While Ford Motors (NYSE:F) has had a good last few months helped by strong North American margins, we take a look at some of the metrics of its financial division and whether it can sustain its profitability. Ford Financial Services earns revenue primarily from interest payments made on its finance receivables and rentals earned on operating leases (such as the daily rent cars). Financial receivables are the outstanding loans and leases credited by the company.
It raises money through various forms of unsecured and securitized funding, for which it needs to pay an interest depending on its own credit rating and the mode through which the money is raised. It earns money through the difference in interest rates between what it charges its customers and what it itself needs to pay, something similar to how a commercial bank operates.
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While revenue for Ford Financial Services is down 6% to $5.7 billion in the first nine months of 2012, so is its interest expense. This is primarily because of the low-interest rate environment created by quantitative easing actions of the Fed. What is worth highlighting however is that the company has been able to maintain the interest rate spread. Furthermore, we believe some of its metrics have improved this year and could lay the foundation for a strong future profitability. At the same time, the automotive sector will have to keep innovating and rolling out better vehicles continually so that the demand for Ford’s loans and leases remains solid.
We believe the following metrics are important to take into account to gauge the long term valuation of Ford’s Financial Services.
a) Loss-To-Receivables Ratio (LTR):
LTR has declined from 0.25% in 2011 to 0.17% at the end of third quarter. LTR is defined as the charge-offs on an annual basis divided by the outstanding receivables. The lower the ratio, the better it is for a financial company.
Ford’s total outstanding receivables (including the operating leases) stood at $85 billion at the end of 2011 and the automaker expects the corresponding figure to be in the range of $85-90 billion at the end of 2012. 
b) Auction Values:
With improved vehicles and a rebounding brand image in the U.S., Ford Financial Services has seen an improvement in the average amount at which it is able to auction off a used vehicle. Ford’s average auction value for 36-month vehicles has risen from $16,845 last year to $17,800 at the end of Q3 2012. The improving auction values help minimize the residual risk.
The residual risk is the probability that the amount Ford Financial Services obtains from auctioning the returned vehicles may be lower than the expected residual value for the vehicle.
c) Managed Leverage Ratio
Ford’s managed leverage ratio has also improved from 8.3 last year to 8.0 at the end of the third quarter. Managed leverage is defined as the ratio of managed leverage and equity. The lower the leverage ratio, the less risky is the credit firm and more likely to receive a better credit rating.
Keeping these things in mind, rating agencies have upgraded Ford’s credit outlook. For instance, S&P upgraded Ford Credit’s outlook to positive from stable in August. In September, DBRS also upgraded Ford’s long-term senior unsecured debt to BBB (low) from BB.
A strong credit rating lowers borrowing costs which in turn gives the company the ability to complement its automotive sector by offering more attractive loans and leases. We believe that Ford’s technological improvements combined with a strong financial division will help the company sustain its future profitability.Notes: