Top Ex-US Case Study: Fiat's Long-term Turnaround Story

The FactSet Top Idea Tournament, a SumZero research contest for buyside professionals, kicks off in about 10 days with Contest #1: Best International (Ex-US).

We have assembled a phenomenal panel of judges including fund managers like Scott Ferguson (Sachem Head), James Montier (GMO), Guy Spier (Aquamarine), as well as large investors like the Notre Dame Endowment, the Virginia Tech Foundation, the UCLA Endowment, and Cook Children's Health Care. Prizes include $160k in cash (up to $56k to one pitch), a full speaking slot at the 10th Annual NY Value Investing Congress, products from FactSet, and more. Those who wish to enter the Tournament (and meet our membership criteria) need to join SumZero here: https://sumzero.com/pro/user_applications/new.

In honor of the upcoming contest and to provide the necessary inspiration, we thought we would highlight some of the finest internationally-focused pitches that have been published within the SumZero community over the years, starting with this pitch on Fiat Spa from September 2012 from Steven Wood of GreenWood Investors. Not merely a case study, the thesis still has massive upside to it. Take a look.

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Unions and Low Margins and Italy. Oh my!
You get that same feeling when you think of lions and tigers and bears, or when you thought about the Detroit automakers in the winter of 2008, the same time we were piling in money into Ford Motor bonds and equity (see our internal memo from 9/25/08). Of course this time around, Fiat SpA (F IM) is the company in question. It has the same symbol, is family-controlled, is run by a fabulous CEO and it has a very similar valuation to Ford's at the time of 2008 congressional hearings, if not cheaper (relative to mid-cycle earnings). The company is ahead of a significant two-year product renaissance, which together with multiple cost-saving opportunities, should go a long way to raising Fiat's mass-market operating margins from 1.5% to at least 5% (excluding Ferrari, Maserati and Chrysler).

While Fiat, as all other global automakers, operates in abysmal Europe, Fiat-Chrysler is actually less exposed to Europe (as a percent of company revenue) than is Ford. And while Fiat is headquartered in Italy, where the government appears increasingly likely to default in the absence of debt monetization by the ECB, there are some stark differences this time around that make Fiat more of a no-brainer than Ford was over three years ago.

An Easier Decision This Time Around (versus Ford in 2008):
1. Generating Cash: You have resilient businesses that are contributing cash to new product investment and the despondent European operations, which will be restructured in 2013 (either the company will begin absorbing current under-utilized capacity by manufacturing additional Alfa Romeo models and Jeeps, or if labor certainty cannot be reached, there will likely be several plants shuttered). Ford did not have any resilient division helping offset North American weakness in 2009. Fiat is EBIT and EBITDA positive, (whereas Ford had negative EBITDA).
2.Superior Capital Allocators: Fiat's CEO, Sergio Marchionne, is perhaps the only auto CEO who understands how to rationally allocate capital. This can be proved numerically: Fiat's share count has actually decreased by 2% since 2006, vs. Ford's increase of 113%. You can see him on 60 Minutes here, or deliver a great speech here.
3.No Hidden Liabilities: There are no massive pension or healthcare liabilities on Fiat's stand-alone balance sheet (thanks to Italy's socialized medicine and generous state pensions). Chrysler's current value is impeded by an underfunded pension, but the rapidly growing operating profits should fully-fund this pension over the next few years.
4.Valuation: Lastly, and most importantly, the current Adjusted EV/EBITDA (Adjusted EV= Market Cap + Net Auto Debt + Pension Underfunding) of 3.5x stand-alone and 2.7x on a proportional basis completely bakes in the negative working capital swings that come along with shrinking production volumes in Europe. Ford's EV/EBITDA was negative back in 2009, not because the Enterprise Value (takeover valuation) was less than zero, but because EBITDA was negative. Fiat's current valuation is bested only by bankruptcy-possible Peugeot.

Fiat in a Nutshell
•Small-car manufacturer that loses money in Europe given low capacity utilization and lack of large and luxury (more profitable) models to offset structural costs. This completely changes with both platform harmonization savings and a re-launch of Alfa Romeo
•The largest auto manufacturer in Brazil, with nearly one quarter of this important market, with a distinct low-cost advantage vs. Volkswagen, GM and Ford (the next three largest automakers in Brazil) as Fiat's massive plant is scaled up to produce 700,000 vehicles a year (contrasted to most plants producing 150,000-300,000)
•A strong commercial van business in both Europe and Brazil
•A 58.5%-owner of Chrysler (soon to be 61.8%), the best performing full-line auto manufacturer in North America in the last year, with options to wholly-own this asset (roughly 40% of these options are struck to be neutral to Fiat's Enterprise Value, and the rest is at a fixed valuation). Using Ford's and GM's adjusted valuations (Adjusted EV= Market Cap + Net Debt - Finco Book Value + Pension Underfunding), the value of Fiat's 58.5% stake in Chrysler is rapidly growing and worth approximately €5.1 billion (€4.05 a share), up from €4.1 billion in the first quarter. This rapid growth is being fueled by the same drivers that will propel Fiat stand-alone in late 2013 and 2014: quickly growing cash-flow that allows the company to pay down debt, a powerful combination to expand the debt-adjusted value of the equity. Of course, Chrysler is growing much more quickly than Ford and GM, and should have a higher historical valuation
•A leader in natural gas / gasoline bi-fuel power-trains (achieving roughly an 80% market share in Europe for natural-gas vehicles), which could be a stealth "Prius" effect in the making. In the US, retail natural gas prices are less than $2.00 per gallon equivalent, and with some infrastructure / distribution upgrades, could achieve parity with the variable costs of electric vehicles while avoiding the $15-30k battery (see Table D). The new Ram pickup will offer this engine combination, and we've been trying to get the company to launch the option across Jeep and Dodge platforms
•A 90% owner of Ferrari and 100% owner of Maserati, which is building out its luxury line-up, with important launches in 2013. Using BMW's current EBITDA multiple, Ferrari would be worth €2.0 billion (€1.63 a share) if it were a stand-alone company. Of course, the durability of the Ferrari brand is much stronger than BMW's (Ferrari has a waiting list for the super car to be sold next year for over $1.5 million, while BMW is buying roughly 30% of its own vehicles off German dealer lots in order to preserve "market share"), so this valuation is quite conservative

And most importantly, valuation: assuming 58.5% of Chrysler's net debt, pension hole, and EBITDA, we are paying 2.4x trailing (at our average price of €4.00) Adjusted EV/EBITDA, levels which completely "bake in" the worst Italian auto sales market in over three decades and do not reflect the 2013-2014 product renaissance and variable cost savings on components and platform harmonization, and certainly no European restructuring, which will inevitably come by next year. Either labor market reforms will explicitly give Fiat a high degree of confidence in the reliability and cost efficiency of a revitalized Italian factory, or the country will lose the opportunity to repeat Volkswagen's solid example of filling unused capacity with high-value production of luxury cars (Audi) and the excess capacity will be shuttered indefinitely.

While a sum-of-the-parts valuation seems compelling (Fiat, Ferrari and Maserati are free if we fairly value the 58.5% stake in Chrysler), we believe the best way to value Fiat is by a proportional method, using either EBITDA or EBIT. Fiat has options to acquire the remaining 41.5% Chrysler stake it doesn't own, 40% of which has a strike price tied to Fiat's own valuation. The remaining options have a fixed valuation given to Chrysler, which is great given the unexpected surge Chrysler is experiencing, surprisingly before its own aggressive product refreshing in 2013. A sum-of-the-parts valuation is unlikely to be actualized over the next few years, but a merger with Chrysler is very likely, thus we value Fiat on a proportional basis, by including 58.5% of Chrysler's operations.

Through re-launching the Alfa Romeo brand, cost savings on driving platform and parts commonality, we believe Fiat stand-alone EBIT will expand significantly from €0.6 billion in the last twelve months to €1.3 billion in 2013 (taking into account a weaker remainder of 2012) and €2.4 billion in 2014. Including a growing percentage of Chrysler's EBIT, we estimate LTM EBIT of €2.1 billion will expand to €4.1 billion in 2013 and €6.5 billion in 2014, more than the current market capitalization. Importantly, this holds global selling volumes constant from Q2 2012, which especially hurts Fiat's stand-alone operations as Italian auto sales hit a multi-decade low in the quarter. We believe it makes sense to estimate an abysmal selling rate in Italy for the foreseeable future.

Download the Full Pitch on Fiat