Fiat's Fragile Renaissance

[Plex]

Small is beautiful. Or at least investors seem to think so when it comes to European auto stocks. Fiat, the Italian small-car specialist, has outperformed the region's other auto makers in the past six months, its stock rising 38%. On 11 times forecast 2011 earnings, Fiat is trading more in line with Mercedes' parent Daimler and truck maker Scania than bigger volume car makers like Renault and Peugeot.

That is a generous view of the risks facing Fiat despite its recent resilience. With wafer-thin operating margins, it remains reliant on governments maintaining incentives for buyers of new cars in Europe to get it through 2010. It has a free option on a U.S. auto-sector recovery in its 20% stake in Chrysler but it is too early to say how much that will be worth. Chrysler's sales sank last year to their lowest since 1962.

After Fiat's €848 million ($1.2 billion) net loss for 2009, Chief Executive Sergio Marchionne forecasts a year of "transition and stabilization," sweetening the pill by recommending the restoration of Fiat's ordinary dividend, with a return to revenue growth and net profit of more than €200 million.

But Fiat will have to earn at least five times that in 2011 to justify its current valuation. And if incentives for scrapping old cars aren't renewed, Fiat says it won't make a profit at all this year. More government aid isn't yet a given. Fiat knows it can't count on an extension in Germany, where the one-off subsidy lifted sales by 42% last year. The Italian government has so far just made encouraging noises about extending its subsidy.

The subsidies are a double-edged sword. They have tilted the market toward less profitable smaller, low-emission vehicles, visible clearly at Fiat. Excluding Ferrari and Maserati, Fiat's automotive operating profit margin fell to 1.8% from 2.6% in 2008. Yet without subsidies, Europe's oversupplied auto market might be plunged into a price war.

Of course, there's more to Fiat than small cars. It remains the top car and light truck supplier in Brazil, responsible for roughly a fifth of sales. Streamlined truck unit Iveco, pushing into China, and machinery maker Case New Holland should benefit from recovering industrial activity this year. But investors shouldn't forget the drag on overall performance of Fiat's European auto business.

WSJ