Investors weren't fans of Ford's (NYSE:F) second quarter results. EPS missed analyst consensus by 8 cents and the market punished the stock, sending it lower by 8%. Despite this negative reaction, my first impression was that Ford delivered great results. Growth didn't go away, but we knew that through the monthly reports already. Revenue rose 6% quarter on quarter from $37 billion to $39 billion.
Profitability shrank a bit, but the company still generated $1.97 billion of net income. In other words, Ford is still a very profitable company. So why the pessimism? The market isn't blind to Ford's profits, but as I discussed in my previous article, investors don't want to experience another catastrophic loss.
Ford is in a cyclical industry, and with the industry potentially on the cusp of another downturn, possibly leading to the aforementioned catastrophic loss, why is Ford a "hold?"
I believe that Ford's current stock price already incorporates the expectation of a downturn within the next five years. Think of it this way, if nothing happens over the next five years and Ford maintains its current profitability, the company will stand to generate $40 billion in profits over this time frame, almost doubling the current market cap of $50 billion. If this scenario is believed by everyone, then the stock certainly would not be trading at an earnings yield of 17% (i.e. 6x P/E).
The current stock price implies that the market is already pricing in a substantial drop in profits in the near future. So even if the cycle turns and Ford starts to lose money, the stock should not experience a significant downward movement, as the impact would have been priced in already. To illustrate, if Ford were to lose $5 billion next year, the two-year average profit (assuming $8 billion during a good year) would be $3 billion. In that scenario, the current stock price would indicate a P/E ratio of 17x, a fairly reasonable multiple.
The Stock Doesn't Trade On Value
The above paragraph makes Ford look like a "can't lose" situation. However, the stock doesn't trade based on value (at least not now). For example, the stock dropped by 8% after earnings just because the management indicated a more uncertain future. This reaction may seem contradictory to what I discussed in the previous paragraph, but it's important to separate belief from what will actually happen.
Do not equate an increase in pessimism to a higher probability of a downturn occurring. Never mind an outside shareholder, even the management cannot predict the ups and downs of the auto cycle. If they could, Ford would never lose money.
Ford's stock will continue to fluctuate based on what investors believe will happen, rather than what will actually happen. There is currently no evidence that definitively points to an inflection point in the auto cycle, other than the fact that vehicle sales are slowing down, which is bound to happen from time to time. Investors' emotion is the key risk that should be holding you back from buying more.
Will Ford Ever Be A Buy?
Yes, but I don't think now is the time. The recession was a great time to buy Ford because we knew that vehicle sales will inevitably rebound, and Ford's balance sheet wasn't as bad as some of its competitors. But today, vehicle sales are topping out:
I'm not implying a doomsday scenario in the immediate future. It is entirely possible that vehicle sales will stay flattish like they did in the early 2000s, but this will not abate current fears regarding a possible downturn. Ford will continue to generate stable profits without substantial growth, but as the stock price shows, profits don't matter if investors' sentiment remains pessimistic.
In contrast, vehicle sales hit rock bottom during the recession, and the only way they could go was up (i.e. fundamentals and sentiment were positive). This tailwind is not something that Ford investors can enjoy today.
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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.