I had planned to write about position sizing this month, following some extraordinary comments on the subject on Twitter and a heated debate with some of my students on a recent webinar on the subject. But a Twitter friend’s quarterly newsletter, which disclosed a 7.5% position in Ferrari, made me wonder.
Then doing the kids’ taxi service this weekend, I saw 7 Ferraris (including two classic Dinos) on Saturday and 4 on Sunday (the latter on a round trip of 3 miles). This popularity made me think about the stock, hence this exploration.
THE BULL CASE FOR $RACE
When a flotation of Ferrari was first discussed, I knew it would go well because I am a car enthusiast and am very familiar with the marque (I have owned more Ferraris than any other make of car). Dureka Carrasquillo, a Senior Portfolio Manager at the Canadian Pension Plan Investment Board, made a convincing argument for the stock at the 2018 Sohn London conference. I even suggested to the hedge fund manager next to me that he could pair it with an Aston Martin short, which I had been proposing at the time – that would have been a highly successful pair trade.
My notes and research highlight the following points from her presentation (my comments in italics, otherwise her forecasts):
· The $570bn luxury car market was expected to grow at about 9% pa for the next 5 years.
· Ferrari is an experiental luxury good, a category projected to grow at an even higher rate.
· She expected Ferrari to increase price by about 4-7% pa.
· Special cars have historically been c.2% of sales but she estimated that by 2022, they would reach 20% of revenues. These limited edition cars are exemplified by the 500 Monzas (>$1m) which sold out on the first day. Spoiler: a few weeks later I bumped into Max Warburton who for a long time was the #1 rated autos analyst when he worked at Bernstein – he told me then that you could still get a Monza at list as they had not sold out. This was a quite critical piece of information, as if Ferrari could not sell all its limited edition models, that was a clear signal that the market was approaching saturation and more likely, had already peaked.
· Gross margins on limited edition cars are about 3x base cars, and Carrasquillo forecast EBITDA margins would increase from 33% to 38%. Sentieo consensus 2024 EBITDA margin is 39%.
· She estimated then current capacity at c. 16,000 units pa, yet only 9000 are made. In comparison, Porsche sold 25-30,000 911s pa.
· Carrasquillo suggested that Ferrari could increase production to 16,000 cars pa and still sell them. Ferrari intended to launch 15 new models in the following 5 years – many more than formerly. The fact that I had seen so many Ferraris on a sunny weekend in central London suggests to me that her target may be ambitious, but there could be significant demand in emerging markets, especially for the forthcoming SUV, the Purosangue. She commented that the Ferrari parc in China was less than 500 cars.
· She outlined 3 potential risks to the Ferrari growth thesis:
1. Do wealthy millennials want a Ferrari? Do they even want to drive at all? Ferrari’s sweet spot is in the 35-50 year age range. Although fewer millennials drive during their 20s than previous generations, by age 30 they tend to catch up.
2. Are there enough wealthy buyers? Ferrari buyers tend to be high net worth individuals with investible assets of >$1m. Ferrari sells cars to 0.5% of this group. In the ultra-high net worth bracket they have 3.25% penetration. Carrasquillo concluded that there is a good runway for growth.
3. Changes in consumer preference. Consumers may become more environmentally conscious? They might prefer to use autonomous cars? The most bullish forecasts suggest that EVs may become 30% of the fleet by 2030. In addition, Ferrari are aiming for 60% of their new cars to be hybrid by 2022. The hybrid cars will have higher price tags and be more profitable.
· Luxury goods companies with a similar financial profile to Ferrari had an average P/E 27. Putting Ferrari on that multiple implied 60% upside. Valuing Ferrari based on cashflow implied a growth requirement of 3.5% per annum, yet it had been growing its top line at 10% per year for the past 20 years.
This was a convincing presentation and Carrasquillo was right – the chart above shows that Ferrari stock has nearly doubled since the presentation on 29/11/18 and the chart below shows the performance since float.
I wanted to review $RACE, using some of the quick look methodology I outline in my book – no in-depth research, just an initial short review to decide if it’s worth further investigation. I do this under a number of headings, and in no particular order.
Ferrari is no longer valued as an automotive manufacturer, but more like a luxury goods stock. The Sentieo print of $RACE as of 26 April, 2021 indicates a P/E of 43x and an EV/EBITDA multiple of 23x are racy multiples (sorry!). They compare with 37x P/E and 19x EV/EBITDA for LVMH, all unadjusted data per Sentieo using consensus estimates for 2021. The data is similar for 2022 – the premium on EV/EBITDA shrinks slightly, but we would need to project the EV using FCF estimates to refine that. The two stocks have had very similar share price performances since Ferrari came to the market. LVMH is quoted in Euros and in dollars has outperformed Ferrari by 8% on our estimates.
Ferrari has beaten LVMH in free cash flow growth in its short history but LVMH has achieved high rates of growth on a high absolute base since 2002, admittedly partly through acquisitions. But valuation is not an obstruction in itself – we need to look more closely at the quality of the business.
One hallmark of a quality company a long heritage. Obviously an internet company cannot have a longer than 25 year life, but other businesses may have shown themselves to be more enduring. Ferrari started producing road cars in 1947, so its heritage qualifies. The sale to Fiat, a jv in 1969 and a further 40% in 1988 ensured none of Aston Martin’s series of bankruptcies. The Fiat stake apparently came about after an approach by Henry Ford. So Ferrari clearly has longevity and its long history in Formula 1 is an integral part of the brand’s character – it’s an expensive hobby though. R&D has averaged over 15% of sales since float, and much of this is the F1 budget. R&D in 2019 was €560m while sponsorship revenues (mainly F1) were €506m.
My fund manager friend thinks that Ferrari’s cars are Veblen goods – the demand increases as the price increases. That is the key attraction to him of the stock. There is no question that Ferrari has considerable pricing power – one of my friends used to enjoy a new Ferrari each year at no cost; he would simply return the car to the dealer at its first anniversary and part exchange it for a new one – the dealer would pay him his original purchase price and sell the used car at a premium. This is the result of constraining supply.
Ferrari sells cars to the rich – even enthusiasts have to be moderately wealthy. The rich are growing in numbers and in affluence. There is a lot to like about Ferrari. The launch of an SUV (former Chairman Luca di Montezemolo vowed that Ferrari would never produce an SUV, but now the bean counters are in charge) is likely to propel sales in China where the rich prefer to be driven.
One risk highlighted is succession. Apparently Jony Ive, former Apple design chief and car enthusiast is rumoured to be a candidate for the CEO’s position which would be an astonishing (and high risk) appointment, in my view. Succession is a minor issue given the strength of the brand.
Ferrari has made significant improvements in financial performance since its IPO, although the trends have tailed off somewhat more recently. Obviously, 2020 is an unfair comparison because the factories were shut, but 2019 is only showing an improvement in adjusted EBIT margin – other financial measures look to be weakening.
Returns on capital are outstanding for an automobile manufacturer – 30% is a good result for almost any company. Gross margins similarly are impressive for a car maker, as is gross profitability. But trends in all these measures look to be weakening, and this would require careful closer scrutiny in any further work.
LONG TERM OUTLOOK
Is this enough to support the Ferrari valuation? Possibly for a while, but longer term I wonder. There is one key issue going forward and that’s climate change. As a small manufacturer, Ferrari does not currently have to comply with emissions directives but how long will that last? Will a manufacturer of over 10k units really be free to pollute? And will all those ESG funds be happy to own a polluter?
Of course, the lineup is moving to hybrid supercars which command an even higher price and the F1 technology means Ferrari is well placed here. But it’s notable that Ferrari has chosen not to produce an all-electric car. There is a really good reason for this, I suspect. And it goes to the heart of what Ferrari is about.
Most Ferraris are hobby cars – an owner will go to the garage to take the car out on a sunny Sunday. Lift the garage door, take the cover off the car – it’s simply beautiful to look at (Ferrari rarely makes an ugly car). Sit in the driver’s seat and start it up – the noise of the engine, usually situated behind the driver’s head is an integral part of the experience. I think it may be difficult to persuade customers that an electric Ferrari will be a real Ferrari.
But things could get worse – what happens when we move to autonomous vehicles? Will you even be allowed to drive yourself, especially in busy city centres? Will a chauffeur-driven Ferrari compete on the same terms as a Roller? Ferrari could even be Rolls’ equal with its customisation possibilities, the quality of the leather and interior fitments, but it’s not competing from its current strong points.
The Market Screener site lists major shareholders as Exor with 24% (a major positive), Baillie Gifford with 6%, T Rowe Price with 4% and Lansdowne with 1%. The first and last are two British funds and investors who deserve respect. Fintel discloses that the Canada Pension Plan Investment Board (where Carrasquillo works) have reduced their stake.
The Mine Safety Disclosures Site gives the analysis in the table of RACE holders from 13-F filings. It’s not complete, as it omits the holders above as well as shareholders like Fidelity, Wellington, Pictet and Capital, all of whom have >$100bn AUM, but it looks a decent summary.
It also lists that Renaissance, Point 72 and Schonfield Strategic Investors have exited their positions. Marshall Wace have sold down and Balyasny have started to build a position (but $7m is like the tea lady’s fund). The Darsana Capital founder is ex Eton Park, but note that AKO, which has an outstanding record in the ownership of quality shares, has a $335m position which they have trimmed. Third Point’s $249m position is a positive and so probably is an increase in Ensemble Capital’s holding, (I know them and respect their writing but have not seen their performance data).
Reviewing the shareholder register is a key part of my initial check methodology and on balance is a small positive, but less so than I expected.
I don’t like using DCFs to value businesses – they are useful for sensitivity analysis but cash flow projections are extremely tricky and hard to produce accurately over a year or two, let alone over several years. I often used to find that there was a much wider range for the cash flow projections for a stock than for its eps number.
A comparison of Ferrari with LVMH is the type of situation where the technique can be helpful. I used the Sentieo free cash flow consensus numbers for the next three years (they didn’t look daft) and a discount rate of 7.5% for the two stocks. Using Sentieo’s numbers and my own adjusted calculation for FCF, I estimated that LVMH’s long term free cash flow growth was over 10% so I used 10% for the long term growth in its cash flows. The next 15 year’s cash flows discounted represent over half of the LVMH market cap today.
To get a similar result for Ferrari requires an assumption of 17% growth in FCF, admittedly not out of line with the recent past, and although a massive premium to LVMH, there is likely to be latent FCF generation capacity in Ferrari. But there is an existential threat to Ferrari in 2035, arguably two of them – EVs and AVs. It’s hard to imagine the world buying fewer handbags, champagne or brandy.
I have done no real work on the long term cash flow potential at Ferrari and it’s possible that 17% CAGR over 15 years is more achievable than 10% for LVMH. But the question of the terminal value still applies – there is clearly huge uncertainty about Ferrari’s value in 2035. There is no such doubt about similar luxury goods manufacturers. To justify its present valuation, I would need to be convinced that the next decade would see massive growth at Ferrari and get comfort on that terminal value. There are not many occasions when your analyst will admit to preferring handbags to Ferraris, and this is likely to be the only one.
2035 is a long time away. But current valuations are high and low interest rates put a premium on growth and emphasise future value. Analysts surely now need to focus more on what the company will look like in 2035 and place less weight on the 2023 profit number. That’s quite a change in approach.
It’s therefore important to ask what multiple should I put in my terminal value for Ferrari? By then, in my view, it’s highly unlikely that it will be on a 40x P/E multiple. Particularly given the astonishing performance of Tesla, I have been surprised that the stockmarket has not devalued automotive manufacturers more aggressively, but I believe there will be a further significant derating in market perception over the next 5-10 years. Even Ferrari will not be immune. It’s a great company but there does not appear to be a sufficient margin of safety in its present valuation.
I generally try to write these blogs to have a longer shelf life, but would love to hear from readers if they enjoy this sort of discussion and also if you disagree – feel free to post withering criticism in the club site. I know who will be first.