Description

An American icon… A market cap in the multi-billions… average daily volume in the multi-millions… and now a VIC posting – how can it be???? Yes, we are suggesting a short sale of Ford Motor Company (“F”).

Quick background

F has been making cars for over 100 years. During that time the company has grown into a behemoth with roughly $170 billion in total revenues, 300,000 employees, and worldwide operations. The company is organized into two segments – automotive (Ford, Lincoln, Mercury, Volvo, Jaguar, Land Rover, and Aston Martin) and financial services (Ford Motor Credit and Hertz). While automotive accounts for approximately 85% of F’s 2004 revenues, it generates only about 15% of F’s earnings. Conversely, the financial services segment is expected to generate roughly 85% of F’s profits even though it accounts for just 15% of total revenues. In some years, the financial services segment generates north of 100% of F’s earnings. For those interested in learning more, further detail can be found on F’s website and in its SEC filings.

Issues

Our short thesis is that a multitude of issues will conspire to result in F’s 2004 EPS of $2.10 +/- being its peak EPS for some time, potentially forever. Here are some of our concerns:

(1) Financial services profitability set to fall. 2004 has been a blockbuster year for F’s financial services segment. Excess profitability has been driven by a particularly steep yield curve, abnormally low credit loss provisions, and lower than usual depreciation expenses. Collectively, these factors have resulted in a return on equity greater than 20% vs. a more normalized level in the low double digits. We believe that rising interest rates, a flattening yield curve, a return to sustainable credit loss provisions, a likely increase in depreciation expense, and a smaller balance sheet will all materially negatively impact financial services profitability beginning in 2005. For reference, a return to a normalized ROE would chop roughly $0.50 from EPS.

(2) Ongoing and/or worsening secular issues. The industry and company specific headwinds facing F are numerous and intertwined. Here we provide some highlights. (a) Incentives. Since just post 9/11/01 incentives to induce purchases (particularly driven by F and GM) have been escalating. Despite all this spending, total car and light truck sales have remained virtually flat, and F and GM have continued to lose market share. Going forward, we think it is likely that F and GM will have to keep increasing incentives to move vehicles, yet still lose market share. That combination will eat into earnings. (b) Concerning credit trends. In our opinion, low interest rates and easy credit provided by captive finance companies have propped up vehicle sales in recent years beyond the true underlying rate of demand. For example, we observe an increasing maturity of new car loans (thereby maintaining monthly payments even though consumers are further in debt) and an increasing spread between consumer loan rates and auto finance rates (evidencing the subsidy captive auto finance co’s are providing to consumers). As with any situation where consumers have been induced to buy on credit, potentially beyond their means, we worry what might happen if credit tightens and/or the economy stumbles. (c) F (and GM) continue to lose market share. In fact, the domestic OEMs have been losing roughly 1 point of market share a year for the last 20ish years. We expect no change in this trend. The fundamental problem is that in general the domestic OEMs make less desirable, lower quality vehicles and spend more money to do so. Compounding the problem of market share erosion is that F has an infrastructure and liabilities that are more appropriately sized for the company’s historic glory days. Many of these costs/obligations are fixed and thus a fall off in volumes is particularly painful. (d) Overcapacity. There is currently too much capacity in the domestic auto industry and based on industry projections the situation is not anticipated to get better. The problem is that while the domestic OEMs are taking out some capacity, the foreign transplant manufacturers are building new factories. Exacerbating the issue is the fact that the plants being opened by the foreigners are typically non-union and far more efficient than the older, unionized plants of the domestic OEMs. Worse still is that much of the capacity being added by the foreigners is to make SUVs and pickups, the last remaining profit centers on the vehicle side for the domestic OEMs. (e) Old and cold products. As discussed, the domestic OEMs have less desirable products necessitating higher incentives than foreign competitors. Unfortunately, this disparity is likely to get worse as over the next four years all meaningful foreign competitors are anticipated to bring out an above average percentage of new models while the domestics are expected to be below average. Thus, in four years, the domestic OEMs will likely have a relatively even less interesting product portfolio than they do today. (f) Building inventory / looming production cuts. It should come as no surprise given all of the above issues that we expect F will have to lower its rate of production in the future. Since F books its earnings when it puts vehicles into the channel rather than when they are ultimately sold, a drop in production directly hits the bottom line. For reference, one street analyst estimates that F overproduced 125,000 light trucks in 2004. Even though these “extra” trucks sit in inventory in the channel, they are estimated to have added $0.29 to F’s 2004 EPS.

(3) Pension, healthcare, etc. / SEC investigation. Typical of many old school companies with a unionized workforce, F has onerous pension and healthcare liabilities. The situation is exacerbated because F currently has more retirees collecting benefits than it has active employees. And now the situation has gotten even worse – as of a few months ago, the SEC’s Division of Enforcement began an inquiry into the pension and OPEB accounting of F and others. We believe the SEC is moving now to try and prevent the type of debacle that has arisen in the airline industry. Our expectation is that the SEC will ultimately require more conservative assumptions which will in turn lead to lower EPS and higher cash funding requirements.

(4) In one form or another, F will likely be required to bailout Visteon. Once a part of F, Visteon is still a critical, if not the most important supplier to F. Additionally, F and Visteon are still financially linked, most directly through the roughly 20,000 union employees Visteon employs which were assigned to Visteon from F at the time of the 2000 spin-off, and for which F assumed the postretirement healthcare and life insurance obligations. Unfortunately for F, Visteon’s results have been very poor. Based on comments from F management, we believe it is likely that F will provide financial assistance to Visteon in the near future. The exact form of such aid is uncertain (e.g., taking union workers back, paying higher prices), but the end result is the same – a negative impact on F’s financial performance and competitive position.

(5) Raw materials costs, particularly steel, have been rising. These increases put F in a difficult position as the company has little power to pass through input cost increases due to the competitive dynamics and over capacity in the industry. The rise in input costs has been somewhat mitigated to date by long-term contracts, however, as these contracts role off, F will have to shoulder even more of the burden. Adding to the sting of the increase in steel prices is the rise in the price of other inputs including plastics and energy. F may also be hurt by the rise in the price of gasoline as, on the margin, that increase may cause consumers to shift purchases to low (or even negative) profit cars away from highly profitable SUVs and pickups.

Risks (i.e., what can go wrong)

F management is hoping to get to $2.50 EPS for 2006. Depending on your views on an appropriate multiple and discount rate, such EPS could lead you to a higher stock price than the current $14.80 per share. While the headwinds facing the company are severe, a bull on F would argue that with roughly $150 billion in automotive sales and another $25 billion in finance company revenue that continued cost cutting opportunities will rule the day and enable management to achieve the $2.50 goal. We agree that there is still fat to be trimmed at F, but note that the company has cut a few billion dollars of costs in recent years. As with any diet, the pounds (i.e., the cost cutting dollars) get more difficult to take off as the program continues. Furthermore, we contend that given the many issues discussed above, even with severe cost cuts F will have increasing difficulty in maintaining current profitability levels let alone growing earnings – i.e., like a runner on a treadmill, F can expend meaningful efforts to stand still, but ultimately the runner will tire and go flying off the back and onto the floor.

Conclusion

Putting it all together – i.e., falling finance company profitability, ongoing and/or worsening secular issues (escalating incentives, concerning credit trends, market share erosion, increasing supply and overcapacity, relatively old and cold products, building inventory, looming production cuts), mounting pension and other legacy liabilities, SEC investigation of pension accounting, potential bailout of Visteon, rising raw material prices – we think F’s 2004 EPS of $2.10 +/- will be its peak for some time, likely forever. For example, it wouldn’t surprise us if in 2006 F earns less than half of what it earns in 2004. Additionally, we believe there is a reasonable possibility that F’s equity is ultimately worth no more than the discounted value of the dividends that will be paid prior to an eventual bankruptcy filing and associated restructuring. As such, in our opinion, at $14.80 per share F is a compelling short.

Catalyst

- Falling finance company profitability
- Ongoing and/or worsening secular issues (escalating incentives / concerning credit trends / market share erosion / increasing supply and overcapacity / relatively old and cold products / building inventory / looming production cuts)
- Mounting pension and other legacy liabilities (including SEC investigation of pension and OPEB accounting)
- Potential Visteon bailout
- Rising raw material prices