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Ford: A High Dividend But Uncertainties Linger

Founded in 1903 in Dearborn, Michigan, Ford (F) is one of the largest automakers. In 2018 the company sold 6 million cars, SUVs, and trucks under the Ford and Lincoln brands in North America, South America, Europe, the Middle East, Africa, and Asia. Last year Ford's worldwide market share was 6%. 

Ford is a very global company, but it remains most competitive in North America where its market share is by far the highest of any region it competes in. 

  • North America: 13.4% market share
  • South America: 8.3%
  • Europe: 7.2%
  • Middle East & Africa: 3.0%
  • Asia Pacific: 2.5%

Unfortunately, Ford's international operations have struggled to produce profits and racked up a $2.2 billion pre-tax loss for the company in 2018. As a result, the company's North American business generates more than 100% of the company's automotive profits.

  • North America: 140% of operating income
  • South America: -13%
  • Europe: -7%
  • Middle East & Africa: 0%
  • Asia Pacific: -20%

Ford's Mobility segment, which invests in future technology focused on driverless cars, is also losing money as the company remains in the early stages of monetizing these long-term investments.

Finally, Ford Credit is the company’s financing arm and helps customers pay for the new vehicles they purchase. Ford Credit is the only other profitable business the company has outside of North American autos and accounted for 37% of the company's total pre-tax profit in 2018. 

Business Analysis
The auto industry has historically been a poor choice for conservative investors seeking safe and growing dividends for several reasons.

First, the industry is extremely capital intensive, with enormous fixed costs stemming from the large factories required to manufacture vehicles. These plants need to be running at high utilization rates to generate sufficient returns on investment. However, the cyclical nature of auto sales means that the industry goes through periodic boom and bust cycles, creating wild swings in margins and profitability.

The second strike against automakers is the incredibly competitive nature of the industry, which results in very few enduring competitive advantages for any firm. Auto manufacturers tend to have little pricing power, in part because they need to keep their costly factories pumping out vehicles to stay efficient, which results in uncapped industry supply.

As a result, these businesses have historically found themselves slashing prices for consumers and selling vehicle fleets at low margins to rental companies during industry downturns to rid themselves of excess inventory.

The U.S. auto industry has been especially vulnerable over the years thanks to a large reliance on higher margin, larger vehicles such as trucks and SUVs, which accounted for nearly 80% of Ford's U.S. auto volume last year. 

The sale of such vehicles can be especially fickle, especially during times of recession or high fuel prices. However, this risk has been reduced by steady improvements in engine technology and fuel efficiency which is why crossovers and SUVs have become more popular not just with US consumers, but around the world.

As a result, Ford announced that by 2020 it will stop selling almost all of its sedans in the U.S. and will focus entirely on crossovers and SUVs (as well as the Mustang and Ford Focus Active). 

Despite the industry's challenges, it's worth noting that Ford has come a long way from the dark days of the Financial Crisis. While the company didn't have to take a bailout from the U.S. government (as Chrysler and GM had to), the automaker was still heavily burdened by: excessive capacity, way too many product lines, and enormous legacy costs such as the United Automobile Workers (UAW) healthcare and pension liabilities. 

Under former CEO Alan Mulally, the company undertook a three-pronged turnaround effort which included:

  • Shedding itself of most of its legacy medial liabilities (tied to labor contracts) to become more cost competitive. The big three U.S. automakers established a health trust (now operated by the UAW) in which they made a one-time payment of $56.5 billion to cover $88 billion in future healthcare liabilities for 750,000 retirees and their dependents.
  • Selling off or discontinuing non-core brands like Volvo, Land Rover, Jaguar, Aston Martin, and Mercury (Ford had 27 global vehicle platforms and plans to have just eight in the future), reducing product development costs.
  • Significantly improving quality to make its vehicles more competitive with companies like Toyota who are famed for their reliability. 

With far less legacy UAW costs, Ford's profitability is now vastly improved. Consider that in 2007 when the Big Three (GM, Ford, and Chrysler) built more than half of all vehicles sold in the U.S. car market, they were losing more than $300 per car produced, according to The Wall Street Journal. Just one decade later, and despite lower market share, the Big Three profited more than $2,500 for every car made in North America. 

However, the company's profitability improvement initiatives are far from complete. In 2017 Jim Hackett (formerly head of Ford Mobility) became Ford's CEO and has announced that Ford is undertaking yet another major global restructuring to reduce costs and improve its competitiveness and profitability around the world.

This $11 billion restructuring plan (expected total cash cost of $7 billion through 2021) is yet another multi-pronged approach that will attempt to turn around Ford's weak profitability in all non-North American markets via a major shift in capital allocation priorities.

Specifically, 90% of future investments will focus on trucks, crossovers, and SUVs which have seen strong market share growth around the world and carry higher margins. That's up from about 64% over the last five-year period and appears to be a logical move given that globally Ford has No. 1 or No. 2 market share in trucks and cargo vans.
Source: Ford Investor Presentation
Trucks and commercial vans accounted for 40% of Ford's volume in 2018 but carried a 14% EBIT margin, well above the company-wide margin of 4.3%, and generated $10 billion in EBIT (143% of Ford's total pre-tax profit).

In the U.S. the Ford F-150 pickup truck has been the best selling vehicle of any type for 37 straight years, the best selling pickup in America for 41 straight years, and the best selling vehicle in the world in 2017 with nearly 900,000 units sold.

In full-size pickups, Ford enjoys 37.6% U.S. market share despite an average selling price of nearly $47,000. And the Ford Expedition (its full-size SUV redesigned in November 2017) had an average selling price of $63,600 in 2018 while still commanding 18% market share.

Simply put, a key part of Ford's capital allocation plan is to double down in its strongest and most profitable business line.
Source: Ford Investor Presentation
Ford is also combining its latest restructuring plan with its earlier strategy of investing $11 billion into electric vehicles (40 new models by 2022). Electric trucks could benefit from greater power (electric motors produce substantial amounts of instant torque), and their naturally higher selling price means that it could be easier to incorporate higher production costs compared to cars.

Within its SUV business, Ford plans to revamp its offerings over the next couple of years. The company has a handful of major refreshes planned that it expects will result in at least 50% of its U.S. and China SUV portfolios consisting of new offerings by the end of 2020 (up from 36% in the U.S. and 20% in China in 2019). 

In Europe Ford's focus will be on shifting production to only its most popular cars (the firm will still sedans there), trucks, crossovers, and SUVs. In South America Ford will be focusing more on crossovers and SUVs (like in the U.S.). 

Ford is also partnering with Volkswagen and Indian car maker Mahindra to help it share the cost of designing new engines and electric vehicles (especially trucks and crossovers) in key global markets. 

All told, Ford expects that once the restructuring is complete and it has improved its global product mix to focus on more popular and higher-margin products, the firm's company-wide adjusted EBIT margin should roughly double to at least 8%. 

Key Risks
While Ford has undoubtedly done an impressive job in turning around the quality of its products and business fundamentals since the financial crisis, there remain numerous challenges ahead that could make it a poor dividend growth stock.

For one thing, Ford remains incredibly dependent on its core North American market for the vast majority of its sales and over 100% of its pre-tax profits. Over the decades, the company has been able to optimize its manufacturing and supply chain in the U.S. far better than in newer markets such as Latin America, Africa, and the Middle East where it frequently loses money.

Commodity prices, tariffs, and currency fluctuations are additional risks outside the company's control that can affect its short-term results. In 2018 these three factors alone reduced Ford's profits by:

  • Tariffs: $750 million
  • Non-tariff commodity price increases: $1.1 billion
  • Currency exchange rate fluctuations: $750 million 

The company also had to spend $775 million related to the Takata airbag recall in North America. The point is that, in addition to operating in a super competitive and capital intensive industry, Ford has to deal with all of these risk factors that make it even harder to consistently generate decent profits and free cash flow.

While the company's turnaround plans in overseas markets seem reasonable, the fact is that Ford's struggles to turn a profit outside of the U.S. have persisted for several years:

  • South America: -$753 million loss in 2017 and -$678 in 2018
  • Europe: $367 million profit in 2017 but $398 million loss in 2018
  • Middle East/Africa: $267 million loss in 2017 and $7 million loss in 2018
  • Asia Pacific: $659 million profit in 2017, $1.102 billion loss in 2018

Ford remains committed to staying in its various markets for now. But it might have to eventually throw in the towel on various money-losing markets (GM sold its entire European business in 2017 after concluding high labor and emission testing costs make it impossible to operate profitably over the long term). 

China especially has given Ford headaches, swinging from a modest $152 million profit in 2017 to a $1.5 billion loss in 2018. While tariffs had a small part to play in that, by far the biggest issue Ford has in the world's largest auto market is its older and less competitive products.

While Ford's 10 new model launches in China might help its boost sales, China is home to hundreds of foreign and local car makers. In other words, new model launches are merely table stakes that hardly ensure success in the future. For example, General Motors is launching 20 new models in China by 2020 and has about 15% market share in that country compared to Ford's 3%.

And investors should also be aware that China's auto market is itself declining for the first time in nearly 30 years, and that's only partially due to the trade war. The highly competitive nature of that market has also resulted in mid-single-digit pricing pressure each year since at least 2012. If China's economy continues slowing down, its auto market could prove to be less of a growth catalyst for Ford than investors hope. 

Investors must also consider the long-term risks of autonomous cars, which are expected to grow rapidly in the coming decades. Driverless cars and ridesharing could reduce overall vehicle ownership rates around the world. In other words,, in addition to the competitive pressures Ford faces in maintaining market share, the overall growth rate of its market could eventually stall or even turn negative.

What about Ford Mobility, which is Ford's hedge against such an uncertain and disrupted future? In 2016 CEO Jim Hackett stated his belief that the global VMaaS (vehicle management as a service) market could eventually reach $100 billion to $400 billion per year and generate operating margins of "at least 20%."

Even if Ford's plan to manage global driverless car fleets (including ridesharing services) works out, it's uncertain how big this market will be, how quickly it will grow, and what market share Ford will achieve.

Crosstown rival GM's Cruise Automation is well ahead of Ford in driverless cars and was last valued by private investors at $14.6 billion in 2018 (RBC estimates it could be worth $43 billion within a few years, more than Ford's current market cap).

Alphabet's (GOOG) Waymo, which was the first driverless car company to launch in 2009, is considered the industry leader and estimated by some analysts to be worth $45 billion today and possibly as much as $175 billion in a few years.

Tesla's (TSLA) fast-growing customer base has been using autopilot for several years as well, providing that company with mountains of data to improve its self-driving algorithms. Competition is steep.

Ford Mobility, which lost $299 million in 2017 and $674 million in 2018, is thus far a money pit. That's because the company has been pouring money into both R&D and bolt-on acquisitions. But with so many large and well-funded rivals to contend with, there is no guarantee that Ford's dreams of winning significant market share in autonomous driving and vehicle management services will ever actually come true. 

Ultimately, Ford Mobility and its operations around the world could prove to be a costly and futile distractions from its lucrative U.S.-based trucks, crossovers, and SUVs businesses.

As if all these risks weren't enough, investors need to remember other industry-specific risk factors such as:

  • Regulatory scandals: on February 21 Ford disclosed a possible U.S. emission violation (VW's emission scandal ended up costing it $30 billion). 
  • Recalls: on February 13 Ford announced a recall of 1.5 million F-150 pickup trucks
  • Brexit: on March 29 Ford said a Hard Brexit outcome "would be catastrophic for the U.K. auto industry and Ford’s manufacturing operations in the country" which could means a big hit to European profitability in 2019 and beyond. 

While none of these issue in isolation is likely enough to materially impact Ford's long-term future, they are challenging for investors to stay on top of and size up.  

Finally, we come to the most important thing for income investors to consider, the safety of Ford's dividend during a future recession.

The good news is that Ford has implemented a hybrid dividend policy, in which it pays out 15 cents per share quarterly, plus a special dividend to achieve a 40% to 50% adjusted EPS payout ratio. The company believes its policy will make the current regular quarterly dividend sustainable in the long term.

The company previously modeled, via a "stress test," a hypothetical future U.S. industry downturn in which sales decline by as much as 36% from 2015's highs. Management projected that Ford's large cash reserves ($26.5 billion at end of 2018) and revolving credit lines (over $10 billion) will likely keep the dividend ($2.9 billion) safe during an economic downturn. 

                                                        Ford's Internal Stress Test
Source: Ford Investor Presentation
However, note that when Ford came up with this variable dividend scenario, the company had a different CEO and CFO. The old regime hadn't yet planned on investing $11 billion into designing new electric vehicles by 2022. And now with Ford announcing an $11 billion restructuring plan, it's possible that Ford will backtrack on its dividend policy, especially if a future downturn is worse than it has simulated in its stress tests. 

In Ford's fourth-quarter 2018 earnings presentation, the company also made clear its prioritization of protecting its balance sheet: 

"Committed to maintaining an investment grade credit rating and debt capacity; fully funded and de-risked global funded pension plans; and cash balances and liquidity at or above $20B and $30B, respectively."

In August 2018 Moody's downgraded Ford's credit rating to Baa3, one notch above junk, and gave the firm a negative outlook. Should management's latest restructuring plan and vehicle design referees fail to deliver their expected benefits, or perhaps be disrupted by a global downturn in auto sales, then Ford may have to seriously consider cutting its dividend to protect its investment grade credit rating. 

On Ford's fourth-quarter 2018 earnings call, management stated that the dividend's safety ultimately hinges on the company's ability to improve its cash flow generation in the future. The balance sheet is strong and supports the dividend during this period of investment, but the dividend's safety really depends on management's forward-looking assessment of the company's earning power:

"The balance sheet is very strong, and we deliberately are running the cash and the liquidity at levels that are above our target, in part because we saw this period of lower cash generation on the horizon, and so we've been planning on that. But at the end of the day, what we as a team have to do is deliver stronger operating performance, and that operating performance includes stronger cash flow...

It's not so binary...if we didn't pay the dividend, we've got $25 billion of cash, I mean, it's really a question, it's not that cash level, it's the ability of the business to generate, as we look ahead, positive cash flow. And we think we are going to be able to do that to a degree that is above and beyond what we delivered in 2018." – CFO Bob Shanks

In prior quarters, when talking about the company's restructuring plans, management made comments that were supportive of the dividend as well:
“It's important to highlight that we believe we can fund these cash effects without impinging on our other capital outlays including investments for growth and our regular dividend.”
The company issued a similar statement in a quarterly filing:
“Based on our planning assumptions, we believe we have sufficient liquidity and capital resources to continue to invest in new products and services, pay our debts and obligations as and when they come due, pay a sustainable regular dividend at the current level, and provide protection within an uncertain global economic environment.”

While the company's strong balance sheet suggests the dividend can be maintained for now even as Ford throws more cash at its restructuring plan, investors need to closely monitor management's efforts to improve the company's operating performance in 2019 and beyond if the dividend is to remain secure in the long term.

Basically, Ford is not a great place for conservative income investors to look for very safe dividends with predictable growth. The auto industry is extremely competitive, capital intensive, and cyclical, and Ford is also dealing with its own company-specific challenges that could create future headwinds.

Closing Thoughts on Ford
Over the last decade Ford has done an impressive job of turning around its previously bloated operations to become a far more streamlined, innovative, and financially healthy company. And its current restructuring and future investment plans, if successful, should improve long-term profitability. 

However, Ford is largely a “show me” story as management seeks to restore credibility with investors (optimizing Ford’s product portfolio and geographic footprint is no small task), prove itself during the next dip in U.S. vehicle sales, and adapt the company’s business model to a long-term future that could require fewer cars.

At the end of the day, the auto industry is one that is generally not well suited to paying safe and steadily growing dividends. The cutthroat nature of the industry, very high capital costs, and cyclical demand trends have resulted in dividend cuts being a common occurrence in the past. When combined with the uncertainty that the industry's business model faces going forward (from autonomous cars), payout cuts could continue to be an issue.
While income investors will continue to be attracted to Ford’s high dividend yield, this is still volatile stock that will get whacked during the next downturn – even if the dividend remains safe. Until management shows sustained improvement in Ford's cash flow generation and signs that the firm's investments for the future are working, the company faces a relatively wide range of potential outcomes. 
Ford’s stock often looks “cheap” due to these concerns, but an investment in the carmaker is not for the faint of heart. Conservative investors, especially those focused on capital preservation, are likely better served avoiding this stock, or at least keeping it as a relatively small position as part of a well-diversified portfolio.

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