Our Ford Thesis

Published on 05/26/21 | Saurav Sen | 3,960 Words

The BuyGist:

New Management has the right strategy in place: Refocus on core products like F-150, Mustang, SUVs, and finally invest in the Electrification movement. The Refocusing strategy should reduce operating costs, which is Ford’s biggest problem.

Why Ford?

I started looking at Ford because it recently made the decisive call to get in on the Electrification movement. I had looked at Tesla last week. Ford was a natural extension. I became more interested as I started digging in because the numbers didn’t make sense to me. For the amount of cash Ford generates, it’s market price is awfully low. Once I dug in, I saw why the sentiment is negative. But I think it’s too negative.

Competitive Advantage: The Castle

Core Competency? Pickup Trucks, SUVs, other Utility-Vehicles and some American Icons.

It’s high time Ford acknowledged that they can’t be everything to everyone – that’s usually a fast-track to mediocrity. And they were on that track just a few years ago. But Alan Mullaly transformed Ford into a great American come-back story, rising from the ashes of The Great Recession. That resurgence lasted a few years. And then it appeared that Ford got lazy again. It looked confused. But it was clear then, as it is clear now, that Ford does pickup trucks and SUVs better than almost anyone. And, of course, there’s the Mustang.

The F-150 pickup truck is the highest selling vehicle in the US. Period. And it has held onto this mantle for years. Clearly, Ford must be doing something right there. In 2017, Ford sold more than 850,000 F-150s in the US. They were followed by GM’s Chevy Silverado with about 585,000 – a distant second.

The Ford Explorer was 2017’s best-selling mid-size SUV in the US. Its popularity has been reasonably steady ever since the debacle with Firestone Tires more than a decade ago. In 2017, sales increased 10%. In the SUV world, Ford Escape is another hit. Ford was audacious to compete with Toyota’s RAV4 and the Nissan Rogue. It found some success. Last year, it sold more than 300,000 units, coming in 3rd behind those two formidable competitors.

The Mustang is not my style, but I can’t deny that it is maybe the most iconic American car. It’s been an icon ever since Steve McQueen set foot in it. Last year it sold about 80,000 units in the US, much higher than its rival – the Camaro. But sales were down as compared to 2016. To counter that, Ford is releasing some new models in 2018, including a new version of McQueen’s Bullitt.

I did some quick math: those 4 products just mentioned – counting just US Sales – account for nearly 40-50% of Ford’s Revenue. Their contribution to profits is probably much higher than 50% - these are their high margin products. It’s not difficult to identify Ford’s core strengths. That’s more than you can say for most companies. I always ask the question: what does this company do better than anyone else? In Ford’s case, the answer is clear and tangible. That’s a good start. But that’s not the whole story. Ford has plenty of lukewarm offerings.

Products: Better or Cheaper? Better in core strengths. Other products are in no man’s land.

Ford’s sedans are the problem. They’re neither hot nor cold – neither markedly better nor cheaper than competitors. Sedans are generally sold to normal folks like you and me. And so, there is a big “fashion” element to them. That involves 3 things – Sex Appeal, Reputation and Reliability.

Ford has never really had much sex appeal in its Sedans. The Ford Fusion isn’t ugly by any means. But is it a lot sexier than a Camry or an Accord? Does the Fusion have the Camry’s reputation for being an “economical, no-hassle, reliable” car? No and No. And it’s unlikely that a Ford Fusion or any other mid-size sedan coming out of Detroit will be able to win against these Japanese icons on a price/reliability ratio basis. And on sex appeal, Ford doesn’t match up to the Germans. Even Volkswagen seems to have a better design sense. And, at home, Tesla is now raising the bar.

Ford’s reputation as a reliable workhorse in trucks and SUVs never really ported over to its Sedans. The Taurus was a big hit in the 1990s. But it lost its way within a decade. Let’s just say it didn’t age well. And now it’s nowhere near the top-selling cars in the US. I should mention that the Fusion, however, made it to the top 10 in the 2017 list of best-selling sedans. But it’s still a far cry from a Camry or an Accord.

Surprisingly, some of Ford’s small cars are mildly competitive. Ford Focus is in the top 10 list of small cars. But can it really compete with a Honda Civic in the long-run? Ford Fiesta, however, is somehow the top-selling car in the UK. Apparently, the Focus and the Fiesta make up close to half of Ford’s volume. That sounds scary, but it’s not where most of the company’s profits are. Those come predominantly from the core products.

Then there is the issue of Lincoln. I wish Ford would get rid of it. They haven’t been able to compete with the luxury brands – definitely not on sedans. How many Lincoln “MKs” are there anyway? In the Deutsche Bank conference in January, Management was asked whether it can make a Lexus out of Lincoln. The answer seemed to be: compete where the German Big 3 are not, just like the RX300 did back in the day. But I wonder which Lincoln car can create a “new category”. Ford seems to think the new Navigator can be the “commercial-luxury SUV” of choice. It’s possible, because the reviews are generally very good. And, just based on anecdotal evidence, Ford seems to always have some in-roads with Government agencies in the US. Maybe it can corner the “Washington entourage” market. But I won’t hold my breath – why does world need that AND a Ford Expedition?

I will refrain from commenting on the Lincoln commercials starring Mathew McConaughey.

Evidence: Historical Profitability? Revenues increasing. But EBITDA declined 10% since 2015.

Ford’s revenues have been increasing even in these dark post-Mullaly days. And here’s the kicker: BOTH price and volume have contributed to those increases. This is much better than GM’s situation. So, where’s the problem? Cost Management.

Ford’s EBITDA and Cash flows haven’t kept up with revenue because of commodity and currency costs. This is something GM has apparently managed much better. The dominant commodities are, of course, Steel and Aluminum. Prices of both have been on the rise for the last 2 years. And compared to GM, Ford does have a higher percentage of Aluminum in their cars. But Ford’s CFO says that Steel costs were the main culprit, and apparently there isn’t a good hedging market out there. It’s unclear to me what GM is doing better, but maybe Ford should look into it.

The encouraging trends in Revenue tell me that Ford’s products – overall – are desirable. And it comes down to what they do well: Trucks, SUVs and Commercial Vans. That’s what the market thinks Ford does well. And that’s the sport they should play. Having 3 Lincoln MKs with Mathew McConaughey in them is a distraction.

Durability of Competitive Advantage: The Moat

Competition? Heavy. GM/Chrysler/Toyota in Utility Vehicles. Almost everyone in Electric.

The stock market seems to prefer the GM story to Ford’s. And that’s understandable. There are 2 main reasons: 1) Costs Management, as mentioned above and 2) GMs decisiveness on Electric Vehicles.

On #2, the Chevy Bolt from GM has received good reviews. And that’s a real credit to the GM team – they made big investments a few years ago. They were much more decisive than Ford on this. However, GM will face stiff competition from Tesla’s Model 3. It also received good reviews and it’s a lot sexier than the Chevy Bolt. And the main advantage of the Tesla is that it charges much faster. The Model 3 is pricier, but not by much. Sadly, there is nothing from the Ford stable that enters this conversation. With the new CEO, Jim Hackett, that’s about to change. But it will take time.

Ford’s core products are not immune to competition either. While the Ford F-150 is the clear leader in the Pickup Truck arena, the Chevy Silverado is catching up. In 2018, it appears that GM has made greater strides in the truck business compared to Ford. A part of the reason is the GM had some recent product launches. Ford has more than 20 product launches planned this year. The game is on. No rest for the weary.

Protection? Somewhat weak. But strong icons and Distribution network.

Ford has a great base on which it can build a wider Moat. Its iconic vehicles have decades of reputation, which are hard to uproot. On its part, Ford must not “mess with these products” and alienate its fan-base. It’s encouraging to hear Management taking a deep look at “where it can win”. And out of the $7 billion or so in Capital Expenditure, I would hope that a large chunk goes into constantly fine-tuning the F-150, the Mustang, the Explorer, the Escape, the Transit and so on. That’s where it can win. And it must constantly invest in them to widen the gap from competition.

Not messing with their core products is going to be a challenge in the Electrification era. Many of Ford’s best-selling products are beefy, American gas guzzlers. How will an electric powertrain on an F-150 be received? Ford is also working on an electric version of the Mustang. That’s almost hard to imagine. The point is that Ford just can’t afford to mess up these American icons as they electrify them over the next decade. The downside is massive. Ford’s brand value depends on these icons. It can disappear in a flash.

One of the things that impresses me about Ford is their distribution network. Of course, they’ve got a vast dealer network in the US, and clearly in some European countries. But they also have an ability to get into some high-volume commercial channels such as Police departments and other government organizations. GM and Chrysler also play this sport. But the other companies aren’t. And part of the reason Ford has made these inroads is because of their specialization in SUVs. Or maybe it’s just that they know the right people. Either way, it’s a Moat. It turns out that the most popular police car today in the US is a modified version of the Explorer. Remember when it used to be the Crown Victoria?

This is an outlier: One of the big investments Ford is making today is in “Mobility”. This is a project that used to headed by new CEO Jim Hackett. It’s now headed by Marcy Klevorn, who used to be Ford’s Chief Information Officer. This is basically an R&D department now, with the hope that they’ll churn out products soon. The objective of Mobility is to research and develop products for the Electric-Car-Autonomous-Driving-Smart-City ecosystem. This sounds like a bit of a theoretical project because, at the moment, it is. But I think this project can have huge payoffs. Electric Cars are an inevitability. Autonomous Driving is an inevitability. Just those two impending changes to our civilization will change the way our infrastructure is set up now. Charging stations are needed. Ride-hailing services will change. The taxi business might go through another disruption. Car sales to people in congested cities may take a huge hit. There is a long list of ripple-through effects. Ford is trying to get ahead of the curve here. That’s a good thing, especially since its been behind the curve on Electrification. I believe this sort of “ecosystem thinking” can create opportunities to build Services and some sort of lock-ins as the world moves towards electric vehicles. For example, Ford is testing the use of Autonomous vehicles with Domino’s Pizza these days. It’s also looking into the possibility of Smart Cities across the world that may want to start Autonomous-Driving taxis. The upside is huge. The downside – in terms of costs and capital expenditure in the short-term is manageable. The payoff could be in the form of a new Economic Moat.

Resiliency of Cash Flows? Standard Cycle products. Products need to be refreshed often.

The Retail element in cars makes it a bit of a “fast-fashion” product. It seems to me that the “economic time” of cars has been shrinking over the last decade or so. I believe the reasons are:

  1. Better information/reviews on cars, at your fingertips.
  2. More people are leasing than ever before, because…
  3. Technology in cars is changing at a faster rate than ever before. There’s always something shinier with better software out in the market.

This is creating some issues for car companies. There seems to be a constant need for product launches, sometimes just to be visible. Numerically, this means more capital expenditure, and more R&D expense. And the payoff period – the potential increase in sales from those investments – lasts maybe 2 years. Cash flows, it seems to me, are less resilient nowadays in the car business in general. Having icons in the stable – like a Mustang or an F-150 – helps smooth out some of that volatility. But barbarians are always at the gate. Moats have to be widened, constantly.

Management Quality: The Generals

Strategy & Action? Mixed. Positive on Strategy. But no clarity on Action.

Ford has a new-ish CEO. Jim Hackett took over on Jun 1, 2017. And the reason Ford’s Chairman Bill Ford brought him in was that Ford needed an Alan Mullaly type of shake-up again. The firm was confused. And its products weren’t refreshed in the right way. There was also ambivalence on the Electrification play, in contrast to GM’s decisive actions. The biggest problem, financially, was on the cost-side. It’s still a problem. Ford consistently lagged GM’s operating margins. And a big part of that reason was overdiversification in the product line-up – the tell-tale sign of a slightly confused company. Hackett wants to change all that.

Hackett likes to talk about improving Ford’s “fitness”. This basically means that Ford needs to reduce costs. Fortunately, he (along with his streamlined management team) have zoomed in on the issue of too many SKUs. As I had mentioned, why does the world need 3 versions of the Lincoln MK series of sedans? And the problem with too many SKUs is: too many parts. There isn’t much “economies of scope”. The “fittest” car companies use common parts for many of their products. For example, the Toyota Camry and the Lexus ES series are practically the same car in terms of parts. Audi and VW cars share the same chassis in many cases. In Ford’s case, according to Hackett, there are just too many parts for too many cars. There is ample room for cost cuts.

The reason I like this strategy is because it’s also consistent with another much-needed strategic move: play-to-win. Ford’s Management has now (finally) realized that they must pick their battles. They can’t win in everything. Sedans targeted at regular folks like you and me, for example, is not their sport. Luxury sedans is definitely not their sport. SUVs and Pickup Trucks are where they can win. And that’s what should dominate their assembly-line schedule and their parts-and-raw-materials supply-chain. This is a decisive step. And I think focusing on their core products will have tangible effects on both the revenue and cost sides of the equation.

Hackett has also been much more decisive on Electrification. They’ve committed about $11 billion in Capex over the next few years towards it. Ford plans on rolling out many EVs by 2020. But there is the overhanging question of whether it’s too little too late. What gives me some sense of hope is: 1) it looks like we still have a few years before the Electrification “tipping point”, 2) the “non-luxury” EV segment is still an open field (I don’t think the Chevy Bolt will dominate that) 3) Ford has had some success with the Fusion Hybrid and 4) Ford’s Mobility initiative may give it a head-start in the Commercial EV segment.

What does not give me a warm and fuzzy feeling is the lack of clarity on tactics. For all the talk of decisiveness and “fitness”, Hackett and team have been decisively cryptic about operational moves that will make Ford fit. For example:

  1. Which product lines are they going to eliminate?
  2. What will be the Capex breakdown for a) bolstering its cash cows and b) developing new electric cars?
  3. Within it’s EV capital expenditure, how much will it spend on new products vs. electrifying its cash cows?

The investment community has no idea. I will be looking for these answers on the next earnings call.

Alignment of Incentives? Poor. CEO paid $16 million for what exactly?

This is another area of much-needed improvement. Hackett is leading a transformation strategy. And while he does that, Ford’s results are likely to be uninspiring. I’d rather see a situation where Hackett and team get paid a lot of money if their strategy increases cash flow over the next few years. Then a $16 million payday might be justified. I scanned some of their corporate governance reports, and the problem seems to be twofold:

  1. Hackett was part of the Board for the last few years. And now he’s CEO.
  2. About 60% of Management compensation is shorter-term-oriented. 40% is longer-term. At a minimum, that ratio should be reversed.

Financial Productivity? Above average. Low-teens ROE. Margins need to improve.

Anemic Margins are Ford’s biggest problem. They can’t seem to contain commodity and exchange rate costs. There are too many cars with too many parts. And we still don’t know exactly what the impact of the Electrification initiative will be. So, “the market” doesn’t expect much in terms of margin improvement. And maybe rightly so, because Hackett and team won’t give us some details on how it will improve Ford’s “fitness”.

Ford’s anemic margins, however, are bolstered by higher turnover and by leverage. Debt/Equity is at about 3X. That’s higher than most companies I look at. But it is a car business. A Financial Services segment is a necessary evil, with which comes a lot of debt. It’s total cash interest bill was about $4 billion in 2017 (for both Financial Services and Autos Debt). That looks awfully high. But this brings me back to margins – a 1% improvement in EBITDA margins would release about $1.5 billion. That goes a long way in paying this high interest bill. Just to put it all in context: Ford generated about $6 billion in Free Cash Flow in 2017, net of all those charges. But until I get more clarity on Management’s execution of its strategy, I will assume that Free Cash Flow will reduce by about 50%.

Sustainable Free Cash Flow? About $3 billion. Translates to rough valuation of $15/share.

My thesis on Ford is basically this: It’s a company that finally has the right strategy in place. Even though execution of that strategy is still a mystery, there is much more upside than downside on cost management. It seems like Management knows what to do. Now it’s a matter of doing it.

Keeping that in mind, the market’s appraisal of Ford doesn’t make sense to me. If I go with the conservative assumption that it generates $3 billion of free cash flow, and it’s sitting on $26 billion of cash on the balance sheet (enough to pay down is Autos Debt entirely), a $43 billion Market Cap doesn’t sound right to me. Looking at it another way, that’s about 1.3 to 1.4 times Book Value of Equity for a company that still generates enough cash flow and a return on capital that exceeds its cost of capital.

Obviously, Mr. Market thinks Ford’s sales will fall. Its costs won’t be contained. And cash flows will decrease from current levels. I think that sales will remain roughly around current levels, and the probability of improvements in cost management are much higher than a further deterioration of margins. Of course, as is customary at The Buylyst, I’ve made no such rosy assumptions in my valuation. The assumptions are in the Valuation Details page.

We use cookies on this site to ensure the best service possible.