Description

Peugeot manufactures and sells cars under the Peugeot, Citroen and DS brands.  It also owns 47% of the Faurecia automotive equipment business (interiors, seating, emissions control).  The company is based in Paris, France.

Peugeot is one of the oldest auto manufacturers in Europe.  Despite being smaller than many peers, performance has dramatically improved in recent years following the hiring of CEO Carlos Tavares in November 2013.  After dramatically improved earnings and a balance sheet solidifying €3B capital raise, the business trades at a ~3x EV/EBIT.

While auto manufacturing is a tough business with many variables outside management’s control, performance actually appears to be improving while the business trades at a very low multiple.  Despite sustainable cost improvements won over the last few years, if we assume 3% long-term median EBIT margins, the business currently trades at 5.0x EV/EBIT.  A mid/high single digit multiple is probably more appropriate, implying nearly ~50% upside.  If we assumed long-term auto margins at 6%, per management guidance and near current levels, upside is even greater.  This business appears to be very inexpensive given its improving performance.

Thesis rests on the following key pillars:

1. New management has instilled a remarkable cultural shift in a few short years, which should continue to benefit shareholders

2. Balance sheet dramatically improved due to joint venture of financing operation, improved business performance and equity raise

3. Operational improvements offer proof that 1 & 2 are having an impact

4. Trades at a significant discount to peers and historical levels despite turnaround that is already underway.

In addition to the above, this formerly family controlled company is now equally owned by 3 key shareholders: Peugeot family, French state and Dongfeng Motors, at ~13% each.  While not central to the thesis, the Peugeot family ceding its controlling stake likely increases the likelihood of Peugeot eventually becoming a takeover candidate.

How we got here / New CEO

After more than a decade of mixed management performance, Peugeot was fortunate to hire Carlos Tavares, formerly COO of Renault.  Tavares had been with Renault 30+ years and is a protégé of industry icon Carlos Ghosn—before his appointment, he was widely regarded as one of the industry’s most talented non-CEO executives and the heir apparent CEO at Renault.  He became available due to unusual circumstances where he gave a Bloomberg interview lobbying for a CEO job, and was soon fired by Ghosn.  As a testament to his quality, Peugeot quickly moved to replace their leader with the newly available Tavares.

In appointing Tavares, the Peugeot-Citroen board has made a shrewd move.  Portuguese-born Tavares is a great product man (his first job with Renault was as a test driver)…He is also an astute, clear thinking businessman and a Francophile.  He has spent more than 30 years with Renault and the Renault-Nissan alliance so he understands the French way of working, he understands how to get the best out of alliances and joint ventures.  He also played a big part in helping turn round Nissan after Renault rescued it from near bankruptcy.  Tavares, an engineer, was described last year by Tom LaSorda, the former president of Chrysler, as “the best up-and-coming CEO in the auto industry” and someone who could run any car company. Just-Auto Global News; 11/23/13

Many point to his focused and competitive nature—along with his obsession with cars—as the secret behind his successes at Peugeot Citroen.  He is seen as the first real “car guy” to run the company for more than a decade… When he is not racing or working, he spends his spare time building and refurbishing cars in a shed in the woods, about five minutes from his house.”  FT.com; 3/6/15

Based on his career performance, deep international background and results thus far at Peugeot, Tavares appears to have every bit the managerial talent as Sergio Marchionne (Fiat Chrysler) and Carlos Ghosn (Renault/Nissan).  I do not believe the broader investment community fully appreciates this potential yet.  Even better for Peugeot shareholders, Tavares only has one company to run, unlike Marchionne and Ghosn, who are each responsible for more than one publicly traded business.  For an interesting perspective on the typical culture of French management, and inference to the potential benefits of an “outsider” CEO (despite being a Francophile, Tavares is Portuguese and has significant global work experience), I found the following archived Harvard Business Review article instructive: https://hbr.org/1991/07/the-making-of-a-french-manager.  

Investors in Peugeot benefit from an underappreciated management that will likely be recognized for their industry-leading ability if impressive execution continues.

Balance sheet

The risk profile of this business has been transformed by a dramatically improved balance sheet.  This business carried ~€20B net debt through most of its operating history but now has net cash, as it 1) transferred finance business to a joint venture with Santander, 2) issued €3B new equity in 2014, led by investments from French state and Dongfeng Motors, and 3) improved operations from cash flow negative to cash flow positive.

The chart above shows the new capital structure, and despite the associated “de-risking” of the business, Peugeot currently trades at ~3.2x EV/EBIT and ~2.1x EV/EBITDA, less than half the 4.6x EV/EBITDA historical median.

Early results

Within a year of joining, Tavares unveiled his “Back in the Race” performance plan, whose goal was to instill a sound operating culture that had been lacking at the company for many years.  The key goals and results of the plan were as follows:

https://www.groupe-psa.com/en/publication/back-in-the-race/

It is rare for a company to exceed targets by the magnitude seen above.  At the time of unveiling, these were not viewed as “sandbagging,” and it provides some credibility toward management’s ability to meet future goals.

While this performance is the sum total of countless small initiatives, it can be broadly summarized into consolidation of models, reduced production costs by manufacturing in lower cost geographies along with more variable manufacturing pay in France, and improved procurement by improved processes and supplier cost concessions.  The quest to improve and sustain margins is a never-ending fight, but research of the industry and prior case studies (especially Ghosn and Marchionne) suggests that there is a very significant management ability to transform the performance of an automaker.  It is rare to find a CEO with the ability to lead a company to optimal performance, but signs thus far suggest that Peugeot may have found one.

Updated Plan

Since the goals of “Back in the Race” were achieved ahead of schedule, management unveiled its current plan, “Push to Pass” in April 2016.  This plan uses the operational foundation established in Back in The Race as a starting point for future growth.

While the plan is in its early days, the company is at or ahead of targets.  The full presentation can be found at: https://www.groupe-psa.com/en/publication/push-to-pass/

Given management’s track record, plus the fact that the above targets are the minimum goal, shares appear very cheap relative to this potential outcome.

To provide some context as to the nature of improvement, the Auto segment EBIT bridge is shown below:

Roughly 2/3 of the improvements generated above were Peugeot-specific, and the company expects to sustain them.  If Automotive segment continues to generate anything in the vicinity of current EBIT, valuation will very likely expand toward the level of peers.

Faurecia

Peugeot owns 47% of Faurecia, one of the world’s largest Tier 1 automotive suppliers, primarily dealing in seating and exhaust systems.

This business serves many of Peugeot’s competitors and operates independently.  Faurecia results are consolidated in Peugeot financials and the Eur1.7B non-PSA ownership stake is backed out as minority interest in valuation.

Partnerships

The company has operational partnerships, the most important with Chinese manufacturers Dongfeng and Changan, and financial partnerships with Santander for the finance operation.  China is Peugeot’s largest market after Europe.  Partnerships are accounted for under the equity method, and contributed €353m to earnings in the 6/30/16 LTM period.

Risks

There are numerous risks, the biggest being that this is a difficult industry to operate in.  To the extent there is a macroeconomic or industry downturn, shareholders don’t have the comfort of owning a “great business.”  That said, ~3x EV/EBIT and a net cash capital structure allay most of my concerns about business quality, as the market has hopefully discounted this in the current price.  A list of potential risks, in roughly descending importance, is below:

• Industry downturn

• Macroeconomic slowdown/ European instability

• Peak margins unsustainable

• Potential surprise emissions cheating accusations

• Government as significant shareholder

• Disruptive potential of Uber/Tesla/Driverless/etc.

Valuation

This trailing valuation is attractive relative to peers, most trading at mid/high single digit forward EBITDA.  It is also attractive relative to historical Peugeot, whose trading history is shown below:

The scenarios above suggests margins above historical averages, but well below current levels.  This seems reasonable, as gains under Tavares are primarily due to structural business enhancements. Current margin improvments do not have to be fully sustained to generate attractive returns, but if they are, upside is well above the scenarios presented.

If we assume operating multiples anywhere near peer levels, the implied margin decline seems highly unlikely relative to improving performance at Peugeot.

Other

Below are several other items that seemed worth including, as the address many of the concerns that I had as I initially began my research:

Significant margin gains despite company multiples well below peak:

Although Peugeot is “subscale” versus most peers, it does have relative scale in its key market, France.  It is also one of the leading players in Europe.  The scale argument comes up as one of the negatives of this business, and while I don’t view Peugeot’s size as an advantage, it does not seem to be as negative as my initial perception.  

The following quote provides some insight on Tavares’ view of scale:

A constant in Tavares’ plans at PSA is the lack of any volume target.  Why?  “Because I am consistent, and volume can be the enemy of value,” he said.  For him, growth is measured by revenue, operating margin and market and product coverage.  “This industry has made many, many mistakes in recent years by always pushing volume.”  A firm believer that pushing volume can destroy value, Tavares last year saw PSA growing not its volume, which was barely flat, but its profits.  “To me, performance matters more than size,” he said.  While not obsessed by volume, Tavares is obsessed by being disciplined in pricing.  “What I have told my brand CEOs is very simple: The first thing you need to do is control pricing.  It is absolutely strategic.”  Automotive News; 10/24/16

The above table also shows that Peugeot’s CEO, who I view as favorably as any in the industry, is nearly the lowest paid.  Management is well aligned with shareholders, although he deserves greater rewards if top-tier performance continues.

Management incentives, although not central to the thesis, are as follows: Fixed part reflects market responsibilities.  CEO fixed salary was €1.3m and has not been increased since 2009 despite recent success.  Variable is targeted at 150% of base salary for CEO, 110% for other executives, all subject to generating both positive Automotive EBIT and positive Manufacturing & Commercial FCF.  Of this amount, 80% is based on achieving targets (40% cumulative FCF of prior 2yrs, 40% recurring EBIT) and 20% based on manufacturing safety and product quality, regional EBIT, etc.  Long-term compensation (performance shares) is performance shares vesting over 2yrs.  Once vested, no shares can be sold for an additional two years.  Managers must retain at least 50% of this award for the duration of their employment.  Awarding of shares is based on 2yr cumulative operating FCF long-term net debt position and recurring Automotive EBIT (1/3 each), as shown below.

Catalyst

Continued performance

Improved macro view of Europe

Capital returns in excess of recently reinstated dividend

Potential industry consolidation 

Russia/Iran/Other emerging market recovery