The Bull Case for Ford

Ford (F -1.92%) has been struggling lately, but that doesn't mean the automaker has run out of steam. On this week's episode of Industry Focus: Industrials, host Michael Douglass talks with senior auto specialist John Rosevear about all things auto, especially Ford.

Some analysts think Ford will snip its 6% dividend, but John has some context from management that might just quell those fears. Find out why he's still bullish on Ford even now, what's coming down the pipe for the automaker, and more. Also, Tesla (TSLA -1.11%) will have to pick up its pace to compete against all the electric vehicles coming out in the next few years. And finally, GM (GM 0.48%) has been putting up rockstar numbers, and shows no sign of slowing down. Tune in to hear more.

A full transcript follows the video.

This video was recorded on Aug. 23, 2018.

Michael Douglass: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Thursday, August 23rd. We're doing a quick update on autos, more specifically Ford, but we'll talk a little bit about some of the other guys. Really, you can't help doing that when you talk about Ford. I'm your host, Michael Douglass. I'm joined by John Rosevear. 

Now, listeners I should mention that this is pre-recorded. As you're listening to this, I'm in the Outer Banks, likely nursing a sunburn. It's distinctly possible things will have changed a little bit and there'll be a couple of things that have shifted by the time this gets to you. We're going to do our best -- we're recording this on Thursday, the 16th -- to say "last week" when we mean your last week as compared to ours. But give us a little bit of grace as we work through that. 

John, welcome back to the show!

John Rosevear: Thank you! We should add that this is why we're not talking about Tesla, because the story will be different in 15 minutes, much less this week. [laughs]

Douglass: [laughs] I think that's incredibly true. Yes. I'm a former Ford shareholder, actually. It's been a story that I've tracked over the years with a lot of, sometimes optimism, sometimes pessimism, but a lot of interest. Let's trace the last month or so for Ford. The first thing that happened is, they had a really tough Q2 earnings report on July 25th. I mean a big negative surprise on profit.

Rosevear: Yeah. I should add, I've been a Ford shareholder since 2009. I'm in this for the long haul. Yeah, second quarter profit was a big eye-opener. It caught Wall Street by surprise. Net income was down 44% to $1.1 billion. Revenue was down 2.5%, which is almost a more significant problem. 

What's going on here is, the good news is, Ford is still selling a lot of pickups in North America. That pays most of the bills. The tough news is that, they had a success story going on in China for a while, and it has completely fallen apart. Ford used to take a couple of hundred million every quarter in equity income from its joint ventures with Chinese automakers. They barely broke even last quarter. That was a real shocker. 

In the meantime, sales have been good in Europe, but profitability has not. They posted a loss in Europe, despite good sales. There's a story there about what's happening. Europeans, like everybody else, want more SUVs. Globally, Ford has an issue where it's at the point in its product renewal cycle where the big selling categories are kind of stale. 

That's brutal in China, because in China, you have all of the automakers you've ever heard of competing, along with a whole slew of domestic Chinese automakers that most Americans have never heard of. The market moves very fast. There's always something new, always something fresh. Ford's Focus was a huge seller in China when it came out five years ago. And now, it's dwindled down to very little.

Douglass: I should note, I'm a proud Focus owner. I have the '09 model. It's a good car! Personal viewpoint, obviously. 

Rosevear: We have one, too. It's a fun car. But it's not the flavor of the month. That matters somewhat in the United States, it matters an awful lot in China. They've missed where the market went. They didn't have, maybe, the local intelligence on-the-ground people who spoke Chinese and deeply understood the market the way they should have. They've missed some things. I mean, we talk in America about everybody going for crossover SUVs. Well, everybody in China's going for crossover SUVs, too. Ford has the Kuga, which is the Chinese version of the Escape -- well, it's the overseas name for the Escape. They also have the EcoSport, the little one that they recently introduced here. 

Sales have been down significantly. The EcoSport has done OK, but sales have not been what they should be. They've had to discount because of the feeling that these products are very dated compared to fresher stuff from other competitors. It's the same problem in the U.S., to some extent, although sales have still been good of the Escape and the Explorer and so on. And in Europe, they also sell the Kuga, the Escape, in Europe. But for them, for years, the big sellers have been the Fiesta and the Focus. They had an all-new Fiesta in Europe last year. It did very well. Sales are up. But it's not delivering the margins they hoped for. They're rolling out a new Focus over the next few months. They're also concerned about the margins there. They're going to get these out there that have fatter profits in all of these markets.

Douglass: Right. And Ford is talking about a "transformation," which is going to cost $7 billion. When you think about $1.1 billion net income in a quarter, that's a pretty hefty price tag.

Rosevear: Yeah, it is. It is. I talked to Bob Shanks, it will be last week by the time our listeners hear this. He points out that that's spread over several years and it's going to come out of cash flow. It's not like they're drawing down their cash reserve to do this. It's going to come out of cash flow. He thinks that, in practice, it's not going to hit like that. They believe in giving you the price tag upfront and dropping the bad news in a very straightforward way. That's why they came out with that.

Douglass: Yeah, there's a car dealership joke there somewhere. I can't quite put my finger on it, but we'll get there. You got the chance to talk to Bob Shank, we'll talk more about that in a minute. One of the interesting things is that an analyst from Berenberg basically argued that a dividend cut would have to come. Ford's dividend is up to, what, 6% now? And you actually wrote about being maybe a little bit concerned about Ford's dividend, as well, I think somewhat understandably, given that all these things are incoming. 

Rosevear: Yeah. This analyst's argument was, "You're losing all that cash from China. You're going to have to keep spending money on all these other things," including the future projects, electric cars, self-driving vehicles, all that stuff that all the automakers are investing in right now. And it's like, "They're going to have to cut the dividend." It's 6%. They could cut it by a third and it's 4% at current prices. He has a sell rating on this stock. He was not optimistic.

I saw that, and I was hearing rumblings from other places and hearing from some readers who were like, "Is this for real?" So, I did an article looking at it. And I said, "Well, Ford said in 2016 that the dividend is at a level that they can sustain," as they put it, "through the cycle, through a recession." As far as I know, that guidance is still operative. But, they have a new CEO since then, and many things have changed. It is true that back when they said that, in 2016, they expected 2018 to be a good year. Things started to go bad earlier than they had expected. So, I raised that question in an article. And that led to a conversation with Ford CFO. [laughs] As these things sometimes do. Bob Shanks, who is terrific. He's very smart, very capable. I said, "Bob, is that guidance operative?" And he said, "It's extremely operative!" [laughs] He only anticipates cutting the dividend in a severe economic situation, as he puts it, the '08-'09 scenario. They carefully set the regular dividend at a level that they're confident they can sustain. And when Bob says confident, he means confident. That's guidance. 

What Ford has done in the last three years is paid a special dividend, sort of a bonus dividend, in the first quarter, to return some of the prior year's strong profits to shareholders.

Douglass: I think that's really interesting. Folks who listen to the Energy show certainly have heard discussions of companies with variable dividends in the past. What this essentially means is, you've got this sort of consistent, guaranteed dividend, and then possibly some variable pieces on top of that, depending on what Ford thinks it can do. That's a smart way to do things. It means you don't have to actually cut that regular dividend if things decline to some extent, and you don't have to be in the spot where you're like, "Well, we've made a promise to shareholders that," well, not a promise, but sort of an implication, that when you set a dividend, hopefully you can maintain it for a long time. Instead, they're saying, "Yeah, we think we can maintain this underlying dividend, but we'll do a little bit of extra when we can."

Rosevear: Right, exactly, and it's to maintain everybody's expectations. With Ford, everybody includes the Ford family, which controls Ford via a special class of shares. But that class of shares gets the same dividend as the common stock. For some members of the Ford family, that's significant cash flow. They can forecast, "What am I going to have next year," and so forth, in terms of income, around that. And that's important. Since there's a Ford who is chairman of Ford's board, Bill Ford, Henry Ford's great-grandson, their interests are represented at the table.

But the interesting thing here is Shank's rebuttal to the, "China's not delivering the money, so cash flow is going to go in the tank," which was what this analyst had said. He said they're all missing something big. Ford Credit, their captive financing arm, their in-house bank, returns a couple of billion dollars a year, or close to it in pre-tax profit, and has for several years now. They've been reinvesting most of that in Ford Credit to grow its asset base, to grow its receivables. They're now at the point where they want to cap it. Ford Credit is big enough. What that means is that that cash is going to start to come back into the company. Ford targets, Bob told me, an 11% return on Ford Credit's equity. The equity is currently around $15 billion. That's about $1.7 billion of pre-tax profit every year at that target. We should note that they have guided to a considerably higher number this year. Bob points out that at that $1.7 billion, that covers around 70% of the regular dividend. It's not everything, but it's an awful lot of it.

Douglass: Of course, the flip side of that is that as those auto loans eventually roll off Ford Credit, they'll need to reinvest some of the cash to put those back in. I should mention, by the way, full disclosure, my very first loan as an adult was with Ford Credit. That's how I financed my Focus. I have thankfully paid it off, given that I was 21 and penniless. I maybe didn't have the cheapest rate in the world, although it was still very payable.

Rosevear: I haven't gone into that in great detail with Bob, what happens as sales go down. Obviously, new loan generation goes down. But three-year loans, whatever, you've got some time before those roll down. Even then, they're still selling a fair number of cars. They may take a larger share of the cars their dealers sell, because they only finance some transactions. Some dealers use other financing companies and so forth. They may find ways to take a larger share of the smaller pie to try and keep Ford Credit in fully invested, with its receivables where they want it to be.

Douglass: The upshot here is basically, if you're thinking of this as a Ford shareholder for a minute, you've got Ford Credit, which can probably cover around 70% of the regular dividend, assuming that 11% return on equity and those numbers that you just walked us through, John.

Then, also, Ford's got a big cash hoard, $25.2 billion as of the end of Q2. I think, if people are concerned about the dividend, the upside here is, it's probably going to be OK. Basically, if the dividend comes under threat, that's going to be because the business is really hurting, in a way that it isn't even currently right now.

Rosevear: Bob makes a point of saying that that cash hoard is specifically to fund things into a downturn and through a downturn. "Things" include the regular dividend. They intend to fund that out of cash. And then, he says, "Of course, if we hit an '08-'09 situation and things get dire, then lots of things go out the window, possibly including the dividend." 

Realistically, they have that cash hoard, and then they have additional credit lines behind that of around $11 billion. It was $10.9 billion as of the end of the second quarter. I suspect that in a protracted recession, as the cash gets low and they're starting to think about trying on those credit lines, that's when the dividend goes out the window. It would have to be a real grinder. 

Douglass: Alright, John, let's talk about Ford as an investment on the whole. The fact that we're even talking about, "Hey, the dividend's probably safe," that's in part a conversation about the fact that the business itself has been, as you alluded to earlier, not been doing great. You're a shareholder. Obviously, you're holding your shares. What's your thought process there?

Rosevear: My thought process is that, part of what's going on is, Ford is shifting gears in a number of different directions.

Douglass: I see what you did there. 

Rosevear: Yeah. Well. [laughs] If you follow Ford long enough, you start to be fond of things like Mustangs. I've never owned a Mustang, actually.

Douglass: Yet!

Rosevear: The Ford guys keep trying to get me to buy one but. But, anyway! [laughs] That's another story. Hi, Ford guys! There are a bunch of things going on here. Let me talk about a few of them. 

First of all, Ford is shifting its business. It's reducing investments in places where it hasn't been earning good margins and investing more in places where it feels it has a strength. Crossover SUVs, commercial vehicles, where Ford is a dominant player in the U.S. and Europe, and it's still a strong player in China, even as its overall sales have diminished. And, performance. If you think that looks like a Ford Mustang, you're partly right. The Mustang is a very profitable product, and it's not going anywhere no matter where car sales go. But, also, performance versions of other vehicles. They're doing a performance version of the Edge crossover, which is a new thing and a different thing and they're trying it to see how it works. Those packages deliver good margins and they create excitement among buyers. People come to the dealers to see them, they consider them. People who buy them are enthusiastic about Ford. They are good business cases for performance vehicles.

That's happening. Bob thinks that 2018 in retrospect will turn out to probably be the trough. As they revamp the product lineups in China and shift gears in Europe and cut unprofitable product lines and so forth and so on, all of this stuff going on all at the same time. That's happening, and things will look better in a few years.

They're also investing, of course, what is -- when we're talking about double-digit billions -- not anything like that, but still real money, serious money, in self-driving and electric vehicles. Those are all coming and will turn, instead of consumers of cash, into revenue and profit generators sometime in the first part of the next decade. Stuff looks tough for Ford right now, but they've got a plan, they're actually acting on it, and the plan makes sense and things will probably look better in a few years. 

The other part of this is that autos is a cyclical business, as we always say. We're probably a lot closer to the end of the cycle than the beginning. Meaning, at some point, a recession hits. What happens in a recession is, automaker profits get squeezed because they have high fixed costs. If they aren't making as many vehicles, then the margin above those fixed costs starts to shrink quickly. Ford says it'll break even at a U.S. market sales pace of around 10.5 million vehicles a year. It dipped below that for several months during the 2008-2009 recession, but it's got to be pretty bad to get down to that level.

We're moving against that. Part of the issues with Ford's stock price --Ford is cheap right now -- is concerns about where Ford is going, which is starting to become more visible, and it's reassuring as it becomes more visible. It's also partly concerns about where we are in the cycle.

As an investment, I would say, if you are thinking long-term, you could probably do worse than to buy it here, reinvest all those dividends. Since auto stocks tend to rise early in the cycle, on the far side of the next recession, when Ford is trading at $13-16 a share, as it very well may be, start to think about where you are.

Douglass: Yeah, I think that certainly makes a fair amount of sense. I mean, it has been frustrating -- I think you share this frustration -- to watch Ford struggling, even though we're maybe not at the end of the cycle quite yet. This has been, economically, a good last couple of years. So, it's certainly been frustrating to see that.

John, since we've got you on the show, let's go ahead and do a couple of quick hits on some auto news. We said we weren't going to talk about Tesla, and we're not going to talk too much about Tesla. But, of course, there are a lot of Tesla challengers incoming. That picture is also starting to firm up. You and I were chatting before the show, and you listed off -- let me see. Jaguar, Porsche, Volvo, Audi, Mercedes Benz, all launching electric cars sometime between now and the end of 2019. 

Rosevear: Yeah, there's a lot coming. We've seen the Jaguar I-Pace. Generally speaking, critics like it a lot. It's in very early production now. Some have been sold in Europe. It will start arriving in the U.S. I think they're saying November of this year. Also coming, Audi has the E-tron Quattro or whatever they're going to call it. It's a mid-sized electric SUV. It's very much a Model X fighter. That is coming early next year. Volvo has a new sub-brand, which is kind of a joint venture with its corporate parent, Chinese automaker Geely, called Polestar. Polestar is going to be bringing out a series of electric vehicles. The Polestar 2, which is said to be coming next year, is an SUV about the size the of the Model 3. It's a crossover. It's a nice, low-slung, all-electric crossover.

Mercedes also has an electric crossover coming next year, the first of several Mercedes Benz electrics that are on the way. They haven't given us a lot of detail about that yet. We've seen a few spy shots. It seems to be in the same size range as if you built an SUV on the Model 3's platform. The much talked-about Tesla Model Y is coming eventually, if Tesla gets its act together. 

These are all coming between now and the end of next year. They're all long-range, range comparable to Tesla, premium electric vehicles built by automakers who will not have Tesla's challenges around manufacturing. It's going to be interesting to see how this plays out. 

Douglass: Yes. And unfortunately, from an investing perspective, a little early to pick out winners and losers, until we really start seeing how these cars come out and what those initial sales numbers look like. 

Let's talk about GM a little bit. We've talked about Ford, we might as well talk about GM. There's a new pickup line that they're coming after.

Rosevear: We should back up one step and say, GM is turning out great profits.

Douglass: [laughs] GM's doing great, yeah!

Rosevear: They did their whole line of crossover SUVs. There are like nine of them that are all-new since the beginning of 2016, all the way from a little Chevy to a Cadillac. There are a few more in the pipe. They're selling like hotcakes in the U.S., they're selling like hotcakes in China. Some of them are over there, as well. The Cadillac XT5 is doing well in China. The Chevy Equinox is picking up steam in China. They have an affordable SUV that they developed under their Baojun brand, which is a joint venture GM set up to compete with domestic Chinese automakers who sell these low-cost SUVs. The idea is, it's a low-cost Chinese SUV but with global automaker quality. It's selling like crazy in China. They're doing well there. So, they're making their making bank. [laughs] They're doing very well. 

Coming up next for them is all-new pickups. These are a big leap ahead, they are saying, from their current pickups. It's all-new from the ground up. Whereas their last new pickups in 2014 were a heavy-duty overhaul of what they'd had before, these are really all-new. They're significantly lighter, they're cheaper to manufacture. They follow the patterns of other GM products in recent years in that they've created more upscale options that they hope will be appealing and expand the overall margins of the truck program. They've had success doing that with the crossovers. The new crossovers, the new Chevy Equinox that came in, is not only nicer in its base version than the older old one by a significant margin, but you can option it up further. That has helped GM's profit margins. Their operating margins have gotten very strong. They're expecting to do the same things with the pickups. 

Now, with GM, they launched the full-sized pickups and the mid-sized pickups and the big SUVs that are based on the same frames, the same platforms. Those are things like the Chevy Tahoe and Suburban, the GMC Yukon and the Yukon Denali, and then the Cadillac Escalade. Those are all going to be all-new, too. Out probably 18 months from the end of the year. And, the new GMC Canyon and Chevrolet Colorado pickups, which are mid-sizers that compete with the upcoming Ford Ranger, which we'll talk about, too. 

GM is doing all of this. It's spending money to do this, but it's making a ton of money from the crossovers, so margins still look pretty good.

Douglass: Yeah. And then, of course, our third quick-hit story, which you teed up there, is that the pricing for the new-to-the-U.S. Ford Ranger pickup was just released.

Rosevear: Well, it wasn't officially released, but Ford made the built-in price tool live on its website. They didn't put out a press release or anything. But there was one day. Starting price on the Ranger is $25,395. That's a rear-wheel drive extended cab XL model. XLT starts at just over $29,000. Then, the top trim for now is going to be a Lariat at $33,300. 

These all have the same engine. It's the turbo 2.3-liter four-cylinder EcoBoost with the new 10-speed automatic transmission. You can get it with a shorter bed or a longer bed. You can get super cab, which has a small backseat, and the super crew, which has a conventionally sized backseat. That's a couple of thousand extra. Rear-wheel drive, four-wheel drive. It's not going to have quite the lavish options list that the F-150 does, but it's a Ford truck. There'll be plenty of ways to configure it. You'll be able to get one stripped for $26,000 for your business, or load one up, probably over $40,000 for a nice daily driver that's comfortable and has the good stereo and the leather seats and all that kind of stuff. 

Douglass: Fancy. I will be in the car market probably in the next six to nine months, so I think you and I are going to have a few more conversations on or off the podcast. We'll figure that out. 

Rosevear: Alright, then!

Douglass: Alright! Well, thank you, John! That's it for this week's Energy and Industrials show. Questions or comments, you can always reach us at [email protected]. As always, people on the program may have interests in the stocks they talk about, and The Motley Fool may have formal recommendations for, so don't buy or sell stocks based solely on what you hear. This show is produced by Austin Morgan. For John Rosevear, I'm Michael Douglass. Thanks for listening and Fool on!