The Cost of Capital Twilight Zone | Exor Case Study

The great thing about thinking about investing is that it allows you to become a bit of a couch philosopher from time to time. I’m not sure where it originates from, but I love the story about the two young fish swimming in a lake. They swim by an old fish who casually greets them by saying “enjoy the water, boys!”. The two fish swim along but after a while, one says to the other: “what the hell is water?” In investing, capital is water. 

Consider the following two general concepts of corporate finance: 

  • The value of a security – be it be stock, debt or anything in between – will depend on its future cash flows, discounted to its present value.
  • A company’s cost of capital is the minimum return that the company must earn on its capital base.

These two concepts fit very neatly together. Profits in the future are less valuable than profits today. There is a time value to money. The riskier a project is, the higher the discount rate should be. The higher the discount rate, the higher the required return. 

What about debt, you might ask yourself? Companies that are leveraged with debt are riskier, yet the cost of debt capital is relatively cheap. Well, the cost of capital has a sort of a calibration mechanism. Debt often has collaterals and priority in a liquidity event, its cost should be lower. When a company adds leverage to its balance sheet, it’s the equity that becomes riskier. You know all this, but anyway.

A company’s cost of capital is the weighted average of debt and equity and should reflect the expected return from the projects the company is invested in. In short, the company’s cost of capital reflects the expected return on its future cash flows. The cost of each security in the capital structure reflects the expected return of the company adjusted for the priority of each security. 

On Market Discounts and Premiums

To continue our philosophical musing, we can look at two other general phenomenons that have been observed in the capital markets:

  • Control Premiums: Investors are willing to pay a premium in the markets to gain control over assets. This makes sense, as being able to affect how a company allocates its capital enables the owner to prioritize the interests of shareholders above other stakeholders. 
  • Conglomerate Discounts: Companies that operate in multiple industries, have been known to trade at a discount to the net asset values. The theory goes that conglomerates are less focused, have an added layer of holding company costs and in some cases, their structure is tax-inefficient. 

Now, you will probably already have noticed that if these two generalities are to be true, then it will make a very strong case against the existence of conglomerates. Basically, to build a conglomerate, you would need to gain control over different companies, thus paying a control premium. At the same time, your conglomerate’s cost of capital will be relatively expensive. It’s a double whammy. 

The European Conglomerate Discount

Theorizing is nice and all, but descending into the particulars is even more fun. So, let us take a page from the Jesuit playbook and delve into a short exercise in casuistry. 

The idea of a conglomerate discount became a theme at the intersection when the GoGo years came to an end and the genesis of the Private Equity industry. Activist investors started targeting bloated multi-divisional companies and dicing them up after gaining control.

More recently, academia and private research have contested the existence of the conglomerate discount. A study from Boston Consulting Group concluded that over the last 20 years, about 55% of conglomerates trade at a prolonged discount. For some reason, the conglomerate discount appears to be more pronounced and prevalent in Europe. One European conglomerate that I find particularly interesting is Exor. 

The Quasi-Conglomerate

First of all, Exor (BIT:EXO) is not a conglomerate in the purest meaning of the term. It’s not a multidivisional corporation. Exor is primarily a holding company that primarily holds control positions. 

Exor Net Asset Value
Exor Net Asset Value on November 15, 2019

Aside from owning the reinsurer PartnerRe outright, Exor’s biggest assets are large control positions in a number of publicly-traded companies, most notably Fiat Chrysler Automobiles, Ferrari and CNH Industrial. 

Exor at a glance: 

  • 4 core holdings: PartnerRe (100%), FCA (28.98%), Ferrari (22.91%), CNH Industrial (26.89%)
  • Transformed Fiat Industrial into FCA, Ferrari and CNH Industrial
  • Acquired PartnerRe 4 years ago at 1.4 tangible book value
  • Capital Structure: Market cap is currently at about €15.5 billion and debt of €3 billion
  • The cost of operating the holding company is 70 million a year or 0.5% of the market cap. 

Exor’s Cost of Debt 

We can start by looking at Exor’s cost of debt as this is a fairly straightforward measurement. In the 2019 half-year report, the management provided an overview of the Exor’s current debt structure. 

Exor Cost of Debt
Exor Issuance and Cost of Debt

The first thing you notice when you look at the overview is that Exor’s most recent debt issuance has come at very attractive rates. Currently, the weighted average cost of debt is around 2.6%. 

Now, this should tell you more about the current interest rate environment of easy money rather than Exor becoming a better borrower. Money is cheap in Europe currently, especially if you have an investment-grade balance sheet. Exor has even been able to participate in the ECB’s Euro Commercial Paper program, which offered rates at a negative yield. Nonetheless, the fact remains that Exor has a pristine balance sheet and creditworthiness. 

Exor’s Cost of Equity

Whilst finding the cost of debt is pretty clear cut, the cost of equity is a bit more open to interpretation. One way to estimate the cost of equity would be to simply invert the P/E ratio of a company. But the P/E ratio is a reflection of history, so you would need to compare it to future earnings. This, of course, is problematic if the company is not profitable. A negative income does not equal negative cost of capital. 

This is not the case with Exor. Accounting regulations require Exor to consolidate the operations of  FCA, RACE, CNHI and JUVE in its financial statements, along with PartnerRe. As a result, Exor reports earnings that include their pro-rata ownership of those holdings. 

Furthermore, there are three analysts covering Exor that have provided their estimates of Exor’s earnings per share for 2020. This gives us a decent proxy for expected returns and cost of equity capital: 

Exor N.V.201920202021
EPS12.986.7018.976
Yield19.00%9.81%13.14%

As you can see from the table above, Exor delivered an impressive €13 per share profit per share in 2019. This was partly from asset sales, hence are not recurring earnings. The analysts are expecting earnings to normalize in 2020 and 2021 to €6.70 and €8.98 respectively. If we use the 2020 earnings estimate as a proxy, Exor’s cost of equity capital is around 10.5% at the current market price of €64.08. 

We can compare this to the earnings yields of the three publicly traded holdings, FCA, Ferrari and CHN Industries. 

StockPriceEst 2020 EPSEPS/Price
BIT:EXO€68.30€6.7019.81%
BIT:FCA€11.78€2.79323.71%
BIT:RACE€150.15€4.1292.75%
BIT:CHNI€8.36€0.8229.84%

FCA currently trades at a forward earnings yield of almost 25% (P/E ratio of 4). At the same time, Ferrari’s 2020 earnings estimate is less than 3% of the current share price. This stark difference reflects investors expectations of the future cash flows these two companies are expected to be able to generate. 

FCA operates in a highly cyclical, capital intensive industry at the brink of fundamental disruption, whilst Ferrari is amongst the world’s most luxurious luxury brands, with significant untapped pricing power and untapped demand. 

Exor’s Cost of Capital

At its current market capitalization, Exor’s weighted average cost of capital is around 9%:

Exor Capital€ BillionCost Share
Equity€15.4410.46%81.95%
Debt€3.402.60%18.05%
Total€18.849.17%100.00%

In the four years after the PartnerRe acquisition, Exor has been paying down debt. Exor has also been a buyer of its own equity. From November 2018 and through August 2019, the company executed a buyback program, buying back €269 million of stock at an average price of €55 per share.

Going forward the market is expecting Exor shareholders to earn around 10% return on equity. 10% return would be higher than the long term average of the S&P500, so obviously nothing to complain about. But how realistic are these expectations?

The Infamous NAV Discount

Those of you who have been following Exor over the years will be well aware that Exor – as any well behaved Euro-Conglomerate – has been trading at a meaningful discount to its Net Asset Value throughout its 10-year history as a publicly-traded company. 

We can rationalize the existence of a holding company discount in a number of ways: 

  • Exor itself is controlled by the Agnelli family. If there is a control premium, should minority shareholders not suffer a non-control discount? 
  • The holding company structure adds an additional layer of costs. That cost should be factored into the price of Exor. 
  • When Exor receives cash distributions from their investments it creates a taxable event. This tax leakage should be factored into the price as it’s more expensive to hold these assets through Exor as it would be to hold them directly. 
  • Holding companies tend to be run by asset hoarders and not all assets hoarder are Warren Buffets. 

Although all of these reasons are good and valid, we need to stay true to the casuistic nature of these musings. We need to ask ourselves why Exor is a public company and what they are trying to optimize.

Is Exor trying to maximize profitability or maximize size? 

Elkann is a Singleton, not a Buffet

Exor is controlled by John Elkann, who is currently the leading figure of the Agnelli family. His great-great-grandfather was Giovanni Agnelli, the founder of FIAT. Elkann is currently the Chairman and CEO of Exor, as well as chairman of FCA and Ferrari. 

John Elkann is somewhat known within value investing circles. He’s been spotted on the Berkshire Hathaway annual meetings and he writes informative letters to his fellow shareholders. Investors and other observers have even speculated whether Elkann is attempting to build a European Berkshire-like holding company. But if we look at the past 10 years, Exor seems more like a Teledyne than a Berkshire.

“Tele-what?” you might ask yourself. Henry Singleton is the least known investor, that the most famous investors known and regularly cite. Singleton ran a company called Teledyne for over 33 years. His track record is one of the greatest out there. What set Singleton apart, was his flexibility in capital allocation. Singleton would issue Teledyne stock if its valuation was rich and buy back stock if it was cheap. He was both a serial buyer and a serial divestor of companies.

If we look at Exor during Elkann’s ten-year reign. We can see more similarities with Singleton & Teledyne than Buffett & Berkshire:

Exor 10-year Portfolio Rotation
Exor 10-year Portfolio Rotation

To answer the question above, Elkann has shown himself to be a profit maximizer. Exor has very actively managed its portfolio of investments, both by selling portfolio companies as well as splitting them up through spin-offs.

At the same time, Exor has gone to the capital markets when the opportunities have arisen, such as was the case with PartnerRe. At the same time, Exor has bought back shares if the discount to NAV widens.

In fact, it should be noted that in our examination of the Cost of Equity above, we used the consolidated earnings to figure out the expected return. Yet if we look at how Exor has created value for its shareholders in the past, it has not just been from generating earnings.

To a large part, the wealth creation has come from, what Marty Whitman would refer to as, resource conversion, by redeploying assets to other usage or other ownership. Through this focus on resource conversion, Exor grew its shareholders’ NAV per share (note the shareholder-friendly metric) at a compounded annual rate of 18.9% during its first decade.

Exor Growth in NAV per share
Exor NAV per share growth

Will Exor find projects that return over 10% in invested capital in the future? I would expect so. What I would also expect is for Exor to create shareholder wealth by utilizing its creditworthiness when funding those future projects.

More on Exor


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