Ford Vs. GM: One Stock Could Have 50% Upside

Five years into a remarkable industry rebound, auto makers — and their parts suppliers — now generate record profit margins that would have been unthinkable a half decade ago.

The streamlining of almost every player has led to robust levels of the most important metric you should track: Free cash flow (FCF). One benefit of such financial strength: stock buybacks have been a major ongoing theme for auto parts suppliers.

#-ad_banner-#Of course, the FCF and other financial metrics grow much larger when you are talking about the industry’s top dogs: Ford Motor Co. (NYSE: F) and General Motors Co. (NYSE: GM). Both firms look far healthier — from a financial perspective — than they did a decade ago. (Earlier this week, Ford preannounced a challenging period ahead but largely reiterated long-term financial targets.)

These companies share so many common traits that it’s easy to compare them on an apples-to-apples basis to see which company’s stock holds greater appeal. Roughly three years ago, I gave Ford the edge — their valuations were comparable, but Ford’s management was much stronger. When I looked at these two stocks again in 2013, I noted that Ford still had the edge.

Little did I know that GM would eventually become embroiled in a safety scandal, which would lead to hundreds of billions of dollars in legal costs.  The issue partially explains why shares of Ford have rallied nearly 10% thus far this year (before a modest pullback related to the pre-announcement)‚Äč, while shares of GM have dropped nearly 20%. As a result, it’s time to ask if GM’s stock is finally the better value.

Ford vs GM
  Ford GM
2014E Sales ($ bill.) $138 $160
2015E Sales ($ bill.) $149 $168
2016E Sales ($ bill.) $156 $174
2015E EBITDA Margin 10.8% 11.2%
EV/’15 EBITDA 3.2 2.3
2015 P/E 8.5 7.3
2015 Free Cash Flow ($ mill.) $7,410 $6,899
Free Cash Flow Yield 14.6% 16.2%
Source: Factset Research, Merrill Lynch Estimates

An updated view of these two firms’ valuations reveal that both are remarkably cheap. And if you own shares of Ford right now, there are many reasons to stay the course, including:

— A well-executed expansion in China
— A proven willingness to invest in cutting edge engine, chassis and body designs.
— The potential for significant growth in the company’s dividend. 
— A shift in Europe from losses to profits.

But it’s hard to get past the remarkable value GM’s shares now hold. Whether in terms of earnings, earnings before interest, taxes, depreciation and amortization multiples (EBITDA) or the free cash flow yield, GM is just about the most inexpensive blue-chip stock you’ll find.

The ignition switch fallout

When news of the GM ignition switch flaw first hit the news, which GM knew about for many years and has been tied to fatal crashes, I thought the company was toast. After decades of putting out inferior products, in recent years GM has become a much improved operator. But this scandal threatened to lead consumers to ditch the company’s brands, once and for all. But that hasn’t happened. GM’s monthly sales results have kept pace with broader industry trends in 2014.

It’s as if most consumers have merely shrugged off the issue. More to the point, this debacle is more closely tied to the “old GM,” which always had quality control issues. The “new GM,” despite the legacy faulty ignition issue, is clearly designing and building much better cars these days. Indeed, it’s hard to argue that Ford, GM or any of their global peers have any sort of statistically significant difference in quality these days. Sure the Japanese auto makers still win the perception gap, but not by nearly as much as they once did.

Looking ahead, GM is facing a solid new product cycle over the next 36 months, the result of current heavy spending on capital expenditures. As a result, GM’s financial metrics should grow noticeably stronger. Analysts at Merrill Lynch think GM could be earning $5-to-$7 a share annually within a few years. “While this may seem stretchy at first glance, we believe it is important to remember that our 2014 EPS [earnings per share] of $2.85 includes $2.5 billion of recall charges and $1.1 billion of restructuring charges, both of which we view as largely non-recurring,” analysts note. Shares have nearly 60% upside to their $52 price target.

Risks to Consider: Most analysts think the U.S. auto and truck market can keep growing before peaking in 2018, but we are already 3-to-4 years into the industry upturn and sales could peak in 2016 or 2017, which would lead to a lower price target by many analysts.

Action to Take–> This is an extremely timely stock to focus on. GM will be holding its annual analyst day on October 1, and the company is likely to discuss the various catalysts that can send free cash flow and profits higher in coming years. As analysts start to digest management’s comments, they are likely to take a more bullish view of GM’s outlook. That should finally help this flagging stock reverse course. In my view, few blue-chip stocks in today’s market are this cheap and few have such robust potential upside.

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