The automotive sector is continuously plagued by numerous headwinds that have driven stock valuations of car manufacturers to the bottom end of the US and European markets. CO2 regulation, technology disruption, recession fears, and the US & China trade war generated a lot of pessimism, which has pushed the prices for some of the automotive companies to deep value levels.
When we see the sheer number of problems that plague this industry, it is tough to invest in it, which is why the majority of market participants neglect Fiat Chrysler Automobiles (FCAU), and precisely the reason why it is worth considering it.
Current, FCA trades at the bottom of the US valuations and in relative terms is one of the cheapest stocks in the automotive and large-cap sectors. Significant undervaluation is supported by the discounted cash flow analysis, which confirms that the current levels provide an attractive entry point with an appealing risk to reward ratio.
During the last shareholder meeting held on April 12th, Chairman John Elkann and CEO Michael Manley confirmed 2019 earnings guidance and said that operating performance would exceed record results achieved during the last year. Additionally, the CEO has announced that from this year FCA will introduce regular dividends, which at the time of payment yielded approximately 5%.
Automotive Industry Sales Development
The forecast is that until 2023, the global light vehicle production will increase by an average rate of 2.9%, at which point it will amount to 110.9 million units, up from 96 million units produced during the last year. Total worldwide sales should approximate the world's GDP growth, but during this period it is expected that the US market will be a laggard. During the first quarter of 2019, the number of units sold in the US fell by 3,1%, and projection is that in the next two years the US market will see approximately 1% decline per year, after which the upward trend should continue.
During the last year, 46% of FCA's revenues came from the US market. Consequently, the company will definitively feel the impact of the weaker US market. Nevertheless, we will see in the DCF analysis that even this kind of market development is all that is needed to turn FCA into an above average investment.
Although the car sales took a dip, during the last quarter the US economy grew at an annualized rate of 3.2%, easily beating growth expectations of 2.5%, and indicating that a US recession is nowhere in sight. Additionally, at the beginning of this month, the FCA Group reported its Q1 results and management reiterated its 2019 profit guidance of €2.70 ($3.03) per share, which at the current market price of €12.94 ($14.54) gives an implied 2019 earnings yield of 20%.
Fiat Chrysler's Bands
FCA is an owner of some distinctive automotive brands. During the last few years, some of them experienced a spectacular rise, while some did not achieve expected results and are a headache for the company management.
Jeep's resurrection started ten years ago, and during this period it evolved to the FCA's top performing brand. Last year Jeep sold 1.56 million vehicles globally, up by a substantial 11.4% compared to 2017. An excellent result during the challenging year for the automotive industry and global markets. The steady growth has positioned Jeep as FCA's top-selling brand and the most important source of revenue and profits.
Until 2022, Jeep has a strategy to enter into new segments, to offer electrification options, and to have two launches per year. Development of the product range should ensure that global sales will continue, and that Jeep continues to be the main driver of the FCA Group's revenues and profitability.
During the last few years, Ram is the second most successful brand in the FCA group. During 2018, sales of Ram vehicles totaled 724,000 units, which was 4% more than in 2017. Similar growth was posted during 2017 as well. This brand is gaining more importance as it becomes not only more popular in the USA, where 82% of its sales take place, but also abroad.
During 2018, Jeep and Ram sales combined amounted to 2.289.000 units, which was half of the group's worldwide sales. Additionally, despite the week market during the first quarter, Ram managed to sell 21% more units compared to the same period during the last year.
The goal for Ram is the production of 1 million units by 2022, which is significant growth from its current 700k range. That may seem a long shot, but we should keep in mind that the same management had grown Ram from 263.000 units in 2009 to 724.000 units in 2018.
The most troublesome unit is Maserati, which has in 2018 sold 31% fewer units. During the first quarter of this year, the negative trend has continued, and Maserati sold 32% fewer units and posted 38% lower revenues. Fortunately, Maserati's share in total revenues is only 2%, and the impact is minimal, but on the other side, this shows that the execution of the strategy is not going as planned. The revival of the brand is jeopardized again, and management should probably sell this brand, and focus its energy and capital on brands that have much better execution and profitability.
The second and much more prominent brand that is troublesome is Alfa Romeo. Two years after the presentation of the SUV Stelvio, which was Alfa Romeo's most significant breakthrough, this brand is now facing uncertain due to the lack of new products. What began as a promising project (Stelvio & Gulia) is now fading away as the growth is rapidly slowing down and no new cars are due to arrive before 2020.
During the last year, Alfa Romeo's sales slowed significantly, and without the new launches, this brand could once again become a headache for the company as its sales numbers could be far from the targets. This brand is another candidate that should be sold to move away from stagnating business units.
For a while, there are speculations that FCA could be taken over, or at least that it might sell subsidiaries like Maserati or Alfa Romeo. The primary candidate for now is the PSA Group, but the Renault Nissan Alliance is not out of the equation either.
FCA is attractive mainly because of its strong presence in the US with its iconic US brand Jeep and the growing truck brand Ram. In the US market, FCA achieves approximately 50% of its sales and 80% of its adjusted operating profits and would be a good fit for the PSA Group which does not have its presence there.
Combined FCA and PSA would produce annually almost 9 million vehicles, which could provide synergies in platform development and electrification, as it would be possible to share huge technology development costs. By acquisition of Opel and Vauxhall, PSA's management proved that it is capable of turning around troublesome companies, which could be replicated one more time with stagnating subsidiaries of FCA.
The negative side of combined companies would be that both companies are pretty weak in China and fast-growing South East Asian economies, where the most significant part of the future growth is expected. Additionally, four mid-market brands (Opel, Peugeot, Citroen, and Fiat) could be too much for a highly developed European market.
Source;*sales numbers include joint ventures
The second potential acquirer could be the Renault Nissan Alliance, which would in combination with FCA become the world's biggest automotive company. There were already speculations that these two companies held merger talks, but blocked by the French government. However, it is more likely that alliance first has to solve its internal problems, and then start with the new takeover talks.
Additionally, Chairman Elkann recently reiterated that the family Agnelli (FCA's biggest shareholder) is prepared to take "bold and creative decisions" to help build a stable and attractive future. The interpretation is that they are open for a possible merger or takeover talks, which is essential as the family Agnelli controls 29.19% of shares and 44.31% of voting rights.
Liquidity & Financial Health
Cash proceeds from the sale of Magneti Marelli are €5.8 billion, out of which extraordinary cash dividend will be paid, which will amount to €1.3 ($1.46) per share or in total approximately €2 billion. Before the sale, Fiat's had a net debt position of €1.9 billion, but after the transaction, the company has significantly strengthened its balance sheet and after the extraordinary and ordinary dividend should have a net cash position of approximately €858 million.
The current net cash position is a sharp contrast to the historically highly indebted balance sheet and points to the lower risk coupled with the flexibility for regular dividends.
Discounted Cash Flow Analysis
As 80% of FCA's adjusted profits come from the US market, I used the US 10-year treasury as the most relevant risk-free rate. Additionally, I used the statutory tax rate of 21% as profits are taxed mainly in the US. For companies that have a net debt position, the weighted average cost of capital (OTC:WACC) is not equal to the cost of equity, but as FCA has a net cash position, the assumption is that these two variables are the same.
In line with the previous market development analysis, I expect that revenues will slightly decrease before they stabilize and again start to rise. FCA's management is for 2019 forecasting an adjusted EBIT of €6.7 billion and an EBIT margin of 6.1%, which could be slightly too optimistic. That is why for 2019 I have used an adjusted EBIT of 5.6 billion and an EBIT margin of 5.3%.
Current working capital is negative, which reveals that FCA is in one part financed through its suppliers. As it will be hard to maintain such a significant negative working capital, I have projected a gradual decline, which negatively impacts free cash flow and lowers target price.
During 2019 CAPEX expenditures were 4.8% of the total revenues, but as we have in mind significant technology disruptions, we should count with the higher CAPEX needs. That is why I have projected that an annual CAPEX will increase to 7.2%.
Even though I am counting with much lower profitability margins than management, and have counted higher CAPEX and decreasing negative working capital, upside potential is still significant and is pointing to the potential of 37%. The target price projection is at €17.80 ($20).
The most significant dangers are the downturn of the US and the EU economies, but as the US first-quarter GDP number came above expectations, this risk has slightly decreased. The forecast is that Eurozone will in this year post growth of 1,2%, and Q1 data confirmed this expectation. Although the economic recession would hurt consumer spending and especially the automotive sector, the global economy does not show any sign of a recession and the demand for cars should be on the worldwide scale stable.
The second most significant risk is definitively further escalation of the trade conflict between the United States and China, which would make it harder to export US produced cars to China. Technology disruption via autonomous driving and electric vehicles will be a risk throughout the next decade.
As the company has significantly deleveraged, the interest rate risk came down a lot, but the significant risk that stays is the CO2 regulation and potential penalties.
FCA is an out of favor stock, which is a part of the industry troubled by many different problems. The whole auto sector is trading significantly below the market averages, and is priced as all companies included in the automotive industry will see its profits fall by more than 50%. Such development could be the case in a span of a few quarters (as we saw during 2008) but is highly unlikely in the long run.
One part of FCA brands are doing great and should follow the technological trends, but the other part is troublesome and could be sold to focus on the core competencies. Nevertheless, the company is profitable, and stable in the US, which is the most important market, and a reason why it is such an attractive takeover target. With its expanding and highly recognizable brands as Jeep and RAM, the group should be able to compete successfully and maintain its profitability, which should be enough for a company that is trading at the deep value forward price to earnings ratio of 5.
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Disclosure: I am/we are long FCAU. 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.