The Ferrari Legacy

Ferrari was the namesake of Enzo Ferrari. An automotive engineer his entire life, Enzo worked with Alfa Romeo for many years, performing every possible function including lathe instructor, test driver, racing driver, and eventually, serving as the director of the Alfa Corse racing division.

In 1929 Enzo founded Scuderia Ferrari in Modena, Italy. Scuderia was a racing stable, where owners could drive and compete with their own cars. Enzo left Alfa Romeo in 1939 to open his own firm, Avio Costruzioni on Viale Trento Tieste in Modena (the plant was eventually moved to Maranello). After the forced hiatus during the second world war, Ferrari launched the 125 S in 1947, and on May 25, 1947, the Ferrari 125 S won its first race, the Rome Grand Prix. Ferrari has since won more than 5,000 races worldwide.

The financial pressures of sustaining the growing high-powered Ferrari family of cars resulted in Enzo partnering with the Fiat Group in 1969, Fiat initially taking a 50% interest, then increasing it to 90% in 1988. Enzos remaining 10% ownership was passed to his son in that same year with his death. It was now the Fiat Group and its family interests that sustained Enzo Ferraris legacy. That legacy was now led by Fiats new CEO, Sergio Marchionne.

Limits to Growth

We pursue a low volume production strategy in order to maintain a reputation of exclusivity and scarcity among purchasers of our cars and deliberately monitor and maintain our production volumes and delivery wait-times to promote this reputation.

New Business Netherlands N.V., Form F-1, U.S. Securities and Exchange Commission.

Like other rare elements, Ferraris value was linked to its scarcity. As illustrated in Exhibit A, Ferrari had methodically controlled volume sales growth, averaging just 4.24% per year over the 19972014 period. Sales growth had actually been even slower than that average rate in the post-2009 crisis period. Total sales volume in 2014 was 7,255 carsan astonishingly small number by any automobile standard.

Scarcity Premiums

In terms of preserving Ferraris value, this relative scarcity was both good news and bad news. The good news was that leadership had clearly maintained the products relative scarcity in a global economy that had grown faster and wealthier at a much more rapid rate. According to a recent study, the number of high net-worth individuals (HNWIs) and their wealth, the target demographic segment for Ferrari sales (at least historically), had grown 8.6% per annum for nearly 30 years.11

The countries driving Ferraris sales reflected that wealth creation. Sales volumes in 2014 were roughly 45% Europe/Middle East/Africa (EMEA), 35% the Americas, 11% Asia Pacific (APAC), and 9% Greater China. This global sales mix seemed to be shifting slightly away from EMEA, with China and APAC garnering the gains. (Global sales volumes are detailed in Appendix 4.) Diving deeper, four countries made up 60% of this global HNWI population: the United States, Japan, Germany, and China.

In its prospectus Ferrari was quite bullish on HNWIs in China. Although China made up only 9% of current sales, the growing wealth and taste for luxury goods in China were promising. China already made up a very large piece of the total sales (2014) for a number of luxury goods producers: Hermes25%; LVMH28%; and Prada30%.12 If that were the case for Ferrari, the company could see growing demand pressures. But there were skeptics, as a number of analysts worried that the Chinese economy was already beginning to slow.

The bad news about this relative scarcity through slow growth was that 4% was not a promising growth rate for an equity if sales and earnings did indeed follow volume growth rates. Publicly traded shares generated income for investors two ways, through dividend yields and capital gains. But with no plans to offer dividends, Ferraris value proposition relied exclusively on hoped-for capital gains.

Differing perspectives on growth had also caused serious debate within Ferrari. Ferraris longtime Chairman, Luca De Montezemolo, had left the firm suddenly in 2015, reportedly over his opposition to the IPO. Montezemolo believed the IPO would force the firm to grow sales volumes at a much more rapid rate. Ferraris CEO, Sergio Marchionne, had repeatedly stated publicly that Ferraris future was as a business, not art: There comes a point when exclusivity, if it becomes unreachable, is no longer exclusivity, its like youre reading a fiction novel . . . lets not fool ourselves, we are in the business of selling cars to people.

Financial Performance

Ferraris financial results for the 20122014 period appear in Exhibit B. The company had a relatively small product portfolio, consisting of eight vehicles that accounted for 70% of total revenue. Its sales and rentals of engines were exclusively to Maserati (it had supplied engines to Maserati since 2003), and its other sponsorship income was tied to Formula 1 racing.

Yet, Ferraris R&D expenses were exceedingly high compared to any other automobile manufacturers.14 Where R&D expenses as a percentage of sales averaged less than 5% for most of the global industry, Ferraris were 20.3%. Porsche, a distant second, was 11.3%, Volkswagen 6.5%, BMW 5.7%, Daimler 4.4%, and Fiat 3.8%.15

Ferraris premium pricing resulted in a gross margin that was more like a Silicon Valley Internet firm than an automobile manufacturer. As illustrated in Exhibit C, Ferraris gross marginnet revenues less direct costswas 45.5% in 2014, more than double that of any other major automobile company. That large gross margin in turn generated an extremely large operating margin (EBIT as a percentage of sales) of 14.1%, again the highest in the industry.

The spread between the two margins, gross less operating, wasat 31delivering financial results far beyond an automaker. That same spread averaged only 12% amongst a peer group of luxury automobile manufacturers, and was twice that of other major players.16 This despite the fact Ferrari was dwarfed by the others in terms of size in vehicles sold, employees, revenues, or even total profits.

Ferraris IPO on Tuesday, October 20, 2015, was by all standards a huge success. Of the 189 million shares authorized in Ferraris incorporation, 17.2 million (9.1%) were sold to the public. At a launch price of $52 per share, Fiat raised $894.4 million. The over-subscription allowance raised another $28.6 million, bringing the total to $923 million.

One of the drawbacks associated with the IPO was that the capital raised was not targeted for reinvestment into the business, as was common in many IPOs, but rather to compensate existing owners (Fiat) for reducing their interest. For a company that believed in investing in technology, this was a loss.

Price Growth

Ferrari has provided some insight into the potential of automobile price growth, repeatedly noting it was committed to raising the average price point of its products. Assuming that the scarcity discipline toward volume growth is maintained, and attention is focused on maintaining a four month waiting period for orders, the baseline analysis assumes that price may grow 2% per year. It is possible, however, that more aggressive annual price increases of 3% to 4% may be achievable.

Other Revenues

Ferraris income from the sale of engines to Maserati, rental incomes, and sponsorship associated with the brand are all expected to grow a moderate 3% per year. Formula 1 income, a small component that leadership believes is critical to the brand, is only expected to grow 1% annually.

Cost of Sales Changes and Gross Margin

Ferrari purchases from a small set of suppliers working under relatively long contracts. It employed 2,858 workers and turnover was low. Labor costs and costs of sales were expected to grow at 2% per annum in the baseline analysis.

SG&A and R&D Expenses

This was in the eyes of many the second most critical valuation component behind that of volume sales. If SG&A and R&D expenses both only grew at 2% per annum, reflecting what many analysts believed to be the companys cost discipline and strategy moving forward, Ferraris operating margin would indeed grow considerably over the 10-year forecast period.

Depreciation and Capex

In its prospectus, Ferrari noted that there would be little additional investment in plant and equipment necessary for expanding volume production in the coming years. The company considered itself inherently agile, production increases were nominal in size, and sufficient capacity existed.

At the same time, historical financial statements indicated continuing capital investments in both PP&E and intangible assets (intellectual property and related engineering knowledge). Depreciation expenses had totaled 120 million in 2013, 126 million in 2014, and were expected to total 130 million in 2015. The DCF baseline analysis assumed no growth from 2015 levels in line with managements direction. However, many analysts believed capital investment had to grow, at least in line with direct costs, if Ferrari is to maintain its technological edge. Capex and depreciation were assumed equal in size in the valuation analysis.

Net Working Capital

Ferraris net working capital (NWC) was unusually long in duration due to its dealer network financing program. Ferrari provided extremely low-cost loans to its dealerships (independently owned businesses) to aid in their purchase of the automobiles for resale. The loans were typically secured by the titles to the cars or other collateral. Total receivables, trade receivables for the cars themselves, and receivables from financing activities, loans to the dealerships, had averaged 180 days of sales in 2014. Ferraris hand-crafted manufacturing had averaged inventory levels of 72 days of cost of sales, and trade payables at 130 days of cost. The baseline DCF analysis therefore assumed 180/70/130 days in A/R, inventory, and A/P going forward.

Terminal Value

Most valuations assume a business like Ferrari will continue to operate for many years. The TV in Exhibit D uses the typical perpetuity calculation form. In an attempt to be conservative with the TV, net free cash flow (NFCF)the sum of net operating cash flow after-tax plus depreciation, capex, and changes in working capitalis assumed to grow at 0% for all years past 2025. The TV for the baseline case, using the corporate cost of capital (discussed next) as the discount rate and assuming a 0% perpetuity growth rate, is 13.748 billion:

Terminal value=NFCF2025 (1+g)kwaccgTerminal value=NFCF2025 (1+g)kwaccg

=1,194.13(1+0%)8.686%0%=13,748=1,194.13(1+0%)8.686%0%=13,748

Note that despite using conservative assumptions, TV still makes up 59% of the total NPV.

Cost of Capital

The final component of the valuation was the calculation of a weighted average cost of capital (WACC) for Ferrari. This was of course challenging given that the company was just now moving from being privately held to being publicly traded.

Debt

Estimates were needed for two costs of debt, both euro-denominated.17 The first was the baseline cost of debt in the European Union and euro-denominated markets, the 10-year German government bond rate. This was considered the risk-free rate of interest in the euro markets (kRF),(kRF), and was currently at 4.000%. The second cost of debt needed was for Ferrari itself (kD).(kD). Although the firm had incurred little debt of its own to date, European banks were quoting the company a rate of 6.000% (therefore a 2.000% credit spread over the risk-free rate). With an effective tax rate of 33.5%, the after-tax cost of debt was 3.990%.

Equity

To estimate the cost of equity (ke)(ke) using the capital asset pricing model (CAPM), assumptions need to be made about the risk-free rate of interest (kRF),(kRF), the market risk premium (MRPm),(MRPm), and Ferraris beta ().(). The cost of equity was then calculated as the risk-free rate plus a beta-adjusted market risk premium:

Cost of equity=ke=kRF+MRPmCost of equity=ke=kRF+MRPm

The risk-free rate was 4.000%, and the market risk premium (MRPm),(MRPm), the average spread of expected returns on equities in Europe over and above the risk-free rate, was currently assumed to be about 5.500%.

Estimating Ferraris beta ()() was in many ways guesswork with no real trading history. A companys beta was measured over time, statistically, as the covariance of the companys return with that of the market, divided by the variance of the market return. By definition the beta of the market was 1.0. A firm with returns that were relatively less volatile than the market might have a beta less than 1, typically between 0.6 and 1.0. A firm demonstrating more volatile returns than the market may have a beta as high as 1.8 or more. With no history, and no clear conclusion over whether Ferrari was an automaker or a luxury good in the eyes of the market (at least not yet), a conservative assumption was a beta of 0.9. The resulting cost of equity was 8.950%.

Cost of equity=keCost of equity=ke

=4.000%+(0.905.500%)=8.950%=4.000%+(0.905.500%)=8.950%

As illustrated in Exhibit E, current estimates of the market cost of debt and equity were used to calculate a weighted average cost of capital (WACC). Ferraris capital structure was largely equity, with interest bearing debt outstanding of 510 million, representing only 5.3% of its capital structure. Note that this analysis calculates Ferraris equity value on its market value, meaning equity value is the companys market capitalization, the share price of 48 per share (market close on December 31, 2015) for the 189 million shares outstanding. The WACC was calculated as 8.686%.

* Uses share price of 48 per share (closing price December 31, 2015) and 189 million shares outstanding.

Using the calculated WACC for Ferrari and its projected cash flows, the baseline DCF analysis in Exhibit D estimated a present value of net operating cash flows of 10.135 billion. The present value of all projected operating cash flow accruing to equity was 9.625 billion after netting the 510 million in company debt. Given 189 million shares, this was a per share value of 50.93 ($56.02 at $1.10 per euro). Further sensitivity and scenario analysis were obviously needed to provide more of a range and context for the DCF valuation.

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