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What if the Market is Right?

In a Nutshell:

In a matter of one month, traders in shares of Fiat-Chrysler and Ferrari have fully baked-in a full-fledged financial crisis into the stock valuations. EXOR’s discount to NAV has gone from under 20% to over 40% in recent days. Fear has begotten fear, and malaise has set in, as friends close to us are straining to hold onto given the torrential climate. We are not only hanging on, but buying more. Underlying fundamentals of all three entities couldn’t be further from the illusory market environment.

In a recent commentary on the market, Howard Marks postulated the market is more often than not reflecting the views of people who know less than sophisticated investors, and is thus infrequently telling us anything that would change our thesis. We invert that argument in this memo, and ask, “What if the market is right?” If the market is right on these companies, we are heading into to an imminent global recession on a scale slightly worse then the 2008-2009 Great Recession. If we are not heading there in the near-term, all three companies represent a compelling short, medium and long-term investment prospect. This tale of two opposing views (market illusion vs. real fundamentals) cannot exist together, they are mutually exclusive. The market’s adventure in wonderland will not last long.

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Disclaimer:

This article has been distributed for informational purposes only. Neither the information nor any opinions expressed constitute a recommendation to buy or sell the securities or assets mentioned, or to invest in any investment product or strategy related to such securities or assets. It is not intended to provide personal investment advice, and it does not take into account the specific investment objectives, financial situation or particular needs of any person or entity that may receive this article. Persons reading this article should seek professional financial advice regarding the appropriateness of investing in any securities or assets discussed in this article. The author’s opinions are subject to change without notice. Forecasts, estimates, and certain information contained herein are based upon proprietary research, and the information used in such process was obtained from publicly available sources. Information contained herein has been obtained from sources believed to be reliable, but such reliability is not guaranteed. Investment accounts managed by GreenWood Investors LLC and its affiliates may have a position in the securities or assets discussed in this article. GreenWood Investors LLC may re-evaluate its holdings in such positions and sell or cover certain positions without notice. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of GreenWood Investors LLC.

Past performance is no guarantee of future results.

This Post Has 14 Comments

  1. Thank you for an interesting report. Whilst I cannot claim to understand the opportunity as well as you there are some observations/questions I have related mainly to Ferrari:

    1. Could you discuss the net debt number you use in a little more detail? It appears that you are netting the Ferrari Finance receivables book off the total number. What is the rationale behind this? The earnings from those Ferrari financed sales are included in EBITDA in the same way that sales on credit are included in earnings and then recorded as accounts receivable. One does not typically adjust net debt by offsetting the accounts receivables balance so why should this be done for the Ferrari Finance receivables? I pose this as a genuine question as I myself am not clear on how the Financing receivables book should be treated.

    2. Whilst I understand why you choose luxury companies such as LVMH and Burberry as peers I do not know that using EBITDA multiples is correct here given the relative capital intensity of Ferrari vs LVMH etc. I would be willing to bet that Ferrari is converting less of its EBITDA into cash than LVMH is so I would not pay the same EBITDA multiple for these businesses even if their brands are equally strong. I must say I was also surprised by the use of this metric given you appear to be keen followers of Buffett and Munger. You have no doubt read their views on the relevance of EBITDA to investors…

    3. A minor point but looking at multiples as far out as FY19 might not make a huge amount of sense if you are not converting them into some sort of present value by discounting FY19 earnings back at an appropriate rate.

    Finally and not really related to Ferrari specifically, I am skeptical of any analysis that looks at share price declines at different periods of time. What matters most, in my view, is the intrinsic value of the business and the price relative to that. Declines in share prices alone do not provide much insight on this.

    Thanks for sharing your detailed and interesting work.

    1. Thanks Jason.
      1) This is industry standard in Autos. Clearly banks EV / EBIT or anything like it is going to be >10x so that would be accretive if I fairly valued the bank and backed it out of Adjusted EV, which I do for FCA but do not do for Ferrari because it’s sort of a drop in the bucket (

      1. I am not sure I follow this explanation and why this balance should not be treated as a standard operating asset of the business (like other working capital accounts).

        To think about it in another way, if Ferrari continues to make a similar level of financed sales in the future surely the balance of this receivables account will stay largely constant (again like accounts receivable)? It is therefore not available to pay down debt like excess cash is (which is what is typically deducted from net debt).

        This may well be standard practice among analysts in the auto industry and, I am certainly no expert on the industry, but I am still not quite clear on the justification for reducing net debt by this amount.

  2. Oh sorry the comment that I drafted looks like it was cut off. To use your own analogy of working capital, where the liability side of the balance sheet is debt instead of a payable (as with all other auto finance banks – most don’t take deposits). You wouldn’t add payables to net debt, and because the debt is offset by assets in a banking-style model, this is why we exclude the debt for “industrial or automotive” debt. In our “adjusted EV” definition we use Market Cap + Industrial Debt – Cash + Pension – Auto Bank. Then we take-out the earnings coming from finance activities to properly account for what the industrial business is being valued at. Given most captive finance companies generate ROEs >20%, this is being conservative, not aggressive.
    Since it was cut off, 2) Ferrari has better cash conversion of EBITDA and EBIT than LVMH. People will knock the “capital intensity” of the Formula 1 and auto R&D spending, but LVMH spends more on selling & marketing than Ferrari spends on R&D (and that figure is coming down). It doesn’t have an advertising budget.
    3) I’m not discounting the forward multiples because I’m not suggesting a price target in the traditional sense of wall street price targets – which are always wrong. We try to quantify the possibilities based on sensitivities instead of focusing on a particular target price.
    Thanks for the discussion.

    1. Thank you this makes more sense. Is a portion of Ferrari’s debt specifically related to (i.e. secured by or ring-fenced to) these receivables? I guess that would demonstrate your point very clearly.

      If however they just have regular group wide corporate style facilities can you not make the argument that the receivables book is just a normal operating asset funded by the equity and debt capital invested in the business?

      Continuing on with the WC analogy which I think is a helpful way to think about it, the trade payables balance, (like trade receivables) remains largely constant as the business continues to buy goods at a similar level to the past. If the debt is normal financial debt it does not have the same “evergreen” nature as payables i.e. if Ferrari has to pay back and/or amortize that debt whilst it maintains the same level of receivables someone has to fund that difference?

      On the EBITDA point. I definitely don’t want to disagree as you have no doubt done more work than I have! I will look a little closer at the EBITDA to cash conversion of luxury players and Ferrari and compare. One thing I would note on what you mentioned above is that LVMH’s marketing expenditure is entirely reflected in its EBITDA whereas much of the Ferrari expenditure you refer to is a capex item and is not in any way captured in EBITDA (although I believe a small portion of their R&D is in fact expensed). I will look into this more closely as this is obviously an easy enough question to answer.

      Thanks for your responses. Very helpful as I improve my own understanding of the business.

  3. Most companies do actually ring-fence the debt at the finance companies. Ferrari has yet to do so, and probably won’t since it doesn’t have a cost-of-funding disadvantage (it is financing at 2%). You can look at it however you want, as no other luxury group provides the kind of financing that Ferrari does, outside of perhaps business jets and larger capital goods. From what I understand, investors in Sotheby’s don’t back out the same kind of receivables from their art sales, so you can value it however you want. I’m merging typical practices in auto companies into the Ferrari analysis.

    Ferrari expenses all of its R&D related to the Formula 1 activities, and D&A is largely equal to capital spending, so EBIT is actually directly comparable to LVMH, who also matches capital spending to D&A.

    Maybe the cleanest way to look at it is FCF, which would also make RACE look incredibly favorable.

    1. I believe a material amount of R&D is in fact included in capex (and therefore not expensed). I am referring to p.84 of the IPO disclosure document that shows 161m of capex on intangibles in 2014.

      I agree that EBIT is a far more appropriate measure but I took issue with the use of EBITDA in the report. Had the charts been on an EBIT basis I think that would have been a fairer basis for comparison. I would note that the ratio of LVMH’s EBITDA – net investing cash flows to EBITDA (a crude EBITDA cash conversion metric) has been around 75% for the last 3 years whilst the same ratio for Ferrari has sat around 57%.

      Also, I am definitely not in fundamental disagreement with you on the business. I believe it is an outstanding and unique company. I also think the current share price is a lot closer to reasonable than it was at listing (i.e. it does appear to be a wonderful company at a fair price).

      Appreciate the discussion!

  4. Right, that original reply I had on EBIT was actually deleted some how. The metrics looks equally compelling if you use EBIT, I just use EBITDA because that’s what most others use in the luxury space. Net income comparisons looks compelling as well.

    A fair amount of R&D is capitalized, yes, but amortization of capitalized development costs is nearly equal to this figure. So EBIT comparisons are apples-to-apples.

    Also EBITDA conversion (EBITDA as % of CFO) and EBIT conversion (EBIT as % of CFO – Capex) is better at Ferrari than LVMH. I’m relying on Factset numbers though.

    1. I think we both agree that EBIT is a better metric than EBITDA. The broader point I am making is that whilst on an EBITDA basis, as presented in your report (Exhibit 13 on p.15), Ferrari may look like it trades at a discount to peers like LVMH (8.8x vs 9.1x for LVMH), on an EBIT basis it actually trades at a meaningful premium.

      On an LTM basis Ferrari trades at ~14.9x EBIT (or 14x if you want to use their adjusted EBIT – and these numbers use the EV from your report that nets the receivables off debt) vs LVMH at 12.5x.

      In other words, Ferrari is not as cheap as it seems.

  5. Just to clarify this last comment, you may be using a dollar EV to a euro EBIT, because Ferrari is currently just under 14x EBIT, about 1.7x shy of the peer group we provided. Our math is: LVMH 12.7x, Burberry 11.7x, Hermes 22.3x, Prada 19.2x, Richemont at 11.6x and VW’s take-out of Ducati at 16.9x.

    So in that context Ferrari is “fairly” valued right now, except for the fact that EBIT is more than doubling and rising a lot faster than EBITDA. So it’s a more favorable way to value Ferrari if you ask us. And, yes, it does sound like we agree EBIT is a more prudent measure.

  6. I agree with you on Ferrari (and FCA…which in many ways is even more compelling), but why use EBITDA – Capex to get to FCF? Why not remove taxes?

    Also, your trailing capex numbers are lower than the ones the company actually provided, any reason for this? Eg. I have them with 356 mill in capex in 2015 and you have them at 317. Capex does appear to be coming down, seems like they had higher than normal levels of PPE for a while (due to building and upgrading some facilities), and the capex related to development costs should also come down (probably next year?) because they’ve just refreshed the lineup. At worst, capex remains roughly flat so capital intensity of the business should decrease sharply over the next couple of years, as you’ve projected. Flat opex + flat capex + high margin sales that don’t require scaling up either opex or capex = beautiful combination.

    Looks cheap on any kind of a fwd multiple…EV/EBITDA, EV/EBIT, EV/unlevered FCF…even earnings (<14x '17). Would be happy with them putting the buyback authorization to use here. Also, excited to see what they plan on doing on the luxury/brand side of the biz next year.

  7. TJ – that way of defining FCF is a relic of my old training in Leveraged Finance – it’s the FCF from an enterprise (debt + equity) point of view. More on the debt side, as paying interest is clearly pre-tax dollars. The net debt is driven off of post-tax operating cash-flow of course, but that additional stat doesn’t back out taxes.

    The difference in capex is we netted out the sales of PP&E from the number, as the company does. Now that F1 season is in full swing and Ferrari is not catching Mercedes, we would guess flat Capex for the next 1-1.5 years, until they can catch Mercedes.

  8. Thanks very much for sharing your very interesting and detailed work. I’ve been reading what you’ve written on Fiat with great interest – not just this blog post but generally.
    I had some questions I’d love to know the answers to:
    1) Where do you get the detail to arrive at the IRR calculations you made for the Alfa Romeo Giulia?
    2) One of the issues I haven’t seen your views on are emissions. Europe is the strictest market in terms of emissions and in 3 years or so non-compliance will result in fines. These could be sizeable and I’ve seen estimates of €1bn+ p.a (indeed one house thinks that for Fiat it could be >80% of group EBIT). What is your take on this?
    3) In one of your reports you discuss the bear points that are often put forward on Fiat. In my reading I’ve also seen the argument put forward that Marchionne’s investment in R&D is lower than peers – specifically in ADAS and Emission technology. The result being that Fiat should be at a discount because it’s an under-invested company not fit to meet the large disruptive challenges coming: ADAS, Emissions etc. Marchionne clearly has a different view. What is your take?

    Thanks again for sharing your work and congrats.

    1. Hey Domingo:
      1) We build a contribution margin for every vehicle based on content, platform costs and ASP. Not sure which IRRs you are referring to – we’ve shown a lot over the last 5 years, but we currently assume Giulia to sell 50k vehicles and deliver a 15% rate of return assuming a 6-year platform life and 3-year refresh rate. If they sell up to 75k, the IRR goes to 35%.
      2) Europe actually has the LEAST STRICT emissions rules. They are much tougher in China and second US. Europe is third, and only modestly above developing world – that’s thanks to the VW crisis and all the governments relaxed emissions. FCA has long been the cleanest manufacturer in Europe, thanks to both its small cars and its leadership in natural gas vehicles. They are least effected by what’s going on, despite whatever Germany and France say on the 500X, which is a minimal issue for the company anyway. We stand by the fact that FCA has not cheated here.
      3) FCA spends more on R&D and Capex than Ford and GM – both companies with significant more scale. This is due to product and geographic expansion, and you’re right, not as much spending on new technology. Marchionne stands by, as we do, the fact that any new technology, now owned by Intel in part, will be made available to all OEMs and so the others are pissing away money. That’s negative ROIC, and Marchionne doesn’t spend capital on negative ROIC endeavors. He simply shuts it down. No one else does this, which is why he’s outperformed them >10x.

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