Ford (NYSE:F) bulls have challenged my dividend warning in the comments to my original article Will Ford Cut Its Dividend Soon?, so let's take a closer look into the key factor that I believe will determine the dividend's future: Ford Credit.
How Important Is Ford Credit?
According to the company's most recent earnings release, Ford Credit added $663 million and $2.6 billion in earnings before taxes ("EBT") in the fourth quarter of 2018 and fiscal year 2018, respectively:
As the above table included in the company's most recent earnings release illustrates, Ford Automotive has seen its earnings before interest and taxes ("EBIT") slashed by one-third, not only in the fourth quarter of 2018 but also fiscal year 2018, primarily due to lower profit margin and lower market share.
In particular, Ford Automotive is significantly challenged in China, where the company lost $1.1 billion in EBIT in the fiscal year 2018, representing a stunning $1.8 billion swing from the previous fiscal year:
Imminent Credit Rating Downgrade
On August 29, Moody's downgraded Ford to one notch above Junk, set outlook at negative, and noted the following:
The ratings could be downgraded absent clear progress in pursuing the Fitness initiatives by early to mid-2019, with evidence that the company is on a strong trajectory for recovery. The rating could also be lowered if Ford is unable to address operational inefficiencies in each of its major regions, while at the same time showing progress under the Fitness program's objective to generate adequate returns across all aspects of its automotive business. Evidence of such improvement could be reflected in the following areas: 1) North America: achieving an EBIT margin above 8%, maintaining market share of at least 14.5%, and lowering the breakeven level; 2) China: successfully launching new products that help grow market share, improve dealer relationships and restore historic levels of profitability; and 3) consolidated automotive operations: making steady progress toward restoring positive free cash flow.
As of the most recent quarter, Ford Automotive:
- failed to achieve an EBIT margin above 8 percent in North America, and its market share in North America declined further to 12.8 percent;
- failed to restore historic levels of profitability in China, and its market share in China declined further to only 2.2 percent; and
- failed to achieve positive free cash flow.
Not only the company has failed to achieve any of the milestones Moody's set forth in its Rating Action, but also nearly all of Ford's fundamental metrics have deteriorated further; therefore, I expect another downgrade from credit rating agencies in the next three to six months.
Downgrade Would Challenge Ford Credit
Ford notes in disclosures to its earnings release that Ford Credit "could be affected by credit rating downgrades" and other factors:
According to the following table included in an Aswath Damodaran study, if Ford's credit rating is downgraded from the current level of investment grade to junk, the company's cost of debt capital could increase by one percent or more, depending on how many notches below investment grade the credit rating is downgraded: In case of a downgrade into junk, even though the company's effective interest expense would not immediately jump, Ford Credit's ability to finance future leases could significantly deteriorate sooner than bulls expect.
One More Thing
The primary drivers of favorable Ford Credit results were:
- stable lease return volumes in recent periods; and
- a two percent year-over-year increase in auction values:
Management noted, however, that it "expects 2019 FY average auction values to be about 4% lower YoY at constant mix," and with the upcoming reveal of Model Y, Tesla's (TSLA) widely anticipated crossover, auction values for internal combustion engine crossovers could take a turn for the worse.
Furthermore, The Washington Post today noted that "A record 7 million Americans are 3 months behind on their car payments," which does not bode well for the financing arms of automakers, including Ford Credit.
Effect On Bottom Line
The following chart illustrates Ford's total debt, including that of Ford Credit:
Needless to say, even a slight increase in the company's cost of debt capital could significantly hit the bottom line, which was already negative as of Q4 2018 on a GAAP basis and had significantly deteriorated on a non-GAAP basis:
A potential credit rating downgrade could tilt Ford into a downward spiral of increasing losses and worsening credit ratings in the second quarter of 2019.
In order to delay this future, I expect Ford to at least cut, and maybe eliminate, the dividend in three months maybe, six months definitely.
If you're interested in my investment methodology and other holdings, join Value Portfolio. I'm confident that you will find my fundamental research to be insightful, and I look forward to discussing ideas with you.
Disclosure: I am/we are long TSLA. 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: In addition to my long position in Tesla, I have a small position in Ford put options.