Description

Fiat Chrysler

This is intended to be a brief update on Fiat Chrysler given that we believe the market and investors in general (even after an 18% rally last week post-results) have yet to get a grip on the transformation that under Sergio Marchionne’s leadership the company has experienced.

Please refer to Pluto’s excellent writeup on Fiat SPA (July 31, 2014) for background on the company and its transformation. I couldn’t have laid out the thesis as elegantly as Pluto did and what he said then has mostly happened today, 26 months later. The only thing still missing is the stock price and it is our belief that within the next 12 months as the results of the transformation are more evident, that gap will close.

What happened since Pluto’s writeup?

Financially-

1. The company has grown in sales something more than 15% while EBIT will almost double this year from 2014 levels. The latter has been a consequence of many things but the most important driver have been NAFTA margins which have gone from 4.2% to an estimated 7.5% this year.

2. Ferrari has been spun off and trades as an independent company.

3. Net debt will be reduced by close to 3bn euro since Pluto’s investment recommendation. Net of the proceeds from Ferrari IPO, the company will generate around 1.5bn in cash and will have reinvested in the business close to 20bn euro in that period of time.

4. The ringfence around Chrysler’s debt has been lifted resulting in much better balance sheet flexibility and a lower interest expense.

Operationally-

1. Alfa Romeo’s expansion was delayed.

2. Jeep has outperformed even Sergio’s optimistic expectations.

3. Brazil and Latam have been much weaker than expected originally.

4. Europe has performed as expected, strong rebound although yet to reach pre 2008 highs.

5. Asia pacific strong as expected.

6. Growing and then stable US SAAR.

7. China just being tapped with the Jeep platform.

I’d say that the only thing that has been below expectations have been Alfa’s product cycle and Brazil given its longer than anticipated financial and political crisis.

However I decided to submit a quick update on Fiat because it is my belief that the just reported 3Q16 was the first earnings report where financial improvements resulting from the transformation were evident, but should significantly accelerate and be more evident when full year results are presented in January and then throughout calendar 2017. If we are correct (and every quarter we confirm the trend), it is our sincere thought that Fiat Chrysler should be worth anywhere between 4 and 6 times the current market price by the end of 2018.

After making such a bold assertment, I will try and validate my line of thinking here. Five main points.

First off- valuation.

We are starting with such a low valuation. There is no rocket science here. In my numbers we are currently paying 1.6x 2016e EBITDA and closer to 1.1x 2017e EBITDA. Four times earnings this year on our estimates going to 1.6x earnings in 2018.

We are starting off with such a low multiple that I believe even in the event of a complete collapse of US SAARs to 14-15 million the company makes money and the multiple re-rates.

We are trimming Sergio’s 2018 plan and still get to a 3x-4x on the equity however it is important to say we don’t need that kind of growth to make this a successful investment. The equity is priced as if Fiat would not exist in two or three years. In our opinion that just won’t be the case. Even if we apply GM or Ford’s current multiples we get potential appreciation in Fiat of 75-90%. It is cheap even compared to the cheapest.

Second- management.

Under Sergio, the company has completely transformed itself. In general analyst and investors are initially brushed off by Mr. Marchionne’s bluntness and maybe lack of political skills. But I would argue there is no CEO in the auto business that has done a better job as a capital allocator/operator than him.

Even within this low return, extremely inefficient industry, we estimate that the new cars that Fiat is producing have mid teens IRR, something plausible by itself in this less than efficient industry.

If you are reading this you’ve surely read his predictions of the future of the industry in his piece “confessions of a capital junkie”. I tend to agree with his thinking. The auto industry is so capital consuming and inefficient, whereas regulation increases the cost per car every year that consolidation in the sector is not so much a matter of if but when. The latter is anyone’s guess.

We do believe that management’s move to completely get out of producing cars in America by 1Q2017 was superbly planned and executed. During last week’s call Sergio also hinted that management had as a priority to close the margin gap versus GM and Ford in North America and that should happen gradually towards 2018. He has talked of 10-12% margins in the past. If he even gets to 10% on 16.5 million US SAAR by 2018 (down from today’s 18) that would by itself make our stock a triple.

I think Fiat, being controlled by a Family (Agnelli through John Elkann’s Exor) is a much more rational capital allocator in this irrational industry and the latter is reflective of all of management's decisions in that arena.

Third- the next two years.

Sure, the US is plateauing although I tend to believe the aging vehicular park makes a strong argument for me to think more in the lines of 16 to 16.5 million US SAAR by 2018. That is just fine. The story of Fiat is not that of ever increasing sales in the US. It is of the reindustrialization of the company and the emergence of a much leaner and efficient enterprise.

Sure, electrification, autonomous driving, shared riding, and who know what will come next are all trends that will affect and are already transforming the automobile industry as we know it. But the industry will not disappear in my opinion (at least within the next 5 years) as it would appear the market is kind of implying.

But- Brazil (where Fiat is the number 1 manufacturer) is closer to a cyclical bottom than not. Marchionne suggested October was the first month where sales were no longer in decline although it is too soon to say. And China is only beginning for Fiat. China’s vehicle sales have continued to be strong (although it is my opinion that this is partly demand being driven from outer years with the subsidies going on and that market could be set for a stronger pullback than the US). Even with this view on China we are not worried for Fiat. The company is just starting to produce Jeeps through a JV and so far it’s been above our expectations. Remember Jeep is like Kleenex to tissue paper. Synonymous to SUV’s in China.

And-Alfa is getting great reviews with the Giulia (which is to be sold in the US starting January) and will announce its first ever crossover this coming month at the Los Angeles auto show. Right now the market is pricing zero success for Alfa. A brand where management has invested more than 6 billion euro and which Marchionne call’s as the best car ever built by Fiat. Let’s not forget Maserati. The month after the new Levante (suv) was launched, 11,000 firm orders were received. We also believe the brand equity is not being appreciated in the case of Maserati.

Finally let’s not forget about Magneti Marelli, the component’s business owned by Fiat. Recently it’s been in the news since Samsung said they would be interested in buying part of the company, plans which have all but stalled following the Galaxy note incident. However we believe this business is not necessarily for sale but if it were to be sold it could fetch between 4.5 to 5 bn euro, close of 50% of Fiat’s value.

Fourth- it’s all about free cash flow

Suffice to say the company recently reaffirmed its 2018 net cash target of more than 5 billion euro by 2018. That means around 10bn euro of free cash flow between 2017 and 2018. Most of this will be geared towards 2018 (perhaps 35/65%) but it makes no sense when reconciled with the company's current value. Remember this is a 9.5 bn market cap company. We actually believe management’s targets are doable.

Fifth- low expectations

I’ve read more than one research report (Morgan Stanley the latest) that actually peg a negative value on a SOTP basis to Alfa Romeo, Chrysler and Dodge. Thereafter a discount to the sum-of-the-parts to get to their price target. IMHO I don’t agree. Even after this they get to close to 80% upside to the stock from today’s prices. That, in my opinion is low expectations.

Suppose you agree with what I’ve laid out here. The obvious question would be what changes the street’s variant perception? I believe it’s the debt. When Fiat gets to the point where they are rated investment grade (we expect could happen by mid 2017) and thereafter a net cash position overall (late 2017 in our numbers) we believe investors will re-rate this stock meaningfully.

A second-step re rating would occur once it becomes evident that the company might actually be in reach of their 2018 financial targets.

Catalyst

When Fiat gets to the point where they are rated investment grade (we expect could happen by mid 2017) and thereafter a net cash position overall (late 2017 in our numbers) we believe investors will re-rate this stock meaningfully.

A second-step re rating would occur once it becomes evident that the company might actually be in reach of their 2018 financial targets.