News Analysis date published New: 
Tuesday, May 31, 2011 - 09:00

Why Short Sellers are Wrong About Ford

America's greatest turnaround story looks like it's stuck in the mud. Shares of Ford Motor Co. (NYSE: F) raced from under $2 in early 2009 to above $18 in early 2011. A move toward the $25 mark started to become the next target for many analysts, myself included. Instead, shares have drifted steadily lower and now trade below $15. Even at that lower level, shares are heavily shorted. Many analysts clearly expect the stock to fall even further, but their logic looks flawed.

A commodity drag
After losing a cumulative $7.5 billion in 2008 and 2009, Ford earned a hefty $6.7 billion ($1.91 a share) in 2010. By late last year, analysts started to wonder if $2.50 a share or even $3 a share in profits might be possible by 2012. Now a series of headwinds have altered that view. Short sellers increasingly aver that Ford's profits may actually drop in 2011 and 2012. They note that commodity prices are rising even faster than Ford can increase prices.

What these bears are missing is the volume part of the equation. Ford looks set to sell even more cars in 2011, leveraging incremental gains off of its massive base of fixed costs. (Industrywide, Merrill Lynch expects U.S. vehicle sales to rise 21% in 2011 to 14 million .) In fact, the gains from increased car sales are likely to be somewhat larger than the drag associated with pricier raw materials.

Let's do the math.

A typical vehicle contains about $3,500 in raw materials. Steel accounts for roughly 30% of that and rubber another 20%. Yet the recent spike in commodities figured to take the total raw material cost up by $800 to about $4,300. But in the past two weeks, commodity prices have cooled a bit, and the raw-material cost disparity now looks to be closer to $400.

That's a key figure for Ford. The company has recently hiked prices on many models by an average of $200, and projections of higher sales volume this year, which generate robust incremental profits on each extra feature sold, could more than offset the $400 drag. Add in the fact that incentives are quickly dropping (they were 19% lower in the first quarter compared with a year ago), and the average selling price is actually more than $1,000 higher for a comparable vehicle.

The Japan factor
It's also become increasingly clear that Japan's woes related to the recent earthquake and tsunami will have a clear, positive effect on the U.S. auto industry. The amount of Japanese vehicles sitting on dealer lots is shrinking fast, with expectations that some models will run out by June. By then, Ford, GM (NYSE: GM) and other non-Japanese manufacturers should be able to pick up some market share throughout the summer, perhaps setting the stage for third-quarter results that are noticeably stronger than current forecasts suggest. A reduced supply of Japanese vehicles carries another implication, as Merrill Lynch's analysts note: "Although this is a near-term pressure on volume, it is also a positive for pricing."

Too conservative?
Unlike short sellers, which have been anticipating an outright drop in profits this year, most Wall Street analysts believe Ford's profits will be flat in 2011 and 2012, as rising sales volume roughly offsets spiking commodities. But as noted earlier, commodities are pulling back a bit and sales volume could prove to be impressive if the company can take market share from the Japanese auto makers.

This is why I think the profit view is too conservative. I increasingly suspect Ford can earn closer to $2.25 a share this year, roughly 15% above 2010 levels. First-quarter profits topped estimates by 24% and Goldman Sachs looks for continued outperformance: "We expect 2Q and 3Q earnings to be positive catalysts illustrating the company's ability to drive earnings growth even in a rising commodity price environment." If Ford could earn $2.25 a share this year, then shares would trade for less than seven times that view.

Yet a price-to-earnings (P/E) ratio may not even be the best gauge, since Ford's earnings before interest, taxes, depreciation and amortization (EBITDA) is far higher than its earnings per share (EPS), thanks to a high degree of amortization and interest expense. Ford shares trade for less than four times consensus 2011 EBITDA forecasts. Do the short sellers really think this stock is overvalued?

The other part of the Ford story can be found on the balance sheet. The company is now minting massive sums of cash, which should enable Ford to start paying dividends in 2012 and eventually push its cash level north of $40 billion by the end of 2013 (from a recent $21 billion).

Action to Take -->
Look for many of these themes to be covered during Ford's annual meeting with analysts, on June 7. By then, Ford should have a clear read on potential market share gains from Japanese rivals and on the impact of the recent pullback in commodity prices on its bottom line. Management is also expected to discuss a possible boost to an investment-grade rating for its bonds by the end of this year or early 2012. This should set the stage for even lower borrowing costs and reduced interest expense at the company's credit division.

Taken together, these tailwinds could help Ford's shares resume their interrupted upward trajectory. If that happens, then look for short sellers to cover their positions, creating even more buying pressure -- and that $25 target may become a reality.

David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.

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