While performing our customary deep dive into Ferrari’s (RACE) stock and financial performance, we revisited and updated our work on its old parent company Fiat Chrysler (FCAU). If I decide to publish our Ferrari article publicly, this will serve as an excellent prelude in addition to a stand-alone analysis of Fiat Chrysler.
There is much to analyze and digest concerning what Fiat Chrysler has done right and wrong over the years, including approving the initial public offering and carve-out of its absolute gem of a brand, Ferrari N.V. Since this is a somewhat sensitive subject (what isn’t these days), I will forewarn readers that I’m going to assess Fiat Chrysler objectively and that means discussing its pluses and minuses. It’s the same approach we always take including in our popular articles on Ford (NYSE:F). Though 90% of our work is now subscriber-only, we made a version of our Ford article public and are doing the same here.
Admitting You Have a Problem is Step #1
Let’s start with what Fiat Chrysler’s own customers think. These individuals have direct experience with their products.
Source: JD Power & WER
Fiat Chrysler is winning the wrong competitions. Of the four marques with less than a 20% customer retention rate, Fiat Chrysler represents three or 75%. Given Smart has left the U.S. market, it’s likely Fiat Chrysler represents all three of the lowest spots. Ouch.
Let’s hear JD Power’s reasoning for the three brands’ poor performance to try to ascertain where the problems and potential solutions may lie.
Dodge is one of just four major car brands with a loyalty percentage below 20%. The brand’s reputation may suffer from a string of recent subpar reviews. Besides Chrysler, Dodge received the lowest score from the American Customer Satisfaction Index, 77 out of 100. And after testing five Dodge models, Consumer Reports declined to recommend a single one
Not great. Let’s move to Fiat.
Fiat’s lack of customer loyalty in the U.S. market may be part of a much larger issue with the car brand’s sales overall. Fiat’s sales dropped by nearly 40% in the first six months of 2019 compared to the first half of 2018. Just 16.5% of previous Fiat owners who got a new car in the last year returned to the Italian auto brand. This is perhaps not surprising as Fiat was rated as the least reliable car brand, scoring just a 5 out of 10 in J.D. Power’s dependability rankings.
There was no coronavirus or other excuse in the first half of 2019, yet sales were down by nearly half compared to 2018. It could have something to do with the fact it was rated as the least reliable car brand. What about Chrysler?
According to the American Customer Satisfaction Index, drivers who get behind the wheel of a Chrysler are less satisfied with their overall customer experience than those who drive another brand from a major car brand. Chrysler’s sales through the first half of 2019 were down more than 27% from the same period in 2018.
With few exceptions, all it takes is one minute behind the wheel of any Chrysler with an MSRP below $30,000 and it’s clear why these products’ reputations are what they are: poor quality. How do Fiat Chrysler’s more specialty brands perform?
Source: JD Power & WER
Fiat Chrysler managed one brand in the top 10 by loyalty: Ram. It’s interesting to see Dodge with the fourth-lowest score and Ram the fourth highest. Rams and Dodges are sold at the same dealerships as far as I can ascertain, but Ram officially separated from the rest of Dodge starting in the 2010 model year.
The excellent driving dynamics of Alfa Romeo, class-leading brand value of Jeep, and impressive customer loyalty of Ram show the combined company has potential when it executes. How does Fiat Chrysler plan on resolving its quality and branding challenges? The same way AT&T (T) or IBM (IBM) does.
Source: Fiat Chrysler PSA Proposed Merger Documents
Fiat Chrysler has been in talks to merge with PSA group for several quarters; PSA is better known as PSA Peugeot Citroën, the result of the 1976 merger between the two French car companies.
To start, successful mergers of this type are about as rare and valuable as a 1962 Ferrari GTO. The Renault (OTC:RNSDF), Mitsubishi (OTCPK:MMTOF), and Nissan (OTCPK:NSANY) “triple alliance” has been a major disappointment, with the combined group’s CEO recently fleeing prosecution from Japan in James Bond fashion. Read this Bloomberg summary and you’ll see I’m not exaggerating. We dedicated an entire article to the disappointing history and data associated with larger M&A deals and Fiat Chrysler is no exception and has failed to meet expectations.
European carmakers are not unique in this regard; Ford and General Motors’ alliances and mergers have been uneconomical at best and solvency-testing at worst. Smart automakers, like Toyota (TM) and Honda (HMC), tend to steer clear and solve problems internally instead of financially engineering through mergers. There are special circumstances where a joint venture on specific technology with well-defined parameters can make sense such as Toyota’s cost sharing with and minority interest in Subaru on the FRS/BRZ project and more recently BMW with the Supra. I believe Ford and Volkswagen’s agreement concerning certain EVs and commercial vehicles follows these same basic parameters.
What do all these successful arrangements have in common? No majority cross-ownership of companies is involved and this is a key. Instead of being run like a bureaucracy, these firms can back out of the partnership when it no longer makes financial or business sense. Toyota’s growing 20% stake in Subaru can be reversed quickly if needed. The employees and business framework remain completely separate. In a full-blown merger, the two companies are effectively married and the cost of divorce is higher than either can stomach.
Source: Fiat Chrysler PSA Proposed Merger Documents
If Toyota wanted to improve its credit standing, it would do what is necessary and get the job done. Cut costs, streamline the product lineup, and make tough decisions. When Fiat Chrysler faces the same challenge, it attempts a merger with PSA. That may seem unfair, but the data shows that these constant mergers provide little or no shareholder value in the long term. A large, financially resilient firm like Volkswagen (OTCPK:VWAGY) can absorb luxury brands like Bugatti or Lamborghini without too much trouble, but a complete merger with another giant like Toyota would require one set of shareholders to pay a massive premium they are unlikely to realize a profit on.
Bloomberg provides historical context on failed automaker mega-mergers in this article. As we discussed with subscribers in-depth in a recent article, the synergies of mega-mergers very rarely pan out. With this backdrop, I could not be more skeptical of the proposed Fiat Chrysler PSA Group merger meeting its intended targets.
Diamonds in the Rough
Fiat’s most valuable asset is arguably Jeep followed by Ram. Jeep is at the intersection of the astounding growth in SUVs, desire for lower cost and reasonably fuel-efficient vehicles, and the market’s appreciation for a vehicle with a history-rich brand. Major reasons so many people love Ford F-150s are because they’ve been around forever, carry an iconic reputation, and offer good value for the money (despite top of the line trucks becoming quite expensive). Jeeps aren’t quite at that level but aren’t far off. They are ideal for “active lifestyle” buyers with pets/children wanting some off-road capability. Frankly, this type of SUV is trendy and that’s a great marketing position to be in.
This is particularly the case for buyers that prefer American brands or simply can’t spend or justify the money for a $40,000 Toyota 4runner or $85,000 Toyota Land Cruiser.
Alfa Romeo is attempting a comeback in the U.S. but it’s been difficult.
I personally like the Stelvio SUV, 4C small sportscar, and Giulia sports sedan Alfa currently sells in the U.S. The problem isn’t beauty or driving dynamics, rather it’s the same issue that has plagued Fiat and Chrysler for decades: poor build quality and engineering. Alfa recently suffered a 27% sales decline in the U.S. despite offering several new models. Recent numbers are even worse though May and June improved over April. It peaked at 23,800 units in 2018 just four years after returning to the U.S. market.
This quote from Forbes sums it up well:
You can’t fault Alfa Romeo for ambition. In 2010 Alfa said it would sell 500,000 cars a year globally by 2014. It sold 68,000. In 2014 it was going to spend $5.8 billion and sell 400,000 cars around the world with 150,000 in the U.S. by 2018. According to carsalesbase.com, Alfa Romeo sold about 83,000 vehicles in Europe last year, and 23,800 in the U.S. with roughly half accounted for by the Giulia sedan and the rest the Stelvio, with a little help from 238 4C supercars.
Maserati, another legendary premium brand under Fiat Chrysler’s umbrella, has produced similarly disappointing results with a >100 million euro quarterly losses in 2018 and continuously lower sales numbers throughout 2019 and 2020. Let’s run through key data points and reconcile those with what we saw profit-wise in 2019.
Source: Fiat Chrysler 20-F
The firm’s cash costs decreased by 6.0% year over year as a percentage of net revenues; that’s a good metric in this low margin business.
Source: Fiat Chrysler 20-F
Total R&D costs rose nearly 20% but that’s not far off the industry average as electrification, regulatory, and autonomous driving programs eat into automaker profits.
Source: Fiat Chrysler 20-F
A big contributor to Fiat’s merger with Chrysler, and why the combined firm wants to join with PSA, is all involved are desperately far behind in key technologies. In today’s environment, that’s autonomous driving and electric drive trains. Fiat was still shopping “damaged startups” for EV tech as recently as the end of 2019. The proposed merged business is in talks with Foxconn (OTC:FXCOF) (the maker of the iPhone in China) to outsource some or all of their EV technology and manufacturing.
Fiat’s standalone performance has been mixed. The automaker only recently reached its sales peak achieved in 2010 at the very start of the global bull market.
Source: Fiat Chrysler 20-F
Although the combined firms’ revenue has been flat for many years, gross profit and earnings per share have increased since 2015 though 2019 appears to be the real winner. If revenue and sales are flat, G&A is only down modestly, and R&D expenses are up significantly, where did these profits come from?
Source: Fiat Chrysler 20-F
Looking through the 20-F filing, we notice Fiat Chrysler sold a division to CK Holdings Co., Ltd in Q2 of 2019 for 3.93 billion euros. Bingo.
If we take 2019’s earnings and subtract them from 2018’s, the remaining 3.0 billion is less than the realized gain shown above. In other words, without this sale, the firm’s profits would be down compared to 2018 rather than up. To Fiat’s credit, their “adjusted net profit” shows a decline year over year of approximately 9.0%.
Source: Fiat Chrysler 20-F
Adjusted EBIT, a high-level cash flow metric that excludes many variables, was down slightly over the period with emerging markets and Maserati representing most of the losses. In terms of Q1, revenues and gross profits fell by 30% and 60%, respectively.
What about Fiat’s balance sheet and liquidity? Unlike many carmakers, this is an area of strength. Fiat Chrysler has approximately 15.0 billion euros in cash. The balance sheet also benefited from approximately $2.1 billion in free cash flow in 2019 before dividend and other voluntary payments but after CapEx. Many carmakers, such as Ford, struggle to generate free cash flow after investing in EV technology and other R&D projects. Fiat Chrysler has built a business that generates meaningful free cash flow despite headwinds. To the extent it should be investing in more technology is another question.
Interest expense has declined in recent quarters and total debt has stayed under control at around the 8-billion euros mark. All in all, the firm has about 30 billion euros in net equity and consistent profitability outside of absorbing a bit but unsurprising hit in Q1 2020.
Valuation
It’s difficult to value a company like Fiat Chrysler. It has a mix of high and low performing brands, pending merger uncertainty, and extremely high R&D requirements in the next few years to remain competitive. That’s not to mention a serious quality overhaul that needs to occur yesterday.
We, like Fitch, assume the pending merger will go through. Also in line with the rating agency, we consider Fiat Chrysler BBB- type risk or one notch from junk. Given that foundation, we think FCAU is reasonably priced at approximately 7.5 times 2019’s free cash flow and approximately 6.0 times normalized earnings (backing out the large one-time gain in 2019 and assuming the drop in Q1’s performance will revert to the mean). This is 20-30% cheaper than high quality peers like Toyota and Honda. Fiat Chrysler’s margins are far superior to Daimler’s (OTCPK:DDAIF) but it doesn’t have the latter’s scale, asset base, or liquidity. Ford looks like the best value of the bunch but its issues in China and Europe continue to be an albatross around its neck.
Overall, we think investors are better off paying a little more for quality (e.g. Toyota or Honda). If a higher risk bet is the objective, we think Fiat Chrysler and Ford are positioned for ~50% upside in the medium-term as the economy and coronavirus related complications eventually fade with time.
An important caveat is Ford’s credit division, and although it carries certain risks (we dedicated a good chunk of our public article on the company to this exact concern), is a major structural advantage that Fiat Chrysler lacks.
Once the dust settles on the potential merger with PSA, we’ll dedicate more time to that outcome. Between serious political challenges, multiple anti-trust lawsuits, and EU investigations, we aren’t going to “put the cart in front of the (prancing) horse” and assume the deal is done.
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Disclosure: I am/we are long F, TTM, HMC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: We may enter into a long or short position in any of the stocks mentioned in this article at any time.
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