Valeo Has a Cash Conversion Problem

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Valeo share price reaction to 2017 results and 2018 forecast seems to rely on an apparent decoupling : orders intake are booming but return on capital and cash conversion don’t keep up.

The automotive equipment maker, one of the largest and most successful in the world, reported an organic growth of 7% last year, with order intake growing 17% to €27.6 billion, which compares with revenue of €18.55 billion. Rather impressive. The problem is that both profitability and cash conversion are not moving in the same direction, at all.Return on capital employed has contracted to 14.8% last year (compared with 17.3% in 2016 – our numbers are different from Valeo which reports 30% for 2017).

Free cash-flow has declined to €253 million in 2017 (vs €590 million in 2016). Worst, Free cash-flow to Net Income has fallen to 29% from 64% a year ago. The metrics has been quite erratic over the last 10 years but the fact that cash available to the company after paying for growth is declining might be a worrying signal if it persists in the future.

It means either that the company doesn’t control costs well enough, or that it’s heavily investing in future growth which should help build it’s moat (or competitive advantage) by becoming an unavoidable equipment manufacturer for automakers around the world. At some point, this should translate into accelerating revenue and profit growth.

That’s exactly what investors bought in the past.

The growth story investors adhered to in the past, centered on both key equipment Valeo provides to OEMs and it’s ability to take advantage of new growth drivers, such as electric vehicles, has some ignition problems right now.

This might just be a temporary setback. Valeo has kept investing in R&D, which should full future growth. The only question is: when is growth going to accelerate or is it going to continue decelerating?

For now, investing in growth hasn’t weighted to much on profitability but there probably be a need to take new cost control measures going forward, to ensure cash conversion ratios improve significantly in the coming years. For instance, the cost of raw materials used to manufacture auto equipment has been increasing and represents a growing share of revenue (71.5% of revenue in 2017 vs 65.5% in 2008) which has been compensated for by reducing the weight of labor cost (15.1% i 2017 from 17.8% in 2008) and direct costs (9.8% in 2017 vs 11.5% in 2008). Valeo has been able to increase labor productivity over the years, with sales/employee moving from 170k€ in 2008 to 180k€ in 2016 before it had to bear a decline to 166k€ in 2017. The average salary/employee has declined to 35k€ from 41k€ in 2008. Workers have been producing more for a lower compensation on average. This doesn’t seem sustainable when you look at the big picture.

Question is: is the company able to provide more value-added to its client and find a virtuous cycle of value creation that benefits both its clients, shareholders and employees? The results of 2017 don’t tick the boxes.

In the meantime, the market is expecting more in the future.

Consensus estimates currently targets sales of €24.2 billion, EBITDA of €3.02 billion and net income of €1.41 billion by 2020. EPS should then reach €5.93, which would translate into a P/E multiple of 9.4x (based on share price of €56), for an EPS growth estimated at 12%/year between 2017 and 2020.

Based on last year results, Valeo has still a lot to do.

For investors, it’s a leap of faith. Either current investments will start paying off and cash conversion starts improving soon. Or there will be more questions on the ability of the company to create value in the long run, and the share price will remain under pressure.

Valeo Share Price History

Source: Bloomberg