Renault SA RNO.FP
December 27, 2006 - 3:14pm EST by
jaxson905
2006 2007
Price: 90.00 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 25,100 P/FCF
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 0 TEV/EBIT

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Description

Renault is a French vehicle manufacturer producing mainly passenger cars and trucks. The company also operates their own finance company, and owns significant minority stakes in Nissan and Volvo.  Backing out the value of the publicly-traded Nissan and Volvo stakes and the book value of the finance business leaves investors paying 1x ‘07 EBITDA for the core Renault auto company:
 
                                    (€ millions)
Market Cap:                 25,100
+ Debt:                         9,600               Note: Financial Liabilities of Auto Biz
+ Pension:                    650                  Note: tax affected
- Cash:                         (7,600)
Enterprise Value:          27,800
 
- Nissan Stake:             (17,500)           Note: 44.3% stake
- Volvo Stake:              (4,600)             Note: 21.5% stake
- Fin Services Sub:       (2,200)             Note: 1x book value
Adjusted Ent Value:      3,500               Note: represents Renault’s core auto business
 
Auto Revs:                   42,400             Note: 2007 Estimate
Auto EBIT:                   850                  Note: 2007 Estimate
EBIT %:                       2.0%
+ Auto D&A:               2,700
EBITDA:                      3,500
Multiple:                       1.0x
 
I believe stock upside is as much as 40% through a valuation re-rating set to begin in 2007.  Reasons are discussed in the valuation section of the write-up.  Downside is limited to (10%), at which price you effectively get the auto business for free.
 
Several items to note on the above calculations.  First, Renault has guided the street to 3% consolidated EBIT margins for 2007.  The above 2% assumption solves for an overall 3% margin assuming the Financial Services segment generates roughly flat operating income from 2006.  Secondly, I have not haircut the minority interests as is traditionally done in these situations to account for a conglomerate discount and/or a tax bill upon a divestment.  I will address the latter issue in the valuation section of the write-up, at which point I do haircut the minority interest investments.  The above presentation is simply an attempt to convey the amount of unrealized value within Renault.
 
Auto manufacturers are generally not good businesses, but I believe 1.0x EBITDA for Renault’s auto business is just too cheap too ignore.  On a relative basis this is obvious.  Most auto manufacturers – even the bad ones facing similar structural headwinds – trade at higher multiples:
 
2007 EBITDA Multiples
GM = 5.8x
F = 7.0x
DaimlerChrysler = 4.6x
Toyota = 7.8x
Honda = 3.0x
Nissan = 4.1x
Volkswagen = 4.3x
Fiat = 4.5x
BMW = 4.0x  
Peugeot = 2.9x
Average = 4.8x
 
On an absolute basis Renault trades at an attractive FCF yield.   The core auto business will earn a 10% yield on its implied valuation in ‘07.  This is all based on the company hitting its near-term goal of 3% EBIT margins.  The company has a 2009 goal of 6% margins with the intermediate years improving EBIT in lock-step fashion.  For the majority of the write-up I will anchor the valuation using 2007 assumptions.
 
There are lots of reasons to like Renault, and just as many reasons most sell-side analysts have ‘hold’ or ‘underperform’ ratings on the company.  I’ll first discuss the positives and then follow-up with the key risks.
 
Investment Considerations
 
1) CEO Carlos Ghosn.
 
Many readers already know Mr. Ghosn, Brazilian born and French educated, as the super-star auto executive who orchestrated one of the most successful turnarounds in Japanese history.  Nissan was on the brink of bankruptcy when Carlos Ghosn took the helm in 2000.  He and his team increased Nissan’s margins from 1.4% in ‘99 to 11.1% in five years.  The company paid down its entire debt load of Yen 1.3bn, and increased its dividend every year since 1999.  The result was a substantial increase in Nissan’s share price as excess cash was delivered to financial stakeholders through deleveraging the balance sheet and increasing the dividend:
 
(Yen millions)
Year                 Net Debt          Dividend/Share             Stock Price      Yield
1999                1,349               0                                  402
2000                953                  7                                  658                  1.1%
2001                432                  8                                  695                  1.2%
2002                108                  14                                926                  1.5%
2003                14                    19                                1224                1.6%
2004                (206)                24                                1114                2.2%
2005                (373)                29                                1195                2.4%
2006                                        34                                1400                2.4%
2007(E)                                   40
 
Today Carlos Ghosn runs both Nissan and Renault, splitting half his time on each company.  This is arguably the best CEO in the auto industry running the least valued company.
 
2) Operational restructuring program.
 
The current restructuring program, aimed to improve operating margins from 2.5% (2005) to 6% (2009), was first outlined in February 2006 after Ghosn had a year to assess the operations.  The intermediate targets are as follows, along with the implied valuation for the core auto business:
 
Year                 Margin Target               Implied EBITDA Valuation on Auto Business
2006:               2.5%                            1.1x
2007:               3.0%                            1.0x
2008:               4.5%                            .8x
2009:               6.0%                            .6x
 
There is widespread skepticism that the company can hit near-term and long-term profit goals due to weak business fundamentals.  In fact, Renault’s Western European unit volumes are down 10% thus far in 2006.  It should be noted, however, that ‘07 goals are mainly affected by cost reduction plans, while 2008 will start to benefit from Renault’s product offensive, introducing a record 26 models within a four-year span (discussed below).  Ghosn’s success at Nissan was centered on his cost cutting methods, and I feel his aptitude with streamlining the Nissan organization will be dutifully applied to Renault.  Currently the global auto industry is rife with restructuring stories, all centered around cost cutting efforts.  GM aims to eliminate $9bn out of its NA cost structure – the equivalent of 8% of NA costs.  Ford has its own version. Volkswagen is undergoing ForMotionPlus, aimed to improve pre-tax profits to €5bn, or roughly 5% of revs, through better efficiencies and cost cutting.  Peugeot, another French OEM, is undergoing a 10k employee headcount reduction.  In each case, there are ample opportunities to reduce low hanging fruit through better processes, consolidation of the supply base, and reducing excess capacity.  Renault has not undergone a deep restructuring program in years, and thus I feel the opportunity to cut costs is no different within Renault as it is in its peers who are characterized as ‘restructuring stories’ and hence trade at multiples anticipatory of a successful turnaround.
 
It should be noted that Ghosn, along with Renault’s top management, will be incentivized through options based on hitting the annual targets and a larger payoff for hitting the 2009 operating margin goal of 6%.
 
3) New product line-up.
 
For the past year Renault has suffered declining volumes and market share losses in Western Europe.  Part of the share loss is due to the product cycle timing and the high average age of its model lineups, embattling the competition with a relatively younger product portfolio (especially Volkswagen).  The other reason is intentional: Renault is exiting low profitable channels -- and in some cases negative profitability -- such as the fleet channel.
 
At its current valuation I believe most of the near-term risks are priced in the stock.  Nevertheless Renault is now a timely investment idea since the company is on the cusp of a major product launch, which should help stem market share losses, grow unit volumes and revenues, and help effect positive operating leverage through higher capacity utilization.  The following is the number of new product launches lined up with Renault’s capacity utilization on an annual basis:
 
            New Product Launches            Capacity Utilization                   Margins
00        4                                              64%                                         5.0%
01        3                                              59%                                         1.3%
02        6                                              59%                                         4.1%
03        6                                              60%                                         3.7%
04        4                                              62%                                         5.2%
05        2                                              60%                                         3.2%
06        2                                              62%                                         2.5%
07E      8                                              67%                                        3.0%
08E      7                                              74%                                        4.5%
09E      9                                              79%                                        6.0%
 
The gradual progression of 60% capacity utilization in 2005 to almost 80% in 2009, mostly driven by higher unit volumes and new product launches, should result in significant margin expansion.  Most of the eight product launches in 2007 are targeted for the second half; therefore second half 2007 is likely to be the first indication of significant margin expansion towards the 6% goal.
 
It should be noted that Nissan’s turnaround exhibited similar volume and op margin goals.  Over the course of its turnaround plan Nissan increased unit sales by 1mm units, or by 44%, and in turn lifted operating profit margins to 10.5%.  Renault’s comparable unit volume target is an increase of 800k units by 2009, representing +32% from 2005’s base.
 
4) Exposure to emerging markets. 
 
Renault is well positioned in emerging markets.  The acquisition of Romanian car company, Dacia, gives the company a strong platform for Eastern European growth.  Additionally, the company has manufacturing plants in Brazil, Argentina, and Turkey. 
 
The Logan is Renault’s attempt to create a low-cost car for the masses in the emerging markets.  It’s a boxy, no-frills vehicle with a $5k sticker price aimed at the middle classes in Eastern Europe, Turkey, Iran, Russia, and soon-to-be India.  While other companies have produced low-cost vehicles often called "world cars" for sales in emerging market countries, Renault is the first company in years to do it so aggressively.  Success spurs competition, and there will be further introductions by competitors.  
 
5) The ace up his sleeve.
 
Carlos Ghosn is cognizant of Renault’s share price, and over longer periods of time does measure his success as a CEO by the shares’ performance.  The shareholder structure and Renault’s minority interests open up some interesting financial engineering scenarios whereby Ghosn can salvage his reputation as a builder of shareholder value in the event the restructuring program does not hit its internal targets.  For example, it’s been speculated Renault would look to monetize its Volvo investment and repurchase the 11% French stake in the company.  There are little synergies between the cars made by Renault and the trucks made by Volvo, and Ghosn has hinted that the Volvo stake is non-core.  2007 is the first year in which the tax treatment on a Volvo divestment will be capital gain tax free.  Proceeds could be used to buyback the French government’s stake, but I wouldn’t expect anything to happen until after the April presidential election. Obvious benefits in such a scenario include simplifying the corporate structure and hopefully creating more transparency on the company’s valuation.  I don’t portend what will happen, but it’s nice to know there are possibilities.
 
Investment Risks
 
The largest knock on Renault is that, at the end of the day, it’s a French company and will always be labored with the issues that come with such – French employees, unions, politicians, etc.  However, it’s not as bad as it appears on the surface.  Renault has moved 50% of its production outside of France.  20% of production is in low cost countries, and as new capacity comes on line this weighting will increase.  Yes the company will be bewildered with French wages and vacation time on half of its production for the foreseeable future, but manufacturing cost cutting and efficiencies will help make the company more competitive with the low cost imports entering France.  Additionally, the Japanese three (Toyota, Honda, Nissan) have not made the same market share gains in Western Europe as they have made in the US.  Their manufacturing prowess will mean further share gains in the future, and Renault, with its alliance with Nissan, will need to learn how to effectively compete against Asian imports. 
 
The other risks are rising costs at home and a global flood of cheaper cars.  Simply stated, I believe these risks were present when the company announced their turnaround plan in February, 2006, and therefore the company took such matters into account when delivering financial goals to investors.  The platforms in which to leverage company strengths to combat such forces include the company’s emerging market Dacia segment and Renault’s alliance with Nissan Corp.
 
What is the Renault Stub Worth?
 
Investors should short 695 shares of Nissan and 31.5 shares of Volvo for every 100 shares of Renault in order to hedge out the financial interests of the minority stakes.
 
I believe the stub, when taking into account book value of the financial subsidiary, should not trade less than zero, and thus downside is limited to €80.  At this price investors will receive the auto business for free.
 
In determining upside I believe a 4-5x EBITDA multiple on the stub is reasonable over time once the company successfully demonstrates to investors that the financial goals are within reach and execution is on target.  A valuation re-rating must occur for the thesis to play out, and I believe several events in 2007 will help drive multiple expansion to a ‘normal’ multiple on the stub.
 
1) We are in the early innings of an operational restructuring, and a successful execution on the first year’s targets will help convince the skeptics that Renault is in fact fixable under the tutelage of Carlos Ghosn.  GM, Volkswagen, and Fiat experienced significant margin expansion of their own once investors saw clear improvements in the core businesses.  Renault remains one of the last European auto restructuring stories that has received investors’ conviction in a successful turnaround.  This amazes me considering Renault’s CEO is superior to its European peers, in my opinion.  
 
Investors may have to wait until 2H 07 for the market to begin pricing in future margin expansion.  It is this time that Renault is scheduled to renew their aging product portfolio in a meaningfully way.
 
2) As I alluded to in my earlier comments, I believe there is a high likelihood that Renault divests its Volvo ownership in 2007, thus mitigating the SOP discount.  Ghosn first hinted of a possible divestiture in early 2006, and 2007 marks the first year in which the company can receive a very favorable tax treatment on a potential sale.  Volvo is currently under intense shareholder pressure to undergo a buyback of their own, and a transaction with Renault would be an easy solution for the capital markets.  Others have speculated that Renault in turn could repurchase the ownership stake held by the French government.  A presidential election this year could open up possibilities on this front.
 
Bears on Renault like to point that through time the auto stub has historically troughed at zero value and peaked at a multiple between 1x - 2x EBITDA.  Thus, the argument goes, Renault looks expensive today when compared to its historical trading range.  I counter that history is by no means an indication of future performance with today’s Renault.  Never before has the company had such strong leadership, lofty goals, and the ability to financially reengineer the capital structure in a tax efficient manner.  
 
Back to the upside case...out of conservatism I’ve valued the finance business at book, and I’ve applied a 20% discount to the minority interests.  Given how interlinked Nissan and Renault have become I doubt Renault will ever fully divest its Nissan stake.  In fact as long as Nissan trades at 4.1x EBITDA, as it is today, it’s in the best interest of Nissan to purchase Renault shares over their own as a means to repurchase company shares at a large discount.
 
Here are the upside scenarios:
 
                                                            4x EBITDA                5x EBITDA
Nissan Stake                                        17,500                         17,500
Volvo Stake                                         4,600                           4,600
Total Minority Interests                         22,100                         22,100
80% Value (a)                                      17,700                         17,700
 
Fin Biz (b)                                            2,200                           2,200
 
2007 Auto EBITDA                             3,500                           3,500
x Assumed Multiple                              4.0                               5.0
= Auto Biz Value (c)                             14,000                         17,500
 
Total Enterprise Value (a+b+c)             34,000                         37,400
Less: Auto Debt                                   (9,600)                         (9,600)
Less: Pension                                        (650)                            (650)
Plus: Auto Cash                                    7,600                           7,600
= Equity Value                                      31,400                         34,800
Per Share                                             €112                            €125
Upside                                                 25%                             40%
 
 

Catalyst

Execution of the turnaround plan, in part driven by record number of new vehicle launches in the 2H 07;
Possible Volvo divestment in 2007 to unlock shareholder value
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