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Stocks  | February 22, 2019

After a disappointing 2018, Ford's (F) stock price remains at rock-bottom levels and trades 26% off of 52-week highs. Despite a market that's going to be unpredictable over the next decade, I view the stock as a bargain for the following reasons:

  • Ford's large dividend boosts return potential and should remain intact for the foreseeable future given strong free cash flow.
  • A Forward P/E of 7.2x assumes Ford continues to under-perform and provides some downside protection. Any positive earnings surprises could result in significant stock appreciation.
  • A conservative discounted cash flow model projects 68% upside potential in the stock price.
  • Ford is preparing itself for a shifting market with electric vehicle investments, a new car lineup, and cost-cutting measures.

Ford's Financial Snapshot

Ford's operating performance was mixed in 2018. Strong revenue was a result of higher pricing and a better sales mix, but margins and profitability have slumped. Ford has struggled in international markets, primarily Europe and Asia, which have seen lower volume, higher costs, and adverse impacts from exchange rates. These factors have undoubtedly had a negative impact on Ford's stock price, especially with ongoing concerns in China. With that being said, Ford's balance sheet is still in good shape and significantly better than before the last financial crisis. Ford has less debt and a more manageable pension commitment, which makes it far more nimble during the next downturn.

Ford's Dividend Analysis

Ford has a long, but inconsistent dividend history that stretches beyond 30 years. Keep in mind that Ford's performance is highly correlated to the economic cycle, where the company outperforms during expansion and struggles during recessions. As you can see by the chart below, this has resulted in numerous dividend cuts and increases. The dividend was eliminated during the last recession, but has since quickly increased on an annual basis.

Note - The table below shows the dividend decreasing and increasing over the last couple of years, but that's misleading. Ford provides an annual dividend that's separate from its quarterly dividend, which hasn't been cut since the last recession.

In terms of dividend coverage (dividends paid divided by free cash flow), Ford is in excellent shape. Its payout ratio has been less than 50% for the last 6 years, which is even more impressive today considering the dividend currently yields 6.8%. This is why the dividend looks so compelling to me, despite Ford's recession risk. Ford is nowhere close to being in a position of needing to cut its dividend, so I see the current payment maintained (and likely grown) over the next few years.

Historical Valuation Analysis:

Based on historical valuation multiples, Ford's valuation looks like a bargain, especially in terms of Forward P/E and Price/Sales: (Data sources: Ycharts & Reuters):

  • Forward P/E of 7.2x (5-year average of 8.0x)
  • Trailing P/E of 9.3x (5-year average of 10.1x)
  • Forward PEG of 1.9x (5-year average of 1.4x)
  • Price/Sales of 0.2x (5-year average of 0.4x)

Ford also looks cheap in terms of Price/Free Cash Flow. Not only is it trading at the bottom of its 5-year range, but it also looks cheap relative to some of the best free cash flow producers on the market (note - I didn't include General Motors (GM) because its cash flow was negative over the last twelve months).

Two-Stage Discounted Cash Flow Model Shows Significant Upside

The conservative model below shows Ford's stock having 68% upside potential. There're a number of reasons this model is conservative and should be attainable. First, I show a free cash flow reduction to $5 billion over the next 5 years (1st Stage). Ford hasn't produced less than $5 billion in free cash flow since 2013. This assumes that Ford's business continues to struggle given continued soft demand in Asia/Europe and uncertainty in the transition to an electric lineup. Second, I assume only a 1% long-term growth rate (2ndStage). That's generally less than inflation, so Ford should be able to achieve that just based on price increases alone. Last, I've assumed a beta of 1.25x (significantly higher than Ford's actual beta), which increases the required rate of return and lowers the projected stock price. Also keep in mind that a target price of $15.01 is well within Ford's historical 5-year range, so it is not as if I'm predicting Ford to break out and reach new highs.

Perhaps an even more compelling way to look at Ford is a simple, single-stage model. If I use all the same parameters as above (i.e. 1% long-term growth, 1.25x beta and 9.9% required return), Ford's stock price of $8.92 corresponds to approximately $3.2 billion in annual cash flow. So as an investor, if you think Ford will produce more than that on average, the stock is undervalued. Keep in mind that Ford has averaged $8.5 billion annually in free cash flow over the last 6 years.

Conclusion

I believe Ford's stock is poised for a rebound just based on its attractive valuation and dividend yield, but there're also other catalysts I believe could push the stock higher:

  • Ford is still in the beginning stages of a $14 billion cost-cutting strategy. This capital will be used to invest in electric cars and boost earnings.
  • Ford has committed to spending $11 billion on electric cars by 2022. Ford expects to have 40 hybrid and fully electric vehicles in its model lineup by then. Of the 40 electrified vehicles Ford plans for its global lineup by 2022, 16 will be fully electric and the rest will be plug-in hybrids. In these plans are an all-electric SUV that will have a 300-mile range and a hybrid F150 (America's top-selling car).
  • One of the core reasons Ford's margins and profits have been slumping is an aging fleet (one of the oldest in the industry), but Ford has promised to revamp three-quarters of its models by 2020.

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