Valeo May Finally Be Bottoming

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About: Valeo SA (VLEEY), Includes: BWA, CTTAY, FURCY, SIEGY
by: Stephen Simpson, CFA
Summary

Valeo managed to beat lowered expectations for first-half margins, and the company continues to outperform global auto production rates.

Orders were quite weak in the first half, and sell-side analysts remain bearish on both the company's investments into its Siemens JV and its near-term margin prospects.

Valeo has to rebuild its credibility, and that will take time, but I believe the current share price doesn't reflect the company's progress in hybrid/EV components.

The best I can say about Valeo (OTCPK:VLEEY) is that the shares of this French auto parts company really haven’t done much worse than the peer group over the past year, a stretch over which only a small group of stocks like Aptiv (APTV) are up, and that the company continues to outperform underlying global build rates. Valeo remains one of the least-liked companies that I follow in terms of sell-side support, with several “Underperform/Sell” ratings on the shares.

I continue to believe that the shares reflect an overly pessimistic assessment of the company’s future, particularly given the potential of its Siemens (OTCPK:SIEGY) JV for electric vehicle components, but not unlike BorgWarner (BWA), questions have arisen as to the true value of the order book and whether future margins will live up to expectations. Management appears to have almost no credibility on the Street, and I consider this a higher-risk candidate, but I believe stabilization in the global car market next year could lead to a re-evaluation of the shares.

Outgrowing A Weaker Market

Although Valeo’s share price performance over the trailing year isn’t impressive, the shares have noticeably outperformed the sector since reporting earnings in late July. Not only did operating earnings come in a little stronger than expected, management’s guidance for the second half was also a fair bit better than expected. Not that many sell-side analysts are taking that at face value, though, and the revisions since earnings have actually been net negative.

Revenue was a mixed bag. A 2% like-for-like decline for the second quarter isn’t much to celebrate (BorgWarner was down slightly), but Valeo did outperform underlying global car builds by 4% in the second quarter after a 3% outperformance in the first quarter. Valeo’s Comfort and Driver Assistance segment, its highest-margin business, outperformed with a 2% organic decline in original equipment sales, while the other segments were down 4% to 5%, though every segment outperformed underlying builds.

Margin appears to be bottoming out, potentially easing a major concern on the part of many investors and analysts. Gross margin was still down on a half-over-half and year-over-year basis (down 240bp), but the decline was less severe than expected, and management guided to improvement in the second half on raw material tailwinds and improving manufacturing efficiency.

First-half EBITDA declined 9% (110bp of margin contraction), with an overall EBITDA margin of 12.5%. At the segment level, C&DA did the best with just 30bp of yoy margin erosion (to 14.6%), while Powertrain margin declined 150bp (to 12.4%), Thermal declined 110bp (to 11.2%), and Visibility declined 200bp (to 10.7%). Operating income declined 32% on an adjusted basis, beating expectations by about 3%, while operating income, including the JV losses, declined 44% on higher losses in that JV.

Orders Down Sharply, But Management Sounding More Bullish

Orders dropped about 21% year over year in the first half, but improved about 9% sequentially, and the company ended with a 1.3x book-to-bill. Orders plunged in China (down 50%), but past order reports haven’t had a particularly reliable correlation with reported revenue. Some of this could be due to unreported order cancellations, but I believe the bigger issue is the same as what companies like Continental (OTCPK:CTTAY) and BorgWarner are seeing and reporting, with auto customers delaying certain launches, launching in smaller-than-anticipated volumes, and otherwise pushing production plans “to the right” and waiting for auto demand to improve.

Relative to the reported results, Valeo management sounded relatively bullish. Management reiterated guidance for the full year despite a lower outlook for global vehicle production, and they believe they will continue to outperform underlying vehicle production rates by a meaningful amount, while also seeing margin benefits from improving materials costs and production/operating efficiency initiatives. Valeo’s outlook for full year global auto production contraction of 4% is basically in line with the outlooks from Continental and Faurecia (OTCPK:FURCY).

Getting Little Credit For The Future

Valeo is a top-four player in almost all of its major markets categories, but it certainly isn’t getting much credit for that now. The problem, at least for the sell-side, is that the company has continued to spend on R&D during this downturn, with operating margin declining from about 8% in 2017 to around 4% in the first half of 2019 (including the JV losses). While it’s true that near-term auto supplier stock multiples correlate pretty tightly with EBITDA margin, it’s not as though the money Valeo is spending is being wasted on frivolities.

I continue to believe that the Valeo-Siemens JV is going to position Valeo as a major player in vehicle electrification, both in hybrids and battery electric vehicles. At this point, of course, separating tomorrow’s winners and losers is a highly speculative exercise, but early analysis of products like the electric motors and e-drive units suggests a very competitive portfolio (in terms of power/weight), as well as a relatively diverse portfolio across motors, inverters, and e-axles, as well as battery cooling and advanced driver assistance systems outside the JV.

It’s odd to me that Valeo is taking hits on both sides of the EV argument. Not only do some analysts fret about the future health of the Powertrain segment (assuming, apparently, that the Siemens JV won’t meaningfully offset weaker global sales of internal combustion engines, despite increasing demand for dual clutches, electric superchargers, and so on), but they also fret about the losses Valeo is incurring to build the Siemens JV ahead of future hybrid/EV platform launches. In other words, they’re criticized for being vulnerable to the ICE-hybrid-EV transition, but also for investing in product development to remain a key supplier during that transition.

The Outlook

Valeo does have to improve their margins; on that much I agree with the bears. I believe they will, as global auto demand recovers (eventually) and as the R&D burden for hybrid/EV systems starts to fade. Better guidance in terms of cost containment and/or operating efficiency would be welcome, though, and I’d hope to hear more about that at the December Analyst Day.

I believe Valeo could return to organic growth in the second half of 2019, but that will require a cooperate macro environment, and I’m still concerned that Chinese auto demand could disappoint. Longer term, my outlook hasn’t really changed – I’m still looking for long-term revenue growth around 5% (similar to BorgWarner) and low single-digit FCF margins largely consistent with the past decade (I’m expecting the weighted average margin over the next 10 years to be 20bp better than the weighted average of the trailing 10 years). From the current low base of FCF generation, that translates into strong annualized free cash flow growth of over 20%.

I also believe Valeo is undervalued on the basis of near-term margins. EBITDA margins in the low-to-mid 12%s over the next 12-18 months aren’t impressive, but should still be worth more than what is reflected in the share price today. Using historical norms, Valeo would typically be expected to trade at 0.8x forward revenue, but even a 0.65x multiple to 12-month forward revenue would support a stock price more than 30% above today’s price. Between discounted cash flow and the multiple-based approach, I believe Valeo shares may be around 15-35% undervalued today.

The Bottom Line

I think we’re seeing the auto supplier segment bottoming out, but it could take a few quarters of bumping along the bottom before outlooks and guidance start improving. To that end, I’m not sure anybody needs to rush to buy Valeo, and management still has work to do in repairing its reputation and credibility with the sell-side and institutional investors. I do believe the underlying business is stronger than the stock would suggest, though, and I continue to believe this is an out-of-favor name for more aggressive investors to consider.

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.