Ford Motor Company (F) Earnings Call Transcript & Summary

Okay. Good afternoon. I think we are live, and I apologize for the technical difficulties and the delay in starting here. Thank you, everyone, for joining. I'm Dan Levy. I lead equity research coverage of the U.S. auto sector at Crédit Suisse. I'm very pleased to have with me on the line key members of the Ford management team, John Lawler, CFO; Kumar Galhotra, President of Americas and the International Markets Group; Marion Harris, President and CEO of Ford Motor Credit; and Lynn Tyson, Executive Director of Investor Relations. Should be a very timely conversation as we'll discuss a number of key topics from the 3Q call as well as a number of broader strategic topics. I'm going to run through a series of prepared questions on the business units and strategic initiatives, including commercial vehicle and EV, and then we'll open it up for questions. Please feel free to e-mail me at dan.levy@credit-suisse.com, and I can ask your question anonymously. Our conversation is set to last until 2:30. And please be advised, we have investment disclosures for the discussion today. Please reach out if you'd like a copy. With that, John, Kumar, Marion, Lynn, welcome and thank you, very much appreciate having you.

Great. Why don't we dive right in. And I think the best place to start is, given there's a new regime in place, Jim Farley is now CEO. I know a number of you are Ford veterans, but a new management team in place. I think that it's probably a good place to start to get a sense of the priorities under the new team. And I want to start with a cultural question. We've heard about the importance of accountability and urgency at Ford in the past. But it seems like under Jim Farley, this theme is really accelerating. So if you could just talk to what specifically is changing under Jim Farley's regime to really drive acceleration of urgency and accountability.

Yes. Well, thanks, Dan. It's John. Let me take that one. I would say that one of the things that's happened now, as Jim came in, and we as a team worked with him leading up to his transition into the CEO role, was, one, he wanted to make sure he got his team in place, and that team was of like mind with him and very focused on the fact that there's a couple of things we need to do. And the first thing is, we need to be laser-focused on fixing our automotive operations, right? Fixing the issues that we have so that we can generate and deliver in the automotive business the types of returns and cash flow we need to fund our growth initiatives. And then once we've done this transformation, this double transformation as we're working both avenues of it, fix our issues, improve our automotive operations, raise our level of execution and then really start to invest in growth opportunities that will be accretive and value-creating for everyone, for our shareholders and all our stakeholders. And so that's what we're laser-focused on. We have a plan. We've got a great team. We know that we need to fix the automotive side of the shop, improve our performance there and then invest to grow.

And how do I balance, one of the things that we heard under Jim Hackett's tenure was this notion of managing multiple clocks. And I think this theme is obviously very relevant today. So you're talking about the near-term automotive operations, but also the longer-term growth. So how does the management of these 2 clocks, the near and the far, the near-term auto biz and the longer-term growth, how does that balance change, if at all? I mean is it arguably the case that without near-term execution, the longer-term growth is just irrelevant? You need to fund that longer-term growth with the near-term execution.

Yes. They're not mutually exclusive. I mean we need to do both, execution in the near term and growth for the long term. That's exactly what we need to deliver. They're complementary. So we need to improve what we're doing today, including launches. We need to improve our costs. We need to improve our warranty cost. And those better results, those will help us deliver, as I said earlier, the profitability, the EBIT margins and the cash flow so that we can invest. And we're laser-focused on getting to that 8% EBIT margin, 10% in North America, 6% in Europe, and that will give us that consistent generation of free cash flow, right, that we will invest in, as I said earlier, in high-return businesses. And the nice thing about it is, not only can we do that on the auto side, but we can also do that around products and services as we expand our bandwidth of what we can do as we lean into electrification, as we lean into connectivity and connected services.

Great. Let's pivot to the business units because I think this is where a lot of the investor questions are lying and obviously, North America. So at the core of your 8% company margin target is 10% in North America. And I think you've talked about there's a number of components in that, the winning portfolio, cost, growth in adjacencies. So let's just start with the 3Q. You put up a 12.5% EBIT margin. That's your best margin in the segment in roughly 4 years. And that was without any benefit from new product, that's without any of your cost initiatives. So how do we look at that 3Q print? What can be extrapolated to future quarters? What can be viewed as a unique onetime benefit? And specific to the pricing side, $900 million tailwind in the third quarter, how much of that was a unique function of the market, reflecting tight supply, or is there potential for that to be extrapolated to future quarters?

Yes. Why don't I start and then maybe Kumar jump in as well. So when you look at it, this year is a difficult year, Dan, as you know, because we have COVID and that's disrupted the business in the second quarter. We took the factories down, and then we came back up. And it's really difficult to get a run rate of the business. As we go into the fourth quarter, we're launching 3 new products. And when you look at what happened in the second quarter, I think there were a couple of things that came together, both internal factors and external factors that drove that. One, the SAAR came back much stronger than we had expected. And that came on the top of having inventory that was constrained given that the plants were down in the second quarter. And so the teams did a really good job as that demand came back, executing in a difficult environment, making sure that our team was safe and protected as we ramped the plants back up. But we also had to do a lot of work with our supply base and worked very closely with our supplier partners to make sure that the supply chain continued to deliver parts into the plant. And we had over 300 suppliers that were on premium freight and different forms of expedited freight. And so the team did an incredible job. Many of our plants worked overtime, worked weekends to keep up with demand and keeping that running in. But that was pulled with a tailwind from incremental demand versus what we expected with low supply. And so that led to some pricing power. And the team did a nice job of managing that pricing power in that strong market. So a couple of those things came together. And as you look at the quarter, we put up very good numbers. We put up good results, but it was really a couple of things coming together that allowed us to do that. Kumar, anything you want to add?

Thanks, John. The only thing I would add is, we remain very focused on getting North America to 10%, which obviously supports the 8% margin for the company. And as you mentioned, it's been a very unique year. In third quarter, the SAAR was substantially stronger than expected. But that's just the demand side, right? If we don't perform from the supply side, you can't capitalize on that opportunity. So really proud of the manufacturing teams who were able to first stop production as quickly as we did and then to come up with a playbook for our manufacturing operations, where we can keep our employees safe, bring in thousands of people for every shift, have very, very clear protocol on how to manage the risks and run our factories, and they did a pretty amazing job. And also, we reduced our structural cost to some extent. The pricing tailwind was good because the inventories were down, not just for us, for the entire industry as well, that really helped as well. So we're taking all these factors into account and obviously working on making sure that the efficiencies that we gained during third quarter as much of that as possible. The reason I say as much as possible is because next quarter is going to be very different. We're going to have -- we're in the middle of the F-150 launch. And we're going to lose substantial amount of units during that launch. So the underlying improvement, we're working on flowing them through to the future quarters as much as possible.

Great. And that's helpful commentary because that tells me, on one hand, you obviously had some unique pricing benefits. But at the same time, we need to consider that you achieved that even in the face of incremental inefficiencies. So that I think bodes well. Let's talk about costs because I think that, that's really top of mind. And I think that sort of gets to what you're talking about, you're mentioning on the structural side. So let's do this, start broadly. Listen, the last, call it, 3.5 years or so, 3Q '16 to 1Q '20, cost was a headwind in North America in basically every quarter, sharp tailwind, however, in the second quarter, flat in the third quarter, but really reversing a trend. So just help us understand what happened on cost in the last couple of quarters that's helped flip the trend. How much cost relief last couple of quarters was temporary versus more structural benefits? And then we can go into the warranty and the materials side.

Yes. Sure, Dan. It's John. I'll start out there. If you look at the second quarter, clearly, that was affected by the fact that we took our factories down with COVID. And so with that, there's going to be a cost input impact to that. And then as we brought production back up, we resumed some costs that came in with that. And then in the fourth quarter, we're going to see incremental costs coming through as Kumar had identified that is associated with the launches. But as Kumar said, one of the things that we're doing is we're looking at the efficiencies that we gained and the improvements that we had as we went down in the second and came back up in the third. And how do we understand what happened there and leverage that to bring that through following quarters. And so we're laser-focused on improving our cost in a couple of areas, in particular, around warranty and material costs. But when you look at second quarter to the third quarter, I think you've got the impact there of going down with production, coming back up with production in the third quarter. In the fourth quarter, we've got some incremental costs coming in for launching the vehicles and launching the brand. But we're very focused on making sure that efficiencies that were gained, we can maintain and retain and flow those through.

Great. Let's talk about the warranty side. Let's zoom out for a bit. Maybe you can help us understand. Look, we've heard about warranty for a while, but it seems like the issue has lingered. So really, could you give us a sense, what's the root cause of all these quality issues? Is it an engineering issue? Is it a manufacturing problem? Is it just on legacy issues? You're still having quality issues on the new vehicles. And as we frame the opportunity, I think you've had in excess of $3 billion of warranty headwinds the last few years. How much of that can you recover?

So Dan, this is Kumar. We're obviously fully committed to very high-quality vehicles. Unfortunately, our warranty costs are up about $1 billion to $2 billion, as you mentioned, since 2017. We are working all levers to improve this as quickly as possible. We've invested very significant resources, for example, in our craftsmanship of our products, and we're starting to see results. So we look at quality through 2 or 3 different ways, right? There is the, what I would say, things gone right, where we're surprising and delighting our customers, as industry standard metric there is appeal by J.D. Power. So we're starting to see improvements there. So we're gaining traction. Another is where it actually is a warranty claim, where something is wrong with the vehicle and the customer has to bring it into our dealership. As you alluded to, those error states occur in 1 of 3 areas. Either there was a design that wasn't robust enough or there was a manufacturing issue where it wasn't put together correctly or it was an issue in our supply base, where the parts that were supplied weren't robust enough or to spec. So we've taken all of our quality issues and are very clear on where those error states lie. And we're dedicating resources to fixing each one of those error states, including a much higher engagement with our suppliers. We're putting measures in place where the suppliers have more skin in the game. This will make us more consistent with the rest of the industry, which we weren't in the past. In terms of speed of resolution, we now have a very visible transparent clock on every one of our issues, every one of the significant issues that is visible to me, to Jim, to the entire leadership team and to people who have to fix it. So a much higher level of focus on speed and accuracy. We've gone back and done an audit of where we may not have proper resources. For example, our last redesign of the business that we did, we found not a lot, but some areas where we had taken out resources such as a group that looks at the supplier quality of inbound parts into our plants. And as we're finding those holes, we're fixing them very, very quickly. So we've put those resources back in the plants where they belong so that we have a feedback loop that directly ties our plant operations to our supply base operations. And finally, we are really leveraging connectivity. 100% of the vehicles we're building in U.S. now are connected. That presents a really significant opportunity for us to diagnose error state sometimes even before they happen. And we're using that both in development of the vehicle. We're using that in launching process, launch process of the vehicle, and we're also using them for vehicles that are in the field, where we can access data over-the-air from the vehicles both for early detection as well as investigation of the problem. So there are several examples where the teams are already doing that. So I think a combination of all those very specific ideas is going to help us bring that warranty down substantially.

Great. That's helpful color. And it sounds like the initiatives have stepped up incrementally versus what you've -- versus your focus or your efforts in the past. Let's ask a similar question with material cost, same deal. We've seen that I think that's been a drag of in excess of $2 billion over the last handful of years. Again, how much of that is recoverable? What's the low-hanging fruit in that? What's the underlying root cause? And again, what's different? We heard about complexity reduction in the past. What makes the opportunity for complexity reduction or other initiatives different or more achievable this time around?

Yes, Dan, it's John. I'll start off. It is a significant focus of ours to continue to drive down the cost. And as we said earlier, getting to the 8% margin for the company really does require us to improve our cost structure. And there's a few areas that we're really focused in on. One of those is around looking at every opportunity we can to optimize the content and features in the vehicle. So really focusing in on what our customers use on a regular basis and what they value. And so looking at reductive design possibilities, opportunities there. Reducing complexity is another lever we can pull that will allow us to take cost out and then designing upfront almost end-to-end for greater cost efficiency. And looking at those 3 areas we're looking at from an end-to-end process throughout the whole development cycle, we're also using benchmarking and looking at competition. In fact, there's the ability now to take a like-for-like vehicle and do an X-ray of that product to really understand what the comparable costs are with competition and to understand where you might be overdesigned relative to others in the industry. And there's a couple of good examples that have come through as we do that from both the X-ray or the reductive design. And I think Jim touched upon those, a couple of those when we had our earnings call, but one of those is the F-150 rear door proximity sensors. And through connectivity and being able to understand what the customers use, we understand that you don't need proximity sensors on all 4 doors. Or if you look at our F-150 jack, it's overdesigned relative to what others provide consumers. So we're looking at everything. But one of the areas that's really exciting for me is the work the team is doing on connectivity and being able to understand exactly what the customers use and what they find valuable and then leveraging that to provide a better product, but one that could be at lower cost.

Great. Excellent. I think that's a good overview on the cost opportunities in North America. Why don't we pivot to Europe, also obviously a very topical business segment. And let's just start with something more near term. Obviously, we saw on the CO2 front, you initially said you were going to achieve the 2020 and '21 CO2 targets without credits or penalties. Obviously, the Kuga PHEV recall changed that, and you took some incremental charges in 3Q, some in 4Q. Does the recall impact your ability to hit the 2021 CO2 targets or do you also need to pull targets for '21 and pool credits for '21? And what's the incremental cost on the '21 pooling, if relevant?

Yes. So first, let me start with 2020 and then come back to more directly answer 2021 as best I can at this point. Yes. We would have met our CO2 requirements in Europe for passenger vehicles had we not had the stop sale, stop ship on the Kuga. But we did, and we had the component issue with the quality issue from a supplier. And we did take a charge of $400 million in the quarter related to the cost to comply with the emission standards as well as the warranty and the manufacturing costs to deal with the issue and customer satisfaction initiatives that we put in place. And we have identified that it will be about $100 million to $200 million in the fourth quarter of cost. But outside of that, we would have met that CO2 target. And the cost that we put in do include the cost for us to now join a pool with Volvo on passenger vehicles. But we haven't announced or we haven't disclosed what that cost is for pooling. That's something that we don't think it's appropriate to put out there at this point. Now we have also exceeded our CO2 requirements on commercial vehicles. And so we are creating a pool for commercial vehicles where others can join us and take advantage of the fact that we are above the CO2 targets for commercial vehicles. And so I think, holistically, as we look at it, we always intend to meet the emissions targets. We have always. And we will continue to meet those emission targets. And so specifically for 2021, I'm not going to comment on how we're going to do that, but it's always our intent that we do that through our product plans.

Great. Let's talk about the path to 6% margin in Europe. And I guess, let's just start with a quick one. How much of that 6% margin target is dependent on material industry recovery or what industry recovery do you need to see to get that 6%?

Yes. Well, the 6% that we put out there is really a sustainable target. We expect to achieve that year in and year out, not just in the best market conditions. But I guess, conversely, I have to say that it doesn't apply if we're seeing a severe market downturn. But we expect that to be at a run rate of the business. And so that's sustainable. I guess when you look at the path to 6%, a big part of that is going to be covered in: one, the businesses that we're focused on; two, fixing our cost issues, addressing cost issues, right; and then three, what we're going to do with our footprint. And so when you look at what the team in Europe has done, they've done a really nice job over the last couple of years taking their structural costs down. They've identified $1 billion of efficiencies in their structural cost that they will achieve by the end of this year, which is starting to show up in the results. And in the third quarter, had it not been for the quality issue on Kuga, Europe would have been profitable. The other thing I have to say is that focusing on our strengths and shifting our attention, as we've been doing in the last couple of years, the European team has been doing into commercial vehicles and into more profitable SUVs is also part of the recovery plan. And we grew our share of commercial vehicles again this quarter, and that's a very profitable business in Europe for us. And then we're also growing our SUV share, which has much better margins than the traditional passenger vehicles. And then looking at our footprint, the team has done a nice job so far of reducing our manufacturing footprint by 6 facilities. And next year, we'll see the full impact of that and the benefit of those actions that we've taken so far. So there's quite a few areas that the European team is focused on. We're starting to see the results of that flow through. And the team is going to continue to work that as we move forward as we drive to get to that 6% sustainable EBIT margin.

And as we layer in increased electrification, does the cost of CO2 compliance, and presumably, that only increases in subsequent years, do all those other actions mitigate those incremental CO2 compliance costs?

So I think we've identified the 6% understanding that there's going to be a shift into battery electric vehicles and a shift into meeting the compliance. And we've taken a holistic approach where not only do we have BEVs, but we have full hybrids and PHEVs as well. But when we identify the target of 6%, that was full well knowing that there were going to be CO2 requirements that we had to meet.

Great. Let's wrap up with sort of one quick one on Europe and maybe an incremental risk. Brexit, to the extent there are different developments on the Brexit front, does that pose any incremental risk for you?

Yes. I mean, we're encouraged by what we're seeing and that both sides are committed to a tariff-free, quota-free deal And that's really what's crucial for and critical for our business in Europe. As you know, our footprint, we have a very large footprint in the U.K. And we're encouraged by what we're seeing. And I would have to say, though, that if there is a failure to reach an agreement and there are tariffs that come into place on vehicles and components, it would have a significant negative impact on our business in Europe and particularly in the United Kingdom.

Great. That's good color. Okay. Why don't we pivot to China. And China, I think, is an interesting region where you're really seeing the benefits of your initiatives there and the growth on your units in second, third quarter are pretty robust, up something like 40-plus-percent in the second quarter, up 20-plus-percent in the third quarter. Give us a sense of the underlying dynamic in China. Is this recovery in volume? Is this just simply easy comps? Or is it the benefits of the new product? And going forward, obviously, your goal is to not only hit breakeven, but to be profitable. How much does the push to NEV impact the road map of China profitability?

Yes. Yes, China did have a good quarter with shipments up, wholesale shipments up 22%. And that, I believe, was the second consecutive quarter of year-over-year growth. So sales are improving there. I guess if you unpack that a bit, there's 2 things that are helping drive that. One is vehicles and the mix of what we're focused on. So we had our strongest sales of SUVs and commercial vehicles in quite a while. SUVs in the quarter were up 13 percentage points, and now they're 36% of our sales. And what we've seen in the last quarter is, we launched quite a bit -- quite a few new vehicles over the first part of the year. First is the Explorer. And what's key about that is the Explorer is now locally produced. And then we have the Lincoln Aviator and the Corsair, which are -- the Lincoln Corsair, which is also locally produced. And so consumers are receiving them well. They're produced in-market. So there's a much lower cost. And so the combination of having new products, locally produced, lower cost structure, you're starting to see that come through the results in China. And what's interesting is Lincoln, now 65% of Lincoln vehicles are produced locally. And that's up from 0 last year. So we didn't have anything locally produced. And we're really seeing a favorable reception of both the Corsair and the Aviator. The other thing, the other strength we have in China is -- and I don't think a lot of people know this, but our commercial vehicles are very strong in China through JMC. Their sales were up 38% versus last year. And that's a strong business for us, and we're continuing to see strength in demand for light trucks, vans and pickups. And so with JMC, we're seeing growth there as well. So I'd say that it's localization, it's new product, it's new product in the right segments. It's a product that's being well received, and then it's the strength of our truck business with JMC.

And then just a question of clarification. You said you're at 65% timing to get to full localization of Lincoln?

Yes. That's going to come in over time. We haven't announced the exact timing of that. And there will be some products that we continue to import that are very low volume, high-margin products that wouldn't make sense to localize.

Great. Let's move on, same spirit of questions for credit. And again, same deal with North America, a really strong quarter, I think $1.1 billion in EBT in the quarter. That was your best quarter since 2005. And I know you know there were some benefits on residuals on the lease book. But could you help us understand, same question with North America, what parts of the third quarter results can be viewed as onetime versus what we can maybe extrapolate to future quarters?

Dan, this is Marion Harris. A lot of that lease performance in the third quarter was, I would say, unusual. It's not often in your career you find yourself with excess supply and then demand, all of a sudden, shoots up dramatically. And that's what happened to us. And not only did the demand shoot up dramatically in the third quarter along with prices, these are units we found ourselves with excess supply going into the third quarter, and we had taken a lot of depreciation on those units in the first and second quarters in anticipation of significantly lower auction values. Not only were they not lower, they were significantly higher. So a lot of that, a lot of the financials came out in the third quarter. So that's what I'd say. But if you look at the business and try to find the signal through the noise for the run rate of the business, in total, auction values are better. They're certainly running better today than we would have expected them at this time. Our actual credit losses are performing better than we had anticipated at the beginning of the year. That being said, we're prepared for escalating losses and an upcoming recession. So if and when those losses occur, it's not necessarily a profit issue as we are appropriately reserved for that. That will be offset by somewhat smaller receivables. But the business itself is continuing to operate very, very well.

Okay. So that's helpful, Marion. So as we distance ourselves from COVID, and obviously, I think you took some conservatism earlier on and now you're benefiting because the market is a bit better. As we distance ourselves from the depths of COVID, are there any lingering issues that would challenge for credit? Whether it's what's the timing to get the lease mix back to the pre-buyers level or the cost of funding given you're now high yield? Just trying to parse through the different puts and takes as it seems like the industry has recovered really nicely, but there's still maybe, I guess, some lingering impacts as far as the cost of funding. Just trying to understand whether we can get back to the full run rate like we saw in 2019 of profit, if possible.