Ford (NYSE:F) reported its Q2 results about two weeks ago. While the company achieved near-record earnings $2 B and adjusted earnings per share $0.52, it missed analysts' estimates by a wide margin ($0.08 or 13%). Even worse, the management stated that its guidance for the year was at risk. Consequently, the stock has plunged 12% since its earnings release. Therefore, the big question is whether the stock has now become a great bargain.
First of all, the stock has become pronouncedly cheap in terms of the conventional metrics. To be sure, while the company is near all-time high levels of profitability, the stock is now trading at a forward P/E=6.5 while it is offering a 5.0% dividend yield. In the current environment of record-low interest rates, in which investors are struggling to find a decent yield, it is highly surprising to find such a well-followed company at such a high dividend yield and a cheap valuation. Therefore, given that the US economy seems to be in a fairly good shape, it is only natural that many investors wonder why the market has punished the stock in such a brutal way and whether the stock has become greatly undervalued.
At this point, investors should note that the company generates 90% of its earnings from the domestic market. While the management keeps emphasizing the promising prospects of China and some other regions, Ford is highly dependent on the US economy, while all the other regions, apart from Europe, hardly contribute to the overall results.
Moreover, the auto manufacturers are extremely sensitive to the prevailing economic conditions. For instance, during the last financial crisis, in 2008, Ford lost the record amount of $14.7 B while General Motors (NYSE:GM) went bankrupt. Therefore, Ford is highly leveraged to the US economy and hence the market attributes a high risk factor to the stock.
This is also evident from the consumer behavior related to car purchases. During a recession most people postpone the purchase whereas everyone rushes to purchase a car during good times. That's why a recession may be more devastating to auto manufacturers than to other industries. While the US economy is in a fairly good condition, the auto sales seem to plateau after many years of growth and are expected to somewhat decline for the next few years. While they reached a record number in the first half of this year, they were greatly supported by incentives, which partially hurt the bottom lines of auto manufacturers. These incentives only confirm the increased competition for market share in the sector. However, these incentives cannot boost sales forever. That's why the management of Ford stated in the recent conference call that it expected the auto sales to start declining from their current level. Goldman Sachs seems to agree on this view, as it recently removed Ford from its "conviction buy" list due to concerns over automobile pricing trends.
To make things even worse, auto manufacturers spend a great portion of their earnings on capital expenses, as they have to keep up with competition. Therefore, they all have leveraged balance sheets and hence they are greatly exposed to economy downturns. That's why the corporate bonds of Ford collapsed to the range 20-25 during the market sell-off in 2008. Ford now has a net debt (as per Buffett, net debt = total liabilities - cash - receivables) $110.6 B, which is about 14 times its all-time high earnings. This is certainly a high debt load, which can greatly burden the company during a downturn. Coincidentally, General Motors has a similar amount of net debt ($113.4 B). It is also worth noting that Ford has spent 52% of its operating cash flow of the last 5 years on capital expenses. This explains the high debt load that has accumulated over the years, particularly given the generous dividend of the company.
The imminent hikes of interest rates by Fed also do not bode well for the company. To be sure, the GDP growth rate is likely to somewhat decrease, as one of its main components, investment, is inversely related to the interest rates, let alone the multiplier effect. Moreover, higher interest rates will make it harder for consumers to pay off their auto loans or initiate new ones. The subprime auto loan market is already in an overheated condition so higher interest rates will certainly not help. Therefore, Ford is likely to face an additional headwind in the next few years.
To sum up, while the US auto sales reached a record level in the first half of the year, they seem to be peaking and are likely to start declining soon. The incentives used by the dealers have markedly increased but are not likely to support this level of sales for long. Moreover, the US economy is in its 7th year of growth so it is only natural that investors expect a recession within the next few years, particularly given that Fed is in the process of raising the interest rates. As Ford is essentially a highly leveraged proxy for the US economy, the market has good reasons for its cautious valuation on the stock. Therefore, I do not believe that the stock is a great bargain right now and it is not a fault of the company; it is just the nature of the auto manufacturers. Nevertheless, as Ford is a leveraged proxy for the US economy, investors who are confident that the US economy will not face a recession for the next few years are likely to greatly profit by purchasing the stock at the current price, as long as they are proven correct. But even those investors should take their profits at some point and keep in mind that the auto stocks are not buy-and-hold stocks, as evident from the lesson of the Great Recession. Instead their high cyclicality dictates that their shareholders have excellent timing skills.
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.