Stock investors do not need to capture a leprechaun to uncover a pot of gold; they merely need to uncover a few stocks which are being unduly punished by the market. Therein lies the rub. How does one differentiate between a pummeled equity which has merit and will recover, versus one which offers little intrinsic value? Further, how can one assess the chances that a highly-leveraged equity will be able to survive a severe downturn in their business cycle? The future cash flows of a business become irrelevant if common stockholders lose their claim on the business through bankruptcy proceedings.
Ford (F) represented just such a dilemma for value investors following the financial meltdown of late 2008 and early 2009. Shares of Ford's common stock dropped to under $2 a share at the same time Ford bonds were trading for pennies on the dollar. Anyone who was paying attention to either the equity or the bond markets was being led to believe that Ford was almost certainly destined for bankruptcy. The 10-year chart for Ford tells the story:
Viewed in retrospect, the equity and bond markets missed the boat, Ford was not going bankrupt even though it was heavily leveraged and was in the midst of a perilous downturn in its revenues and cash flows. The sudden down turn was reflected by the companies' negative free cash flow (FCF) figure of nearly $6.9 billion for the 2008 fiscal year.
The question in retrospect is whether Ford represented a suitable risk/reward scenario when it was trading near its lowest point or whether it was merely a reckless gamble which turned positive for lucky, rather than savvy, investors?
The answer to that question is extremely hard to ascertain without a thorough examination of Ford's debt. One would have to review the covenants and other details of the debt in retrospect to determine whether Ford was "saved by the bell" in terms of the sudden economic up tick which was facilitated by the actions of the Federal Reserve. Further, would the government have intervened on Ford's behalf just as they had done with the other car makers?
Clearly, the answer to the latter question is yes and that fact alone largely resulted in a quick rise in the price per share of Ford stock in early 2009. With the threat of bankruptcy off the table, leverage is not nearly as risky a proposition. While excessive leverage and a slow economy can temporarily cripple the sales and profits of a cyclical company, the result is generally not lethal so long as the company has sufficient forward earnings power. That was certainly the case with Ford; the company went on to record FCF of nearly $11.5 billion in 2009.
Obviously, Ford represented a potential value proposition in late 2008 and early 2009, despite its extensive leverage, if an investor was able to deduce with a high degree of certainty that the company would not be turned over to the bondholders. But was the company really as cheap as its $2-per-share price would indicate?
In the case of Ford, the U.S. government eventually backstopped the equity price of the company by supplying loans to other automobile manufacturers although Ford never accepted any financial aid. Of course when the stock was trading at its lowest point in late 2008, investors were not privy to the upcoming bailouts unless they were clairvoyant. In this article I will assume that the risk vs. reward scenario was not influenced by the prospect of government intervention. That was the case when Ford was trading at its lowest point.
Interest Coverage for Ford in 2008: EBIT vs. FCF
Interest coverage refers to the ability of a company to generate sufficient earnings to pay the interest on its borrowings. The standard calculation is EBIT/Interest expense. Any figure under 1.5X is considered risky and a figure under 1x indicates that a company's revenues are insufficient to cover the interest payments on its debt.
An alternative formula would use FCF/interest expense to estimate the ability of a leveraged company to meet its interest obligations.
Interest coverage ratios in highly cyclical companies can change rapidly. Companies which are highly solvent during times of economic prosperity can quickly turn insolvent when financial turmoil erupts. In the case of Ford, the company's EBIT was highly negative for not only 2008, but also the two prior years. An examination of the company's 10-year trailing EBIT reveals the 2006 to 2008 shock to its interest coverage.
Income Statement - 10 Year Summary (in Millions)
|Sales||EBIT||Depreciation||Total Net Income||EPS||Tax Rate (%)|
Ford's interest expense in 2008 was approximately $9.7 billion. For the period between 2006 to 2008 the company had experienced EBIT losses of in excess of $30 billion; the stock hit its lows just as the U.S. was in the midst of it worst financial crisis in decades. By viewing the EBIT-based interest coverage and the price of Ford bonds, bankruptcy appeared imminent.
However, if one viewed the interest coverage of Ford in terms of FCF rather than EBIT, the picture was not nearly as bleak. According to the figures supplied by GuruFocus, with the exception of 2008, Ford was generating positive FCF. Additionally, until the period between 2006 and 2008, the company had been within reasonable interest coverage ratios when one used FCF/Interest coverage > 1.5 as a metric.
Certainly the period of 2006 through 2008 was a major concern, particularly the year-end results for 2008 which had turned negative; however, the virtual certainty of bankruptcy was not nearly as clear when FCF figures were substituted for EBIT.
Source of data: http://www.gurufocus.com/financials.php?symbol=F,
Make no mistake, by year end 2008, Ford was in a highly tenuous situation from a liquidity prospective. In no way would a conservative investor risk money in Ford during that period unless he/she was privy to information that the government would intervene in the automotive sector. However, the point remains that investors who used FCF instead of EBIT in calculating interest coverage had a much more accurate perception of the company's ability to survive its temporary liquidity issues.
A Realistic Valuation of Ford in 2008
There is one other factor involved in evaluating whether Ford common stock was a legitimate buy at around $2 a share, in late 2008 and early 2009. Again I am assuming that investors were not privy to the information that the government would decide to backstop the entire automotive sector. Specifically, from a private market valuation perspective, based upon a 10-year cyclical FCF to enterprise value metric, was Ford stock cheap at $2 a share?
The average 10-year trailing cash flow for Ford was about $12.35 million per year. Bear in mind that the figure was enhanced by two years of excessive of cash flow in 1999 and 2000. However, those years were mitigated by the uncharacteristically poor years in 2007 and 2008; hence the figure is probably representative of Ford's average earnings power.
If we divide $12.35 billion into the enterprise value of Ford at year end 2008 (average 10-year FCF/EV), we arrive at the figure 12.35/135 or an earnings yield of slightly over 9%. Of course if one ignores the debt and substitutes market cap then the stock was sporting an average earnings yield of over 250% of its cyclical-adjusted FCF. Such is the absurdity of calculating earnings multiples on extremely leveraged companies without factoring in the level of their debt and cash on hand.
When one invests in highly leveraged cyclical companies, the primary concern involves asking the question: Will the company survive? Understanding the debt covenants and calculating the interest coverage of the company become much more important than any of its valuation metrics. Liquidity supercedes all other factors for investors in common stock; that applies in spades for highly leveraged companies.
I never considered buying Ford in 2008, nor would I consider buying the company in the future if a similar scenario unfolded, barring a substantial deleveraging of the company. I'm sure that many readers would disagree with that view point.
I rarely consider purchasing shares in highly levered companies, particularly ones with dangerously low levels of interest coverage in addition to low cyclically adjusted FCF/EV earnings yields. They are simply too risky and have virtually no chance of being acquired or taken private. If I was to consider such a purchase it would be in the form of bonds which were trading for pennies on the dollar. By purchasing the bonds the investor is assured of high dividends payments if the company survives. If the company goes under, the investor is likely to receive at least a partial repayment of his capital or a substantial stake in a reorganized company, although the ultimate settlement may take years to process.