• Phronimos

the name is awful, but there is some sparkle to Stellantis

Peugeot reported an 85% decline in first half operating profit to EUR 482m. Net income fell 68% to EUR 595m.

This is an incredible result!

Amazon, Apple and PayPal might be shooting the lights out during the pandemic, but I have much greater respect for those who can turn a profit when your market drops by half (you don't need to be a genius to report good growth with an e-commerce tailwind of 150 miles per hour).

Consider the circumstances for Peugeot: the firm's core European auto market declined by 39% in the first half and the Southern European countries where Peugeot ('PSA Group' as it is officially known) is strongest were even worse. PSA's volumes fell 46% and revenue declined 35%. Most of their European plants were closed for around seven weeks. That is a brutal environment for a business with low margins, high fixed costs and the need for large amounts of capital reinvestment.

And yet PSA's auto segment operating margin remained a remarkably healthy (for an auto company) 3.7%.

To see how solid that is just look at the peer group. French competitor Renault just booked its worst loss ever of EUR 7.3bn, an astonishing amount. Even excluding Renault's share of Nissan's results, Renault's first half loss was EUR 2bn. The formidable VW posted a first half operating loss of EUR 800m. General Motors managed to hold the line with a first half EBIT of just US$133m (including all restructuring costs, which is the fair comparison with Peugeot's unadjusted numbers), while Ford reported a US$4.3bn operating loss. PSA's resilience in this period has been nothing short of stellar.

2020 was always going to be tough for PSA even before the Coronavirus hit. Draconian new CO2 emissions rules (95g/km fleet average vs 120g/km in 2018) in the EU meant a regulatory-driven push to sell more expensive electrified vehicles, with some economists expecting auto sales to decline by around 10% given the higher prices for electrified models. Given the operating leverage in these businesses that promised a very large decline in earnings from the extremely solid 8.5% group operating margin PSA posted in 2019 (one of the best in the industry by the way).

With EUR 7.9bn in net cash for the group coming into this year, PSA had a fortress balance sheet. As the Coronavirus hit our only concern was how big the losses would be and how much of that cash buffer would disappear by year end. After several years of restructuring and taking out costs under CEO Carlos Tavares, the company was telling us that its break-even production level was 1.8m units. That is a huge improvement given PSA posted operating losses in 2013 when it was selling 2.8m vehicles. If the company's estimates were correct, even with volumes down 46% in the first half to 1m units, PSA would be around break even. And if full year volumes were 30% lower (the European Automobile Manufacturer's Association expects -25% for the full year) PSA would post a small profit. We figured that with depreciation running at EUR 3bn a year and business as usual capex of EUR 4bn, full year cash burn (ignoring working capital and dividends) would be EUR -1bn to -2bn and even if that figure was EUR -3bn, you still had a business worth just EUR 8bn net of cash.

Probably less than Tesla's value changes on an average day.

Well the crisis in the first half demonstrated the strength of PSA's balance sheet. They didn't need to draw on any of their credit lines let alone seek a bail out from the government, unlike Renault. But the first half cash impact has been somewhat worse than we had hoped with net cash of EUR 4.7bn being consumed and the balance sheet net cash position declining to EUR 2.9bn. It looks bad, but the largest drain on cash is a massive working capital outflow of EUR 4.4bn mostly related to a decline in payables. That is, they increased they payments to suppliers by EUR 4.5bn in the half. Excluding the drain on working capital free cash flow was positive at the automotive division to the tune of EUR 153m, and the good news is that the working capital impact should reverse as production comes back on line and ramps up over the second half.

Management wouldn't commit to getting to free cash flow positive for the full year, but the fact it is even a possibility is a positive. It means that by year end we could be we will probably be within our estimate of EUR -1 to EUR -2bn in cash outflow.

And that makes the current share price and market cap of EUR 13.3bn a pretty attractive level for a 50% interest in the world's 3rd largest auto company by revenue when the PSA-FCA merger is completed by next year. The combined group, apparently to be named Stellantis (perhaps I should revisit my enthusiasm?), will enjoy massive economies of scale, substantial cost savings from combining procurement and streamlining operations, strong competitive positions in hybrid and electric vehicles and commercial vans in Europe and light trucks in North America, and a $7bn R&D budget to go head-to-head with the likes of VW, Toyota and GM. It will rival VW in terms of European market share at around 25%.

It will also be led by one of the best CEOs in the industry with a track record of delivering operational and financial performance, overseen by Fiat family scion John Elkann as chairman. Mr Tavares has the track record to lead this combination. And although counting synergies before they hatch is a fool's errand, Carlos Tavares recently suggested that the estimated EUR 3.7bn in savings by combining the firms should be seen as a floor, not a target.

What's more, the new Stellantis will be the only leading auto company without a significant presence in China; a failure that both FCA and PSA have been heavily criticized for up to this point. We take a different view. Given the slowdown in China after two decades of incredible growth, global and local competitors that are now well entrenched, and the growing risk of strategic rivalry with the US, we think the rewards for any latecomers to the Chinese market will be slim.

Better to focus elsewhere. And in fact the opportunity might just be closer to home and one where PSA (or Stellantis) might just have a first mover advantage: Africa.

While the world is fixated on the emerging market giants of China and India investors often completely overlook the fact that over the next 30 years Africa will double its population to 2.5bn, or one quarter of humanity. Nigeria will overtake the United States to become the world's 3rd most populous country with 400m people. If you can think even longer term than that (we have a very long investment time horizon - it's one of our very few competitive advantages) a recent paper by The Lancet has Nigeria becoming the world's second most populous country by 2100 with 790m people, second only to India. It will be bigger than China, given China's dismal demographics.

If you think that's insane take a look at The Lancet's predictions for Niger: 21m to 185m.

Yes, Africa is a small market for new vehicle sales with estimates putting it at around 1.5m units. But some forecasters predict that will grow to 10m by 2050.

The reason this looks interesting for the French auto companies is their strong links to Morocco. Morocco has provided strong incentives for auto makers to establish manufacturing plants there and both Renault and PSA have moved in. PSA's Kenitra plant is doubling production to 200k units by September of this year. Since 2018 Morocco is also part of a continent-wide African free trade agreement, which should in theory make it the perfect springboard to export vehicles into the rest of the region - especially the historically French-speaking territories in West Africa where those brands resonate.

2020 is a dark year for the auto companies, but that light at the end of the tunnel might just be Stellantis.

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