Initiation Report: Stellantis

Deep value play de-risked by strategic positioning

This report was written in August of 2024. I initiated a position in the Company in April 2024 around US$25/share, and then added to my position at ~$16/share resulting in a cost base of roughly $18.75/share.

To date, this position has been absolutely horrible for me, down 41%. I will be following this report with an update on the name very shortly thereafter and discuss how my thinking has evolved since making the investment.

Introduction

Stellantis is the world’s third largest automobile manufacturer as measured by revenues, with a portfolio of fourteen brands, operating globally, and geographic exposure to six regions: North America (“US”), Europe (“EU”), the Middle East and Africa (“MEA”), South America (“SA)”, and China, India, and Asia Pacific (“APAC”).

We believe the market has failed to adequately value the economic benefits of Stellantis’s global scale and resulting cash generating profile as compared to its competition, while also over emphasizing a short-term deterioration in market share and free cash flow as the business transitions to its next generation of powertrain agnostic vehicle platforms. We believe the business will benefit from a recovery in market share and free cash flow generation in the second half of 2024 as new products gain traction, with further expected upside in the next 24 months as interest rates begin to decline. Long-term, we are confident in Stellantis’ ability to retain cost leadership and generate value in a competitive market, while also building out its internal financing division, an initiative that will provide an industry-agnostic growth driver in the medium term.

Our view is that the business is heavily undervalued with an approximately 80% discount to fair value, implying returns of 21 to 50% per year from now until the end of 2028. Even with extremely conservative forecasts that reflect permanent losses of market share and cost advantage, we believe the business is capable of earning a return of 4% per year over the same period. Stellantis also has a robust capital return program that is equivalent to 18% of the company’s market cap, with a dividend yield of approximately 9%, with said capital return program fully covered by free cash flow.

Competitive Moat

As a vehicle OEM (original equipment manufacturer) Stellantis has capabilities in the design, engineering, and manufacturing of automobiles that are primarily distributed through a network of dealers or national distribution companies in the Company’s key regions. Stellantis is the result of a merger between the Fiat Chrysler Group (“FCA”) and Peugeot (“PSA”) in early 2021, with the stated aim of achieving greater scale to capitalize on the emerging trends of electrification and vehicle connectivity.

As a result of Stellantis’ consolidated scale, the Company has a substantial cost advantage relative to other global automotive peers, primarily through the optimization of fixed manufacturing costs, but also through SG&A and R&D expenses. For example. Stellantis’ EBIT margin was roughly equal to Toyota’s, despite generating three quarters of the former’s revenues, and almost 500bps above Volkswagen’s on 30% less revenues.

Stellantis’ discipline on fixed costs extends to the variable costs of vehicles as well. The company has prioritized cost leadership on all vehicle platforms, including its portfolio of battery electric vehicles (“BEV”). While many competitors such as Ford and GM are struggling to produce BEVs profitability, Stellantis has launched four BEVs with price points at or below €25K that are profitable on day one. Most impressive of all, Stellantis has beat the BEV-leader Tesla to the market with an entry-level BEV vehicle. Cost leadership is not limited to BEVs either, as the Company has developed four vehicle platforms, covering all major segments, that are capable of incorporating all current powertrain technologies: internal combustion (“ICE”), hybrids (“HEV”), plug-in hybrids, (“PHEV)”, BEVs, and fuel cell electric vehicles (“FCEV”). While Stellantis has achieved an enviable position in vehicle cost, there is still room to improve; as of 2024, BEVs were 30% less profitable than ICE equivalent vehicles. The Company’s ambition is to achieve margin parity by 2027, providing a tailwind to current gross margins if successful.

The Company is also a global leader in the commercial vehicle segment. Stellantis holds the #1 position for commercial vehicles in the EU, MEA, and SA regions, and is #3 in the US. This business accounted for a third of revenues in 2023 (approx. €70B) and contributed operating margins in excess of the consolidated average.

On a regional basis, the US and EU are the key drivers, as they represent roughly 80% of revenue and profits for the entire company (US is 47% and 54% of 2023 Revenue and Adjusted Operating Income, and EU is 37% and 25% respectively). However, both the MEA and SA region are increasingly contributing to the overall results of the company. The combined results of Stellantis’ “third engine” (MEA, SA and APAC combined) produced adjusted operating income that exceeded the EU region’s operating earnings in H1 2024. We believe exposure to emerging markets with favourable demographic trends and increasing vehicle ownership penetration will support Stellantis in the long-term as well, while also de-risking exposure to the more competitive markets of the US and EU.

Ultimately, the global automotive market is highly competitive, with minimal differentiation present particularly in the entry-level vehicle segments. Therefore, we conclude that the broader market is fairly commoditized, with market success determined by offering the level of performance expected from customers at the most economically attractive price. Cost leadership thus stands as the primary differentiator to providing customers with the most compelling value proposition relative to competitors and is therefore a major enabler of sustained market share capture by a vehicle OEM.

As noted previously, Stellantis is also able to offer each vehicle platform with every powertrain option available. We believe this is a compelling advantage when the end result of vehicle electrification is known but the medium-term adoption curves are difficult to predict. We therefore expect Stellantis to have durable operating earning and free cash flows in every conceivable BEV adoption scenario, while avoiding the volatility that pure-play BEV manufacturers are exposed to.

Lastly, prior to the merger, Stellantis did not offer an in-house financing program for its customers and dealers in the US market. As a result, the Company has prioritized the build out of a vehicle financing division for this market, significantly expanding its capture of the overall vehicle industry value chain. Stellantis thus has a significant amount of white space to capture vehicle financing revenues irrespective of the overall vehicle industry’s performance, leading to above average long-term earnings and free cash flow growth. Stellantis has also been expanding its aftermarket parts business in the MEA and SA region adding further tailwinds to the business, but we have not modeled this due to low visibility.

In summary, Stellantis possesses a strong competitive moat through super scale economics, profitable powertrain-agnostic vehicle platforms, a world-class commercial vehicles business, and robust operations in the high-growth markets of MEA and SA.

Strategy

Currently, the automotive industry is being shaped by four major trends:1) zero-emission mandates and vehicle electrification, 2) increasing vehicle connectivity and software functionality, 3) new market entrants, either pure-play BEV manufacturers and/or Chinese manufacturers, and 4) de-globalization. We have assessed each trend with its potential implications for Stellantis, while also commenting on the Company’s mitigating factors and unresolved risks for each.

Zero-Emission Mandates

Governments in developed economies, particularly the US and EU regions have released targets for all passenger vehicles sold to be zero-emission by 2035 or later. Vehicle OEMs that are unable to design and manufacture compelling zero-emission vehicles will essentially be forced out of business as a result. However, there is an uneven and unpredictable rate of adoption from current technology to a 100% zero-emission vehicle offering.

We believe that Stellantis’ approach to developing powertrain agnostic platforms to preserve profitability in all scenarios is a highly pragmatic mitigant to this risk. We also believe that management understands the market demand for BEV vehicles priced equivalent to ICE vehicles and are working aggressively towards that target, further positioning them for market leadership when BEV adoption increases. We consider Stellantis to have effectively mitigated this risk with their strategy, with the only remaining risk stemming from a failure to execute on strategy.

Increasing vehicle connectivity

The amount of technology features that customers expect to have in vehicles has been increasing. Features include assisted or fully autonomous driving, entertainment, over-the-air updates, and customization. This increase in expected technology is leading to an increase in the semiconductor content in vehicles. Companies that are unable to design vehicles with functional technology or secure reliable semiconductor supply at competitive costs will be at a distinct disadvantage. Stellantis has been proactive on this front, establishing a joint venture with Foxconn for automotive semiconductors that will meet the Company’s own demand as well as supplying other OEMs. Additional partnerships with Qualcomm, QNX, BMW, and AWS for software functionality, including autonomous driving also position Stellantis to capitalize on this trend.

New Market Entrants

A number of new competitors have entered the automotive OEM industry, primarily as a result of the disruption posed by BEV technology. Competition has arisen from developed market entrants (Tesla), and emerging markets such as China (BYD, SAIC, Li Auto, Geely, Nio, and XPeng). New entrants have been able to compete with incumbents through superior BEV technology and/or a cost advantage arising from manufacturing in a low-cost country. As stated elsewhere, we believe that Stellantis’ product roadmap adequately reflects the need for a competitive BEV product offering in its markets. Additionally, Stellantis cost advantage positions it more favourable to compete in a price war with Chinese competition, relative to other OEM incumbents, as do manufacturing operations in low-cost areas such as Mexico, MEA, and SA. Stellantis is also working to further its cost advantage by increasing the amount of components sourced from Best Cost Countries (“BCC”). Beyond the previously mentioned factors, Stellantis has remarked that an increase in the EU tariff rate from 31 to 38% on Chinese vehicles would reduce their cost advantage by 30%. Given the geopolitical nature of automotive manufacturing, we see most developed markets as biased against allowing Chinese competitors to take advantage of their price advantage. Finally, Stellantis joint venture with Leap Motor positions it to offer ultra low cost products manufactured in China to other markets in a capital efficient manner.

De-Globalization

Increasingly, the world is characterized by higher friction trading between countries and a greater preference for favoring domestic competitors. Nowhere is this trend more prevalent than in the highly global automotive industry. The automotive sector has always had tariff regimes, but these programs will increasingly restrict the flexibility for automakers to manufacture vehicles or source components from low-cost jurisdictions, rather than reducing barriers to international expansion. The direct implication is that a local, economically competitive manufacturing base is needed to support local demand. Stellantis has 34 plants in the US region, 22 in the EU, 9 in MEA, and several in SA (exact figure not provided by Stellantis). Interestingly, Stellantis states that 80% of capacity in the MEA region is cost equivalent to Chinese vehicles. As a result, we believe that Stellantis is well positioned to meet market demand in a fractured global economy.

Financial Performance and Benchmarking

Since the merger between FCA and PSA in 2021, Stellantis has consistently grown revenues, despite experiencing a softness in unit volume in 2022 that reflected the COVID-related supply chain issues that many OEMs faced. The majority of Stellantis operating regions saw material growth in selling price in 2022, reflecting inflationary trends. However, some of this growth in selling price has unwound in 2023, reflecting the market adjustments to higher interest rates and resulting impact on vehicle affordability.

Over this same period, Stellantis has been able to moderately improve its gross margin by 40bps. Both SG&A and R&D expense as a percentage of revenue have declined over the same period. The combination of higher margins and lower fixed costs have driven an increase in EBIT margin of 60 bps. We are impressed with Stellantis ability to achieve these results while executing one of the largest mergers in automotive history, navigating wide-ranging supply chain disruptions, and developing a BEV technology platform and vehicle portfolio.

Concurrent with EBIT growth, Stellantis has grown Industrial Free Cash Flows, its preferred method of calculating enterprise-level free cash flows. We note that Stellantis definition of cash flow includes lumpy items such as proceeds from asset disposals, and also excludes cash outflows related to the expansion of its US financial services business. We have not forecast any asset disposals and included investments in vehicle lease assets in our forecast, adding conservatism to our projections.

Stellantis maintains a very conservative balance sheet. All debt is rated BBB, the lowest investment grade level. Gross debt has approximated 1.0x reported EBITDA and is negative on a net debt basis (cash on-hand exceeds gross debt). Interest coverage is extremely healthy, at 15-20x on an EBIT basis. Comparatively speaking, Stellantis is under levered relative to its peers (A net cash position vs. mean net leverage of 6.0x EBITDA for competitors).

To conclude this section, we benchmark Stellantis against its automotive OEM peers:

As observed in the above chart, Stellantis is an industry leader in terms of gross and EBIT margins. The only competitors to exceed Stellantis’ margins are Mercedes, who benefits from greater exposure to the premium vehicle segment, and Honda, who has exposure to a high-margin motorcycle business that is not directly relevant to Stellantis. Additionally, Stellantis has the highest EBIT margin of its peer group, despite lower revenues compared to VW and Toyota, and greater exposure to more price competitive entry-level classes compared to Mercedes and BMW. We believe this analysis succinctly captures Stellantis cost advantage relative to competitors.

Valuation & Expected Returns

The majority of Stellantis’ business is derived from highly competitive, mature markets that are undergoing a once-in-a-lifetime period of disruption. We have thus sought to create a valuation based on modest volume growth, inflation-based increases in selling prices, and rising investments in R&D and CapEx to reflect the investments needed to remain competitive during the transition to zero-emission powertrains. At the same time, we have forecasted an aggressive expansion of Stellantis’ financial services business in the US region that helps the overall business grow faster than the overall industry. We have deducted the cash investment necessary to build out this asset intensive business, adding further conservatism to the model.

We developed three cases for our forecast, summarized as follows:

· Base/Medium Case: a weak 2024 for the US and EU markets, driven by volume, ASP, and vehicle level profitability declines, followed by modest (1%) volume growth and inflationary ASP increases. MEA and SA grow above trend in terms of volume and ASP. Inflationary increases in manufacturing overheads, SG&A, accelerating investments in R&D expense, growth in CapEx, and elevated levels of capitalized R&D investment. Build out of financial services to modestly below peer penetration rate in US (9% of US revenues vs 10-15% for peers historically).

· Low Case: weak 2024 is followed by no volume growth and -2% YoY ASP declines to reflect competition in US and EU markets. No ASP growth in MEA or SA, and moderate volume growth. Vehicle contribution margins also decline 1% YoY in all regions. No growth in manufacturing overhead given minimal volume growth. Above trend SG&A cost inflation and R&D expense investment, inflationary CapEx growth, and 5% capitalized R&D growth.

· High Case: less muted 2024 and faster recovery in US and EU markets (2% volume and ASP growth) along with aggressive volume growth in MEA (15%) and SA (7.5%) and above inflation in ASP for the same regions. Increasing contribution margins per vehicle to reflect success in cost down programs, minimal manufacturing overhead growth, economies of scale for SG&A, R&D and CapEx, and sustained 5% growth in capitalized R&D.

Our current estimate of intrinsic value per share is ~€66/share, assuming: the base case scenario, WACC of 6.7% (reflecting Stellantis’ net cash position and resulting low beta), and terminal value based on a 1% growth rate yield. This implies a discount to fair value of 78% leading to a substantial margin of safety at the current price of ~€15/share.

The implied period return given these assumptions is 5.8x the original investment, or 49.5% on a compound annual basis. Our holding period return is driven by an intrinsic value of ~€85/share reflecting the same assumptions noted in the prior paragraph. A summary of the key return drivers is provided in the graph below:

We can see that the largest driver of return is earnings growth, reflecting the growth in free cash flow of Stellantis over the forecast period. The next largest driver is the increase in financial position driven by positive free cash flows to 2028; cash generation alone would drive a 2x return over the same period. Multiple expansion is the smallest driver of return, although it is still close to 80% of the current equity value of the business.

To conclude our assessment of intrinsic value, we look at the range of expected holding period returns using a sensitivity analysis for the various cases, the discount rate, and long-term growth rate. These findings are summarized in the following two charts:

Given this analysis, we see that our downside return is 3.9%, or roughly equivalent to a 5-year Treasury note at the time of writing. There is effectively no downside risk with an equity investment in Stellantis, and substantial returns available for highly conservative forecasts of results, discount rates, and terminal growth rates.

Finally, from a pure return per share basis, we also note that Stellantis’ capital plan of €7.7B per year equates to 18% of the company’s market capitalization, while its dividend plan is equal to almost 9% of market cap. An investor can therefore reasonably expect to earn a minimum of 9% per year through yield alone, materially offsetting any unanticipated price declines.

Management and Execution Capabilities

Broadly speaking, we have much to admire in Stellantis’ management team. Their track record to date has demonstrated exceptional execution capabilities as they have met or exceed targets for realized synergies in the FCA/PSA merger and expected timeframes for achieving them. They have done the same for the build-out of the US financial services business, and also for free cash flow and adjusted operating metrics to date. We also see the management team as high integrity; they have been forthright when missing the mark, as most recently occurred during the disappointing H1 2024 results. Management will also regularly call out when they have got things wrong and devote attention to understanding and fixing issues. In short, we have high confidence in the character of the team and their achievements to date.

In addition, the structure of management compensation is highly aligned with shareholder interests. Almost 90% of the CEO’s pay is contingent on performance. Long-term incentive (“LTI”) programs for the CEO and broader management team are 100% at risk if targets are not met, with 5-year lock-up periods in place for LTI equity grants. We also see that payouts are regularly based on the achievement of financial metrics such as Adjusted Operating Income, Free Cash Flow, and Total Shareholder Return. Finally, the Short-term incentive program does not pay out any amount if free cash flow is negative, and there are no LTI payments when total share holder returns are below median.

Governance and Shareholder Alignment

Stellantis is owned by two key groups that hold over 20% of the business: Exor (15.3%), the family holding company of the Agnelli family, led by John Elkann (Chairman of Stellantis), and Peugeot Freres (7.7%), the family holding company of the Peugeot family. These two groups hold voting rights equivalent to 33% of the company. While this exceeds the economic interest of both parties, we do not see it as excessively out of proportion. Of Stellantis’ eleven board seats, four are held by Exor or FCA-related nominees, and four are held by Peugeot Freres or PSA-related nominees.

We note that John Elkann receives performance-based compensation for his role as Chairman, based on the achievement of similar, shareholder-aligned incentives that determine performance-based compensation for the management team. As such, we see alignment at the governance level with the greatest economic interests in Stellantis.