One trump card Ford Motor Co. (NYSE:F) has had up its sleeve since the Great Recession is Ford Credit. Because the automaker drove through the financial crisis without needing a government bailout -- thanks to $23.6 billion in loans secured prior to that by then-CEO Alan Mulally -- it wasn't forced by Washington to spin off its banking arm, unlike crosstown rival General Motors, which is still rebuilding its finance division. What few investors realize is that Ford Credit is a profit machine and, thanks to some changes we'll cover below, its cash flow is going to help support the automaker's dividend payment.
That's good news for investors interested in the automaker's dividend, which currently yields 6.3%, and also good news for those concerned about a possible payout cut. However, no investment thesis is foolproof, so let's also consider what could hobble Ford Credit, and make it more difficult for Ford to maintain its dividend.
It's easy to lose track of how important Ford's financial arm is to its bottom line. But last year, Ford Credit easily generated more in adjusted pre-tax earnings than all of the company's international automotive segments combined.
You'll notice that Asia-Pacific was also a strong source of earnings for the company last year, but since then, its results there have changed drastically: During the second quarter of 2018, Ford produced a massive $394 million loss in the Asia-Pacific region. In Europe, it also swung to a loss of $73 million during Q2; combined, its international operations lost $596 million. That caused Ford's adjusted operating cash flow to drop from $3.0 billion during Q1 to a cash burn of $1.8 billion in Q2.
Those losses have caused some Wall Street analysts to ask if Ford should cut its dividend. In response to questions on that front, Ford CFO Bob Shanks explained why Ford Credit could now help cover the dividend, and why the funds from that division hadn't been channeled toward that in the past. Essentially, Ford Credit's cash flow had been reinvested in its business, and put toward growing its total "managed receivables." Ford Credit is now nearing its target of $155 billion in managed receivables (it was about $4 billion short as of Q2), and can now send roughly $1.6 billion to $1.7 billion back to Ford to help fund the dividend instead -- an amount that could cover roughly 70% of the payout.
What could go wrong?
Ford Credit's ability to send cash to Ford is why Shanks confident the company can maintain its current payout level, but other things could interfere. The downside of having a finance division is that outside factors can send its profitability downhill suddenly. For example, when Ford Credit leases a vehicle, it must estimate what the value of that vehicle will be when it's returned at the end of the lease. If Ford estimates appropriately, or if residual values of its vehicles are better than anticipated, that's great news for its bottom line. However, if residual values decline more rapidly than anticipated, leases become less profitable, or lose money. If that occurs, it will hinder Ford Credit's ability to help fund dividend payouts while the automaker works on turning around its international operations.
For an example of how drastically such a turn of events can impact a financing arm's results, let's hark back to the Great Recession. It should be noted that Ford Credit's pre-tax income is the not the same as its cash flow, but this graphic provides a more stable picture of its core business and shows how suddenly things can change.
As you can see, a large decline in residual values crippled Ford Credit's underlying business in 2008; while nothing so drastic is being forecast in the near term for residual values, there are some warning signs. Last year, Bank of America/Merrill Lynch analyst John Murphy issued this dire warning about used car pricing: "If the industry is not large enough to absorb the 3.5 million units coming off lease this year, we may see significant pressure on used-vehicle pricing ensue this year in a very material way and spike down the cycle faster and more furiously than even we're expecting."
Fast-forward to today: Cox Automotive's 2018 Used Car Market & Outlook report predicts 3.9 million off-lease vehicles will return to the used market this year, roughly equivalent to 10% of the 39.5 million used vehicles Cox Automotive expects will be sold. Moody's Analytics forecasts the used car and truck Consumer Price Index (CPI) will decline 1.07% during 2019, and predicts prices will drop again in 2020.
What investors should think
The first takeaway from Shanks' comments and the graphic above is that Ford Credit has been consistently profitable since the recession. Henceforth, more of Ford Credit's cash flow will be sent back to Ford, where it can help fund its dividend even as its overseas operations struggle with profitability. Because of Ford Credit's consistency in recent years, investors should remain confident that Ford can maintain its current payout level as Shanks' states.
However, investors should watch what happens to residual values of vehicles over the next few years as waves of off-lease vehicles continue to hit the markets. Those could send prices lower, potentially reducing Ford Credit's profitability, its cash flow, and its ability to contribute to the dividend. So far, used-vehicle demand has been strong enough to absorb the increasing numbers of off-lease vehicles flooding the market, but more will continue to arrive, so lower purchase prices and reduced residuals remain a real risk. That's a major threat to Ford's dividend that many investors are missing.