For quite a long time Ford Motor Co. (F, Financial) has been sailing through the rough waters which is evident from the fact that two of its main competitors essentially went out of business and then saved by government bailout.
Let us run through a precise health checkup of Ford business. Let us look at Ford's margins as a way of assessing the health of the current business and any risks or upside to those margins and what it could mean for shareholders.
Margin Talks
First, let us take into consideration Ford's gross margins. Success for any company can be recognized at the first instance from its gross margins as this tells you how much it costs for a company to make whatever it's selling. This is a reflection of the business' capability to show pricing power with its suppliers and demand from its customers in the face of intense competition.
It is evident that Ford's gross margin has been into the rough waters for the past ten years. Ford was a blockbuster brand in the early part of the 2000s but its growth got jilted by rising gas prices trimming the demand for its highest selling models in early 2006 and Ford had to take the hit. Margins are razor thin in the auto industry in the first place but given Ford's macro conditions, an already poor environment for margin got highly aggravated. However the agility of Ford’s management team saw to it that Ford quickly responded back to the depleting business and margins scaled back up gradually to close to 20% before beginning a second round of down slide in the past three years. Margins are set to come approximately in line with 2013 this year so the trend continues.
Falling margins are never a favorable symptom for any business progress since everything a company pays for – from A to Z - comes out of gross margins. When gross margins fall the number of dollars available to pay employees, invest in the business, buy things, etc. is diminished to the equal proportion of the margin fall. But most of all, the worst hit area due to falling margins is profit, the bottom-line of any business and that is why it is so important to keep a close watch and control on margin movements of a business.
Dissecting the Margins
Now let’s explore further into the margins and get into operating margins, though here the story is not repetitive but it is in sync with the gross margin movement.
Operating margins gives the best insight of how a business’ Health. It is simply the measure of a company's profits before taxes, interest and other expenses that are not directly related to making and selling things. In this way we get a clearer understanding of how well the business is performing without the clamoring of GAAP accounting policies.
Ford's operating margins have actually dropped below zero thrice in the past ten years, a figure which triggered the panic button amongst investors to such an extent that Ford shares have traded at two bucks near the lowest lows of its downturn. Investors often carry the notion that margin can be no less than zero which means the company earns back what it spends but this is not entirely true especially in a business like the auto sector where the margins are so less, that a couple of adversities can push the margins to sub-zero levels. Hence the moment margins get southbound, they can go way south in a hurry triggering panic in the market.
So what does this mean for the shares and shareholders? The picture isn't exactly rosy and rather quite gloomy. However, the stocks look attractive from the valuation point of view. The shares are not just cheap but there is also the cyclicality of Ford's business. Every auto maker goes through cycles of undulations owing to the nature of the business domain and currently Ford is near the bottom of its downside. Revenue and margins have been flagging recently but with an array of new models about to hit the roads in the next couple of years I think Ford's drive looks to be brighter in the uphill direction.
Ford management has also evolved with time and has developed the smartness of controlling operating expenses more efficiently than their predecessors. Analysts have noted that the spread between operating profit and gross margins has flattened out over time. The following chart shows the difference between gross margins and operating margins; in other words, it shows the percentage of revenue Ford spends on operating expenses each year, or the difference between the first two graphs.
Cutting the Cost according to the Cloth
Ford has managed to effectively trim its operating expenses to half as a percentage of revenue since 2009 and while the number has crept up since 2011 it is still at the lower side going by Ford’s historical standards. This means that when gross margins move up Ford is well positioned to take full advantage of the incremental gap between the earnings and expense thus adding much of it to the net profit numbers instead of spending it.
Ford Harvesting
With this combination of positive factors, the cyclic downside in margins is close to the last point of the trough and from these levels we can expect Ford to upsurge 20% in gross margins and 6%+ in operating margins. This means billions of additional profits each year taking into consideration the enormity of Ford’s revenue base and this would mean an up-swing in Ford’s share price.
Currently the market sentiments are far too negative on Ford and if the margins movements do not get hit by any other unprecedented incident, the upside will be substantial. For now as investors it would be best to keep a close watch on the margins since if they slide further down Ford could trade for $10 but the moment the downturn ceases and the up-swing starts, $20 to $25 per share can be the scene in the near term.
