American automaker Ford (F) reported fantastic third quarter earnings Tuesday morning in spite of persistent weakness in Europe. Revenue fell 3% year-over-year to $32.1 billion, which was still much higher than consensus estimates. Operating profit, which excludes special items, surged 18% year-over-year to $0.40 per share, 25% higher than consensus estimates. For a read on how we value Ford via an extensive discounted cash-flow model, please click here (it may be worth a quick read and then come right back to this article).
The real story at work during the third quarter was the undeniable success of One Ford in driving operating margin expansion. While revenue in North America increased 8% year-over-year to $19.5 billion, operating margins expanded a whopping 340 basis points to 12%. As a result, pre-tax operating profit surged 50% year-over-year to $2.3 billion. Our main thesis behind the company is that operating leverage is always mispriced, and Ford's huge incremental bottom line growth relative to top line growth provides a clear example. Only through a DCF valuation model can operating-leverage truly be captured appropriately, in our view.
Unfortunately, market share gains from 2011 have been wiped out, as US market share currently sits at 15.2% compared to 16.5%. Though some market share moderation was to be expected given last year's supply-chain constraints from Toyota (TM), Honda (HMC), and Nissan, we're slightly disappointed that Ford's market share has fallen so substantially. We think consumer frustration with MyTouch and other electronics have hurt the brand, which fell to 27 out of 28 in vehicle reliability, but not as much as some may believe. Rather, we think years of lousy vehicles and reputation have hurt the company's perception with thousands of perspective buyers. We think CEO Alan Mulally will increase the company's focus on improving the "infotainment" system, and we think Ford can eventually win back some of its former customers with continued focus on great products.
Ford South America did not follow the North American path, as operating margins tumbled to 0.4%, down substantially from 9.3% during the same period a year ago. Revenue also tumbled 23% due to unfavorable currency exchange rates and an unfavorable product mix. Though the segment contributed nicely to profitability last year, we don't expect much this year. South American results are more industry-related rather than company-specific, in our view.
Ford Europe, to no one's surprise, was absolutely terrible. The company announced last week that it will move to cut supply, as the European automakers need to "right-size" - much like what we saw occur in the US just a few years ago. Ford intends to remove 18% of capacity, cut 13% of its European workforce, and yield annual cost savings of $450 million to $500 million. Revenue fell 25%, while the segment's loss ballooned to $468 million. The company reiterated its guidance to lose $1.5 billion in Europe for the full-year, with profitability in the region achieved by the mid-decade or later. Failing to engage in price wars, market share has fallen to 8% (only 30 basis points lower than a year ago). We foresee weakness continuing in the region for the next several years, but we're optimistic One Ford can successfully transform the business as it did in the US.
Results in Ford Asia-Pacific Africa and Ford China were pretty solid, in our view. Revenue jumped 13% year-over-year to $2. 6 billion, while the firm swung to a profit of $45 million. The Ranger and Focus were cited as strong performers in China, and we think the Lincoln brand could be a large success. The country remains an investment rather than a profit center for the time being. However, we think it could eventually become a meaningful portion of the profit mix.
Ford Credit expects to see a profit of $1.6 billion, and distributions to the parent company of $600 million. Due to terrible vehicle sales throughout 2008 and 2009, the segment has been unable to sell vehicles coming off a lease for a profit like it has in the past several years. However, we expect profitability to rebound strongly when 2010-2011 models start rolling off leases.
Overall, we thought the quarter's results were incredibly strong, especially given the headwinds that persist in Europe. The firm remains on track to hit its internal operating margin goals, and industry SAAR volumes in the US look to be stronger than initially anticipated. Ford has been able to keep its cost structure in check, and it continues to generate automotive cash flow while reducing pension obligations. We're disappointed that market share losses have been so drastic, but we have faith in Mulally to make market share gains without sacrificing margins. If Ford Europe was even close to breakeven, we think the stock would be substantially higher than it is today, but the segment's weakness continues to weigh on investors.
Nevertheless, we continue to believe shares are undervalued (click here to learn about how we value stocks), and we get paid to wait as the company converges to our fair value estimate in the portfolio of our Best Ideas Newsletter (please see links on the left side bar for more information). The firm scores a 2.2 on our Valuentum Dividend Cushion measure.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Additional disclosure: F is included in the portfolio of our Best Ideas Newsletter.