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Valeo (OTCPK:VLEEY)(OTCPK:VLEEF) has only gone downwards for years, but we think that while there are potential speedbumps along the way, the highly depressed price of the stock on the back of quite probably profit growth makes this a relatively high-likelihood appreciation opportunity. The only issue we have with it are that the speedbumps are being corroborated in other parts of our coverage. Things could still go wrong and this could impact IRR, and the PE multiple could be a little lower to account for the potential issues on the powertrain side, but it’s looking rather attractive considering conservative management estimates get the company to FCF yields way in excess of 10% starting in 2024.
Earnings
There are two key elements to the earnings, which is the high voltage powertrain business and the driving assistance and comfort segments. Valeo sells these components for cars, as well as lights and heating, but powertrain and CDA are the segments that matter.
Segment Info (FY Pres)
The CDA segment is represented almost 50% in the recent major order intakes. It is a relatively unimpeachable segment, and it also has the company’s highest margins. This is in part because it has a higher intensity of aftermarket activity. A rule of thumb is that aftermarket should be around 20% of sales for industrial manufacturers, particularly in automotive. Valeo is under this but the aftermarket sales are skewed towards strong segments like CDA and also lighting.
Naturally, CDA is the growing segment because it is more technologically and future oriented. But it is also resulting in higher R&D spend, which is reducing some of the marginality even though overall segment EBITDA is still on the up. There are also substantial software opportunities in ADAS, which could further improve Valeo’s economic profile in the future. R&D increased a lot for Valeo, around 30% over the last two years, and it is being driven by the CDA segment.
However, the margin pressure from this growing element should be short-lived. Part of the general strategic plan is to be more disciplined on passing on costs. Valeo is very low profitability on an after depreciation basis, which is something that has to stop. It is not very cash generative either on EBITDA due to the intensity of fixed capital investments. Some R&D is capitalised, which is why for the valuation we’ll focus on cash flow figures later. Nonetheless, pricing initiatives means that the burgeoning backlog on CDA should liquidate at incrementally better margins.
Powertrain also received around 6 billion EUR in orders. If all goes to plan, including general pricing and cost cutting initiatives, and backlog liquidates nicely, free cash flow should improve from the 379 million that they are at now, which is around a 12% FCFY – already very compelling. They think they can get free cash flow to 650 million EUR, net of some “one off” CAPEXing, in 2025, which would be a 20%+ FCFY on today’s market cap. It sounds absolutely great.
Risks
However, there are some risks. We cover Matthews International (MATW), and their growth story is based on BEV equipment manufacturing sales, specifically focused on the battery. Markets reacted negatively to the news that there have been some delays in customer deliveries due to customers delaying their receipt of equipment into factories. This is being driven by much lower than hoped volumes of demand for EV, where major manufacturing initiatives like those by Ford (F) and GM (GM) in the US are getting pushed out a little as they “wait and see”. The Valeo backlog including the 6 billion EUR in new powertrain orders could be an optimistic signal, where the reality might be that this backlog liquidates at an unhelpfully slow pace. Note the comments by management, after acknowledging that EV volumes were really much lower that hoped, and that volumes were actually in decline in some instances – if not all instances:
(Prepared Remarks)
This outperformance is mainly driven by Europe at plus 3 points even after taking into account the lower High Voltage volumes on certain electric vehicle platforms in Q3…
Edoard Pirey, CFO of Valeo
(In the Q&A)
…I will take the first question and hand over to Edouard for the second question. Well, I mean, you said it, the volumes on EV are extremely volatile. They are volatile and they are quite different or in some cases, extremely different from what was planned in the contract. Therefore, whenever the volumes are lower, significantly lower than what it is on the contract, we go for compensation.
The backlog could really result in nothing, and analysts are thinking about what would happen in that case – we wouldn’t want to rely on compensation. Also, the reason why inventories have not really declined is because of this segment and all the electronic components that are not moving into customer hands from this segment. We think that this is what is capping priced despite all the other segments being so optimistic. Therefore, any sign that EV demand will recover will be a major catalyst for this stock. In fact, this would be the ideal way to play long any information that the EV market is recovering. However, the segment is still growing currently in sales and margins, although much of this is likely inorganic due to consolidation effects of Valeo Siemens. Organic growth might have been negative.
With Valeo Siemens eAutomotive integrated within the Group from July, the Powertrain Systems Business Group’s high-voltage business grew by 32% and its losses were halved compared with the prior year, as set out in our strategic plan.
It’s an infrastructural problem. We don’t see a guarantee that EVs take off. There are some good reasons for concern. This is the stumbling block.
Valeo is interesting. They are already accounting for a certain degree of volume declines in their estimates, but the long-term opportunity of EV is in question right now which should raise serious alarms. There may be a political angle on this as if in major markets like the US as well as the EU, a right-wing wave takes things over, plans for investments in EV infrastructure that would be needed could dwindle. Since we already are saddled with an EV-related exposure with Matthews, we are probably going to wait and see here.
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.
