Fiat Chrysler Automobiles NV (FCAI)

[Wildbilly]

Cost synergies from Fiat's integration with Chrysler are yet to be realized.
by Richard Hilgert Authors can be reached at Analyst Feedback Morningstar's Editorial Policies
Investment Thesis 18/09/2014

In our view, the market has unfairly discounted the intrinsic value of Fiat SpA. We believe there are substantial benefits to be derived from the Fiat and Chrysler combination. Greater scale can be achieved in components, platforms, and capacity. An array of brands reduces reliance on any one vehicle category. Greater scale across more geographic regions lowers the company's costs and reduces Fiat's dependence on domestic (Italian) volume. Nonetheless, we think that only those willing to accept the risks of a highly leveraged turnaround situation in a competitive, capital-intensive, highly cyclical industry should consider investing.

The combined entity has eight brands that cater to nearly all customers (passenger and light commercial). The downside to more brands is higher marketing and distribution costs. Poor product execution results in look-alike vehicles with only a grille badge to differentiate the brands. On the upside, a diversified portfolio of well-differentiated brands reduces exposure to any single vehicle segment and substantially increases economies of scale. The scale of the combined entity is around 6 million vehicles, the sixth-largest car company in the world.

As a market leader in Brazil (low 20s share), Fiat will benefit from that country's rising middle class. However, the company was late to Russia, India, and China and will undoubtedly lag already-established competitors' market shares. Even so, we expect Fiat to participate in the above-industry-average growth in emerging-market demand. Jeep's re-entry into China will provide Fiat with a turbo boost to its share of the market.

While management views the group's parts-making operations as strategic to its auto-assembly operations, we believe that parts and systems manufacturing should be completely separate. Even though the economic environment ultimately drives demand for both the automotive original-equipment manufacturers and the parts suppliers, the dynamics of the businesses are quite divergent. However, to management's credit, profitability and returns on Fiat's parts businesses are competitive with those of other major European auto suppliers.

Economic Moat 18/09/2014
In general, automotive manufacturers are no-moat companies that lack barriers to entry (other than substantial capital investment) and make products that are easily substitutable by consumers. Fiat is no exception. Even though the automobile is a modern-day technological marvel that requires enormous engineering talent and organizational skill to design, develop, and bring to market, a lack of barriers to entry is evidenced by global industry overcapacity of roughly 30 million units. Including Chrysler, Fiat, Ford, General Motors, and PSA Peugeot Citroen facility closures in North America and Europe from 2009 through 2014, total capacity reduction has only been around 3 million units. Most industry executives agree that overcapacity is the top problem facing manufacturers today and that the problem will only get worse, exacerbated by many manufacturers' new capacity plans in China and Mexico.

Hard-fought market share is won and temporary economic profits are achieved by three typical routes. First, automakers seek to introduce a radically new design that defines a new vehicle niche (Chrysler's introduction of the minivan in the 1980s). Second, original-equipment manufacturers race to be the first to market a dramatically differentiated technology (Toyota's introduction of the Prius hybrid in the early 2000s). Finally, some firms consistently have the youngest portfolio of products through frequent new vehicle introductions and substantial redesigns. The Japanese in the 1980s and 1990s had a competitive advantage by cutting their time to market in half relative to other manufacturers.

Even though Fiat enjoys premium pricing with its Ferrari and Maserati brands, competitors have been able to achieve the same perceived value among consumers. While these brands evoke images of wealth, luxury, and exotic street-legal racing machines, consumers of these products can switch to a competitor's product such as Lamborghini, Aston Martin, or Rolls-Royce. Also, these consumers have the wherewithal to simply add more cars to their own personal fleet of ultraluxury vehicles. In price-conscious, high-volume markets, fickle consumers can switch among competing brands, and quite often, they do. The latest fads, hottest styles, high-profile recalls, high dependability ratings from consumer publications, and utilitarian needs can all factor into consumers' buying decisions.

For penny-pinching, educated shoppers, dependable transportation at an affordable price is all that's required, and it doesn't matter which manufacturer's vehicle they buy, just as long as it's the best deal they can find. In this instance, consumers can easily switch from Fiat to Volkswagen, Peugeot, Opel, or Toyota, then back again. Other consumers view their vehicles as extensions of themselves and are willing to pay a premium for a machine that exudes a certain image. Fiat's Maserati brand might be a consideration for such a consumer, along with Audi, BMW, Lexus, Mercedes, or even Cadillac (which is enjoying resurgent popularity in the United States). However, Fiat does benefit from a sense of nationalism in its domestic market of Italy, just as Peugeot, SEAT, and Volkswagen do in their respective domestic markets of France, Spain, and Germany.

Fiat's captive auto-parts operations should also be considered no-moat businesses because of the intensely competitive nature of the automotive industry, the industry's cyclicality, pricing leverage exerted by external customers, and an inability to sustain returns throughout economic cycles. However, because of regular introduction of new technology, highly integrated and long-term customer ties, customers' steep switching costs, and moderately improving pricing power, some suppliers have succeeded in establishing economic moats, for example, Autoliv, BorgWarner, Gentex, and Johnson Controls.

Valuation 14/10/2014
We use a 9.2% weighted average aftertax cost of capital to discount Fiat's future cash flows, resulting in our expected-case $19 fair value estimate. Fiat's revenue cyclicality and operating leverage, in conjunction with its financial leverage, result in our very high systematic risk rating. Consequently, our cost of equity assumption is 14%. Given the company’s highly leveraged balance sheet, we assume a 19% equity and 81% debt capital weighting. We also assumed a 12.5% cost of debt to adequately reflect the leverage risk. We tax-effect our weighted average cost of capital assuming a 35% long-run tax rate. Our $19 fair value estimate also includes the assumptions that 2014 European new-vehicle demand will remain weak but perk up just a bit in the first half with more difficult comparisons in the second half, offset by a decline in passenger-car demand in the Brazilian market. In addition, cost savings from the Fiat-Chrysler integration should begin to emerge, masked by continued Italian operating losses, with substantially improved operating leverage building in 2016 and beyond. We assume volume increases will average 4% per year over our five-year forecast period compared with an average annual increase of 8% under the current Fiat Chrysler plan. Fiat Chrysler's historical three-year average EBIT and EBITDA margins are 4.1% and 9.4%, respectively. We believe that higher volume on demand recovery in Europe and Brazil, plus a slightly richer mix from improved Alfa Romeo and Maserati sales, should raise Fiat Chrysler's break-even point. As a result, we assume midcycle EBIT and EBITDA margins of 4.9% and 10.3%, respectively, in the fifth year of our forecast. In comparison, Fiat Chrysler's five-year plan forecasts 6.6%-7.4% EBIT margins and 12.5%-13.3% EBITDA margins in 2018. We think Fiat Chrysler will execute and at least realize enough of management's vision to reach our discounted cash flow model assumptions. Our assumptions significantly discount the volume buildup at the back end of management's plan. We expect margin improvement due to operating leverage from improved market conditions in Europe and Brazil in the fourth forecast year. We expect the operating leverage to support an EBITDA margin peak of only 11.2% compared with management's peak in year five of at least a 12.5% EBITDA margin.

Risk 18/09/2014
Risks include an unexpected drop in global vehicle demand, an unfavorable shift in vehicle mix, execution risk of successfully and fully integrating Chrysler operations, difficulty in penetrating the U.S. market, government stock ownership, union stock ownership, and a unionized workforce. In addition, if the EU sovereign debt crisis escalates into a severe credit crunch, consumers' ability to finance vehicle purchases may be severely constrained, potentially stifling European demand. U.S. penetration is integral to achieving greater scale. The UAW VEBA's 41.5% ownership of Chrysler could represent a significant hurdle to overcome for management if the agenda of the UAW differs from Fiat's strategic initiatives.

Execution risk associated with Fiat's integration with Chrysler may be possible, but we see only a minimal probability. There's potential for a considerable amount of internal upheaval to be created when combining R&D, engineering, component suppliers, supply chain logistics, vehicle architectures, corporate functions, and rationalizing capacity. However, the group has already successfully launched new models within 18 months of Fiat's control--astoundingly impressive given that most development times range between 18 and 36 months.

While Fiat has had favorable union relations, a unionized workforce can become onerous. CEO Sergio Marchionne was interviewed on Italian television and essentially said Fiat auto would be profitable were it not for its Italian factories, no doubt stirring animosity among Italian workforce leaders and government officials. Investors should be heartened by this comment because it indicates management will resist union pressure to coddle chronically unprofitable operations.

Management 18/09/2014
Fiat is in effect controlled by the Agnelli family through the family's holding company, Giovanni Agnelli e C. Sapaz, which controls EXOR, an investment company that owns about 30.5% of Fiat SpA. Under Italian securities regulations (CONSOB, Italian securities market regulator), shareholders who own at least 1% of ordinary shares may submit lists of candidates for election to the board of directors. The voting list system for the election of directors was used for the first time at Fiat's general meeting in March 2009. EXOR has been the only shareholder to submit a list of candidates and, as such, all of the candidates on EXOR's list have been elected. John Elkann, Fiat's and EXOR's chairman, and Andrea Agnelli, a director on Fiat's and EXOR's board, are both grandsons of Gianni Agnelli, the great grandson of the founder of Fiat, Giovanni Agnelli.

Sergio Marchionne was appointed CEO of Fiat SpA and Chrysler in 2004 and 2009, respectively. The dual responsibility is intended to enable integration of Fiat and Chrysler as well as facilitating day-to-day operations of the group as a single entity. Fiat's bylaws allow for 9-15 board members. Before the demerger of the Industrials business, the board had the maximum at 15 members. Shareholders voted in April 2012 to limit the number of board members to nine. Three of the nine are considered executive directors, six are considered nonexecutive, and four of those six are considered to be independent under legislative mandate. Although we prefer the board to consist of a larger portion of independent members, Fiat's structure isn't uncommon among international companies. Fiat annually publishes a corporate governance report, which includes copious amounts of policy information. Nevertheless, we would like to see the company provide additional disclosure on the financial metrics used to determine cash and stock option bonuses.

Overview

Profile:

Fiat SpA makes automobiles (Fiat, Chrysler, Dodge, Alfa Romeo, Lancia, Abarth, Fiat Commercial, Ferrari, and Maserati), automotive parts (Magneti Marelli and Teksid), and industrial robots (Comau). As of January 2014, Fiat acquired the remaining interest in Chrysler Group that it did not already own and will be renamed Fiat Chrysler Automobile.

FCAU : Fiat Chrysler Automobiles NV Analyst Report

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