On the skids

Ford has reacted to S&P’s decision to downgrade the auto giant with a mixture of bafflement and anger. Alan McNee reports

Investors in automotive industry credits suffered two blows in quick succession in October and November, when rating agency Standard & Poor’s downgraded DaimlerChrysler and Ford. S&P announced on October 21 that it was lowering DaimlerChrysler’s rating from BBB+ to BBB with a negative outlook. At the same time, it put Ford on creditwatch negative. In the end investors breathed a sigh of relief when S&P cut Ford’s rating to BBB- on November 12 but crucially gave the automaker a stable rather than negative outlook.

S&P also lowered Ford’s commercial paper rating from A2 to A3, despite hopes that it might leave this rating unchanged in view of Ford’s unusually deep liquidity.

“Ford’s profitability and cashflow remain poor, and S&P believes that only limited improvement will be achievable over the next few years,” said S&P credit analyst Scott Sprinzen, announcing the downgrade. Ford had reported its third-quarter results on October 16. The firm’s $25 million net loss beat Wall Street forecasts and compared favorably with a net loss of $326 million in the same quarter last year. It raised its full-year 2003 earnings guidance to between 95 cents and 105 cents per share (from a previous forecast of 70 cents per share), and reaffirmed its commitment to breaking even before tax in its automotive business.

In the face of better than expected third-quarter results and improved earnings guidance, S&P’s October 21 decision to put Ford on creditwatch surprised many investors and caused Ford spreads to widen significantly – although, paradoxically, the announcement of the actual downgrade on November 12 was greeted with a rally in Ford’s commercial paper and term debt: the firm’s main benchmark bonds tightened by around 60 basis points and credit default swap spreads by around 40 basis points.

“The move to put Ford on creditwatch negative was a surprise,” says Peter Jacobs, transportation analyst at Ragen MacKenzie. “Ford has hit most of their own financial targets this year, and the targets set for them by S&P. Therefore, I don’t really understand S&P’s motive other than citing the difficult competitive conditions in the US and Europe, but that’s been the case for the past couple of years.”

However, S&P argues that once restructuring and other charges are taken into account, it expects Ford’s overall automotive business to generate a pre-tax loss of approximately $600 million in full-year 2003. “We decided that the earnings performance was weaker than breakeven would suggest,” said Sprinzen during a conference call to discuss the downgrade. He cited changes to accruals related to pre-existing warranties as one factor that would make Ford’s earnings look less healthy if stripped out.

S&P also cited the possibility of further restructuring costs in Europe, where Ford made a $452 million pre-tax loss in the third quarter. A major restructuring costing around $56 million is under way in Europe, and S&P’s Sprinzen says that while this will result in a “near-term reduction in losses”, the rating agency is less convinced that it will lead to meaningful gains in profitability in the future.

Speaking during a conference call held after S&P put Ford on creditwatch, Sprinzen said he was worried by the company’s reliance on its light truck business. In the US, the light truck business segment comprises a few products – medium, large and luxury SUVs (sports utility vehicles), and full-size pick-up trucks – which account for a disproportionately large share of Ford’s North American auto earnings, leaving it exposed to greater competition from Asian manufacturers such as Honda and Toyota.

Sprinzen argues that despite its improved financial situation, Ford “has relied on extensive cost-cutting to offset the ruinous price discounting and market share weakness in North America”. Sprinzen believes that any benefits to be gained from further cost savings will diminish as time goes on, and greater emphasis will have to be put on marketing performance.

Ford itself reacted angrily to the downgrade. Ford chief financial officer Don Leclair said Ford did not believe the S&P decision “accurately reflects the state of our business and the positive progress we have made over the past two years”. For example, Ford argues that the lower expenses for recalls and warranties reflect the improving quality of its products, and should therefore be taken into account in its results.

Among analysts and the investment community, however, reaction was more mixed. Even those analysts who agreed with the decision expressed some surprise about its timing. “The third quarter is always a weak quarter for auto manufacturers, so it might have made more sense to either wait until the end of the year or do it earlier,” says Michie Yana, auto analyst at Commerzbank Securities.

S&P’s decision to drop Ford’s commercial paper rating to A3 was also surprising to some, given that S&P had already acknowledged that Ford enjoys massive liquidity from Ford Credit, its captive financial services business. But Sprinzen also pointed out that as a captive business, Ford Credit has to support the marketing efforts of the parent, so it does not have the flexibility to manage its asset levels in the way that a bank or independent financial company might.

This appears to have been central to S&P’s decision to cut the commercial paper rating. Ford argues that it has “exceptionally strong liquidity”, with $48 billion in cash and equivalents. S&P, however, says that while Ford Credit is expected to remain a solid earnings and cashflow contributor, “its financial performance will likely moderate in the near term as funding costs increase and its portfolio of finance assets shrinks”. Some critics of the S&P decision highlight the irony that any rise in Ford’s funding costs would be due to the cut in Ford’s credit and commercial paper ratings.

Peter Jacobs of Ragen MacKenzie says: “The financial services business is performing well, but it does need to regularly access the credit markets. Therefore, a rating downgrade could have more of an impact on the good-performing financial services business, while the poor-performing automotive business should not need to access the capital markets any time soon given its $12 billion net cash position and only about $1 billion in debt due in the next five years.”

Other analysts say Ford Credit’s position as a captive mean it is inevitably subject to the vagaries of the auto business. “It’s true that Ford Credit has very deep liquidity,” says Michie Yana of Commerzbank, “but it is still a captive finance subsidiary and at the end of the day it is dependent on Ford Motor Company to generate its business. If something happened to the motor company, Ford Credit couldn’t survive as a stand-alone entity.”

Another autos analyst says Ford needs a fundamental rethink of its credit company. “They make a lot of money from the credit company, but its existence is dependent on the credit rating of their automotive operations. They have in-built advantages in originating car loans, but the credit rating – and therefore the financing of those loans – is dependent on the auto business. They need to think about a tie-up with a financial institution which would put the onus of financing those loans onto the capital markets.”

While sufficiently rattled by its downgrade to hold a conference call with analysts and other interested parties, Ford is publicly sanguine about the impact of the ratings downgrade on its cost of funding. Ford treasurer Malcolm Macdonald said: “Our limited debt maturities and extremely strong cash position mean the impact of the ratings change should be minimal.”