Pirelli: Another alternative investment in the EV sector?
Opdateret: 3. maj 2022
The electronic vehicles sector is a popular sector to invest in. We have seen the share prices of companies such as Tesla and Nio surge over the last 1,5 year or so. We also had the IPO of Rivian, which further attracted investors, and at some point Rivian was valued more than Volkswagen. With the current valuations of EV carmakers, it might be time to look elsewhere for companies that will benefit from the transition from ICE vehicles to EV vehicles. One of such companies could be Italian tiremaker, Pirelli.
This is not a financial advice. I am not a financial advisor and I only do these post in order to do my own analysis and elaborate about my decisions, especially for my copiers and followers. If you consider investing in any of the ideas I present, you should do your own research or contact a professional financial advisor, as all investing comes with a risk of losing money. You are also more than welcome to copy me.
This analysis will be a bit different from what you are used to read in my blog. Pirelli has only been listed on the stock exchange since 2017, and because of that, I believe it is better to do a discounted cash flow analysis. So instead of using the principles I have learned from my Phil Town workshop, I use the principles I have learned from the GOAT academy. I should also mention that most of the numbers I use in this analysis is from Finbox, which I believe is a great tool to get different numbers from various companies.
For full disclosure, I do not currently own Pirelli in my portfolio that you can choose to copy. However. I have added Pirelli to my watchlist. The reason I became aware of Pirelli is that a Danish investment fund that focuses on compounders has Pirelli in their portfolio. Hence, I have decided to do my own research on the company that I will share with you here.
Pirelli was founded in Milan, Italy, in 1872. However, in 2015 China National Chemical Corp. (a Chinese state-owned company) took a controlling interest in Pirelli. It has previously traded on the Milan stock exchange and got reintroduced in 2017. It is a large company with plants in 12 different countries all over the world, and their products can be bought in 160 different countries. Pirelli solely focus on the consumer tire market, which includes tires for cars, motorcycles, and bicycles. They particularly focus on the high value tire market, which generate 70 % of their revenue, while the standard tire market generates 30 % of their revenue. Besides their high-quality tires, they are also known for the Pirelli calendar. which is produced with limited availability of 20.000 annually that is given as corporate gifts to celebrities and Pirelli customers. The calendar helps building the brand of Pirelli as an exclusive brand due to the choice of photographers and models. The brand is what gives Pirelli a moat, which was very well explained by the CEO in their latest annual report: "Our brand remains a fundamental strength. Everywhere, in fact, Pirelli is synonymous with safety, technology, reliability, as well as competition, aesthetics, entrepreneurial culture".
Their CEO is Marco Tronchetti Provera. He joined Pirelli in 1986 and became the CEO in 1992. He has a degree in Economics and Business Administration from Bocconi University in Milan. He is also the chairman of Marco Tronchetti Provera & C, which controls Camfin that holds just over 10 % of the shares of Pirelli. He is is also the co-chairman for the Italian branch of the Council for the United States and of the Italy-Russia Entrepreneurial Committee for Economic Cooperation. When he took over in Pirelli the company was close to bankruptcy but was saved due to him cutting cutting costs by closing factories, eliminating jobs, and selling a division of the company. He realized that Pirelli needed to change to compete in a global economy, and it resulted in him deciding that Pirelli couldn't compete in the mass tire market and switched focus to high-performance tires with higher margins, which is why Pirelli is where it is today. His changed restored the financial health of Pirelli, and by 1996, Pirelli was profitable once again. He is known to work long hours and having a very competitive spirit. He is a great believer in technology advancement, both when it comes to developing new tires but also in the factories that produce the tires. With the results that Marco Tronchetti Provera has delivered in the past, combined with his vast experience, I feel comfortable in him being able to grow Pirelli moving forward.
I believe that Pirelli has a strong brand moat. And I feel very confident about management as well. Later I will do a discounted cash flow model to calculate a price for Pirelli but before I do so, let us just have a look at some key financial metrics.
Down below we see some key financial metrics from the last 3 years. Looking at the numbers it is obvious that Pirelli has a very bad year. in 2020. However, 2021 was much better for Pirelli, as they are growing their revenue again. Gross profit margin is also increasing and is better in 2021 than it was pre-pandemic and is higher than other tire companies such as Michelin and Goodyear. Operating margin is also growing, albeit it hasn't reached the pre-pandemic levels yet. It should also be noted that their operating margin is lower than some of their competitors, despite them having a much higher gross profit margin. However, the operating margin is also higher than for other companies in the sector, such as Goodyear. EPS is still below the pre-pandemic level but much higher than the awful year in 2020.
Before we continue to the discounted cashflow model, I would like to investigate the risks and potential of Pirelli. Let's us start with the risks. One risk is the price of raw materials, if the price of raw materials rises, it will hurt the margins of Pirelli. In their latest quarterly conference call, Pirelli announced that the increased price of raw materials is expected to negative impact net sales by -3,5 %. If prices of raw materials continue to rise, it will continue to hurt Pirelli. The competitive dynamics of the sector is another risk. Pirelli compete with other companies that have a significant financial and industrial resources and have brands of international renown. Increased competition could impact sales of Pirelli moving forward. Continued semiconductor shortages will hurt Pirelli, as if there are produces less cars there are less need for tires, and in their latest conference call, the management of Pirelli said that they have already felt it, as less cars are produced. However, it will probably not hurt Pirelli as much as other companies, as the tendency is that carmakers protect their high-end product portfolio because of profitability, which is where Pirelli excels. Finally, we still have the pandemic, and due to new variants, we see societies closing again. If Pirelli has to halt their production once again, 2022 could resemble 2020.
However, there are also a lot of potential for Pirelli moving forward. In the headline I wrote that Pirelli might be a bet on the transition to electric vehicles. Tires for electric vehicles is still a small market but Pirelli is growing their market share. Last year they had a market share of 6 % while it has increased to 10 % this year. The management of Pirelli expects that they will continue to take market share in tires for electric vehicles, where they already cooperate with companies such as BMW, Volkswagen, and Nio. Another growth potential is them continuing to outperform the general market. In the first 9 months of 2021, the global tire demand increased by 13 % compared to last year. However, Pirelli outperformed the global market as their sales increased by 24 % in the same period. Pirelli is the market leader of high-end tires in China. The GDP of China is expected to grow at a higher percentage than any other country except for India. Pirelli is already the market leader in the country, and with higher sales of high-end cars, it will be good news for Pirelli. ESG investing could be another way to share price appreciation. You might not think that a tire company would make a great ESG investment, but you might be wrong. Pirelli has made the world's first FSC-certified tire, and in 2023 they are expecting that more than 60 % of the raw materials used for making their tires will be renewable. They have very high sustainability goals, and is getting recognized for their efforts, as they are the only automobiles and parts sector company that has been added to the list of companies in the Global Compact LEAD of the United Nations. Finally, higher margins would be another reason to invest in Pirelli. In 2020 their EBIT margin was 11,6 %, and they are expected to grow that to 14 % - 15 % in 2021, 16 % - 17 % in 2022 to 19 % - 20 % in 2025. In the latest conference they confirmed an EBIT margin between 15 % and 15,5 % in 201, meaning they are on track to delivering on the EBIT margin. In the next paragraphs I will go though my calculations to find the intrinsic value of Pirelli.
I have now investigated the financials, risks, and potential of Pirelli. I will now look at the price by doing a discounted cash flow model. To do so I will need some numbers that you can see below. The numbers are the 2021 numbers, which I could find at Finbox. However, the perpetuity growth rate and the discount rate are numbers I have come up with myself. The reason I chose 5 % as perpetuity growth rate is that it is usually a between the historical inflation rate of 2-3% and historical GDP growth of 4-5%. I decided to go with 5 %, which I usually use. The chosen discount rate of 12% is because it is usually between 9-12%, and due to the current market conditions, I decided to go with the higher option of 12 %. Remember that all the numbers made in these calculations are in millions.
I also need to determine how much EBIT, Depreciation & Amortization and Net Working Capital will evolve over the next couple of years. I believe that Pirelli will grow their EBIT with 12 % year over year moving forward, which is in line with analysts expectations. I believe that Depreciation & Amortization will grow with 6 % year over year moving forward. Finally, we have the Net Working Capital. I believe that the Net Working Capital will pretty much stay the same as the average in the last 5 years (249), as the management in the latest conference call stated: "We do not see any specific change in working capital policy". Unfortunately, I cannot find a smart way to share the whole sheets with calculations in here, but I gave you the numbers, so you can do it yourself. However, once I my calculations, I found that the intrinsic value of Pirelli to be 5,9 euros.
Having investigated Pirelli, I find the company to be interesting. I believe they have a brand moat, which was very well explained by the CEO. Speaking about the CEO, I really like his previous results and the vast experience in the industry. A number I didn't share in the analysis is the ROIC, which unfortunately is a bit underwhelming at an average of 6,3 % pre-pandemic. Pirelli is also facing some short-term headwind with the prices of raw materials and semiconductor shortages. However, I see most of the risks being short-term. I really like that Pirelli is focusing on ESG and if we see improved margins and larger market shares, Pirelli could be an interesting investment going forward. My calculations show that unless we have another year like 2020, Pirelli is trading at a discount to intrinsic value. If I can get Pirelli below 4 euros, I would be intrigued.
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