Description

Introduction

This investment idea originated from a variant perception we had recently.  When attending an auto parts symposium, we heard a steady drumbeat from presenters (and attendees) that both autonomous cars and electrification were so far away in the future that they were completely immaterial to their business prospects.  It reminded us of newspapers claiming the internet would benefit them.  While the auto parts industry is saying self-driving isn’t coming for years and years, some of the people who are actually working on it (Google) are saying they’re opening services to the public this very year.  GM and others are saying more like 2019.  So while basically half the industry thinks autonomous vehicles are coming in five years; we think they’re coming in two.  It is more well known that virtually every major auto OEM is coming out with electric and hybrid models in the early 2020s. We believe EV adoption will take place faster than do most observers.  

We believe we have found a reasonable way to be aligned with these trends through investment in Aptiv.  Basically, Aptiv makes a lot of the stuff that goes into autonomous and electric vehicles.  They should experience solid revenue growth as these trends take hold and they increase their content per vehicle.  In a few years’ time, as these trends become more generally accepted and the investing public gets excited, we believe Aptiv could see significant multiple expansion as one of the few pure play options to take advantage of this investing theme.  In the meantime, it is a profitable, well-run company, one that is of decent quality while not having a wide moat, that is trading as a reasonable price given its growth potential.  

This is a somewhat long-term play that we intend to hold into the early 2020s when the electric and autonomous trends are fully underway.  Using conservative assumptions we think Aptiv could do $7 in EPS by 2022 (consensus is more optimistic at $8) and with no multiple expansion at 20x would be worth $140, or 50% upside as a conservative base case.  We think both operational results, and especially the multiple, could surprise to the upside as the trends described above take hold.

Aptiv the Company

Aptiv is the descendent of Delphi Automotive, itself once upon a time the auto parts spin off from GM.  In order to be fully aligned with the above described trends it recently spun off its powertrain segment into what is now Delphi Technologies, and it renamed itself Aptiv.  Headquartered on the island of Jersey (and therefore not a real beneficiary of recent US tax reform), Aptiv is a global company with revenue about equally split between US, Europe, and Asia that works with every major OEM.  Though an auto parts supplier, they are no longer really a “metal bender” as the products they make are primarily electronics and wires.  The company has 6,000 engineers focused on software development and ships over 40 billion lines of code daily.

Their largest segment is Signal and Power Solutions with $9.5B in revenue and $1.3B of operating profit.  The segment basically makes cables and other power distribution equipment.  Management expects this division to grow 2 to 5% faster than the overall automotive market.

Their other segment is Advanced Safety and User Experience with $3.4B in revenue and $300MM of operating profit.  It makes sensors for automatic safety features like lane departure and automatic braking, as well as the software and computing power needed to power those systems.  It also makes “infotainment displays” (most of the current revenue) and has a fledgling “connected services” data subdivision designed to help with things like secure over the air software updates to vehicles and the collection and eventual marketing of data.  Management expects this division to grow 10% faster than the overall market.  

While this was not our reason for purchase, we do like that this company was part of a spin off situation recently.  Even though it was the parent and not the actual spinoff, our research has indicated that parents as well as spinoffs outperform the general market on a statistical basis.  They did appear to do a substantial roadshow before the spinoff but nevertheless this is somewhat of a new pure-play automotive trend company and we would expect the story to continue to become more well known over time.

It’s also worth noting that this company bears little resemblance to the original Delphi that filed for bankruptcy in ‘05.  They shed major divisions during bankruptcy and more recently sold their thermal systems business in ‘15 and spun off their powertrain business in Dec ‘17.  Like much of the automotive ecosystem, they got religion on debt after the financial crisis and today carry only $2.5B in debt versus $2B in EBITDA which covers interest 15 times.  It has been consistently profitable on both a net income and free cash flow basis since its emergence from bankruptcy in 2011 (not saying much).  Their return on invested capital has been well north of 20% during this period as well; over half of management’s incentive compensation is related to return on capital.  With this capital, management has been a steady purchaser of shares reducing the share count from 328MM to 266MM most recently.  They have also done a number of small bolt on acquisitions in growth areas which they intend to continue to do.

A quick pitch on electric and autonomous cars

A big part of the investment thesis is the faster-than-expected adoption of autonomous and electric vehicles.  The arguments for this adoption are available elsewhere but since they are an important part of the pitch, and are not universally accepted, we will offer a very brief explanation for our thinking.  

For autonomous, the reason to believe adoption is around the corner is mostly due to what the companies themselves are saying.  Google/Waymo has been the most vocal about their progress, saying that they’ve had fully driverless cars on the road in Arizona since mid-Oct 2017 (employees still in the car, just not the driver’s seat), and that they will have a fully driverless mobility service in Arizona in “early 2018”.  GM/Cruise has said they will have a fully autonomous (no steering wheel) public ride-sharing system service across several cities by 2019.  Aptiv, which has its own “turnkey” autonomous driving suite, will have a commercial test deployment in 2019.  2019 appears to be shaping up as the year of the autonomous vehicle.  These specific, near-term claims of deployment to us are more convincing than the mostly vague claims of skeptics that these technologies are “many years off”.  It is worth noting that one of the reasons the development of this technology has been accelerating is the continued advancement of deep learning techniques, which allow for AI to help determine how to drive through the introduction of massive amounts of data, whereas previously autonomous driving software had to be programmed to react to each individual situation.  One of the main roadblocks to adoption that skeptics see are regulatory.  We believe these roadblocks will largely disappear once there is a demonstrated effective autonomous driving network in place, which as stated above, we believe will take place in 2019, probably in Arizona.  We believe opposition will evaporate upon proof-of-concept due to safety concerns.  40,000 people in America die every year in auto accidents, the vast majority of which are due to human error.  Of course, these deaths are not nearly as emotional as the few hundreds that die each year due to school shootings or terrorism, but one can imagine that, once-proven, there will be a large constituency pushing for the removal of regulatory barriers to adoption of autonomous driving.

For electrification, the climate-change-related advantage of not directly emitting CO2 is well publicized and understood.  It is worth noting that the sometimes encountered “long tailpipe” argument that electric vehicles are just as or more dirty than conventional internal combustion engine (ICE) vehicles basically does not hold unless the power charging the vehicles comes solely from coal (which is being phased out by regulation and market forces).  Electric vehicles have other advantages over ICE vehicles in having much simpler engines with far fewer moving parts, meaning less maintenance and lower costs.  EV acceleration is generally better as is handling due to the ability to put a heavy battery in the bottom.  The problem of course is cost, which is basically a battery concern.  If you get the cost of the battery down, EVs would appear to be superior.  The costs of batteries have indeed been coming down, and given the massive amounts of money that are flowing into the area, we expect this trend to continue.  According to Andreesen Horowitz, most analysts assume electric cars will be equal to the cost of ICE cars without subsidies by 2025.  However, we think adoption will not be driven slowly by consumer choice, but rapidly by regulatory action.  Climate advocates for EVs are of course, quite passionate.  The main opposition to EVs is cost-based, and once EV’s achieve near cost-parity, we believe opposition will largely evaporate.  We believe that once near cost-parity is achieved, regulators will cram EV’s down our throats by basically outlawing or taxing ICEs out of existence.  Numerous European countries have set targets for banning the sale of ICE vehicles, but China probably has the most aggressive targets of anyone, due not to fears of global warming, but pollution.  It is worth noting that all ICE vehicles emit nitrogen oxide gases and fine particulates that cause public health issues, as science and the public are becoming increasingly aware.  There are of course other barriers to the complete widespread adoption of EV’s, but to keep this short it will suffice to say that we believe these barriers will be overcome in large part due to the regulatory response driven by popular concern over climate change.

How does Aptiv benefit from these trends and competitive landscape

Basically Aptiv makes the stuff that cars already need, but that they need more of when they become electric and autonomous.  For autonomous, this includes things like sensors, computing power, and signal and power wiring to connect it all.  For safety reasons, in a fully autonomous vehicle all the signal and power distribution needs to have redundancy in order to not fail, which means more material.  We have heard Aptiv’s Multi-Domain Controller, which “fuses information from sensing systems as well as mapping and navigation data to make driving decisions,” called the “picks and shovels” of autonomous.  For electric (and hybrid), Aptiv makes wires, connectors, and distributors necessary for the distribution of high voltage electric power throughout the car.  They also make charging technologies.  

On the most recent call, management (somewhat worryingly) declined to state the increase in Aptiv content that would be implied by electric vehicles, but our industry specialist friend informs us the increase is six fold. Lear is a competitor to Aptiv in electrical systems and they publish content per vehicle (CPV) of about $400.  Considering ⅔ of Lear’s revenue is in their seating division, one might estimate their electrical CPV at $135.  On the Q4 transcript, the SVP of Lear’s E-systems said that their incremental CPV for 48 volt mild hybrids was $300, and for full EVs was $2,000.  $2,000 / $135 implies a fifteen fold revenue opportunity in the transition from today’s ICE to fully electric vehicles.

Unfortunately at this time we do not have have an estimate at the increase in CPV for today’s cars versus fully autonomous cars, but the related part of Aptiv’s business that provides Level 1 and 2 automated driving (active safety) recently grew at a rapid 65% pace.

To be clear, Aptiv is not the only company that makes many of these products, and they will face competition.  Furthermore, there are many different companies and alliances competing for dominance in these fields, and it is not at all clear who the winners will be.  We approach this investment not from the standpoint that Aptiv will necessarily be the winner themselves, but more from a standpoint that a rising tide lifts all boats.  If the demand for high voltage auto electrical distribution systems increases exponentially, then all makers of high voltage automotive electrical distribution systems will likely benefit.  

Aptiv works with all major OEMs (including Tesla) so Aptiv should benefit to some degree regardless of whoever “wins the race”.  Even if the first to market is not a traditional OEM, the example of Tesla’s production struggles has shown that if the winner wants to take full advantage of their first mover advantage by making a meaningful number of cars they will probably have to partner with the existing auto ecosystem.  Aptiv has said they have no interest in being a direct “mobility on demand” service provider like Uber/Lyft/Waymo.

Aptiv has partnered with Intel and Mobileye on their “CSLP” platform, which is their full stack “turnkey” autonomous solution which will supposedly be commercially available in 2019.  So perhaps they will be a direct winner outright.  Navigant recently published a report on the automated driving leaderboard and they placed Aptiv at 7th (ahead of all other parts manufacturers).  

In addition to offering their full autonomous solution, Aptiv has indicated a willingness to partner with any player on basically handling any part of their system.  For example, perhaps one partner prefers to use their own software and computing hardware, but wishes to utilize Aptiv’s sensor and signal technology.  According to the recent Navigant leaderboard report, the current leader is GM, who is Aptiv’s largest customer.  In second place is Google’s Waymo, which is reported to make their own sensors, but also recently placed an order for thousands of minivans from Fiat Chrysler, who is Aptiv’s third largest customer. Number 6 on the leaderboard is BMW-Intel-FCA, the BMW part with which Aptiv has a separate partnership to provide a next generation radar and high-end vision sensor suite powered by their ADAS multi-domain controller.  Thus it is easy to see how Aptiv could benefit from the above described trends despite the fragmented and unclear competitive space.

Valuation

While we believe the real opportunity is long term, Aptiv currently  trades at a consensus forward PE of 18 and a good argument can be made for 20 based on sensor, connectivity, and cable companies like TEL and APH .  Their forward EV/EBITDA is 11.7 and they should probably get a little credit for only being a 15% tax payer.  The forward FCF yield is 3.5%.  So the company is not cheap, especially for an auto parts supplier, but one has to remember that they have low debt, good return on capital, and good growth prospects.  We feel somewhat guilty posting this idea to a value website but certainly you could find many growth companies that are significantly more expensive.

Model Drivers

Basically we think for the near term they can hit management’s guidance which will provide an acceptable return (the major potential upside comes in a few years as the mega-trends really get going).  This guidance assumes revenue growth consistent with previous MSD performance, and adjusted operating margins increasing from 12.5 to 14.2%.  This along with $350MM of buybacks per year (compared with ~$1B in FCF and a historically high buyback rate) results in EPS doubling in 5 years.

Risks

Macro / car cycle - Aptiv is an auto supplier and not insulated from the auto cycle which is often influenced by macroeconomic concerns.  One either has to not buy it now and try and time the cycle or just be ok with the risk.  We choose the latter.  Aptiv is somewhat insulated to regional swings by being truly global.  For example US SAAR declined last year as did Aptiv’s US revenue by 6%, but this was offset by 11% growth in Europe, 5% growth in Asia, and 26% growth in South America.

Trends take longer to materialize - it could be that our core thesis is wrong and in five years there are no level 5 fully autonomous cars on the road and that EVs fail to gain meaningful adoption.  This would lead to slower than anticipated growth only in line with the overall auto market.

Aptiv doesn’t benefit as much from these trends as expected - it is not impossible to envision a future where there are a few electric autonomous fleet managers, none of whom have chosen to buy many of Aptiv’s products to assemble their fleets, or Aptiv otherwise fails to take advantage of the trends they are targeting.  As discussed in the write up above, we believe this risk is somewhat mitigated by Aptiv’s working with all major OEMs and willingness to engage with partners with as much or little input from Aptiv as the customer prefers.

We go completely to autonomous fleets and fewer cars are produced - perhaps the autonomous technology is so effective that people stop buying cars and instead utilize mostly autonomous mobility on demand services.  This could results in fewer cars being produced and lower revenue for Aptiv.  We think that both private ownership of cars and autonomous mobility on demand services will coexist for some time, certainly within our investment timeframe of five years, but it is a risk.  A partial mitigant is that if everyone switches to use the cars in these fleets they will see much more use and wear out faster, somewhat muting car volume declines.  Overall miles driven should increase as cost (whether in terms of one's own time or employing a drive) decreases.

Catalyst

Fully autonomous ride hailing systems are introduced in 2018 and 2019.  Significant numbers of mass-producible EVs are introduced in 2020 and 20101.  Adoption of these trends becomes more certain and acknowledged.  Operational results and growth forecasts increase.  Multiples expand.