When Ford (NYSE:F) reports earnings on Oct. 28, investors should anticipate better-than-expected earnings, sending Ford stock up in the short run. That’s according to Deutsche Bank analyst Emmanuel Rosner.
But as I’ve written before, low-returning companies also make the worst long-term investments. Though Ford might reward investors this year, investors with longer-term horizons should consider better bets.
In the race to find the best legacy car manufacturer, one surprising company stands out: Fiat Chrysler (NYSE:FCAU). Here’s why investors looking to profit from a post-pandemic recovery should dump Ford and buy FCAU instead.
FCAU vs. Ford Stock: Battle of the Legacy Makers
Before that, here’s an important disclaimer: legacy carmakers have often disappointed long-term investors. They’re extraordinarily capital-intensive and face highly cyclical demand. That lowers return on invested capital (ROIC) and makes them prone to bankruptcies – two terrible qualities for long-term investment. U.S. carmaker stocks haven’t looked particularly attractive since the 1960s.
But with the coronavirus pandemic, even growth investors like myself have started looking at cheap carmakers. And that explains Ford stock’s recent popularity.
Ford Stock: Cheap, but not Cheerful
In September, Robinhood, a popular trading app, showed Ford stock as the No. 1 holding by investors on the platform. Never mind that the automaker had averaged just 3.3% ROIC over the past decade (the median large-cap company earned 8.2%). Or that Ford was in the red with -15% and -40% EBIT margins in its two growth markets: South America and China. And that was in 2019 before the coronavirus pandemic sent profits even further down the drain.
Investors only seemed to care that Ford stock looked cheap.
Today, Ford trades at just 9x forward earnings. That means even a minor re-rating to 12x would (mathematically speaking) push the stock up by a third.
And that’s what investors are hoping to see. U.S. dealerships are now carrying lower-than-normal inventories from spring-time factory shutdowns. And with analysts like Rosner calling for positive earnings surprises, Ford stock could rise in the short term. But there’s an even better choice than Ford.
FCAU Stock: Quieter Name, Better Stock
Since its merger in 2014, Fiat Chrysler has proven itself adept at self-help. EBITDA margins improved from 8.5% in 2013 to 9.6% in 2019 as Fiat capitalized on its partner’s premium-segment profitability. (Ford’s EBITDA margins sank from 14.8% to 5.7% during the same period).
The company is also relatively cheap, thanks to its higher margins. Whereas Ford trades at 9x times forward earnings, FCAU trades at just 7x times, one of the lowest in the automobile industry.
How has FCAU managed such profits? Thank Fiat Chrysler’s late CEO, Sergio Marchionne. Under his leadership, the combined company cut costs, brought Chrysler back from the brink, and revitalized its sales in emerging markets.
Consider Chrysler today. Dodge Ram (owned by Chrysler) is the No. 2 pickup truck sold in the U.S. That’s right behind Ford’s F-Series. But on average, Rams are priced $3,000 higher. In automobile terms, that’s a world of difference. Chrysler’s U.S. EBIT margins are now 7.4%, compared to Ford’s 2.5%. It’s the same story in Latin America, where FCAU earns 2.5% EBIT margins compared to Ford’s -24.1% losses.
So why is Fiat Chrysler so cheap?
FCAU-Peugeot Merger: A Leap of Faith
For car manufacturers, no turnaround is ever complete. FCAU’s ROIC of 4.6% still lags the average company. (After all, it’s still a car company). And its European operations still doesn’t earn its cost of capital – Fiat’s Italian unions are famously difficult to work with, and the European car industry has long grappled with oversupply. (Ford also loses money in Europe.)
There’s also another wrinkle in the FCAU saga – in December 2019, the company announced a planned merger with rival Peugeot (OTCMKTS:PUGOY) to face its massive upcoming investments in electric vehicles (EVs).
It’s an ideal merger of equals that should help both companies.
“Peugeot has demonstrated that it has capable and pragmatic management,” writes Maryann Keller, a transportation analyst. “The company took on General Motors’ unprofitable European operations and turned them around a year later.”
But for every successful merger like Fiat/Chrysler or Volvo/Geely, there are equally unsuccessful ones like Daimler/Chrysler and Renault/Nissan. And in finance, risk creates price discounts. Both companies have already made concessions to address antitrust issues.
On the other hand, Ford holds $40 billion in cash and equivalents, as much as its entire market capitalization. In other words, investors buying Ford stock today (worth around $7.50) will get around $10 of cash for every share they purchase and receive the rest of the company for free. Getting paid to own stock sounds like a great deal.
But then, there are valuations.
What’s Ford Stock Worth Compared to FCAU?
Calculating FCAU’s value independently of the Peugeot merger puts fair value around $36/share or 10.8x 3-year trailing earnings. That implies a substantial 180% upside from today.
The same calculation run on Ford’s stock comes to a fair value of $0. (That’s what happens when companies earn below their cost of capital for the long run). In other words, Ford’s current earnings projections won’t cover debt repayments at Ford Credit, its junk-rated financing arm. That would trap Ford in an endless cycle of debt, turning the firm into a “zombie company.”
So, if you’re thinking of buying Ford stock, think again. Buying a money-losing company is much like playing consecutive games of roulette with a green “house-takes-all” slot on the wheel (also known as the “0” or “00” slot). Players might score big wins at first. But play the game long enough, and there’s little chance for a good outcome.
On the date of publication, Tom Yeung did not have (either directly or indirectly) any positions in the securities mentioned in this article.
Tom Yeung, CFA, is a registered investment advisor on a mission to bring simplicity to the world of investing.
