Last week, Ford Motor (F 0.29%) reported solid results for the third quarter. Nevertheless, shares of the No. 2 Detroit automaker plunged 6.6% on Thursday -- the day following the earnings release -- as investors reacted negatively to Ford's reduced full-year guidance.
Ford certainly has a lot of work to do to fix parts of its business that are struggling and adapt to an expected shift toward electric vehicles. That said, the headwinds it expects for the fourth quarter are likely transitory. As Ford continues to execute its turnaround strategy over the next couple of years, profitability should improve significantly.
Good third-quarter results, but bad guidance
Ford's revenue decreased slightly on a year-over-year basis last quarter, falling from $37.6 billion to $37 billion. However, its adjusted operating margin improved to 4.8% from 4.4% a year earlier, as some of the company's initial restructuring moves began to pay off and its Ford Credit subsidiary continued to post big profits.
As a result, Ford's adjusted operating profit rose to $1.79 billion from $1.67 billion in Q3 2018. On a year-to-date basis, adjusted operating profit has increased 6.3% to $5.89 billion. These solid operating results also powered strong growth in adjusted earnings per share, which reached $0.34 last quarter, up from $0.29 a year earlier. This smashed the average analyst estimate of $0.26. Free cash flow also improved slightly year over year in the third quarter and has increased by just over $1 billion for the first nine months of the year, reaching $2.29 billion.
Unfortunately, Ford expects to face greater headwinds in the fourth quarter. The company reduced its full-year adjusted operating income guidance by $500 million, to a new range of $6.5 billion to $7 billion.
The new guidance implies that Ford's adjusted operating profit will come in between $600 million and $1.1 billion this quarter, down from nearly $1.5 billion a year earlier. Most of the expected drop can be attributed to the ratification bonus payments that Ford's unionized employees will probably receive later this quarter. Still, the result is that Ford will fall short of its goal of growing adjusted operating profit this year.
Digging into the guidance cut
While bonus payments will drive most of Ford's likely earnings decline in 2019, this expense was already built into the company's previous forecast. There were three main factors behind the recent reduction to its full-year outlook.
First, warranty costs are coming in higher than previously expected, particularly for 2018 model year and older vehicles. Second, Ford has had to ramp up incentive spending recently to stay competitive in certain vehicle segments. Third, the Chinese auto market is taking longer to recover than expected, with total auto sales down 11.7% in the first nine months of 2019 on top of a 3% dip last year.
On the bright side, quality improved significantly on 2019 model year vehicles, which suggests that warranty costs should eventually recede. Additionally, Ford executives said that the competitive environment remains quite rational with respect to incentives. As Ford updates and expands its portfolio of SUVs and trucks, pricing trends may improve.
It will take longer to fix China. But Ford has already started to reduce its losses there, and it plans to produce more vehicles locally in the years ahead, which should significantly improve its profitability. In a worst-case scenario, it could always pull out of the market, where it lost more than $1 billion last year.
Ford is in better shape than the skeptics think
Ford stock currently trades for just seven times earnings. This indicates that investors generally doubt the company's ability to turn itself around. To be fair, Ford faces significant headwinds, including slowing auto sales in many markets and the cost of developing hybrid and electric vehicles.
However, Ford also has a huge opportunity to improve its core business with recent moves to freshen its vehicle portfolio (particularly in North America) and restructure its unprofitable international operations. There will undoubtedly be ups and downs in the years ahead. In the long run, though, Ford stock is likely to head higher as the benefits from its turnaround initiatives start to outweigh any temporary headwinds the company may face.