With the exception of a brief dip in November, Ford Motor Company (NYSE:F) stock currently trades at its lowest levels in over four years. And Ford stock certainly looks cheap. F stock trades at about 6.7x estimated 2017 earnings per share — one of the lowest earnings multiples in the entire stock market.
At first blush, that simply looks too cheap. The macro picture looks reasonably strong, and in theory that should help auto demand. Ford remains an iconic brand, and unlike rival General Motors Company (NYSE:GM) didn’t go bankrupt during the financial crisis. Ford stock offers a 5.3% dividend yield at this point.
And yet Ford stock now is worth less than that of Tesla Inc (NASDAQ:TSLA), whose production is just a fraction of Ford’s.
But there’s good reason for the low valuation placed on F stock. It certainly appears that the auto cycle is at a peak — and the same may be true for Ford margins. The company itself is guiding for a 9% decline in 2017 EPS. And while Ford is pointing to 2018 as a rebound year, higher commodity costs (notably steel) already are casting a shadow on future profitability. And longer-term concerns remain.
Ford stock is cheap — but it’s cheap for a reason.
Ford Earnings on the Decline
It’s a very dangerous effort to try and figure out when a declining business is just “too cheap.” Obviously, the question relative to Ford stock is whether this really is a declining business, over the long-term, or whether 2017 guidance for a 9% decline in EPS is just a short-term blip.
There should be real concerns that 2016 represents a peak, or something close to it. Overall sales numbers are coming down, with March numbers the worst in two years. Inventories are up, and production is down — despite higher incentives from manufacturers and dealers.
The problems aren’t just short-term. The intense contraction in auto sales during the financial crisis led to an increase in the average age of U.S. cars. That in turn led to a pent-up amount of replacement demand earlier this decade, which boosted sales and profits for Ford, GM and other auto makers. But that demand now has been met, and it certainly appears as if auto sales should return to more normalized levels.
That’s a problem for Ford. The fixed-cost nature of the manufacturing model and wage inflation in the U.S. means even flat revenue leads to lower profits. (Indeed, that’s precisely what is expected in 2017.) And with so many foreign manufacturers having built capacity in the southern U.S., lower demand is going to lead to higher competition — and higher incentive spend, further pressuring margins.
If 2016 is a peak, then it’s simply difficult to buy F stock at almost any price. Declining businesses are difficult to value, and usually come with a nasty surprise. The obvious concern relative to Ford stock is: if 2017 is what happens when the economy is good, what happens when the next recession comes?
Help Is Not on the Way for Ford Stock
If the U.S. market is at a peak, that’s a major problem for Ford — because there really aren’t any other ways to drive growth. North America pre-tax profits in 2016 were $9 billion; the rest of the world contributed just $400 million, or about 7 cents per share after-tax. That’s unlikely to get much better, even though Ford is expecting some overall improvement in 2017.
For one, the strong U.S. dollar hurts Ford’s competitiveness overseas. Secondly, competition, particularly in developing markets, is intense. GM actually sells roughly triple the amount of cars in China that Ford does. Ford has a sub-3% share in India as well.
Ford really is at the mercy of the domestic market — and that’s a problem.
And F Stock Is Not Alone
It’s not as if the market is only punishing F stock and GM stock for its overall concerns. Major auto parts manufacturers such as Lear Corporation (NYSE:LEA) and Dana Inc (NYSE:DAN) are trading at sub-9x forward P/E multiples.
It’s possible the market is wrong — but that doesn’t necessarily mean Ford stock is the best way to bet against the “peak auto” argument. Many suppliers would benefit from better-than-expected sales, and without the risk from Ford’s debt and pension obligations.
The one out for Ford stock is to win in either electrical vehicles or autonomous driving — and that seems tough to project at this point. Tesla has a pretty solid head start — even if TSLA bulls might be a bit ahead of themselves. Early autonomous and EV development is going to center on the same smaller cars where Ford has struggled to compete for decades.
There’s a path to upside for Ford stock — but it’s hardly guaranteed, or easy. The risks are real, and from here it looks like the market has F stock priced about right. Yes, 6x earnings is cheap. But if those earnings are declining over the long-term, then it’s not cheap enough.
As of this writing, Vince Martin has no positions in any securities mentioned.