Ford: Leasing Could Be a Big Drag on Its Earnings (NYSE:F) | Daily News Byte

Have you ever tried to buy a new car during the COVID-19 pandemic? My guess is that it wasn’t easy and you had to wait months, if not years. Even used car haters like my dad consider used cars. Yes, no new and someone has driven it before you. But what do you do if you need a new car and the car maker tells you to wait a few years before it’s delivered?

Many people like my father have raised prices for used cars over the past few years. Prices for used cars increased by 27% in 2021 and 14% in the first six months of 2022. This brought huge profits not only to car dealers, but also to leasing companies that resell used cars at higher prices or, as they call it, “auction values.” As Ford (NYSE:F) and GM ( GM ) has one of the largest leasing companies in the US, established automakers have also benefited from this. The higher auction value helped them increase their profits and increase dividends.

Recently, the tide has started to turn. Interest rates rose as used car prices fell. Of course, this drags down the revenue of the leasing units and the traditional car producers. The main question is whether the trend is short-term or whether it will have a long-term impact on leasing companies.

I believe the recent changes will have a lasting impact on the entire car industry and the leasing units. Rising interest rates and higher demand for electric vehicles will penalize prices for combustion engine cars. If customers turn away from combustion engine cars when interest rates are high, it will be the kiss of death for the leasing business. While all the top car manufacturers will suffer, some of them will be punished more. We are busy looking for which one.

Leasing: What? How? Why?

We all know how expensive cars are. And yet, we love them so much. Sometimes you want to buy one but you don’t have enough money to buy it. But don’t worry! Leasing is here to help you. You pay a small initial price and you can drive the car, paying money every month for 4-5 years. After a few years, you can choose to pay off the remainder and own the car, or you can simply return the car to the leasing company.

The leasing company issues the loan, borrows money from clients for several years, and gets the car as security. If the car is returned after a few years, the leasing company sells the car on the secondary market. Alternatively, the company may be paid for the car at the first agreed upon price.

When car prices rise, it becomes profitable for customers to buy the car at initial price and resell it on the secondary market. When car prices drop, the buyer is likely to return the car to the leasing company. If car prices drop too much, the leasing company has to resell the car at a loss.

Historically, prices for used cars have been very volatile, causing large fluctuations in profits. From the chart below we can see how quickly prices have risen in 2021. This has created huge support for car makers with leasing divisions.

To assess the importance of leasing for various car players, we took a detailed look at Ford, GM, VW (OTCPK:VWAGY), Daimler / Mercedes (OTCPK:MBGAF), and BMW (OTCPK:BMWYY). We can see that Ford gets almost 50% of its EBIT from the leasing divisions. The contribution to leasing of other players is lower, but more than 25%. I mean EBIT. Leasing brought in a smaller share of revenue, as it was more profitable than vehicle manufacturing. Therefore, almost all car players also lease.

In fact, leasing plays an important role in the time of Covid-19. This became the business stabilizer. In 2022, used car prices dropped, which had a significant negative impact on the leasing business. We see this especially with Ford. Its EBIT is almost the same in 2021 and 2022, but the leasing contribution is completely different.

In the past, prices for used cars have always recovered after sharp declines. Today, it may be different. Most used cars are combustion engine vehicles, but the share of electric vehicles in sales is increasing rapidly. For example, the US share of electric vehicles was only 1.6% in 2021, but it reached 6% in October 2022. The trend is expected to continue in the future, with McKinsey estimating the EV share at around 30 % in 2026. a widespread adoption of EV vehicles could penalize the demand for combustion engine vehicles. In this case, clients will be willing to buy them, but only at a lower price. If EV adoption reaches such widespread acceptance when interest rates are still high, it could create a perfect storm for leasing companies.

Right storm or kiss of death: leasing becomes expensive due to high interest rates and suppresses car demand. Falling prices for used cars are forcing leasing companies to sell used cars at a loss.

Ford, GM, BMW, Daimler, VW: Who will be left behind?

To understand which companies will suffer the most from the storm, we compared car manufacturers in terms of leasing size. We benchmark them based on leasing. Below, we see that leasing contributed significantly to GM and BMW, while cash flow from Ford Leasing fluctuated widely.

Leasing is smaller by Daimler and Volkswagen. Daimler’s lease contracts in relation to total assets are only 7.3%. Also, the leasing segment is not separate from Mobility services in its reporting. This is a clear sign that the company is not considering hiring a serious driver.

Volkswagen leasing also doesn’t make much money, and doesn’t really affect the company’s financial stability. Operating cash flows from Financial Services are approximately 20% of the entire cash flow. The EBIT generated by Financial Services is around 25%. Although the financial liabilities associated with Volkswagen Financial Services are high, only 11% of debt consists of floating rate bonds and 89% of fixed bonds, mitigating interest rate risks.

Therefore, to identify the most vulnerable stocks, we focus on Ford, GM, and BMW.

Ford, GM, BMW: Where’s the danger?

Looking at the debt structure, Ford has the highest debt to EBITDA (Net Leverage). This metric is useful for benchmarking debt because it shows it relative to business performance. This is also reflected in Ford’s credit rating of BB+. On the other hand, GM has an investment grade rating of BBB- and BMW of A.

If we look at Ford’s debt, we can see that a large chunk of the debt will mature in the next few years. Even though a large portion of the debt has been settled, it will still need to be refinanced in the coming years. It’s common practice to refinance debt rather than pay it off, but higher interest rates make debt refinancing more expensive. This will put an additional drag on revenues. In 2021, Net Income is $17.9 billion, while Interest is 1.3%. A 2.0% increase in the interest rate corresponds to an interest rate of 3.3% and therefore Net Income decreased by $2.15 billion.

Higher interest rates will also result in higher leasing costs and a larger share of defaulting customers. We don’t see any alarming dynamics at the moment, but as the interest rate policy works on lags, we can expect more issues ahead.

Car manufacturers primarily use leasing divisions to finance sales of its own vehicles. Therefore, the share of electric vehicles in the total sales of the respective car producers plays a large role. The more electric cars are sold, the more are sold through leasing. This means that the overhang of previously sold combustion engine cars will be smaller in the case of a larger share of EV sales. According to the latest available data, Ford has the lowest share of EV cars at 4.0%, GM at 8.0%, and BMW at 7.3%. This makes Ford the most likely candidate for SELL if used car prices drop significantly.

Appreciation

To compare the valuation of all five car producers, we used the EV/EBIT metrics. From the chart we see that Ford has a higher EV/EBIT of ~15x. This is higher than GM and higher than its European peers. This is another argument that Ford may suffer the most from negative leasing trends.

Risks

Interest rate and inflation risk

The current high inflation may moderate if the Fed can control wage dynamics. Interest rates will fall following the moderation of inflation, which will reduce the likelihood of a recession. This could be a positive catalyst for highly cyclical automotive stocks.

Timing risk

Interest rates are likely to disappear soon as the market transition to electric vehicles will be delayed due to scarce raw materials and poor charging infrastructure. This will give the leasing divisions enough time to adapt to the new dynamics.

Conclusion

Leasing can change from a car business stabilizer to a business destabilizer. After looking at the top five car players, we believe the most destabilizing effect may be Ford. The combination of high debt levels, low EV share, and high relative valuation only supports our previous skepticism about Ford.

Although established car players have very low valuations compared to EV players, they seem reasonable as there are many risks that could happen in the future. But not all car makers are like that. We found one that has a strong chance of surpassing Tesla (TSLA) in terms of self-driving capabilities. We will publish our review of this stock soon.

Meanwhile, keep riding the cycle.