Ford: 5 Compelling Reasons Why The Bears Have It Wrong, And Where Shares Should Be Expected To Trade

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About: Ford Motor Company (F)
by: Jason Phillips, CFA
Summary

Compelling evidence that despite an 8-year bull market, auto sales are still below previous cycle "peaks."

Proof that the 5% dividend yield is "safe" and should be expected to provide a "floor" on the company's share price at current levels.

Analysis on where Ford shares should be expected to trade based on historical averages and "justified" analysis.

Note to the Reader

This article is designed to address why the "bears" currently have Ford (NYSE:F) shares incorrectly priced at $11, offering compelling evidence as to why the auto cycle today is actually somewhat far from "peak sales" seen in past cycles and, in addition, offers fundamental support as to why Ford shares have probably already bottomed out at current levels.

In my new Marketplace service, "Valuation 360," I do a deeper dive into the valuation of Ford - the complete valuation range or "where it should trade" as well as fair value or "where it will trade" - and outline how to go about implementing an option strategy depending on your outlook for the shares as well as your risk tolerance.

Why I Couldn't Wait Any Longer for Ford to Trade at $10

In a post written in August of last year on Seeking Alpha, titled, "Ford - Why It's Better to Wait For $10," I suggested Ford Motor Co. shares were worth $15 based on a mid-cycle valuation.

However, I concluded that at a share price that was closer to $12 at the time, the reward of $3 per share or a return of a little under 25% didn't justify the risk, particularly given the leveraged nature of Ford's balance sheet, not to mention the leveraged nature, operationally speaking, of the automotive industry.

A little under a year later, I've lowered my price target slightly to $14, and yet last month I went long the position, feeling the risk/reward had tilted in my favor in that there was very little risk that shares would trade under $11 for any considerable length of time.

I was no longer willing to pass up on what I felt was a trade that offered "deep value" - the type of deep value that is becoming increasingly difficult to find in today's market.

In my personal account, where I don't trade options, I bought shares at $11.05, and in the concentrated, hedged, alpha OPM portfolio that I co-manage, we are long Ford the January 2019 call options.

Evaluating the Automotive Market - Applying Second-Level Thinking to the Problem

The much-talked about, much-debated issue (and major threat) to an investment in Ford shares today is the health and direction of the overall automotive market.

Especially in recent months, much is being made of the fact that we are in the now eighth year of the current bull market, or to put it another way, that we may be in the eighth inning of a nine-inning game.

Make no mistake about it, this conversation is equally applicable to the auto market, specifically.

In a forthcoming post titled, "Are we in a bubble? Maybe not...” I address the topic of whether we are indeed in a market top or not and question whether when everyone is "telling you to sell" if that is truly the right time to be selling, holding all else equal.

Whether we are indeed in a bubble or not, it bears adding that having managed money for investors for more than a couple of years, I acknowledge (as do many other historically successful investors like Warren Buffett and Howard Marks, to name just a couple) that predicting the level of market is an exercise in futility.

Simply speaking, the consensus view among many seasoned investors is that it is much "easier" to follow a bottom-up approach looking for undervalued businesses than it is to devote the resources and expertise required to predict market tops and bottoms.

So we return to Ford once again, what I feel is an undervalued business, and the issue of the market for auto sales.

Before delving into why I believe Ford shares offer solid value at $11, I am going to present two strong pieces of quantitative data to suggest that the auto cycle has perhaps not yet reached "peak" levels, and thus, why the notion that Ford does not offer compelling value at $11 is being distorted by "market fears."

Rolling 6-Year Sales Still Below Previous Cycle Peaks

The table below shows Rolling 6-year U.S. Vehicle Sales since 2000.

The idea behind using the "Rolling 6-year cycle" is that the average new car owner keeps his or her car for a period of about 6 years, on average, replacing the car every 6 years. This is the "car refresh cycle," essentially.

U.S. Vehicle Sales 2000-2017

Rolling 6-Year Sales

2017

100,725,118

2016

96,257,578

2015

90,164,331

2014

82,930,869

2013

79,580,597

2012

80,157,469

2011

82,417,975

2010

86,821,386

2009

92,347,433

2008

98,712,832

2007

102,358,292

2006

103,370,355

2005

104,133,047

2004

104,103,446

2003

102,772,160

2002

101,302,578

2001

99,620,038

2000

97,263,985

The data above shows that based on year-to-date sales for 2017, the number of vehicles sold over the past 6 years are still below the previous cycle, from 2002-2007, when rolling 6-year sales remained above 100 million units for a considerable period. Not to mention that gas prices are materially lower than during that period, making a new vehicle purchase more affordable for the consumer today.

Suggesting that we should not expect to see sales maintained at current levels would mean that we are expecting a secular downtrend in auto sales, that people are not replacing their currently owned cars with new ones.

While some will suggest the threat of driverless cars or ride-sharing services, a) driverless cars are not in the market presently, so should not have any effect on consumers' purchasing decisions; and b) ride-sharing services have effectively made new vehicles more affordable and more valuable.

To elaborate, consumers who in past years may have opted for a used vehicle can now purchase a new model and have ride-sharing revenue effectively pay for a portion of the purchase price, not to mention the value to these ride-sharing drivers of having a presentable, new car.

While the long-term argument of how driverless cars will "disrupt" existing technologies is certainly valid, it is still several years away, beyond our "long-term outlook of 3-5 years."

Unit Growth Well Below Long-Run Averages

Prior to the 2008-09 financial crisis, average annual auto sales for the ten-year period 1997-2007 were 17.1 million units. Now, going back to 1990 and looking at annual U.S. sales up to 2016, average annual unit growth was 0.93% per year.

Applying that 0.93% annual growth rate to the previous cycle average of 17.1 million units during the 1997-2007 period would suggest that auto sales in 2017 should be closer to 18.9 million units rather than the 17.9 units sold in 2016 or the 17.5 million pace we are on track for in 2017.

Yes, this is "simple" math, but it does support the thesis that unless we are in a secular decline for auto sales, there is little evidence to suggest the market is currently in "peak" or "bubble" conditions.

These Figures Actually Suggest Growth for the Auto Cycle

The aforementioned two arguments actually suggest that auto sales should be expected to remain at current levels, or even increase, to maintain consistency with historical averages.

Sure, we shouldn't expect to see double-digit unit growth like in 2010-2012 or even mid-single digits as was enjoyed between 2013 and 2015. Yet, the notion that the absence of above-GDP-trend growth suggests the "sky is falling" seems overly dramatic to this author.

Also, keep in mind that if the market is decidedly bearish on a company or idea, like auto stocks today (and this has been the case for a while now), how many people do you think are left holding this view that haven't already sold?

In other words, have the bears already "exhausted" themselves?

The Dividend - Secure and Providing a Floor on Ford's Share Price

Ford shares pay a dividend of $0.60, or a yield of 5.45% at today's $11 share price. With 3.9 billion shares outstanding, it means that the company will make approximately $2.4 billion in dividend payments this year.

Compare this with trailing-twelve month free cash flow (FCF) of $10.8 billion.

Not bad at all.

Or, the fact that over the past 8 years during this auto cycle, the lowest level of FCF the company has generated was $3.5 billion, back in 2012.

Still good.

Even if Ford failed to make any profits this year (which is not my outlook at all - even the most bearish analyst estimate is forecasting EPS of $1.30 in 2018), the company, after paying for working capital investments and capital expenditures would only have a shortfall of $2 billion in financing the dividend.

This compares extremely favorably to its available liquidity, which is $27 billion as of the writing of the company's 2016 annual report.

Note: Keep in mind, EPS of $1.30, which is the most "bearish" outlook of any sell-side analyst over the next two years, would result in a surplus of $3 billion after paying for the dividend.

So far we should be feeling pretty confident about the ability of Ford to finance the dividend with organic cash flow.

Can we go as far as to say the dividend is "safe" based on all available evidence? I would say so.

All this leads us to the fact that a safe dividend yield above 5% should provide some degree of downside protection to the share price.

This gives me a great deal of comfort that Ford shares will not fall much below $11 and is a big part of the reason why I gave up on waiting to get the shares at $10 - I just didn't think it was going to happen.

Understanding the Fair Value of Ford Shares

Having addressed the condition of the broader U.S. auto market and, additionally, the potential downside risk (or lack thereof) of Ford shares, we can get to understanding where shares should be expected to trade.

Owing to the cyclical nature of the automotive industry, not to mention the heightened degree of operating and financial leverage of the company itself, earnings and EPS are by definition going to be highly volatile and difficult to predict. Therefore, we are better off using a metric like price-to-book (P/B), often used by value investors, or price-to-sales (P/S), as these measures will be more stable or consistent than EPS.

However, the problem with using P/B in the case of Ford is the company's book value has been under some dramatic ebbs and flows over the past ten years, meaning we unfortunately can't get a very reliable reading from this indicator.

Thankfully, price-to-sales is reliable. Over the past 3-year and 5-year periods, Ford's P/S metric has traded between 0.30x and 0.45x.

Applying this to forecast sales for 2018 of $143 billion, or $36.72 per share, tells us we should reasonably expect the stock to trade between $11.02 and $16.52. The $16.52 price would work out to a 3.63% dividend yield, assuming no dividend increases.

Or we could also take a look at the underlying fundamentals to see how this compares to our estimated range.

Ford averages a profit margin of about 4%. The company has a beta of 1.33x, and combining this with the 10-year US Treasury bill yield of 2.5% and an expected risk premium of 7.5% gives us an estimated cost of equity of 12.5%.

Additionally, the company's recent average sales growth is about 2%. Giving us:

4% / (12.5% - 2%) = 0.38x Justified P/S ratio

This would work out to a $13.99 fair value or about the mid-point of our range, or 25% upside from the current share price.

Conclusion

Normally, a 25% expected return wouldn’t be enough to get me out of my chair, but we should keep in mind that Ford is essentially, a "mega-cap" stock and is thus heavily followed and scrutinized. This means that the share price by nature just won't be as volatile as some of the smaller, more neglected stocks we follow.

In order to leverage up the returns, my preferred play on this trade is to buy deep in the money call options. Additionally, this trade can be engineered to provide additional yield through a diagonal calendar bull spread strategy or a covered call strategy.

In my new Marketplace service, "Valuation 360," I do a deeper dive into the valuation of Ford - the complete valuation range or "where it should trade" as well as fair value or "where it will trade" - and outline how to go about implementing an option strategy depending on your outlook for the shares as well as your risk tolerance.

Disclosure: I am/we are long F. 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.