Description

Long- Stoneridge (SRI)

We believe Stoneridge represents an attractive way to invest in the growing technology sector surrounding the auto and commercial vehicle industry with multiple ways to win.  Through acquisitions, dispositions and strong product development, the Company has transformed itself from a cyclical, low-margin auto and commercial vehicle parts company into an industrial technology company with the potential to outgrow its underlying end markets by double digit rates over the next several years.  Most significantly, a game-changing new product called MirrorEye should transform the Company’s earnings power and growth trajectory.  MirrorEye is a camera mirror system for commercial vehicles that replaces traditional mirrors and provides much better visibility for drivers.  SRI is currently launching its first two major MirrorEye OEM vehicle programs within the next six months which should serve as a catalyst for investors to understand the potential of this product.  We believe that SRI currently trades at a discount to the value of its core business and that investors are totally ignoring the value of MirrorEye.  Over time, that MirrorEye alone should be worth $35.55 or 107% more than SRI’s entire current market capitalization. 

Despite SRI’s attractive future growth outlook, its shares have been punished over the past year as the Company was uniquely negatively impacted by the electronic component shortages impacting the auto and commercial vehicle industries.  Most of the products SRI produces contain semiconductor chips which have been in short supply over the last year.  With lower volumes and limited ability to pass higher costs onto customers in the short-term, SRI has seen a gross margin squeeze.  Additionally, many of SRI’s research and development costs are currently fixed as the Company gears up to launch major growth programs including MirrorEye over the coming years.  While SRI has been able to keep its revenue a mere 4.5% below its initial forecasts, EBITDA is expected to come in 62% below forecasts due to supply chain costs and the negative impact of operating leverage.  This has caused SRI shares to decline by 50% from its highs in early 2021.  We believe that this decline is short sighted and that the core business alone ex MirrorEye is worth $25.04 per share, or 46% above the current share price, based on quality vehicle supplier peer multiples, as EBITDA recovers and the chip shortage wanes. 

Overall, it seems that investors are overlooking an attractive longer-term growth trajectory due to short-term industry challenges and are ignoring a transformational hidden asset in MirrorEye.  We see the following catalysts driving share price upside: 1) higher than expected take rates in the first two MirrorEye programs launching in 2022 highlighting that this product alone is worth significantly more than the current share price; 2) an easing in the semiconductor shortages drives a strong 2H 2022 margin and revenue growth recovery, demonstrating the longer-term earnings power and highlighting the undervaluation of the core SRI business which easily supports the current share price; and 3) improving production from SRI’s customers over the course of 2022 and beyond providing a stable intermediate-term backdrop for SRI to finally execute on its growth and margin goals. 

Ultimately, we believe the Company will become an attractive takeout target for a larger company seeking to improve its technology portfolio and growth, as SRI returns to more predictable growth and margin performance and MirrorEye demonstrates its potential.  Over time, we believe that SRI is worth $60.59 per share representing upside of 254% based on peer multiples on the core business and MirrorEye’s earnings power. 

MirrorEye Launch Should Transform SRI’s Earnings Power

We believe that investors are dramatically undervaluing SRI’s opportunity to become a dominant market leader in camera mirror systems for medium- and heavy-duty trucks globally.  Ultimately, we believe that the MirrorEye product alone could be worth $35.55 per share, representing 207% of the current share price. 

SRI’s MirrorEye product has clearly become the industry standard as it has won all but two of the programs awarded for camera mirror systems on heavy-duty trucks.  Currently, SRI has won three large North American programs representing 75% of the market and two European programs representing 33% of the market.  Additionally, only one program has been awarded to a competitor to-date, so SRI still has ample opportunity to win business that has yet to be awarded.  Overall, SRI has $500 million of annual revenue potential on the programs that it has already won, which represents 67% of the Company’s 2021 revenue. 

Unlike most products SRI sells that are automatically designed into a car or truck, MirrorEye is an optional product that an OEM offers to its customers.  The customers must then decide if they are willing to pay for the upgrade.  Therefore, when SRI has discussed the financial implications of its MirrorEye opportunity, the Company is required to estimate a take rate of customers who are likely to select the option.  Thus far, since MirrorEye is just launching on its first OEM program, SRI has used a conservative 15% take rate to estimate the MirrorEye opportunity based on initial OEM guidance.  Even at that take rate MirrorEye is expected to contribute $75 million of incremental revenue which would represent around 10.0% of the Company’s estimated 2021 revenue.  More importantly, since most of the engineering, marketing and R&D costs around the product are fixed, that revenue should drop to the bottom line at a very attractive 27.5% contribution margin, suggesting an EBITDA contribution of $21 million.  At a growth vehicle supplier EBITDA multiple of 11.7x, that alone would be worth $8.86 per share or 51% of the current share price.  However, we believe that a 15% take rate for the product is too conservative and as investors realize the potential for much higher take rates, the shares should appreciate substantially. 

Source:DAF Trucks Landing Page as of 2/28/22 ( https://www.daf.com/en/sites-landing )

There are several strong indicators that SRI’s take rates should meaningfully exceed the 15% level.  We believe that this will become evident in SRI’s first OEM program launch that is happening with major European truck supplier, DAF.  First, MirrorEye is prominently featured in the marketing of DAF’s new heavy-duty trucks in Europe.  As the picture above demonstrates, the first image of the new truck on DAF’s website shows a view of the interior with the MirrorEye system as a focal point.  Incidentally, the digital display pictured is also a new SRI product which shows how important these products are to the consumer.  Additionally, this new line of trucks was awarded International Truck of the Year 2022 and one of the key features cited was SRI’s “digital vision system that replaces the traditional side view mirrors and the new corner view camera – offer all-around view, protecting vulnerable road users.”  Since protecting other vehicles from trucks is a key regulatory priority in Europe, we believe that camera mirror systems could ultimately be mandated.  SRI’s quoted take rate for this vehicle is 17%, but we would expect it to be substantially higher and anticipate favorable updates throughout the year. 

In SRI’s second program with PACCAR (PCAR) in North America, we see strong indications that fleets will drive adoption of MirrorEye and bring their OE partners along with them.  MirrorEye will be offered on PACCAR’s new Kenworth trucks starting mid-year 2022.  PCAR has been actively marketing its system and has dedicated an entire section of its website to digital mirrors complete with a video (https://www.youtube.com/watch?v=qlFKu2oZ_yE).  We believe that in North America positive input from fleets will be a much bigger driver of adoption than in Europe.  Thus far, MirrorEye has been publicly endorsed by JB Hunt Transport Services (JBHT), Schneider National (SNDR), Tyson Foods (TSN), Maverick, and Montgomery Transportation, with the latter three committing to adopt the technology across their entire fleet.  Currently, SRI is actively retrofitting camera mirrors on five fleets with 20,000 trucks demonstrating the interest in MirrorEye. 

MirrorEye clearly fits well in the macro trends that global fleets are looking to address.  First, removing mirrors or replacing them with much smaller mirrors improves fuel economy.  In the US, the fuel savings alone will allow MirrorEye to pay for itself in under three years and in Europe the payback is closer to one year.  Additionally, with fleets trying to meet ESG and carbon reduction goals, improving fuel economy is a priority above and beyond dollars and cents. 

Safety is another priority for trucking companies that impacts both ESG and reputational goals, as well as the bottom line.  Trucking accidents have continued to increase in frequency and cost, and MirrorEye has demonstrated a track record of accident reduction.  Data from the National Highway Traffic Safety Administration from 2010 to 2019, accidents involving large trucks have increased by 95% including a 105% increase in injuries and a 43% increase in fatalities.  This represents a much higher growth rate than that of overall motor vehicle crashes of 24% over this period with a 10% increase in fatalities.  As such, fleets and insurers of trucking companies are laser focused on safety.  MirrorEye has demonstrated a significant and measurable improvement in safety with a Federal Motor Carrier Safety Administration study indicating that MirrorEye could reduce blind spot commercial vehicle accidents by 30%.  SRI’s data from actual fleet trials indicates a reduction of blind spot crashes by 40% and a 50% reduction in accident costs.  As this data is validated by insurance companies with more MirrorEye trucks on the road, they could offer reduced rates for these trucks which should result in digital mirrors becoming standard equipment on new trucks. 

In addition to safety and fuel economy, MirrorEye may represent an important tool for driver recruitment and retention.  In 2021, the American Trucking Association has estimated that the industry is short by 80,000 drivers.  As older drivers retire and fewer younger people choose to be truck drivers, this shortage continues to grow every year.  Therefore, trucking companies have continued to attempt to find technologies that make operating a truck easier for less experienced drivers.  We believe that MirrorEye is such a technology.  Indeed, in the recent past, trucking OEMs began to introduce Automated Manual Transmission (AMT) in order to improve the ease of driving.  This technology enjoyed an extremely rapid adoption curve with the take rates improving from 20% in 2012 to over 80% in 2018.  We believe that MirrorEye could see a similar rapid adoption curve over the coming years.

The financial impact of MirrorEye to SRI should be transformational.  Over time, we believe that MirrorEye take rates should approach 80% on heavy-duty trucks, which represents a $400 million annual revenue opportunity on the programs that SRI has already won.  This represents 54% of projected 2021 estimated revenue, and the profitability impact should be even more extreme.  At a 27.5% contribution margin, MirrorEye could add $110 million of EBITDA, essentially doubling SRI’s longer-term profitability.  At a vehicle technology peer multiple of 11.7x, discounted back at 10%, this opportunity alone is worth $35.55 per share or 207% of the current share price. 

Additionally, SRI has further opportunities for MirrorEye penetration outside of the current OEM awards that could further expand the value of this product.  First, OEMs that control 25% of the North American market and 33% of the European market have yet to make an award to a camera mirror system supplier.  As SRI is already the dominant player in the market, they would have the best chance of winning this business which could add over 30% to the MirrorEye revenue opportunity.  Second, SRI’s awards currently only comprise the heavy-duty or Class 8 truck market for MirrorEye, where it is most crucial.  However, if heavy-duty trucks were to adopt camera mirror systems, medium-duty vehicles would ultimately follow suit.  Since the number of medium-duty trucks sold is roughly the same as heavy-duty, this could double the opportunity for MirrorEye.  Furthermore, thus far, SRI has primarily focused on the developed markets of North America and Europe, but several of the OEMs that SRI has contracted with also serve Brazil and other emerging markets which could further expand the total addressable market over time.  Finally, SRI has designed a MirrorEye product specifically for the bus and coach market and has already won business on several small bus manufacturers.  However, if SRI could further penetrate this market, that would provide further upside.  While none of these opportunities are necessary for our investment case, they demonstrate that SRI will still have substantial growth potential even after it fully ramps its current OEM contracts.

 Recovery Opportunity in the Core Business Should Drive Significant Value

While we have focused on MirrorEye because it is transformational, SRI has an attractive product portfolio that would be a focal point for many other lower growth vehicle suppliers.  Many companies in the auto and commercial vehicle space have struggled to adapt to electrification and automation, but SRI has fashioned its product portfolio to benefit from these megatrends.  Outside of MirrorEye, the Company is a leader in driver information systems, connectivity and controls, and sensing and axle-based actuation systems.  These products play a significant role in electrification and carbon reduction, improved safety and user experience, and automation.  Additionally, 85% of SRI’s portfolio is drivetrain agnostic, meaning that SRI is well positioned on internal combustion engines, hybrid vehicles and battery-electric vehicles.  SRI excluding MirrorEye should grow at least 5.0% in excess of its end markets over the next several years.  This outlook is driven by several important program wins that are just beginning to convert from backlog into revenue.  As these program ramps continue to accelerate, investor confidence should grow given the strong visibility to future growth.

However, the auto and commercial vehicle industry has been experiencing a critical chip shortage over the last year.  Among its industry peers, SRI has been perhaps the most negatively impacted by this issue.  As an advanced technology company, SRI relies on semiconductor chips as essential inputs in the vast majority of its products.  Therefore, SRI’s profitability has taken a larger hit than most peers in 2021 for several company-specific reasons.  First, SRI is facing lower sales as it is unable to keep up with customer demand because it cannot source the chips needed to produce its products in a timely manner.  Second, SRI has taken a gross margin hit because it takes time to win cost concessions from customers while SRI must pay higher prices and transportation rates to source its key semiconductor components.  Third, a large portion of SRI’s selling general and administrative expenses are quasi-fixed.  As SRI supports key product launches including MirrorEye and positions itself for strong growth of its end markets, the Company has not cut its research and development or engineering budgets to support upcoming launches.  Instead, SRI had planned to keep these expenses relatively flat and leverage them with growth in sales and gross profits.

We believe that SRI’s spending on growth, while many peers have decreased spending, should position the Company well for the long-term.  However, investors have been spooked by the decline in near-term profitability.  In 2021, SRI has been able to maintain sales within 4.5% of its initial outlook due to high demand for its products despite much lower than expected end market performance because of shortages.  However, due to the previously described cost pressures and resulting negative operating leverage, SRI’s EBITDA should come in 62% below its outlook at the beginning of the year.  SRI’s poor performance this year has understandably disappointed investors.  Nevertheless, we believe that investors have mistakenly extrapolated these weak results forward and have ignored the prospect of positive operating leverage that SRI will see as these issues resolve. 

At the beginning of 2021, SRI shared a plan for revenue and margins going out to 2025 that was received favorably by the market at that time.  SRI projected revenue in excess of $1.1 billion and EBITDA margins of 15.0%, resulting in $165 million of EBITDA.  Additionally, we believe that this outlook included only around $20-25 million of EBITDA from MirrorEye due to the conservative 15% take rate assumptions embedded in SRI’s outlook.  Shortly after providing this outlook, SRI’s shares ran up to $38.20 per share or 123% above current levels.  However, investors currently seem concerned that this outlook is no longer valid and have adopted a short-sighted approach to valuing SRI’s core business.

We believe that SRI’s 2025 outlook has been much less impaired than market participants appear to believe.  Since issues around chip shortages should be resolved by 2025 and SRI has not lost any significant business, the Company’s revenue estimates for that year should be largely intact.  In fact, they should be significantly conservative if MirrorEye take rates begin to exceed expectations as we expect.  However, given the Company’s weak margin performance in 2021, investors appear concerned that SRI will guide to much lower 2025 margins relative to the outlook provided early in 2021.  We believe that the most conservative way to think about this is to assume that SRI will be unable to offset the negative impact of normal price downs that vehicle suppliers face, which average approximately 1.5% per year.  If we conservatively estimate that unplanned inflation caused by the chip shortage issues lasts for two years and that SRI cannot offset price downs during this period, 2025 margins could approximate 12.0% rather than 15.0%. While lower margins on the core business would be disappointing, we believe that investors are discounting a much worse scenario.

Despite a muted 2025 margin outlook, we believe that the core business alone is worth more than the current share price at these margin levels.  Since SRI excluding MirrorEye does not have the same growth potential, we have valued this business at a high-quality vehicle supplier multiple of 7.6x EBITDA rather than a vehicle technology multiple of 11.7x, like MirrorEye.  If we take out MirrorEye EBITDA and apply the 7.6x peer multiple on SRI’s EBITDA and discount back at 10% that suggests that the core business is worth $25.04 or 46% higher than the current share price.  In summary, while the margin degradation caused by inflation is disappointing, we still believe that this core business value provides strong downside protection for the shares while enabling investors to capture the significant upside that MirrorEye should generate. 

End Market Tailwinds Should Provide a Multi-Year Runway for SRI to Execute 

Given SRI’s high level of fixed costs and operating leverage, the biggest risk for the Company outside of execution missteps would be a weak macroeconomic environment in its key commercial and light vehicle end markets.  Fortunately, we believe that such an end market environment is extremely unlikely in the near future barring a significant recession. 

While the recent chip shortage headwinds have been painful for SRI, the Company’s end markets are positioned to shift nicely in SRI’s favor over the next several years.  The US Auto industry is currently SRI’s largest end market and is facing a record shortage of cars available for sale.  In November, the ratio of auto inventories to sales hit an all-time low of 0.24x.  This compares to the low prior to this recent cycle of 1.4x and is one-tenth of the average ratio of 2.5x.  This trend has been mirrored by record low inventories of trucks in SRI’s key commercial vehicle markets in the US and Europe.  Therefore, in addition to normal demand, vehicle suppliers like SRI should also benefit from a prolonged inventory restocking cycle.  This will either result in a period of super charged demand or, more likely, a longer cycle of above normal demand.  For a supplier with high operating leverage like SRI, this is an ideal situation.  Since SRI has incremental margins of around 27.5%, every 10% of demand results in $25 million of EBITDA.  At a high-quality peer multiple of 7.6x, this would result in an additional $7.09 per share of value or 41% of additional upside for the stock. 

Valuation and Conclusion 

We believe SRI shares provide investors with multiple ways to win as: 1) MirrorEye provides transformational earnings power and growth; 2) improved execution in the core business translates to a strong margin recovery as the semiconductor shortage wanes; and 3) a multi-year recovery in the Company’s end markets allows SRI to leverage its fixed costs and deliver strong earnings growth. 

Over time, we believe that SRI’s shares could be worth $60.59 or 254% above current levels as both the core business value and the MirrorEye opportunity can justify valuations materially above the current share price.  However, as SRI is a high-growth technology company with high fixed costs, the Company has experienced large fluctuations in earnings over the past several years.  Ultimately, we believe that a company with this profile would be better off as a high-growth segment of a larger, more diversified auto or commercial vehicle supplier.  As SRI’s portfolio should offer above-market growth and exposure to the major themes of electrification, safety and automation, we believe that the Company would be extremely attractive as a takeover target over time.  There is currently strong interest in auto technology companies as a recently announced sale of Veoneer (VNE) demonstrates.  VNE is a high growth but unprofitable auto technology company that spun off from Autoliv (ALV) in 2018.  Despite a history of mixed execution, VNE agreed to be acquired by Magna International (MGA), an auto parts company, this summer at a 56% premium to its share price at the time.  However, later QUALCOMM (QCOM), a technology company, emerged with a private equity partner to outbid MGA and agreed to buy VNE at an 86% premium to its unaffected share price.  This purchase price represents a multiple of 12.0-13.0x 2025 EBITDA estimates even though VNE has incurred substantial EBITDA losses throughout its history and will not become profitable until mid-2023, at the earliest.  We believe that SRI would provide a buyer with a cheaper asset than VNE, similar growth from MirrorEye, and much less risk as it has an established core business with a history of profitability.

Any forward-looking opinions, assumptions, assessments, or similar statements constitute only subjective views. This information should not be relied on for investment decisions and is subject to change due many factors, including fluctuating market conditions and economic factors.  Such Statements involve inherent risks, many of which cannot be predicted or quantified and are beyond our control. Future evidence and actual results could differ materially from those set forth in, contemplated by, or underlying these Statements, which are subject to change without notice.  In light of the foregoing, there can be no assurance and no representation is given that these Statements are now, or will prove to be, accurate or complete. We undertake no responsibility or obligation to revise or update such

Catalyst

• Information around MirrorEye take rates higher than expectations
• Longer-term earnings guide and confidence around it
• Data around improvements in the auto chip shortage

SRI reports earnings tomorrow, but this is not a catalyst our thesis is based around either way