Valeo Still Outgrowing The Market, But Investors Stung By Weak Guidance

Summary

• Valeo's fourth quarter results were better than expected, with improving performance relative to underlying auto production and better than expected margins.
• Guidance was weaker than expected and confusing, with management guiding about 7% below the Street on "conservative" assumptions that seem to imply lower content-per-vehicle.
• Valeo has logged some early wins on hybrid/EV models, but management really needs to deliver on more EV wins in 2021 to shift sentiment.
• Mid single-digit revenue growth and mid-to-high single-digit FCF growth can support a fair value 30% above today's price, but management has to deliver on content growth, EV wins, and margins.

The fourth quarter/second half earnings and 2021 guidance from Valeo (OTCPK:VLEEY) (FR.FR) seem like a Rorschach test of sorts for analysts and investors. If you liked the company/stock/story before, you'll find reasons to keep liking it as auto production recovers in 2021. If you didn't like it, you'll find reasons to stay negative, particularly on a pretty weak guide for 2021 revenue.

I'm in the former camp, as I feel Valeo's leverage to EV/hybrid launches and trends like advanced ADAS still don't get full credit as the company incurs the costs today for greater revenue and margins down the road.

These shares have risen about 17% since my last update, a very mediocre performance next to peers like BorgWarner (BWA), Continental AG (OTCPK:CTTAY), and Faurecia (OTC:FAURY), particularly after the earnings report. At this point I still see these shares as meaningfully undervalued, but I do note that Valeo management has to start delivering better results to change the tone, particularly with respect to EV wins in 2021.

Business Is Recovering…

Valeo reported fourth quarter and second half results that were better than expected, with better profitability and free cash flow generation relative to the company's early release in mid-January. As a reminder, Valeo reports detailed financial results only twice a year, with quarterly revenue updates in between.

Fourth quarter revenue showed a return to growth, with like-for-like revenue up 4% to EUR 5B, about 1% better than expected. Valeo's Original Equipment revenue rose better than 5% (to EUR 4.2B), outgrowing underlying production by about 200bp as the company starts to recover from some headwinds including launch delays. Aftermarket revenue declined about 2% to EUR 0.5B.

By segment, Comfort and Driving Assistance revenue rose 7% to EUR 0.98B, beating production by 400bp. Powertrain rose 5% to EUR 1.3B, beating by 200bp, but it remains to be seen if the company has restored some momentum here relative to Continental (which reports on March 9). Thermal revenue rose 4% to EUR 1.1B, 100bp ahead of production, and Visibility rose 5% to EUR 1.5B, beating by 200bp.

For the second half of the year, revenue declined 1% in like-for-like terms, with flat OE revenue. Gross margin improved 10bp from the year-ago level to 17.6%, while EBITDA rose 2% to EUR 1.3B (margin up 70bp to 13.9%). EBITDA was 8% better than expected, and while adjusted operating income fell 10% to EUR 0.47B (margin down 40bp to 5.0%), that was still good for a 9% beat.

… But Guidance Was Weak And Confusing

The general theme across the auto sector has been one of healthy recoveries in demand and positive outlook for ongoing production improvements, even with the near-term semiconductor shortage causing some problems. That made Valeo's significant guidance cut all the more surprising and damaging to sentiment.

Management guided to a revenue midpoint (between their base case and worst-case) of EUR 17.9B, about 7% below the sell-side expectation going into the report and suggesting around 9% growth. Valeo management's production target of 10% for the industry is lower than the IHS estimate of 13.7%, but I've now seen several companies guiding to around 10%, so that's not so strange.

Management also guided to a 500bp outperformance relative to underlying production, offset by some forex headwinds. The trouble is, it's hard to reconcile those numbers without a decline in content per vehicle - something management hasn't acknowledged, and that doesn't really bode well for the near-term, particularly as electric and hybrid projects ramp up.

I suspect Valeo management is acting from an abundance of caution, having been taken to task by analysts and investors in the past for past guidance shortfalls. Fair enough, I suppose. I also note that the EBITDA guide of EUR 2.35B (at the midpoint) is only 4% short of prior expectation, so Valeo is expecting to be more profitable in 2021.

Management did also note a strong improvement in orders, with a book-to-bill of 1.7x in the second half. While this metric should normalize to around 1.4x to 1.5x in the coming quarters, I would still expect to see a significant jump in order activity for the Valeo-Siemens (OTCPK:SIEGY) joint venture (power electronics for EVs and hybrids). If that growth doesn't materialize, you can expect a lot of sharp questions about how Valeo is really stacking up against rivals like BorgWarner, Conti, and so on with respect to race to "win" the switch to hybrids and electrics.

The Outlook

I think there are some reasonable explanations for recent underperformance in the Powertrain business - namely an adverse mix in South Korea and launch delays on key projects in North America. I'd also note that the company has scored some meaningful wins with Chinese automakers like Geely (OTCPK:GELYY), but has also seen some clients like Ford (F) choose others for certain e-vehicle projects (like the Mustang Mach-E).

All in all, I believe Valeo has a compelling platform for hybrids/EVs, including an e-drive unit with leading power/weight performance and a robust offering in power electronics (including inverters, motors, and chargers). Will companies like BorgWarner and Nidec (OTCPK:NJDCY) get notable wins? Absolutely, but I think Valeo will be among the leaders as the dust settles on the strength of its full suite of offerings in motors and power electronics, not to mention offerings in areas like advanced ADAS.

I expect Valeo revenue to accelerate meaningfully on auto production recoveries and new hybrid/EV launches over the next three years, with those launches helping drive operating scale for the Siemens JV over a three to five year period. I expect to see long-term annualized revenue growth of around 4% and FCF growth around 7% over the next decade, with near-term EBITDA margins moving from around 13% in '21 to over 14.5% in '23.

The Bottom Line

Between discounted cash flow and margin-driven EV/revenue, I believe Valeo shares remain meaningfully undervalued with over 30% upside. For the stock to deliver that upside, investors are going to need to see strong order growth in the Siemens JV (platform wins on hybrid/EVs), improved results from Powertrain overall, and good margin execution, as well as ongoing outgrowth over underlying auto production volumes. That's a significant to-do list, but I think Valeo will achieve it over the next 12-18 months, and I think the shares are still worth serious consideration.

Analyst’s Disclosure: I am/we are long BWA, VLEEY. 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.