Ford: The Hidden Red Flag, And How You’ll Know It’s Turned The Corner

Summary:

• Ford’s warranty accounting methods are crucial for investors to understand, as they significantly impact reported profits and liabilities.
• Higher interest rates and warranty costs, not EV issues, are the primary factors affecting Ford’s profitability.
• Ford’s management must count warranty costs accurately, and address the underlying causes, to regain investor confidence and stabilize financial projections.
• I continue to rate Ford as Avoid until warranty issues are resolved.

I was a regular writer on Ford (NYSE:F) when I first joined Seeking Alpha, but the article I wrote in October marked my first return to the ticker for seven years. Because the article took an extra day to refine and publish, it actually dropped on the same day as Ford’s Q3 earnings report. That wasn’t a bad thing since my article was about long-term fundamentals and intricacies of EV credit accounting that are often overlooked; it wasn’t quarter-specific.

But the reaction to the Q3 earnings call has highlighted another thing about Ford that is not always properly understood: how its warranty issues are reflected in its earnings reports and where early signs of a turnaround from those issues are likely to be found.

Since I couldn’t really cover warranties the way I wanted to last time, I want to return to the issue of Ford’s methods of accounting for complex products like warranties one more time. I don’t think investors have been well served by some of the media commentary and analysis from those who don’t understand the intricacies of Ford’s numbers.

Looking Beyond The Noise

I’m well aware that it has become fashionable in certain circles to hold up Ford’s EV issues as the quintessential example of government overreach and effectively blame the company’s woes almost entirely on the Biden Administration. I don’t want to have a political debate in this article, but EVs are only one of many factors and frankly not the most important one. I covered all of this last month, so I won’t belabor the points.

But in my mind, Ford has been hit by the Fed at least as hard as it has been hit by the EPA. Ever since Bernanke took rates to 0 after the GFC in 2008, Ford has essentially been riding, like all other automotive manufacturers, an unreasonably low interest rate to boost demand for its vehicles. Like many companies that unmitigated flood of generosity perhaps made it a little lazy; Ford’s cost structure clearly needs to adapt to a long-awaited return to a much more normal rate environment.

And while its EV segment is nothing to write home about, I doubt it is doing quite as bad as Ford’s approach to accounting for costs makes it appear. As I demonstrated in my last article, warranty costs and interest rate increases alone account for over 100% of the decline in Ford’s profit, ex-Rivian (RIVN) movements. Much of the loss on EVs may simply represent a mischaracterization of the value of the compliance credits EVs generate, as well as perhaps a front-loaded method of expensing what is really more of a capital asset like R&D.

What Ford really needs is both fewer recalls and, perhaps, just time to get out of a fourteen-year comfort zone that the Bernanke Zero era represented. Unlike federal EV mandates, those are both things that management should be able to control.

Model e’s Got The Blues

In some ways, that quarter report was more of the same. Ford Blue and Ford Pro continue to perform, Model e and warranties continue to be major issues. But as I noted in my last article, accounting matters for understanding these things. In the first place, a lot of Ford Blue’s profits may simply reflect free compliance credits from Model e that it was previously paying third-parties for.

What’s more, automotive sales are somewhat idiosyncratic in what categories they define costs. I covered all this in October, so I’ll be brief, but we all know that Ford Credit doesn’t really offer 0% financing because it has some super-secret source of free lending funds. The cost of that promotional financing is buried in the selling price of the car. But Ford’s division splits means that Ford Credit reports the interest costs on the debt it takes out for those loans, while Ford Blue accrues the profit from the selling cost of the car that actually implicitly includes some interest. The R&D cost allocations suffer similar issues.

All of these are points by which costs which are really just part and parcel of selling cars somehow become separate from the underlying transaction, allowing Blue and Pro to report outsized profits while other divisions take the hit.

Warranty Accounting

Warranties are also a little interesting, however, in that they are actually something which is not simply a cost of selling vehicles that is being creatively allocated to another division. Warranties are actually a properly separate category of costs which good management can reduce without affecting sales. Almost every manufacturer offers promotional financing and all of them have R&D costs. But good operators have fewer bad warranty surprises than their peers.

Warranty costs are of course something Ford investors are already aware of – they’ve been hearing about them nonstop for quite a while now. The news reported widely last year that Ford had paid $4.8 billion in warranty costs in 2023 and that was why the results were down. Warranties did bring results down, but that number is actually the wrong way to think about the accounting again.

Ford records warranties twice in its reports – once when it sells a car and issues a warranty, and then again when it actually pays out to fix something broken on the car. This means at time of sale it must make an estimate of how much it expects to pay out. It also means that every quarter, Ford is both accruing new warranties and making payouts on old ones. When warranties are going well, these amounts are roughly the same and it doesn’t matter which one you focus on.

The key point is this: contrary to the popular media narrative, which almost always reports the payouts numbers, it is the accrual of warranty liabilities that represents a diminution of Ford’s profits. When Ford is having warranty troubles, its warranties become more expensive, and its new accruals begin to become larger than its payouts on the two- and three-year old warranties on its formerly more reliable cars.

When this happens, Ford records the excess of accruals over payouts on its balance sheet as a liability in the ‘other liabilities’ section. It also reports a corresponding decline in profits simultaneously. Again, this is important for investors to understand. When Ford accrues warranty liabilities is when it records the hit in the income statement.

The Real 2023 Numbers

This is why the common reporting is wrong; while Ford paid $4.8 billion for warranty expenses in 2023, it accrued $7.3 billion. The common media report that Ford expenses on warranties rose $800 million Y/Y is wrong; the increase in accruals Y/Y was almost triple that, $2.2 billion, and that is what is reported on Ford’s earnings reports.

In fact the increase in warranty accruals in 2023 was actually twice the total reduction in its net profit year over year, again excluding Rivian’s gyrating write-ups and writedowns.

Payouts And Paydowns

One other implication of this is that payouts on warranties, which have become such a major focus of most reporting on this issue, are not only not a hit to profit; they’re almost a good thing.

Payouts on warranty liabilities are in a strange way almost a form of debt reduction; when Ford pays out more on old warranties than it accrues in new ones – a state of affairs Ford investors can only hope comes soon – its liabilities are reduced and its common equity book value grows, just like when it pays off a bond with cash flow.

Solid Accounting Principles

I want to emphasize that this is not a criticism of Ford. My article on the EV accounting in October made the point that Ford’s accounting was somewhat counterintuitive and perhaps did not serve investors as well as different approaches might – though I was also careful to note that there are certain benefits to the way Ford accounts for EV costs.

On warranties, however, there is no dispute; Ford is doing exactly what it should be doing. Noting future obligations and making sure they are properly accounted for on the balance sheet and the future projections is exactly what a publicly traded company’s earnings statement is supposed to be doing. The problem here isn’t Ford’s approach, it is that the common narrative just isn’t understanding the issue correctly.

The Two Warranty Buckets

I won’t seek to drown the reader in math and minutia, but we do need to go just a little bit deeper on this, and then I promise we’ll be through.

Ford reports warranty costs in two components. Ford’s warranty accruals for new vehicles were holding steady around $4 billion in 2021 and 2022 before spiking to $4.7 billion in 2023. They will almost certainly spike again next month when Ford closes the books on 2024.

But the total amount in outstanding liabilities for estimated warranty costs on the outstanding fleet rose even more in 2023, from $9.2 billion to $11.5 billion in a single year. A 25% increase which ameliorated only slightly by rising 9% in the first half of 2024. In Q3 they spiked higher again by another 6% in a single quarter.

That’s because it isn’t just the new vehicles. Ford also regularly updates its projections for ‘pre-existing warranties,’ ie., increases in estimates of warranty costs for vehicles already sold in prior years. In fact, Ford’s accruals for pre-existing warranties actually started rising sooner than new vehicles did, from a mere $200 million in 2021 to $1.1 billion in 2022 and a staggering $2.6 billion in 2023. Again, this is as expected; as Ford realized it was having a problem with its existing vehicles, it expected it would probably have the same problem in new cars that shared those flaws until they could be fixed. It therefore began raising new car warranty estimates after a period of time where its problem became manifest in its existing fleet.

Please note the numbers don’t add exactly because there’s also relatively small things impacting the accrued total like foreign currency shifts.

Ford’s Continuing Travails

The Q3 report did not bring the good news some might have hoped for, though again it was somewhat obscured by the two-step process used to account for these things. Through the first nine months of the year, Ford has made payouts of $4.4 billion and accrued $4.3 billion in new car warranties. So far so good, the two numbers are starting to balance one another again. Albeit at uncomfortably higher levels.

However, there is trouble in the next line item. For all the writedowns and increased liabilities Ford has already reported on its existing warranties, it continues to update its projections for liabilities on pre-existing warranties – and always in the wrong direction. Ford has accrued an additional $2.2 billion on warranties for vehicles already sold in prior years.

In a way, that’s even worse than the new car numbers, because if Ford was doing a good job of estimating warranty costs it wouldn’t need to be revising existing fleet estimates upwards. Not only does Ford have a problem building reliable cars, even after their unreliability becomes clear Ford apparently can’t tell just how unreliable ‘unreliable’ is.

In a solid warranty operation, estimates are usually accurate when the vehicle is sold, and the pre-existing category moves up and downward in roughly equal amounts over time in different quarters. Remember, Ford in 2021 was only reporting a couple hundred million in preexisting warranty accruals. A consistent upward trend such as has been evident the past few years does nothing to reassure about management’s grip on the problem.

What A Good Warranty Quarter Looks Like

Based on these numbers, any expectations that Ford has gotten a handle on its warranty issues may be premature. The question then becomes, how should Ford’s earnings report be interpreted when it does get a handle on it? If Ford does begin to trend in the right direction on warranties, how should we expect that to manifest itself in the early stages, so investors can get in on the ground floor of any bounce?

Ford management itself has indicated in the past that it sees a high correlation between 90-day warranty costs – the costs for cars in the first ninety days after they leave the lot – and total warranty costs for vehicles. That means that they should be able to project with fairly high accuracy quickly, even within a single quarter, what the lifetime costs of a vehicle warranty are likely to be.

It also means that when Ford improves its warranty problems, we should expect to see the improvement show up in its new car warranty numbers much earlier than it does in the used car numbers. Ford can’t do anything about the unreliable cars that are already out the door; it will have to continue to service those, and if it has underestimated the impact of those it will continue to report additional accruals in the ‘existing warranties’ section.

But as it improves quality, the 90-day servicing costs should decline, and as they do Ford should incorporate that improvement into its projections about how much those vehicles will cost going forward. That in turn should be reflected in lower accruals for new vehicle warranties in the earnings report.

Other Companies Automotive Accounting

It took considerable time to do a deep dive on Ford’s financials, and it was not possible to be similarly comprehensive on other companies. But while no two companies count in exactly the same way, many of these points should translate reasonably well to other auto manufacturers. General Motors (GM) has to do all the same projecting, servicing, accruing and paying as Ford does, and Tesla’s (TSLA) numbers are if anything even more elaborate because it also carries some lingering obligations for free Supercharging on its balance sheet, which is basically just vehicle servicing in another guise.

I can’t pretend to advise on those companies without doing more analysis of their specific accounting methods, but the key point is this: investors should always, when doing their due diligence on an automaker, take note of when and how it assimilates a long-term obligation into the balance sheet reports. Does it do so when it accrues or when it pays out? Are such obligations recorded as liabilities or as contra-revenue? Are its liabilities projections or legally binding caps on exposure?

These questions are important because without knowing the answers, and given the latitude companies have to do their own accounting, it is a mistake to assume that ‘other liabilities’ means at Ford exactly what it means at Tesla. Indeed, it would be a mistake to even assume that ‘other liabilities’ is where the obligation is being recorded. Perhaps it’s found somewhere else in the report.

Investment Summary

Ford’s EV operations really don’t bother me, although I agree that they’re going less than great right now. Higher interest rates are probably here to stay, but I believe in time management can adapt to those.

What I really want to see is the warranty issue finally grappled with properly and brought to a resolution. At this point it’s not even about what the number is anymore; what investors really want is to stop being told time and again that Ford’s estimate of the damage last quarter was too low, and is going up again this quarter. We haven’t seen that yet, so I continue to rate Ford Avoid. And I hope investors now have a better understanding of how that damage is finding its way into the numbers.

---

Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Seeking Alpha’s Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.

---