Ferrari: The Value of Polishing a Rough Diamond

26 April 2024 | by Ensemble Capital

During our first quarter portfolio update, we profiled portfolio holding, Ferrari (RACE). Below is a replay of our live commentary on the company from our quarterly portfolio update WEBINAR and an excerpt from our QUARTERLY LETTER.

Ferrari N.V.: Ferrari has had a very successful run since we first bought shares in the company in 2017. It has been one of our most successful investments since, with shares rising over five times, and understandably so given how phenomenal this business is and how well it has been managed.

Initially spun out of Fiat (now Stellantis) in 2015, it was a rare jewel within the parent company, where its value was hidden among more standard and premium cars sold under brands such as Fiat, Alpha Romeo, Maserati, Chrysler, Jeep, and others. Under the leadership of the astute business manager Sergio Marchionne, who had run Fiat since 2004, Ferrari came to be recognized as the undervalued and unique asset that it was within its parent.

It was being run below its potential, perhaps because of over-conservatism in reverence to its legacy – a legacy of offering products that were highly desired by many and undersupplied to only a limited set of privileged customers, who built up their relationship with Ferrari buying nearly two-thirds of its annual output. This allowed them to continue getting access to the most desirable, collectible models Ferrari built in the future.

“Build one less car than the market demand” is a quote attributed to founder Enzo Ferrari, yet where that line stands is more art than science. Conservatism on the supply/demand balance is generally a healthy strategy in protecting the value and exclusivity of the brand. But being too conservative results in too much unrealized value left on the table.

After the company went public in 2015, it reported revenue of just under €3 billion for the year while shipping less than 8,000 cars at an average selling price (ASP) of €270,000 per car. EBITDA margins were 25%. Importantly, by our calculation, its return on invested capital (ROIC) was over 100%.

Ferrari was demonstrating economics more in line with digital and luxury businesses and deserving of a much higher valuation, more like a Hermes or Apple, rather than a typical auto company.

In 2024, the company expects to generate over €6.7 billion in revenue in 2024 with EBITDA margins exceeding 38%. We expect over 14,000 cars to be shipped with an ASP over €400,000 – that is an ASP increase of €100,000 over the past 5 years!
There were two important things we recognized that the market did not appear to fully back in 2017 that made this an attractive investment for us.

When we did our first deep dive into the business in 2016, we estimated there were 2-3 million potential high net worth customers who could afford to buy a Ferrari. Consequently, selling less than 8,000 cars meant a customer capture percentage of less than 0.1% in any given year. Even this year, when the company will likely sell 14,000 cars, we believe it is still selling to less than 0.1% of its potential market. That seemed a very conservative ratio, albeit limited by the appeal of its 2-door, 2-seat ultra-high performance sports car form factor. But we came to believe that Ferrari could increase its appeal to a broader set of customers (increase demand) by widening its form factors to 4-door cars and SUVs.

In addition, its ASP had only risen at a slightly higher than inflation rate of 4% per year over the prior decade. And the company had long wait lists at those prices that sometimes surpassed 18 months. Meanwhile, the wealth of customers in this segment grows at something like 5-10% per year from returns on their assets and businesses.

We realized there was a growing gap between the wealth of their customer base and the pricing that Ferrari captured. For a material proportion of the customer base, Ferrari’s appeal as a Veblen good, means that the more people who could afford one, the less desirable the product because its value comes from its differentiation from the ordinary. A Veblen good is one where demand increases with price precisely because they are so hard or expensive to attain.

Ferrari’s current CEO Benedetto Vigna has succinctly described Veblen good’s relevance to Ferrari saying:
“The client is giving a value to our cars because they are unique, because they are limited, because they are exclusive. We could make more, but that does not make sense. We will offend our clients.”

Our view was that Ferrari would be required to raise prices at a rate that kept pace with their customers’ wealth to continue delivering to customers the Veblen expectations of the product, with shareholders disproportionately benefiting from the increased pricing growth.

It was clear to us that there was a large gap between market expectations priced into Ferrari’s stock and the higher fair value implied by our analysis. Interestingly the large gap persisted for years even after Ferrari began to confirm our thesis when it revealed its 2022 financial targets at the 2018 Investor meeting.

Under Sergio Marchionne, Ferrari began to push the envelope on volumes but in an intelligent manner that included leveraging its core assets to build new form factors that would expand the appeal of its cars to new customers. For example, the Ferrari Roma has been a much bigger hit with women than the traditional style of the 488, F8, or 812. The recently launched Purosangue appears to have every sign of success with those that might have the means to buy a Ferrari but would rather it come with the utility of four doors that can also bring three passengers and some gear along for a weekend.

Ferrari also rolled out the SF90 and 296 GTB/GTS plug-in hybrid models that appealed to a younger segment of its market while making strides towards the global trend of cleaner emissions, but without sacrificing the performance and driving dynamics of Ferrari. These hybrids are likely to also do well in the Chinese market over time, a large fast-growing market for high net worth (HNW) individuals.

These new form factors have increased the appeal of Ferrari across new HNW customer segments without necessarily oversupplying Ferraris within each model line thereby preserving its exclusivity. We see evidence of this from the fact that nearly all models are sold out through 2025 with average selling prices approaching a record €400,000.

This also confirms our initial thesis that Ferrari’s customers would accept higher prices while driving margins and profits benefiting shareholders.

With the launch of the Icona design-oriented collector cars such as the SP1, SP2 and SP3, Ferrari was able to effectively sell high value limited cars more often per decade than when it was strictly reserved for hypercars like the LaFerrari, the Enzo, or the F40. These cars sold for more than €1MM, while the SP3 now surpasses €2MM.

Ferrari also opened up the €500,000+ pricing tier with its higher priced SF90 and Purosangue for the normal production, non-collector cars, which sell in higher volumes further supporting the brand’s higher pricing strategy.
The result of this more aggressive (and in our view more customer aligned) pricing strategy has resulted in faster revenue growth and higher margins. The market has taken notice in recent quarters and for the first time substantially closed the gap we persistently saw with our own fair value estimates.

In conclusion, we believe that management at Ferrari has built one of the strongest luxury brands and customer bases in the world with a complimentary robust business model that uniquely plays to these strengths. They have indeed succeeded in polishing the rough diamond that Fiat spun out 8 years ago. Having recognized the jewel of a business that it was early on, as shareholders we were richly rewarded as the company executed a value enhancing strategy and as the market came to recognize its pricing and earnings power over time.

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