STLA - Ford: The UAW Wildcard Could Drive A $6 Billion Wipeout

2023-09-22 11:47:57 ET

Summary

• Ford's momentum has been overshadowed by the ongoing UAW strike, raising concerns about near-term productions and longer-term profitability.
• The strike, which is expected to last through October based on historical trends and the widening divergence between the Detroit-3 and the UAW's demands, risks disrupting Ford's recently raised EBIT outlook.
• The longer-term implications on Ford's cash flow trajectory are even more concerning, adding incremental pressure to its already capital-intensive and urgent EV transition.

Following the solid Q2 beat and raise, Ford's ( F ) momentum has been largely overshadowed by the UAW strike in recent weeks. The ongoing negotiations have brought about a combination of worries - primarily over the potential implications on cash flows underpinning Ford's valuation prospects. An outsized wage increase would bring incremental headwinds to profitability and, inadvertently, cash flows critical to funding the EV transition. Meanwhile, an extended strike would also limit near-term output volumes and risk thwarting growth.

Taken together, the latest development increases concerns that Ford's recently raised EBIT outlook might face disruption. The company's 20% wage increase offering, which is likely what has been baked into guidance, was rejected by the UAW, with the union counter-demanding a 36% raise. We believe the combined impact of the ongoing UAW strike and ensuing pay raise is capable of driving the Ford stock as much as 10% lower from current levels. Paired with the upcoming earnings season, for which we expect ongoing negotiations to remain unsettled, the stock is likely to face increased volatility over the coming weeks.

The UAW Strike

The UAW, which represents the majority of hourly employees working at the U.S. manufacturing plants of Ford, GM ( GM ), and Stellantis ( STLA ) - collectively, the "Detroit 3" ("D3") - began striking on September 15. Contract negotiations between the UAW and the D3, due every four years, had unsurprisingly ended without a new deal upon expiry of the previous agreement.

In the latest round of negotiations, the UAW has demanded a 36% pay raise - down from the original ask of 40%. In addition, workers are requesting the restoration of a " cost of living allowance " ("COLA") that incrementally accounts for inflation; the COLA was dropped during negotiations in 2009 amid the ongoing financial crisis. There are also demands for pensions, retiree health care benefits, and shorter work weeks.

The UAW has implemented a different negotiation strategy this time around. Instead of targeting the strongest of the D3 to walk-out on, and using the resulting contract as leverage to negotiations with the other two, the UAW has staged a simultaneous strike impacting operations of all three automakers. In a strategic set-up, the UAW plans a phased walk-out as the negotiations progress - this essentially aims at providing the union with more leverage at the negotiating table, while also preserving its $825 million strike fund.

During the first week of the strike, which began September 15, about 13,000 UAW workers (~9% of total union members) have joined the picket line, affecting production of Ford's Bronco SUVs and Ranger pickups, GM's Chevrolet Colorado and GMC Canyon pickups, and Stellantis' Jeep Wrangler SUVs and Jeep Gladiator trucks. More critical, high-volume output facilities - such as those manufacturing the best-selling F-150 - remain in operations, giving the UAW leverage if negotiations continue to drag on and fall out of their favour.

Two Adverse Implications for Ford

We expect the strike to last through October - that's when the strike fund is expected to start running low , even on spaced-out strike strategy, and auto inventories start to take a hit, incentivizing real progress on negotiations from both sides. Adverse implications stemming from the ongoing UAW negotiations for Ford are likely to unpack in two primary ways - 1) near-term implications on production volumes, and 2) longer-term impact on profit margins.

Near-Term Productions and Sales

The immediate concern over the ongoing UAW negotiations and worker strike is their impact on vehicle production volumes. The automotive sector had just recently come off of a yearlong component shortage that had cost them more than $200 billion in lost sales. Just as volumes have started to pick back up to address pent-up demand, the UAW strike risks interfering with Ford's race against time. The company is likely aiming to sell as much as they can in the near-term to retain market share from spilling over to competition, as uncertainties loom over how much longer the strength of consumer spending can persist amid tightening financial conditions.

However, we expect strike-related impacts on production to stay manageable for Ford. As discussed in the earlier section, the strike is likely to take place in low-impact plants first before emerging to more critical facilities. The U.S. auto industry currently has about 58 days' inventory, which compares to the norm of about 60 days' inventory. The average transaction price ("ATP") has also stayed at about $47,000, which is approximately 30% above pre-pandemic levels and provides some protection to the industry's near-term sales outlook.

At Ford, specifically, inventory has stayed in the 50-day range, recovering from historical lows during the worst of component shortages during 2021/2022, despite being below pre-pandemic levels of about 70 to 80 days' supply. However, the company benefits from a higher than industry average ATP of about $55,000, which is more than a third higher than pre-pandemic levels. This is in line with management's recent credit to "higher net pricing and volume" to EBIT outperformance during the second quarter.

The company has also stepped up in ramping up volumes in August just before the strike took place, with the best-selling F-150 boasting 98 days' supply at the end of August. This will likely help to partially cushion some of the anticipated impact of ongoing UAW negotiations on Ford's ability to meet pent-up market demand and fend off competition from non-union automakers.

The near-term fundamental dynamic resulting from the UAW strike is also expected to be relatively benign. Our thinking is that any reduction in inventory will give Ford an upper hand in pricing, with rivals undergoing the same situation likely to moderate the impact of competitive sales incentives offered to customers. We think this partial remedy will be more evident for Ford Blue sales - the company's sales and profit driver - and less so for Model E sales given its EV rivals are typically non-union and likely looking to take advantage of the ongoing strike. The expectation for a maintained balance between Ford Blue inventory and sales, and potentially limited Model E sales through the UAW strikes and 2H23 could actually net out to be a limited impact on guided EBIT, in our opinion, since the latter experiences more acute pricing pressures and adverse margins amid intensifying competition in the EV industry.

Longer-Term Profitability

The more concerning part of ongoing UAW negotiations is the uncertainty over how much the resulting deal will cost Ford's profitability. While the union has pointed to Ford's ballooning profitability in recent years, benefitting from wage and benefit reductions since 2009, the automaker is also pressed for cash to fund its urgent EV transition.

In order to gauge the potential impact of a wage increase of as high as 36%, as the UAW has demanded, on Ford's cash flow and valuation prospects, we have performed a preliminary sensitivity analysis. Our computation concludes that a wage raise of as much as 36% could potentially impact the stock's performance by as much as 10% from current levels. In the worst-case scenario, where the anticipated increase to UAW wages and benefits is met with a weakening demand environment due to the weight of macroeconomic headwinds on consumer affordability, the extent of such as raise could really put Ford " out of business " - a concern that CEO Jim Farley had expressed.

For simplicity, our sensitivity analysis is performed based on our updated base case fundamental forecast for Ford based on its actual Q2 performance, 2023 guidance, and forward outlook based on ongoing growth investments. The forecast expects revenue to expand at a 3.8% five-year CAGR, driven primarily by Ford Model E (+11.2% five-year CAGR) and Ford Pro (+7.5% five-year CAGR), and offset by modest growth at Ford Blue and Ford Credit (+1.1% five-year CAGR) in line with their stabilizing market share.

We expect combined EBITDA margins averaging 9.7% over the forecast period, in line with management's expectations for resilient long-term EBIT contributions from Ford Blue to drive Model E's path to 8% EBIT by 2026.

Ford_-_Forecasted_Financial_Information.pdf

By applying a 12% WACC and 1.5% perpetual growth rate to projected cash flows, adjusted for the company's net debt profile, Ford's stock has an estimated intrinsic value of about $13 per share. The discount rate takes Ford's capital structure (including capital attributable to Ford Credit) and risk profile into consideration. Meanwhile, the estimated perpetual growth rate captures Ford's maturing growth trajectory, with the impending ramp-up of EV sales expected to displace its legacy auto business rather than being accretive over the longer-term.

Now, back to the sensitivity analysis - we look at three wage increase scenarios: +20% (Ford's offer), +28% (mid-point), and +36% (UAW's demand).

In Ford's 2022 10K filing , it had disclosed that approximately 57,000 hourly employees in its U.S. operations were members of the UAW.

Under the previous contract, hourly employees at Ford, represented by the UAW, were paid on average $112,000 per year in wages and benefits. This means UAW wages and benefits had represented about 4.4% of estimated 2023 cost of sales, or $6.38 billion.

By holding all key fundamental growth assumptions unchanged from base case estimates, and flexing only the estimated UAW wage contributions to estimated costs based on the 20% to 36% range of pay raise through 2027, we isolate the estimated impact of impending wage increases on Ford's profitability and valuation prospects. Our analysis expects the upcoming contract to drive an 80 bps to 140 bps headwind to base case EBITDA margins over the forecast period.

Considering Ford's 20% raise offered to the UAW in August, we expect this to have been management's base case already factored into the company's recent guidance. As such, we have run a DCF analysis on the estimated cash flows under a 36% UAW wage increase scenario instead to gauge the worst-case scenario impact; the analysis holds all key valuation assumptions unchanged from the base case. The resulting estimated equity value of $11 apiece underscores more than $6 billion in potential downside to Ford's current market cap if the UAW's demands are met in the contract that dictates wages for the next four years.

The Bottom Line

Ford's stock has largely underperformed its peers and the broader market this year, with the latest UAW strike likely to push the stock down another leg due to the double-whammy of near-term production impacts and longer-term profit implications on its cash flows. Combined with an elevated risk-off market sentiment after the Fed's recent signal for higher for longer rates, we expect further compression to broader market valuations, adding pressure to Ford's stock. While there are some potential mitigation levers to pull, such as moving some of its longer-term productions to non-union facilities and/or reducing its count of hourly employees represented by the UAW, the near-term weakness in sentiment is likely to incentivize investors to stay on the sidelines and consider the worst-case scenario in the meantime.

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