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Stock Strategist

Fiat's Patience Pays Off

We applaud management for remaining constant in the face of union pressure for a higher price.

 Fiat  said Wednesday that it had reached a deal with a United Auto Workers trust to buy the part of Chrysler it doesn't already own. In mid-December, we said Fiat would pay EUR 3.2 billion for the rest of Chrysler. At the current exchange rate of $1.3738 to EUR 1, $4.35 billion is EUR 3.166 billion. The final consideration is not what the union said it expected to get from an initial public offering, which was more than $5.0 billion.

We do not anticipate any change to our $19 and EUR 14 fair value estimates for Fiat, since we hit the valuation nail squarely on the head. However, there could be a slight upward bias because we included the assumption that the deal would be closed by the end of the second quarter. With the deal closing possibly Jan. 20, nearly two quarters of Chrysler earnings at 100% of ownership are not accounted for in our fair value estimate. But since the incremental earnings are in the first part of our five-year discounted cash flow model, we expect the upward bias to be minimal. Still, the 5-star-rated shares represent exceptional value for those investors who are willing to accept the risk of a highly leveraged turnaround situation in a cyclical, capital-intensive, globally competitive industry.

The deal will be funded by Chrysler's payment of a $1.9 billion dividend to its equityholders--the  voluntary employees' beneficiary association and Fiat. Fiat takes its share of the dividend and uses it in the transaction. Fiat will also take $1.75 billion from its coffers to pay for the deal. That brings the total to $3.65 billion for the Chrysler shares held by the VEBA. However, Fiat also committed to $700 million in additional VEBA funding, which brings the total to $4.35 billion. The $700 million will be paid in four annual installments. The first installment is paid at the close of the transaction to buy the Chrysler shares from the VEBA. As a result, Fiat will take a total $1.925 billion out of its cash account at closing. There will be three more installments of $175 million each in the next three years on the anniversary of the closing date.

Fiat-Chrysler Combination Has Substantial Benefits
In our view, the market has unfairly discounted the intrinsic value of Fiat. We believe there are substantial benefits to be derived from the Fiat and Chrysler combination. Greater scale can be achieved in components, platforms, and capacity. An array of brands reduces reliance on any one vehicle category. Greater scale across more geographic regions lowers the company’s costs and reduces Fiat's dependence on domestic (Italian) volume. Nonetheless, we think that only investors who are willing to accept the risks of a highly leveraged turnaround situation in an extremely competitive, capital-intensive, cyclical industry should consider investing.

In total, the combined entity has eight brands that cater to nearly all customers (passenger and light commercial). The downside to more brands is higher marketing and distribution costs. Poor product execution results in lookalike vehicles with only a grille badge to differentiate the brands. On the upside, a diversified portfolio composed of well-differentiated brands reduces exposure to any single vehicle segment and substantially increases economies of scale. The scale of the combined entity is 5 million-6 million vehicles, the sixth-largest car company in the world.

As a market leader in Brazil (23% share), Fiat will benefit from that country's rising middle class. However, the company was late to Russia, India, and China and will undoubtedly lag already-established competitors' market shares. Even so, we expect Fiat to participate in the above-industry-average growth in emerging-market demand. Jeep's re-entry into China will provide Fiat with a turbo boost to its share of the market.

While management views the group's parts-making operations as strategic to its auto assembly operations, we believe that parts and systems manufacturing should be completely separate. Even though the economic environment ultimately drives demand for both original-equipment manufacturers and parts suppliers, the dynamics of the businesses are quite divergent. However, to management's credit, profitability and returns on Fiat's parts businesses are competitive with other major European auto suppliers.

Industry Overcapacity Prevents Moat Formation
In general, automotive manufacturers are no-moat companies that lack barriers to entry (other than substantial capital investment) and make products that are easily substitutable by consumers. Fiat is no exception. Even though the automobile is a modern-day engineering marvel that requires enormous engineering talent and organizational skill to design, develop, and bring to market, a lack of barriers to entry is evidenced by global industry overcapacity of roughly 30 million units. Including Chrysler, Fiat, Ford, General Motors, and PSA Peugeot Citroen facility closures in North America and Europe from 2009 through 2014, total capacity reduction has only been around 3 million units. Most industry executives agree that overcapacity is the top problem facing manufacturers today and that the problem will only get worse, exacerbated by many manufacturers' new capacity plans in China and Mexico.

Hard-fought market share is won and temporary economic profits are achieved by three typical routes. First, automakers seek to introduce a radically new design that defines a new vehicle niche (Chrysler's introduction of the minivan in the 1980s). Second, original-equipment manufacturers race to be the first to market a dramatically differentiated technology (Toyota's introduction of the Prius hybrid earlier this decade). Finally, some firms consistently have the youngest portfolio of products through frequent new vehicle introductions and substantial redesigns. The Japanese in the 1980s and 1990s had a competitive advantage by cutting their time to market in half relative to other manufacturers. Fiat-Chrysler combined had launched approximately 15 new or redesigned models through 2011.

Even though Fiat enjoys premium pricing with its Ferrari and Maserati brands, competitors have been able to achieve the same perceived value among consumers. While these brands evoke images of wealth, luxury, and exotic street-legal racing machines, consumers of these products can switch to a competitor's product such as Lamborghini, Aston Martin, or Rolls-Royce. Also, these consumers have the wherewithal to simply add more cars to their own personal fleet of ultraluxury vehicles. In price-conscious, high-volume markets, fickle consumers can switch among competing brands, and quite often, they do. The latest fads, hottest styles, high-profile recalls, high dependability ratings from consumer publications, and utilitarian needs can all factor into consumers' buying decisions.

For penny-pinching, educated shoppers, dependable transportation at an affordable price is all that's required, and it doesn't matter which manufacturer's vehicle they buy, just as long as it's the best deal they can find. In this instance, consumers can easily switch from Fiat to Volkswagen, Peugeot, Opel, or Toyota, then back again. Other consumers view their vehicles as extensions of themselves and are willing to pay a premium for a machine that exudes a certain image. Fiat's Maserati brand might be a consideration for such a consumer, along with Audi, BMW, Lexus, Mercedes, or even Cadillac, which is enjoying resurgent popularity in the United States. However, Fiat does benefit from a sense of nationalism in its home market of Italy, just as Peugeot, SEAT, and Volkswagen do in their respective domestic markets of France, Spain, and Germany.

We consider Fiat's captive auto-parts operations to be no-moat businesses because of the intensely competitive nature of the automotive industry, the industry's cyclicality, pricing leverage exerted by external customers, and an inability to sustain returns throughout economic cycles. However, because of highly integrated and long-term customer ties, customers' steep switching costs, and moderately improving pricing power among OEM customers, some suppliers have succeeded in establishing economic moats--for example, Gentex and Johnson Controls.

Demand, Integration, and Union Pressure Are Risks
Risks include an unexpected drop in global vehicle demand, an unfavorable shift in vehicle mix, the execution risk in successfully and fully integrating Chrysler operations, difficulty in penetrating the U.S. market, government stock ownership, and a unionized workforce. In addition, if the European Union's sovereign debt crisis escalates into a severe credit crunch, consumers' ability to finance vehicle purchases may be severely constrained, potentially stifling European demand. U.S. penetration is integral to achieving greater scale.

Execution risk associated with Fiat's integration with Chrysler may be possible, but we see only a minimal probability. There's potential for a considerable amount of internal upheaval to be created when combining research and development, engineering, component suppliers, supply chain logistics, vehicle architectures, corporate functions, and rationalizing capacity. However, the group has already successfully launched new models within 18 months of Fiat's control, which is impressive, given that most development times range between 18 and 36 months.

While Fiat has had favorable union relations, a unionized workforce can become onerous. In an interview on Italian television, CEO Sergio Marchionne essentially said Fiat auto would be profitable were it not for its Italian factories, no doubt stirring animosity among Italian workforce leaders and government officials. Investors should be heartened by this comment, however, because it indicates that management will resist union pressure to coddle chronically unprofitable operations.

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