This is a follow-up to the Renault stub trade I presented last year. I still believe the idea offers investors with an asymmetric risk/reward at current levels.  To review, Renault SA is a French vehicle manufacturer producing mainly passenger cars and trucks. The company also operates their own finance company, and owns significant minority stakes in Nissan and Volvo.  The idea predicates on shorting Nissan and Volvo to capture the core Renault auto company, which is trading at 1.3x ‘09 EBITDA.  Investors were rewarded with a 70% appreciation in the stub in 2007, but this was primarily due to the decline in Nissan’s stock price.  Renault’s stock has appreciated 8% during this time, and I believe significant upside still remains.  Downside is limited to €77, the price at which you get the auto business for free when backing out the publicly traded minority stakes and the book value of the finance business.  I refer readers to last year’s write-up for additional background.

 

Today, the auto business is roughly valued at €7.8bn, and should generate $6bn in EBITDA in 2009:

 

                                    (€ millions)

Market Cap:                 27,100

+ Debt:                         9,600               Note: Financial Liabilities of Auto Biz

+ Pension:                    660                  Note: tax affected

- Cash:                         (8,100)

Enterprise Value:          29,260

 

- Nissan Stake:             (14,200)           Note: 44.3% stake

- Volvo Stake:              (5,000)             Note: 21.5% stake

- Fin Services Sub:       (2,300)             Note: 1x book value

Adjusted Ent Value:      7,760               Note: represents Renault’s core auto business

 

Auto Revs:                   52,700             Note: 2009 Estimate

Auto EBIT:                   3,100               Note: 2009 Estimate

EBIT %:                       5.5%

+ Auto D&A:               3,000

EBITDA:                      6,100

Multiple:                       1.3x

 

Management is currently guiding to 6% operating margins in 2009, which should be conservative since product launches do not peak until 2010.  My EBITDA assumption is consistent with management’s targets.

 

Where are we now?

I was originally excited about Renault last year since it was the European OEM with the most aggressive launch schedule at the time, and thus having the most exciting revenue and EBIT growth for the following 2-3 years.  Meanwhile, Renault was trading at a significant discount to the group at 1x EBITDA.  Even after launching eight new products this year, the company STILL has the most aggressive launch cycle of any European OEM today.  The only changes from last year is that Renault is one-year closer to reaching it’s 6% margin target in 2009.  Meanwhile, the stock is still trading at an EBITDA multiple with a one handle. 

 

Many of the company’s 07 launches occurred late in the year, the financial benefits of which have yet to manifest themselves in the P&L (partly why the Renault stock hasn’t moved).   Additionally, the company is set to launch seven new vehicles in 2008, followed by nine new models in 2009.  The following is my calculation of Renault’s weighted average age of the product portfolio:

 

2000A= 4.1 yrs

2001A = 4.1 yrs

2002A = 4.5 yrs

2003A = 3.3 yrs

2004A = 3.3 yrs

2005A = 3.6 yrs

2006A = 3.1 yrs

2007E = 3.1 yrs

 

Why is this important?  Traditionally, product cycle improvement is highly correlated with margins, all else equal.  This is because aging products either get sold at a lower transaction price, or have to have all kinds of goodies added to them to make them more attractive, negatively impacting the contribution margin.  Also, new products tend to have higher selling rates, which improves capacity utilization and allows auto OEM’s to absorb fixed costs with more unit volumes.  Renault expects margins to improve from 3% in ’07, to 4.5% in ‘08 and 6% in ‘09, something I believe is reasonable.  Management believes 2010 margins will be higher than ’09 due to continued product launches in that year.  And as the recent Lazarus-like resurrection of Volkswagen has shown, once margins are moving in the right direction, the market is keen to extrapolate the positive trend.

 

It is clear that the valuation does not discount the company hitting their 2009 targets.  However, even if the company reaches 1/2 or 2/3 of their target, the company is still trading at a steep discount to the group’s 5x EBITDA multiple:

 

EV / EBITDA at 6% ‘09 EBIT margins = 1.3x

EV / EBITDA at 4% ‘09 EBIT margins = 1.5x

EV / EBITDA at 3% ‘09 EBIT margins = 1.7x

 

The path to success for this idea are many, and some of the financial restructuring options that I pointed out last year are still valid, including selling their Volvo stake, which management believes is non-core to the company.  Absent any financial or operational restructurings, I still see 09 EBITDA to easily achieve the €6bn range.  Assuming the auto business trades to the industry mean of 5x EBITDA, upside potential is €180, or 85% upside from current levels.

 

Looking back it appears I was a bit early on the timeliness of the idea, but I believe the Renault investment thesis is as strong as ever.