Description

Autoliv has been written up previously by leob710 in Dec 2016. In hindsight not the best timing as he/she forecasted earnings 2 years out of c. $5 and a P/E of 15x for a TP of $75 in the write-up and they ended up being $1.12 with a share with a share price of $15 in early 09...

Many things have changed since then, but if anything I found re-reading this old write-up very useful, as it is a reminder that two key things have not changed:

-       1) Autoliv is a very high quality business (admittedly in a very low quality sector) and by the way interestingly since that write up 12 years ago, the company has out-performed the S&P 500 by 40% which is very honourable

-        2) The auto sector is generally a poor sector to be involved in, and at this stage in the cycle, there are obviously significant risks to the downside which is the general cave-at for this investment idea

Yet, I also believe that precisely at this stage of the investment cycle, one should focus on (i) high quality companies with (ii) idiosyncratic growth drivers, (iii) a strong balance sheet, (iv) a driven management committed to create shareholder value and (v) catalysts / events that underpin the share price.

Autoliv pretty much ticks all those boxes – more below.

What is Autoliv?

It is a large-cap company with excellent investor disclosure so will try to keep it very brief. Recommend the slides of the recent CMD for a general introduction to the company https://www.autoliv.com/investors/reports-presentations-transcripts

In a nutshell, Autoliv is a global automotive supplier that has consolidated its leadership in Passive Safety (i.e. seatbelts and airbags) whilst strongly investing in Active Safety which they define as a mix of safety electronics (which is not particularly high-tech but still growing nicely) and stuff that is at the technological border of autonomous driving but with a safety angle (i.e. the car detects a pedestrian in the night or detects you’re falling asleep and acts accordingly). Note a JV with Volvo on Autonomous driving as well.

A high quality company and a committed management team

On the face of it, Passive Safety is not a particularly exciting business. Seatbelts and Airbags are very commoditized and in a ruthless industry, the pricing deflation on those products are as high as it gets. Yet, having been dealt sub-optimal cards, the company played its hand masterfully. They continuously re-invested in production efficiency, growth and in R&D, always staying at the technological frontier of this very commoditized industry. This is evidenced by their market share growth which went from c. 32% in 2008 to c. 40% currently.

Then, they also got lucky and Takata, one of their big competitors in Japan with a c. 20% global market share in 2014 ended up manufacturing faulty airbags, which resulted in a few deaths and a classic Japanese cover-up. The company subsequently went into administration and is currently being acquired by Sino-American company “Key Safety Systems”. In the meantime, they obviously won zero new contracts and their global market share decreased from c. 20% to c. 10% today.

As usual in business, someone’s loss is someone else’s gain, and Autoliv’s global market share of orders in the past 3 years ended up being slightly above 50% from previous 40%.

As an order takes a good two years to start translating into sales, these increased orders haven’t yet shown in sales, but as it stands, the company is on track to outperform global auto production by close to 15% over the next 3 years as their share increases towards 45% in 2020.

If they can continue to command a c. 50% market share in orders in the next 2-3 years, which seems more likely than not, then strong organic growth would continue for another few years until 2022 or so as they effectively reach c. 50% global market share in sales.

Obviously – they got lucky, but they also seized their luck. Today – they are by a factor of c. 3x the dominant player in this space (ZF have c. 15% and KFS+Takata might end up at c. 15-20%), they have the most efficient production, are at the technological frontier, and are basically owning the market.

This Passive Safety business has consistently generated high RoS of c. 10%, high ROCEs and a solid cash flow generation.

Yet, management has also expanded the businesses by investing very strongly in “Active Safety”. There – they obviously were at a strong competitive disadvantage vs. behemoths Continental and Bosch of Germany, both masters in electronics and much bigger / more solid companies. As it stands – the jury is still out – Conti and Bosch are leading this nascent high-growth market with c. 20%+ market share whilst Autoliv is slightly below 10% as far as I can tell and is hence a slightly distant number 3.

The financial characteristics of this division couldn’t be more different from the Passive Safety one:

-          - Very high growth

-          - Low RoS (currently negative)

-          - Very high capex / R&D and generally a cash-burn situation

Things had gotten to a point were the market was arguably not giving any value (or even a slightly negative?) to this high-growth loss-making and more speculative division, instead valuing the company on consolidated earnings / CF multiples.

So the management team decided to spin-off this business in a non-taxable event, something that is likely to happen in Q3 2018, hence realising the SOTP value of the business and something that is likely to support the share price.

Incidentally, the commitment to shareholders of this company has been extremely strong over long periods of time. Whilst they have always invested enough to guarantee growth and taking a LT view, they have also always had a consideration for shareholders returning excess capital when they could etc.. A very rare blend of LT strategic thinking and value-driven attitude! Typically – they maintain two listings, one in Stockholm and one in the US, this gives them access to 2 pools of investors helping the shares sustain a solid rating even if one of the markets is depressed.

The math

In my view, the SOTP math should look something like this – and I am using 2020 numbers here as it feels like the right duration, but also to tie up with targets the company is providing.

For Passive Safety, the management views is that global car production should grow at 2% CAGR and Passive Safety should outgrow that by 1.5% point – both statements are strongly backed by their materials, although I personally would take a more cautious view assuming global car production flat with no outgrowth. As a result, they are forecasting 2020 sales of c. $ 10.5bn. I am personally estimating c. $10bn as a result (although to be fair I am adding something for the latest FX move with the US$ weakening since the CMD).

The operating leverage on the market share gain should be very high (c. 20%) given central costs and R&D shouldn’t be particularly higher. Management estimates a c. 13% ROS in 2020 which might be on the high side, so lets’ call it 12% in a more muted growth environment. This works out to c. $ 1.2bn of OP. By then however, the 2y forward growth should remain very compelling given market share should still have room to increase from c. 45% to c. 50%, so I believe that a multiple of c. 11x OP is not crazy for an EV of this business then of c. $13bn. This multiple is backed by a very high FCF generation that is likely to be returned to shareholders and works out to a c. 6.5% FCF yield.

Net debt at de-merger should be c. $1.5bn (it is $0.5bn now but I assume the Active Safety /electronics business is capitalised to the tune of c. $1bn), however FCF generation in the next 2/3 years means that 2020E net debt could be close to zero.

Looking at Electronics / Active Safety, the target is c. $3bn in sales o/w Active Safety is c. $1bn, with  a RoS target of 0-5%. Starting net cash I estimate at c. $1bn but that should be burned over the next few years. The valuation of that division is a bit tricky. Sell-side estimates range from $2.5bn to $4bn. I am personally rooting for c. $3bn or c. 1x Sales although the ranges discussed are sensible to me, and ultimately a lot will be dependant on execution over the next 2-3 years.

One added thought is that the electronics / active safety business will be ripe for consolidation / acquisition and should be an attractive target for a few competitors. This is not openly discussed but we believe it is one of the reasons for the spin.

This works out to a conservative SOTP of c. $16bn vs. a market cap of c. $12bn today for c. 30% upside over two years.

If management targets are right as far as production / margin goes which would be more of an upside scenario for me, then the Passive safety business should be worth closer to $15bn in 2 years time for c. 50% upside.

So on average 30-50% upside on a 2 year view, so call it c. 20% on a 1 year view. 

Against that – it is hard to see a lot of fundamental downside given the solidity of the Passive Safety business (50% global market share in a business with high barriers to entry is not common...) and the sustainability of the FCF that will be generated, the fact that the SOTP will be crystallised in a very efficient manner and the fact that there is no leverage today.

Risks:

Whilst we believe the quality of the business, the strength of its market position and related cash generation, the idiosyncratic strong growth and the crystallisation of SOTP act as strong mitigants to any downside risk, it is clear there are a few risks:

-         - Stating the obvious, this is an auto supplier, and one needs to be comfortable that there will be no strong downturn in the global auto industry in the next couple of years

-          - The company is currently being investigated by the European Commission for anti-competitive behaviour, and potential fines could reach c. 500mm. Whilst not something that should derail the case, there is headline risk.

-          - The behaviour of competitors will also be important, in particular will KSS/Takata be on a mission to gain market share? We believe the industry is in an oligopolistic situation, and the challengers are more likely to want to generate cash rather than sacrifice margins for topline growth, but it remains a risk.

-          - Finally, there is always an industrial risk of something going wrong with their products especially as they tough safety which is a very sensitive issue. We believe Autoliv is extremely well managed and careful about this, but that risk will always be there.

Catalyst

As per above, the key catalysts are the spin-off. The detailed prospectus / numbers with more detailed targets and a clearer sense of the balance sheet should be published in April / May. The physical separation I estimate to happen just after the summer. Other catalysts are obviously order numbers, and if those point out to a share in passive safety orders cotinuously at or above 50%, this should have a real impact on the exit multiple as it would point out to many years of idiosyncratic strong organic growth and operating leverage.