Valeo Hammered On Operational Challenges And Future EV Fears (OTCMKTS:VLEEY)

The last seven or eight months have been brutal for tier one European auto suppliers. It’s bad enough that component shortages have led OEMs to produce less than they’d like, but erratic start/stop schedules have wreaked havoc on supplier operations, and supply and labor challenges have done them no favors either.

The best thing I can probably say about Valeo‘s (OTCPK:VLEEY) performance since my last update is that a quick glance at Faurecia (OTC:FAURY) and Vitesco (VTSCY) shows that it could have been even worse, though all of these have underperformed American suppliers like Aptiv (APTV) and BorgWarner (BWA).

It’s not smooth sailing ahead for Valeo just yet. While the company should be past the worst of the production disruptions, I expect the Street is still going to fret about losses tied to the EV development programs and the risk that EV component insourcing limits the long-term opportunity. These aren’t new concerns, but there aren’t many positives to offset them now. I believe that Valeo is materially undervalued here, but the company needs beat-and-raise reports (particularly on margins) to shift sentiment.

Hit Hard By Production Disruptions

Looking back at Valeo’s financial results for the final period of 2021, there wasn’t much to like. While the company did ultimately come in a little better than expected on revenue, the close of the year saw a lot of operating pressure, with the company posting a fairly rare underperformance versus global builds (900bp, or 500bp ex-geography) on customer-specific disruptions.

Fourth quarter revenue declined 15%, with a 19% decline in OE sales, while second half sales declined 12% and 16%, respectively. Driver assistance and thermal both modestly outperformed, both helped by new product launches, and the former does help a bit more, as the company is seeing good margins on new L2+ offerings.

I was surprised that second half gross margin held basically steady, limiting the EBITDA damage to a 15% decline (margin down 50bp to 13.4%), but EBIT was still weak, falling 55% when including losses from the Siemens (OTCPK:SIEGY) JV, with margin cut in half to 1.9%.

Management also guided to softer results for FY’22, with revenue, margin (EBITDA and EBIT), and free cash flow all below sell-side expectations, as well as my expectations at the time of my last update. Should Valeo hit my below-midpoint expectations for FY’22, the company will still see close to 12% year-over-year revenue growth, though about 350bp of EBITDA margin erosion due to ongoing operating difficulties and losses tied to EV product development.

EV Spending Continues To Pressure Margins And The Payoff Is Uncertain

Valeo and Siemens finalized a transaction early in February that transfers full ownership of their former joint venture in high-voltage components (chargers, inverters, and converters, as well as e-motors and other components) to Valeo.

Valeo paid a net price of just EUR 277M to consolidate the JV, and it’s worth noting that expectations for the business have definitely come down over time. Back in early 2018, management talked about EUR 2B in revenue in 2022 with double-digit EBITDA margins, and those expectations have eroded to EUR 2B in revenue by 2025 with breakeven EBITDA.

Bearish analysts have tried to tie the estimate revisions and the lower price accepted by Siemens as “proof” of underlying weakness in the business, but I think that’s premature. A global pandemic happened in the meantime, and that has altered launch plans for several hybrid programs on which Valeo has content. What’s more, Siemens has been undergoing a multiyear simplification plan to focus on what management views as its core long-term competencies, and I believe management wanted an earlier exit from this JV, accepting a lower price to do so.

I’d also note that Valeo has a new CEO now, and it’s not exactly unusual for a new leader to take the opportunity to set lower initial targets in the interest of building an “under-promise/over-deliver” reputation early in their tenure.

I do still see risks in the EV program. Valeo came charging out of the gates with strong initial orders, but that pace has slowed. Where Valeo was once well ahead of the competition in terms of announced BEV-related orders, they’ve fallen back some toward the pack, with Bosch taking a clear lead and Valeo, Nidec (OTCPK:NJDCY), and BorgWarner now more muddled around #2 (with Vitesco and Schaeffler further back).

I believe Valeo may have underpriced some of those initial contracts and overestimated how much of its R&D would be applicable to a broader range of OEM programs (underestimating the amount of customization required), and I think they’ve since gotten a little stricter on pricing, choosing to shore up margins in future business rather than target share for share’s sake.

Still, not all that much has changed in terms of my fundamental views. As I said in that last article, I expect quite a bit of e-motor content to be insourced, and Valeo has recently backed that view, indicating that they expect 30% of e-motors to be outsourced versus for 40% of overall high-voltage content and even higher amounts for components like chargers (90%).

Management continues to target more than 10% share of what is outsourced, and the order intake to date supports that. The company also mentioned supply agreements with companies like Renault (OTC:RNSDF) (OTCPK:RNLSY) that are otherwise insourcing components (Valeo will be supplying stators for Renault’s “insourced” motors). I believe this is another trend set to become more clear in the coming years – a lot of this “insourcing” will in fact include meaningful outsourcing for critical components.

Ongoing Opportunities Outside Of Powertrain

Valeo isn’t just a powertrain electrification story. The company has the second-largest thermal management business in the supplier space (behind Denso (OTCPK:DNZOY), I believe), and the company is seeing strong order growth from BEV platforms and about 2.5x content growth for its battery-related thermal management products.

Advanced driver assistance systems (or ADAS), too, remain a meaningful opportunity. More advanced systems (L2+ and beyond) have meaningfully better margins than the base business (300bp or better), and the company has a strong entrenched position in the market. While the move toward automation/autonomous driving (or L4) does risk disrupting the industry, Valeo is still the only company that can supply all of the needed components in-house.

The Outlook

I’ve been bullish on Valeo, but my modeling assumptions have not been all that aggressive. That sets up an odd situation where the narrative on Valeo now is how disappointing the guidance looks through to 2025, but the reality is that management’s targets are still well ahead of my expectations circa mid-2021.

I have reduced my FY’22 assumptions due to the ongoing disruptions from component shortages in the auto supply chain, as well as input cost pressures on Valeo, so my expectations for the year are below management (EUR 19.3B revenue and an EBITDA margin of about 11%). For FY’25, though, my estimate hasn’t changed much (revenue of EUR 23.3B versus 23.5B) and is still meaningfully below the EUR 27.5B management target.

Likewise with EBITDA and FCF, where I’m looking for an EBITDA margin of 13.75% (versus 14.5%) and FCF of EUR 461M (versus a range of EUR 800M to EUR 1,000M). I do note, though, I have lowered my margin/FCF estimates more relative to my prior outlook than revenue (my FCF margin has gone from 3.25% to 2.75%).

Long term, I’m still looking for around 3% to 4% long-term revenue growth as Valeo picks up share and content in EVs, with FCF growth of around 5% as the company will eventually scale up EV component production and benefit from lower R&D expenses. I’m looking for “future Valeo” to be more profitable than historical Valeo, with long-term FCF margins in the 3%s versus a historical average in the low-2%s, but I’d note again that Valeo has been investing in EV and ADAS development (hurting margins) for many years.

Discounting those cash flows back, I believe Valeo is substantially undervalued and priced for a low double-digit annualized return. I likewise believe the company is significantly undervalued on the basis of trough margins. I expect next year to be the worst for margins and the market would normally pay more than 0.6x revenue for EBITDA margins of 10.75%-11%. That’s not true of the sector now, but I don’t expect trough margins to last and even a 20% discount to a 0.6x multiple (or around 0.48x) supports a share price 50% above today’s price.

The Bottom Line

The auto supplier space has been hit hard, and it’s going to take normalization of production rates and some easing of input cost inflation to change sentiment. Neither seems particularly likely before the second half of 2022 and maybe not even until late in 2022. At the same time, the market continues to fear OEM insourcing and lower structural margins for the industry on a long-term basis. Today’s prices seem to factor that in and more though, so I think patient value-oriented investors may want to take a look at this beaten-up sector and this beaten-up stock in particular.