Why Ford's Second-Quarter Profit Fell -- and How It Plans to Recover

By Markets Fool.com

Sales of Ford's F-150 pickup have been very strong, driving goodresults. But incentives are up from a year ago, when supplies of the then-new F-150 were very tight -- and that increase dented the Blue Oval's bottom line in thesecond quarter. Image source: Ford Motor Company.

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Ford Motor Company (NYSE: F) said on Thursday morning that its second-quarter profit fell 9% to $1.97 billion, or $0.49 per share, on weaker results in China and higher incentives in the United States.

Ford's profit result fell well short of the $0.60 per share expected by Wall Street analysts, though its $39.5 billion in revenue came in ahead of analysts' expectations.

Ford's share price dropped over 7% shortly after the news was announced.

The key numbers

Here's a look at how Ford's second quarter compared with its year-ago result. As you can see, while revenue was up and cash flow was strong, overall deliveries fell slightly, and margins and profits fell short of year-ago results.

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Metric Q2 2016 Q2 2015
Revenue $39.5 billion $37.3 billion
Wholesale deliveries 1,694,000 1,696,000
Pre-tax income $3.0B billion $2.7billion
Pre-tax automotive profit margin 7.7% 8.4%
Net income $2.0billion $2.2billion
Earnings per share $0.49 $0.54
Automotive cash flow $4.2billion $1.9billion

Data source: Ford.

Note that automotive profit margin and automotive cash flow include only the results from Ford's core business of auto-making. Results from Ford Credit, the company's financial-services arm, are excluded from Ford's automotive calculations.

Why did Ford's profit decline?

During an early morning interview on Thursday, Ford Chief Financial Officer Bob Shanksemphasized -- quite rightly -- that Ford's second-quarter result was still a very good one. But, he told me, there were a few factors at work in its slight profit decline from a year ago. (See here for details of Ford's results in each of its regional business units.)

First, Ford's incentives are rising in the United States. Incentives, those cash-back or cheap-financing deals often advertised on TV, are part and parcel of the business of selling cars. In recent years, Ford (like most of its rivals) has kept incentives to relatively modest levels in an effort to sustain strong profit margins. But with the overall market now leveling off afterseveralyears of strong growth,competition is leading automakers to boost their discounts.

Shanks said that Ford's incentives have since returned to what he sees as "normal" levels, but in recent months those normal levels have been slowly rising across the industry. Ford has kept pace, he said, but it won't crank up incentives excessively. So far, the impact has been modest:Ford's profit margin in its North America business unit was 11.3% in the second quarter. That's very good, but it is down from 12.2% a year ago, when supplies of Ford's then-new F-150 were tight and its incentives were unusually low.

Challenging conditions in South America and the Middle East weighed on results from those regions. That wasn't a surprise. But Ford also lost a bit of ground in China, where a sluggish market and stronger efforts from domestic Chinese automakers pushed the Blue Oval's market share down to 4.4% from 5.3% in the year-ago quarter.

Ford is already taking steps to turn that around, Shanks said, noting that Ford's monthly China market share had already risen from 4.1% in April to 4.7% in June. But that came at the cost of some discounting -- not excessive, but enough to impact the profit margin. That said, Ford's profit margin in its Chinese joint ventures was still very impressive at 16.1% for thequarter. Shanks expects that new products, and increased local production of the hot-selling Ford Edge SUV, will help improve results by the end of the fourth quarter.

Ford's bottom line was also hurt as profit at Ford Credit also declined 21%. The company's in-house financing arm is struggling with falling resale values on smaller vehicles. Buyers of used cars (like buyers of new ones) are turning away from small cars in favor of trucks and SUVs; that hurts Ford Credit's effort to get good prices at auction for some of the cars it gets back when leases end.

One bright spot: Europe -- despite Brexit

Ford Europe's pre-tax profit rose to $467 million in the second quarter, up $306 million from a year ago. Industrywide sales are strong, and Ford is reaping the benefit of a turnaround plan set in motion by former CEO Alan Mulally back in 2012. Part of that plan called for Ford to expand its European product portfolio to include more higher-profit SUVs and more (highly profitable) upscale trim lines on its vehicles.

It has since done so, and the results are clear to see. Shanks told me that improvements in the mix of products it sold in the second quarter accounted for $182 million of its year-over-year profit gain in Europe.

This gain came despite concerns about the United Kingdom's decision to exit the European Union. Shanks said that while the drop in value of the U.K. pound versus the dollar after the "Brexit" vote hurt Ford's second-quarter results by about $60 million, Ford has hedged a great deal of its currency risk and won't suffer drastically from Brexit. He estimated that Brexit's impact on Ford will total about $200 million for the full year, considerably less than some analysts had feared.

Cash, debt, and Ford's pension plans

Ford ended the quarter with $27.2 billion in cash, up $6.5 billion from a year ago. It has $13.1 billion in well-structured long-term debt, for a "net cash" position of $14.1 billion.

Ford generated an impressive $4.2 billion in operating cash flow in the second quarter, for a total of $6.9 billion in the first half of 2016. But, Shanks noted, Ford plans to spend much of that in the second half of the year, as it gears up to launch several new products including its first new-from-the-ground-up Super Duty pickups in almost two decades.

Cost cuts are already helping, but more will be needed to meet guidance

Ford had previously said that its total pre-tax profit, earnings per share, automotive revenue, and automotive operating margin would all be equal to or higher than its impressive 2015 full-year results. Ford didn't change any of that guidance on Thursday, but Shanks and CEO Mark Fields both said that there are "net risks" to those goals because of rising costs and a plateauing U.S. market.

But, they said, Ford is committed to delivering additional cost cuts that will allow it to meet its previously stated guidance despite the headwinds. Shanks said that Ford was able to deliver about $1.6 billion in cost cuts in the first half of the year and that it would build on those efforts in the coming months.

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John Rosevear owns shares of Ford. The Motley Fool owns shares of and recommends 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.