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We’ve received a great counter thesis to our European auto investments, and we wanted to share the counter-view to the bull thesis on Renault and Fiat. To summarize:
- The industry has a history of poor economics and they are essentially low-margin industrialbusinesses attached to profitable banks. The investor was not sure that characterization didn’tdeserve a discounted valuation
- If we want exposure to a European turnaround, why not own Volkswagen? Companies like Fiat and Renault are subscale, which is why they are cheaper. Renault-Nissan and Fiat-Chrysler are late to the globalization game, VW is already on the next phase of the platform harmonization
- The scale advantage helps VW, which spends substantially more in R&D than Renault, which will hurt as efficiency standards come into place, and has an impact on vehicle prices. VW has been winning European share every year since 2003, go to any dealer in Europe and the cost of financing is only 2% vs. 6%+ from Renault and Fiat, how can they compete?
To be clear, we referred to the undervaluation in our Renault write-up relative to the historical valuation multiples in the industry – they are all cheaper than they have been on a historical basis.
We agree with much of these points, we just look at it from the other side of the glass. As for over- capacity, we think the scariest thing for investors is what happens if the Chinese auto market doesn’t grow as everyone predicts – the lion’s share of capacity expansion has been going into China and if faced with over-capacity there, the we’d likely end up with a trade war as those autos would definitely make their way to richer markets.
As for scale: the investor is right, Fiat-Chrysler has about the same scale as Ford, and even if the plan comes true, they’ll be 3 million vehicles short of the Big Global 3. Yet, Ford and Hyundai have often led the industry in operating margins, and they have far less scale than the big boys. Renault-Nissan will come close to selling 9 vehicles in the next 12 months, and we wonder if it makes a huge difference – selling 9 vs. 10? Furthermore, most of the scale hasn’t been achieved, as the investor accurately points out, on global platforms at Renault-Nissan or Fiat-Chrysler. We view this as substantial margin opportunity going forward – GM, VW, Toyota, Ford have all completed these globalizations and that’s reflected in the margins. Interestingly, Renault’s low-cost Dacia brand has the highest operating margin at the company – it’s able to sell these cars at far cheaper prices than VW, and it’s been able to do it at roughly 10% operating margins.
The Reanult-Nissan group spends exactly half of what VW spends on development if one includes capitalized development costs and capex. And that includes spending that has already beaten VW to the punch on next generation power trains. There’s a price we’d pay for nearly any asset, but VW deserves to be at the bottom of the valuation spectrum given the capital allocation nightmare it has become. It uses stock to finance acquisitions at 2-3x its own valuation, and German press has leaked that internal brand managers have been asked to pull more costs out of their segments because the returns on MQB platform spending are at risk.
In our experience in commodity industries, capital allocation is responsible for all of the performance of the company vs. the industry. We admit Renault has already burned ~€1 billion on developing a loss-making electric vehicle fleet, yet at least it’s not issuing capital to finance such endeavors. This comes from an analyst who is less skeptical and more scared of the power VW will be able to wield after it converts all of its vehicles onto MQB. For the entire industry, hopefully it won’t be cutting price to drive volumes if the margin targets are already at risk. Eventually the D&A coming from the astounding €84 billion it is spending on vehicle development and expansion is going to start hitting results.
The investor made a great point on financing costs, yet borrowing costs have been declining for the French and Italian lenders, and the spread in financing costs is reflected in the current market shares, not particularly indicative of future market share gains/losses.
In all actuality, we’d probably own VW if the RNO & Fiat opportunities didn’t exist, but we really like the idea of margin expansion through globalization of products, as we did very well with Ford 5 years ago, which implemented the same plan. We’re actually not all that bullish on European auto volumes, but it’s hard to think that the cycle hasn’t at least bottomed. All of the estimates we’ve put in the write-up exclude any material gains from the macro environment. If VW decides to take its cost savings and “reinvest in price,” as the Best Buy CEO so hilariously put it (he is French too boot), investors will not want to own any automaker, especially VW. The last time that industry dynamic played out, Chrysler was running “Buy one, get one free,” promotions and GM was stuffing channels. No one will relish that scenario.
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