2023-10-24 10:31:27 ET
Summary
- Ford Motor Company is set to unveil its second-quarter earnings on October 26th.
- The financial health of Ford Credit, particularly amidst rising auto loan defaults, warrants scrutiny.
- The upcoming earnings call presents a pivotal moment for Ford's management to address credit concerns and provide clarity.
Ford Motor Company ( F ) is set to unveil its second quarter earnings on October 26th. While the attention is fixated on the UAW strike, its EV advancements and ICE vehicles, a potentially overlooked aspect that warrants scrutiny is the financial health of Ford Credit, especially amidst a backdrop of rising auto loan defaults. An evaluation of the credit quality and the impending risks associated with Ford Credit could unveil a less rosy picture, challenging the recent optimism from the Fitch Ratings bond upgrades on September 6th . Management should make special note of this on the call to increase clarity.
Introduction
On October 26th, Seeking Alpha estimates are expecting Ford to report a profit of $0.46/share and revenue of $42.51 billion. While Ford’s CFO proclaimed on the last call…
...disciplined capital allocation, provides significant flexibility to fund our growth while also consistently returning capital to our shareholders. We continue to target returning 40% to 50% of free cash flow to investors. - Ford Q2 2023 Earnings Call
…I would argue that management should consider saving these cash flows to shore up the balance sheet in the event of credit losses in Ford Credit.
For years, Ford Credit has been a significant revenue & profit driver for Ford Motor, facilitating customer and dealer financings. Yet, the post-pandemic economic rollercoaster, marked by a new surge in subprime auto loan defaults, casts a shadow on what the state Ford Credit will be going forward. This concern is exacerbated by the potential misclassification of subprime borrowers during the pandemic.
Rising Subprime Delinquency Rates
According to data from Bloomberg in September, the subprime 60-plus-day delinquency rate for U.S. automotive retail financing has risen for five consecutive months, increasing to 6.11% in September 2023 up from the previous high of 5.93% in January. This is before student loans resumed in October and a higher number than anytime going back to 1994.
60 days late Auto Subprime Loans (Bloomberg/Fitch)
This points to rising credit risk in Ford Credit's subprime portfolio. I cannot find a spot where Ford actually breaks down the credit risk of their consumer loans in their recent 10Q or on the recent earnings call. Their overall average default (and 60+ days past due) rate is well below the subprime rate but we do know that some of their portfolio is subprime (see section below). We are not sure how much (however). Bloomberg is not the only one noting the state of the subprime auto loan market. Some of these stand-alone subprime lenders have shuddered this year and dealers are having a harder time sourcing loans for subprime customers.
Policy Changes
In 2021, Ford Credit amended its policy to allow longer-term loans to subprime customers, potentially extending credit to a broader swath of consumers, thereby possibly increasing exposure to credit risk. Ford Credit actually removed the minimum credit score loan for 84 month auto loans. I cannot find any sources to state they have reapplied this policy. When CNET asked at the time for comment from Ford Credit this is what they had to say:
??Our proprietary scoring models already do an excellent job of assessing the probability that an applicant will be able to pay. FICO is one input to our models. Eliminating the separate FICO requirement opens the prospect of financing to more customers who would qualify for 84-month financing within our models. FICO qualifications are included sometimes as part of marketing programs -Ford Credit Representatives.
Interesting.
Misclassification of Borrowers
Beyond clear subprime borrowers, during the pandemic, fiscal relief measures temporarily boosted credit scores, potentially upgrading subprime borrowers to prime, which could have long-term repercussions as these relief measures wane. CFPB noted that many credit scores increased during COVID. These consumers still had the same buying & savings patterns but had a reprieve from student loans, got COVID stimulus checks, and stayed in meaning they had excess savings (this is widely known). According to the Ford Credit scoring model (noted below and taken from the 2022 10K) it appears that the FICO score (which was likely artificially inflated) plays a key role in how they price the credit risk of a consumer (outside the 84 month subprime loans):
When originating consumer receivables, Ford Credit uses a proprietary scoring system that measures credit quality using information in the credit application, proposed contract terms, credit bureau data, and other information. After a proprietary risk score is generated, Ford Credit decides whether to originate a contract using a decision process based on a judgmental evaluation of the applicant, the credit application, the proposed contract terms, credit bureau information (e.g., FICO score), proprietary risk score, and other information. The evaluation emphasizes the applicant’s ability to pay and creditworthiness focusing on payment, affordability, applicant credit history, and stability as key considerations. - Ford 2022 10-K
Bull Case (what I could be missing)
It could be likely that subprime (whether actually subprime or underwritten as prime) auto loans are inconsequential to the Ford Credit loan portfolio. People watching & in the automotive industry have been generally concerned about subprime auto loans since before COVID (going back as far as 2016-2017). In fact, there’s a sell article on Ford from 2017 that echoes some of the same points I make here. I could definitely be wrong. However, below, I'll go into some key assumptions Fitch appears to have missed. In addition, the underlying consumer credit health is different than in 2017. Inflation has certainly been higher too.
Valuation & Financial Ratios
While we don’t know for sure how many of Ford Credit’s consumer loans are with a buyer that has long run subprime spending patterns, I do think it's interesting that Ford trades at the highest price to book valuation of any of its Big 3 Piers.
Company: | Ford ((F)) | General Motors ( GM ) | Stellantis ( STLA ) |
Price/Book (Trailing 12 months) |
I would argue that a large captive financing organization like Ford Credit is probably worse for the price to book ratio than having a standalone arm. The loan quality of a captive financing organization was one of the reasons GM spun out GMAC (turned Ally Financial) during the 2008/2009 crisis. This was a separate bank holding company that needed financial assistance. I am not saying Ford Credit will take large losses, it’s just that a bank like entity on the balance sheet does not seem to be in favor of the market right now.
What’s interesting as well is that Ford (with a bank-like entity on its balance sheet) also trades above the price to book ratio of a semi-similar bank. A look at a local regional bank auto loan competitor (GM’s spinout Ally Financial) appears interesting.
Company: | Ford ((F)) | Ally Financial ( ALLY ) |
Price/Book (Trailing 12 months) |
While you can argue that auto loans have a better recovery ratio that the Commercial Real Estate mortgages that have ensnared much of the regional banking sector, used car prices have started to fall , and the kicker is Ford Credit was likely writing loans (through its dealerships) on many of its new cars off the lot during the latter ½ of COVID at or above MSRP (usually there is “cash” on the hood meaning cars sell for less than MSRP). This means that Ford Credit probably issued loans on cars that were (in a lot of ways) overvalued at the time of the sale. There is evidence that these cars (now classified as used) still trade at a 30+% premium to where historical trends indicate the price for used cars should be. Ford’s CFO noted on the last call that default rates are rising (back to a normal range) and that auction prices for cars the repossesses in Ford Credit are falling:
Credit loss performance remains strong and below our historical average but is expected to increase and auction values remain robust but are down from their peak in the first half of 2022. -Ford 2Q 2023 Conference Call
It appears that total auction values are down about 9% from 1H 2022 to 1H 2023 ( 10Q ).
Auction Values Ford Credit (Ford 2Q 10Q)
This could crimp profit margins, just when Fitch expects Ford Credit to start paying distributions to the parent company. For reference, Ford Credit does not appear to have made a cash distribution to Ford in the first ½ of 2023, yet these distributions underpin part of the Fitch Upgrade (10Q). And the key factors are going in the opposite direction right now (defaults coming up from near perfect credit conditions).
I’m not sure what happens in a scenario where Ford Credit has to get more funds from the parent company (its bonds are guaranteed by the parent company) and how this effects Fitch’s credit rating or management’s plans to pay a dividend or distribute “40% to 50% of free cash flow to investors” -2Q 2023 Earnings Call.
Ford Credit Distributions (Ford 2Q 10Q)
The Kicker
Ford noted in their 10Q they like to keep its financial leverage ratio of Ford Credit somewhere between 1:9 and 1:10 debt to equity. The current ratio is 1:9.9 with still abnormally low trailing 12 month default rates (2Q 10Q). Fitch noted :
While Ford Credit's leverage is higher than other captives and standalone finance and leasing companies, Fitch believes it is mitigated by the higher quality loan and lease portfolio, which has shown superior credit performance relative to peers. -Fitch
I’m not sure how you can actually assess true credit performance when consumers were showered with trillions in pandemic stimulus.
When these default rates normalize (or go higher) and used car prices fall more (meaning loan recoveries drop), I struggle to see how this will allow Ford Credit to make distributions to Ford to support Fitch. Again, this was a key underpinning assumption in the upgrade. Ford not being the target of a UAW strike was also a key underpinning and we see where that went . I’m not sure how Fitch will take these developments.
What Management Should Do on the Conference Call
Among normal conversations with Wall Street (around the EV transition and UAW strike of course), it's imperative for Ford's management to provide a clear assessment of Ford Credit's credit quality, delve into the measures in place to mitigate potential fallout from rising defaults, and articulate a prudent capital allocation strategy amidst these uncertainties. Until we have more clarity on Ford Credit, I don’t think it's prudent to own Ford (hence why I think it’s a sell). This could very well be a good play in the long run, but for now the risks seem to outweigh the rewards.
Bottom Line
Despite the more optimistic outlook on Ford's transition to electric vehicles, the looming credit concerns at Ford Credit could potentially hamper Ford's financial stability. A higher than competitors’ price-to-book ratio means the company has to be better than average to justify its valuation. The upcoming earnings call presents a pivotal moment for Ford’s management to address these credit issues head-on, thereby offering investors a clearer insight into how they plan to navigate this murky credit landscape. Ford management should take the opportunity.
For further details see:
Ford Q3 Preview: Ford Credit Subprime Troubles?