Shares of Ford Motor Co. (F, Financial) took a beating after its second-quarter earnings release on July 23. The stock lost a third of its market cap, with shareholders selling approximately $19 billion.

Despite disappointing earnings and the recent sell-off, there are several tailwinds, solid fundamentals, attractive dividend yields and a cheap valuation that an existing or prospective investor can hang on to. Ford could turn into a profitable bounce-back trade.

Business overview and stock performance

First things first, let's have a look at the company's structure.

Headquartered in Dearborn, Michigan, Ford is far from being a small company. In fact, it is one of the most iconic American companies. The car manufacturer has the best-selling cars in several categories and continues to generate tremendous amounts of cash and value in the form of dividends for its shareholders - among which is the Ford family, guaranteeing shareholders will continue to be rewarded for holding shares.

Source: insideevs.com

Ford is composed of three distinct business units. The first is the reliable cash cow internal combustion engine unit called Ford Blue. Then there is the cash-burning but growing Ford Model (electric vehicle unit) and the promising but smaller Ford Pro (commercial vehicle unit).

ICE is the core of the company. Ford has the first place in the world in terms of pickup sales for a manufacturer. Its pickup line known as the F-series is a U.S. best seller (up 30% from the first quarter). In the hybrid segment, the company is also scoring high as its Maverick hybrid is the best-selling hybrid in the U.S.

So what exactly happened to the stock to have seen one-third of its value burn within days?

Recent earnings caused the stock to be sold off, but solid financials back the buying narrative

One item that soured investors' attitudes was the $800 million warranty costs spike. The amount of the cost itself is not significant relative to its revenue of $47.80 billion, net income of $1.80 billion and adjusted Ebit of $2.80 billion. The market is not concerned about the spot impact on its cash flows; rather, it is focused on the quality of new Ford cars. Indeed, these costs spiked because more cars are being brought back by customers for repairs, but also due to inflation in labor costs, causing the repairs to be costlier. The spike in part caused adjusted Ebit to come in at a mere $3.80 billion, $1 billion below consensus estimates.

This has two implications. The first is that the manufacturing process is flawed and more cars will need to be repaired. The second implication is the repair process of a new car is usually not an enjoyable experience for customers; word-of-mouth could push consumers to instead buy a vehicle from a competitor like General Motors Co. (GM, Financial).

Ford CEO Jim Harley, however, expects technology to significantly reduce these warranty-related costs as the implementation of more mature technology in both cars and the quality and assurance department should solve the issue.

Another potential tailwind that caused the recent broad market sell-off is the rise in unemployment could start pushing down labor costs and hence, repair expenses for the company.

Further, electric vehicle production is struggling in the U.S. this year due to high interest rates and labor costs. Ford's Model E segment continues to burn a lot of cash ($1.10 billion in the second quarter), but this was expected.

On the bright side, the company sold 1.14 million cars (up 2% year over year), pushing revenue up by 6%, well above Wall Street's estimates of about $45 billion. While ICE sales are down 1.90% from the same period last year, EV sales are up 63.90% and hybrid sales rose 49.20%.

Further, expectations for full-year 2024 adjusted Ebit remain unchanged in the $10 billion to $12 billion range, while adjusted free cash flow outlook was raised by $1 billion to the $7.50 billion to $8.50 billion range. This is truly impressive and provides more than enough comfort that the company's financial situation is healthy.

Cash flow machine, high dividends and cheap valuation

Ford's ability to generate cash is the main reason to include it in a diversified or dividend strategy portfolio. Its funds from operations cover debt interest servicing by a multiple of over 20, showing the company remains comfortable in servicing its debt despite a high interest rates environment. If high interest rates are extended by the Federal Reserve, which is unlikely, the liabilities should not cause any issues.

The adjusted free cash flow outlook for 2024 more than covers the expected $3.12 billion total paid in dividends to shareholders. Ford pays 15 cents per share on a quarterly basis (60 cents per share annually). Its dividend yield is currently above 6% per year with a share price at the time of writing below $10.

Its valuation also remains attractive with a GF Value of around $14.85 (40% upside) and the street projecting $13.85. Both targets are close to the price it was trading at before the earnings release. If we take the earnings as a whole and if investors see that the warranty costs spike was a spot even (and not a trend), it is likely that they will flock back into the high dividend-paying stock.

Further, if U.S. treasury and corporate bonds yields continue to decline, fixed-income investors may also be likely to consider Ford for their portfolios.

Looking at a multiple of total enterprise value to revenue, we are clearly at the lower end with 0.9. instead of the historical median above 1, and this is despite the revenue hit from the warranty costs spike. From a forward price-earnings perspective, the stock is again trading at a clear discount at a multiple of 5 while the recent range is closer to 7.

All these indicators further confirm the fair value suggested by GuruFocus and the price target average of Wall Street analysts.

Risk factors to my case

As always, there are risks to consider. The main one for this historical car manufacturer is inflation, particularly labor cost pressures. A tight labor market and supply chain disruptions cause car repairs to be more expensive, further increasing the probability of warranty cost spikes and burning some cash that could have been returned to shareholders.

Additionally, if new technologies do not perform as expected and too many vehicles continue to be recalled and repaired, the sell-off could spiral far past one single earnings release. Indeed, the Ford customer base could grow tired of quality issues and switch completely to a competitor.

For the moment, the spike in costs seems to be a spot event. If the costs continue to spike in the next earnings readings, investors' fears might be confirmed that the problem lies within the quality of the vehicles and of the manufacturing process. In this case, the fundamentals of the company will be severely impacted.

Bottom line

While there are real risks and fears related to the stock, the art of investing is also the ability to take risks on a single bet within a diversified portfolio. Given how cheap the shares have become, its high dividend yield and the overall healthy financial situation of the company, the stock could well prove to be an attractive investment with an interesting medium-term risk-reward ratio.

The trade could turn out to be profitable by the time of the next earnings release, where investors will scrutinize the warranty costs. Given the recent fiasco in that category, it is highly likely the management team will make it a top priority. This could be the start of an interesting turnaround story; as such, it might be worth going further with the stock.