At first glance, the headline number looked OK, but not great: Ford (NYSE: F ) reported third-quarter income of $1.6 billion, or $0.41 a share, down from $0.43 a share in the third quarter of last year.
Hmm, you might say. Looks like Ford's slipping a bit. Time to sell. And sure enough, the stock was off more than 6% in early trading on Wednesday.
But this was one of those cases where the headline number doesn't really tell the whole story -- because the story is actually pretty good.
A little context
Here's some context for that number: First, despite being a bit lower than year-ago results, this was the second-highest third-quarter result in Ford's entire 108-year history. It does look like a big drop from the $2.4 billion Ford earned in the second quarter, but that's normal: Ford's third-quarter profits tend to look relatively weak because that's when the company retools its factories for the upcoming model year. Retooling means the factories are shut down for a time, and that means lower production, which in turn means lower profits relative to the first and second quarters. It's not worrisome.
Second, and more to the point, that headline number reflects an unusual accounting charge that doesn't actually affect Ford's cash situation.
Ford, like most companies of its size and structure, buys and holds derivatives to hedge its exposure to the risks of unfavorable changes in exchange rates and commodity prices. ("Derivatives" has become a scary word, thanks to the epic abuse of complex securities that led to the banking crisis, but this is a prudent use of them, one that significantly lowers Ford's risks.) Ford doesn't actually buy commodities directly, according to CFO Lewis Booth, but its suppliers do, and the prices Ford pays for parts and materials fluctuate with global commodity prices. Hedging with derivatives allows Ford to offset the risk that commodities prices will go up sharply -- if they do, Ford will have to pay more for parts, but its derivatives will increase in value.
That's sensible business. But what happened here is that prices of some key commodities, aluminum and copper, dropped sharply in late September. That meant that Ford's derivatives were worth less on paper as of the end of the quarter, and accounting rules require that that decline be shown as a "non-cash writedown" -- a loss, effectively, of $350 million.
Did Ford actually lose $350 million of its cash on derivatives? No, at least not yet; for now, it's just an on-paper adjustment to satisfy the accounting rules. And as Booth pointed out repeatedly during a call for analysts and media on Wednesday morning, if those commodity prices stay low, Ford will more than make up that $350 million in savings on the parts and materials it buys to build its vehicles. And if they rise again over the next 18 months, that $350 million loss could be reversed, and could even turn into a profit as the derivatives appreciate in value.
Long story short, it's no big deal when viewed in context. But it affects some near-term indicators, and that seems to be spooking some investors.
Margins may suffer, but fundamentals remain strong
Those hedging losses will probably push Ford's margin for the full year down to 5.7%, Booth said, down from 6.1% last year. Ford now expects to spend $2.2 billion more on commodities this year versus last year, up from $2 billion previously forecasted. But its structural costs for new-product development are rising less quickly than expected -- Booth now forecasts a rise of $1.6 billion, versus an earlier prediction of $2 billion. That's due, he said, to the company's continued very strong focus on reducing costs.
That's one sign that Ford's business fundamentals remain very strong. There were lots of others, including strong sales and revenues in the U.S. (which remains the "engine" of Ford's business, Booth said, allowing the company to invest for growth around the world), promising results in Russia, major investments under way in China (where rival General Motors (NYSE: GM ) is already a dominant player), and further reductions in the company's once-towering pile of debt, which now stands at a post-crisis low of just $12.7 billion.
And quality remains strong, executives said, despite a jarring downgrade of sorts from Consumer Reports, which on Tuesday dropped Ford from 10th to 20th in its reliability survey. Mulally noted that the Consumer Reports rating drop reflects issues with a few specific new models and features -- issues related mostly to software, he said -- that the company identified and took steps to correct earlier this year. Ford had been making inroads in those ratings, dominated for decades by import brands like Toyota (NYSE: TM ) and Honda (NYSE: HMC ) , so the latest results do represent a setback. But Mulally expressed confidence that the company's efforts remain on track.
A good outlook, despite economic concerns
Ford's guidance remains essentially unchanged: The company expects "moderate" global growth to continue, despite challenges in Europe, and said that its plans around the world remain on track. Those plans include investments in factories in emerging markets, which are expected to drive significant growth in a few years, as well as investments in product development. Mulally noted that the company is just beginning to realize the benefits of its "One Ford" plan, as it prepares to bring the last of its new generation of global products to market.
Here's the takeaway: Ford is trading at less than 7 times earnings as I write this. All signs are that this company is solidly on track in the U.S. and Europe and poised for growth in emerging markets in the coming years. It just completed a landmark labor deal and is continuing to generate solid profits despite significant economic headwinds around the world. I'm starting to think that, sooner or later, this stock will have a catalyst -- the resumption of a dividend (which didn't happen this quarter, but could in January), Ford's return to investment grade -- that will drive its price up sharply. If you've been thinking about buying, you might want to do it soon.
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