Fiat Chrysler Automobiles Stock Upgraded: What You Need to Know

Every day, Wall Street analysts upgrade some stocks, downgrade others, and "initiate coverage" on a few more. But do these analysts even know what they're talking about? Today, we're taking one high-profile Wall Street pick and putting it under the microscope...

Fiat Chrysler Automobiles (NYSE:FCAU) stock is on a runaway train,�rising 72% in price over the past 12 months, even in the face of a looming trade war between its two home bases of Europe and the U.S. In just a few weeks, the car company will report its fiscal Q2 2018 earnings, potentially giving investors a chance to keep on winning.

Today, one analyst on Wall Street says the stock could in fact have more room to run.

Image source: Getty Images.

Upgrading Fiat Chrysler stock

This morning, Jefferies & Co. announced it's upgrading shares of Fiat Chrysler Automobiles to buy and assigning the stock a $23 price target, as reported on StreetInsider.com�(subscription required). As the analyst explains, valuation plays a big part in Jefferies' upgrade -- but not the only part.

Over the past 12 months, Fiat has generated $7.3 billion in positive free cash flow from its business which, as Jefferies points out, is equivalent to 24% of the company's $29.3 billion market capitalization -- what the analyst calls a 24% "FCF yield." (Flip your numerator and denominator, and it's also what we'd ordinarily call a price-to-free-cash-flow ratio of 4, which I agree is pretty darn cheap.)

Fiat Chrysler isn't quite as cheap as it looks on the surface, mind you. The company does carry a modest $5 billion in net debt on its balance sheet, which gives it an enterprise value-to-free cash flow ratio of 4.7. But even that valuation is very attractive.

Cheap -- and getting better

Jefferies also notes that in some ways at least, Fiat Chrysler is getting better even as its stock gets cheaper. The analyst cites a "step-up in margin" for one thing. Gross margin at Fiat has inched up 150 basis points over the past five years (to 15.3%), and operating margin has expanded nearly twice as much -- up 290 basis points to 6.4%, according to data from S&P Global Market Intelligence.

Jefferies believes these improvements are "ongoing," and will permit Fiat to maintain its 24% free cash flow yield in 2018, and create enough cash to keep the yield around 15% in 2019.

Caveats and provisos

No company is perfect of course, and Jefferies does have a few quibbles concerning Fiat Chrysler. "[D]elayed RAM production" is one concern. (Fool.com auto specialist John Rosevear notes�that "FCA has had some trouble getting its all-new 2019 Ram into full production.")

Trade war worries aren't lost on this analyst, either, with Jefferies ruminating about the potential effect of tariffs on "an estimated 30k units imported from the EU into the US ... and c.14k Jeeps exported to China." The analyst also notes that "NAFTA re-negotiation is a risk that remains difficult to quantify."

Still, it's hard to argue with a valuation this cheap, and Jefferies seems to believe that the discount investors are applying to Fiat Chrysler stock is excessive relative to the stock's risks.

Valuing Fiat Chrysler stock

Is Jefferies right about that? According to data from S&P Global, the consensus analyst estimates show that Fiat Chrysler's profitability will pretty much peak in 2018, topping out at $3.94 per share (pro forma) this year, inching up to $3.95 per share next year, but then falling back to $3.60 per share in 2020.

At the same time, the free cash flow that so attracts Jefferies today is expected to fall by more than half over the next two years, to less than $3 billion in 2020. Even at that level, though, Fiat Chrysler stock would be selling for less than 10 times FCF at today's prices, while its P/E ratio (a number more commonly tracked by investors) would be a mere 5.2 at current valuations.

Long story short: Fiat Chrysler is a cheap stock. Jefferies is right to recommend it.