- Some investors erroneously point to large consolidated debt balances at incumbent auto OEMs to argue they have a balance sheet problem.
- The vast majority of this debt is from captive financing arms and is more than offset by financial assets and equity cushion.
- OEMs like Ford are in a much stronger financial position than it appears on the surface and have substantial financial resources to compete with Tesla in EVs.
"We would all like to have a warning bell that rings loudly whenever we are about to make a serious error, but no such bell is available." - Dan Kahneman
Given the massive increase in Tesla's (NASDAQ: NASDAQ:TSLA) market capitalization over the past year (still up over 800% from its March 2020 lows, despite the recent selloff), it's not surprising, given human nature, that many investors seek out reasons to justify holding onto their positions. This includes longer-term holders sitting on gains, as well as more recent investors nursing losses.
Everyone is guilty of confirmation bias, the favoring of information that confirms existing beliefs and dismissing information that does not. However, recognizing our biases can help us avoid mistakes. A great free e-book on Behavioral Finance by Meir Statman is offered by the CFA Institute here. Statman puts it well:
"We use confirmation shortcuts when we examine evidence to confirm or disconfirm beliefs, claims, or hypotheses. We use confirmation shortcuts well when we search for disconfirming evidence as vigorously as we search for confirming evidence and assign equal weight to disconfirming and confirming evidence. We commit confirmation errors when we search for confirming evidence while neglecting disconfirming evidence and when we assign less weight to disconfirming evidence than to confirming evidence."
Source: CFA Institute
One of the more egregious confirmation-bias fueled narratives that has made its way into the Tesla zeitgeist over the past several quarters is that incumbent automotive OEMs have "bad" balance sheets with mountains of debt, while Tesla, fresh off of equity raises, is in much better shape. The implication is that the other OEMs are on the brink of disaster and won't be able to mount a credible threat to Tesla's early lead in EVs. Below are just a small sample of the type of arguments being put forth on social media:
We don't have to take RamboWarFace's word for it. Indeed, if look at Yahoo! Finance we can see this sad reality for Ford (F) investors right through our confirmation bias goggles:
Source: Yahoo! Finance
The data is clear, right? Nope.
The concept of "Enterprise Value" is often used (correctly and incorrectly) to assess what the market is valuing a business at, regardless of how the business is capitalized or how much excess cash it has on its balance sheet. What is the value of the "business" or enterprise? Two businesses identical in every way would have the same enterprise value, but if one has a large surplus cash balance, the market would likely value that cash and its market cap would be higher. Similarly, if one company had debt outstanding, the value of the enterprise wouldn't change, it would just be split between the two securities that have claims on the business (debt and equity). Below is a simple example:
If that is too much math, think about it this way: If you own a house worth $500,000, its value doesn't change if you have a $400,000 mortgage. Only the value of your equity in the home is different.
The Yahoo! Finance data on Ford appears to be straightforward enough. In addition to Ford's cash balance of $25.2 Billion, we can get close to Yahoo!'s reported "Enterprise Value" of $181 Billion:
Source: Keubiko calculations based on Yahoo! Finance data
Shrewd readers that have looked at the Yahoo! Finance data may have spotted one obvious problem already, in that Yahoo! Finance seems to have excluded other short term cash equivalents in the cash balance:
Source: Yahoo! Finance
While that minor $25 Billion oversight might seem large (at over half of Ford's market cap), it pales in comparison to a much bigger problem.
Before we go there, let's quickly look at what Yahoo! Finance reports for the "Enterprise Value" of JP Morgan, the largest bank in the United States:
Source: Yahoo! Finance
Spot the problem yet?
No, JP Morgan's business is not worth negative $161 Billion. The problem is that, just as kids shouldn't play with matches, people shouldn't be applying a shorthand financial calculation intended for non-financial businesses to banks and other financial services companies. The reasons are fairly straightforward for those with a basic understanding of how banks and finance companies operate. These businesses raise money from lenders (e.g. depositors and bondholders), and lend those funds to borrowers. The difference between what is charged to borrowers and what is paid to lenders is net interest income and the key financial driver for lending businesses.
Trying to use the basic enterprise value calculation (Market Cap + Debt - Cash) with a bank or other financial services company would have you include a massive amount of debt (especially relative to equity as these are leveraged operations), but completely ignore the entire loan book (asset) of the bank, because they are not "Cash". Hence the wonky negative enterprise value result for JP Morgan above. The square peg will fit in the wrong hole if you smash it enough times with a sledgehammer, but it does not mean it's a worthwhile endeavor.
So what does any of this have to do with Ford and other OEMs? They aren't banks, they make and sell cars, right? No and yes. While it's true that these OEMs make and sell cars, they also have substantial "captive finance" subsidiaries that operate much like banks do - raising debt financing, and lending money to creditworthy borrowers, namely consumers that purchase and lease vehicles, as well as dealer inventory financing. By using a basic enterprise value calculation on the consolidated operations of an automobile OEM, an investor would be completely ignoring the massive loan book asset, the same as in the JP Morgan example above, and get wild results. It is also why so many people wrongly conclude that that OEM debt balances appear to be enormous. In fact, at the "industrial" company level, most OEMs have a net cash balance, with cash on hand exceeds their total debt.
Let's go back to our Ford example to illustrate. First, we can pull up Ford's consolidated balance sheet from the company's 2020 10-K.
Source: Ford Motor Company 10-K
One can quickly see that there is about $98 Billion in finance receivables (loans made to creditworthy borrowers) and another $28 Billion in leases that are being completely ignored by those pointing only to the debts to argue Ford and its ilk are "in trouble".
The most appropriate way to evaluate an Auto OEM is to deconsolidate the captive finance arm and automotive businesses and evaluate them separately (and then combine on a rational basis with an understanding of the underlying facts, if one chooses). Only then can one compare automobile companies on an apples-to-apples basis. Alternatively, at a bare minimum, the financial assets of the financing arm should be included if you are going to include the liabilities. Not doing so is ignorant or disingenuous.
Most, if not all, auto OEMs make this a relatively pain-free exercise, as it's how Wall Street analysts and professional investors look at these companies. It does, however, involve taking a bite of that forbidden fruit known as opening an SEC filing such as a 10-K. Go ahead and be one of the 7 people in 2021 that have opened a 10-K by clicking on this link. Congratulations.
Ford makes it exceptionally easy to look at the assets and liabilities of the automotive business and Ford Credit, its captive financing arm:
Source: Ford Motor Company 10-K
You can see in the table above from Ford's MD&A, that while Ford Credit has $144.5 Billion in total liabilities, it has $158.5 Billion in total assets, made up primarily of cash, finance receivables, and leases (vehicles owned and leased to customers). All but $14.3 Billion (the cash at Ford Credit) is completely ignored in a standard enterprise valuation calculation, as well as by those arguing that OEMs are overleveraged.
Using the data in the above table for the industrial business (the auto company), we can get a better assessment of Ford's automotive/industrial debt and cash position, compared to Tesla (which does not have a large captive finance arm to speak of):
Source: Keubiko calculations, data from Ford and Tesla 10-Ks
Far from being a liability, financing arms can be a significant source of profit, in addition to providing strategic value to the automotive business. Sticking with Ford, and using the financial statements of Ford Credit (found here), on an equity base of about $14 Billion, Ford Credit generated about $1.9B in after-tax income in 2020 (a pandemic year), a return on equity of roughly 14%. To put that in perspective, Ford Credit alone earned 2.6x Tesla's entire 2020 net income of $721 million (Note: without $1.58 billion of regulatory credit sales, Tesla would have lost about $860 million in 2020).
It's also worth noting that captive financing arms are generally not in the subprime lending business. For example, Ford Credit's average FICO score at time of loan origination in 2020 was 739. A FICO score of over 700 is generally considered "good", and according to Experian the average FICO score in the U.S. in 2020 was 710. Additional credit metrics are below:
Source: Ford Motor Credit
So what can we do with this information? First, we can easily dispense with the notion that legacy auto OEMs have a debt problem. The debt in the financing arms is more than offset by financial assets (cash, loans, and leases), supported by significant equity capital. Second, by adjusting for these captive financing arms, we can get a better assessment of what the market is pricing the automotive business of these OEMs at, so that apples to apples comparisons can be made between OEMs (e.g. comparing Ford to Tesla).
The main point of this article is to shine a spotlight on the existence of captive finance companies, show why it's silly to focus on only the liability side of their balance sheets, and why adjustments need to be made when looking at things like credit quality, financial capacity, or valuation metrics. Below is a very basic attempt to do this for Ford, if one is interested in looking at Ford's automotive business and comparing it to Tesla, for example.
Source: Keubiko calculations based on Bloomberg data
The point of the table above isn't to argue whether or not these multiples are justified or that Ford hasn't had its share of problems to deserve a lower multiple, but at least the comparison is on a somewhat apples to apples basis. It's also indicative of just how much Tesla needs to grow into its extraordinarily high valuation. The automobile business is tough, low margin, competitive, cyclical, and capital intensive, which is why, historically, multiples have been low. Even Tesla, despite having most of the EV market to itself to date, hasn't been able to consistently turn a profit without selling regulatory credits to other OEMs.
A similar story exists with all OEMs with captive financing arms. Below is a screenshot from Volkswagen's 2020 annual report that shows a seemingly eye-watering EUR 190B in Volkswagen Financial Services debts offset with well over EUR 200B in assets, and an equity cushion of EUR 32B.
"It ain't what you don't know that gets you into trouble. It's what you know for sure that just ain't so."
- Mark Twain
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