Ford (F, Financial) is one of the largest U.S. automakers headquartered in Dearborn, Michigan in the United States. Ford recently slashed its 2014 profits outlook because of lower than expected sales in Europe and South America, the rising cost of vehicle recalls and plant shutdown cost for retooling Ford F150 trucks. As a result, the Ford stock price declined significantly, dropping from a three-month high of $17.50 to a low of $13.26 and ultimately bouncing back to $15.44.
Leadership and strategy
To analyze Ford’s strategy we have to go back to September 2006. This period was marked with the welcome appointment of Alan Mulally as the CEO of Ford. Mulally's leadership was instrumental in driving Ford’s turnaround from a net income loss of $12.8 billion in 2006 to profitability with the 10-year highest net income of $6.6 billion in 2010. To achieve profitable growth, Mulally laid down four key strategic priorities for Ford in what was termed as “ONE Ford plan”:
- Aggressively restructure to operate profitably
- Accelerate development of new products that customers want and value
- Improve balance sheet
- Work together effectively as one team
Under the leadership of Alan Mulally, Ford achieved a full-year 2009 net income of $2.7 billion, the first full year of positive net income since 2005. The net income of 2009 was an improvement of $17.5 billion as compare to the previous year. Similarly, steady growth in shareholders’ equity, net income and EBT margin suggest that Ford’s ONE plan was well on track to achieve profitability and strengthen its balance sheet. The success of restructuring Ford’s operations can be observed in declining operating expense as a percentage of revenues from 2007 to 2013 as seen in the table below.
Ford market share data
Source: Ford annual reports
The underline boxes in the table show positive growth in market share from the prior year. Ford continues to gain a foothold in Asia Pacific and Africa with steady increases in market share. The market share gain in Asia Pacific also includes a 50% sales growth in China. Ford is about breakeven in South America and plans on introducing new cars to increase its market share. The increase in its U.S. market share, which is up 0.5 percentage points from previous year of 2012, and steady increases in Asia Pacific market share combined with the increase in sales revenues suggest that Ford is introducing new cars that consumer demands and value. To date Ford has been successful in executing its strategy and evaluating its achievements against the four pillars of ONE Ford plan.
These impressive achievements have gained Mulally the title of "Hall of Fame" CEO from Ford executive chairman William Clay Ford Jr and rightfully so. Mulally endorsed Mark Fields as his successor to continue his good work and lead Ford forward. Although the profits in the third quarter of 2014 declined 34% to $835 million, Fields remains positive and expects 2015 pre-tax profits to be better than 2014.
Valuation
Based on my valuation, the intrinsic value of Ford stock is $36.11. Based on the current market price of $15.50, there is an upside of 134% or a margin of safety of 134%.
I have used traditional DCF (discounted cash flow) model which discount the cumulative cash flows to the firm by the weighted average cost of capital (WACC).All valuations calculations, tools and techniques used are explained further in Aswath Damodaran’s Investment valuation book.
Calculation of operating income
I have capitalized the research and development (R&D) expenses of Ford in an attempt to value research asset with an amortizable life of the R&D asset to be five years. This is an assumption about how long it takes for research and development to be converted into a finished product. [Reference: Investment valuation/Damodaran 3rd ed, pg 233]
Adjusted operating income = Operating income + R&D expenses – Amortization of research asset.
I have also converted Operating leases of Ford’s automotive sector into debt by the following formula
Adjusted debt = Debt + Present value of lease commitments.
Growth rate
The five-year analyst growth forecast from Morningstar is 11.1%.
The annual earnings growth estimate from etrade for the next three years is the following:
This gives a growth rate of about 15.6% over a four-year period.
I have been conservative in my valuation growth inputs and hence I have based my growth rate on the trailing 12-month fundamental operating performance of Ford. The growth rate from the fundamentals is about 4.4%. The growth rate is the product of reinvestment rate and return on capital. The model calculates the reinvestment rate and return on capital as follows:
Reinvestment = (Capital expenditures – Depreciation + Change in noncash Working Capital)/EBIT (1-t)
Return on capital = EBIT (1 – t) / (BV of equity + BV of debt – Cash)
The Reinvestment rate is 48.22% and Return on capital is 9.09%.
The valuation model adjusts the growth rate as it approaches the end of growth period of 5 years.
Source: Aswath Damodaran FCFF excel model
Growth rate in stable phase
Since the constant growth in stable phase (in perpetuity) cannot be greater than the overall growth rate in economy, I am using a constant growth rate of 1% in stable phase. Following are the valuation at the end of growth phase:
The following table shows the market value of equity/share of $36.11.
Risk
Ford’s debt is about 4.5 times its equity, but its interest coverage ratio for the trailing 12 months is 7.39. This means it can easily pay the interest expense on its outstanding debt.
Source: Morningstar
The following summarizes the credit ratings of Ford. Rating agency Fitch has maintained a positive outlook on Ford and Ford Credit.
Conclusion
The successful execution of ONE Ford Plan gives me confidence in Ford’s management abilities to achieve its strategic growth priorities for the next 5 years. This along with a favorable valuation price of $36.11 per share makes Ford stock a good buy at the current price of $15.44.
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