We recommend the purchase of Exor preference shares (EXP IM) which could ultimately be worth ~€21, representing ~75% upside from current prices based on a Fiat share price of €15 and a discount to the NAV of Exor's publicly listed holdings of 25%.  Various stub and capital structure arb positions could make some sense but we focused on capitalizing on the undervaluation of Fiat, Exor share price to its' NAV and Exor preference to ordinary shares. Despite recent appreciation, we believe that the shares still afford an investor significant upside.

NOTE - Market cap listed above is based on the preference share price.

Thesis summary

• At current share prices for Fiat (€ 9.89) and Exor preference (€ 12.14), an investor would pay € 2.60, netting out Exor's publicly holdings and Fiat's listed stake in CNH, for Fiat's automobile and commercial truck businesses which are worth over € 9 and should generate over € 3 per share in EBITDA in a pessimistic scenario.

• Discounts should continue to close for both the discount of Exor preference to ordinary (currently at 23% down from 40% 3 months ago) and discount of both to NAV.
• Conglomerate discounts on Fiat and Exor should continue to diminish with the de-merger of Fiat, a rebound in Fiat's performance with economic stabilization and further evidence of corporate governance improvements at Exor. This would be especially true if Agco's publicly expressed interest in CNH were to lead to a bid.
• Exor preference shares should trade close to parity with its' ordinary shares as investors take note that the Company is aggressively repurchase the preference class, ~2.5% purchase in the last 3 months. The Company treasury now holds over 12% of the preference class. 

 Background

            Exor is the Agnelli (founder of Fiat) family's publicly listed holding company formed out of the merger of IFI and IFIL in early 2009. Fiat has long been a substantial portion of the Net Asset Value, if not dominating it as it does now. The Company is substantially owned (over 51% of combined shares) and controlled by Agnelli descendents. However, the CEO and other executives are the significant decision makers as the Agnelli family takes a deferential stance towards executives whom they trust, especially at portfolio companies, evidenced by Marchionne's threat to leave Fiat had the Agnelli's lost control in 2005 (http://www.bloomberg.com/apps/news?pid=newsarchive&sid=azISsGbxSFPo) .

 Current valuation

            At current market prices, Exor preference shares have an NAV of publicly listed holdings 80% higher and a total NAV 109% higher (it is coincidence that current upsides are similar to our targets presented prior).

Share classes

            The recent, extreme discount of preference shares to ordinary shares is unwarranted and was likely exacerbated by the unwinding share class arbitrage positions. After consulting Italian legal experts, we believe that Exor preference shareholders have adequate legal protections. Preference shareholders have an equal economic claim on the firm, but have priority in dividends and liquidations. Italian securities law stipulates that companies may not take actions that materially disadvantage one share class over another. Despite egregious past examples of unequal treatment, it seems Italian regulators have become more protective of minority shareholders (mentioned later). Despite not having a vote at the annual general meeting, Exor preference shareholders arguably have better voting rights for two reasons: 1. The Agnelli family controls over 50% of the ordinary share class making separate ordinary share class votes meaningless in many circumstances; 2. Preference shareholders have greater influence over an extraordinary shareholders vote, although this may not afford substantial protections. 

Exor management

In spite of mitigating factors, Exor investor's should consider the effects of management influence, namely corporate governance and capital allocation, within a company whose chairman and controlling shareholder representative (John Elkann) is a 34 year old heir to a multibillion €o fortune. However, former business associates and advisors paint a picture of a serious, motivated businessman who is driven by facts and trusting in his appointed executives. Exor's management team consists of individuals with significant experience in operating businesses and within capital markets.  In our discussions with the Company, management has reiterated the Company's stated principle of diligently compounding NAV utilizing its' patient, permanent capital. As far as economic incentive alignment, the Agnelli family has a lot at stake given its' ownership of 51% of Exor equity. We like the fact that both the Company and the Agnelli family are purchasing a greater percentage of the preference class.

Corporate governance

We believe that corporate governance concerns, although present, are mitigated by: 1. The Company's concerted effort to address and reduce conflicts (http://www.exor.com/uploads/683515-CORPORATE%20EXOR%20ING%202009%20internet.pdf ; http://www.exor.com/sito/procedure/en/EXOR_Related_party_transactions-English.pdf); 2. A completion of an IFI-IFIL consolidation which reduces conflicts; 3. Current pressure and undesired scrutiny from CONSOB (Italian securities regulator) on Exor; 4. New Italian regulations protecting minority shareholders such as new related party rules adopted in 2010.  In the context of corporate governance, two episodes warrant mentioning, an equity swap for Fiat stock executed in 2005 and the IFI-IFIL consolidation. Summarily, in 2005, IFIL and Exor executed an equity swap on Fiat to retain control of Fiat after dilution from convertible debt without triggering a mandatory bid for the entire company per CONSOB regulations (http://www.economist.com/node/5026856). We view this simply as a measure for the Company and the family to retain their Fiat legacies with limited cash resources, and do not view this as harmful to Exor/IFIL shareholders per se.

 In 2008, Exor was created by merging IFIL into its' majority shareholder (~70%) IFI whose only material asset were shares in IFIL. IFI had an unlisted class of ordinary shares and a listed class of preference ("preference") shares (which survive as the Exor preference shares), while IFIL had listed ordinary and savings shares. The controversial aspect was the choice of an exchange ratio of 0.265 which was a blend of: 1. The trailing 6 month ratio of IFI preference (now Exor preference) and IFIL ordinary ; 2. The ratio of NAV's between IFI and IFIL. Leonardo & Co. (a holding of IFIL's) and Goldman Sachs advised on the deal. Preference shareholders were unhappy about using the ratio of the trading prices as this incorporated the discount to NAV at which IFI preference shares traded. Had the ratio of NAV's been used the ratio would have been closer to 0.2. We are not overly concerned given that it could be argued that the preference share price discount appropriately reflected different rights and it would have been in the Agnelli's best interest to use only NAV values to the disadvantage of IFIL shareholders. We believe the outcome represented a middle ground.

Capital allocation

            Exor's capital allocation seeks to maximize NAV and outperform the MSCI World Index over a long time horizon by patiently deploying capital into businesses in an active manner to improve long term performance [check recent investments]. While our preference would be for a static portfolio to reduce uncertainty, the Company has made generally good investment decisions over the last 5 years with some notable exceptions like the purchase of a portion of Cushman & Wakefield in 2007.  Interestingly, the glacial investment pace is a reason cited by sellside analysts for their low opinion of the stock. We disagree with a view expressed by HSBC in July 2008: "IFIL missed the golden years of private equity (2002-2005) However, IFIL has not changed its business model from a traditional holding company into a private equity fund model." As mentioned, Exor has increased the rate of share buybacks, although admittedly we would like to see an even faster rate and the deployment of all investment monies into its' existing portfolio at half off.

Fiat

            As the value is driven by the discount of Exor preference shares, we will be brief in laying out our thesis on Fiat. A previous Fiat write-up covers some additional background.

• Fiat is in the midst structural and operational changes which could create significant value and lead to a higher collective valuation of the company's assets:
  • Sergio Marchionne, Fiat's much lauded CEO, intends to continue dramatic operational improvements and cost cutting which he started in 2004 and which were partially derailed by the dramatic global recession of 2008 & 2009. In pointing out Marchionne's inability to meet his previous 5 year targets, many sellside analysts fail to mention the attenuating circumstances of a dramatic global recession and credit crisis.
  • Marchionne has extremely ambitious plans to increase Fiat's annual automobile sales from 2.2MM in 2009 to 3.8MM in 2014 which would contribute to the approximate doubling of Fiat automobile's revenue from ~€32bln to €64bln over the same timeframe. Getting less than half of this targeted increase could justify a stock price 130% higher without considering a potential Chrysler turnaround.
  • Fiat struck an extremely advantageous deal for Chrysler which will give the Company 200,000 in incremental car sales and €350mln in cost savings, conservatively. This doesn't include the potential 50-100% upside solely from a Chrysler turnaround through a potential 35% equity stake in Chrysler that Fiat received for nearly zero incremental investment.
• With no growth and limited rebound, Fiat could be worth €16 assuming fairly conservative margins and multiples [Base case]. Getting even halfway to Marchionne's plan, Fiat could be worth €18-€30 (€25-€40 with a Chrysler turnaround) [Upside]. With the draconian assumption that the auto business is worth zero, Fiat could be worth approximately €5.
• By year-end 2010, Fiat intends to break-up into 2 companies, Fiat automobiles and Fiat industrial. This separation should reduce the discount associated with Fiat's industrial segments being conglomerated with Fiat's lower-quality automobile assets.

Management

Fiat management centers on the exceptional operational and management talent of Sergio Marchionne. In speaking with contacts, he has wrung costs out of Chrysler in months that no previous operator had found. His enthusiasm for turning around Fiat and building a globally competitive company is apparent.

Valuation and financials

            Relative to Fiat circa the previous write-up, Fiat automobiles is significantly more attractive with a leaner operation and more exposure to Brazil. Our conservative base case assumes limited rebound in financial performance and marginal synergies from collaboration with Chrysler. Our valuation by segment is as follows:

To support our revenue and margin assumptions, here are segment performance metrics for 2008 and 2009:

In thinking about the optionality on the upside, we assume that Fiat achieves a lower percentage of Marchionne's goal with shortfalls deducting from margins at 15% incremental rate. Here are our assumptions as a percentage of TOTAL revenue (eg, 70% of 2014 is about halfway to the targeted increase):

These assumptions generate the following forecasts for the respective segments:

In valuation, we utilize 2014 estimates discounted back to 2010 at a 10% discount rate. We chose this method as we believe that significant upside in the stock rests on the relative success of Marchionne's plan.

We valued the automobile business at 4x -7x  EBITDA multiple and the industrial business at a 6-10x EBITDA multiple which we believe are substantially justified as upside multiples given comparable company multiples over long periods of time. However, this admittedly translates into a 5-6% free cash flow yield assuming capex scales down with EBITDA on a 1 to 3 basis.

Operations and competition

In the interest of brevity, we will touch on the critical Fiat automobile issues of low Italian capacity utilization and market share in Brazil and Italy, and will address the critical drivers of CNH. These are the principal issues which should drive performance. Fiat's ultimate operational goal is to drive up Italian plant utilization through the Company's growth plan. To the extent that this is not successful, Fiat will continue to clash with obstinate labor interests. We have been relieved by Fiat's recent tough stance with its' Italian base, threatening to not move Panda production without an agreement by labor unions and a public shaming that Italy is Fiat's only loss making operation. Brazil is now one of Fiat's largest markets where the Company has a leading passenger car market share at 24-25%. Fiat assumes deterioration in market share of close to 1%. Any surprising share losses or downturn in Brazil would dramatically affect financial performance. In Italy, Fiat Auto retains above a 30% market share in Italy. With a drop in subsidies, especially for CNG vehicles, we are hesitant to read much into a recent drop in overall sales and market share in Italy. North American and South American agricultural equipment are the critical divisions within CNH, given the size of their North American business and the expected growth in South America. It will be critical that CNH maintain its' top 2 presence in these markets.

Risks

Exor related

Pernicious treatment of minority shareholders through unequal share class treatment or improper transactions.

Destruction of value through ill-advised investment decisions

Fiat related

Increased investment in Italy without reaching appropriate terms with unions.

Slowdown or increasing competition in Brazil.

Severe Italian recession possibly precipitated by a debt crisis.

Continued repurchases of Exor preference shares.

Separation of Fiat automobile and Fiat industrial.