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How Ford Found a Tax Break to Offset a Profit Drop

Analysts weren't expecting a big second quarter from Ford Motor Company (NYSE: F). Wall Street analysts polled by Thomson Reuters before Ford's report on Wednesday had predicted that the Blue Oval would report adjusted earnings per share of $0.43, down from $0.52 a year ago.

But Ford surprised with net income of $2.05 billion -- or adjusted earnings of $0.56 per share, which was up $0.04 from the second quarter of 2016

Why the surprise jump in profits? The first clue was that Ford's pre-tax profit fell year-over-year, but its net profit rose. Ford paid a much lower tax rate than Wall Street had expected, and lower than Ford itself had guided to earlier in the year. 

Ford also reset its full-year guidance, saying that it now expects a lower tax rate for all of 2017.

How did it manage that?

Bob Shanks, Ford's chief financial officer. Image source: Ford Motor Company.

How Ford managed to cut its taxes by two-thirds

To find out, I went right to the source: I asked Bob Shanks, who is Ford's chief financial officer. Here's how he explained it:

As you know, what we had been guiding toward for the year was something around a 30% tax rate. What happened is that our fantastic tax office had been working in anticipation of a potential corporate tax reform taking place. They had been working to identify [potential tax opportunities], largely around losses that we've incurred overseas, that could be brought back into the United States as foreign tax credits, if you will, and added to our balance sheet as tax assets. 

What happened here is that they executed one of those actions in the second quarter. That generated good news in terms of tax of $421 million, which gave us a 10% tax rate.

Shanks said that there's more to come:

[Ford's tax office] has additional actions that they have high confidence in. We've actually built into our guidance for the balance of the year. That's giving us the view that our tax rate for the full year will be about 15%, which is about half of what we guided to before.

As you'd expect, that led Ford to change its profit guidance for the full year. But that change wasn't as upbeat as you'd think -- which is why Ford shares fell after its earnings report on Wednesday.

Ford changed its guidance, but didn't really raise it

Ford had previously said that it expected its full-year pre-tax profit to come in around $9 billion, down from $10.4 billion in 2016, on higher commodity costs and increased spending on future products. After Ford reported a $1.6 billion year-over-year decline in pre-tax profit in the first quarter, the hint was that the rest of 2017 would roughly track 2016's good results. 

But Ford threw investors a curve. On Wednesday, it restated its full-year guidance, saying now that it expects adjusted earrings per share to come in between $1.65 and $1.85. So how does that compare to the prior guidance of $9 billion in pre-tax income -- and how does the lower tax rate play into that?

Here's how Shanks explained it:

When you look at that adjusted EPS range that we provided for full-year guidance of $1.65 to $1.85, that would compare to the way we did guidance previously to about $1.58. So it's higher -- but even at the high end of the range it's more than explained by the tax rate. 

The high end of the range, if I compute it out, it's a little less than $9 billion [in pre-tax income]. It's a little bit lower [than Ford's prior guidance] because of our view that we'll see higher incentives across all regions of the world. We'll also see some higher warranty expense in the U.S., and both of those will be partially offset by stronger profits at Ford Credit. 

The upshot: Ford thinks the new-car market waters will get choppy

So what really happened here? 

Ford has come to the conclusion that new-car markets around the world are likely to be weaker by the end of 2017 than it had expected earlier in the year -- and so it appears that it found some tax breaks to help offset a greater-than-expected decline in its pre-tax income.

That's good news in a sense: Less money paid in taxes means more money that can be reinvested in the business or returned to shareholders. But the underlying takeaway is that Ford thinks the global auto cycle is trending downward more steeply than it expected just a few months ago -- and might mean rough seas ahead. 

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John Rosevear owns shares of Ford. The Motley Fool owns shares of and recommends Ford. The Motley Fool has a disclosure policy.