The Ford/GM Run-up Has Gotten Out of Control

Adam is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

I was a fan of Ford (NYSE: F) and General Motors (NYSE: GM) through all of 2012.  Both companies seemed undervalued and were beaten down by overblown worries about weakness in the European auto market. 

Yet both have been growing margins in the U.S. through careful cost and capacity management, while gaining market share in China, which is now the world's largest auto market.  Since bottoming out last summer, both companies' stocks have gone on a tear, and have recently reached new 52-week highs

The biggest catalyst was GM's announcement last month that it will buy back a substantial portion of the U.S. government's ownership stake, and that the Treasury department will sell the rest over the next 12 to 15 months.  Ford's recent doubling of its dividend has also had a positive impact on its share price.

Ford and GM each have a shot to deliver further earnings growth by turning around their European operations and retaking share in the U.S. through product improvements.  However, the competition is not standing still, and I think that some recent developments could put significant pressure on both companies' results.

On the accounting side, Ford's EPS this year will be pressured somewhat by the conversion of expiring warrants to common stock, which will dilute Ford's earnings by approximately 3%.  This is double the company's last estimate of the dilutive impact, which is a result of the stock's strong Q4 performance.  Meanwhile, GM's EPS will benefit from the recent share buyback, but this will likely be offset by a reversal of the company's valuation allowance, which would increase GM's effective tax rate going forward.

On the fundamental side, both companies have been introducing more competitive products into the U.S. markets, but again there have been significant hiccups.  GM's performance in 2013 will depend heavily on consumer demand for its new line of pickup trucks. 

However, the company has built up very high inventory of older-model pickup trucks (over 220,000 as of Dec. 31, 2012).  It will be hard for GM to sell those trucks without resorting to heavy discounts, once the new models start arriving.  Moreover, the switchover to the new models will put pressure on earnings for the next two quarters or so, due to heavy plant downtime associated with retooling.

On the other hand, GM could benefit if the new trucks are well-received, but the resulting market share gains would come largely at Ford's expense.  Ford has also been plagued by numerous quality control problems in the past year.  This has resulted in frequent recalls and a drop in the reliability rankings.  Over the long term, this could lead customers to shun the Ford brand (or at least unproven new models), with negative consequences for the company's financial results.

Lastly, Ford and GM have benefited from the strong yen over the past several years.  While Japanese auto giants such as Toyota (NYSE: TM) and Honda (NYSE: HMC) have moved much of their production for the U.S. market to North America, they still import roughly 20% of their vehicles from Japan.  Moreover, many of their suppliers are still in Japan.  The strong yen made Japanese auto production very expensive, making it hard for Japanese automakers to compete on price. 

However, a change of governments in Japan has resulted in a nearly 15% slide by the yen versus the dollar since late September.  I estimate that this change in exchange rates (assuming it holds steady through 2013) effectively cuts costs for Japanese automakers by 4%-6%, depending on the extent to which they source/manufacture in Japan.  Ford seems particularly vulnerable because its U.S. margins have exceeded targets in recent quarters.  Heavier discounting by Japanese automakers could cause profit-sapping margin dilution for Ford.

Given how quickly the stock prices for Ford and GM have run up, I think it's time to take a breather.  Heavier competition from Japanese automakers, as well as idiosyncratic headwinds may pressure results in 2013.  In the past month, I have taken profits in my Ford and GM positions, and I will not look to re-enter either stock until I see tangible improvement in results or a significant stock price correction from current levels.

adamathm has no position in any stocks mentioned. The Motley Fool recommends Ford and General Motors. The Motley Fool owns shares of Ford. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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