Description
Summary
I am recommending the purchase of Fiat Industrial Preferred (FIR IM) shares. Fiat Industrial Preferred (FIR IM) shares are currently trading at a 47% discount to Fiat Industrial Voting Shares (FI IM) despite representing the same economic interest as the voting shares. By acquiring these shares one is creating Fiat Industrial Preferred at 5x 2012 net earnings, which is a very attractive absolute and relative valuation. At current prices for Fiat Industrial preferred shares one is acquiring a stake in the third largest capital goods company in the world (after Caterpillar and Volvo) for less than half the multiple of comparable companies such as: Caterpillar, Deere, Volvo, MAN Group.
Background and Share Class Structure
In January 2010, Fiat Group separated its capital goods business, Fiat Industrial, and its auto business, Fiat Auto. For every share of Fiat Group, shareholders received one share of Fiat Auto and one share of Fiat Industrial. The share class structure of Fiat Group was retained. Fiat Industrial has a total of 1,276 million shares outstanding: 1,092 common shares, 80 million "preferred" shares, and 104 million "saving" shares. All shares represent the same economic interest in the company. Common shares have full voting rights. Preferred shares have limited voting rights, a preference in terms of dividends, and are senior to the voting shares in liquidation. Saving shares don't have voting rights, have a cumulative minimum dividend, and are senior to the other two classes in liquidation. For a more detailed explanation of the share classes, please see articles 6, 20, and 23, of the company's bylaws and/or pages 28 and 29 of "Information Document" published by Fiat Group on December 15,2009.
Business Description
Fiat Industrial is the third largest capital goods company in the world with worldwide sales of EUR 21.3 billion. Through its 89% ownership of Case New Holland (CNH), Fiat Industrial manufactures, markets and distributes agricultural and construction equipment. Through Iveco, Fiat Industrial manufactures, markets, and distributes a range of branded trucks and commercial vehicles. Through Fiat Powertrain Technologies, Fiat Industrial manufactures engines for industrial and marine applications. The company operates globally. It generates 24% of sales in North America, 17% in South America, 44% in Europe, and 15% in the rest of the world. Visit the Fiat Industrial website for more detailed information about the company: www.fiatindustrial.com
Investment Thesis
Fiat Industrial is an execution story, a turnaround story, and a classic spin-off story. The voting shares are reasonably valued based on current earnings but are very attractively valued if management can deliver on its financial targets. Fiat Industrial management presented 2011-2014 targets for sales, EBITDA, capex, and net debt ahead of the spin off and reiterated and reiterated those targets at its June 28, 2011, analyst day. Construction equipment, which used to generate one third of CNH's EBITDA, is currently loss making but in the process of turning around. Iveco is recovering from cyclically low volumes of truck sales in Europe. Below is a link to a presentation which includes management's recently reiterated financial targets:
http://www.fiatindustrial.com/it-IT/investor_relations/investors/presentazioni/FiatDocuments/Fiat%20Industrial_June%2028%20-%202011.pdf
In terms of spin-off dynamics, the company is still developing an institutional following. The daily dollar value of trading volume of Deere stock, which is a smaller company in terms of sales and a similar company in terms of EBITDA, exceeds the Fiat Industrial's volume by a factor of 5 to 1. Fiat Industrial is listed in Italy, which accounts for only 11 percent of consolidated sales.
Even though the voting shares might be interesting, the real opportunity lies in the preferred shares. Since the spin-off the "preferred" shares (FIR IM) have sold off significantly relative to the voting shares (FI IM). They currently trade at a 47% discount. To put it in perspective, Fiat Group's preferred shares, the predecessor company, have traded in a wide range relative to the common since 1986. At the lows they traded at a 52% discount and at the highs at a 33% premium. Even though there is no imminent catalyst for the current discount to narrow, we are close to extreme levels in terms of historical precedent.
The primary reason for the discount between the two share classes is liquidity. The voting shares trade on average 5.2 million shares a day (trailing 60 day average) versus 320 thousand shares a day for the preferred shares. I don't expect this discount to disappear entirely, even though it has at times in the past. However, I believe that dividend growth at Fiat Industrial will ultimately drive a narrowing of the discount. Fiat Industrial has announced a 20% payout ratio for this year. Consensus earnings estimates are EUR 0.56 per share for 2011 and and EUR 0.82 per share for 2012. The current dividend level is not meaningful enough to entice investors to accept lower liquidity; however, in a few years it will be. The company has announced that it will be debt free by 2013 and will revisit its payout ratio then.
Valuation
By acquiring the preferred shares, one is creating the company at a EUR 5.6 billion market capitalization. Add net industrial debt of EUR 2.1 billion to arrive at an enterprise value of EUR 7.7 billion. For companies that have financing businesses such as Caterpillar, Deere, and CNH, one excludes the financial debt and financial assets from the enterprise value calculation, and one includes the value of the finance subsidiary at book value or a multiple of book. In this case, I will exclude the value of the finance subsidiary for simplicity. Consensus EBITDA for this year and next is EUR 2.3 and EUR 2.7 billion. Based on consensus EBITDA, one is creating the Fiat Industrial through the preferred shares at 3.4x this year and 2.9 next year's EBITDA. Consensus estimates are conservative relative to management's financial targets. In its financial projections management estimated that it would be debt free by 2013, and it is targeting an EBITDA of EUR 4.1 billion by 2014. In terms of earnings, the company is trading at 7x 2011 and 5x 2012 consensus earnings. This is roughly equivalent to half the multiple of comparable companies. In summary, the valuation provides a significant margin of safety if management does not deliver on its plan and significant upside if it does.
Risks
Execution- Management's targets are ambitious, but they are not unrealistic. The margins embedded in the targets are reasonable on a business by business basis when compared to other companies with similar scale, market share, and geographic footprints.
Cyclical risk- This is the biggest risk. If the economy goes back into recession or if farm incomes decline, sales and profitability will be significantly impacted.
Catalyst
There is no hard catalyst.
Management execution.
Deleveraging and a higher dividend payout ratio.