VLEEF - Valeo: Primed To Benefit From The EV Transition

2023-06-14 14:19:41 ET

Summary

• Valeo's expertise in powertrains, lighting, and ADAS positions the company to outperform as the world transitions to electric vehicles (EVs).
• The business is expanding its target market, diversifying and creating new growth opportunities.
• The key concerns we have are the poor margins, lack of growth in distributions, and large financial commitments to support growth.
• Despite poor margins, I believe the current valuation (3.7x NTM EBITDA) is considered too low given the company's strong commercial factors and growth potential.

Investment thesis

Our current investment thesis is:

• Valeo's scale and expertise in powertrains, lighting, and ADAS (in particular) have positioned the business to outperform in the coming years as the world transitions to EVs.
• The business is expanding its target market, further diversifying the business and creating new growth opportunities.
• Margins are poor but the current valuation (3.7x NTM EBITDA) is far too low relative to the impressive commercial factors.

Company description

Valeo SE ( VLEEY ) is a company that specializes in designing, manufacturing, and selling automotive components, systems, and services globally.

The company operates four segments:

• Comfort & Driving Assistance Systems - offers products such as ultrasonic sensors, radars, and cameras that aid in parking and driving assistance.
• Powertrain Systems - focuses on electric powertrain systems for electric vehicles.
• Thermal Systems - designs and manufactures systems, modules, and components that optimize thermal management.
• Visibility Systems - designs and produces lighting and wiper systems.

Share price

Valeo's share price has declined across the historical period despite an improvement in financial performance. The initial gains are a reflection of EV momentum building and investors pricing in the potential tailwinds for Valeo. Subsequently, this view looks to have soured (for reasons we will discuss shortly).

Financial analysis

Presented above is Valeo's financial performance for the last decade.

Revenue & Commercial Factors

Valeo has grown its revenue at a CAGR of 5% across the last 10 years, which is a good performance in our view given the maturity of the automotive industry.

Valeo is a truly global business, with no single region generating more than 45% of revenue. This allows the business to benefit greatly from geographical diversification, reducing downside risk (weaknesses in regions) while allowing the business to partake in growth regions. The only issue here is FX risk as the business reports in Euros.

Further, the business boasts some of the largest automakers in the world as clients, reflecting what is an impressive market position in a highly competitive industry.

This implies Valeo's overall offering is one of the best in the industry. In order to serve this many leading players, a company must be in a position to both meet the demand operationally (Scale, flexibility, etc) and to create a range of products that meet the various quality requirements.

Valeo has a high-quality business model in our view. The company operates a range of related divisions, which are both complementary and broad in their offering. Firstly, Valeo provides several services to the automotive industry allowing the business scope for cross/up selling, as well as benefit from shared competencies. Further, the broad approach to innovation allows the business to service industries beyond just automotive. For example, Valeo's products are also used in other transportation, as well as lighting expanding beyond just car lights. This has allowed the business to reach a substantial scale globally by leveraging its competencies. This increases its total addressable market and deepens its relationship with clients, making demand sticky.

The critical factor underpinning the business model is innovation. Valeo is not producing simple products for cars, it is operating in highly complex segments where very few are able to operate at scale. For this reason, continued spending is critical, which we have seen with R&D spending increasing at a CAGR of 13% and Capex at a CAGR of 3%. With the large-scale expertise, the business is in a positive development cycle, where it is able to continually innovate on top of its current products to further push its superior position.

The key growth area in the automotive industry is electric vehicles. This poses a major threat to most parts businesses, as EVs come with a reduced number of parts, and more complex, OEM parts, fundamentally changing the industry. Valeo is well-positioned to capitalize on this trend with its expertise in electric powertrain systems, battery cooling solutions, and advanced charging technologies. The company is already servicing many of the large producers.

The development of autonomous vehicles is rapidly transforming the automotive industry, representing another growth area. Valeo's expertise in advanced driver assistance systems (ADAS) positions the company to benefit from the growing demand for autonomous driving technologies. Management expects the market to grow at a CAGR of 15% to 2025, with the content per car increasing by 1.4x.

Lighting continues to be a core success segment for Valeo, a market in which Valeo has the largest market share. This segment is also seeing growth in usage per vehicle, with the average content per car increasing by 1.2x.

Future profitability will be driven by the transition toward EVs, as the legacy offering becomes a smaller part of the overall group. Unlike other businesses, we do not see risk around disruption, especially given the successful innovation thus far.

Expanding beyond cars is a smart move by Management, as rapid technological development means the future of travel is uncertain. Further, the company has capabilities that can expand beyond cars and so this looks to be a natural transition to increase the company's total addressable market. We see material scope for value with commercial vehicles, which are going through a similar electric / ADAS transition.

Moat

Valeo's has a strong moat in our view. Its scale and deep expertise have allowed the business to develop a market-leading position. Smaller players may be in a position to develop a superior product, but they are unlikely to reach the scale required to serve the large players.

Economic & External Consideration

Softening economic conditions could represent a near-term risk to the business. With high inflation and elevated rates, we are seeing softening spending as consumers protect their finances. This is extending to the automotive industry, which will impact the demand for parts. This said, we do not see this as a material concern.

Margins

Valeo's margins are quite poor in our view. The company has an EBITDA-M of 8% and a NIM of 1%.

The reduction in margins in the last 3 years is a reflection of the Covid-19 impact, as well as inflationary pressures impacting its supply chain. We expect this to subside in the coming year as inflation continues its slow decline. This said, it is unclear if margins will materially bounce back.

The poor NIM is not due to a material change in below-the-line charges, but instead the weakness in operating profitability. We believe this to be the fundamental reason for the poor share price development in the last decade. Investors are dissuaded by investing in a marginally profitable business.

Management is seeking to rectify this, targeting a several percent improvement in the coming years. The improvements will stem from operational improvements, both efficiencies and cost-cutting. We are always hesitant when this is the strategy, as in many cases, businesses face slowing growth by cutting costs. The difference here potentially is that Valeo's demand is relatively sticky.

Balance sheet

Valeo has been raising debt in recent years as a means of continuing its investment in expansion. With a ND/EBITDA ratio of 2.3x, we believe the company is still in a comfortable position.

Cash flows show little volatility and sufficiently cover debt commitments and capex. However, the absolute value remaining is unattractive. Due to this, distributions have been extremely poor (no buybacks or dividend growth), compounding the unattractiveness of the stock to investors.

Outlook

Presented above is Wall Street's consensus view on the coming 5 years.

Analysts are forecasting an impressive revenue growth rate in the coming years, with the rate improving to 9%. This is a reflection of the EV transition and the general commercial strength of the business in our view (and looks reasonable).

Margin improvement looks small, with FCF equally poor. This suggests analysts are also hesitant about how this will materialize.

Valuation

Valeo is currently trading at 6x LTM EBITDA and 3.7x NTM EBITDA. On a NTM basis, the company is trading at a discount to its historical average.

We believe there to be sufficient justification for a premium relative to the company's "average" position in the last decade, namely:

• The EV transition looks to be successful and legislation is in place across many large nations to phase out Petrol/Diesel. This should support increased growth as this transition intensifies.
• R&D investment looks to be yielding improved commercial attractiveness, reflected in the development of several leading products such as the electrified powertrain segment and ADAS.
• Industry tailwinds in Lighting and ADAS represent an opportunity to accelerate sales growth and customer wins. This is a rapidly accelerating development which Valeo has not yet fully benefited from.

Although not directly comparable, Continental AG ( CTTAF ) (c.10% EBITDA-M, lower growth rate) is trading at 4x NTM EBITDA and Denso ( DNZOF ) (c.12% EBITDA-M, lower growth rate) is trading at an 8x multiple, further supporting the assertion that Valeo is attractively valued.

The key issue and factor holding the company back is its poor margins. That said, at 3.7x NTM EBITDA, investors cannot have everything.

Catalysts

Financial performance has been resilient despite economic concerns. A strong performance, especially if beating analyst estimates, could contribute to a share price rally (boosting NTM EBITDA multiple to the 4-5x range).

Conversely, the margin profitability means if Valeo slipped to a negative NIM, markets would not take kindly to this given the maturity of the business.

Key risks with our thesis

The risk to our current thesis is continued margin slippage from supply chain issues, as well as difficulties with the realization of margin improvement. Although we are hesitant about the realization of the whole amount Management is forecasting, we are expecting some improvement.

Final thoughts

Valeo is a high-quality business and a commercial powerhouse. It has a deep moat, with a large scale, deep expertise, and an impressive client base. This will marry well with industry tailwinds and successful innovation in next-generation technologies.

We believe the forecast uptick in growth looks reasonable but remain hesitant about the overall attractiveness of the company given the poor margins. Management's focus should remain on this.

Concerns aside, the business is trading at 3.7x NTM EBITDA, which is far too low in our view.

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