Financial writers that cover Ford stock, the iconic Detroit automaker, have recently taken to declaring that the Ford dividend is safe for the long term. The analysis seems to be something like this: “Ford is earning around $1.65 per share in profits, and only pays out $0.60 per share as a dividend, which is only a third or so of current profits, so the dividend is probably sustainable for the long haul.”
This type of thinking fundamentally ignores the high fixed cost business model and the general history that Ford possesses.
Over the past generation, investors have become spoiled by the asset light business that has driven many prominent companies to success. A company like Alphabet’s subsidiary Google has a very asset light business model, despite having over 80,000 employees. If there are 30% fewer Google searches next year, the profits at Google may only go down 35%. There is a close relationship between profits and usage. As a rough estimate, it would take something like an 85% decline in Google searches for Alphabet to stop earning a profit from this subsidiary.
Ford is not that kind of business. It has to sell $150 billion worth of vehicles just to earn a $6 billion profit. Even in today’s relatively robust economy, Ford is still earning only a 4% profit margin (compared to the 18% profit margins that it earned in the late 1970s). And there is about a $125 billion fixed cost base, that, if sales fall below that, everything becomes a loss. The business model is something like: “There is no profit margin until $125 billion in cars are sold, and there is a 30% profit margin thereafter.”
A failure to realize this could cause a lot of self-delusion about the dividend stability because paying out $2 billion out of a $6 billion profit pie, as Ford is doing now, seems like something that ought to be sustainable for generations to come. What some people may not realize is that it only takes a 20% decline in demand for those $6 billion in profits to disappear.
And that is what happened during the last financial crisis. Ford was earning $2.13 per share in profits in 2004 and paying out $0.40 as dividends, a seemingly “safe” dividend payout that was only 18% of overall profits. Boom, the financial crisis happened, the dividend was cut, and by 2008, Ford was losing $7 billion each year and borrowing at a 7.5% interest rate to avoid the bankruptcy fate of General Motors. It somehow recovered, and began the dividend process anew with a $0.20 annual dividend declaration over the course of 2012.
On the surface level, a long-term investment in Ford stock sounds tempting. The stock trades at a low dollar price, which has a certain psychological cachet. The dividend yield is 5.28%, which is a lot higher than the dividend yield from most other companies that you know of. The dividend is only about a third of Ford’s overall profits. It all sounds safe-ish.
But I would not purchase Ford stock with the expectation that the dividend will be at its current rate or higher during each year for the next twenty. Recessions are brutal for carmakers, and profits turn to losses quickly due to the high fixed cost nature of operations. The $2 billion in dividends are the first thing to go when you’re losing $7 billion, as Ford rightly decided during the last recession. Ford could be a perfectly fine investment, for both income and capital appreciation investors, for the next few years, but it is not something you make a generational or legacy holding in your portfolio. The fact that the stock is trading at the same price as it did in 1987–thus generating a capital gain of 0% over the past three decades–reinforces this point.
Originally posted 2018-05-06 14:24:03.