Why Ford's Stock Surged

Not a bad way to end the week: Shares of Ford (NYS: F) were up 4.16% on Friday after a Labor Department report showed that unemployment fell to a three-year low in January.

Falling unemployment is great news for lots of businesses, of course. More people working leads to a rise in consumer spending, the thinking goes, and that means more sales of everything that requires disposable income, from iPhones to dishwashers to brand-new cars.

All automakers doing business in the U.S. should benefit as the economy continues to recover. But Ford -- and, to some extent, rival General Motors (NYS: GM) , which also saw its stock jump on Friday -- is particularly well positioned to reap big gains as auto sales rise.

Revving up Ford's profit engine
Ford has operations all over the world, but its North American division -- specifically, the U.S. market -- is the "engine" of the company's profits, as CEO Alan Mulally has said. Almost $900 million of Ford's $1.1 billion profit last quarter came from North America, as the company's overseas operations struggled with tough economic conditions.

More to the point, consider this: Excluding one-time items, Ford made $8.8 billion in 2011, most of that in the United States. That's a solid profit -- and it came as the total number of cars and light trucks (pickups and SUVs) sold in the U.S. was about 12.8 million.

We've become used to good quarterly profits from Ford and GM in recent quarters, even though the economy isn't in great shape. But Detroit's ability to make money in times like this is a new thing.

Making good money in a marginal environment
Until recently, Detroit simply couldn't have made money at the current level of auto sales. Ford, like all automakers, has massive fixed costs. Between factories, labor, machinery, and all of the other pieces that go into making millions of vehicles every year, Ford needs a certain level of auto sales just to break even.

That level used to be much higher than today's sales rate, but one of the great benefits of Ford's dramatic restructuring is that the company's breakeven level is much lower than it used to be. Ford now says that it will profit as long as that U.S. vehicle-sales total stays above 10.5 million or thereabouts. GM executives have said much the same thing.

The 10 million mark actually represents a very low number -- the rate of sales one would expect in a deep recession. Even during the most awful months of the economic crisis, the annualized sales rate didn't fall much below 10 million -- and it quickly recovered to a more sustainable level, long before the economy gathered steam.

The thing is, even though Ford and GM have been posting solid profits in recent quarters, they're doing so in what is, historically speaking, a tough environment. That sales total from last year, 12.8 million, is far below what was considered "normal" (or even "lousy") in the years leading up to 2008.

Yet Ford is solidly profitable at the current level, as is GM, as are Toyota (NYS: TM) and Honda (NYS: HMC) . The latter two are truly impressive given the tremendous challenges the two Japanese giants have dealt with in the past year.

So here's the interesting question: What happens to Detroit's profits when sales start going up?

Sales will go up eventually, but how far?
In 2007, automakers sold 16.1 million cars and light trucks in the United States. That sounds like a lot in the context of more recent totals, but it's a number that was cited with concern at the time. It was then the lowest total in nearly a decade -- since 1998. Automakers had sold more than 16.5 million in 2006.

It's unlikely that we'll see totals like that again for some time. Last decade's high sales numbers were almost certainly inflated by the easy availability of credit and were certainly driven in part by cultural attitudes toward consumption that have since shifted.

But 13.5 million or more for 2012 isn't out of the question if things continue to improve. While Ford's own outlook for 2012 has so far been subdued, many observers think auto sales could rise sharply from here. The average age of cars and trucks in the U.S. is near an all-time high, suggesting some pent-up demand that will emerge as consumers become more willing and able to spend.

The one thing Ford needs most
Ford's massive fixed costs mean that the incremental profit per vehicle sold goes up substantially as volumes rise. A boost in the overall level of auto sales will do more for the Blue Oval than any new car or truck possibly could. Think about it this way: If Ford's making zero dollars at 10.5 million sales, and $8.8 billion at 12.7 million, what will it be making at 14 million?

I can't say with any precision -- there are a lot of variables to account for -- but it'll be a lot.

And that's why Ford and GM were up big on Friday.

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At the time thisarticle was published Fool contributorJohn Rosevearowns shares of Ford and General Motors. You can follow his auto-related musings on Twitter, where he goes by@jrosevear. The Motley Fool owns shares of Ford.Motley Fool newsletter serviceshave recommended buying shares of Ford and General Motors, as well as creating a synthetic long position in Ford. Try any of our Foolish newsletter servicesfree for 30 days. We Fools don't all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Motley Fool has adisclosure policy.

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