Why Ford Motor Company's Profit in Europe Will Drop in 2017

By John Rosevear Markets Fool.com

Ford Motor Company's (NYSE: F) earnings in 2017 will take a hit of at least $600 million from currency effects related to Britain's vote to leave the European Union, Ford's European chief told Reuters on Friday.

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Ford earned $1.2 billion in Europe in 2016 after several years of work on a turnaround plan. The news is a setback for Ford and its investors.

What Ford's Europe chief said about the impact of Brexit

Ford Europe chief Jim Farley told Reuters that currency hedges have shielded Ford from much of the impact of the British pound's loss in value versus the U.S. dollar following the country's referendum last June. But, he said those hedges will expire in the first half of 2017 -- leaving Ford exposed to pound-related currency risk as the year goes on.

Ford Europe chief Jim Farley. Image source: Ford Motor Company.

Why Ford is so exposed to the British pound

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Ford has two factories inthe U.K. that both make engines for Ford vehicles manufactured in other European countries. Meanwhile, Ford imports lots of vehicles manufactured in other European countries (and elsewhere in the world) to the U.K. for sale: Ford is the country's largest-selling vehicle brand, with about 12% of the market.

Long story short: Ford earns a lot of pounds in the U.K.

Why a drop in the pound's value hurts Ford's bottom line

Ford earns a lot of pounds in the U.K., but it's an American company that counts its earnings in dollars. The issue is that those pounds are worth fewer dollars now than they were before the Brexit vote. On June 22 of last year, the day before the Brexit referendum, one British pound was worth about $1.48. But now, a pound is worth only about $1.26.

Ford's Dagenham plant near London makes engines for Ford vehicles built in Europe. Image source: Ford Motor Company.

Ford had been able to hedge that risk using derivative securities that paid the company if the value of the pound fell below a certain level in dollar terms. What Farley is saying is that those derivatives will expire over the next few months, and the total hit to Ford's pre-tax bottom line could be $600 million or more.

Does that mean Ford's European profit will be cut by $600 million in 2017?

Here's what Ford CFO Bob Shanks said about the outlook for Ford Europe in 2017 during the company's earnings call on Thursday: "For 2017, we do expect Europe to remain profitable, but it will probably be lower than in 2016. That's driven by the effect of Brexit on the sterling along with higher costs that we expect associated with the launch of the Fiesta and EcoSport, along with continued investments that we plan to make in the business moving forward.

Shanks didn't quantify exactly how much lower Ford's European profit is likely to be in 2017. And during the same call, CEO Mark Fields emphasized that cost improvements were responsible for nearly $400 million of 2016's strong profit in Europe. That's a hint that Ford will try to find ways to offset the impact of the pound's fall versus the dollar again in 2017.

Why this is a setback for Ford and its investors

Simply put, Ford Europe had a great year in 2016. That great year followed several years of turnaround efforts initiated by now-retired CEO Alan Mulally in 2012 after heavy losses. Investors were cheered when Ford was able to post a small profit in 2015, and Ford followed that up in resounding style with a terrific $1.2 billion pre-tax profit for 2016.

That was a nice validation of the turnaround plan, which worked out pretty much as Mulally and other Ford executives had predicted. But now, it looks like Ford will have to find more ways to cut costs and boost profits as it tries to offset the currency impact set in motion by last year's Brexit vote.

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John Rosevear owns shares of Ford. The Motley Fool owns shares of and recommends Ford. The Motley Fool has a disclosure policy.