The past seven or eight months have been brutal for Europe’s tier-one automotive suppliers. It’s bad enough that component shortages have led OEMs to produce less than they’d like, but erratic start/stop times have taken their toll on vendor operations and supply and labor issues also did them a disservice.
The best thing I can say about ValeoThe performance of (OTCPK:VLEEY) since my last update is just a quick glance at Faurecia (OTC: FAURY) and Vitesco (VTSCY) shows that it could have been even worse, although all underperformed US providers like Aptiva (APTV) and BorgWarner (BWA).
Navigation is not yet easy for Valeo. While the company should be past the worst of the production disruptions, I think the street will still be worried about the losses associated with electric vehicle development programs and the risk that the internalization of electric vehicle components will limit the long-term opportunities. These aren’t new concerns, but there aren’t many positives to offset them now. I think Valeo is significantly undervalued here, but the company needs beat and stimulus reports (especially on margins) to change sentiment.
Hard hit by production disruptions
Looking at Valeo’s financial results for the final period of 2021, there wasn’t much to like. Although the company ultimately performed a little better than expected in terms of revenue, the end of the year was marked by heavy operational pressure, with the company posting a fairly rare underperformance against global builds (900 bps or 500bp outside geography) on customers- specific disruptions.
Fourth-quarter revenue declined 15%, with OE sales down 19%, while second-half sales were down 12% and 16%, respectively. Driver assist and thermal outperformed slightly, both helped by new product launches, and the former helps a little more as the company sees good margins on new L2+ offerings.
I was surprised that the second half gross margin remained almost flat, limiting the damage to EBITDA to a decline of 15% (margin down 50 basis points to 13.4%), but EBIT was still weak, falling by 55% if the losses of the Siemens (OTCPK:SIEGY) JV, with a margin cut in half to 1.9%.
Management also guided to weaker results for FY22, with revenue, margin (EBITDA and EBIT) and free cash flow all below sell-side expectations, as well as my expectations at the time of my latest update. If Valeo were to meet my expectations below the midpoint for FY22, the company would still see nearly 12% year-over-year revenue growth, although an erosion of EBITDA margin of around 350 bps due to operating difficulties and losses related to the development of EV products.
EV spending continues to pressure margins and the gain is uncertain
Valeo and Siemens finalized a transaction in early February that transfers full ownership of their former joint venture in high-voltage components (chargers, inverters and converters, as well as electric motors and other components) to Valeo.
Valeo paid a net price of just 277 million euros to consolidate the JV, and it should be noted that expectations for the business have definitely diminished over time. At the start of 2018, management was talking about €2 billion in revenue in 2022 with double-digit EBITDA margins, and those expectations have eroded to €2 billion in revenue by 2025. with a breakeven EBITDA.
Bearish analysts have tried to tie the estimate revisions and Siemens’ accepted lower price as “evidence” of underlying corporate weakness, but I think that’s premature. A global pandemic has occurred in the meantime, and this has changed the launch plans for several hybrid programs on which Valeo has content. Additionally, Siemens has embarked on a multi-year simplification plan to focus on what management sees as its core long-term competencies, and I believe management wanted a quicker exit from this joint venture, accepting a lower price for the make.
I’d also like to note that Valeo now has a new CEO, and it’s not really unusual for a new executive to seize the opportunity to set lower initial targets in the interest of building a reputation for “under-promise/ over-delivery” at the start of their term.
I still see risks in the EV program. Valeo came out with strong initial orders, but that pace has slowed. Where Valeo was once well ahead of the competition in terms of announced BEV-related orders, they have fallen back a bit towards the pack, with Bosch clearly in the lead and Valeo, Nidec (OTCPK:NJDCY), and BorgWarner now more confused around #2 (with Vitesco and Schaeffler further away).
I think Valeo may have undervalued some of those initial contracts and overestimated how much of their R&D would be applicable to a wider range of OEM programs (underestimating the amount of customization required), and I think that they’ve since gotten a little tougher on pricing, opting to shore up margins in future business rather than target share-for-share.
Still, not that much has changed in terms of my core beliefs. As I said in that last article, I expect a lot of electric motor content to be outsourced, and Valeo recently backed that view, indicating that they expect 30% of electric motors are outsourced versus 40% of total high-voltage content and even higher amounts for components like chargers (90%).
Management continues to aim for more than 10% share of what is outsourced, and order intake to date confirms this. The company also mentioned supply agreements with companies like Renault (OTC:RNSDF) (OTCPK:RNLSY) which are otherwise outsourced components (Valeo will supply stators for Renault “outsourced” engines). I think this is another trend that should become clearer in the coming years – much of this “insourcing” will actually include significant outsourcing for critical components.
Continued opportunities outside of the powertrain
Valeo is not just about powertrain electrification. The company has the second-largest thermal management business in the vendor space (behind Denso (OTCPK:DNZOY), I believe), and the company is seeing strong growth in orders from BEV platforms and content growth of around 2.5x for its battery-related thermal management products.
Advanced driver assistance systems (ADAS) also remain a significant opportunity. More advanced systems (L2+ and beyond) have significantly better margins than the base business (300 bps or better), and the company has a strong market position. Although the move towards automation/autonomous driving (or L4) is likely to disrupt the industry, Valeo remains the only company capable of supplying all the necessary components in-house.
I’ve been bullish on Valeo, but my modeling assumptions haven’t been that aggressive. This creates a weird situation where the narrative on Valeo is now how disappointing the forecast is through 2025, but the reality is management’s targets are still well ahead of my expectations towards mid-2021.
I have reduced my assumptions for FY22 due to continued disruptions from component shortages in the automotive supply chain, as well as input cost pressures at Valeo, so my expectations for the year are lower than management (19.3 billion euros in revenue and an EBITDA margin of around 11%). For FY’25, however, my estimate has not changed much (revenue of €23.3 billion from €23.5 billion) and remains well below the management target of €27.5 billion. euros.
Same with EBITDA and FCF, where I’m looking for an EBITDA margin of 13.75% (vs. 14.5%) and an FCF of EUR461m (vs. a range of EUR800m to EUR1,000m). I do note, however, that I lowered my margin/FCF estimates more from my prior outlook than from revenue (my FCF margin went from 3.25% to 2.75%).
Long term, I’m still looking for revenue growth of around 3% to 4% long term as Valeo picks up share and content in EVs, with FCF growth of around 5%, as the company will eventually increase production of electric vehicle components and benefit from lower R&D spending. I want the “future Valeo” to be more profitable than the historic Valeo, with long-term FCF margins in the 3% vs. historical average in the low 2%, but I note again that Valeo has been investing in the development of electric vehicles and ADAS (hurting the margins) for many years.
Discounting these cash flows, I think Valeo is significantly undervalued and priced for a double-digit annualized return. I also think the company is significantly undervalued based on the lowest margins. I expect next year to be the worst for margins and the market would normally pay more than 0.6 times revenue for EBITDA margins of 10.75% to 11%. That’s not the case with the industry right now, but I don’t expect hollow margins to last and even a 20% discount at a multiple of 0.6x (or around 0.48x) supports a price action of the stock 50% higher than today’s price.
The auto supplier space has been hit hard, and it will take a normalization of production rates and some easing of input cost inflation to change sentiment. Neither looks particularly likely until the second half of 2022 and possibly not even until the end of 2022. At the same time, the market continues to fear OEM internalization and declining structural margins. of the industry in the long term. Today’s prices seem to reflect that and more, so I think patient value investors may want to take a look at this beat sector and this beat stock in particular.