Is it time? The market is struggling, many signals are screaming SELL and the volatility has increased in the last few months.
However, for value investors, with a long-term view, this can be the best time to initiate a position in good companies.
During the last few months we have watched the sell-off of the auto parts industry. Auto manufacturing rates keep decelerating in the EU and China due to the new world-harmonized light-vehicle test procedures (WLTP).
The tax Imposed by the WLTP created slower demand, which led to lower revenue and margin guidance in the auto parts industry.
Among the many losers, we started analyzing Valeo (OTCPK:VLEEF) and try to understand if it could be one of the long positions in our portfolio.
Only two years ago VLEEF was trading around 60 euro per share. In 2017 the company had around EUR 18.4 Bil in revenue and around EUR 0.88 Bil in net profit (EPS EUR 4.34).
From that point, VLEEF’s shares plunged after the French car parts maker cut its profit forecast because of a slowdown in China and new rules on emissions testing in Europe. The announcement evidenced that consumer demand in China is slowing along with the economy.
A combination of a hike in raw material prices, lower auto production and a sharp increase in the workforce forced VLEEF’s share price down by almost two-thirds.
Exibhit 1: VLEEF share price – Source: yahoo.com
The Industry - When Regulation Affects Demand
While the momentum is bad for the auto industry and, consequently, for the auto parts industry, we believe that some companies are not correlated to the industry’s economic cycle problem.
The companies more linked to the electric car industry should have constant demand growth thanks to the government's stimulus.
Governments are promoting EVs across the world by providing a range of subsidies and other benefits, both on the demand and supply side.
Reducing emissions (both CO2 and NOx) is one of the key reasons, but other considerations (such as economic benefits or gaining a technological edge) also play a role.
The short-term slower demand for auto parts should not impact the long-term future for the companies that provide electric and hybrid components.
Electric cars currently account for less than two percent of global vehicle sales. The technology is expensive and cities lack sufficient infrastructure to charge the vehicles.
Exhibit 2: Global EV/PHEV sales % market share – Source: CEIC - Macquarie Bank
At same time, car manufacturers have ramped up spending on electric cars in following the collapse of diesel car sales across Europe. An increasing number of cities also are planning to ban older cars or impose electric-only zones – with the stringent CO2 rules that come into force in 2021.
New research by Bloomberg New Energy Finance suggests that sales of electric vehicles will hit 30 million by 2030, representing 35 percent of new light-duty vehicle sales. Continuing reductions in battery prices will bring the total cost of EV ownership below that for conventional-fuel vehicles by 2025, even with low oil prices.
Valeo – Among the most promising companies
We believe that thanks to the segment exposure VLEEF will be one of the biggest beneficiaries of increased electric vehicle sales.
There are many auto parts companies, but we see not all made enough investments to anticipate industry needs for the next electric revolution.
We selected the five most promising segments for the electric revolution:
- Electrical/Electronic Content
- Fuel Economy
- Electric Vehicles
Based on our research we see only six companies competing in all segments:
- Valeo (OTCPK:VLEEF)
- Delphi (DLPH)
- Continental (OTCPK:CTTAF)
- Denso (OTCPK:DNZOF)
- Hyundai Mobis
- Bosch (OTC:BSWQY)
If we take a look at those players’ market share during the last 10 years, we see it is almost constant.
This helps us to understand that entry barriers are present. Big investments are required and economy of scale can help to capitalize and create an advantage in terms of R&D.
Although tech companies are starting to enter the industry trying to find a market niche, such as sensors, cameras, semiconductor components, etc., we don’t see those entrants being a problem yet.
They need to scale up revenue and be present around the world. Automakers need a mega supplier who can provide products in all regions.
Moreover, automakers need support aftermarket on the vehicle maintenance, crash, and repair markets.
VLEEF is structured around four well-balanced, coherent business groups that offer innovative solutions to meet the major changes taking place in its markets, aimed at reducing CO2 emissions and developing intuitive driving.
Exibhit 3: VLEEF revenue breakdown – Source: Company presentation
Exibhit 4: VLEEF revenue breakdown in % – Source: Company presentation
Exibhit 5: VLEEF market share – Source: Company presentation
Why does this opportunity exist?
VLEEF has the right long-term strategy. The company is concentrating on supplying ever more advanced technology to the world’s largest car companies.
VLEEF is in very fast-growing market segments, such as electrification of the power-train and driving assistance, for its business groups. It has real growth potential.
VLEEF's capex is huge compared to the industry average. Its capex/depreciation has been on average around 1.6x in the last five years, while the competitors had around 1.25x.
This led to fast revenue growth.
The company could spend less and increase its margin and FCF, but this would not help in the long-term.
Since VLEEF is in a changing and fast-growing industry, they do not mind having lower profits and margin in the short-term. They believe it is the right move to create value for shareholders.
Exibhit 7: VLEEF vs Industry Capex/Depreciation – Source: Author’s Work
Bradley, Hirt, and Smit wrote in their book ( Strategy Beyond The Hockey Stick) that there are 10 “moves” (variables) that make the difference in business. One move is the strong capital program. They found that when capex/sales exceed 1.7 times median for at least 10 years, the capex turn into a big move.
In the last five years, VLEEF Capex/Sales is about 7.96 percent, while the industry median is 5.21 percent. This means 1.53 times the median. Although did not exceed the 1.7 of the median, we believe that VLEEF is in a position to do so in the next five years.
Based on relative valuation, VLEEF should trade around EUR 34 per share.
Exibhit 8: Relative valuation – Source: Author’s Work
We also decided to run our earnings power value and DCF model to understand if there is enough margin of safety.
About the assumptions of our model, you can read one of our old articles where we explain the method. (Consolidation Is Changing The Airline Industry)
Exibhit 9: Earnings Power Valuation – Source: Author’s Work
Our EPV model gives a value per share of EUR 31.40.
The increase in the Capex reduced the company's FCF. For this reason, we decided to use a normalized FCF to value VLEEF.
We assumed that VLEEF can increase revenue by 3 percent every year for the next ten years.
In the last five years, VLEEF was able to generate CFO/Revenue of 11 percent.
We concluded that this is a sustainable yield and that the company will generate the same percentage of cash from operations.
Since the company will continue spending, we expect that Capex/Revenue will be 9 percent for the first five years and it will decrease to 5 percent in later years.
Using a WACC of 10 percent, we have an equity value of EUR 7.17 Bil, which implies a share price value of €30.22
If our assumptions are right, VLEEF should trade around €32 per share.
If the company continues spending instead, we believe the lower FCF will be compensated with higher revenue in the future.
Moreover, by spending more, the company is consolidating its position in the auto parts industry to increase the moat around its business.
However, today’s price doesn’t give enough margin of safety. We will consider adding VLEEF in our European Value Portfolio when and if the price will be around €22-23.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in VLEEF 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.
Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.