Participating in secular trends, when executed correctly, can end up being a veritable magic carpet ride to investment success and financial security. The automotive industry could be witnessing the evolution of one such trend as the electric vehicle gains popularity and penetration in the market. Of course, whether electric vehicle production can continue progressing to allow the product to truly end up achieving the level of acceptance that would see it be a prominent share of the industry will only be known years in the future. Let's start with what we already know, and what is currently being projected. As noted by Bloomberg, electric vehicle sales grew by about 60 percent worldwide last year. As Wikipedia concurs, we have seen this adoption of electric vehicles in major markets across the globe:
Likewise, current long-term forecasts are, let's just say, optimistic. Bloomberg continues by noting that technological advances in electric vehicle production are increasing the relative attractiveness of the price point when it explains that "battery prices fell 35 percent last year and are on a trajectory to make unsubsidized electric vehicles as affordable as their gasoline counterparts in the next six years... by 2040, long-range electric cars will cost less than $22,000 (in today's dollars), according to the projections. Thirty-five percent of new cars worldwide will have a plug." (emphasis mine) Again, their prediction for the effect of this electric/internal combustion equivalence on demand errs to the side of optimism:
The 41 million annual sales figure Bloomberg forecasts by 2040 really only represents around 11.5% annualized growth, however. Navigant Research provided another shorter-term forecast when it projected that "the global light duty EV market is expected to grow from 2.6 million vehicle sales in 2015 to over 6.0 million in 2024 under a base scenario." Not as promising as Bloomberg, but this would still be around 9% annualized growth. Clearly, electric vehicles are not being seen as a fad, but a possible major demand contender in the future of the automotive industry.
When thinking about major industry shifts, it is not the readily seen, first-order effects which I find most captivating, or even likely most profitable, sources of investment opportunity. It is the second and third-order effects that can often leverage the trend and be a source of optionality. What is truly driving the efficiency advances in electric vehicle production? As Bloomberg continues on to explain, it's really all about the batteries:
In a press release for the study, Colin McKerracher, lead advanced transportation analyst at Bloomberg New Energy Finance, said, " At the core of this forecast is the work we have done on EV battery prices. Lithium-ion battery costs have already dropped by 65% since 2010, reaching $350 per kWh last year. We expect EV battery costs to be well below $120 per kWh by 2030, and to fall further after that as new chemistries come in." (emphasis mine) Which brings me to my higher order idea on the electric vehicle trend: Gentherm Incorporated (NASDAQ:THRM).
Gentherm Incorporated is a global technology and industry leader in the design, development, and manufacturing of innovative thermal management technologies and automotive cable systems. As the business summary of the most recent 10-K says, the company's automotive products "provide solutions for automotive passenger comfort and convenience, battery thermal management, remote power generation and other consumer and industrial temperature control needs. Our products can be found on the vehicles of nearly all major automotive manufacturers operating in North America, Europe and Asia. We concentrate our research on the development of new technologies that will enable new products, improve overall effectiveness of existing products and maximize customer satisfaction. We also focus on developing new design applications from our existing technologies to create new products and market opportunities for thermal comfort solutions. Our customers include light vehicle original equipment manufacturers ("OEMs"), commercial vehicle OEMs, and Tier 1 suppliers to the automotive OEMs, including automotive seat manufacturers."
Note the mention of "battery thermal management" near the beginning of the business summary. In perusing the document, you'll also see this term come up in the business strategy section: " Our strategy includes the following key elements: Penetrating new markets and industries by creating new innovative solutions and products such as battery thermal management, waste heat recovery, remote power generation, automotive thermal convenience, heated and cooled mattresses, and heated and cooled office furniture among others." (emphasis mine)
What exactly is battery thermal management (or BTM)? It is effectively a temperature control system, of which Gentherm has developed an innovative solution that improves the performance and useful life. As explained in the 10-K, "Thermal management is critically important for the long-term operation of advanced automotive batteries. The expansion of electrified vehicle applications, such as 48V electrical networks, start-stop systems, regenerative braking systems and other micro-hybrid battery implementations, have drastically increased the demand for BTM systems solutions which enable wider operating temperature ranges, enhanced driving range and prolonged life of the battery. Gentherm's BTM system can provide precision battery cooling on pack or cell-level using patented TED technology. The BTM system maintains the temperature of the lithium-ion battery or other advanced chemistry battery within an acceptable temperature range without the use of chilled liquids or refrigerant loops, making it a light weight, highly scalable, compact solution ideal for automotive applications. Gentherm's proprietary BTM system is compact and energy efficient, resulting in a minimal energy budget for an electrified vehicle. The performance improvements realized with this product have been validated through the award of production BTM systems by two flagship OEMs. We are currently working with other OEMs in an effort to secure more production contracts." (emphasis mine)
A visual on Gentherm's website is effective at highlighting the important attributes of the company's new system:
The real reason Gentherm has piqued my interest in this regard is that its BTM product is still in its infancy, having thus far contributed essentially nothing (other than R&D expense) to the company's financials. As CEO Daniel Coker noted in the most recent earnings call for Q2 2016, "we will have some dribs and drabs of revenues as these things [BTM programs] start to go, but when we are referring to a launch in 2017, the full volume will start at one of our programs in 2017 and the second program will follow at 2018. So there will actually be small revenues here and there as the customers buy early stage production runs, but it won't be anything significant until 2017 and 2018." Earlier this year, Gentherm secured its second contract for its BTM system from one of the major automotive OEMs. As PR Newswire summarized, "The five-year contract, awarded by a major automotive strategic partner, could generate up to $8 million in annual revenue with the first shipments to begin for model year 2018... Gentherm previously announced in July 2015 it had been awarded its first BTM contract by a major automotive manufacturer that could generate up to $25 million in annual revenue. This new award supplements that achievement." This thus allows us to evaluate the financials and the existing business as effectively the standalone foundation of the investment, knowing that we have optionality in the hidden exposure to a higher-order play on a major secular trend.
Outside of battery thermal management, Gentherm has still become an industry leader, and as mentioned before, its products are used by essentially all of the major automotive OEMs. The largest product lines, by revenue contribution, are currently climate control seats (or CCS) and heated seats. As noted in the company's 10-K for fiscal 2015, "Sales of CCS products contributed 47%, 45% and 40% to our total product revenues for the twelve-month periods ending December 31, 2015, 2014 and 2013, respectively... Sales of heated seat products contributed 32%, 37% and 43% to our total product revenues for the twelve-month period ending December 31, 2015, 2014 and 2013, respectively." Again, the end-user OEM make up is a veritable who's who of the industry:
Nevertheless, it is very important to note the actual dynamic of these relationships, however. As the 10-K explains, "For our most recent fiscal year, our revenues from sales to our three largest customers, Johnson Controls, Lear Corporation and Bosch Automotive were $193,381,000, $192,335,000, and $74,736,000, respectively, representing 23%, 22%, and 9% of our total revenues, respectively. Revenues from Johnson Controls and Lear Corporation represent sales of our seat comfort, thermal convenience and interior comfort products. Revenues from Bosch represent product sales based on our automobile cable system technology and are used primarily in the production of automotive oxygen sensors. The loss of any one of these customers is likely to have a material adverse impact on our business; however, as noted above, our strategy is to market our seat comfort products to the OEMs who then direct their suppliers, such as Johnson Controls and Lear Corporation, to work with us." (emphasis mine) Not exactly ideal, therefore, as customer concentration is actually much more risky than would be led on by the illustration of the OEM breakdown. But let's get on to the financial performance for now. Over the past few years, we have seen revenues grow, margins hold respectably (important, as absolute revenue has been affected by M&A activity - more on that below), and signs of scale emerge:
Measures of safety have also remained positive, with a current ratio above 2, and though debt has increased relative to equity, the absolute level should be perfectly manageable, particularly given the company's strong cash flow generation:
The note on cash flow generation is important, in my opinion. One point of concern with Gentherm, as mentioned above, has been the company's historical M&A activity, which has at points been aggressive enough to bring questions of excess. However, most, if not all, have made sense strategically, with Gentherm absorbing real competitors and thus preserving the integrity and competitive advantage of its intellectual capital. The 10-K notes that its patent portfolio is extensive:
"As of December 31, 2015, Gentherm held 471 issued patents, of which 197 were U.S. patents and 274 were non-U.S. Patents. A total of 24 patents were held jointly with other companies. Gentherm held 343 patents directed to climate control products and thermoelectric technologies, 100 patents directed at heating elements and technologies and 28 patents directed to air moving devices."
Thus, management seems to have been exercising prudence in the M&A activity. Two useful measures for management effectiveness, free cash flow generation and cash return on invested capital have thus been mixed, but certainly respectable:
After falling short of analyst expectations in the second quarter of this year, however, shares experienced a pullback, and relative measures of value are looking much more compelling:
I also took a look at the valuation using a residual income model. First, note that even with the miss in Q2, the company still expects to come in at the low end of guidance for full-year 2016. CEO Daniel Coker noted this in the Q2 earnings call when he said, "We are fairly confident right now that the 10% looks solid for the full year based upon what we see in terms of releases for the third and early releases for the fourth quarter." Additionally, he reiterated that "we are very focused on achieving our corporate goal of growing 10% to 15% per year and we believe that we have the underpinnings for that to continue in 2017 and actually may be even accelerate in 2018 and 2019." Thus, I ran two scenarios: one in which the company continues growing at the low end of guidance (10%), and one in which it grows at the high end of guidance (15%):
Note that the model generates a ratio called "IVP," or intrinsic value-to-price. I got the idea for this model in an old issue of Dylan Grice's Cred and Credulity back when he worked for SocGen. For example, an IVP of 1.1 would indicate 10% upside based on the model. As you see above, the two growth assumptions produced values of 0.89 and 1.15, respectively. The equal-weighted average of these (given that I have no reason to lean one way or the other) is 1.02, indicating fair valuation at current prices. However, remember that we're trying to understand the optionality afforded by the battery thermal management system. Also remember that CEO Daniel Coker explained that revenues from that program will not be at all significant until next year at the earliest (and more likely 2018), and that there is thus possibility of accelerated growth in 2018 and 2019 beyond the base corporate goal of 10-15%. Given this, I ran another scenario in which the company grows at the low end of guidance (10%) for the next two years (in addition to meeting the low end of guidance this year), but then growth accelerates to 25% for the next three before falling to a long-term perpetuity of 3%:
As shown, this produced an IVP of 1.51, indicating 51% upside. And this, of course, included no dividend assumption, which could be an additional possibility in the coming years if M&A activity slows down given the company's strong free cash flow generation, as illustrated earlier.
Gentherm Incorporated has found itself in a unique position in the electric vehicle business. Having developed a technology that improves the efficiency of what many believe is the key focal point of improving electric vehicle production, namely the electric vehicle battery, Gentherm shares have unique embedded optionality as this battery thermal management program begins to be fully rolled out and the electric vehicle trend is also allowed to play itself out. Given the company's exposure to major automotive OEMs, a successful launch of this product could open the door to very material new revenue streams. There are risks, of course. First of all, even with the recent pullback seen in Gentherm shares after missing second-quarter expectations, shares appear to be fully valued on the existing business. Additionally, the company has a history of aggressive M&A activity, and while I believe management was acting mostly prudently in the past, if organic growth fails to meet corporate growth goals, M&A activity could be relied upon to fill the gap, leaving shareholders ever waiting to have cash returned to them. Finally, the electric vehicle trend could simply fail to develop as forecasted, either because of a failure of additional progress in manufacturing efficiencies or because a new, perhaps unforeseen, technology moves in to shake up the industry before electric vehicle acceptance is allowed to reach maturity. Still, I feel the strong fundamental base that is Gentherm's existing business, coupled with the opportunity provided with the battery thermal management business gives the shares a unique optionality that is hard to ignore.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.