting back onto my watchlist is just the beginning, however. Before I can seriously consider it as an investment, however, I need to dig a little deeper.
Consequently, now it is time to switch it up a bit and look at the company in more depth. Here I plan to focus on its FCF (free cash flow) performance by passing Ford through my five FCF tests.
These tests form the first steps in my analysis of a company. Although far from exhaustive, it gives me a good indication of its competitive advantages, its FCF health and efficiency as well as the debt and dividend position. Fair value based on FCF alone is also calculated. These tests merely mark the first step in what may develop into a more thorough analysis of the business in the future. So let's get started.
A Little About Ford
Very little has to be said about Ford, I am sure. It is, of course, an iconic car brand. Globally it continues to command robust market shares with 7.3% of cars sold globally in 2015 coming from the Ford stable:
Yet Ford does not just make money by directly selling cars to consumers. It also makes money from helping those buyers finance their purchases. The manufacturing segment may generate 94% of all revenues, but the finance segment contributes nearly 20% to company profits:
Ford Credit has proven to be a valuable and stable earner for Ford during a period when its income record has been erratic to say the least from the automotive segment:
This double-layered dimension to the business has important implications on how we assess the company as will become clear later on. For now, it is enough to say that Ford has a series of car brands which have strong market positions across the globe and a highly profitable financial arm.
So let's get down to assessing Ford's FCF performance.
1: Positive FCF
First is a simple test. All I look for here is that Ford managed to generate positive FCF in the last five years. Ford gets off to a solid start on this front:
Despite a somewhat erratic FCF performance, Ford has maintained a positive FCF throughout the last five years. Therefore it earns a PASS on the first test.
2: FCF to Debt Ratio
Now we get to the matter of debt. In keeping with many car-makers it has high levels of debt. Ford, however, does carry more than most:
Yet as noted in my previous article where you can find more detail, most of this debt in holed-up in the Ford Credit part of the business. Considering over 94% of the company's revenues are produced by Ford Automotive it may seem strange that Ford Credit absorbs over 90% of its debt:
The reason is quite simple. Debt held at Ford Credit is, for all intents and purposes, "good" debt. Ford borrows money to lend out to consumers at a higher interest rate.
Consequently, as Ford's CFO Bob Shanks noted, the Ford Credit debt is discounted by credit agencies when assessing the company's financial strength. Here I plan to follow the same course. Therefore, the debt actually under assessment looks like this:
What really concerns me with this test, however, is not the absolute value of the debt. Instead I want to see a healthy coverage of this debt by FCF. My target here is 25% FCF coverage of that debt. This would mean that the company could pay off the entire debt in just four years.
So how does Ford do? Again
Ford, therefore, pulls together a pretty strong looking FCF coverage of its automotive debt. Even in the years when FCF was far weaker and debt far higher (2012 and 2013) it managed to have FCF cover its entire debt by around by 25% target. Outside those years it comfortably surpasses my target.
Indeed, in 2015 it covered it by nearly 70% suggesting it would, in theory, take less than one-and-a-half years to repay its entire automotive debt using FCF alone. Ford offers up another compelling PASS here as well then.
3: CROIC: Cash Return on Invested Capital
Next is a more challenging test: CROIC. The Cash return on Invested Capital is calculated by dividing the FCF by the sum of the company's debt (in this case, still only automotive) and its shareholder's equity.
The CROIC gives us an indication of the cash-generating efficiency of the company. A CROIC of 10% means that for every $100 of capital invested, it produces $10 in FCF. That is a very attractive return and, indeed, serves as my CROIC test target.
Again, Ford performs extremely well here:
Ford did dip below my 10% target (though hardly substantially) in 2013. Yet outside of this year it has been comfortably above my threshold with it, in fact, crossing the 20% mark last year. Ford produces another strong PASS here as well.
4: FCF Yield
Now to the all-important dividend. Ford's recent dividend history has been less than stellar. Indeed, that is the chief reason I have overlooked Ford up to now. Sure, since 2011 the dividend has grown at a remarkably swift pace. Yet that was on the back of an absence of dividend since 2006:
Nonetheless, the current ordinary dividend does not look under threat. Right here, however, I want to see a handful of things for Ford to pass my FCF yield test:
A FCF yield (that is, the yield if they paid out all their FCF as a dividend) of 3.5% or more. An ordinary dividend FCF payout ratio of 75% or less.
So how does Ford do here? Well exceedingly well indeed:
Not only does Ford come out with an epic 16.8% FCF yield (well above my 3.5% target) but it also pays out just 27% of its FCF to supports its current 4.5% yield. It must be said that this remains the strongest performance here across all the "FCF 5" tests I have done. Another PASS here.
5: FCF Valuation
Finally we come to the valuation point. What I want to see here is the current share price to be below my fair value assessed by FCF metrics. For this I use the enterprise value to FCF ratio. Over the last five years, Ford has had a somewhat erratic EV/FCF ratio:
This would suggest an average EV/FCF ratio of 10.5. I'd argue, however, that 2012 and 2013 were particularly anomalous years due to their weak FCF performance and therefore should be set aside in ascertaining a fair value ratio. Doing so offers us a fresh EV/FCF ratio of 7.5 instead. I will use this instead.
Next I need to predict Ford's FCF over the next two years. This I achieve by taking the consensus revenue estimates for those years and multiplying them by my target FCF/Revenue figure. This I calculate by taking the average FCF/Revenue figure from the last five years and that of last year specifically. These were:
- 5-year average (hereafter, FY): 4.07%
- Last year (hereafter, LY): 6%
These are then fed into this simple formula which gives twice the importance to last year's FCF/Revenue performance to reflect any recent improvement or deterioration:
- Predicted FCF to Revenue Ratio = (FY + (LY * 2)) / 3
This produces a predicted ratio of 5.36% for Ford. The revenue estimates for the next two years are then multiplied by this FCF/Revenue figure to produce predicted FCF figures. I then average these two-year FCF predictions and multiply by the fair value EV/FCF ratio (7.5).
Doing so gives me a FCF fair value of $14.79. With Ford currently trading at just a little over $13 at the moment, this suggests that Ford is currently over 10.5% below my FCF fair value.
All in all, another PASS for Ford.
Once you have got a firmer handle on the nature of Ford's debt situation, it becomes clear that this iconic automaker is looking pretty attractive right now. Indeed, Ford managed to pass all of my FCF tests comfortably including (unusually at the moment) the valuation one. Ford has, of course, had a fairly rough few years (as testified by their recent dividend history). Yet it is clear that it is performing extremely strongly at present.
Yield hunters may well be tempted by the high ordinary yield and potentially lucrative opportunities for further special dividend's in the near future. Nonetheless, it is clear that for those attracted to robust companies that produce strong cash flows, Ford also offers a great deal.
With it still trading over 10% below what could be considered a fair and far from strenuous FCF valuation it looks a pretty compelling buy right now. Sure, it operates in a cyclical industry which has struggled in recent years. Yet Ford remains an impressive and iconic player in this space. If you are looking for exposure to the automaker sector, I'd find it hard to argue against Ford right now.
Unless otherwise stated, all graphs and tables and the calculations contained within them were created by the author. Image reproduced from Flickr user Ford Motor Company.
Disclosure: I/we 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.