Autoliv: Leader In Strong Industry With Deceivingly Attractive Metrics

| About: Autoliv Inc. (ALV)
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Autoliv (NYSE:ALV) is a leading manufacturer of safety equipment for the automotive industry. The company has been an industry stalwart over the years: the company has grown revenue consistently at about 7% CAGR since 1997 while the broader market has only grown at 4%. Other historical achievements are its significant patent portfolio, its ability to reduce costs, the consistent decrease in capital employed, and the decrease in number of defects. The company is poised to continue strong performance due to the industry's barriers to entry, increased safety regulation and demand, the company's ability to generate free cash flow, the company's position as a low-cost producer, the stable demand for its traditional products and the takeoff of the active safety industry. The company has weaknesses such as price pressure from major manufacturers, lack of technological differentiation from key competitors, exposure to European market, lesser relative exposure to growing emerging markets, and antitrust issues. On a relative and historical basis the company appears slightly undervalued; after adjusting for one time irregular charges, valuations look significantly more attractive. However, a DCF yielded a reasonable upside, but not with a significant margin of safety. Consequently, Autoliv is a strong company that is a good but not great investment at this point.

Revenue Analysis

The company's geographic and product line distribution of revenue are summarized by the graphs below.

Source: 2011 ALV Annual Report

These figures present positives and negatives. Regarding the geographic distribution, the company has a significant portion of revenue from Europe, where revenue declined organically by 7% over the first three quarters of this year. Additionally, the company does generate sizeable revenue in Japan. This revenue is likely to grow more slowly than competitors', such as Takata, revenue in Japan. In the first three quarters this year, organic growth in Japan was 16% lower than light vehicle production (LVP) growth there, because Autoliv is focusing efforts on emerging markets growth, and Takata and Toyota have market strongholds in Japan. The company remains strong in the Americas and China. While Europe is a major portion of sales, the company has significant geographic revenue distribution, preventing overexposure to certain regions, and providing steady growth over the long run.

About 2/3 of Autoliv's revenue comes from airbags, a market in which Autoliv has approximately a 35% market share. The concentration of revenue here is a positive because the airbag market is likely to grow faster than that of seatbelts. Growth of safety products is driven by, among other factors, individual wealth, as safety is often the first extra feature consumers look for in cars, and government regulations. Seatbelts were introduced significantly earlier in history, are cheaper than airbags, and seatbelt regulation was introduced before airbag regulation. Consequently the seatbelt market and technology has reached maturity because of widespread customer adoption. Airbags, however, are still developing, and more airbag legislation is imminent. Examples, according to Takata's and Autoliv's most recent annual reports, include Brazil's requirement for frontal airbags in all cars in 2014, the U.S. requirement for all new vehicles in September 2013 to have side airbags, and India's consideration of a new crash test system. These factors should make airbags a relative growth market.

Active safety represents a miniscule revenue stream currently; however the market is expected to rapidly expand in the coming years at 31% per year. This is reasonable given the nascent level of the market ($0.8B vs about $20B for seatbelts and airbags) and its significant benefits. The difference between passive safety (airbags, seatbelts) and active safety (collision warning, blindspot assist) is mitigation vs. prevention, with the latter being far superior.

Lastly, the company's products makes Autoliv attractive for investors. According to consumer reports safety is one of the, if not the, leading factors in buying a car. While Autoliv is dependent upon the automobile industry, its products are a necessity amongst other parts ensuring sales for years to come provided the automobile remains a primary transportation mode.

Industry And Competitor Analysis

Autoliv operates in an oligopolistic market with worldwide distribution to a small number of purchasers. Key competitors in the seatbelt and airbag markets are Takata, a Japanese company, and TRW automotive holdings (NYSE:TRW). According to Autoliv's annual report, the company holds about 6300 patents while Takata has about half of that; TRW has approximately 7100.

Source: 2011 ALV Annual Report

Given these numbers, that the company is focusing on reducing costs, and the similarity of company offerings upon company website examination, it appears that within the industry these firms primarily compete based upon price. However, industry barriers are extremely high. The various companies' refined production process and supply chain took years to develop, preventing others from competing on price. Above all, they developed a track record and relationships with leading auto manufacturers. Even if an entrant could generate a similar patent portfolio, it would take years to refine the production process to meet industry safety requirements, which are extremely high given the liability of a malfunction. Only manufacturers with proven records of production perfection satisfy manufacturers; for example Autoliv currently has a rate of five defects per million parts produced. These factors make these companies' positions very stable.

Another important industry characteristic is the small number of purchasers of these companies' products. This characteristic gives purchasers significant bargaining power to the auto companies, which Autoliv admits in its annual report:

"The extent of pricing reductions varies from year to year, and takes the form of reductions in direct sales prices as well as discounted reimbursements for engineering work."

Autoliv and others have offset these price reductions by decreasing materials used, sourcing to more low-cost countries and pursuing efficiency improvements, as illustrated below.

Source: 2011 ALV Annual Report

These figures explain why Autoliv has grown market share; the company has successfully decreased production costs. However, further cost improvements will certainly be more difficult, especially as Autoliv is already close to some productivity goals. Future reductions will also be smaller as a percentage of revenue. If manufacturers continue to squeeze Autoliv and others on price, margins could compress. More likely is the scenario that margins continue to increase but at a slower rate.

Autoliv appears to have a relatively strong position concerning the geographic and consumer distribution of revenue compared to Takata and TRW. Autoliv's, Takata's, and TRW's customer distribution can be seen below:

Sources: ALV Annual Report; TRW 10K; Takata Annual Report

TRW, in comparison to the others, is dependent upon a much smaller range of customers. While Takata and Autoliv have a similar amount of revenue dependent upon top customers, Autoliv serves manufacturers from across the globe and companies producing upper-end cars such as BMW, where Autoliv's more expensive safety products can gain traction.

TRW's and Takata's geographic distribution of revenue can be seen below.

Sources: TRW 10K; Takata Annual Report

TRW has much more exposure to the difficult European markets and significantly less exposure to the growing emerging markets. Takata on the other hand is the opposite. Autoliv in comparison has a much more geographically diverse revenue breakdown. Takata's concentration in the Japanese and Asian markets could create difficulties; the Japanese population is rapidly aging, reducing the number of people operating cars. Chinese and Japanese conflict has already hindered Japanese automakers in China; this could prevent growth in this market.

While the companies' main offerings are very similar, Autoliv is the only one actively pursuing the active safety market. According to its web site, TRW only has electronic systems focused on cruise control, integration of brakes, and a vibrating steering wheel; similarly Takata only mentions a lane departure system on its website. Autoliv has all of those features and many more. This difference is growing as Autoliv's recent acquisitions have exclusively focused on active safety. While this market is unlikely to have an appreciable impact upon the companies' bottom lines in the near future, this is a major long-term trend and it appears that Autoliv is ahead of competitors.

Finally it appears that Autoliv is the lowest-cost producer in the industry, illustrated by the margins below:

Sources: ALV Annual Report; TRW 10K; Takata Annual Report

Autoliv and Takata make a direct comparison because their product lines are virtually identical. Autoliv and TRW are an imperfect pair because only the gross margin for TRW as a whole was available, and TRW makes chassis and products outside of safety. However, the market for chassis has properties similar to those of safety markets. These figures, especially the comparison to Takata, illustrate that Autoliv operates with lower variable and fixed costs. This should allow them to continue to win market share and survive a market downturn which lowers prices.

Other Company Strengths

One reason that the company is a low-cost producer is the company's flexible cost structure. The company is constantly restructuring to optimize plant usage and bring utilization rates up. In fact the company states in its most recent annual report that Autoliv can change production levels faster than automotive companies, allowing them to avoid the effects of sharp demand changes.

The company's large amounts of R&D and capital expenditures are deceiving and may in fact be a strength. Last year R&D was $568MM or 6.9% of sales last year. However, $127MM of this came from customer funded projects, implying a true expense of $441MM. Of the remaining amount, 75% was related to projects for which Autoliv had customer orders, and the other 25% was for new innovations. Thus Autoliv's R&D is going directly to high yielding and low risk projects that solidify its products and relationships, unlike the R&D expenses of a pharmaceutical or video game company.

Capital expenditures have already been nearly $265MM through three quarters this year and are on pace to be 4.5% of sales according to management. CAPEX has grown rapidly from $140MM recession levels in 2009. However, from 2002 to 2011, Autoliv's capital expenditures grew at 5.56% CAGR. The company has increased its capital expenditures recently to catch up on investment, develop active safety and pursue growing emerging markets. For example, the company states:

"In October, Autoliv announced its single largest capital expenditure of $33 million. The expenditure relates to a new plant in China that will manufacture propellants for airbags to help satisfy the strong long-term demand for automotive safety products in Asia. The new plant, Autoliv's twelfth manufacturing facility in China, will increase the Company's global propellant capacity by approximately 25%, thereby enabling Autoliv to increase its annual airbag production capacity by 25-30 million when the propellant capacity is fully utilized."

While CAPEX may increase faster than it has historically, these investments will have strong returns, and over the long run, CAPEX growth is likely to regress to lower historical trends.

Source: 2011 ALV Annual Report

Finally, the company appears to have very shareholder friendly management. The company makes statements in its annual report that "cash flow from operations should only be used to finance investments in operations until the point when the return on investment no longer exceeds the cost of capital," and, "Since Autoliv has historically used both dividend payments and share buybacks to create shareholder value, the Company has no set dividend policy. Instead, the Board of Directors regularly analyzes which method is most efficient, at each instance, to create shareholder value." It was actually a positive to see the company cut its dividend during the recession after years of increase.

Source: ALV 2011 Annual Report

It generated the free cash flow necessary to pay the dividend, but wanted to be conservative in the harsh economic climate. This illustrates a long-term perspective from management, and not one that will succumb to short sighted shareholders. In addition to the cost efficiency measures the company has pursued, management has been successful at increasing sales and profits while decreasing capital employed from over $3.5B in 2007 to $3.2B in 2011. While further efficiency improvements can not be predicted, this illustrates a shareholder friendly attitude.

Weaknesses And Risks

In addition to the dependence upon the cyclical automotive market, price pressure from manufacturers, lower exposure to emerging markets, exposure to Europe, and slower margin expansion, there are other issues particular to Autoliv. First and foremost are potential anti-trust issues. The company was already investigated by the US DOJ, to which it paid a $14.5MM fine. This investigation has triggered subsequent investigations by similar authorities in Japan, Canada, and Europe. Most troubling, the company recognizes this issue and states:

"Although the duration or ultimate outcome of the EC (European Commission) investigation cannot be predicted or estimated, it is probable that the Company's operating results and cash flows will be materially adversely impacted for the reporting periods in which the EC investigation is resolved or becomes estimable."

The fine, although detrimental, is not the most significant potential consequence. If the companies in the industry are found guilty of price collusion or other illicit behavior, future prices could be perpetually lower. However, evidence suggests that Autoliv is not hurting customers for company profit, a hallmark of companies that lost anti-trust cases. One should remember that Autoliv is constantly squeezed by car companies and yet is still innovating, as evidenced by Autoliv's new offerings and reduction in defect percentage.

The company's worldwide presence makes it sensitive to currency fluctuations. Changes in exchange rates had an impact of $259MM through the first three quarters of this year. These figures hide that the company has grown organically by almost 5% yoy. While currency changes are a small percentage of sales, they have a significant impact upon margins as currency changes trickle directly down to the bottom line. Currency neutral margins can be seen below.

Source: 3Q ALV 10Q

These numbers illustrate the significant impact of currency changes. The company does hedge to some degree and somewhat offset by a foreign currency translation adjustment for the first nine months of $24.3MM. Over the long run, however, currency effects are unlikely to have a major impact upon Autoliv because of its geographic diversity. In fact these numbers reveal that the company has performed quite well on a currency neutral basis, and may explain the low valuations of the company.

The company also has a significant portion of unionized labor. This is particularly true for Autoliv's facilities in Europe. Additionally, the company did experience a labor strike in Korea recently.

Finally, the company is dependent upon natural resources and niche producers. Autoliv makes very few parts and depends upon suppliers. 54% of all expenses derive from direct supply of parts; 51% of this cost is raw materials, and the remaining is manufacturer value add. Autoliv and its suppliers have leverage over the other in different ways. However, given the tight controls on the company's supply chain, a disruption in part supply would be very detrimental to Autoliv. The company has in particular been hurt by the significant increase in steel prices, as out of the 51% of raw material costs, 35% is steel, which equates to 9.6% of sales. This is likely to create headwinds in the near future as "Changes in most raw material prices affect the Company with a time lag, which is usually three to six months for most materials" However, a strong case has been made by investors such as David Einhorn, that steel prices will not continue to rise and may fall due to decreased Chinese demand and influx of supply. In fact prices have already started to fall which should boost profits in future quarters.

Financial Analysis And Valuation

The company currently has total debt of $655MM but a net cash position of approximately $250MM compared with total assets of about $6.5B. This compares to a net debt position of $1.2B at the end of 2008. The company has solidified this position to give it the flexibility to make acquisitions in the active safety market and respond to potential. The company has been very adept at managing its assets, keeping operating working capital less than 10% of sales over the past decade. These changes further support the ability of management.

The relative valuations for Autoliv and TRW for the past 12 months and Takata for fiscal 2012 can be seen below:

Source: ycharts.com; yahoo finance

Autoliv appears to be the cheapest on a FCF yield, while TRW appears cheap based upon a P/E ratio and EV/EBITDA ratio. TRW has historically had a low P/E ratio because of its significant debt levels. Takata has a negative free cash flow, and if one goes back to the profitable year of 2011, Takata's FCF yield is 5.59% while Autoliv's would be around 10% for the same period. The difference in FCF yield between TRW is not substantial, but Autoliv has generally traded at a premium to TRW based upon FCF yield, seen in the charts below displaying FCF yield over time and as a histogram:

Source: ycharts.com

After removing the recession outliers, TRW has traditionally traded at a FCF yield of 9.81% while Autoliv has traded at 8.55%. The closure of this gap represents an opportunity for significant price appreciation of Autoliv stock.

On a different note, the above graph illustrates the profitability of the industry and the adroitness of management. Between the two companies, there have only been three quarters of negative FCF over the past 10 years. All three of those belong to TRW.

It appears Autoliv is trading at a slight premium to historic FCF yields. However, currency effects and artificially high steel prices to some degree, have irregularly deflated valuations, which can seen through currency neutral valuations. Given the aforementioned cost breakdown, about 9.6% of the company's sales go to steel. If one assumes that steel prices stay flat over the coming 12 months, and compare that on a percentage basis with the average price of steel over the past 12 months, one obtains a decline of 4.65% of steel costs or $37.1MM of savings. This results in the following chart.

Source: 2012 3Q 10Q ALV; ycharts; yahoo finance

Even without the impact of lower steel prices, the company now is quite attractive on an absolute metric basis. Although currency effects are important, over the long run Autoliv impact will be small for a geographically diversified company like Autoliv, and it should be valued on a currency neutral basis.

Finally a DCF for Autoliv was run. The DCF should be reasonably accurate given business' maturity and industry's stability. It should be noted that currency effects were ignored for the DCF because attempting to predict them is akin to macroeconomic currency investments which is outside this analysis.

The DCF began with a revenue model for airbags, seatbelts and active safety. Future results were grown from currency neutral 2012 prorated results at a specified rate; however, this growth rate would gradually step down at 1/15 this rate to reflect market maturation. A regression was performed to determine a function for operating income as a function of sales. This regression illustrated moderate correlation. To be conservative the operating margin was modeled as the 2011 margin plus a percentage of the difference between the predicted margin and the 2011 margin.

The model relied on a significant number of inputs; these values and determinations are in the appendix. 3 different cases were run, and Autoliv inputs and results can be summarized as follows:

The market multiplier represents how Autoliv has grown sales faster than Autoliv markets, and is likely to continue this trend because of Autoliv's low cost structure. The next three inputs represent the growth rates of the various markets. The operating margin factor represents the percentage of the difference between predicted and 2011 operating margins applied.

The base case represents a scenario in which business continues to expand, although at a slightly lower than historical rate, while margins continue to expand. These growth figures were based off numbers provided by the company's 2011 annual report. The bull case represents a scenario in which emerging markets grow faster than expected primarily because the security content per vehicle rises as wealth increases. This results in higher market growth and faster growing margin. Finally the bear case represents a situation in which the overall market does not grow as fast and the company gain of market share slows, resulting in slower margin expansion.

Given these results it appears that the market is pricing in the bear case. However, the base case represents a good but not great upside. While conservative measures were taken when possible, the DCF is just one measure of value that relies upon numerous assumptions, necessitating a large margin of safety. The upside results are based on a share price of $62.14 as of 12/14/12. Autoliv appears undervalued, but not to the point of a significant margin of safety.

Conclusion

Autoliv is a strong and well-run company in an industry with strong intrinsic fundamentals. There are numerous reasons, including government regulation, rise of active safety systems, and rising wealth internationally that should keep the company growing. While there are risks to the company, such as dependence upon the auto industry, anti-trust issues and exposure to Europe, these factors are outweighed by the company's strengths. The company appears undervalued on a historical, relative and absolute basis. However, it appears that the price offered by the market offers a good but not great investment.

Appendix

D&A Growth Rate: Historically D&A has grown negligibly. But that has made significant CAPEX recently so this trend should change slightly, but still less than CAPEX.

Tax Rate: Tax rate should increase from the past couple of years due to the expiration of a Chinese tax credit, but should be lower than the 30% typical of earlier years because of more international exposure.

CAPEX Growth Rate: CAPEX from 2002 to 2011 grew at 5.6% but growth should be higher in the coming years.

CAPEX Growth Step Down: CAPEX growth rate will decline this amount each year until historical levels are reached.

Working Capital Growth Rate: CAGR of working capital from 2006 to 2011

EBITDA Exit Multiple: Assume a 10% compression from current multiple to be conservative

Equity Beta: yahoo finance. Likely conservative because this is high for a company producing such a necessary product

Return On Debt: Interest payment/total debt from first 3 quarters 2012 prorated to full year

NOLs: From company annual report

Market Value of Equity: Google finance

Book Value of Debt: Google finance

WACC: CAPM model

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in ALV over 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.