Originally published on Dec. 22, 2014
One of the original reasons I decided on an unlevered investment in Ford is the degree to which the company is exposed to both operational and financial leverage. Leverage on top of leverage on top of leverage is not generally a good recipe for long-term success in the markets, though short-term gains from this kind of layering can be breathtaking.
Several years ago, Ford management made a strategic decision to increase operational leverage that would allow them to be more competitive in a high oil price environment. I am sure that the huge drop in WTI has some people in Dearborn, Michigan, on edge, and I also feel the need to consider how large an impact a prolonged low oil price environment will have on the likelihood of different IOI valuation scenarios for Ford.
U.S. car companies make a lot of money on their truck and SUV lines. Industry common wisdom is that profits from truck sales subsidize losses or bare break-evens from economy car lines, and that if it were not for truck sales, U.S. automakers would be much less profitable than they already are.
During the mortgage crisis, investors suddenly realized that when housing starts slowed, sales of trucks sold through to construction contractors also hit the skids.
Of all the trucks in the U.S. market, the Ford F-150 line is now, and has been for a long time, the head-and-shoulders winner in the battle for market share. To say that the F-150 is Ford's golden goose is, in fact, barely an exaggeration.
So the news that Ford would spend nearly $850 million to convert its F-150 line from a steel body to an aluminum one was big. Aluminum body cars are not new - the first one came out in the mid-1990s - but by switching to aluminum, Ford management was boldly breaking the "If it ain't broke, don't fix it" rule, since sales of the F-150 were doing fine just as they were.
However, Ford management noticed that truck sales tended to be tied to the price of gasoline; when prices ticked up near $4 per gallon or above, truck sales "hit an air pocket." They decided to try to pull further ahead of their competition by offering an aluminum body truck. Using aluminum, the company could cut about 300 pounds off the weight of the truck (which would improve gas mileage) while not sacrificing power or structural strength.
This decision, while bold and sensible, has various repercussions. First are the added fixed costs of retooling mentioned above - there are nearly one billion reasons why Ford needs this switch to work out for them from a competitive standpoint. Second are the added variable costs associated with using aluminum - usually a more costly material than steel - costs that are unlikely to be able to be completely passed through to the end consumer. Third is the marketing impact of a switch to aluminum - could it be that the saying "Real men don't eat quiche" will be replaced by "Real men don't drive aluminum trucks"?
The assumption underlying the Ford strategy to switch to aluminum is that oil prices are high and will remain so indefinitely into the future. As oil prices go higher and higher, the relative attractiveness of lighter, more fuel-efficient trucks should increase as well. But if the underlying assumption proves incorrect, the company will be ill-positioned.
The costs it has incurred and must incur going forward remain constant. If revenue drops - either due to the real-men-don't-drive-aluminum-trucks effect or because General Motors (NYSE:GM) or other of Ford's competitors decide to "buy market share" by lowering the price of their own trucks and SUVs - Ford's revenues will have a hard time covering all the costs. With less revenues to cover more costs, profit margins will be squeezed.
This dynamic is precisely what people mean when they talk about "operational leverage." The retooling of the F-150 factory is done, and depreciation has to be charged against those assets whether they are producing robust revenues or not.
The IOI Model Portfolio's investment in Ford is based on a thesis that the firm will be able to raise profits by finding operational efficiencies. While factory closures and rationalization is continuing apace, my thesis may well be undone by the negative effects of operational leverage mentioned here. I'll be paying close attention to Ford's annual earnings and will continue to read about oil price dynamics; the small IOI investment in Ford has been a disappointment thus far, but I'm averse to making hasty investment decisions without a clearer view of the underlying economics and valuation.
Disclosure: Long F.