FIN 380

IPO Case

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 Table of Contents
Executive Summary

The Ferrari Brand

Ferraris Primary Market

Challenges Facing Ferrari

Ferraris Global Financial Performance

Valuation Methods
DCF
Comparables
Hybrid Method

Key Variables in Valuation

Discounted Cash Flow Analysis

Comparables Analysis

Ferraris Worth

Final Lap

Appendix
Executive Summary

Ferrari is an automobile company that has relied on its iconic brand, global access to growing
wealth, premium pricing with minimal costs strategy to create value. Currently Ferrari has gone
public and it opened at a price of $52 per share. Given Ferraris past success we analyzed this
move to see if going public would benefit the company, or if there were other motives. We also
did our own valuation analysis to find out what Ferrari was truly worth.

We ran a discounted cash flow analysis and a comparable analysis to come up with a valuation
for Ferrari. We found that all together Ferrari was worth right around $10 billion. Given this
information, we support Ferraris decision to go public.

The Ferrari Brand

Ferrari is considered one of the worlds most powerful brands. They focus on the quality of car
production rather than the quantity to garner customer loyalty and reinvestment. The company
scores highly on a wide variety of measures on Brand Finances Brand Strength Index from
desirability, loyalty, and consumer sentiment to visual identity, online presence and employee
satisfaction. It is one of only eleven brands to be awarded AAA+ brand rating and has the
highest rating overall. What sets the brand apart from all others is its ability to monetize the
brand.

Ferraris Primary Market:

- High Net worth individuals

- Emerging global markets (China)
-9.3% of sales in 2014
-Greater China had a 1.79% increase in car sales for the 3 months ending
March 31st from 2014-2015.
- Americas (America, Canada, Mexico, Caribbean, and Central and South
America)
-33.94% of sales in 2014
-UK
-9.72% of sales in 2014
-3.14% increase in car sales for the 3 months ending March 31st from
2014-2015
-APAC (Japan, Australia, Singapore, Indonesia, and South Korea)
-11.63% of sales in 2014
-Germany is losing market
-3.78% decrease in car sales for the 3 months ending March 31st from
2014-2015

Challenges facing Ferrari

As a publicly traded company Ferrari can generate income for its investors through two ways.
One is the dividend yield, and the other being its capital gains. Ferrari does not offer a dividend
so as a result Ferraris value relies solely on its expected capital gains. Ferrari focuses heavily
on its exclusivity as a brand and as a result focuses on low production while also putting an
emphasis on quality. As a result, Ferrari has a comparatively low growth rate for an equity of
only 4%, which is not a promising if sales and earnings follow growth. Ferrari also faces
regulatory limits within the U.S. Since it currently only has an annual production under 10,000
units it is not subject to U.S. gasoline mileage targets and restrictions. If it were to exceed this
limit it would be required to manufacture models with smaller engines and better fuel mileage,
which in a sense neutralizes one of the largest factors that attracts a majority of Ferraris
customers, which is the performance and speed of their cars. This is obviously a major wall
facing Ferraris prospects at growing its revenues and adding value for investors. Ferrari can
continue to operate with a low growth rate and grow revenues at a much slower pace to the ire
of possible future investors, but still maintain the quality and performance of the cars its
produces and keep up its exclusive image. On the other hand, ferrari could increase its annual
unit output which could increase its growth rate dramatically possibly making it a much more
attractive investment. This comes with the risk of losing its exclusivity while putting the quality of
the cars produced at risk since its extreme attention to detail in the manufacturing of its cars
could become diluted. A majority of Ferraris success will derive from its ability to balance and
maintain the image of the brand it has built up until now, while also finding a way to grow its
sales and keeping its investors satisfied.

Ferraris Global Financial Performance

Ferraris financial performance exceeds the standards of their competitors with higher gross
margins (45.5%) and higher operating margins (14.1%) Exhibit 9. Ferrari was able to achieve
such high gross and operating margins due to their premium pricing and minimalist cost
structure due to their low volume and low number of employees as seen in Exhibits 10 - 11.
With small product portfolio (eight vehicles), that only consists of 70% total revenue, Ferrari also
makes money off of engines and sponsorship branding with Formula 1 racing Exhibit 13. The
auto manufacturer thrives off of low production volume, only producing 7,255 vehicles in 2014,
which is 1,733,845 less than the second least Audi. Concerning R&D expenses with Ferrari and
vehicles per employee, they stand at the lowest with 2.5. This statistic proves why they are the
highest investors in R&D and are willing to spend more on employment to create high quality
luxury vehicles. The following is a summary of their financial comparisons:

-Higher Margins
-Gross Margin: 45.5%
-Operating Margin: 14.1%
-Net Margin: 9.6%
-Gross-Operating Margin: 31.4%

-Lower Production Volume (vehicles)

-1,733,845 less than second least (Audi)

-Less employees
-61,549 less than the second least (Audi)

-Higher Vehicles/employees
-2.5 lowest
Valuation Methods

DCF
The methods for valuing private companies are largely the same as those for publicly
traded companies. However, private companies have such little history and are facing
so much uncertainty that the problems are magnified. There are two common
approaches to valuing private companies. One approach is using a discounted cash
flow. Discounted cash flow analysis is an essential element in the evaluation of assets,
projects, and companies. It is based heavily around the idea of the time value of money,
which is the idea that money that is available today is more valuable that the same
amount in the future due to its earning potential. Discounted cash flow analysis, DCF,
utilizes future free cash flow analysis and discounts it to evaluate the attractiveness of
an investment. If it is projected that the value of the investment turns out to be greater
than the initial cost of it, it is one indication that this is a worthwhile venture. The basic
idea of DCF valuation is that the value of an investment is determined by its ability to
generate future cash flows for the investors. One thing to understand about DCF
valuation models is that almost always the estimates will be imprecise due to the
terminal value, which is the forecasted horizon of an investment at which growth is
calculated to be constant, of an investment being extremely sensitive to even small
changes.
Comparables
The other approach is through comparables by using ratio analysis and/or multiples.
This approach uses the ratios of earnings or sales of similar (i.e., comparable) firms,
assuming that our firm should have the same multiples (P/E or P/S). A simple example
of how to use comparables is to find similar companies in the same industry. Then,
calculate their average price/earnings ratio (where P and E are the prices and earnings
of the comparable companies). So, the price per share of your company would be the
average P/E ratio of comparing companies multiplied by your companys earnings per
share. The problem with using comparables is that there is no clear guidance about how
to adjust for differences in expected future growth rates, risk, or differences in
accounting policies. Using multiples will not help us determine if an entire industry is
overvalued because they only provide information regarding the value of a firm relative
to other firms in the comparison set.
Discounted cash flows methods can incorporate specific information about the firms
cost of capital or future growth. The Multiples/Ratio Analysis approach only works if you
can find really good comparables. All approaches require assumptions and forecasts.
Most real-world practitioners try to use a combination of approaches and gain
confidence if the results are consistent across a variety of methods.

Hybrid Method

The best way to use comparables to value a company is to get the future exit value,
then work back. The first step is to estimate when the company will go public. Then you
estimate the earnings or sales at that future point or at the time of the IPO. Next you
multiply that estimate by a ratio based on comparable public companies. Adjust for net
positive or negative cash flows that are expected between now and the IPO which is
most likely due to additional VC rounds. Then discount your forecast of the future value,
plus the interim adjustments, by your desired rate of return to get the amount you
should be willing to pay today. This is a hybrid or combination of the comparables
method and the DCF method. A key advantage of this hybrid approach is that you only
have to forecast a few years into the future and then you use the exit value based on
comparables as your terminal value. This is the best way to use comparables because
the company that youre valuing is more likely to be truly comparable to a public
company at the future exit time, when its ready to go public or be acquired.

Key Variables in Valuation

The most critical variable in Ferraris valuation is the volume growth. Ferrari has pursued a low -
volume production strategy in order to maintain a reputation of exclusivity and scarcity among
purchasers of our cars and deliberately monitor and maintain our production volumes and
delivery-wait times to promote this reputation. Ferrari cars were comparable to other rare
elements, in that their value was linked to its scarcity. Ferrari had methodically controlled their
volumes sales, averaging 4.4% growth per year from 1997-2014 period. Their total volume was
much smaller than any other automobile manufacturer as seen in Exhibit 10. This scarcity was
both good news and bad news as the high net worth individuals that were Ferraris target
market had been growing 8.6% per annum for nearly 30 years. The bad news about the scarcity
was that 4% was not a promising growth rate for an equity, if sales and earnings did indeed
follow volume growth rates. Since Ferrari had no plans to offer dividends, Ferraris value
proposition relied solely on prospective capital gains, and investors typically demanded double-
digit rates of return. Ferraris leadership team assured investors of slow volume growth, and
forecasted an annual volume growth rate of 4.4% beginning with the 2015 volume of 7,500. This
variable is important, because Ferraris value is linked to its scarcity and by increasing the
volume they may be lowering their value. They will also face stricter regulations by increasing
their volume.

SG&A and R&D expenses were another critical component of valuation. Many believed both
these would grow 2% per annum, reflecting the companys cost discipline and strategy moving
forward. This would lead to Ferraris operating margin growing considerably over the 10-year
forecast period. Ferraris R&D expenses were exceedingly high compared to other automobile
manufacturers. For most of the industry R&D expenses as a percentage of sales averaged less
than 5% for most of the global industry, while Ferraris were over 20%. Some argued that as
volume sales grew this percentage would not grow as fast, as the company would enjoy scale
benefits of the previous investment. Other analysts argued that the company would struggle to
maintain its current investment and expense structure as it worked hard to maintain its
performance edge and brand value. We accounted for both of these scenarios in our DCF
analysis. The cost of capital is also extremely critical in the valuation of the company and this
was given to us in the case as being 8.686% which was used in our DCF analysis to find the
present value of the company.

Other key variable lied in the comparables of the company. The price to earnings ratio and
enterprise value to EBITDA multiple are important components in valuing the company
compared to to other similar companies in their industry. We go into more detail about this
further on in the paper.
Discounted Cash Flow Analysis

We used three different scenarios in our discounted cash flow analysis to get a range of values
that we feel represents Ferraris value taking many different scenarios into account. Our
analysis ran for 10 years starting in 2015 and ending in 2025. We had a baseline scenario, an
aggressive scenario, and a conservative scenario. In the baseline scenario as seen in Exhibit
14 the share price in USD was $56.03 and at 189 million shares this resulted in a market
capitalization of $10.6 billion. Based on the information we provided there were several
assumptions that we used. Ferrari promised slow sales volume growth to their investors while
committing to building just under 9,000 units by 2019. This translates to an annual growth rate
of 4.4% and is the rate we used for sales volume growth. For price growth, a 2% growth rate
was used as Ferrari had stated that they were committed to raising the average price point of
their products. Other revenues were expected to grow 3% per year, while Formula 1 income
was expected to grow at 1% per year. Since Ferrari had a small number of workers and
turnover was low, cost of sales was expected to grow 2% per year in the baseline analysis.
SG&A and R&D are a critical component of valuation and were expected to grow 2% per year
based on Ferraris cost discipline and strategy going forward. If they grew at 2%, Ferraris
operating margin would grow considerably. And as seen in Exhibit 9 Ferrari's operating margin
is already high at 31.4% compared to automobile industry average of 13%. A growing operating
margin would just put Ferrari that much further ahead of other automobile companies. In the
baseline analysis, the average gross margin is 54.4% with an average EBIT margin of 28.4%. It
is important to note that the baseline analysis held capex at a constant $130 million, which is
something that we felt was unrealistic and changed in our other scenarios.

In the aggressive scenario, we kept many of the assumptions the same, however we changed a
few key growth assumptions as seen in Exhibit 15. The first assumption that we changed was
increasing our sales price growth from 2% to 3%. As stated in the case it is possible that
aggressive price increases of 3%-4% were possible. We also decreased our R&D expense
growth rate from 2% to 1.5%. Our reasoning behind this was that with an increase in volume
sales Ferrari would be able to enjoy economies of scale and decrease R&D expenses. We also
increased our capex by a yearly growth rate of 2% because we felt it was unrealistic to keep it
constant at $130 million and 2% matched the cost of sales growth. In the aggressive scenario,
we end up with a share price of $67.34 which results in a market capitalization of $12.7 billion.
This gives us an average gross margin of 55.9% and an average EBIT margin of 31.1%.

In the conservative scenario, we decreased sales price growth from 2% to 1.5%. The reasoning
behind this was that with sales volume growth of 4.4% Ferrari is going to produce more than
10,000 cars by 2022. Under U.S. law once we break that 10,000-unit barrier we would not be
able to sell our cars in the U.S. market without the company altering its product mix to reach
fleet mileage targets. This means that we would have to launch models with smaller engines
and better mileage. Due to this we may have less control over the average pricing of our
products as we will have to increase our product mix. The EU has also been revising their
restrictions on government emissions and mileage limitations for the 2017-2021 period, and this
may limit Ferraris growth. In the conservative scenario, we also increased the R&D expense
growth rate from 2% to 2.5%. The reason we did this is because we believe that Ferrari may
struggle to maintain its current investment and expense structure while also working to maintain
their performance edge and brand value. Ferrari may also face increased R&D expenses due to
stricter regulations on emissions and gas mileage which are problems R&D will tackle. It is also
rumored that development of an electrically powered model is underway. In the conservative
scenario, we end up with a share price of $47.39 which gives us a market capitalization of $9
billion. We get an average gross margin of 53.6% and average EBIT margin of 26.3%.

Overall our DCF analysis gives us a range of share prices from $47.39 - $67.34. It also gives us
a range of values from $9 - $12.7 billion. The average market cap of Ferrari given these three
scenarios is $10.8 billion with an average share price $56.20.

Comparables Analysis

From the comparables analysis we found that Ferrari was more in line with the luxury industry
than the auto industry. In Exhibit 3 you can see that compared to the auto industry, Ferraris
multiples are much higher. We believe this is the reason why Ferrari shares were valued so high
at their IPO. You can see how Ferrari is more like a luxury good in Exhibit 6. Their multiples are
comparable to Hermes and the luxury industry in general. You can also see in Exhibit 18 that
Ferraris EV/EBITDA multiple is right in line with the average of their European Luxury Peers.
Ferrari had a multiple of 11.4 compared to the group average of 12.1. The value that we got
from the comparables was smaller than what we got from our DCF analysis. The share price
from the comparable analysis is $41.94 while the range we found through our DCF was $47.39 -
$67.34. The number is more in line with our conservative scenario.

With all our analysis, we support Ferrari going public. Although, Ferrari is down 30% we believe
that the market is mispricing Ferrari and given our analysis their intrinsic value is higher than
what the market is currently valuing them at. With all the information, together we found that the
value of Ferrari is $10.1 billion with an average share price of $53.93.
Appendix

Exhibit 1: Ferrari Sales Volume

Exhibit 2: Results of Operations

Exhibit 3: Auto Industry Multiples

Exhibit 4: Auto Industry Dividend Yield

Exhibit 5: Auto Industry Price per Share

Exhibit 6: Luxury Industry Multiples

Exhibit 7: Luxury Industry Dividend Yield

Exhibit 8: Luxury Industry Price per Share

Exhibit 9: Financial Margin Comparison

Exhibit 10: Vehicle Production (2014)

Exhibit 11: Number of Employees

Exhibit 12: Vehicles Per Employee

Exhibit 13: Percentage of Revenues (2012-2014)
Exhibit 14: Baseline Discounted Cash Flow
Exhibit 15: Aggressive DCF Analysis
Exhibit 16: Conservative DCF Analysis

Exhibit 17: Comparable Analysis

Exhibit 18: Ferraris EV/EBITDA

Exhibit 19: Final Value