In May 2012, Moody's became the second major credit rating agency to give Ford Motor (NYSE: F) an investment-grade credit rating. This was a huge milestone, as it allowed Ford to regain full title to its U.S. assets, including its iconic "Blue Oval" logo. Ford had been forced to post these as collateral for a massive loan that enabled it to avoid bankruptcy during the Great Recession, unlike rival U.S. automakers.
However, Moody's is now taking that investment-grade rating away. On Monday, the prominent rating agency downgraded Ford's credit rating to Ba1, the highest rung of non-investment-grade (or junk) territory.
In the short term, this development won't have much of an impact on Ford. But if another one of the major credit rating agencies downgrades Ford's debt to junk status, the company would likely face higher borrowing costs, which could pinch its profits (particularly in its Ford Credit financing subsidiary). That said, the analysis behind this downgrade underestimates how quickly Ford is likely to recover from its recent struggles. If profitability rebounds as I expect, Moody's could restore Ford's investment-grade rating within a year or two.
Moody's cuts Ford's rating -- despite its strong balance sheet
As my Foolish colleague John Rosevear recently noted, the Moody's downgrade was somewhat confusing. Moody's expects restructuring costs to weigh on cash flow for the next few years, but it seems bullish about Ford's efforts to boost its profit margin over time by exiting unprofitable markets and product lines, while refreshing its core offerings. Moody's also acknowledged that Ford has a solid balance sheet, including $23.2 billion of cash (which exceeds its automotive debt load). Thus, the company has the financial flexibility to pull off its restructuring plan.
Image source: Ford Motor Company.
The main reason why Moody's is cutting Ford's credit rating is that it expects the Blue Oval's profitability to remain under pressure until at least 2022. This projection of subpar earnings in 2020 and 2021 makes Moody's downgrade understandable, as it means that Ford would be in a weak position to withstand incremental headwinds like a severe recession, a spike in commodity costs, or an all-out trade war.
Profitability in North America is set to surge
Moody's downgrade note highlights that Ford's adjusted operating margin in North America has fallen to around 8% in 2018 and the first half of 2019, after exceeding 10% as recently as 2016. The rating agency thinks Ford may get back to a 10% operating margin in its home market eventually but not for a few years.
However, Ford is already close to an inflection point for its profitability in North America. The automaker has been phasing out most of its (unprofitable) traditional car models since early 2018. An upgraded and expanded portfolio of crossovers, SUVs, and trucks will be the key to holding unit sales steady at greatly improved margins. (A recent decline in commodity costs should help, too.)
So far, Ford has seen great success with the latest version of its Ford Expedition and Lincoln Navigator full-size SUVs. It recently boosted production by 20% to meet red-hot demand. The Ranger midsize pickup has also sold well since being reintroduced in North America in early 2019. Ford has also seen smaller success from bringing the EcoSport subcompact SUV to the U.S. for the first time and introducing the Lincoln Nautilus to replace the fairly boring Lincoln MKX midsize crossover.
The Ford Ranger was reintroduced in the U.S. earlier this year. Image source: Ford Motor Company.
That said, the Ford Escape, Ford Explorer, and the latter's police variant accounted for more than two-thirds of the nearly 800,000 crossovers and SUVs that the Blue Oval brand sold in the U.S. last year. All three have been badly in need of updating. Domestic sales of the three models combined fell 14% year over year in the first half of 2019. Fortunately, all-new versions of the Explorer and the Police Interceptor went on sale this summer, and an all-new Escape will follow later in the year.
These much-improved models, along with two new Lincoln crossovers, should drive rapid improvement in sales and earnings trends in North America over the next few quarters. The reintroduction of the Ford Bronco off-road SUV and a smaller sibling in 2020 -- along with the launch of an all-new Ford F-150 -- should drive further gains in 2021. As a result, I expect Ford's North American operating margin to return to the 10% level by 2021 at the latest.
Ford won't be pressed for cash
It may take longer for Ford to fix its business outside North America, but the company is already making progress. Moreover, Ford's home market generates more than half of its unit sales, more than two-thirds of its revenue, and more than 100% of its automotive profit. Thus, revenue growth and margin expansion in North America over the next two years would drive strong earnings growth at the company level, even if results in other regions remain weak during that period.
Strong profitability in North America -- along with dividends from the Ford Credit subsidiary and gradual improvement in the rest of the world -- should enable Ford to produce positive free cash flow in 2020 and 2021 despite incurring high restructuring costs. That would run contrary to Moody's expectations.
Other developments that will bolster Ford's cash position include VMWare's pending deal to buy Pivotal Software for $15 per share -- making Ford's stake in the latter worth more than $250 million -- and Volkswagen's recent investment in Argo AI. Volkswagen is buying half of Ford's interest in the self-driving car start-up for $500 million, while agreeing to invest another $1 billion in Argo AI and contribute other assets to the company. This will reduce the amount that Ford will need to invest to continue Argo AI's research and development efforts.
In short, Ford isn't likely to experience nearly as much cash flow pressure over the next two years as Moody's expects. Moreover, its profitability is likely to improve rapidly over that period. If that happens, Moody's is likely to recognize the error of its ways and restore Ford's investment-grade rating before too long.
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