Description

The following is a recommendation for a long position in the core Renault auto stub.  It will require the investor to take a long position in shares of Renault and then short out Renault’s exposure to Nissan, Volvo, and AvtoVAZ.  AvtoVAZ is small and illiquid, so it may be difficult to borrow.  Given that it accounts for <5% of the offsetting short position, any inability to short it is unlikely to affect the overall opportunity in any material way.  Nissan and Volvo are large, liquid stocks with available borrows. 

 

The story here is quite simple.  When I started writing this summary, Renault’s profitable and growing auto business was trading at a negative valuation.  After some appreciation in the past two days it’s now trading at €1.05 per share, or an implied market value of only €291 million, or about 0.3x 2007 EPS and 0.2x 2008 & 2009 EPS.  This extremely compelling valuation is most likely related to (1) the complexity of valuing Renault’s investments in Nissan and Volvo, (2) lack of confidence in management’s ability to reach its 2009 performance targets, (3) long-only managers’ lack of appetite for exposure to Nissan and/or Volvo via Renault, and/or (4) great distaste, at present, for owning any cyclical, consumer-driven businesses with commodity input cost exposure.  However, at this point I believe all of these arguments are pretty irrelevant when discussing Renault’s core auto operation because – again – the market is currently assigning a almost no value to this profitable and growing business.  Even GM, among the sickest of the sick automakers, has a market cap of $5.5 billion. 

 

Renault owns about 44% of Nissan, nearly 21% of Volvo, and 25% of AvtoVAZ.  The company would owe no capital gains if it sold/distributed its Nissan or Volvo stakes and would pay capital gains at a 29% rate if it sold its AvtoVAZ stake.   The AvtoVAZ gains are immaterial given this investment is Renault’s smallest and was only completed in February of this year. 

 

After subtracting from Renault’s market cap the value of its investments in these publicly traded businesses, we’re left with an almost immaterial value placed on Renault’s core auto business.  As you’ll read in a moment, this valuation appears to drastically undervalue the earnings power of the business.  The table below provides some of the specifics:

 

RNO: Core Business Trading at Negative Value
Investment	Shares (mm)	RNO Ownership	Share Price (in €)	Capital Gains	Market Value of Renault's Investment
Nissan	4,520.7	44.3%	4.84	0.0%	€ 9,703
AB Volvo A Shares	1,450.8	9.6%	7.34	0.0%	€ 1,018
AB Volvo B Shares	677.6	44.7%	7.03	0.0%	€ 2,129
Total AB Volvo	2,128.4	20.7%			€ 3,147
AvtoVaz	2,719.5	25.0%	0.92	29.0%	€ 736
			Total Renault Investments		€ 13,586
			Shares Outstanding		278
			Investments per Renault Share		€ 48.86
			Renault's  Share Price		€ 49.91
			Shares Outstanding		278
			Renault's Market Cap		€ 13,877
			Implied Price for Core Renault:		€ 1.05
			Implied Mkt. Val for Core Renault:		€ 291

           

Here’s a look at the headline results for Renault’s core business in recent years.  Note there are NO contributions here from any of the aforementioned investments.  Renault does not consolidate results from any of these entities since it does not have a majority/control stake in any of them.  It simply includes its share of earnings in the ‘earnings from affiliates’ line on its income statement.  

 

 

As the numbers above indicate, Renault operates a real business with substantial revenue and earnings.  I included the book value of the financing business simply to show that the company is even trading way below the book value of this wholly-owned entity, thus implying substantial negative value for the auto segment.  Further, leverage is minimal as cash at the end of 2007 stood at €4.7 billion vs. debt of €6.9 billion, for net debt of €2.2 billion.  Finally, unlike the US automakers, the company has no pension or healthcare liabilities thanks to the benevolence of the French government.

 

 

Brief Background on Renault

Renault is run by CEO Carlos Ghosn, who also runs Nissan and is best known for his turnaround of that carmaker earlier this decade.  He’s a no-nonsense manager focused on results and creation of economic value.  I’d recommend a quick look at one of his shareholder letters to get a flavor for his style.

 

Renault itself is carmaker, not a truck or SUV maker.  Unlike the US automakers, it has a negligible presence in the imploding SUV market and is actually among the top-ranked European carmakers for production of efficient, emission-friendly cars. 

 

Over the past year, Renault has been unveiling its most significant lineup of new car models in years.  The effort involves a nearly total reinvention of the lineup through 2009, thus providing potential customers with an expanded and enhanced offering of Renault vehicles to choose from.  By way of background, prior to 2006, Renault released 2 to 4 new cars per year.  These models were oftentimes extensions of existing models and/or enhanced engine offerings on existing models that were described as “new cars.”  As a consequence, models were on the market for, on the low end, 7 years and, in the worst cases, 14 years.  To put it mildly, Renault’s models grew quite stale in recent years.  Many of the Renault models were so old I wonder how any were selling at all, which speaks to strong brand loyalty.  In 2006, the Company committed to rolling-out 8 new cars per year, resulting in an average replacement life of 3 years. 

 

 

Renault’s 2009 Targets

Back in 2006, in conjunction with lining up its new product offering, CEO Carlos Ghosn set some performance targets for the company in terms of unit quality, profitability and growth which he calls Commitment 2009: 

 

• Quality: the quality goal is two fold: (i) improving customer satisfaction and (ii) improving car emissions. 
• Profitability: the second pillar of Ghosn’s strategic plan is to significantly increase profit margins from just over 2% bps 2006 to at least 6% by 2009.  The timeline for expansion was 3% in 2007, 4.5% in 2008 and 6% in 2009, achieved through a combination of reducing fixed costs, improving purchasing savings in conjunction with Nissan, and margin leverage realizable through unit volume growth.  
• Growth: improving unit volumes by 800K by the end of 2009, thus implying ~3.2 million units sold in 2009 vs. the 2.4 million units sold in 2006 (implies 30% volume growth over the period) 

The most significant recent new model releases designed to drive volume growth are the Logan and the Twingo.  The Logan is the first of a recent wave of low priced cars from Renault which are designed to appeal primarily to customers in emerging markets.  In these markets, the Logan has a sale price of around €7,000-€8,000.  Sales results are exceeding expectations thus far in volume and pricing. 

 

The Twingo is the smallest car in Renault’s fleet, with only two doors.  Until recently, the car had not been updated in 13 years and, even with the old model, the Twingo was still selling at least 60K units annually.  Since it’s re-launch last year the car has sold almost 73K cars in the first half of 2008 and it is on track to sell close to 150K for the full year, also ahead of expectations.  Driving the high demand is a strong push by consumers for small, fuel-efficient cars and a pre-existing, almost cult-like, core customer base.

 

Arguably more important than growth from new models, only two of which are highlighted above, is the expansion into emerging markets.  The Logan was the first foot in the door, and as a low cost vehicle it has become a disruptive vehicle option for emerging market customers now able to afford a car for the first time.  The growth also helps to diversify the customer base away from the traditional Western European market.  At the onset of Commitment 2009, sales outside of Western Europe were only 30% of all units.  The goal is to increase that mix to 40% of vehicles by 2009, and as of 2007 the company was already halfway to that goal.  That shift represents a growth rate in the BRIC regions in at least the mid-teens. 

 

Targets Achievable?

Based on the action in Renault’s stock price this year, the market clearly does not believe the 2009 targets will be reached.  Most likely they won’t.   Given surging steel costs and a weakening consumer environment in Europe and, possibly, other parts of the world, it’s certainly conceivable volumes will fall short of the company’s ’09 target and, in turn, so will margins.  In fact, just last week Renault disclosed that 1H08 revenue was up only 4.3% YOY, leaving the company short of the 10% revenue growth needed in 2008 to remain on track for Commitment 2009 (although comps become MUCH easier in 2H08 which is also when the new model launch schedule accelerates) .  Still, I included the above discussion to underscore that the company is, indeed, growing and has a plan for sustained growth and margin improvement going forward.  Those generally aren’t characteristics of a business for which the market is ascribing almost no value. 

 

The chances of the company dipping into the red in a manner so severe as to heighten credit risk and justify the current valuation remain very remote, in my opinion.  First, recall that the company had a net debt position of only €2.2 billion at the end of 2007.  That figure may have inched up slightly since then because the company spent approximately €660 million to acquire 25% of AvtoVAZ back in February (specifically, Renault spent €660 million upfront, which is 70% of the total payout for the 25% stake; the other 30% will be paid in 2010 with final consideration dependent upon AvtoVAZ’s performance).  Liquidity remains more than ample.  Second, despite surging commodity costs, Renault continues to take costs out of its business.  I can get into more specifics in the message board discussion, but as an example I’d note that the company realized €1.4 billion in purchasing savings in 2007 by using more efficient global purchasing arrangements.  By comparison, raw material costs rose only rose €700 million in 2007, so Renault was able to more than offset that headwind.  More cost savings are expected in 2008 and 2009 which will serve to buffer commodity costs.  As volumes grow further (which they absolutely should), these savings should create more margin leverage. 

 

Stepping back again, I’d reiterate that most of these concerns are pretty irrelevant at this point since the market is assigning this business almost no value. 

 

 

Realistic Outlook?

So, if the 2009 targets aren’t achievable what might a more realistic outlook look like?  If I were to take a stab at where revenue and operating margins might end up in this tougher economic environment, I’d note the following points: 

 

• The quality goal has been attained in the new model introductions, which, by and large, have been very well received.  Renault is also on track to maintain one of the lowest CO₂ emitting fleets in the industry, so that should improve the attractiveness of its vehicle offering in this environment as “green” awareness builds.   
• It’s very likely that the goal of 6% margins is unrealistic for the 2009 timeframe given the drastic increase in raw material costs.  I would expect that 6% remains a longer-term goal for the Company, but that it gets pushed back to a reasonable period in which the Company may be able to benefit from greater unit growth and more stable commodity input costs. A 6% margin might be more realistically achievable by 2010 or 2011.   
• Despite the fact that Renault is actually gaining share in Europe’s two largest markets, Germany and France, it is going to be very difficult to reach the additional 800K volume goal in a flat to declining Western European market.  This goal may also get pushed back to the 2010 time period, or maybe even later.  

Upside Potential

The table below assumes Renault falls short of its 2009 unit goal by 10% (~2,9 million units vs. goal of 3.2 million units) and falls short of its 2009 EBIT margin goal by 17% (5% margin vs. goal of 6% margin).  As you can see, in this scenario I’d still estimate the core auto business could generate €3.9 billion in EBITDA and over €4.00 per share in EPS (excludes any contributions from Nissan,. Volvo, or Renault).  Note that these forecasts adjust European accounting to US GAAP by expensing certain R&D costs that Renault has historically capitalized. 

 

If we simply applied a 7x P/E multiple to those '09 earnings (which is where solvent auto peers trade today) we’d be looking at a price for the core auto business of over €28 per share.  That’s nice upside relative to the current market-implied price of just over €1 per share. 

 

RNO: Growth and Profit Estimates
Stub Financials	2006A	2009E	'09 Peer Multiples	Implied Valuation
Unit Volume	2,433	2,884
Revenues	€ 40,332	€ 47,200
OP Profit	€ 1,063	€ 2,369
OPM	2.6%	5.0%
EBITDA (1)	€ 3,013	€ 3,906
EBITA (1)	€ 874	€ 1,970
Core EPS (2)	€ 0.95	€ 4.08	7.0x	€ 28.57

 

 

If we took a more pessimistic view and assumed core EPS reverted back to their 2006 level of €2.85 we’d still have a share price of about €20 per share assuming that same 7x multiple.  Even at 2005 EPS of €0.95 per share, when the auto lineup was incredibly stale, costs were high, and volumes were shrinking, we’re still looking at a share price of €6.65 per share. 

 

At risk of stating the obvious, each of these scenarios yields a valuation that is very materially above the current €1.05 price at which Renault’s auto business currently trades. 

 

 

Application of Position

Application of the trade is fairly simple once you sort through the various exchange rates.  The basic idea is to pick a size for your long position in Renault and then take offsetting short positions in Nissan, Volvo, and AvtoVAZ that are equal to their proportional share of Renault’s current market cap.  As touched on above, AvtoVAZ might be tough to borrow and, if so, could be ignored without impacting the overall opportunity since the Nissan and Volvo stakes currently account for about 93% of Renault’s total market value. 

 

Assuming a long position of 100,000 shares of Renault, here’s how the position sets up at prices and FX rates as of mid-day on 7/15/08:

 

RNO: Application of Stub Trade
	Local		Share	Shares Owned	Value of RNO's	% of RNO
Investment	Price	EUR FX Rate	Price in EUR	by RNO	Stake (EUR)	Market Cap
Nissan	JPY 808	€ 166.83	€ 4.84	2,004.0	€ 9,706	69.9%
Volvo A	SEK 67	€ 9.49	€ 7.06	138.6	€ 978	7.0%
Volvo B	SEK 70	€ 9.49	€ 7.35	302.9	€ 2,226	16.0%
AvtoVAZ	RUR 34	€ 36.88	€ 0.92	679.9	€ 623	4.5%
					€ 13,533	97.5%
Renault	€ 49.91	€ 1.00	49.91	NA	€ 13,877	100.0%
	Position		Price
Company	Size	Type	(in EUR)	Value
Renault	100,000	Long	€ 49.91	€ 4,991,000
Nissan	(720,771)	Short	€ 4.84	(€ 3,490,921)
Volvo A	(49,851)	Short	€ 7.06	(€ 351,823)
Volvo B	(108,947)	Short	€ 7.35	(€ 800,456)
AvtoVAZ	(244,521)	Short	€ 0.92	(€ 224,176)
Total Short				(€ 4,867,376)
Gross Position				€ 9,858,376
Net Position				€ 123,624

 

Catalyst

Time for core Renault valuation to correct;
Resetting of 2009 targets to levels market believes are achievable (should re-ignite interest in the stock, especially for long-only managers); 1H08 earnings results showing business remains stable