Valuation of the Week
#6: Premium Brands and Premium Prices
Ferrari, one of the world's premier automobile brands is going public soon and it has just filed its prospectus. The company is currently owned by Fiat Chyrsler and the prospect of the Ferrari IPO (which was announced in October 2014) has pushed FCA's stock price up.
Ferrari was founded in 1947 and for much of its early existence, it was privately owned by the Ferrari family. Enzo Ferrari, the founder, sold a 50% stake in the company to Fiat in 1969 and that holding was subsequently increased to 90% in 1988 (with the Ferrari family retaining the remaining 10%). The company acquired its legendary status partly on the race tracks, but some of its standing comes from its connection to celebrities.
As anyone who has dreamed about owning a Ferrari, it is priced out of reach for most of us. In its prospectus filed a few weeks ago, Ferrari reported that it generated 402 million Euros in pre-tax operating income on revenues of 2,763 million Euros in the last twelve months ending June 30, 2015. While the revenues registered a jump of about 14% over the prior year, the company sold only 7255 cars in 2014, a number that has not changed much for most of the last five years.
A Super-luxury Car
In valuing Ferrari, it is important that I first recognize that this is less auto company and more status symbol, drawing its allure from four key characteristics:
- Styling: I don't crave a Ferrari, but even a non-car lover like me recognizes a beautiful object. A Ferrari is a work of art.
- 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 with dreams of being a Formula 1 driver, a Ferrari is probably as close as you are going to get to these dreams.
- Story: The car comes with a story that draws from its celebrity connections than its speed exploits. You too can be Justin Bieber or Kylie Jenner, if you truly want to.
- 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.
Over the last five years, super luxury car manufacturers have seen sales grow faster than the rest of the auto industry, with much of the additional growth coming from newly minted rich people in emerging markets, in general, and China, in particular.
||# Cars sold
|Australia & New Zealand
|Central and South America
|Eastern Europe & Russia
Valuation Narratives/ Valuations
If valuation is driven by stories, here are a two that you can use to value Ferrari:
- Status Quo: Ferrari remains a extra-exclusive automobile company, keeping production low and prices super-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 on expensive ad campaigns or selling. It also will keep reinvestment needs to a minimum, since capacity expansion will be limited. 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; I give it a cost of capital of 6.96% (in Euros).
Rev it up: Ferrari tries to broaden its customer base, perhaps by introducing a lower-cost version; this would mirror what Maserati did with its $100,000 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%.
- Inputs: Revenue growth rate of 4% a year for next 5 years, Operating margin stays at 18.20%, Cost of capital of 6.96%, Return on capital in perpetuity locked in at 14.56% (much higher than the cost of capital of 7% in stable growth.)
- Valuation yields a value for equity of 6,310 million Euros (approximarly $7,000 million)
- Inputs: Revenue growth rate of 10% a year for next 5 years, Operating margin drops to 15%, Cost of capital of 8.5%, Return on capital in perpetuity locked in at 12% higher than the cost of capital of 7.5% in stable growth.)
- Valuation yields a value for equity of 5,741 million Euros (approximarly $6,500 million)
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.
Where is 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)
||Reason for difference
||Ferrari's operating margin is 18.2% versus Industry average of 6.58%.
||Ferrari EBITDA/Invested capital is 15.68% versus Industry average of 14.45%.
||Ferrari has a debt ratio of 9.43% versus Industry average of 39.06%.
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
- 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 proceeds will go Fiat 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).
- Number of shares/IPO price per share: Note that in both valuations, I have focused on the value of equity, rather than a per share value. That is because of 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 it really does not matter and this is why. If the value of equity is 6 billion Euros, Ferrari can create 100 million shares at 60 Euros per share or 2 billion shares at 3 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 investment bankers are planning to create 200 million shares, and if that is the correct number, the value per share that I arrive at is about 30 Euros per share.
- Control: After the IPO, Ferrari will become an indepdendent 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 additional voting rights on their shares for their loyalty; their shares will have twice the voting rights as the rest of us. The two big owners, Exor (the investment fund for the Agnelli family) and the Ferrari family will control 51% 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.
- Ferrari Prospectus
- Auto Industry Data
- Ferrari Valuation (Status Quo)
- Ferrari Valuation (Rev it up)
- Google Shared Spreadsheet: Ferrari Valuations