EUR 850.00 For Business Accounts Only

Morningstar | Initiating Coverage of Veoneer with a Narrow Moat Rating and a $24 FVE

We are initiating coverage of Veoneer, supplier to the global automotive industry of advanced driver assist systems, or ADAS, highly automated driving, or HAD, and automated driving, or AD, technologies, with a narrow moat rating and a $24 fair value estimate. We expect global automakers' adoption of Veoneer technologies to support estimated 12% average annual revenue growth for the next 10 years. Veoneer technologies enable automakers' vehicles to receive coveted four- and five-star crash test ratings.

Even so, the stock market has been enamored with ADAS, HAD, and AD technologies due to growth potential that significantly outpaces the growth potential of global light vehicle demand. We agree with the market's assessment of Veoneer's growth potential but disagree with the premium valuation attributed to the shares. Because of the sophisticated nature of ADAS, HAD, and AD technologies, the company needs heavy R&D investment for several years as vehicle programs incorporate the new technologies, becoming standard equipment in some instances, during the next 10 years. Proforma 2017 revenue was $2.3 billion but R&D at 16.2% of revenue resulted in an operating loss of $79 million. We estimate net losses through at least 2020.

We expect a high level of R&D investment to persist throughout our 10-year Stage I forecast as automakers launch more vehicles containing Veoneer technologies, resulting in our 12.3% normalized sustainable midcycle EBITDA margin assumption. We would have to believe that Veoneer could generate a 24% normalized sustainable midcycle EBITDA margin to force our DCF model to generate a fair value equivalent to the current $50 sell-side consensus price target. In our view, the market treats Veoneer's valuation as though economic cycles no longer exist. The 1-star rated stock currently trades at a 104% premium to our $24 fair value estimate.

Veoneer's economic moat is primarily derived from an intangible asset source and a switching cost source. The intangible asset moat source flows from a product pipeline continuously filled with intellectual property development. Steep switching costs result from incremental engineering, development, and tooling costs; the need to relocate or even repurchase large, heavy industrial equipment; the risk that the automaker's assembly line may be shut down during a switch; lengthy time to develop the competing supplier's product to customer specifications; and preproduction validation to ensure process and product integrity.

In 2016, The National Highway Traffic Safety Administration, or NHTSA, said that a total of 20 automakers had voluntarily agreed to equip all new passenger vehicles, by September of 2020, with low-speed automatic emergency braking, or AEB, that includes forward collision warning, or FCW, both of which are ADAS technologies. In a progress report at the end of 2017, NHTSA said that four out of 20 automakers made AEB standard equipment on more than 50% of their 2017 model year vehicles, while another five OEMs said that 30% of their vehicles produced in 2017 were equipped with AEB.

Veoneer forecasts total addressable market growth of roughly 12%, going from approximately $20 billion in 2017 to $49 billion in 2025. The rapid growth in Veoneer's market results in high growth potential for order intake within a relatively short period of time. Current order intake stands at $1.1 billion versus proforma 2017 revenue of $2.3 billion. Management guides that $1.0 billion in order intake accumulates to $4-6 billion in lifetime revenue. Once an order is taken, development for a vehicle program takes two to four years. The revenue generation phase lasts between four and six years. Veoneer's large number of new contracts in development phase versus the lengthy period until revenue generation ramps-up, leads to estimated net losses through 2020. We also estimate positive free cash flow in 2022 and economic profits in 2024, barring a downturn in the automotive demand cycle.

ADAS penetration drives growth during the first five years of our Stage I forecast, followed by another technology penetration wave from HAD and AD in the second half of our 10-year Stage I. We estimate that Veoneer reaches $3.1 billion and $4.2 billion in revenue versus management's forecast for $3.0 billion and $4.0 billion in revenue in 2020 and 2022, respectively. In 2025, management has set a greater than $6.0 billion revenue target, while we forecast $6.7 billion. However, the R&D required to develop programs prior to launch results in estimated net losses through 2020 and economic value destruction through 2023.

Veoneer 2020 adjusted EBIT margin guidance is between 0-5%, a wide estimate range to be sure. The margin variance is attributable to order intake, potentially resulting in more resources necessary for development. We forecast that Veoneer will reach an inflection point between revenue growth and development cost as a percent of revenue in 2020, with roughly a 1% adjusted EBIT margin, on the assumption that Veoneer order intake will be higher than management's expectations.

We expect the company to reach plateau staff levels in the second half of our Stage I. Furthermore, we estimate the company turns free cash flow positive in 2022 and generates economic profit in 2024 as new vehicle programs with ADAS are generating more revenue in 2021 and again when HAD and AD programs begin to generate revenue in 2024. Revenue generation from ADAS programs launched in the first five years supports operating leverage and margin progression in the second five years to our normalized sustainable midcycle 12.3% EBITDA margin assumption as the company develops and launches vehicles equipped with HAD and AD technologies.