Why I'm Buying this Iconic American Brand
Matthew is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
In today’s trade for the “No Drip, No Mess” Portfolio we’re going to use a very strategic approach to acquire shares of an iconic American brand. We’ll use a combination of options and direct ownership as a way to smooth out the volatility as we begin to back out of the driveway and invest in Ford Motors (NYSE: F). While there is a lot to like about Ford’s long-term outlook, we’ll take advantage of Wall Street’s short-term concerns as we drive away with some long-term gains.
Few brands in America are as iconic as Ford’s and they’ve done a great job in preserving the brand by being the only US automaker that did not need a government bailout during the financial crisis. Their financial strength has positioned them in the pole position to take advantage of some major positive trends I see on the horizon. With GM (NYSE: GM) still working its way back to the top after going bankrupt and Toyota (NYSE: TM) still struggling post-tsunami, Ford has been able to focus on making cars customers want to buy.
Total vehicle sales for Ford were up 7% for the month of June in the US and those operations contributed $2.1 billion worth of pre-tax income for the first quarter of this year. While both GM's 16% year-over-year gain and Toyota’s 60% sales gain were excellent results and they will benefit from the trends we’ll be discussing, I like how Ford is investing aggressively in Asia -- they have eight plants being developed. They are planning on doubling their workforce and dealerships in China by 2015 while also launching 15 new models to appeal to the Chinese consumer. A small loss in the first quarter for their Asian operations is expected to reverse to a full-year profit. The one major pothole that’s unavoidable at the moment is their European operations, which we will look at later on.
The big trend that we’ll be watching is for an improvement in new car sales over used cars being scrapped. From 2000 until the end of the housing boom the US was buying 3 million more cars than were being scrapped each year. This was partially due to more Americans owning cars as ownership went from 73 cars per 100 Americans in 2000 to 80 cars per 100 Americans in 2007. That number has since slid down to 77 cars per 100 Americans but what’s more important is that Americans are simply holding on to their cars longer -- last year the average age of a vehicle on the road was 10.8 years, up from 8.4 back in 1995. This has caused the scrappage rate, which dropped to a negative number in 2009, to remain below normal as it is projected at just 2 million cars in 2012. As Americans begin to scrap their older cars for newer, more fuel efficient cars Ford will sell a lot more cars.
Even without factoring in those two potential catalysts, Ford is already very profitable and just took its idled dividend out of the garage, with a yield currently coasting right around 2%. Over time I think that the company will accelerate its payout to shareholders and we plan on enjoying the ride for a long, long time. As the company’s Asian business shifts into high gear, the company’s overall profitability should accelerate as well. The market is undervaluing this future, and some have put its current fair value as high as $16 a share. While I’m not quite so optimistic, Ford currently trades at just 8.9 times free cash flow, and a 10 times free cash flow multiple puts shares at $10.67 a share. I think that’s a fair price to pay for the shares.
We’re going to approach our ownership in Ford a bid differently than most of the trades I’ve recommended. Given the risks and volatility that I’ll detail in a moment, I want to use options to smooth out our risks and potentially bank a healthy short-term profit as we ease our way into our Ford position. While we’re going to back into a full 5% allocation, we’re not afraid to tap on the brakes if Ford starts barreling ahead. We’re going to write a Covered Straddle consisting of buying 300 shares while writing two calls and two puts at $10 strike prices expiring in September. Notice that we’ll be leaving 100 shares uncovered and that’s by design. We want to profit from the upside while earning some income from the options. I chose September because I’d like to write options more frequently to bank more consistent income. In this trade we’re looking to collect a total of $225 of income, which is about 4.5% to be earned on the capital at risk. If Ford stays under $10 a share we’ll be fully allocated and look to ladder some covered calls. While Ford’s shares going above $10 would have us let our shares be called, locking in an additional 2% of capital gains and the writing puts to restart the options income engine.
Risks and Why We’d Sell
The biggest risk to Ford is the currently shaky global economy. Sales in Europe continue to be sluggish and as employment remains weak in the US, it doesn’t give them too much margin for error in terms of product and pricing. The biggest road block though is Europe, which led to losses of $149 million in the first quarter and stands to lose over $500 million for the second quarter. If Europe’s problems boil over and become our problems, it could cause consumer confidence to remain low as they’ll hold onto their clunkers even longer.
The second risk that needs to be watched is their debt level. While the company currently has more cash on their balance sheet than debt, and are on their way to becoming investment grade, if the economy does go into a tail spin, Ford might need to revert back to the debt markets to cover any holes in their cash flow. A credit downgrade would be a sign that we need to apply the brakes here and reevaluate whether this company should be parked outside our portfolio.
Ford along with the rest of the Detroit automakers have risen from the ashes of the financial crisis. I think they are among the best positioned to drive away with a growing portion of sales as consumers finally trade in their old cars. While Ford will have an initial 5% allocation to the portfolio, I’m not opposed to adding an automotive supplier such as Autoliv (NYSE: ALV) or Gentex (NASDAQ: GNTX) to the portfolio once the concerns in Europe and our own fiscal cliff have passed. I think the industry as a whole is poised to enjoy a new cyclical upturn. Both Autoliv and Gentex are safety focused suppliers and as the middle class subset develops across the world, more car buyers will demand additional safety features being added to their cars. In the meantime, we’ve got many profitable options as we straddle the open road with Ford.
latimerburned owns shares of Autoliv and has a synthetic long on Ford. The Motley Fool owns shares of Ford and Gentex. Motley Fool newsletter services recommend Autoliv, Ford, and General Motors Company. 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. If you have questions about this post or the Fool’s blog network, click here for information.