Yahoo Finance Why I Can't Bring Myself to Buy Ferrari
I have been neutral on Ferrari NV (NYSE:RACE) for some time. However, with momentum dwindling and the stock's valuation unjustifiable in my view, I am expecting to see the car company give back some of its gains in the second half of the year.
It is a brilliant company, boasting strong brand recognition perhaps unmatched across the world of motoring and incredible margins. However, the company's growth is limited by its business model, which presents a trade-off between volume and margins. In this analysis, I explore that trade-off and explain why it has convinced me the stock is simply overvalued at the current price.
Sector-topping margins
Ferrari's margins are far in excess of any of the other listed car companies. The company's gross margin as of March stood at 50.67%, representing a huge premium to the automobile sector average. Its gross margin is also better than 94.49% of the 1,271 companies operating in the vehicles and parts industry.
This is reflected in the adjusted Ebit margin of 27.90% and adjusted Ebitda margin of 38.20% for the first quarter of 2024. Both figures represent a modest increase from the prior year, when the Ebit margin stood at 26.90% and the Ebitda margin at 37.60%.
These margins are only possible because of the company's business model. Enzo Ferrari once said the company he founded would always sell one car less than the market demands. This policy has been retained and it is part of the reason coupled with a streamlined manufacturing process honed over decades Ferrari is able to achieve these sector-topping margins.
In addition to excellent margins, the business model has cultivated a loyal customer base with excellent repeater revenue. In 2023, 74% of new vehicles were sold to existing Ferrari owners. The impact of its sales policy is amplified by the closed nature of the Ferrari Owners Club, which requires new members to verify their ownership and submit an application. In turn, this appears to be cultivating more demand with management recently highlighting very long waiting lists.
The order book that we have goes well into 2026, this is very important. I want to clarify this because we have models that are, let me say, for which we have a long, long waiting list, CEO Benedetto Vigna said at the end of the first quarter.
In short, Ferrari's visibility on earnings and strong margins are the envy of the automotive sector. All investors should be interested in purchasing a stock like Ferrari, because, as Warren Buffett (Trades, Portfolio) tells us, quality which includes things like profitability, stability of earnings and the health of the balance sheet is of foremost importance. Ferrari ticks all of these boxes.
Unjustifiable valuation
The stock experienced some fresh momentum in the early part of 2024, notably driven by the announcement that seven-time (eight times in my humble opinion) F1 world champion, Lewis Hamilton, would be joining Ferrari's F1 team for 2025. When it comes to the sport, there is no one who comes close to Hamilton in terms of celebrity status. While there is no guarantee that he will deliver success on the track, he will likely drive sales of Ferrari merchandise. However, the share price has leveled out in recent months.
It can be challenging to ascertain what the fair value is for Ferrari as it is not clear whether it should be valued as a car company, a luxury stock or both. However, while Ferrari is a great business, I find it hard to justify the current valuation.
The stock is currently trading at 49.70 times non-GAAP forward earnings. This puts it at a premium to all companies in the automotive sector, with the exception of Tesla (NASDAQ:TSLA), which is valued as a tech company rather than a car producer. Ferrari's trailing price-earnings ratio currently sits at 52.60, a remarkable premium to the 10-year average of 39.10.
Moreover, earnings per share growth is expected to be relatively modest in relation to the current earnings multiple. Analysts have forecasted earnings growth of 14.40% annually over the next three to five years. That represents a 26.60% premium to the average growth rate for the consumer discretionary sector, but is not enough to justify the stock's valuation, in my view.
In turn, this growth rate leads to a price-earnings-to-growth (PEG) ratio my favorite valuation metric of 3.41. This suggests overvalued conditions and this is supported by the below GF Value chart. GuruFocus data suggests the fair value for Ferrari would be somewhere around $337 per share, representing a downside from the current price.
On a price-sales basis, Ferrari looks equally expensive at 11.50 forward revenue. This puts it at a huge premium to the likes of BMW (BMWYY) at 0.36 and even Tesla at 5.48. This premium is also visible when we compare Ferrari with luxury brands like LVMH (LVMHF), which trades at just 4.06 times forward sales and 23.50 times forward earnings.
Of course, all of this belies the fact Ferrari is a very strong business, and many analysts look to free cash flow as one of the truest metrics for understanding a business' earnings. In recent years, FCF has surged, going from $129.20 million in 2020 to $847.7 million in 2023. However, Ferrari is trading at 32.80 times forward FCF. At a 241.9% premium to the consumer discretionary sector, this FCF is very expensive.
Ferrari's trade-off
My issue with the company's valuation is linked to its business model which is excellent, but restrictive. Ferrari cannot simply ramp up production volumes to increase earnings because it would negatively affect the delicate balance between demand and supply that has allowed margins to become so healthy.
It is rumored that Ferrari has a production ceiling somewhere around 15,000 units a year that is around 10% higher than the 2023 output. The company has already released an SUV the Purosangue a widely implemented strategy across the sector that has allowed sports car makers the opportunity to deliver volume growth without cannibalizing their traditional markets. Moreover, with a gross margin already above 50%, I am just not sure how much higher it can go.
While there are some misleading figures online suggesting Ferrari makes as much money from merchandising as it does from cars, that is simply not the case according to first-quarter earnings. Sponsorship, commercial and brand revenue, which includes earnings generated by the racing team as well as revenues generated through the Ferrari brand, including fashion collections, merchandising, licensing and royalty income equated to just 9.10% of net revenue for the period.
So while analysts anticipate earnings to grow by 14.40% annually over the medium term, Ferrari is priced for perfection. I believe the data suggests there is little room for growth in both volumes and margins.
The bottom line
While I love investing in great businesses with all the qualities investors like Buffett admire, I just cannot justify Ferrari's valuation. As I have attempted to highlight, the company cannot simply ramp up production due to its business model, which has served it well over the decades. And as indicated by the PEG ratio and other metrics, the stock looks overvalued.
This article first appeared on GuruFocus.
