Frari was the namesake of Enzo Ferrari. An automotive engineer his entire life, Enzo worked with Alfa Romeo for many years, performing every possible function including lathe instructor, test driver, racing driver, and eventually, serving as the director of the Alfa Corse racing division.

In 1929 Enzo founded Scuderia Ferrari in Modena, Italy. Scuderia was a racing stable, where owners could drive and compete with their own cars. Enzo left Alfa Romeo in 1939 to open his own firm, Avio Costruzioni on Viale Trento Tieste in Modena (the plant was eventually moved to Maranello). After the forced hiatus during the second world war, Ferrari launched the 125 S in 1947, and on May 25, 1947, the Ferrari 125 S won its first race, the Rome Grand Prix. Ferrari has since won more than 5,000 races worldwide.

The financial pressures of sustaining the growing high-powered Ferrari family of cars resulted in Enzo partnering with the Fiat Group in 1969, Fiat initially taking a 50% interest, then increasing it to 90% in 1988. Enzo's remaining 10% ownership was passed to his son in that same year with his death. It was now the Fiat Group and its family interests that sustained Enzo Ferrari's legacy. That legacy was now led by Fiat's new CEO, Sergio Marchionne.

Limits to Growth

We pursue 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.

?New Business Netherlands N.V., Form F-1, U.S. Securities and Exchange Commission.

Like other rare elements, Ferrari's value was linked to its scarcity. As illustrated in Exhibit A, Ferrari had methodically controlled volume sales growth, averaging just 4.24% per year over the 1997-2014 period. Sales growth had actually been even slower than that average rate in the post-2009 crisis period. Total sales volume in 2014 was 7,255 cars?an astonishingly small number by any automobile standard.

Scarcity Premiums

In terms of preserving Ferrari's value, this relative scarcity was both good news and bad news. The good news was that leadership had clearly maintained the product's relative scarcity in a global economy that had grown faster and wealthier at a much more rapid rate. According to a recent study, the number of high net-worth individuals (HNWIs) and their wealth, the target demographic segment for Ferrari sales (at least historically), had grown 8.6% per annum for nearly 30 years.11

The countries driving Ferrari's sales reflected that wealth creation. Sales volumes in 2014 were roughly 45% Europe/Middle East/Africa (EMEA), 35% the Americas, 11% Asia Pacific (APAC), and 9% Greater China. This global sales mix seemed to be shifting slightly away from EMEA, with China and APAC garnering the gains. (Global sales volumes are detailed in Appendix 4.) Diving deeper, four countries made up 60% of this global HNWI population: the United States, Japan, Germany, and China.

In its prospectus Ferrari was quite bullish on HNWIs in China. Although China made up only 9% of current sales, the growing wealth and taste for luxury goods in China were promising. China already made up a very large piece of the total sales (2014) for a number of luxury goods producers: Hermes?25%; LVMH?28%; and Prada?30%.12 If that were the case for Ferrari, the company could see growing demand pressures. But there were skeptics, as a number of analysts worried that the Chinese economy was already beginning to slow.

The bad news about this relative scarcity through slow growth was that 4% was not a promising growth rate for an equity if sales and earnings did indeed follow volume growth rates. Publicly traded shares generated income for investors two ways, through dividend yields and capital gains. But with no plans to offer dividends, Ferrari's value proposition relied exclusively on hoped-for capital gains.

Differing perspectives on growth had also caused serious debate within Ferrari. Ferrari's longtime Chairman, Luca De Montezemolo, had left the firm suddenly in 2015, reportedly over his opposition to the IPO. Montezemolo believed the IPO would force the firm to grow sales volumes at a much more rapid rate. Ferrari's CEO, Sergio Marchionne, had repeatedly stated publicly that Ferrari's future was as a business, not art: There comes a point when exclusivity, if it becomes unreachable, is no longer exclusivity, it's like you're reading a fiction novel . . . let's not fool ourselves, we are in the business of selling cars to people.

Financial Performance

Ferrari's financial results for the 2012-2014 period appear in Exhibit B. The company had a relatively small product portfolio, consisting of eight vehicles that accounted for 70% of total revenue. Its sales and rentals of engines were exclusively to Maserati (it had supplied engines to Maserati since 2003), and its other sponsorship income was tied to Formula 1 racing.

Yet, Ferrari's R&D expenses were exceedingly high compared to any other automobile manufacturers.14 Where R&D expenses as a percentage of sales averaged less than 5% for most of the global industry, Ferrari's were 20.3%. Porsche, a distant second, was 11.3%, Volkswagen 6.5%, BMW 5.7%, Daimler 4.4%, and Fiat 3.8%.15

Ferrari's premium pricing resulted in a gross margin that was more like a Silicon Valley Internet firm than an automobile manufacturer. As illustrated in Exhibit C, Ferrari's gross margin?net revenues less direct costs?was 45.5% in 2014, more than double that of any other major automobile company. That large gross margin in turn generated an extremely large operating margin (EBIT as a percentage of sales) of 14.1%, again the highest in the industry.

The spread between the two margins, gross less operating, was?at 31?delivering financial results far beyond an automaker. That same spread averaged only 12% amongst a peer group of luxury automobile manufacturers, and was twice that of other major players.16 This despite the fact Ferrari was dwarfed by the others in terms of size in vehicles sold, employees, revenues, or even total profits.

Ferrari's IPO on Tuesday, October 20, 2015, was by all standards a huge success. Of the 189 million shares authorized in Ferrari's incorporation, 17.2 million (9.1%) were sold to the public. At a launch price of $52 per share, Fiat raised $894.4 million. The over-subscription allowance raised another $28.6 million, bringing the total to $923 million.

One of the drawbacks associated with the IPO was that the capital raised was not targeted for reinvestment into the business, as was common in many IPOs, but rather to compensate existing owners (Fiat) for reducing their interest. For a company that believed in investing in technology, this was a loss.

Price Growth

Ferrari has provided some insight into the potential of automobile price growth, repeatedly noting it was "committed to raising the average price point" of its products. Assuming that the scarcity discipline toward volume growth is maintained, and attention is focused on maintaining a four month waiting period for orders, the baseline analysis assumes that price may grow 2% per year. It is possible, however, that more aggressive annual price increases of 3% to 4% may be achievable.

Other Revenues

Ferrari's income from the sale of engines to Maserati, rental incomes, and sponsorship associated with the brand are all expected to grow a moderate 3% per year. Formula 1 income, a small component that leadership believes is critical to the brand, is only expected to grow 1% annually.

Cost of Sales Changes and Gross Margin

Ferrari purchases from a small set of suppliers working under relatively long contracts. It employed 2,858 workers and turnover was low. Labor costs and costs of sales were expected to grow at 2% per annum in the baseline analysis.

SG&A and R&D Expenses

This was in the eyes of many the second most critical valuation component behind that of volume sales. If SG&A and R&D expenses both only grew at 2% per annum, reflecting what many analysts believed to be the company's cost discipline and strategy moving forward, Ferrari's operating margin would indeed grow considerably over the 10-year forecast period.

Depreciation and Capex

In its prospectus, Ferrari noted that there would be little additional investment in plant and equipment necessary for expanding volume production in the coming years. The company considered itself inherently agile, production increases were nominal in size, and sufficient capacity existed.

At the same time, historical financial statements indicated continuing capital investments in both PP&E and intangible assets (intellectual property and related engineering knowledge). Depreciation expenses had totaled ?120 million in 2013, ?126 million in 2014, and were expected to total ?130 million in 2015. The DCF baseline analysis assumed no growth from 2015 levels in line with management's direction. However, many analysts believed capital investment had to grow, at least in line with direct costs, if Ferrari is to maintain its technological edge. Capex and depreciation were assumed equal in size in the valuation analysis.

Net Working Capital

Ferrari's net working capital (NWC) was unusually long in duration due to its dealer network financing program. Ferrari provided extremely low-cost loans to its dealerships (independently owned businesses) to aid in their purchase of the automobiles for resale. The loans were typically secured by the titles to the cars or other collateral. Total receivables, trade receivables for the cars themselves, and receivables from financing activities, loans to the dealerships, had averaged 180 days of sales in 2014. Ferrari's hand-crafted manufacturing had averaged inventory levels of 72 days of cost of sales, and trade payables at 130 days of cost. The baseline DCF analysis therefore assumed 180/70/130 days in A/R, inventory, and A/P going forward.

Terminal Value

Most valuations assume a business like Ferrari will continue to operate for many years. The TV in Exhibit D uses the typical perpetuity calculation form. In an attempt to be conservative with the TV, net free cash flow (NFCF)?the sum of net operating cash flow after-tax plus depreciation, capex, and changes in working capital?is assumed to grow at 0% for all years past 2025. The TV for the baseline case, using the corporate cost of capital (discussed next) as the discount rate and assuming a 0% perpetuity growth rate, is ?13.748 billion:

Terminal value=NFCF2025 (1+g)kwacc?gTerminal value=NFCF2025 (1+g)kwacc?g

=1,194.13(1+0%)8.686%?0%=13,748=1,194.13(1+0%)8.686%?0%=13,748

Note that despite using conservative assumptions, TV still makes up 59% of the total NPV.

Cost of Capital

The final component of the valuation was the calculation of a weighted average cost of capital (WACC) for Ferrari. This was of course challenging given that the company was just now moving from being privately held to being publicly traded.

Debt

Estimates were needed for two costs of debt, both euro-denominated.17 The first was the baseline cost of debt in the European Union and euro-denominated markets, the 10-year German government bond rate. This was considered the risk-free rate of interest in the euro markets (kRF),(kRF), and was currently at 4.000%. The second cost of debt needed was for Ferrari itself (kD).(kD). Although the firm had incurred little debt of its own to date, European banks were quoting the company a rate of 6.000% (therefore a 2.000% credit spread over the risk-free rate). With an effective tax rate of 33.5%, the after-tax cost of debt was 3.990%.

Equity

To estimate the cost of equity (ke)(ke) using the capital asset pricing model (CAPM), assumptions need to be made about the risk-free rate of interest (kRF),(kRF), the market risk premium (MRPm),(MRPm), and Ferrari's beta (?).(?). The cost of equity was then calculated as the risk-free rate plus a beta-adjusted market risk premium:

Cost of equity=ke=kRF+?MRPmCost of equity=ke=kRF+?MRPm

The risk-free rate was 4.000%, and the market risk premium (MRPm),(MRPm), the average spread of expected returns on equities in Europe over and above the risk-free rate, was currently assumed to be about 5.500%.

Estimating Ferrari's beta (?)(?) was in many ways guesswork with no real trading history. A company's beta was measured over time, statistically, as the covariance of the company's return with that of the market, divided by the variance of the market return. By definition the beta of the market was 1.0. A firm with returns that were relatively less volatile than the market might have a beta less than 1, typically between 0.6 and 1.0. A firm demonstrating more volatile returns than the market may have a beta as high as 1.8 or more. With no history, and no clear conclusion over whether Ferrari was an automaker or a luxury good in the eyes of the market (at least not yet), a conservative assumption was a beta of 0.9. The resulting cost of equity was 8.950%.

Cost of equity=keCost of equity=ke

=4.000%+(0.905.500%)=8.950%=4.000%+(0.905.500%)=8.950%

As illustrated in Exhibit E, current estimates of the market cost of debt and equity were used to calculate a weighted average cost of capital (WACC). Ferrari's capital structure was largely equity, with interest bearing debt outstanding of ?510 million, representing only 5.3% of its capital structure. Note that this analysis calculates Ferrari's equity value on its market value, meaning equity value is the company's market capitalization, the share price of ?48 per share (market close on December 31, 2015) for the 189 million shares outstanding. The WACC was calculated as 8.686%.

* Uses share price of ? 48 per share (closing price December 31, 2015) and 189 million shares outstanding.

Using the calculated WACC for Ferrari and its projected cash flows, the baseline DCF analysis in Exhibit D estimated a present value of net operating cash flows of ?10.135 billion. The present value of all projected operating cash flow accruing to equity was ?9.625 billion after netting the ?510 million in company debt. Given 189 million shares, this was a per share value of ?50.93 ($56.02 at $1.10 per euro). Further sensitivity and scenario analysis were obviously needed to provide more of a range and context for the DCF valuation.

Ferrari believed its value arose from scarcity. Do you agree with Ferrari's leadership that a slow volume growth strategy to maintain that scarcity is the best strategy for the company in order to maximize value for investors? Based on the DCF analysis and other information provided in the case, do you think that the IPO was correctly priced?

A-4 APPENDIX A American Eagle Outfitters, Inc., 2017 Annual Report AMERICAN EAGLE OUTFITTERS, INC. Consolidated Balance Sheets February 3. January 28 (in thousands, except per share amounts) 2018 2017 Assets Current assets: Cash and cash equivalents 413,613 $ 378,613 Merchandise inventory 398,213 358,446 Accounts receivable, net 78,304 86.634 Prepaid expenses and other 78,400 77,536 Total current assets 968,530 901,229 Property and equipment, net of accumulated depreciation 724.239 707,797 Intangible assets, net of accumulated amortization 46,666 49,373 Goodwill 15,070 14.887 Deferred income taxes 9,344 49,250 Other assets 52,464 60.124 Total assets 1,816,313 S 1,782,660 Liabilities and Stockholders' Equity Current liabilities: Accounts payable 236,703 $ 246.204 Accrued compensation and payroll taxes 54,324 54,184 Accrued rent 83,312 78,619 Accrued income and other taxes 12,781 12,220 Unredeemed gift cards and gift certificates 52,347 52,966 Current portion of deferred lease credits 11.203 12,780 Other liabilities and accrued expenses 34,551 36,810 Total current liabilities 485,221 493,783 Non-current liabilities: Deferred lease credits 47.977 45,114 Non-current accrued income taxes 7,269 4.537. Other non-current liabilities 29,055 34,657 Total non-current liabilities 84,301 84.308 Commitments and contingencies Stockholders equity: Preferred stock, $0.01 par value, 5,000 shares authorized; none issued and outstanding Common stock, $0.01 par value; 600,000 shares authorized; 249.566 shares issued, 177.316 and 181 886 shares outstanding, respectively 2,496 2,496 Contributed capital 593,770 603,890 Accumulated other comprehensive loss, net of tax (30,795) (36.462) Retained earnings 1,883,592 1,775,775 Treasury stock, 72,250 and 67,680 shares, respectively, at cost (1,202 272) (1,141.130) Total stockholders' equity 1,246,791 1.204,569 Total liabilities and stockholders' equity 1,816.313 S 1,782.660 Refer to Notes to Consolidated Financial StatementsAPPENDIX A American Eagle Outfitters, Inc., 2017 Annual Report A-5 AMERICAN EAGLE OUTFITTERS, INC. Consolidated Statements of Operations For the Years Ended February 3. January 28, January 30, (in thousands, except per share amounts) 2018 2017 2016 Total net revenue S 3,795,549 S 3,609,865 $ 3,521,848 Cost of sales, including certain buying, occupancy and warehousing expenses 2,425,044 2,242,938 2,219,114 Gross profit 1,370,505 1,366,927 1,302,734 Selling, general and administrative expenses 879,685 857,562 834,700 Impairment and restructuring charges 20,611 21,166 Depreciation and amortization expense 167,421 156,723 148, 156 Operating income 302,788 331,476 319,878 Other (expense) income, net (15,615) 3,786 1.993 Income before income taxes 287, 173 335,262 321,871 Provision for income taxes 83,010 122,813 108,580 Income from continuing operations 204,163 212,449 213,291 Discontinued operations, net of tax 4,847 Net income 204, 163 S 212,449 $ 218,138 Basic income per common share: Income from continuing operations 1.15 S 1.17 1.10 Discontinued operations 0.02 Basic net income per common share 1.15 $ 1.17 $ 1.12 Diluted income per common share: Income from continuing operations $ 1.13 S 1.16 $ 1.09 Discontinued operations 0.02 Diluted net income per common share 1.13 S 1.16 1.11 Weighted average common shares outstanding - basic 177,938 181,429 194,351 Weighted average common shares outstanding - diluted 180, 156 183,835 196,237 Refer to Notes to Consolidated Financial Statements