Ford Motor Company (NYSE:F) had warned us that its third-quarter profit would be down sharply from a year ago, and it was: Ford's third-quarter net income of $957 million was down 56% from its result in the third quarter of 2015.
What was the story behind that drop? Much of it had to do with North America -- and some of the factors that caused the drop will be with us for a while.
Why the "engine" of Ford's profits sputtered last quarter
Ford's North America unit is the "engine" of the company's profits, as former CEO Alan Mulally liked to say -- by far the most profitable of its regional operations. The problem in the third quarter is that the engine sputtered on several cylinders.
CFO Bob Shanks didn't mince words during Ford's third-quarter earnings call:
Going across the page, volume was down 11%. This was stocks primarily, negative change in stocks, market share, a little bit of industry. Revenue was down 8%. That was driven by volume. Market share was down 0.5. Now within that, that's the region, Canada was actually up 1.6 points, and Mexico was up 0.3 point. The U.S. was down 0.7 point. That's what drove the overall region.
Shanks explained that the third-quarter sales declines in the U.S. had to do with retail sales of cars and SUVs as well as a year-over-year variation in the timing of Ford's deliveries to rental-car fleets.
The fleet issue isn't a concern, but the retail numbers deserve a closer look. U.S. sales of Ford-brand cars were down 20% in the third quarter, as buyers continue to migrate away from sedans and toward SUVs. But surprisingly, Ford's SUV sales were down 3.4% during the quarter, suggesting that Ford isn't capturing all of those lost sedan sales.
But the retail sales decline was just part of the story behind the year-over-year profit drop, as Shanks explained:
This is the slide that essentially explains [the results for] the whole company. North America, down $1.6 billion. There are three things that are happening here. I'll go through them in order of magnitude, but they are all roughly about a third of the entire decline.
The first impact is the Super Duty launch. This is the effect of less volume, but also launch cost that always comes along with the launch.
During the quarter, Ford ramped up production of its all-new 2017 Super Duty pickups. This is a major launch that required some factory downtime to retool, and some supplier issues made for a rollout that was slower than Ford had hoped. That meant that supplies of the new pickups were tight during the third quarter, depressing sales. Sales for the F-Series line as a whole, including the F-150 as well as the Super Duty models, were down 3.3% from a year ago.
The second issue is a related one: In the third quarter of last year, Ford had just finished launching the then-new F-150. Demand was high and the "mix" of models that Ford sold was extremely profitable -- unusually so. By last quarter, things were back to normal, and that made for an unfavorable comparison, as Shanks said:
The second item is around normalization of F-150. When you look at the normalization of F-150, there are two things going on. If you go back a year ago, we were coming out of the launch of Kansas City toward the end of the second quarter. So in the third quarter, we were restoring the pipeline at the dealers. The units that we were selling were essentially all retail, no fleet, and we had very, very high mix. In this particular quarter, we had a normal balance of retail and fleet units, normal balance of series mix and options, although it's still very strong.
The third item wasn't a surprise: Ford warned in September that a recall of defective door-latch parts could cost as much as $640 million. That actually came in a little lower than expected, just under $600 million.
So why did Ford lose market share?
The U.S. new-car market is still strong, but it's not as strong as it was a year ago. Some of Ford's rivals have been boosting incentives (or, put another way, discounting) in order to try to generate some year-over-year sales growth.
That left Ford with a tough choice. It could either boost its own incentives, hurting profit margins, or it could accept the lost sales and reduce production in order to preserve its strong pricing. As CEO Mark Fields explained during the call, Ford chose the latter approach:
Our view is that the industry is [still] at a relatively strong level, but the retail market is softening and the pricing environment is getting tougher. And as you've seen and as we've communicated previously, we have taken some production adjustments on a number of selected models to match production to demand. That's consistent with our strategy.
Fields said that Ford would trim production of some models further in the fourth quarter (it already did so in October). He said that Ford would continue to have "competitive" incentives, but not excessive ones. "Our approach [with incentives] is to be competitive and disciplined. And I think as you've seen in certain segments in the last few months, when the competition has increased incentives, we have prioritized margins over market share. You can see that in our results."
The upshot: Ford is doing what Alan Mulally said it would
One of Mulally's frequent refrains during his tenure as Ford's CEO was that the Blue Oval would always seek to "match production to demand." Detroit automakers historically overproduced as the market slowed, and then were forced to discount heavily (trading away profits) to clear out excess inventory in soft markets. Mulally changed that at Ford, keeping a close eye on market shifts, and trimming production where needed to prioritize profits over production numbers or sales totals.
It's a very sensible approach, and Mulally's very capable successor, Fields, is sticking with it as the U.S. market slows. That might mean that Ford loses a few points of retail market share to rivals that are more willing to discount. But Fields believes, as Mulally did, that preserving pricing (and thus profit margins) is more important. As a longtime Ford shareholder, I agree.
John Rosevear owns shares of Ford. The Motley Fool owns shares of and recommends Ford. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.