The post below is an excerpt from the recent ENSEMBLE CAPITAL QUARTERLY CONFERENCE CALL. You can read the full transcript HERE.

Ferrari (RACE), manufactures super cars that are specifically made to cater for the pleasure of drivers and collectors at the top end of the automotive food chain, those in the top 0.1%.  Its cars are luxury goods that are inspired and derived directly from the Formula 1 racecars the company designs, builds and races through its Scuderia Ferrari racing team.

Ferrari’s cars are anything but practical cars – they are race-inspired expressions of something about their owners, who are among the elite few that are able to possess and experience one of their machines.  It is a purely luxury item that is either the fulfillment of a dream, a statement that you have arrived, are a passionate auto aficionado, or that you are free.

Ferraris are more about the emotion, the passion, and the experience than they are about transportation. The sound, the speed, the F1 racing legacy, and the conspicuous shapes are all part of the experience that come with owning and driving a Ferrari.

Ferraris are an entirely discretionary purchase, akin to other luxury good items like high-end handbags, watches, jewelry or art.  All of these serve a more abstract purpose outside of the semblance of utility their exact form may indicate.

Its brand and reputation was born of F1 car racing when its founder and race car driver turned businessman Enzo Ferrari founded his own racing team and race cars in 1945 then later decided to sell a few of his race inspired cars to help fund his racing ambitions.  That DNA and reputation has helped carry the brand to its place today, as an expression of the limits of what a car can achieve with a distinctively Italian design flair.  From the core of its performance capabilities, to the way it looks, and sounds, and ultimately how it makes its driver feel about himself or herself, the cars that Ferrari builds are an experience built on a long legacy and culture of racing, passion, and winning.

Of course, we haven’t mentioned a very important aspect of owning a Ferrari — that is being part of an exclusive club. There have only been 7-8K Ferraris sold globally in each of the last 5 years. In order to buy the latest high-demand Ferrari or a limited edition supercar, you have to own one or more Ferraris first.  In other worse, being able to afford one does not entitle one to actually buy one. 2/3 of new Ferrari buyers are repeat buyers, at an average price of $250K-$1MM+. These are incredible statistics that bode well for the makings of a highly profitable and defensible business.

To get a sense of how limited Ferrari’s cars are, in 2016, there were 1.3 million individuals in the US with a net worth over $5 million and only 2700 Ferraris allocated to the US. So only 2 out of every 1000 of these individuals could actually buy a new Ferrari. Of course, many of these folks couldn’t care less about a Ferrari, but it goes to show the relative scale of potential buyers to available cars. The company actively cultivates a supply-demand imbalance in order to preserve the value of both new and used Ferraris thereby creating scarcity value.  This is a tactic that many other luxury brands employ as well, including luxury hand bag brands like Hermes (RMS FP) and swiss watch makers to create both an aura of exclusivity among their customers and preserve the value of their products.

All of these examples comprise a category of goods referred to as Veblen Goods. These are products whose attractiveness to their consumers actually increases as their price premiums increase, in contrast with the economic principle that applies to most goods that demand increases as price decreases.  This increasing price tactic is offset by the ability of numbers of consumers who can actually afford to buy their goods despite their increasing desire to buy them. And that is where the supply/demand and pricing balancing act comes in.

In fact, when it comes to its very limited edition supercars like the LaFerrari, Ferrari’s million dollar plus sale prices still leave a lot of money on the table for its elite cadre of customers who see the resale value of their cars rise to multiples of their purchase price.  The LaFerrari went into production in 2013 with the limited run 499 vehicles that sold for over a million dollars each.  Resale values were in the $3MM range immediately after they went into production and more recent sales indicate a value of $5-7MM just a couple of years after production ended.  It’s no surprise that the two most expensive cars ever sold at auction are both Ferraris as are 7 of the top 10 and 15 of the top 20! This phenomenon is a huge contrast to the price of 99% of cars, whose value declines the minute you drive it off the lot and continues to do so every year thereafter.

The strong brand and experience is at the heart of Ferrari’s moat and drives the underlying economics of its very profitable business.  It is also what points to our analogy of comparing Ferrari collectors to art collectors with price appreciation dynamics that accompany the limited run pieces.

As a result, Ferrari shows an exceptional return on invested capital of ~100% with very little incremental capital required for it to grow its business at the rates it targets, in the 5-10% range. The low capital intensity results in strong free cash flow generation, which is at the heart of any company’s long term value. Finally, its 12-18 month waiting list and its deliberate strategy of undersupplying its market demand makes it highly resistant to declines during recessions, adding predictability and resiliency to its business model.

By comparison, the average S&P 500 company has about a 10% return on invested capital. Incredibly, Ferrari’s return on invested capital is in the same league as high IP content, asset light companies such an Apple (AAPL), Alphabet (GOOGL) or MasterCard (MA). Most analyst compare it to high margin, highly valued consumer luxury goods companies like Hermes (RMS FP), Richemont (CFR VX), and LVMH (MC FP) instead of the traditional capital intensive, cyclical, low P/E automakers for the same reason.

Just like Paychex (PAYX), a company we’ve discussed in a past conference call, we believe the high sustainable return on invested capital coupled with strong free cash flow generation entitles Ferrari to a much higher than average P/E multiple in the high 20’s, despite the fact that it is not a super-fast growing company.   If you are interested to learn more about Ferrari and how we view its valuation, we invite you to read our blog post published in May on the Intrinsic Investing website titled “Tesla vs. Ferrari – What RACE and TSLA Tell Us About The Winning Formula For Stocks”.

Ensemble Capital’s clients own shares of Alphabet (GOOGL), Apple (AAPLE), Ferrari (RACE), Mastercard (MA) and Paychex (PAYX).

For more information about positions owned by Ensemble Capital on behalf of clients as well as additional disclosure information related to this post, please CLICK HERE.

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