We have a young child and have created a small UTMA (Uniform Transfers To Minors) account for him. We have set up limit buy orders for Ford (NYSE:F) in this account at $11 (corresponding to a FW PE only about 6.2x as you can see from the table below). And in the last few weeks, these orders have been triggered and we have accumulated some actions.
And that brings me to the thesis of this article – the developments that squeezed F prices down to as little as $11. There are indeed some headwinds, fairly strong headwinds, horizontally. And you’ll see that the difficult environment in China is one of the main ones, followed by raw material costs and global supply chain disruptions. In addition, there is also the possibility of an 8,000 layoff as mentioned in a Bloomberg report (unconfirmed by F though). These are things I will be looking forward to hearing from management during the Q2 report.
However, for accounts (like our UTMA account) that can wait out these short-term issues, F’s current conditions will offer favorable return potential even if he loses half of his earnings, as shown below.
Our UTMA account holdings
More details about our UTMA can be found in our recent article or on this Fidelity page (where our account is). In case this interests you, the key considerations for us to have such an account boil down to 3 buckets. First and foremost, provide a nest egg for our son. Second, use it as a teaching tool for him to learn about investing and financial responsibility (it’s a wish and we’ll see how it turns out when he’s old enough). And finally, it offers certain tax advantages and the time horizon to accommodate more aggressive investment ideas. Our current holdings are listed below. A few comments :
- Due to our relatively small account size and time horizon, we hold an even more concentrated portfolio than our other accounts. You need to adjust your diversification and exposure accordingly.
- For performance tracking purposes, I used prices from July 11, 2022 (when I first published this portfolio) on SA as the entry price. This makes it easier for readers to check and track its performance even if I have held certain stocks for a while. It has led SPY by a small margin of 2.9% since then, adjusted for dividends.
- The actual size of our portfolio is considerably smaller and the starting size of $100,000 for this model portfolio serves only to simplify calculations and remove the role of rounding errors.
Ford’s second-quarter earnings: China and layoffs take center stage
Management and the market have already worried about the Chinese front. As an example, the following Q&A exchange during its first quarter results reflected these concerns (abbreviated and underlined by me):
Question from Mark Delaney (Goldman Sachs): … we unfortunately had the war and also the new COVID restrictions appear in China. I hope to better understand how Ford always achieves this 10% to 15% growth?
Response from Jim Farley (F CFO): It really comes down to commodities — the semiconductor commodities that have crippled us. We’re obviously spending a lot of money on premium freight and other things to get around China’s COVID escalations.
Response from Hau Thai-Tang (Chief Industrial Platform Officer): Regarding China, we are resizing the Shanghai area. We have about 50 Tier 1 suppliers there. We are focused on our profit pillar vehicles and, as Jim mentioned, expedited freight optimization. We have secured fast ocean shipping as well as airlift capability to protect our suppliers. And then they’re just starting to have a whitelist process to allow vendors to resume production. We are therefore working with our teams on the ground in China to help these suppliers become partially operational.
However, despite management’s efforts, Ford China’s most recent results turned out to be even worse than expected. It reported the worst quarter in its history since the first quarter of 2020 (the peak of the COVID pandemic in China) with a 22% drop in vehicle sales. It only sold 120,000 vehicles in Greater China due to COVID-induced lockdowns and ongoing global supply chain issues.
Meanwhile, a Bloomberg report recently mentioned that F could cut up to 8,000 jobs in the near future. Citing comments provided by people familiar with the plan, the report added that the motivation for the layoff is to increase profits to fund its push into the electric vehicle market.
I will of course be eager to hear management’s comments on such a plan during the Q2 report. If the plan is confirmed, I feel sorry for the people who are about to be fired. However, for the company itself, I wouldn’t be too worried as a long-term investor. As you can see in the following graph, for such a large company, its workforce fluctuated regularly by a few thousand over the long term. And 8K represents about 4% of its average workforce. Moreover, in terms of measures of profitability per employee, F can indeed use some efficiency improvements. As you can see on the second graph compared to its peers, its revenue per employee is lower than GM and its net income for employees is slightly lower than Tesla.
After the bad news, here is the good news. I’m impressed with F’s impressive product lines – an important consideration in my investment thesis. A number of its recent launches have been hugely successful, including iconic new ones such as the Bronco, Bronco Sport, Maverick. At the same time, it also offers a range of rugged electric vehicles, including the Mustang Mach-E, E-Transit and F-150 Lightning. Consumers love these products. For example, the F-150 has just started full production and has received over 200,000 reservations. As another example, Consumer Reports chose the Ford Mustang Mach-E as its first choice of electric vehicle to replace the Tesla Model 3.
Ford Stock – Valuation and Expected Return
On expected valuations and returns. As detailed in our previous article, in the long run,
Return on investment for a business owner is simply the sum of two things: A) the price paid to buy the business and B) the long-term growth rate of the business. Specifically, Part A is determined by the Owner’s Yield (“OEY”) when we purchased the business. And part B, the long-term growth rate, is governed by the ROCE (return on capital employed) and the reinvestment rate.
F’s ROCE averages 40.5%, as you can see in the first chart below. And as mentioned above, its current FW PE is only around 6.7x. Using its FW EPS as a proxy for its owners’ earnings, its OEY is over 14.9%. Assuming a sustainable reinvestment rate of 4%, the long-term growth rate would be around 1.6%. This is the real growth rate, and the nominal growth rate would be higher by indexing to inflation. Thus, the long-term total return at the current valuation would be around 17%, as shown by the blue line and the green symbol in the second chart below. The red line in the graph shows the case where F loses half of its gains permanently. From now on, the OEY will be halved to 7.4%. Adding the new OEY to the growth rate would still give us a double-digit long-term return.
Final thoughts and other risks
For F, the gap between its long-term outlook and its current valuation is too big to ignore. Certainly, there are indeed some speed bumps in the near future. But for accounts that can wait for short-term swings, it’s a good investment that offers favorable odds for a double-digit return even if it loses half of its earnings.
In the near term, besides the challenges in China and the layoff plan, there are a few other risks that I would pay particular attention to in the second quarter. A key assumption in F’s forecast involves pent-up demand beyond its bank of orders. This is a key assumption that needs to be rechecked given the new macroeconomic developments of recent months. Next is commodity prices and inflation. F expected commodities to cause a headwind of about $4 billion in the first quarter. As inflation showed no signs of slowing down in Q2, this is another assumption that needs to be rechecked in Q2.