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Fiat Chrysler and Peugeot: Intended Merger Could Benefit Both Companies

Earlier today, on Dec. 17, the boards of Fiat Chrysler Automobiles NV (NYSE:FCAU) and French automaker Puegeot SA (XPAR:UG) met to discuss a binding memorandum of understanding to merge. The tentative initial proposition is a $50 billion merger that would create the fourth-largest automaker in the world, and the signing of a binding memorandum is expected within the next few days.

The merger would ostensibly be 50-50, though Puegeot may have the upper hand as it will control the combined company's board. If the deal does not fall through due to regulatory concerns or another factor, Fiat Chrysler and Puegeot seek to hammer out the terms of the deal by the end of 2019.


Potential benefits

Seeking to keep pace with rivals when it comes to low emissions technology and innovations such as electric and self-driving vehicles, Fiat Chrysler has been looking for a partner that has an established electric vehicle line and can share the costs of investing in research and development. The company has a current ratio of 0.82 and an Altman Z-score of 1.36, meaning its debt is such that a significant decline in cash flows could send it straight to Chapter 11 bankruptcy. Under these conditions, the company has not been willing to further its debt for the development of new technology.

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In addition to making it part of one of the largest automakers in the world with an estimated 8.7 million cars sold per year, the deal would also provide Puegeot with more exposure to the U.S. market. While European cars in general are not popular among older generations in the U.S. due to poor road quality and cheap gas prices (which are ideal conditions for high-off-the-ground gas guzzlers), they are becoming increasingly popular among younger Americans, who tend to prefer smaller and more environmentally friendly cars.

Regulatory hurdles

Last year, Fiat Chrysler's proposed partnership with Renault SA (XPAR:RNO) was blocked by the French government due to concerns of how Renault's Japanese partner, Nissan (TSE:7201), would be affected. Regulatory concerns for the merger in France center around concerns that the overlap between the two companies' small cars businesses would cause job cuts, though both sides promised not to close any of their plants solely due to the deal, as the merger itself should not cause a decline in demand.

On the Fiat Chrysler side, U.S. economic advisor Larry Kudlow said in November that the Trump administration intends to review the merger for potential connections to China. China's Dongfeng Motor Group (HKSE:00489) owns 12% of Puegeot, though it intends to sell a portion of its shares back to the French carmaker. If the merger and share resale are completed, it would drop Dongfeng's stake in the company to 4.5%, but the subject of partial Chinese ownership of a company with a strong U.S. presence is a subject of contention for the Trump administration in light of the trade war.

Global auto sales decline

Global car sales are set to drop by 3.1 million in full fiscal 2019, according to economist forecasts from Fitch Ratings, which would mark the steepest auto sales decline since the 2008 financial crisis.

"The downturn in the global car market since the middle of 2018 has been a key force behind the slump in global manufacturing and the car sales picture is turning out a lot worse than we expected back in May," Fitch Ratings' chief economist Brian Coulton said in a statement.

The decline is occurring across most of the world, though it is worse in some countries than in others. Auto sales are expected to decline by 4% overall, 2% in the U.S. and 11% in China.

Germany's Center for Automotive Research also predicts a decline in auto sales, estimating that the number of cars sold will drop more than 4 million in fiscal 2019. The German research company accounted for higher losses due to U.S. sanctions and stricter emissions regulations in Europe. Both research reports expect the decline in sales to occur in 2019 and stabilize at those levels for the next few years (most likely through 2022). Professor Ferdinand Dudenhoeffer, the director of the German Center for Automotive Research, said that the report does not account for any fallout from Brexit or potential U.S. tariffs on European vehicles.

"If the U.S. president puts into action his latest threat to impose further punitive tariffs on more than $300 billion in U.S. imports, there is a danger of a global car crisis," Dudenhoeffer posted on Twitter earlier this year.

Fortunately for Fiat Chrysler and Peugeot's revenues, neither company relies on China for a significant portion of their sales, but an escalation of trade tensions between the U.S. and Europe could cause problems if the companies merge, making it more difficult to cross-sell their products in new markets.

Creating shareholder value with declining sales

As you can see in the charts below, which detail quarterly revenue and net income, Fiat Chrysler has seen its sales decline more in recent quarters than Puegeot. Fiat has a three-year revenue growth rate of 0.2%, while Puegeot has an three-year annual growth rate of 10.3%.

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Perhaps because investors are already beginning to see the decline in auto sales, though, both companies are firmly in undervalued territory according to their Peter Lynch charts.

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It is inevitable that further drops in demand for their products will see decreases in the share prices of both companies. However, a merger would serve to protect the financial health of both companies in times of meager earnings, perhaps saving Fiat Chrysler from seeing a bankruptcy like that of Chrysler in 1979.

Additionally, a merger with high synergy potential and the creation of one of the largest companies in its sector would increase investor optimism, which is arguably the factor with the most influence on a company's share price. Unfounded optimism is what creates economic bubbles, and reasonable optimism can often lessen damage from market cycles and other temporary setbacks to profitability.

Regardless of any potential short-term increase in optimism or share prices, it is most likely wiser for investors to avoid establishing new positions in the automobile companies right before an industry-wide decline, though current shareholders might have reason to consider holding on to their shares and closely following new developments.

Disclosure: Author owns no shares in any of the stocks mentioned. The mention of stocks in this article does not at any point constitute an investment recommendation. Investors should always conduct their own careful analysis or consult registered investment advisors before taking action in the stock market.

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This article first appeared on GuruFocus.