Thursday, October 15, 2015

The Ferrari IPO: A Price Premium for the Prancing Horse?

I live in a prosperous suburb, sustained largely by financial service businesses, but as far I know, there is only one Ferrari in my town. Much of the week, the car sits in a garage which has its own security system, more secure than the one protecting its owner's house, and on a nice weekend, you see the owner drive it around town. It is a remarkably inefficient transportation mode, too fast for suburban roads, too expensive to be parked at a grocery story or pharmacy, and too cramped for car pool. All of this comes to mind, for two reasons. The first is the imminent initial public offering of the company, with all the pomp and circumstance that surrounds a high-profile offering. The second is that this offering has set in motion the usual talk of brand names and the price premiums that we should pay to partake for investing in them.

Ferrari: A Short History and Background
The Ferrari story started with Enzo Ferrari, a racing car enthusiast, starting Scuderia Ferrari in 1929, to assist and sponsor race car drivers driving Alfa Romeos. While Enzo manufactured his first racing car (Tipo 815) in 1940,  Ferrari as a car making company was founded in 1947, with its manufacturing facilities in Maranello in Italy. For much of its early existence, it was privately owned by the Ferrari family, though it is said that Enzo viewed it primarily as a racing car company that happened to sell cars to the public. In the mid-1960s, in financial trouble, Enzo Ferrari sold a 50% stake in the company to Fiat.  That holding was subsequently increased to 90% in 1988 (with the Ferrari family retaining the remaining 10%). Since then, the company has been a small, albeit a very profitable, piece of Fiat (and FCA).

The company acquired its legendary status on the race tracks, and holds the record for most wins  (221) in Formula 1 races in history. Reflecting this history, Ferrari still generates revenues from Formula 1 racing, with its share amounting to $67 million in 2014. Much as this may pain car enthusiasts everywhere, some of Ferrari's standing comes from its connection to celebrities. From Thor Batista to Justin Bieber to Kylie Jenner, the Ferrari has been an instrument of misbehavior for wealthy celebrities all over the world.

The Auto Business
In earlier posts, where I valued Tesla, GM and Volkswagen, I argued that the auto business bore the characteristics of a bad business, where companies collectively earn less than their cost of capital and most companies destroy value. In fact, I used the words of Sergio Marchionne, CEO of Fiat Chrysler (and the parent company to Ferrari) to make the case that the top managers at auto companies were delusional in their belief that the business would magically turn around. Looking at the business broadly, here are three characteristics that reveal themselves:

1. It is a low growth business: The auto business is a cyclical one, with ups and downs that reflect economic cycles, but even allowing for this cyclicality, the business is a mature one. That is reflected in the growth rate in revenues at auto companies.

YearRevenues ($)% Growth Rate
20061,421,804.2 11.54%
20071,854,576.4 30.44%
20081,818,533.0 -1.94%
20091,572,890.1 -13.51%
20101,816,269.4 15.47%
20111,962,630.4 8.06%
20122,110,572.2 7.54%
20132,158,603.0 2.28%
20142,086,124.8 -3.36%
During this period, the emerging market economies in Asia and Latin America provided a significant boost to sales, but even with that boost, the compounded annual growth rate in aggregate revenues at auto companies between 2005 and 2014 was only 5.63%.

2. With poor profit margins: A key point that Mr. Marchionne made about the auto business is that operating margins of companies in this business were much too slim, given their cost structures. To illustrate this point (and to set up my valuation of Ferrari), I computed the pre-tax operating margins of all auto companies globally, with market capitalizations exceeding $1 billion, and the graph below summarizes my findings.

Source: S&P Capital IQ
3. And high reinvestment needs: The auto business has always required significant investments in plant and equipment, but in recent years, the advent of technology has also pushed up R&D spending at auto companies. One measure of the drag this puts on cash flows is to look at net capital expenditures (capital expenditures in excess of depreciation) and R&D, as a percent of sales, for the entire sector:

It is this combination of anemic revenue growth, slim margins and increasing reinvestment that is squeezing the value out of the auto business. (You can download the data for all auto companies, with profitability measures and pricing ratios by clicking here.)

The Super Luxury Automobile Business
If, as has been said before, the only difference between the rich and the rest of us is that the rich have more money, the difference between the rich and the super rich is that super rich have so much money that they have stopped counting. The super luxury car manufacturers (Ferrari, Aston Martin, Lamborghini, Bugatti etc.), with prices in the nose bleed segment, cater to the super rich, and have seen sales grow faster than the rest of the auto industry. Much of the additional growth coming from newly minted rich people in emerging markets, in general, and China, in particular. Like the rest of the companies in the super luxury segment, Ferrari is less auto company and more status symbol, and draws its allure from four key characteristics:
  1. Styling: I am not a car lover, but even I can recognize that a Ferrari is a work of art. That is not accidental, since the company spends substantial amounts on styling and the little details that go into every Ferrari.
  2. Speed: There is no absolutely no chance that you will test the upper limits of the car's engine capacity, but you could get from LA to San Francisco in about 3 hours, if you could maintain the car at its top speed (I am not recommending this). So, if you grew up with dreams of being a Formula 1 driver, and now have the money to fulfill them, a Ferrari is probably as close as you are going to get to these dreams.
  3. Story: The car comes with a story that draws as much from its celebrity connections as it does from  its speed exploits. 
  4. Scarcity: Notwithstanding the first three points, it would be just another luxury car if everyone had one. So, it has to be kept scarce to command the prices that it does, both as a new car and in its used versions.
To illustrate how exclusive the Ferrari club is, in all of 2014, the company sold only 7255 cars, a number that has barely budged over the last five years. (The Lamborghini club is even more exclusive, with only 2000 cars sold annually.)  The company has its roots in Italy but is dependent on a super- rich clientele globally for its sales:

Note that a significant slice of the revenue pie comes the Middle East and that Ferrari, like many other global companies, is becoming increasingly dependent on China for growth.

Valuing Ferrari
As many of you reading this blog are aware, I am a believer that all valuations start with stories and that different stories can yield different valuations. With Ferrari, there are two plausible stories that you can offer for the future of the company, with valuations to back them up:

1.The Status Quo (Super Exclusive, Low Production, High Margin)
The story: Ferrari remains a extra-exclusive automobile company, keeping production low and prices high. The benefits of this strategy are high operating margins (Ferrari has among the highest in the auto business) partly because of the high prices, and partly because the company does not have to spend much on expensive ad campaigns or selling. It also will keep reinvestment needs to a minimum, since capacity expansion will not be necessary, though the company will continue spending on R&D to preserve its edge (on speed and styling). In addition, by focusing on a very small group of super rich people around the world, Ferrari may be less affected by macroeconomic forces than other luxury auto companies.
The inputs: The inputs into my valuation reflect the story, with low revenue growth, high margins and low reinvestment driving value:

The valuation: With these assumptions, the value for equity of 6,310 million Euros (approximately $7 billion). You can download the spreadsheet here.

2. Rev it Up (Increase production, Introduce a lower-priced model)
The story: Ferrari tries to broaden its customer base, perhaps by introducing a lower-priced version; this would mirror what Maserati did with its Ghibli model. That will allow for higher revenue growth but like Maserati, Ferrari will have to yield some of its operating margin, since this strategy will require lower prices and higher selling costs. Seeking a larger market will also expose it to more market risk, pushing its cost of capital in high growth to 8.5% and its cost of capital beyond to 7.5%.
The inputs: This strategy will generate higher sales (doubling number of units sold in next ten years) but at the expense of lower margins (from lower prices and higher selling costs) and higher risk (as the clientele will be more sensitive to economic conditions).

The valuation: With this strategy, the value for equity of 6,042 million Euros (approximately $6.75 billion). You can download the spreadsheet here.

At least based on my estimates, it is more sensible for Ferrari to stick with its low-growth, high price strategy and keep itself above the fray of the auto business, a bad business where most companies seem to have a tough time earning their cost of capital.

The Brand Name Premium
There is a lot of casual talk about how Ferrari will command a premium because of its name and some have suggested that you should add that premium on to estimated value. In an intrinsic valuation, it is double counting to add a premium and the reason is simple. The values that I have estimated already incorporate the premium. If you are wondering how, take a look at the operating margin of 18.20% that I have used for Ferrari, a number vastly in excess of the margins earned by other auto companies. That high margin, in conjunction with limited growth in cars sold, also allows Ferrari to earn a return on capital of 14.56%, well above its cost of capital. These inputs yield a value premium, with the magnitude varying across multiples:

Ferrari (my estimated value)Auto SectorReason for difference
EV/Sales2.100.94Ferrari's operating margin is 18.2% versus Industry average of 6.58%.
EV/Invested Capital1.971.02Ferrari earns a much higher return on capital (14.56%) than the sector (6.68%)
EV/EBITDA12.579.05Ferrari EBITDA/Invested capital is 15.68% versus Industry average of 14.45%.
PE22.8710.00Ferrari has a debt ratio of 9.43% versus Industry average of 39.06%.
PBV2.561.29Ferrari has a slightly higher ROE and lower equity risk (because of less debt)

Thus, the intrinsic value estimates already are building in a hefty premium for the effects that Ferrari's brand name has on its operating margins and return on capital.

Is it possible that the brand name can be utilized better? That is always possible but there is nothing to indicate that the brand is being mismanaged or that it can be easily exploited to generate additional value. In fact, the consolidation of voting power in the hands of the existing owners suggests that there the firm will remain largely unchanged after the IPO.

IPO Related Issues
An initial public offering does create a host of issues that can affect valuation, sometimes tangentially and sometimes directly. In the case of Ferrari, the three issues that merit the most attention are whether the proceeds from the offering will affect value, what the value per share will be, and how the augmentation of voting rights for the existing stockholders will play out.
  1. Use of proceeds: The proceeds from an IPO can have a feedback effect on value, but only if the IPO proceeds are kept in the firm to cover current or future investment needs. In this IPO, the billion dollars expected to be raised from the offering will go to Fiat for cashing out some of its ownership stake, and thus not benefit Ferrari stockholders. There is therefore no need to add these proceeds back to the cash balance (as I would have, if the IPO proceeds had been retained by the firm).
  2. Number of shares/IPO price per share: Note that in both my valuations, I have focused on the value of equity, rather than a per share value, for two reasons. The first is that the number of shares is still in flux (notice all the empty spaces in the prospectus). The second is that the per share value will be a function of the number of shares created in the company. Thus, if the value of equity is 6.3 billion Euros, Ferrari can create 100 million shares at 63 Euros per share or 2 billion shares at 3.15 Euros per share, with the same end result. The number of units and offering price will be set jointly, because setting one will also determine the other. The talk of the town is that the company will be valued at 50 Euros per share and the value of equity will be 10 billion Euros. At least based on those rumors, it seems like the Ferrari will create 200 million shares, and if that is the correct number, the value per share that I arrive at is about 31.5 Euros per share (based on my 6.3 billion Euro status quo value).
  3. Control: After the IPO, Ferrari will become an independent firm but control will still remain concentrated in the hands of its current owners, Fiat and the Ferrari family. In fact, the existing owners will get twice the voting rights on their shares, relative to the those who buy shares in the IPO, for their loyalty. The two big owners, Exor (the investment fund for the Agnelli family) and the Ferrari family will control 49% (Update: I erroneously stated the they would control 51% of the voting rights, but with the rest of the holdings dispersed, that is effectively majority control) of the voting rights with about 33% of the shares. The shares that you and I will have a chance to buy at the IPO will be the low-voting right shares, I guess because we are disloyal investors. I don't see much of a discount on these shares since even without the additional voting rights, it is unlikely that anyone can force the company to change its operations, if that change is against the wishes of the Agnelli/Ferrari clan.
It will be interesting to see this game play out, as the offering gets closer. There is a push to attach a valuation of 11 billion Euros for the Ferrari shares, both because it will get more cash for Fiat from the offering, and more importantly, because the increased value of its remaining holdings in Ferrari will then feed into Fiat's market capitalization. The push may succeed because investors seem eager to buy these shares, at least according to this story, and the price premium will be justified with the argument that Ferrari is a premium brand that caters to the rich. Off to the races!

YouTube Video

Data Attachments
  1. Ferrari Prospectus
  1. Auto Industry: Company Data
  2. Ferrari Valuation (Status Quo)
  3. Ferrari Valuation (Rev it up)
  4. Google Shared Spreadsheet: Ferrari Valuations


T Mng said...

The company has said that it will not need to invest in PPE to scale up production. Each car is sold at a 60% margin. Most of the SG+A expense and R+D is NOT related to selling cars (but to the company's formula one activities). This means that the company will be able to take advantage of operating leverage by increasing production. EBIT margins at 9k cars would be well above 25% (with revenue around 4 billion, operating income will exceed 1 billion by 2018). I feel your valuation is not taking this into account. A lot of people aren't realizing this but Ferrari is actually a potential double over 2-3 years based on current valuation, and this is without taking into account additional revenue that the company will be generating from growth in engine sales.

Anonymous said...

Hello Professor Damodaran,

Have you considered the income Ferrari receives from licensing? I'm not sure if this is broken out in the prospectus but they do sell the name for use on everything from t-shirts to pencil erasers

Sandeep said...

superb analysis.

Anonymous said...

As an Italian and at the same your constant musing on markets follower I was just about to ask you if you could twit about Ferrari IPO and you actually did it. Wonderful, going to see in detsils the valuation.

Aswath Damodaran said...

T Mng,
I am puzzled. If Ferrari has all this untapped potential (in terms of growth, capacity and being able to raise prices), why has it not been able to do it so far? As I see it, as part of FCA, and run by the same management team that will run it after the IPO, no one put shackles on the company's growth and FCA needed cash desperately. It seems like magical thinking that somehow mangers will behave differently, if Ferrari is a stand alone company, reporting its own numbers.

T Mng said...

Ferrari has essentially been leaving a lot of money on the table for the past decade. If I gave you 300k cash to go buy an F12 Berlinetta, you would be placed on a waiting list that could last a couple of years. This is because Ferrari has purposely chosen to pursue a strategy of "exclusivity". There's a reason the word "exclusivity" shows up over and over again in the prospectus. The cap has been voluntary, the "shackles" were placed by the company itself. The previous head of Ferrari (Luca di Montezemolo) did not want to increase production but Marchionne did, as he realizes that a couple thousand more Ferraris around the world is not going to make a big difference to "exclusivity" given how rare the cars already are (plus there are now more pockets of wealth around the world for Ferrari to sell into). The previous head of Ferrari was effectively kicked out because of his unwillingness to expand the Ferrari brand. Even at 9k units sold, Ferrari will be leaving money on the table, but less than before.

Ferrari is not your typical car company, it has and continues to care more about it's brand than maximizing profits. Cars don't appreciate in value after they have been used but many Ferrari models do. A lot of the purchases of customers are recurring, mainly because a) they love Ferrari cars and b) if they want access to the more exclusive, higher end Ferrari models like say a LaFerrari, they need to show loyalty to the brand (ie. need have purchased 5-6 Ferraris before). The demand side is something Ferrari does not need to worry about, the excess demand is there at 7k units supplied and it will be there at 9k units supplied. The company's concerns are more on maintaining the right level of supply so to not dilute the brand (but also not being "too exclusive" either where people never see a Ferrari on the road). Ferrari's customers (1%ers) are more insensitive to price increases than the average middle or upper middle class guy so that combined with excess demand has given the company pricing power (historically it has raised prices by more than inflation). Ferrari saw a negligible drop in revenue and units sold during the financial crisis, that's how easily it has been able to fulfill a demand of ~7k units/year. It's basically the only car company (though it also has other revenue streams outside of car sales) in the world that is not cyclical. Marchionne is correct in stating that Ferrari should be valued more like a luxury goods company rather than a car company. As he expands production to take advantage of the operating leverage and achieves operating margins that are more in line with luxury products than auto OEMs (Ferrari already has best margins in auto industry this year, last year it was second to Porsche I believe), this will become obvious to the broader market.

Anonymous said...

Hi Prof.,

This is not related to this article but thought to put it as I know you read most, if not all comments.

With Walmart shares and the recent adjustments, do you have any current valuation on the stock? Stocks at this size usually not 'fun' to value ;) ..... I kinda have a feeling it is on your list of posts so I thought I ask ... I am having a hard time and based on my rough valuation, to me investors are overacting and there could be a buy time (some limit orders) ... let me know if anything you got on hand.

Again, thanks for all your posts. I personally appreciate the time and efforts you put on your blog, videos and etc to interact with all of us.


Anonymous said...

ferrari margins are IFRS, not GAAP. seen some sell-siders say gaap margins probably lower.

SJK GANESH said...

Hello Professor,
Why is the beta of Ferrari so low? being a part of the super luxury segment shouldnt it be higher? around 1.5 to 2?

Rozapk said...

Ferrari has essentially been leaving a lot of money on the table for the past decade. If I gave you 300k cash to go buy an F12 Berlinetta, you would be placed on a waiting list that could last a couple of years. This is because Ferrari has purposely chosen to pursue a strategy of "exclusivity". There's a reason the word "exclusivity" shows up over and over again in the prospectus

Winston Swomley said...

Hi - you mentioned that 12x EV/EBITDA was your price, or around there. Why did you exclude D&A, and only use EBIT, in your calculation? That would add maybe ~280/yr to your EBIT number, which gets us to $680.

Lastly, and as T Mng mentioned, they have operating leverage and pricing power, and that (accompanied by decent margins) is a wonderful combination. Your EBIT assumption was 400, but TTM EBIT is 500, so let's add 100...We are at $780 now.

Also, and of particular note, look at the numbers for the beginning of this year...EBIT margins are steadily increasing largely because of revenue increases (presumably, price hikes), and to a lesser extent a smaller COGS #. If COGS was the driver, I would say that maybe the margin boost was from low commodity prices, and transitory. But, COGS is not materially lower, and sales is materially higher...did they perhaps decide to start being more aggressive with their pricing power once they decided to IPO? If I owned the company pre-IPO, I would certainly have done that, if for no other reason than than to draw attention to that particular attribute.

Anyways, 500+280=780, Mkt cap is 8.75, (.6) net debt, EV/EBITDA = 8.15/7.8 = 10.5...

Why did you not add D&A back when calculating FCF in your DCF? That would have gotten you a much higher equity value, and probably explains why my multiple (which includes D&A) is so much lower than yours, even though my market cap (equivalent to your equity value from DCF) assumption is much higher. Also, I am not sure why you excluded net debt in your EV/EBITDA calc (B45 on valuation output tab). That $600 million is a real $600 million - it is worth something!

I'm not disagreeing with your 12.5x EV/EBITDA multiple, I'm just disagreeing with the number you used for FCF (in the DCF), and also the EBIT number you used to calculate your multiple. You might say that exlcuding D&A from both cancels out, but this is simply not true. It might have a net-zero effect on the multiple, e.g., if you exclude D&A from your DCF and also exclude it from the denominator in your EV/EBITDA calc, then the EV/EBITDA multiple very well could be the exact same as it would have been had you included D&A in both. But, that is not the issue. The issue is that when you multiply 12.5 by 460, as you did, you get a much different number than you would if you multiplied 12.5 by 800, as I did.

With EBITDA of maybe ~800 for the full 12 months ending December 2015, a mkt cap of $8.75, and net debt of -.6, isn't the company undervalued? At a 12.5x multiple of ~$800 million Euro (+20 compared to our 780 figure, to round out 2015 but in a conservative fashion), we arrive at an EV of $10 billion, or Mkt Cap of $10.6 billion, which is a little over 20% higher than the current market price...

Winston Swomley said...

Apologies, should have done some more diligence before posting.

It doesn't look like the increasing EBIT margin was due to pricing power. It looks like units sold was up considerably (~20%), but COGS was actually down $10 million, so the recent margin expansion does look like it can be attributed to depressed input costs.

My question about EBIT vs EBITDA still stands.

I did notice that the EBIT numbers you used track pretty close to FCF, if you include CapEx and Purchases of Intangibles (that's how Morningstar organizes CFI outflows). So, even if you agree with my assertion about adding back D&A after multiplying EBIT by (1-t), it doesn't really impact the model, since D&A is roughly equal to CFI outflows over the past couple of years.

That's what you did, right? Netted CFI against D&A, and then just skipped those steps?

I'm going to go read into those CFI numbers...what are all of these intangibles they are purchasing?!

Simone Cisternino said...
This comment has been removed by the author.