Are Ford's Margins Set to Shrink?

Ford's (NYS: F) incoming chief operating officer Mark Fields made headlines on Wednesday when he said that the Blue Oval's profit margins in North America were likely to narrow in coming quarters.

Speaking at a conference hosted by Barclays, Fields said that growing inventories will force some of Ford's rivals to discount prices, and that pressure to respond would cut into Ford's margins in its home market in the near term.

That in and of itself is no big deal - but other pressures will lead Ford's margins to drop to a lower level by mid-decade, Fields said. Given that Ford's profits in North America have essentially been carrying the business for several quarters, is it time for investors to worry?

Getting the most out of its factories
To answer that question, we first need to understand that Ford's profit margins in North America, at about 12%, are exceptionally high - historically high, well beyond what most automakers have managed. There are a couple of big reasons for that - but the biggest are factors that probably aren't sustainable.

First, the Blue Oval's factories are humming. Ford's North American manufacturing chief, Jim Tetreault, recently said that the company's factories in the region are running at 114% of what Ford considers "full capacity:" two eight-hour shifts. Ford already has five factories running three shifts - around the clock, in other words - and several others adding overtime hours on a regular basis.

As a general rule of thumb, auto factories break even when they're running at about 80% of capacity. That's because the factory, its complex tooling, and its unionized workforce represent high fixed costs. The more cars you can make without significantly increasing fixed costs, the more money the factory will make. Eighty percent of capacity is where the equation turns in the automaker's favor - and obviously, the more the factory is making beyond that point, the bigger the profits.

That's a great situation for Ford to be in. During its painful restructuring last decade, CEO Alan Mulally and his team were able to close several underutilized factories and consolidate production. That left Ford with a smaller manufacturing footprint in North America, and that in turn meant that as U.S. auto sales started to recover, those factories would be very busy - and very profitable.

At some point, Ford will have to expand
Ford has already taken some steps to squeeze more production out of its existing factories. But at some point, as the U.S. economy continues to recover, Ford is going to need to "add capacity" - build more factories - or risk losing market share. Sales of "light vehicles" (cars, pickups, and SUVs) in the U.S. will probably total around 14.5 million in 2012. That's up significantly from what we saw in 2008 and 2009, but it's a far cry from the 16-million-plus units that was typical in the years leading up to the economic crisis.

Assuming the economy continues to gather strength, U.S. auto sales could get back up to that level in a couple of years. Ford still has a little room to go before it effectively maxes out its North American factories - but not much, and production of some key models is already maxed out, or close.

If Ford wants to keep pace with the market as it grows, it'll eventually need more factories - and those factories could cut into its margins.

Another big factor likely to cut into Ford's margins over time has to do with the mix of vehicles it sells in the U.S. - and the ways in which that is likely to change over the next few years.

More small cars equals slimmer margins
Like rival General Motors (NYS: GM) , Ford makes a lot of money from pickup trucks. At least one high-profile analyst, Morgan Stanley'sAdam Jonas, thinks that Ford's well-regarded F-series pickup line accounts for the vast majority of the Blue Oval's global profits.

Protecting that franchise is a high priority for Ford - as it should be. But the simple fact of the matter is this: Ford needs to sell a lot more than pickups in order to be sustainable over the long term. As gas prices increase, and fuel-economy regulations continue to tighten, a larger percentage of Ford's total sales in the U.S. will be made up of cars, particularly small fuel-efficient cars.

The good news is that Ford is ready for those buyers. Unlike in past years, when Ford customers seeking fuel-efficient small cars turned to Toyota (NYS: TM) and Honda (NYS: HMC) instead, Ford is now well-positioned to retain those buyers. The latest version of Ford's compact Focus is excellent: Widely acclaimed by critics, it has quickly become one of the world's best-selling cars. Ford's smaller Fiesta (a best-seller in Europe) and brand-new midsized Fusion are also strong, no-excuses entries.

The bad news, though, is that cars are less profitable than pickups. That's a big part of why Fields sees Ford's North American margins slipping from the 12% we saw last quarter to something more like 8%-10% by mid-decade. Fortunately, with profits from Ford's overseas operations likely to improve - Fields expects global margins of 8%-9% by then - investors shouldn't have too much to worry about.

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The article Are Ford's Margins Set to Shrink? originally appeared on Fool.com.

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