This month, Ford (NYSE:F) received a seemingly unwelcome surprise. Bond rating agency Moody’s cut the rating on Ford bonds to “junk” levels. And while that cut focused solely on the company’s credit, it had a ripple effect on Ford stock. The F stock price opened down almost 5% the following day.
That said, Ford stock quickly recovered most of the losses. Though the stock has drifted slightly lower since then, other factors — notably a strike at rival General Motors (NYSE:GM) — may be playing a role.
I still think Ford stock is an intriguing, if high-risk, play. The company’s strategy makes sense for the “new normal” in automotive manufacturing. The Moody’s cut aside, the balance sheet seems to be in reasonably good shape. Valuation is attractive, and a 6%+ dividend yield helps the case as well. Moody’s may think Ford bonds are “junk,” but I’m far from believing that’s the case for Ford stock.
F Stock and the Moody’s Cut
Moody’s cut its rating on Ford to “Ba1,” one notch below investment grade. And while the headlines screamed “junk,” it’s important to put that cut into context.
First, Moody’s, at least so far, is alone in making that move. Rivals Fitch and Standard and Poor’s both have maintained Ford bonds at investment-grade (albeit at the lowest level). And as the Los Angeles Times pointed out, Ford bonds already were trading at more than a 3-point spread to U.S. Treasuries.
In other words, bond investors weren’t necessarily treating Ford credit as investment-grade to begin with. From both standpoints, the downgrade isn’t necessarily news. And with the other issuers keeping Ford in investment-grade territory, Ford’s borrowing costs aren’t necessarily set to rise, as might be the case if all three agencies moved in lockstep.
That said, even investors in Ford stock should pay attention to some of the issues raised by the rating cut. Moody’s noted that the company’s operational restructuring will have cash costs of some $7 billion. Those costs often are excluded from adjusted earnings calculations and forecasts. But at nearly 20% of Ford’s market capitalization, they can’t be ignored.
Moody’s also highlighted weakness in the company’s business overseas and domestically. Ford posted a $1 billion profit in China in 2016. It’s now posting a loss. Margins in the core North American business are shrinking. And the agency highlighted the risk of a recession to the automaker.
As far as bearish argument goes, it’s a solid one. But it’s also an argument well-known to equity investors at this point. And it’s an argument that still strikes me as too pessimistic.
The Case for Ford Stock
As even Moody’s pointed out, Ford actually has a rather strong balance sheet at the moment. The cash in the automotive business still exceeds the company’s debt.
That alone doesn’t remove the risk from Ford stock. Again, the company needs substantial cash for its restructuring. In a recession, dividends from Ford Credit will dry up — and credit losses can amplify that effect. Ford and Tesla (NASDAQ:TSLA) famously are the only two U.S. automakers to avoid bankruptcy.
Still, Ford is in a much better position than it was last decade, when it narrowly survived the financial crisis. And its strategy going forward makes sense. It has shrunk its product lineup domestically, finally giving up on trying to compete with Toyota (NYSE:TM) and Honda (NYSE:HMC) in smaller cars.
Instead, Ford is going to sell pickup trucks and SUVs — still a great business, as Barron’s detailed last week — and electric vehicles. Perhaps lost in the coverage of the Moody’s cut was that the company announced plans to launch eight new electric vehicles in Europe. That effort is part of a plan to drive over half of revenue from electric cars by 2022.
Given the valuation assigned Tesla stock, success on the EV front could lead to significant multiple expansion and a big jump in the F stock price. After all, Ford stock trades at less than 7x earnings. Even a double-digit P/E multiple, including dividends, suggests 40%+ total returns from current levels.
Don’t Focus on Just the F Stock Price
That said, investors shouldn’t ignore the downgrade altogether. Just because Ford stock is cheap doesn’t mean it’s a buy. And chasing a 6%+ yield, on its own, is a dangerous strategy, as investors have learned with other U.S. manufacturers of late. (General Electric (NYSE:GE) probably is the best example.)
Even though it’s a credit rating agency, Moody’s raises some good points when it comes to Ford stock. Still, the rating itself doesn’t change the case, and F stock has faced more than its share of skeptics in recent years. I still believe those skeptics will be proven wrong at some point.
As of this writing, Vince Martin has no positions in any securities mentioned.