The Ferrari IPO: A Price Premium For The Prancing Horse? by Aswath Damodaran, Musings On Markets
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 $67 million in 2014. Much as this may pain car enthusiasts everywhere, some of Ferrari’s standing comes from its connection to celebrities. From Thor Batista to Justin Bieber to Kylie Jenner, the Ferrari has been an instrument of misbehavior for wealthy celebrities all over the world.
Up-and-Coming Small- and Mid-cap Portfolio Managers #MICUS (Morningstar Conference)
The Auto Business
In earlier posts, where I valued Tesla, GM and Volkswagen, I argued that the auto business bore the characteristics of a bad business, where companies collectively earn less than their cost of capital and most companies destroy value. In fact, I used the words of Sergio Marchionne, CEO of Fiat Chrysler (and the parent company to Ferrari) to make the case that the top managers at auto companies were delusional in their belief that the business would magically turn around. Looking at the business broadly, here are three characteristics that reveal themselves:
1. It is a low growth business: The auto business is a cyclical one, with ups and downs that reflect economic cycles, but even allowing for this cyclicality, the business is a mature one. That is reflected in the growth rate in revenues at auto companies.
|Year||Revenues ($)||% Growth Rate|
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.
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:
- 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.
- 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.
- Story: The car comes with a story that draws as much from its celebrity connections as it does from its speed exploits.
- 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.
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 Sector||Reason for difference|
|EV/Sales||2.10||0.94||Ferrari’s operating margin is 18.2% versus Industry average of 6.58%.|
|EV/Invested Capital||1.97||1.02||Ferrari earns a much higher return on capital (14.56%) than the sector (6.68%)|
|EV/EBITDA||12.57||9.05||Ferrari EBITDA/Invested capital is 15.68% versus Industry average of 14.45%.|
|PE||22.87||10.00||Ferrari has a debt ratio of 9.43% versus Industry average of 39.06%.|
|PBV||2.56||1.29||Ferrari 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.
- 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).
- 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).
- 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 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 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.
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 by the argument that Ferrari is a premium brand that caters to the rich. Let the race begin!
- Auto Industry: Company Data
- Ferrari Valuation (Status Quo)
- Ferrari Valuation (Rev it up)
- Google Shared Spreadsheet: Ferrari Valuations