Ferrari Defies Gravity For Now, But It Will Return To Earth (NYSE:RACE)

Auto analysts appear to be optimistic as a group, but the Ferrari analysts are luxury goods focused and take optimism to an extreme. I wrote an article back in February at Ferrari’s then peak of $181 per share encouraging investors to either sell or short RACE (How to Destroy a Great Brand). It was clearly anathema to the cultists and investors in Ferrari. The stock was crushed along with the markets during the initial phases of COVID-19, and recovered recently to new highs just shy of $200 per share. It would not be surprising, but the obvious nature of Ferrari’s problems seems to be increasing yet the street seems to be oblivious.

I intentionally have neither written much nor focused on short-term issues for Ferrari, as I viewed RACE as a clearly evolving short situation, as the auto market goes through so many changes. Instead, I have focused on my favorite longs, particularly value names (Bullet-Proof Portfolio) that are clearly coming back into favor.

This morning, Morgan Stanley analyst, Adam Jonas put out a note discussing Ferrari moving to “all electric” and his view that this could cause margins to move higher. I just read their RACE report and I say confidently that Mr. Jonas does not understand how pricing works in the exotic car market. This is the ultimate case of garbage in garbage out. His note argues that the pricing that Ferrari has today, which is not even a reflection of current production, but rather of 40 years of undersupplying the market, will hold going forward, despite the lagged impact of their doubling of production. More importantly, he is saying that pricing is going to hold despite the fact that:

1. EV-based engines completely commoditize one of the two drivers of Ferrari’s historical pricing power – its differentiated engine and performance (the other one being design, which I would argue is also much less differentiated than it used to be historically). With little or no differentiation in engine technology, this will significantly hurt their pricing power as Ferrari DNA is based on Formula 1 where performance is the only differentiator.

2. EV-based engines hurt pricing power beyond commoditization (commoditization reduces differentiation and barriers to entry), which is due to the cost curve of batteries looking like the cost curve of semiconductor manufacturing as opposed to the internal combustion engine which has a cost curve that is that of a traditional manufacturing business. With a much steeper cost curve, this means that the cost to manufacture that engine next year will be much lower, and the following year much lower still. How can Ferrari expect to hold pricing when the cost of making the most valuable part of the car is falling so rapidly?

No. The move to EV will make the car industry look much more like the PC industry, where the name of the game is to be able to lower your cost faster than your pricing is falling. While many Ferrari customers are wealthy (remember the majority of Ferrari customers finance their purchase), the majority of them choose Ferrari over other brands because historically they have depreciated less than their competitors. If your production costs are falling this fast, residual values will fall very fast as well. In the end, most Ferrari customers focus on the total cost of ownership, not the MSRP. While the cost of ownership will already increase due to the lagged impact of Ferrari doubling production, it will increase much further as a used Ferrari will be worth much less. This is due to the fact that the cost to replace it will be much lower since battery costs have fallen so much since that car was new, in addition to the fact that the rate of performance improvement will be greater in an EV engine.

3. Finally, the beautiful ferocious gurgling sounds along with the mechanical feeling of an internal combustion engine are what make the experience of an exotic car unique. I can say very candidly, I would never own a single exotic car without these two factors. Case in point, I can buy a Porsche Taycan today, with more performance than an exotic car, for half the price. Have I done so? No. I would rather buy more Trinseo in front of their quarter. The auto market including exotics/supercars will continue to change and move to EVs. The supercar manufacturers have already ramped production to satisfy any and all demand. COVID-19 certainly put a short-term damper on many products and industries, but there are simply too many great alternatives, and residuals for Ferraris (and other manufacturers) will continue their decline.

I encourage investors to sell their Ferrari stock and buy TSE prior to the quarter, as numbers will have to move higher, and analysts will ultimately upgrade, as this run will continue for several years. And while you are buying TSE, buy some OLN, WRK, and CPRI to round out the portfolio. Trinseo (TSE), Olin (OLN), Westrock (WRK), and Capri (CPRI) are a few of my favorites that have performed well since bottoming in March, but are just getting started, and have a lot of room to run to the upside. For TSE, we have just seen Alembic Global and Jeffries put out thoughtful upgrades recently, while the rest of the street remains with NEUTRAL or SELL ratings, and will likely capitulate as TSE is likely to break-out well into the $30s when they report their next quarterly earnings report in the next two weeks.

Disclosure: I am/we are long TSE, OLN, WRK, CPRI. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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