While the market has been in a twilight zone for the past year, many investors have been lost between loss-generating companies defying gravity and IPOs commending higher prices. Most importantly, many seem to have forgotten about investing’s fundamental commandment: return on capital. At its core, what is the return of $1 invested internally by the company.
This question is more imperative than whether a company is currently profitable. As we have talked about before on this blog, a CEO can either return the cash flow to its shareholders (via dividends or buybacks); or reinvest it back in the business. Each affects an investor’s IRR differently. The former is dependent on the company’s valuation, the later not so much. For example, buybacks add value only if the company performs them at an attractive price, otherwise it can be value destructive. Reinvesting in the business, given it surpasses its cost of capital, is mostly value creative.
We use cost of capital as a negative screen in our research process, basically eliminating companies and/or industries that don’t meet this hurdle rate. To illustrate our point, we revisited this presentation by Sergio Marchionne, the former CEO of Fiat Chrysler Automotive, called “Confessions of a Capital Junkie”. Sergio was a one-in-a-million kind of CEO, skillful in operations as well as capital allocation. He was able to turn Fiat around in the early 2000s, and then orchestrated one of the largest mergers in the auto industry with Chrysler.
Sergio knew that in order for an auto maker to be profitable they needed to take an even bigger step. Shortly after FCA’s up-listing on the big board, he released the presentation laying out his theses for more consolidation. At the center of his argument was the fact that the auto industry could not earn its cost of capital. Below is a table of various industries’ EV/ product development ratios; a ratio measuring capital intensity. The auto industry’s average is 4 years, and only 2 of 10 had a respectable ratio. In a previous post we talked about why we don’t invest in Oil & Gas; the graph below shows that O&G’s ratio is fairly low as well.
From the other below graph we can see that Mainstream OEMs (red) do not earn above their cost of capital (WACC in blue). Today that number is lower due to lower interest rates. This has brought new competitors into the market; but even now sustainable profitability has been elusive due to the industry cost structure, as described in the presentation.
Unfortunately, Sergio was not around to see his vision put in place. FCA recently merged with PSA Group in an equal merger and while we can’t predict the outcome, the merger is going to tackle duplicate costs as outlined in the presentation. FCA estimated potential commonality close to 50% of development costs. In fact, when the presentation was floated, FCA was trying a tie up with General Motors.
Most of the time, a lower ROIC means lower valuation, as seen in the table above. But in the current market, that relationship can break. It is our job as analysts to not fall prey to the market’s mood and recognize where the mismatch exists. This is not an investment pitch on Stellantis nor the auto industry, in fact quite the contrary. The auto industry continues to require large investments without getting properly rewarded. Knowing where not to fish is usually a great starting place.