Ferrari: Low Cash Conversion Makes It Look Very Expensive

seekingalpha09-04

Ferrari's strong brand heritage and Veblen effect allow it to increase prices while maintaining or increasing demand, ensuring high profitability and exclusivity.Despite a pristine balance sheet and ...

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So up until now, I have only covered the big French fashion luxury houses. Today, I want to switch over to Italy and write about Ferrari N.V. (NYSE:RACE). Since Ferrari is one of the most-known brands in the world, I will skip the rest of the introduction and dive right into it. Ferrari's Operations Ferrari operates in two main business lines: (1) Cars and spare parts and (2) Sponsorship, commercial and brand. The third \"Other\" line is mainly related to financial services and some other activities, I won't bother with it because it is meaningless overall. \"Cars and spare parts\" is pretty self-explanatory. It is the largest business line with 86% of total revenues. Ferrari manufactures and sells a variety of luxury sports cars and divides their cars into (a) Range Models and (b) Special Series and Limited Edition Models: (a) Range Models (Q2 24 Investor Presentation - Slide 15)(b) Special Series and Limited Edition Models (Q2 24 Investor Presentation - Slide 16) Range Models are as far as you will get to \"everyday vehicles\", including various models of the Ferrari Spider or the Ferrari Purosangue which is a sort of Ferrari SUV. The Special Series and Limited Edition Models are exactly as described, highly exclusive Models that cost a small fortune. The 499P Modificata for example comes in at $5.4 million, without VAT of course. \"Sponsorship, commercial and brand\" includes net revenues earned by Ferrari's racing teams (mainly in the Formula 1 World Championship and the World Endurance Championship) through sponsorship agreements and Ferrari's share of the Formula 1 World Championship commercial revenues. Revenues generated through the Ferrari brand like fashion collections, licensing and royalty income is also included here. Up until 2023, Ferrari also reported \"Engines\" as a separate business line. Since 2024, Ferrari stopped reporting this as a separate revenue source because the supply contract with Maserati (which was the main customer for the engines) ended at the end of 2023. Here is a table showing the revenue mix since Ferrari's IPO back in 2015: Ferrari Revenue Mix (Company reports - Compiled by Author) Here we can see that the Engines segment became meaningless over the past few years, while Cars and spare parts extended their relevance to the current level of 86% of sales. Sponsorship & Brand revenue is nearly unchanged in nominal terms (€488 million in 2016 vs. €608 million for the trailing twelve months), but down in mix due to the rise in Cars and spare parts revenue. For now, we can conclude that Cars and spare parts is, unsurprisingly, by far the most important business line for Ferrari. Brand Heritage The next topic is \"Brand Heritage\", which is the main reason for Ferrari's success. Besides Ferrari, there are several other high-end car makers like Aston Martin, Lamborghini (part of Volkswagen AG), Maserati (part of Stellantis N.V.) or Bugatti (majority stake sold by Volkswagen AG in 2021). Bugatti was sold by Volkswagen AG due to ongoing unprofitability. Aston Martin stock is down 95% over the past 5 years. The only peers for Ferrari would be Maserati and Lamborghini. According to the annual reports of Volkswagen AG and Stellantis N.V., Maserati increased total vehicles sold from 23.4 million to 26.7 million and Lamborghini from 8.9 million to 10.6 million in 2023. For comparison, Ferrari shipped 13.6 million vehicles in 2023 (more on that later). So Maserati sells around 2x the number of Ferrari while Lamborghini sells a bit less. Unfortunately, Maserati and Lamborghini are not separately listed entities. Since we can't directly participate, I won't bother with a more detailed comparison. Ferrari has a great overview of its history on its website, so I will just lose some words on the most important things. Ferrari S.p.A. was founded in 1947. In 1961, Ferrari made a very important strategic decision when some top executives were fired due to differences in opinion regarding the direction of Ferrari. While the founder Enzo Ferrari wanted to maintain the exclusivity and high performance of the brand, the executives wanted to increase production volumes which would have diluted the Ferrari brand. If Enzo Ferrari hadn't had the last word back then, Ferrari most likely wouldn't exist in its current form. In 1969, Ferrari was acquired by Fiat due to financial difficulties, only to be spun off from Fiat Chrysler in 2016, leading to Ferrari now trading as a separately listed entity for nearly a decade. Since its IPO, Ferrari returned 806% or 28.6% CAGR not including dividends. Without a doubt, the Ferrari spin-off was an incredible success. Racing Throughout the 1960s and 1970s, Ferrari dominated the racing world with legendary drivers such as John Surtees, Niki Lauda and Jackie Stewart. This success story was later continued by Michael Schumacher who won the Formula 1 World Championship seven times, in the years 1994/1995 and then each year from 2000 to 2004. In 2025, Lewis Hamilton, the most successful Formula 1 driver of all time (ranked by the number of wins), will drive for the Ferrari Formula 1 team, also called \"Scuderia Ferrari\". So throughout the racing history, Ferrari was one of the most successful brands to grace the racing tracks. This racing heritage is deeply enrooted within the Ferrari brand which makes it so strong. Veblen Product In the comment section of my Hermès articles, some of my readers pointed out that what Hermès sells is called Veblen products. Since I didn't know about this term, I educated myself and will share my findings here. In textbook economy, we learn that there is a relationship between pricing and demand, also called the law of demand. If I sell Lemonade at $1 per bottle, I will have some buyers. If I sell it at $10 per bottle, the number of buyers (aka demand) will decrease. If I start selling it at $0.10 per bottle, customers will rip it out of my hands. So in conclusion, rising prices will lower demand and vice versa, which makes perfect sense. Now for a Veblen product, this isn't the case. For Veblen products, the demand increases as the price increases, a contradiction to the law of demand. The term is named after Thorstein Veblen, an American economist and sociologist who died in 1929. Veblen explained this phenomenon with \"status-seeking\", the idea that the longing for status acts as an incentive to spend. As an investor, this is our dream. A company that can raise prices while increasing demand at the same time. Of course, this is a very hard thing to do and can only be done by the strongest brands in the world which sell very scarce products at the same time. Both of this is true for Ferrari and it explains Ferrari's success story. Financials As usual, I will split the \"Financials\" section into three parts: Balance sheet, Earnings, and Cash Flows. Let's start with the balance sheet. 1. Balance Sheet Regarding the balance sheet, I usually look at only two metrics: Capital Employed and Net debt. As for net debt, Ferrari reports what it calls \"Net Industrial Debt: Net Industrial Debt (Q2 24 Earnings Release - Page 14) It is common practice for car manufacturers to offer financial solutions like financing or leasing to their customers. Net Industrial Debt excludes the net debt that stems from Ferrari's financial services activities which makes perfect sense. I also exclude lease liabilities, so Ferrari's net debt stood at €315 million at the end of Q2 24. Compared to the TTM operating earnings (or EBIT) of €1.75 billion, the net debt position is meaningless. Ferrari's balance sheet looks very strong. Regarding Capital Employed, I calculate it as Shareholder's Equity + non-current liabilities - net cash if there is any. Since Ferrari had no net cash since its IPO, we don't need to bother with this position. Here is a chart showing the development of Ferrari's Capital Employed since its IPO in 2016: Ferrari Capital Employed (Company Reports - Compiled by Author) As an investor, we want to see a steady rise in Capital Employed coupled with consistent or rising returns on capital (ROCE). Here we can see that Ferrari was able to increase Capital Employed steadily, a good sign that Ferrari was able to \"create value\" as I always call it (I will come back to this process later). To conclude this balance sheet analysis, Ferrari has a pristine balance sheet and the rise of Capital Employed is a good indicator that it can consistently create shareholder value. 2. Earnings I will start this section with a discussion of Ferrari's revenue drivers. Usually, the assumption is that luxury goods manufacturers increase supply very carefully while using the pricing power of the brands to increase revenue. With supply growth in the low single-digits and pricing growth in the mid-single-digits, these companies can grow revenues in the high single to low double-digits over very long timeframes (which is also the reason for the very high valuation multiples these companies demand). So naturally, the first thought would be that Ferrari increases the vehicle supply far below prices. Let's see if this is true. Here is a chart showing the YoY change in shipped units and revenue per unit: Shipped Units vs. Revenue per Unit YoY (Company Reports - Compiled by Author) I calculated revenue per unit by dividing the revenue from the cars and spare parts segment by the number of shipped units. Here we can see that Ferrari indeed increased prices in the mid-single-digits, excluding the outlier years 2018 and 2023. However, Ferrari also increased the number of shipped units at an unusually fast pace. For the TTM, shipped units are only up 0.6% compared to the full year 2023, so Ferrari seems to be aware of this and started to slow this process while simultaneously increasing prices at a faster rate. This is a good thing, at least for long-term investors, because it conserves the status of Veblen products. The next thing I want to talk about is margins. But first, I have to lose some words on accounting because it is important in the case of Ferrari. Since Ferrari is based in Italy, it doesn't adhere to US-GAAP accounting standards. Instead, Ferrari uses the International Financial Reporting Standards (\"IFRS\"). IFRS has some differences from US-GAAP. In the case of Ferrari, the problems arise from different ways it can account for R&D costs. After US-GAAP standards, R&D costs are usually expensed when they occur. IFRS standards on the other hand allow companies to capitalize R&D costs if some criteria are met. Ferrari decided to capitalize R&D costs that are attributable to \"new technologies\", so electric and hybrid vehicles, and only expense R&D costs for combustion vehicles when they occur. This led to artificially higher operating earnings. Since this sounds very technical, let me show you in numbers (in € million):   Year 2016 2017 2018 2019 2020 2021 2022 2023 TTM   IFRS R&D Expenses 614 657 643 699 707 768 776 882 909   Actual R&D Expenses 651 742 846 890 847 937 934 987 1,020   Difference (positive earnings effect) 37 85 203 191 140 169 158 105 111   as % of EBIT 6.2 10.9 24.5 20.8 19.5 15.7 12.9 6.5 6.3   Click to enlarge The actual R&D Expenses are the directly expensed combustion R&D expenses plus the capitalized part of Intangibles CAPEX (which is separately reported by Ferrari for clarity). The IFRS R&D expenses are lower because the amortization on past R&D expenses (that were capitalized) is always lower than the capitalized number for the current year. We can see that this effect was extremely high in the years 2018-2021. It became less relevant over the past few months but still makes up over 6% of EBIT. Going forward, I will use what I call the R&D Adjusted EBIT (I will just call it EBIT or operating earnings going forward). Since I don't know the exact tax effects, I will stick with EBIT and ignore net earnings. Here is a chart showing Ferrari's EBIT since its IPO in 2016 (in € Thousands): Ferrari EBIT since 2016 (Company Reports - Compiled by Author) Ferrari has grown EBIT at a CAGR of 15.3% since its IPO in 2016, a very impressive growth rate. We can see a big jump in 2023 which is related to margin expansion. Revenues grew at a CAGR of only 9.8% in the same timeframe (still impressive) so there must have been quite some multiple expansion. Here is a chart showing Ferrari's EBIT Margin development since the IPO: Ferrari EBIT Margin since 2016 (Company Reports - Compiled by Author) As we can see, FY23 saw a big jump in profitability. If we go back to my \"Shipped Units vs. Revenue per Unit YoY\" discussion, this makes a lot of sense. FY23 was the year with the by far largest price hikes since Ferrari's IPO in 2016. Logically, margins will rise. Meanwhile, Ferrari still managed to increase shipped units by 3.3%. This is the power of the aforementioned Veblen effect and the strong brand. The price hikes weren't the only reason for the margin increases though. At the beginning of this article, I mentioned that Ferrari used to sell engines to Maserati. I assume that this was a less profitable part of Ferrari's business. Another reason is simply that Ferrari increased the number of shipped units and therefore benefits from scale efficiency. The more vehicles it produces, the lower costs per unit get. Ferrari increased shipped units at a CAGR of 7.9% since its IPO in 2016 and still only manufactures around 14,000 cars annually. There is much more room for scale efficiency going forward. Let me end this section by taking a look at Ferrari's ROCE. I always calculate ROCE as Operating Earnings (or EBIT) divided by Capital Employed. Here is a chart showing Ferrari's ROCE since its IPO in 2016: Ferrari ROCE since 2016 (Calculated by Author using Company Reports) Here we can see that Ferrari usually generates returns on capital (or ROCE) in the range of 20%+. As I said earlier, we want to see consistent returns on capital coupled with a growing capital base, something that Ferrari delivered masterfully. High returns on capital show that a company can consistently create value for us. As one of my favorite investors Terry Smith said: If a company generates returns on capital above its cost of capital, it creates value. If it generates a return on capital below its cost of capital, it destroys value. 3. Cash Flows Cash Flow is Ferrari's big weak point. Let me start with Ferrari's definition of Free Cash Flow: Ferrari Free Cash Flow Definition (Q4 23 Earnings Release - Page 14) Ferrari reports the classic Free Cash Flow (FCF), defined as Operating Cash Flow - CAPEX. Besides that, Ferrari also reports what it calls \"FCF from Industrial Activities\", excluding FCF from the Financial Services operations. I will not follow this logic and use my own calculation of FCF (in € Thousands): Author's FCF Calculation (Numbers from Company Reports) I adjusted CAPEX by sales of PPE and deducted payments for lease liabilities and share-based compensation (which I always treat as a cash expense). To explain my reasons for deducting payments for lease liabilities, I would have to do another deep dive into IFRS accounting. I will spare you and answer any questions in the comment section. The problem with Ferrari's Cash Flows becomes clear when we look at the title-giving rate of cash conversion. Cash conversion tells us how much FCF a company generates for every $ or € of earnings. In the case of Ferrari, I will divide my FCF numbers by my EBIT numbers. Here is the result:   Year 2016 2017 2018 2019 2020 2021 2022 2023 TTM   Cash Conversion (%) 119.2 35.7 44.0 80.3 16.1 56.7 52.6 53.0 49.8   Click to enlarge Ferrari's cash conversion ratio is low. If we exclude the outlier years 2016 and 2020, Ferrari's average cash conversion is slightly above 50%, so Ferrari earns around 50 Cents in cash for every $/€ of earnings. This makes sense because, unlike Veblen product peers like Hermès, manufacturing cars is capital-intensive compared to producing silk scarves of leather bags. Valuation The problem that arises from the aforementioned low cash conversion rates becomes even clearer when we try to value Ferrari. As I am writing this Ferrari is trading at $486.02 on the NYSE or €443.55 in Milan, Italy (closing price). I will just use the € amounts because the reported earnings and FCF numbers are also € numbers. With 180.2 million fully diluted shares outstanding, Ferrari is currently valued at €79.93 billion ($88.21 billion). The R&D Adjusted EBIT currently amounts to €1,637 million for the TTM. So Ferrari currently trades at 49x operating earnings, undoubtedly a high valuation multiple. However, we know that Ferrari only generates FCF of 50 Cents per €/$. In conclusion, Ferrari has to trade at around 100x FCF, right? By my definition, TTM FCF for Ferrari amounts to €816 million (if I were to use Ferrari's numbers it would be roughly €867 million). So with my number, Ferrari trades at 98x FCF. With Ferrari's number, it \"only\" trades at 92x FCF. I usually argue that long-term return prospects for any stock should always be the sum of (a) the FCF Yield (in our case 1/98 = 1.02%) and (b) the FCF growth rate. So with the FCF Yield component of this formula being so low due to the valuation, the FCF growth rate would need to be 10%+ for a very very long time. However, Ferrari has historically traded at very low FCF Yields. The market seems to value Ferrari differently than other companies. Here is an overview I came up with trying to figure out how the market values Ferrari: Ferrari Valuation (Author) Right after the IPO, Ferrari was valued at only 19x operating earnings. If we exclude the outlier from the pandemic, the average Price to Adjusted EBIT multiple was around 34.3x, with the median coming in at 35.5x. Compared to the current 49x, Ferrari looks overvalued. Conclusion Since I will ultimately give Ferrari a neutral rating, expressed by my hold rating, I will skip a separate risks section and go straight into my conclusion. Ferrari is one of the strongest brands on the planet. Its brand heritage allows Ferrari to increase prices while demand increases simultaneously, also called the Veblen effect. Quality-wise, Ferrari is in a league of its own with the likes of Hermès. As for the financial analysis, Ferrari has a very strong balance sheet and consistently generates value for its shareholders by growing the capital base (Capital Employed) and returns on capital (ROCE). Surprisingly, Ferrari relied more on increasing production volumes or \"shipped units\" as I expected. Big price hikes in 2023 led to new heights in profitability. Ongoing scale efficiencies and price increases above production cost increases should allow Ferrari to further expand margins going forward. Ferrari's biggest weakness is the low cash conversion ratio due to car manufacturing being a capital-heavy business. The low cash conversion ratios make Ferrari look very expensive from a traditional FCF approach. Ferrari currently trades close to 100x FCF. However, the market seems to value Ferrari by its EBIT rather than FCF. Excluding some outlier years, Ferrari traded at around 35x EBIT. At the current valuation of close to 50x EBIT, Ferrari seems overvalued.  In conclusion, I will have to initiate coverage on Ferrari with a neutral rating, expressed by my hold rating.","kind":null,"is_publish_news":true,"is_publish_highlight":false,"is_publish_live":false,"is_publish_wemedia":null,"editions":null,"column":"","sentiment":"0","news_tag":"","news_rank":0,"symbols":[],"gpt_button":0},"commentList":[],"isCommentEnd":true,"newsSizeData":{"likeSize":0,"commentSize":0,"repostSize":0,"favoriteSize":0,"likeStatus":false,"favoriteStatus":false},"APP":{"userAgent":"Mozilla/5.0 AppleWebKit/537.36 (KHTML, like Gecko; compatible; ClaudeBot/1.0; +claudebot@anthropic.com)","isDev":false,"isTTM":true,"deviceId":"web-server-community-laohu8-v3","version":"4.29.2","shortVersion":"4.29.2","platform":"web","vendor":"web","appName":"ttm","isIOS":false,"isAndroid":false,"isTiger":false,"isTHS":false,"isWeiXin":false,"isWeiXinMini":false,"isWeiBo":false,"isQQ":false,"isBaiduSwan":false,"isBaiduBox":false,"isDingTalk":false,"isToutiao":false,"isOnePlus":false,"isHuaWei":false,"isXiaomi":false,"isXiaomiWebView":false,"isOppo":false,"isVivo":false,"isSamsung":false,"isMobile":false},"href":"/m/news/2464377277"}