This article is part of our Rising Star Portfolios series.
When Ford Motor (NYSE: F) landed on the watchlist for my Messed-Up Expectations portfolio, I was a bit surprised. With better than a dozen analysts following the company, I wouldn't expect the market to ever reach a point where growth in free cash flow (FCF) was expected to be so low as to pass my screen, but that's exactly what happened. And I, for one, am not going to let the opportunity to invest in this strong, and strengthening, company pass me by.
The catalyst to this opportunity, I believe, is Ford's recent earnings report, which wasn't quite what the market expected. First, analysts were worried about costs in the fourth quarter that increased more than expected. Several analysts asked questions on the conference call focusing on this issue. Second, Ford's European division reported an operating loss of $51 million and more than a percentage-point drop in market share. Third, in the days following the report, several analysts cut their one-year estimates and/or price targets.
While those concerns are valid, I believe Ford is doing several things to minimize their effect. In combination, they show that Ford is focused on margins and growth.
Ford's response
First, the company's "One Ford" strategy is simplifying its engineering and manufacturing process. One result is that Ford is now building cars off the same base, with just regional differences, all around the world. CEO Alan Mulally referred to this in the last call when he said, "10 different top hats off that new C1 platform, with 80% of the parts the same." With that much the same, efficiency -- and cost savings -- follow all down the line.
Second, Ford consciously chose not to chase low-margin business in Europe last quarter. While that hurt market share in the short term, Mulally is confident that the new models coming out and the recovery in "the fundamental market" will lead to renewed growth in Europe.
Third, of the U.S. and Asian automakers, Ford was one of only two to significantly reduce incentives in the U.S. in January. While Ford's January sales grew by 13%, behind GM's 22% growth, boosting incentives to grow sales is of limited value over the long term, especially when costs increase, like commodity costs are doing currently.
|
Company |
Average Incentive |
Year-on-Year Change |
|---|---|---|
| Chrysler | $3,414 | (1.3%) |
| Ford | $2,407 | (11.0%) |
| General Motors (NYSE: GM) | $3,663 | 16.0% |
| Honda Motor (NYSE: HMC) | $2,016 | 41.0% |
| Nissan | $2,510 | (16.0%) |
| Toyota Motor (NYSE: TM) | $1,962 | 24.0% |
Source: Autodata Corp.
Finally, Ford has done a wonderful job toward right-sizing its balance sheet. In 2010, it paid off $14.5 billion in debt and ended the year with its automotive division in a net cash position. Considering that it had $8.7 billion more in debt than in cash a year ago, that's outstanding. The discipline and focus that that demonstrates will serve Ford well going forward.
A kicker
The biggest risk Ford faces is a collapse of the world economy back into recession. Yet the further we get from the end of the Great Recession, the less likely that appears, at least in the near term.
On top of that, there's pent-up demand. The recession put a damper on new car buying, with auto sales dropping for three straight years before 2010 saw a turnaround. Just before the Presidents Day holiday, one dealer in Boston noted, "The average age of the car on the road right now is in excess of 12 years, which is the oldest it's been since World War II. So a lot of people will be buying out of need versus desire."
My response
At last night's closing price of $15.23, Ford had very low expected growth of FCF priced in. Just 3.5% per year for the next five years, 1.8% for the following five, and nothing after that (discounting at my hurdle rate of 15%). Given the above, I believe that is too low.
Analysts are expecting earnings to grow by nearly 18% per year for the next five years. Given the company's increased efficiency and pent-up demand, I can easily see Ford growing by 10% for the next five years. If it does that and then drops down to a 2.5% terminal growth rate, the company is worth over $21 a share, nearly 40% higher than it is currently.
Ford is a cyclical company in a cyclical industry. While 2010 was great, I believe we're still on the upswing side of the cycle. Tomorrow, the Messed-Up Expectations portfolio will buy about $350 of this carmaker, with an eye toward increasing this initial 2% portfolio position.
After you add Ford to My Watchlist, come tell me what you think on my discussion board or follow me on Twitter.
