I am recommending purchase of CNH shares, as a proxy for Fiat Industrial (FI IM).  CNH is in the process of being acquired by Fiat Industrial (FI IM), which currently owns 88% of the company.  We regard CNH as the cheaper way to play FI IM (due to the existence of the 3.8% arb discount.)

 

Since FI IM will be the surviving company this write-up will mainly focus on why we believe FI IM is a compelling investment opportunity, on an absolute and relative basis.  OM730 has previously written up Fiat Industrial (in July of 2011), highlighting the attractive discount available in the preferred shares.

 

Based on revenues, Fiat Industrial is the fourth largest capital goods company in the world, behind Caterpillar, Volvo and Deere.  Moreover, the company is the second largest agricultural equipment manufacturer in the world (behind Deere.)  In light to heavy commercial vehicles, the company is top three and the company is a large player in construction equipment as well.

 

The Fiat Group has been on a path to simplifying its operations and ownership structure for several years.  The last three years have been particularly active, with the spin-off of Fiat Industrial, the consolidation of the Fiat Industrial share classes and the acquisition of CNH/listing of Fiat Industrial in the US (yet to close).  

 

Fiat Industrial had been part of the Fiat Group for 100 years prior to its spin-off.  Fiat Group had historically relied upon the strength of industrial assets to help support the auto business.  However, Fiat Industrial’s asset mix, industry competitive dynamics, growth characteristics and cyclicality are far different that of the automobile industry.  Fiat’s historically complex structure led to suboptimal capital allocation and operating inefficiencies. 

 

While the spinoff has unlocked value – the share price of Fiat prior to the spin-off announcement on April 21, 2010 was 10.40 euro per share, versus a combined value of Fiat and Fiat Industrial of 13.37 euro per share today – Fiat Industrial continues to trade a significant discount to global industry peers.

 

This discount reflects, we believe, four principal factors: (1) holding company structure; (2) Italy listing; (3) limited investor awareness, associated with relatively recent separation from Fiat Group; and (4) depressed margins/earnings in several of its businesses.  The first three factors are set to change, as discussed below, while the fourth is arguably a good reason to own the stock going forward.   

 

To date, we believe Fiat Industrial's valuation has, in part, been held back by a holding company discount, reflecting CNH's separate listing (FI IM's 88% ownership stake).  

 

CNH itself has had difficulty attaining a fair public market valuation, due to its limited public float and fears that Fiat Industrial would disadvantage minority shareholders in any kind of private market transaction.

 

The minority investor concerns were largely being born out in the CNH / Fiat Industrial merger terms.  Though Fiat has recently rallied, thereby benefitting CNH shares, the revised merger terms (which were announced on November 19th) valued CNH shares at only 4x 2012 EBITDA (based on prior day closing prices), a large discount to public agricultural equipment comps AGCO and DE. 

 

The holdco structure will be eliminated following the completion of the merger between FI IM and CNH.  

 

Since its separate listing on January 3, 2010, Fiat Industrial has been unable to achieve the valuations of its capital goods equipment peers, most notably Deere. 

 

Following completion of the transaction, FI IM will absorb CNH’s listing in the US and be re-domiciled as a Netherland’s company.

 

The effect of this relisting should be meaningful, as US investors have historically been able to invest in only two liquid ag equipment securities, DE and AGCO.  Pro forma for the merger, the combined company’s float will be $11.8 billion, more than 9x the $1.3 billion float for standalone CNH today.  Deere's market cap is roughly $33 billion and AGCO's market cap is $5 billion.  Pro forma Fiat Industrial will have a market cap approaching $17 billion.  

 

While Fiat Industrial has broad analyst coverage in Europe (24 analysts), US investor ownership and awareness is relatively limited.  Following its listing in the US market, the company is likely to pick up meaningful US coverage.  Fiat's CNH subsidiary has historically been unknown and under-owned relative to its main peer Deere and smaller competitor Agco.

 

For comparison, only eight analysts cover CNH versus the 24 analysts that follow Deere.

 

Fiat Industrial doesn’t screen particularly well on earnings, as several of the businesses are not performing anywhere near their potential, as discussed in more detail below.  These businesses include: (1) Iveco; (2) CNH construction; and (3) FPT Industrial.  Collectively, these businesses generated 14.6 billion Euros of revenue in 2012, but an estimated operating profit of only 560 million or only 4%.

 

The company's investor presentation from June 28, 2011 lays out Fiat Industrials’ long-term revenue and margin targets for its business segments (see page 7).

http://www.fiatindustrial.com/it-IT/investor_relations/investors/presentazioni/FiatDocuments/Fiat%20Industrial_June%2028%20-%202011.pdf

 

Applying the company’s 2014 mid-cycle margin targets to 2012 reported revenues implies an additional Euro 875 million in operating income upside potential.  The rough breakdown is as follows:

 

CNH Construction -280 million

Iveco -367 million

FPT Industrial -228 million

Total875 million

 

CNH's agricultural business is the second largest competitor in the world, behind only Deere.  In recent years, Fiat Industrial growth has been driven by the agricultural equipment operations.  Fiat Industrial now derives 45% of total consolidated company revenue and, more importantly, over 80% of equipment operating income from the attractive CNH ag equipment business.  

 

Operating profit has climbed from US$712 million in 2009 to US$1.68 billion in 2012, with operating margins rising from 6.7% to 10.7% over this time period.  This compares to DE's 2012 ag equipment operating profit margins of 14.5%.  While John Deere is clearly a world-class company, with a different product mix, the margin gap between the two companies is indeed substantial.  Based on 2012's sales base, closing the entire 380 basis point margin gap would result in a US$594 million or Euro 450 million lift to total consolidated operating profit, using current Euro exchange rates of 1.32/US$.   

 

CNH construction has been the worst performing of the business segments and currently operates at a break-even operating margin, on a 2012 base of $3.8 billion (Euro 2.935 billion) of revenue.  The construction equipment segment hasn't generated material profits since 2007, when the business generated US$412 million of operating income and ran an 8.2% operating margin.  Deere's construction and forestry segment, which has a $6.4 billion revenue base, operates at a 7.5% operating margin.   Even at a 5% operating margin, CNH Construction would produce $US190 million (Euro ~150 million) of operating profit

 

In 2012, Iveco had 11% market share in Western Europe, which experienced unit contraction of 7%.  Latin American units were down 14% year over year and market share was 11.6%.  Full year equipment revenues were down 7.5% to Euro 9.5 billion.  Equipment trading margins were 5.8% in 2012, down from 6.8% in 2011.  If management can improve margins in this business, given its large size, the impact on overall profitability would be material.  Each 100 basis point upside to Iveco is worth roughly 100 million Euros.  

 

In 2013, Iveco projects a flat market in Western Europe and 10% growth in Latin America, driven by Brazil improvement.

 

FPT manufactures and supplies engine and transmission systems for trucks, commercial vehicles, marine vehicles and power generation.  FPT generated Euro 2.9 billion of revenue in 2012, down 9% from 2011.  Revenues from related parties, CNH and Iveco, accounted for 66% of total revenues, down from 67% in 2011.  Unit sales to Iveco and CNH represented 31% and 27%, respectively, of total unit sales.  Trading margins, though still low, were up, despite the revenue decline - 4.8% vs. 3.3% in 2011.

 

Consensus earnings estimates for Fiat Industrial for 2013 and 2014 are Euro 0.92/share and Euro 1.07/share.  If we adjust 2013 estimates for interest expense savings and apply the company’s long-term targeted operating margins (original 2014 targets) to 2012 reported revenues, we calculate mid-cycle earnings power of about Euro 1.40 per share.  This assumes no growth in top-line and no additional improvements in the agricultural segment. 

 

We see a number of near-term and long-term value drivers for Fiat Industrial.

 

•Closing of CNH/Fiat Industrial merger

•Analyst/Investor day this spring

•$140-$150 million euro in interest savings following the close

•Potential for share repurchases and dividends – expect a 25-35% payout ratio, consistent with management targets

•Three businesses (Construction, Iveco and FPT) operating at cyclical troughs, with combined incremental earnings power of 875 million Euros

•Increased emphasis on improving operating efficiency as financial engineering/rationalization of holding company structure gives way to increased focus on execution

 

Adjusting for the value of the financing business at book value, FI IM is trading at about 5x 2012 trailing EBITDA.  Through CNH, investors can create FI IM at less than 4.9x EBITDA, given the 3.8% arb spread that exists today (3.828 shares x 1.32 exchange rate.)

 

This valuation compares with DE at 6.9x 2012 EBITDA and AGCO at 5.8x EBITDA, on this same basis.  We believe Fiat Industrial can trade at a meaningful premium to AGCO, given its substantially larger size and float combined with the free options we get on a recovery in Construction and Iveco, two businesses operating at cyclical troughs.  If we begin to see evidence of operating improvement in Iveco or Construction, it is quite likely that Fiat Industrial’s valuation will approach that of bellwether DE.  

 

We believe the stock is attractive on an absolute basis, but particularly so on relative basis.  We expect the valuation discrepancy between Fiat Industrial and Deere to narrow, as investors become more familiar with the story and management further improves operations.

 

•Family maintains significant control through loyalty voting structure

•Exposure to Western Europe

•Capital allocation, though not an issue to date

•Exposure to the economy