Earnings Call Transcript - F Q2 2024

Operator, Operator

Good day, everyone. My name is Gary, and I will be your conference operator today. At this time, I would like to welcome you to the Ford Motor Company Second Quarter 2024 Earnings Conference Call. Please note this event is being recorded. At this time, I would like to turn the call over to Lynn Antipas Tyson, Executive Director of Investor Relations.

Lynn Antipas Tyson, Executive Director of Investor Relations

Thank you, Gary. Welcome to Ford Motor Company's second quarter 2024 earnings call. With me today are Jim Farley, President and CEO; and John Lawler, Vice Chair and Chief Financial Officer. Also joining us for Q&A is Cathy O'Callaghan, CEO of Ford Credit. Today's discussion includes some non-GAAP references. These are reconciled to the most comparable U.S. GAAP measures in the appendix of our earnings deck, and you can find the deck along with the rest of our earnings materials and other important content at shareholder.ford.com. Our discussion also includes forward-looking statements about our expectations. Actual results may differ from those stated. The most significant factors that could cause actual results to differ are included on page 20. Unless otherwise noted, all comparisons are year-over-year. Company EBIT, EPS, and free cash flow on an adjusted basis. Now, I'll turn the call over to Jim.

Jim Farley, President and CEO

Thanks, Lynn. And thanks for joining us. First, I wanted to thank our global team. Remaking Ford into a high-margin, high-growth, more capital-efficient, and a more durable business is really hard work. It requires focus, collaboration, and excellence. I also want to thank our investors. We're committed to creating value consistently over the long term, and we appreciate your support and input. Execution against our Ford+ plan allows us to break free from the low-margin, capital-intensive, and cyclical attributes that have constrained legacy auto valuations for a long time. This process does not happen in a straight line. We are absolutely a different company than we were three years ago, and our pace of change is intensifying. The creation of Ford Pro, Blue, and Model e have been huge catalysts for transparency, accountability, and more rigorous capital allocation. Our Ford Pro business is amazing. It's a high-margin business tracking towards $70 billion in revenue this year, with further opportunities for profitable growth outside of vehicle sales, parts and service, and software. A good example of that is a recent decision by our team to add 100,000 units of capacity of Super Duty in Canada. It not only serves our customers but is capital-efficient and has very high returns for many years to come. As you know, we flipped our international operations many years ago from deep losses to now profits and positive cash flow with more opportunities ahead, and that includes China. We also took our product portfolio from too many generic vehicles and infused it with passion and purpose. We built out our iconic F-Series and Transit lines, as well as passion vehicles like Mustang and the new Bronco lineup, sub-brands like Raptor and Tremor and Dark Horse. Few OEMs can offer a customer choice like Ford at our scale. Ford is number one in our home market for internal combustion. We're number two in EVs and have been for 2.5 years. We are the number three hybrid brand in the U.S. But what's less visible, but incredibly important for investors is the foundational work underway in the company to move to software-defined vehicles and breakthrough digital experiences. This will have significant operating leverage. Ford+ is on track. Today we reaffirmed our adjusted EBIT guidance for the whole year and raised our outlook for adjusted free cash flow. I'm going to comment on our EV landscape and strategy, software technology and services, our Ford Pro business, and quality. On electrification, we've been vocal about why electric vehicles are so important and a great choice for customers and businesses. Customers' usage data and cost of ownership data indicate about 50% of customers who buy automobiles would be better served by buying an electric vehicle. There's a lot of misconceptions around EVs regarding costs like resale value and insurance, range and charging, and battery life, and OEMs like Ford must do a better job of educating our customers about the advantages that EVs offer in terms of cost of ownership. We are the number two EV brand in the U.S. for over 2.5 years. That's a long time, and we've learned a lot and now we have used those learnings to sharpen our strategy. We learned that it's incredibly important to be transparent about Model e losses. Inside the company this has forced accountability, and the result is our team is getting much more resourceful in terms of turning the business around. We are more disciplined in terms of capital and expense. This means we will not launch vehicles at a loss that are not good for our business knowing what we know now about the reality of the market equation. We clearly see China and Tesla as the cost benchmark. We also see excess capacity that will lead to more pricing pressures, which is in our business plan, more consolidation, and many more partnerships. We see less vertical integration in some areas to relieve capital, and we see a lot of tough choices on footprint. Early majority customers are really different than early adopters, particularly in retail. We see more openness to hybrids and extended-range electric vehicles we call E-REVs. Also, we see a divergence in electrification adoption between commercial and retail. Commercial customers focus on total cost of ownership. They use vehicles much more intensely and do not overbuy batteries like retail customers. They are also investing in our Pro charging depots and our integrated software because they want to be smart about the cost of charging their vehicles. I'm happy to say that our EV Pro contribution margin for our EV vans is now already positive. We have also learned a lot about the size of the vehicle. We believe smaller, more affordable vehicles will be the way to go for EV in volume. Why? Because the math is completely different than internal combustion engines (ICE). In ICE, the business we've been in for 120 years, the bigger the vehicle, the higher the margin. But it’s exactly the opposite for EVs; the larger the vehicle, the bigger the battery, the more pressure on margin because customers will not pay a premium for those larger batteries. Lastly, compliance. There is a lot of pressure on compliance. The lower demand for EVs, especially the pricing means that CO2 credits will likely be needed for fleet flexibility and optionality and will be critical strategy choices for any company. What are the success criteria for EVs in the future? First, have the right mix of fully and partially electric solutions. You must have a compelling product roadmap and very flexible manufacturing. A good example is our hybrid business. The global hybrid portfolio at Ford is on track to grow 40% this year across nine nameplates. We really bet on hybrid trucks. In the first half of the year, our hybrid pickups, Maverick and F-150, grew more than three times the rate of the overall hybrid segment. Our F-150 hybrid with Pro Power onboard is a game-changer for our customers. Commercial customers have power on the run at job sites, and our retail customers have emergency power backup. We've seen this in Texas and all the other extreme weather events, how important this is for our customers. The second success factor is matching the cost of Chinese OEMs and Tesla, especially on affordable EVs. People often hear about affordability and think about small and unaffordable, but we are designing a super-efficient platform, leveraging innovation across our product development, supply chain, and manufacturing teams. With no engine or drivetrain, a smaller vehicle can have a roomier package with a small silhouette. This is a big advantage for customers versus ICE. We are focusing on differentiated vehicles priced under $40,000 or even $30,000, focusing on two segments: work and adventure. This matters because the use case for smaller, affordable vehicles means shorter trips and more urban locations. Affordability, smaller batteries have an outsized impact on the cost and margin of the vehicle. The consumer tax credit in the U.S. has become a larger part of the sticker price of the vehicle, supercharging the lower cost of ownership that EVs already offer without it. Finally, we must be careful about larger EVs. They will be part of the picture, but success requires breakthroughs in cost efficiency, smarter choices on segments—in our case, work and commercial—along with many partnerships and various technology pathways. Overall, the EV journey has been humbling, but it has forced us to get fit as a company, including applying it to our ICE business, and that will pay off in the long run. I am so happy we scaled 2.5 years ago, and we have the option to incorporate these learnings into our next generation of EVs launching in the coming years. I want to double-click on the software technology and services business. Ford, alongside Rivian and Tesla, are the only non-Chinese OEMs controlling software across all vehicle domains. Most companies are doing over-the-air (OTA) updates on vehicle entertainment. Ford now has multi-year experience updating powertrains, braking, the fundamental performance of the vehicle, and connectivity. The breadth of our portfolio, including F-150 and our Pro business, reveals a much more complicated customer use case than Rivian and Tesla. Our vehicles are increasingly general-purpose computers capable of delivering the type of application environment and AI for our customers and user experiences that we expect from all of our digital devices. This allows us to create powerful, connected, ever-improving customized experiences. Many of you may be surprised that Ford leads on OTAs. According to the 2024 OEM OTA capability rankings in North America, we are the leader based on the quality of our updates. This is not about how many updates we do, although we do a lot; it's about the ability to improve the fundamental performance and capability of the entire vehicle and all the modules in the vehicle. There's no better evidence than Mach-E. Longer range, better efficiency on the battery, faster zero to sixty times, better BlueCruise performance. We've done it all with Mach-E for many years now. Our vision is not just a powerful computer on wheels. It's actually a robot that will link with these digital experiences—things that only a vehicle can do, like safety, security, and other innovative use cases we shared with you at Capital Markets Day. These experiences will drive higher profitability and accretive revenue and are the reasons for customers to stay with Ford and Lincoln. This will lower marketing costs, which are now becoming clear to us. One example on the retail side of technology is our first implementation of the Phoenix system, which we call the Lincoln Digital experience with our new panorama display in the new Nautilus. This experience is really a differentiator in the luxury space with Google Maps, Google Assistant, and enhanced CarPlay. Our sales for Nautilus surged by 48%. We now have a much younger customer demographic. The biggest application for this technology is BlueCruise and ADAS. It's the leading hands-free driving technology in America, we believe. We now have 415,000 enabled vehicles on the road. That's a 25% increase in one quarter. We have driven together over 213 million miles—all hands-free since launch. To better dimension our progress on software technology and services; in this quarter alone, total company paid subscriptions grew 40% to over 765,000 paid subscriptions. Our integrated service revenue is now on track for double-digit growth this year. We are targeting $1 billion of revenue next year for our software, with gross margins of over 50%, which drives significant operating leverage and improved capital efficiency. A major part of this new software business is Ford Pro, so let me touch on that. The foundation of Pro is simple: our vehicles. A robust and fresh lineup, the freshest we've ever had at Ford in ICE, hybrid, and EVs, includes the all-new Super Duty, the all-new Ranger globally, the all-new F-150 that has just finished its launch, the all-new custom Transit in Europe, and our two small vans in Europe, the new Transit Connect and Courier, and the new extended-range two-ton electric Transit we sell in both Europe and North America. These brands and vehicles are seeing resilient revenue streams based on a much longer tail spending on the infrastructure by government and private enterprise. We also have a robust and diverse customer range. We dominate small and medium business with tradesmen, but we have very large customers. We have state, local, and national governments, and even rental agencies, which are very profitable for Pro. In fact, in the U.S., one out of four of these fleets, from mom-and-pop tradesmen to large companies, are Ford-only fleets. The big opportunity for Pro is beyond vehicles—that's where we're focusing. With Pro Power Intelligence, we offer a highly differentiated telematics offering, providing real-time driver coaching, which significantly improves driver safety and is now available in about half of our modem-enabled Pro vehicles. This includes features like seatbelt and speed monitoring and harsh braking notifications. Pro Intelligence is also a platform for vehicle controls. Our first major offering is Fleet Start Inhibit, which protects Pro vehicles from theft and unauthorized use. We will expand these vehicle controls to speed control and acceleration limits in the near term. No third-party telematics solution can offer this functionality because it's related directly to the vehicle. We call it our uncrossable moat for our software business. Over four billion miles have been traveled in the first half of this year on vehicles equipped with Pro telematics, insights, and controls. Our paid subscriptions for Ford Pro Intelligence grew 35% year-over-year, now including 610,000 paid subscriptions, with triple-digit growth in telematics fleet management and charging depot software. Turning to physical service, which is the second major non-vehicle revenue and profit for us at Pro, we have a massive opportunity to grow physical services and parts. In the first half of this year, Ford Pro was only 24% of our after-sales revenue; it's a huge upside. Bank of America estimated the profit pool for maintenance, repairs, and parts physically, which escape our dealer network, at about $135 billion. That's 2.5 times the profit dealers capture through vehicle sales and financing. This is a huge untapped total addressable market (TAM). Ford Pro already has the largest physical and mobile service network in North America, but for specialized commercial service, many of which are open 24/7 for our customers with specialty technicians. We continue to expand that physical network, giving us a competitive advantage by adding Pro Elite centers and mobile service units. We are on track this year to reach 27,000 commercial service bases by the end of the year, up 20% year-over-year. Growth will be led by the Elite base, the largest and most capable service base for Pro, which will more than quadruple this year to 1,300. We are on track to increase our mobile service units by 45% to 2,500 service trucks and vans—10% of our entire physical network. This mobile service network is incredibly important competitively. None of our competitors offer this kind of scale. We are addressing many repairs, limiting our downtime for our customers. We service multi-make fleets, which helps our competitive position. Global mobile repair orders generated from this fleet are up 115% in the quarter. Our focus on software and physical service expands the moat for Pro while helping our customers improve productivity and grow their businesses. Pro is on track for software and physical services to contribute 20% of our EBIT by 2026. Regarding quality, we are making progress with our latest vehicles. Ford jumped 14 points in the latest J.D. Power's 2024 U.S. Initial Quality survey. We went from 23rd in the industry to ninth. Bronco Sport is now named the best small utility in initial quality, outperforming 18 competitors. Our launch in initial quality are leading indicators for warranty in the future, and we expect to see benefits in the future. However, we did see warranty costs increase in Q2, tied to new technologies, field service actions (FSAs), and inflationary pressures for the cost of repair. We expect technology-related warranty costs to normalize as technology matures, and we deploy our OTA capability to address known issues. We are confident we are on the right trajectory with a very clear and non-negotiable mission at Ford—to deliver best-in-class quality. I'll close with this: The remaking of Ford is not without growing pains, but it is unlocking opportunities to serve our customers in ways we never thought possible. My confidence comes from the fact that we have built a world-class team, and we are executing on a compelling strategy. No other company has Ford Pro. We intend to fully press that advantage. No company has a more compelling product lineup with an attractive mix of ICE and partially and fully electric options for both work and retail customers. We also know we have a lot to prove. We look forward to proving our EV strategy, which has become sharper in the tough environment. Thankfully, we scaled years ago. We are confident we can reduce the losses and maintain a profitable business in the future with everything we've learned. We look forward to proving that we can be profitable with smaller vehicles, not just electric vehicles but across all powertrain choices. It's time to prove our recent quality gains are repeatable and will flow to the bottom line. Plenty of work ahead, but the direction is crystal clear to us. We are building a high-growth, high-margin, more capital-efficient, and more durable Ford.

John Lawler, Vice Chair and CFO

Thanks, Jim. I want to thank the entire Ford team for their hard work and continued focus on executing our Ford+ strategy. More importantly, we are aggressively working to remake Ford into a higher-growth, higher-margin, and more durable business, as you said. Frankly, a higher-performing company. Our automotive business is solid and consistently generating strong free cash flow, which is a core ingredient for driving total shareholder returns over time. In the quarter, we generated nearly $48 billion in revenue, with growth of 6%. Wholesales were up 2%, as our fresh and compelling product line gave our retail and commercial customers unmatched freedom of choice. The quarter benefited from record Transit wholesales, as well as the completion of our all-new F-150 launch, including the drawdown of the inventory we held at the end of the first quarter. We delivered $2.8 billion in adjusted EBIT, with a margin of 5.8%, as higher costs were partially offset by the continued strength in Pro. Costs were up year-over-year, reflecting an increase in warranty reserves, higher new product-related material costs, and higher manufacturing costs. If you step back and look at our sequential performance, Q2 saw revenue growth of 12% on a 9% increase in wholesales, driven by higher truck volume and the strength of our product portfolio. Despite this revenue growth, EBIT was flat, reflecting primarily higher warranty and manufacturing costs related to the inventory, which was driven by seasonality and high-volume launches. We remain on track to deliver $2 billion of material, manufacturing, and freight efficiencies over the full year, which will partially offset higher labor and product refresh costs. We're seeing emerging headwinds in warranty and inflationary pressures in Turkey, and we are working to mitigate these costs. Now, I have more confidence in today's business than ever. Our strong global product lineup is differentiated and driving continued top-line growth. We are slowly and steadily improving our industrial system and shedding behaviors that have held us back in the past. We're on track to deliver our full-year guidance, and we are generating stronger and more consistent cash flow than just a few years ago, evidence that our Ford+ plan is working. Adjusted free cash flow was $3.2 billion in the quarter and $2.8 billion through the first half, resulting in a cash conversion rate of 51%. Our $1 billion increase to adjusted free cash flow guidance for the year underscores our growing confidence in the business. Our balance sheet remains strong with close to $27 billion in cash and $45 billion in liquidity, providing considerable flexibility in a very dynamic environment. I'm also pleased to announce the declaration of our third quarter regular dividend of $0.15 per share payable on September 3rd to shareholders of record on August 7th. Let me spend a few minutes summarizing the financial performance of our customer focus segments and highlight how each of them drives Ford+ and makes our business stronger. Ford Pro delivered a 9% increase in revenue on a 3% increase in wholesales. The segment has consistently delivered year-over-year revenue growth each quarter since we re-segmented our businesses. EBIT was a solid $2.6 billion with a healthy margin of over 15%, reflecting increased Super Duty and Transit volume that are both capacity-constrained, along with higher net pricing. Ford Pro is the prototype for sticky high-margin, non-cyclical revenue. Pro's results this quarter continue to demonstrate the consistency, predictability, and resiliency of this higher-margin growth business. Ford Model e generated a loss of $1.1 billion as continued industry pricing pressures and wholesale declines of 23% more than offset lower costs. Our team's intense focus on cost delivered about $400 million in savings to the bottom line in the quarter. Key factors included reductions in material costs, improved battery economics, and lower engineering. This builds on the cost reductions we have achieved since the launch of our first-generation products, helping to improve our profit outlook as we head into '25. Ford Blue revenue grew by 7% on a 3% increase in wholesales, led by growth in trucks and strong pricing, though wholesales were impacted by the launch of the Explorer, as we ended the quarter with about 21,000 vehicles in inventory for quality checks. EBIT of $1.2 billion and a margin of 4.4% were both down year-over-year, mostly driven by higher warranty. Once again, Blue was profitable in every region. Our hybrid sales, up 34% in the quarter, continue to shine, and our global hybrid mix is now approaching 9%, up over 2 points year-over-year with more products on the way. Ford Credit generated an EBT of $343 million, slightly down year-over-year. Auction values declined by 9%, and lease return rates continued to normalize from historic lows. Credit losses and insurance losses were higher, but mostly offset by an improvement in financing margins. We continue to originate a high-quality book, with U.S. retail and lease FICO scores again exceeding 750 for the quarter. Our exposure to EV residual risk is low, as EVs represent less than 5% of our lease portfolio. Now let me turn to our outlook. As I referenced earlier, we continue to expect full-year company adjusted EBIT in the range of $10 billion to $12 billion. In general, we see supply and demand for vehicles in balance. Industry dynamics, including market equations for our four segments, are playing out similarly to what we forecast at the beginning of the year. We are increasing our adjusted free cash flow guidance by $1 billion to $7.5 billion to $8.5 billion, supported by strong earnings and lower-than-planned CapEx. We are keeping our CapEx target range of $8 billion to $9 billion and are focused on delivering at the low end. Our outlook for the year assumes a flat to slightly higher SAAR in both the U.S. and Europe. Our planning assumption for the U.S. is 16 million to 16.5 million units. A full year of customer demand for our all-new Super Duty should contribute to better market factors for Ford Pro. We expect lower industry pricing of roughly 2%, driven by higher incentive spending as we move through the second half of this year. For Ford, we expect this to be partially offset by top-line growth from the launch of our new products, warranty reserve increases from software, higher repair costs, and FSAs. Our segment outlook anticipates continued Ford Pro strength, and we are increasing our EBIT range to $9 billion to $10 billion, reflecting further growth and favorable mix, partially offset by moderated pricing. As expected, losses in the range of $5 billion to $5.5 billion for Model e, driven by continued pricing pressure and investments in new vehicles. For Ford Blue, we are trimming our EBIT range to $6 billion to $6.5 billion, reflecting a balanced market equation and higher warranty. We expect Blue's profit trajectory to significantly improve in the second half, reflecting higher volume with the F-150, Explorer, and Ranger launches that are just completed, as well as our recent capacity expansion on Bronco. We expect Ford Credit's EBT to be approximately $1.5 billion, indicating double-digit growth year-over-year. Our performance this quarter demonstrates the positive progress on our Ford+ plan. We are disciplined with capital, we have the right portfolio of products, and we are delivering consistent cash generation to reward our shareholders. We are relentlessly seeking out new ways to make our business better and remain focused on driving improvements in both quality and cost. That wraps up our prepared remarks. We'll use the balance of time for questions. Thank you.

Operator, Operator

Your first question comes from the line of Adam Jonas with Morgan Stanley. Please go ahead.

Adam Jonas, Analyst

Hi, everybody. Jim, you said that Ford is a different company from what it was three years ago, but the stock market really doesn't seem to agree with you at all on that. The stock is down about 10% after hours and around $12 a share. My team just ran the numbers, Ford ranks 494 out of 500 companies in the S&P on PE. Jim, do you—my first question is, do you think Ford's stock is good value?

Jim Farley, President and CEO

Yes. Yes, we're—

Adam Jonas, Analyst

Then why does your—then why does your Board refuse to authorize a share buyback? And people on this call, I think they understand the reason, like the family element. But in your opinion, if you're telling me the stock is a good value, and it's like the bottom one-percentile of the S&P, what's the plausible reason why—do you really think you have better uses of capital than that?

Jim Farley, President and CEO

Yes, we do. It's hard for people to understand those possible uses of capital, but we have so many exciting businesses to invest in. Pro is a great example. I'm not going to get into specifics, Adam, but I think people will understand over time how many exciting opportunities there are at Ford. I'm not just referring to vehicles; I'm referring to non-vehicle activities. We have 27,000 service bases. There are lots of opportunities. As I said, when you look at Ford Pro, I'll just deep dive on that one, and I'm so glad you asked this question, by the way. Ford Pro is a very, very high percentage of our company's profit. Just look at the ratio between the overall company's EBIT in Pro and our guidance. Think about our after-sales business; only 24% of our revenue comes from Pro-related vehicles. We could spend a lot of time discussing this opportunity, but that's why I highlighted in my comments; there are so many places for us to grow Pro on the physical services. They're like 35% margin, but it's hard stuff, right? It's like bays and technicians and a lot of work. We have exciting electrical architecture investments that we have to make in our future that will really change our ICE vehicles and their revenue potential. That revenue won't just be when we sell the vehicle; it will be over time, which we're seeing with Pro already. I don't want to belabor the point. I'll just tell you there are plenty of opportunities. Anything else?

Adam Jonas, Analyst

Okay. Just a follow-up on Skunkworks.

Jim Farley, President and CEO

Yes.

Adam Jonas, Analyst

Your team has made a number of visits to China over the last couple of years, including, I think, just a couple of months back, I believe you were there. What are you learning from these trips? Specifically, I mean, you mentioned China along with Tesla as the cost benchmark, but do you think Ford can bring to market a low-cost EV profitably without help from your partners in China, or is China part of the solution? And if China is part of the solution, then what are you going to do about it?

Jim Farley, President and CEO

Yes, great question, an important question for any OEM as the EV market evolves here. Look, we made the bet on CATL many years ago. It was very important for our company to localize LFP cells in North America, which happens to be in Michigan. We're two years into that project. That is a signature partnership. CATL is the largest battery maker in the world, and they lead iron phosphate cost and reliability. That is a signature partnership we launched many years ago that we've been working hard on, and Marshall is on track. Look at what Volkswagen is doing with XPeng, and many others are taking a Chinese low-cost platform and using that. That's not our strategy. Our partnership strategy will be on the component side, going deep into the supply chain for intellectual property that is critical and unique. I'm not going to get into specifics, but CATL is one example, and we're going to learn how to do that at the company. We believe that this is essential know-how for the company because the true fitness test for EV profitability will be on these small vehicles. We learned from our experience with Mazda and Kia and many others that we have to have this know-how in the company because it applies across all of our vehicles, not just EVs. The lowest cost is the most important capability. Many of our competitors will turn to their Chinese either independent companies or partners to use their platform globally. We learned a lot, not just from China, but from MEB. We've been scaling MEB. We know the cost of Volkswagen. They're one of the leaders in scale. What we found in that trip and subsequent trips to China is that we have a competitive battery with CATL, but many of the Chinese players in the lower-cost segment have very affordable batteries, but they lack the most efficient design outside of the battery on other EV components. Our team, the Skunkworks team, we might as well call it a big team now because it's no longer Skunkworks, we're betting on them as our affordable platform. They have designed breakthrough EV components that we think are better and cheaper. We have a very competitive battery localized with the IRA benefit. The partnership discussion will largely focus on larger vehicles. We think that's where the big partnership opportunity lies. In the commercial vehicles I mentioned, we have nothing to say right now, but this is why the partnership is important: because for larger vehicles, these have an inverted cost structure, and partnerships allow for better capital efficiency and higher returns.

Operator, Operator

The next question is from Bruno Dossena with Wolfe Research. Please go ahead.

Bruno Dossena, Analyst

Yes, thank you for taking the questions. I was wondering if you could just contextualize what fundamentally within the organization you think is leading to these persistent warranty issues. I realize partly it's because it was on a prior industrial system, but just given how frequently the surprise warranty issues keep popping up, how do you have visibility or how can investors really build confidence in an earnings trajectory when, every year the surprise warranty issues keep happening? Thanks.

Jim Farley, President and CEO

Thank you. The most important evidence is the J.D. Power's Initial Quality Survey. That's a big point of evidence for everyone. Our internal data has been suggesting for some time. It's now verified. Cutting the initial quality defects to a fully competitive rate, where we're leading in some segments, will clearly reduce our warranty over time. But it takes time. You must launch vehicles, drill down the industrial system, and make sustainable changes. It is painful to have great launches quarter after quarter, but we do not release them until we're satisfied with quality and testing. It makes our quarters lumpy and challenging, but that's the right thing to do. When you look at the root causes for these issues, I can go through hundreds of them; it's clear many of these are issues we could have caught at launch. That is what is happening now at Ford. We must go through all these launches to identify these problems. Over time, we believe they can be reduced. We've introduced a lot of new technology in our vehicles. This new technology poses challenges for dealers in diagnosing issues when customers come in saying something is wrong, leading to unnecessary component replacements that hit our warranty reserves. Fortunately, the fixing of these issues is different than mechanical fixes. Our OTA capability redirected toward these defects can effectively reduce our costs. We are actively managing those cost curves for each of our models. John, do you have anything to add?

John Lawler, Vice Chair and CFO

Yes. There's always a lag between quality improvement and warranty run rates improving. The first step is quality improvement, which is expected to lag by 12 to 18 months, and then we should see the warranty coming in. With the previous models, the vast majority of warranty claims are coming through FSAs. We're working to fix those faster and limit their impact. It's an issue the team is focused on, and the encouraging thing is that quality is improving, which is critical for the future business and our long-term trajectory.

Jim Farley, President and CEO

What we won't do at Ford is reduce our actual cash expense at the expense of our customers. We will fix these problems. We will do the right thing. I don't care if it costs rental cars or whatever; we want to turn these quality issues into positives for our customer experience.

Bruno Dossena, Analyst

Okay, thank you. To step back, and I think this touches on Adam's Skunkworks questions, but when you compare Ford now to history, earnings are significantly higher. The capital base has expanded such that returns really haven't improved. This isn't just Ford; it's most Western automakers. The earnings part of the equation is partly in your control, but the structural costs are. How are you thinking about the trajectory of structural costs from here? Are they going up or down? And why are legacy OEMs all doing this independently? Why aren't there more partnerships?

John Lawler, Vice Chair and CFO

You must consider how to fundamentally change the development process; that's the core. It's not just doing it with others. Sure, we're looking to be as capital-efficient as possible and bring partnerships in for capital, but you can also make changes on components and in other ways. We have done a lot of work understanding what has kept this industry in the penalty box that Adam mentioned. We are not capital-efficient, lower-margin, lack growth, and are not resilient; it's a very cyclical business, and we're working to change that. We're addressing key areas to improve efficiency. The Skunkworks team is doing something very different. That team is unique for a traditional OEM; their talent is doing an agile, waterfall, systems-integrated design process, which no other traditional OEM has done. We're really working it to be focused on what can happen from a tech standpoint. That vertical integration helps drive lower costs. We're finding ways to be more efficient, and we see this working out in our affordable EVs.

Jim Farley, President and CEO

Yes. I would emphasize that the ambition at Ford for partnering on EVs is at record levels. We're not making any announcements on the earnings call, but this is a flip-the-script moment for our company. We have partnered before, like with Volkswagen, and we've learned how to be successful with the one-ton Transit, including electric vehicles. We see incredible opportunities ahead. However, we won't delegate our future and the fitness for cost competitiveness outside the company. If we partner, we must have that transfer function John mentioned. The industry is also going through a transformation, and we believe Ford is ahead, given the complexity of our platforms compared to Rivian and Tesla.

Operator, Operator

The next question is from John Murphy with Bank of America. Please go ahead.

John Murphy, Analyst

Good evening, everybody. Just to take it back to the core of the business. Jim, I want to go through some numbers regarding the Ontario Super Duty capacity addition. It’s a big step-up in capacity of 100,000 units. It seems like current demand would absorb that reasonably well. However, do you think we might be hitting a peak in terms of this truck? What’s your take on sustaining high levels of demand and sell-through? How should we think about incremental margins on that? It seems like a $3 billion investment might have a payback of less than two years.

Jim Farley, President and CEO

Correct.

John Murphy, Analyst

Spin out a lot of cash real quickly; it might be a really good investment. So, could you talk about that, and what kind of powertrains those trucks will have?

Jim Farley, President and CEO

Yes, so powertrain-wise, it will be a diverse powertrain—a multi-energy platform. I'm not going to get into specifics, but you can imagine what we've done with F-150 and Transit Van; we’ve moved toward all our commercial vehicles being a multi-energy platform. We will offer customers choices that no competitor will have. We believe we'll be a first-mover, if not the first-mover, in multi-energy Super Duty. Look, we saw the $1.2 trillion investment in the Infrastructure and Jobs Act. There's about $300 billion going toward a 5G upgrade. The real part of our Super Duty business that has been under constant supply strains is our chassis business. It's about 25% of our entire Super Duty business. These aren't pickup trucks; they're used for things like 5G upgrades and heavy construction. It's a demand we could not fill. Ford dominates the ambulance industry in the U.S. The average age of an ambulance is 15 years now; they're falling apart. We haven't been able to service that industry, and now we can with this incremental capacity. There's an aged fleet, and the chassis business has a strong investment tail. We lead the industry due to our upfitter products. We're taking the lead on the multi-energy front as well. That’s the story, and it will yield great payback. We wouldn't do it unless we thought this demand would last for many years.

John Murphy, Analyst

If I could sneak one more in, maybe for Cathy, regarding the used vehicle residuals at auctions. It seems that although they're down year-over-year, they've stabilized and started to improve over the last three quarters. I'm curious about your outlook there and what you're seeing in the market. It seems like the supply will remain constrained in the late-model used market, which could be good for Ford Credit, for resids, and potentially provide support for new vehicle pricing. What are your expectations?

Cathy O'Callaghan, CEO of Ford Credit

We're seeing auction values down about 9% this quarter year-over-year, but up sequentially about 3%. We're expecting auction values to continue to decline in the second half of this year, and we're also expecting our return rates to increase as well.

Operator, Operator

The next question is from Dan Levy with Barclays. Please go ahead.

Dan Levy, Analyst

Hi, good evening. Thank you for taking the questions. I wanted to start first with a question on Pro, where we're seeing these continued strong results. Pricing is doing a lot of strength, so I understand all the bits about pent-up demand helping. Could you give us some color on the sustainability of this pricing? Specifically, how long is this pent-up demand expected to last? How much of the pricing is contractual versus more spot retail, which would be more subject to market fluctuations? Any insights on pricing in Pro?

John Lawler, Vice Chair and CFO

Yes. Looking at Pro, we've noted that the demand-supply imbalance has been great for the top line; it's been running strong. We forecast that we expect some top line to come off as we move into the '25 model year. That's in our guidance. We understand that over time that'll be chipped away a bit. We believe there are underserved segments like chassis where we'll provide product with price stability moving forward. We don't see prices collapsing. About 60% of our business comes from fleets, which are negotiated annually and remain strong over the past couple of years. We'll start to see what the '25 contracts look like as we move through the third quarter. Early indications are continued demand beyond what we can supply. We're watching this closely, but so far, early indications for '25 are positive.

Jim Farley, President and CEO

I wish there were car wars for commercial. If there was, we would see product freshness at Ford be an outstanding situation for us. The freshness of our lineup is critical. I've been here for 16 years, and I've never seen all of our core products updated within a 12-month period like this.

Dan Levy, Analyst

Great, thank you. That's helpful. As a follow-up, Jim, could you address the electrification strategy in light of the November presidential elections? We know there's one candidate talking about pulling back on the EV mandate—the implications on IRA or federal or California mandates. You've mentioned flexibility in your strategy, and you referenced earlier about credits playing a role, but could you provide a sense of how your strategy might change depending on the elections?

Jim Farley, President and CEO

Thank you. Ford has had years of experience with elections. Our strategy is this: we believe that the fitness of Chinese EVs will eventually impact our entire industry in all regions. We believe that, even if there are short-term adjustments we can make to a compliance-led, lower requirement lineup, we won't approach it that way. We believe many Americans would find that an electric vehicle lowers their cost; not everyone, but a significant percentage. Our strategy needs to focus on full compatibility globally. We can't handicap our strategy based on presidential elections. Ford didn't go bankrupt; we have a history of endurance. Our aim is to make money on small EVs and commercial vehicles—that's our bet. You'll see this play out in the coming years. It's a major adjustment from our Gen 1 products. Thankfully, we scaled 2.5 years ago, allowing us to learn about market equations requiring us to move faster. The EPA could change, but it would take years of legislation and lawsuits. We can't rely solely on administration changes. I've spoken to many leaders in the country, and I always emphasize the subset of customers that can save money and the need for partial electrification. Ford's strategy will be about choice, manufacturing flexibility, and choice. We will not avoid investing in smart electrification. We are focusing on smaller vehicles, commercial aspects, and exploring all pathways and partnerships ahead.

Operator, Operator

The final question today is from Ryan Brinkman with Barclays. Please go ahead.

Ryan Brinkman, Analyst

Hi, Ryan Brinkman from JPMorgan. Thanks for squeezing me in. I wanted to ask on warranty performance that led to higher cost. I remember a similar issue with warranty expenses back in 2022; you then tied it to a transmission installed on vehicles from years prior while noting quality on newly built vehicles had improved. I know you're prioritizing launch quality, including with the F-150, you discussed at length last quarter. Any color you could share, like whether the higher warranty provision this quarter relates to a discrete issue like in 2022, or could you share what age cohort of vehicles is driving the higher cost this quarter? With this new provision, do you think you have a better grip now on future costs and can provision in future quarters normalize lower as soon as the next quarter?

John Lawler, Vice Chair and CFO

Yes, Ryan. The warranty issues are from older models. The largest issue involves a rear axle bolt from vehicles engineered for the 2021 model year. Such problems can develop at a higher time in service. If we're made aware of them, we fix them. Several of these issues are coming through on older models. There's a failed oil pump issue from 2016-launch vehicles. It’s obvious that over a period, the robustness wasn't what it needed to be, and that's showing up. It's hard to predict when these long-term durability and quality issues can arise on older units. We'll work through those and believe overall, as we improve our near-term quality and that starts to reflect in the field, we will be able to bring down our overall accrual level.

Ryan Brinkman, Analyst

Okay, thanks. What do your comments mean regarding Ford controlling the software stack bumper to bumper, with all OTA update capabilities? What do these new capabilities mean for troubleshooting or preventing warranty issues in the future?

John Lawler, Vice Chair and CFO

Those are critical because these problems that have been out in the field for a while have crossed over from, say, a '16 model year introduced in '13 or '14, etc. With connected vehicles, controlling our software allows us to get timely signals off the vehicle to tell us if we have issues with certain components. If we know early, we can minimize overall impacts, perform OTA updates to address issues, creating a much cheaper process than a field service action where you're replacing components. These connected data capabilities will enhance our warranty system significantly. That’s more on the physical side. With software, we can detect when issues arise much earlier and correct them through OTA updates.

Jim Farley, President and CEO

During our launches, Kumar and Doug partnered in a way that hasn't been done at Ford in a while. We now test vehicles to failure and individual components to failure, which is beyond our launch standard. We're analyzing DTC codes from vehicles, mainly powertrain-related, while running these vehicles at high mileages, which exceeds our launch standards. Doing this helps us catch many, many problems in our industrial system that we can fix before we release the vehicle. It's tough to keep all the vehicles over quarter ends, but it's the right move for the company, and it’s the only way I believe we can manage our warranty spending.

Ryan Brinkman, Analyst

Very helpful, thank you.

Operator, Operator

This concludes the Ford Motor Company's second quarter 2024 earnings conference call. Thank you for your participation. You may now disconnect.