Ford's On Track and Undervalued

 Ford (F) reported third-quarter results that did not materially deviate from its analyst day guidance in late September, so we are maintaining our fair value estimate. Adjusted earnings per share of $0.24 beat consensus of $0.19, but automotive revenue declined more than 3% to $32.8 billion and missed consensus of $33.1 billion. A 3.2% decline in wholesale volume, higher recall costs in North America, weakening South American currencies against the dollar, and lost F-150 sales due to a five-week shutdown of the Dearborn assembly plant to retool for the 2015 model led to automotive operating margin declining 450 basis points year over year to 2.5%.

Only North America and China are contributing meaningful profit for Ford, with the North American and Asia Pacific segments the only profitable ones in the quarter. Excluding the $632 million increase in North American warranty charges, North American margins still declined year over year by 70 basis points to 10.2%, mostly due to insufficient F-150 production and higher structural costs probably attributable to the new-generation F-150 due out at the end of this year. We do not expect a positive catalyst out of Ford North America in the fourth quarter, given that the new pickup truck will not be fully in production in both Dearborn and Kansas City until the second quarter of 2015. Management's North American guidance for 2014 and 2015 is an operating margin of 8%-9%; the margin in the first nine months of 2014 was 8.7% and guidance is for the low end of 8%-9% in 2014, so this implies another soft quarter coming up.

Although Ford's stock looks very undervalued to us, we do not see a near-term catalyst for the shares. Uncertainty about pricing and margins for the new F-150 will remain an issue into next year. Investors willing to wait for the recovery that we expect in 2015 and beyond are getting paid to do so, with a dividend that we think is quite safe and currently yielding 3.6%.

Making Better Cars Pays Off
Ford continues to increase its consideration in America, mostly because it did not take government loans and is making better cars. More emphasis on quality is paying off as well. In the United States last year, Ford gained the most share of any major automaker. Ford now makes cars people actually want to own instead of vehicles that are purchased only because of heavy incentives. Ford's challenge is to keep increasing share profitably while also elevating Lincoln into a global luxury brand. The mostly no-moat nature of the auto industry will make these tasks difficult.

Another key change is building more Ford models on common platforms, which will improve economies of scale. By 2016, Ford expects 99% of its global production to come from nine core platforms: five global and four regional. The move to nine platforms from 15 this year and 27 in 2007 will also allow Ford to switch production faster to meet changing demand while drastically cutting costs via better economies of scale than in recent decades. This change could save Ford billions of dollars in development costs. Management targets eight platforms as a long-term objective. The global subcompact and compact platforms (B and C segments) now each get more than 2 million units of annual volume. Before former CEO Alan Mulally's arrival, Ford had a different platform in each segment for each part of the world. The old way wasted billions and had volume too low to achieve the economies of scale Ford can achieve going forward.

The Ford and Lincoln brands are critical to the company's success. Fuel-efficient models such as the Fiesta, Focus, and Fusion have been very well received. A strong luxury group will increase profits because it will allow Ford to sell to all consumer variants while retaining current Ford customers and selling Lincolns for more profit than Ford brand vehicles. For now, however, Lincoln's offerings put it more in the premium segment, so better product is needed, and this transformation will go beyond this decade. Lincoln's transformation will center on several new vehicles over time. Lincoln also entered China in fall 2014.

Barriers to Entry Diminishing
Ford does not have a moat, and we do not expect that to change. Vehicle manufacturing is a very capital-intensive business, but barriers to entry are not as high as in the past. The industry is already full of strong competition, so it is nearly impossible for one firm to gain a sustainable advantage over another. Foreign automakers from China and India may soon enter developed markets such as the U.S., and South Korea's Hyundai has become a formidable competitor. Furthermore, the auto industry is so cyclical that in bad times even the best automakers cannot avoid large declines in return on invested capital and profit. Cost-cutting helps ease the pain, but it does not restore all lost profit.

Barriers to entry are declining as a growing global market reduces fixed costs as a percentage of sales for new entrants. The company operates in a very cyclical industry that is coming out from one of its worst-ever downturns. A key risk to Ford long term is that the United Auto Workers will go back to a more hard-line negotiating style at the next contract talks in September 2015. There is uncertainty as to whether the UAW will succeed in eliminating the Tier II wage structure in place at U.S. plants.

Management Using Cash Wisely
Ford's capital allocation has dramatically improved the past few years. Return on invested capital has easily exceeded cost of capital the past four years, and we are pleased to see Ford use its cash to substantially reduce debt. We also agree with management's goal of fully funding the pension plan in the next few years, as doing so should remove a major overhang on the stock. In the first quarter of 2012, Ford resumed its dividend, doubled it in 2013, and raised it 25% in 2014. We think management would not have done this unless it was confident the dividend could be maintained in nearly any type of recession. The board approved a small repurchase plan in May for up to 116 million shares to offset dilution from options and any share issuance related to Ford's 4.25% senior convertible notes. Once the company better funds the pension, we want to see it start a meaningful share-repurchase program. The shares currently trade well below our fair value estimate, and a buyback would offset dilution from multiple share issuances in 2009.

Ford made a bold move in September 2006 by hiring Alan Mulally to be president and CEO. Mulally united the company under his One Ford mantra and brought better economies of scale by using more global platforms. New president and CEO Mark Fields joined Ford in 1989 and succeeded Mulally in July 2014. We think Fields will keep Ford on the course Mulally set. Fields' own extensive experience with Ford in Asia, Europe, North America, and South America means he brings deep automotive experience back to the CEO role. Like many family companies that trade publicly, Ford has two share classes. Class A shares are available for any investor to purchase, and each share equals one vote. The Ford family always has 40% voting power through ownership of Class B shares. We would prefer to see one share class so outside shareholders can have some influence in running the company. Still, the Ford family's high ownership aligns its interests with outside shareholders'.