A Little Industry Background (Long-Term)
The auto industry is in the early stages of a disruptive evolution. Cars will not be replaced, but in the future cars will be thought of much differently than in the past. When I was growing up many people associated different car makes as symbols of status while others considered cars as nothing more than transportation. A Mercedes Benz was near the top of the heap, with Cadillac, Jaguar, BMW and a few others a bit behind. The Corvette was one of those cars that most boys could only dream of; the others dreamed of a Ford Mustang GT, a Chevelle Super Sport, or maybe a Dodge Charger (my apologies if I inadvertently missed your favorite). I owned a Ford Fairlane station wagon with a Thunderbird 352 cubic Inch V-8 engine. I was not the most popular kid in high school. But, then again, I did have a car and it got me where I wanted to go. It was transportation but not much of a status symbol. Beggars can't be choosers, right?
Thus far not much has changed in terms of cars being either a sign of status or merely transportation. I think that utility and status ebb and flow in terms of popularity. Right now, with the price of gasoline down by almost half from its peak, more people are buying trucks and SUVs. Within their respective circles those vehicles hold relatively higher status than a sedan. When the price of gasoline rises again more people will be looking for better mileage vehicles.
But something else is happening. I know more and more young people in their twenties who do not want to drive for one reason or another. Many consider the cost of owning a car prohibitive; car payments, maintenance, fuel, insurance are all very expensive for someone just starting out in life. Some almost have to have a car to get to work. But more and more kids, especially those in the cities, are considering using Uber, public transportation or riding with friends when needed. It is an entirely different mindset than what prevailed when I was a kid.
Uber is a potential disruptive force that could hurt car sales in the future and, when combined with the autonomous, driverless vehicles that are coming to us soon, could bring down the cost of hailing a ride considerably. That would make owning a car in most cities relatively much less necessary. Uber will eventually set up car pools to take groups of people to work and back from home with a fleet of driverless cars. Two-car households will become one-car households and one-car households could become careless. Families that will not own a car in the future will not necessarily be without drivers but will be more likely to rent a car for those occasions that require such transportation like vacationing or visiting relatives. It will be far cheaper than owning. This future will probably take a couple of generations to become a reality. Most folks my age may not be around to see it. The industry will change slowly over the next few decades but the overall change from today to the end of the evolution will likely be very dramatic.
The biggest problem for the industry is that we as a society will need a lot fewer cars. A second problem is that those car companies that remain will become more technology focused than just design, marketing, distribution and manufacturing. The evolution has already begun. Companies like Uber can hardly wait because those companies will be able to dramatically lower cost while providing better value pricing to customers. Car manufacturers will be more focused on catering to the fleet owners and will necessarily need to charge far more for cars sold to individuals because that market will be shrinking while costs continue to rise. The difference between owning and just paying per ride will grow significantly to the point where owning will become prohibitive.
My writing that this evolution to autonomous cars could take a decade or more to gain widespread acceptance may upset some Tesla (NASDAQ:TSLA) shareholders since that company could benefit significantly from that move. However, what shareholders need or want to happen is of no concern to the general market or the vast number of people who will be making the decisions. It will be a process and it will develop at its own pace. It may be fast enough to make those shareholders happy or it may not. Product adoption rates fit into the "S Curve" theory.
The theory states that, as a rule, the length of time it takes for a product to reach ten percent adoption by the potential market will approximate the same amount of time is will take for adoption to reach the 90 percent saturation level. Usually, something as dramatic as a mass movement away from manually driven cars to autonomous cars will be adopted slowly at first, taking several years to reach that first ten percent adopting point in the curve. But once that level is achieved the slope of the curve turns much higher in degree and the adoption rate accelerates. As adoption nears the 90 percent level the slope begins to level off. There are a lot of federal and state regulations that will need to be addressed before adoption can begin. Insurance companies will need to weigh in on the subject as will many other entities. Change as massive as this will not come easily, no matter what the advantages are. It will take time. And shareholders of any company will have little, if any, say in the matter. Although each major auto maker will have its say before a Congressional hearing or two along the way, along with associations and union leaders and many, many others. These things must go through the government to get approval and that takes time (lots of it).
More Industry Background (Short to Intermediate-Term)
Currently, auto sales are still at lofty levels even though it appears that the record unit sales achieved in 2015 may represent the peak for this cycle. According to both Ford Motor Company (NYSE:F) and General Motors (NYSE:GM), 2016 sales will likely fall slightly compared to last year and 2017 sales will probably fall a little more. Both are cited in this article from Fortune with expectations. Earlier in the year, Automotive News reported that vehicle sales in 2016 would reach another record between 17.5 and 18 million units. What difference nine months can make. Now most major auto company executives are expecting that the peak has already been reached and that sales could taper off next year. And that will only hold true if the economy does not slow down further.
In order to keep sales at elevated levels car makers have already been making more sales to subprime buyers and offering incentives. In the future, as sales slow, Ford and GM will most likely increase incentives to try to lure people to buy before they would otherwise be interested in a new car. That is called pulling future sales into the present and it can only go on for so long. It works until it no longer does. Then sales fall below levels that would have been because a portion of the future demand is no longer there. We are nearing that point in the cycle, in my opinion.
From this point forward I expect the incentives and falling sales to begin to squeeze margins and profits for auto manufacturers. The downward slope of the cycle could take several years to play out before the bottom is reached and sales begin to increase again. The slope may be gentle or it make be painfully harsh. It depends upon how well the general economy holds up and how well auto makers manage the expense side of the equation. Of course, rising incentives will automatically hurt margins so it remains to be seen if management of either company can cut other costs to offset at least part of that impact. Either way the future does not portend a lot of good tidings for shareholders.
Next I want to take a look at each company by the numbers.
Ford by the Numbers
First off I should explain that the above table of data is the result of 2,500 calculations done by an algorithm that uses the GAAP data reported to the SEC for the last ten years. If there is a lot of green in the table, especially in the third column from the right, it is a good sign. If that column is dominated by brown then it is a bad omen. The more green the better, the more brown the worse.
I like companies with ample FCF (free cash flow). This is indicated by the line labeled Friedrich Cash Machine in the table. Over the TTM (trailing twelve months) Ford has produced FCF of only 1.37 percent of its revenues. That is down from 5.7 percent in fiscal 2015 and well below the peak of 12.8 percent in 2011. My preference is to find companies that consistently produce FCF of 15 percent of revenues.
I also like to see strong FROIC (FCF return on invested capital) and use the 20 percent level to help identify companies with strong management allocating capital efficiently. Ford is running at two percent, well below the level I want to see to expect good future prospects.
I also like revenue growth of five percent or better. Ford is at four percent which is not bad but, as I noted above, I expect that number to go negative possibly as early as next year.
Look at the amount of cash flow that is needed for capital expenditures, I prefer companies to be below 33 percent. This is shown in the line called CapFlow Ratio in the table above. The higher the CapFlow ratio the less cash that is available to expand the business, pay dividends or buy back shares. The lower it is, the more flexibility management has in plotting the future course of the company through acquisitions and the more it has available to reward shareholders. A rising trend does not bode well for future dividend increases.
If we look at the column for 2011 Ford looked much better and that would have been a better time to consider the stock for a purchase than today. Just look at all that green and the price of $9.87. The price has topped $17 twice before beginning to descend to its current level; a trend that could continue into the next year or two.
Now let's take a look at GM for comparison purposes.
GM by the Numbers
The last two columns of the GM table contain a lot more green and very little brown. So, at first glance I would have to say that GM looks to be in much better shape than Ford. But, of course, GM has the benefit of having gone through a government guided bankruptcy that allowed it to reduce its pension obligations and cut other costs significantly. Since the IPO for the new GM entity did not occur until November of 2010 we should ignore the earlier columns.
GM even looked good to Friedrich by 2012 sporting a super six score of six out of six. But that was short lived. Today the company is ranked at only three. Here is why.
First the Friedrich Cash Machine, our measure of FCF to revenue, is only 5.73 percent. While this is much better than Ford, it is still well below that 15 percent level I look for when considering whether a company is of high quality with strong future prospects.
Next is the CapFlow ratio of 52 percent. Again that is a better reading than Ford but is still too high for my liking. Remember, the higher it is the less flexibility management has. I prefer a company with more options to grow in the future.
Finally, the third problem with GM is that the FROIC is below 20 percent. At 17 percent, I night consider giving it a pass if it were not for the other two poor scores. In all GM looks to be in better shape this time than Ford at the top of the cycle. But it is still the top of the cycle and the future for both companies is less than appealing for either a short-term trader or a long-term investor.
I cannot recommend buying either company at this time. Even though GM shows a fair value based upon the Friedrich algorithm (Main Street Price) that is above the current market price (Wall Street Price), the environment tells me to pass due to the risks that I believe are coming.
As many of my readers know I have bought very few stocks since 2014. In December of that year the S&P 500 got as high as 2088. Today it is trading at about 2154, or less than 3.2 percent higher over nearly two years. I do not feel like I have missed that much. My three purchases during that period are up 10.4 percent, not including dividends.
I am a long-term optimist in that I believe that our economy will eventually right itself and get back on a track of higher growth. But I also believe that we will need to go through another difficult recession before that growth returns. I also believe that the Fed and central banks around the globe are losing their respective grips on the demand/supply imbalances that are faced by the global economies. Those bodies are also losing credibility. I do not doubt that they will continue to do all they can to keep assets inflated for as long as they can. But it cannot go on forever. Interest rates cannot remain near or below zero without damaging certain important sectors of the economy. Corporations cannot continue to add debt (well, some of the strongest probably can for a while) without future dire consequences.
Demand continues to slow while we have capacity underutilization all over the globe and current supplies of raw materials such as ores and oil exceed demand. And the middle class in America is shrinking. These type of macro-economic events will not sustain unending growth, even the meager growth we are experiencing, forever. Recession happen. Economic contractions are a normal part of the business cycle that no force on earth can escape. A recession is coming. I do not know when. But it will come and it could be as bad as the Great Recession. If it is I would rather be holding cash than shares of either of these companies.
As always, I welcome comments and will try to address any concerns or questions either in the comments section or in a future article as soon as I can. The great thing about Seeking Alpha is that we can agree to disagree and, through respectful discussion, learn from each other's experience and knowledge.
For those who would like to learn more about my investment philosophy please consider reading "How I Created My Own Portfolio Over a Lifetime."
I have recently created a new blog that includes my writing about " What Stocks I Own or Want to Own." I plan to make a new entry once a week.
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.
Additional disclosure: DISCLAIMER: This analysis is not advice to buy or sell this or any stock; it is just pointing out an objective observation of unique patterns that developed from our research. Factual material is obtained from sources believed to be reliable, but the poster is not responsible for any errors or omissions, or for the results of actions taken based on information contained herein. Nothing herein should be construed as an offer to buy or sell securities or to give individual investment advice.