Description

At an estimated 8.2x 2011 EPS, 3.3x 2011 EBITDA, and a 2011 FCF yield of 18.9%, Valeo equity presents an opportunity to gain exposure to the global automotive sector, which we believe is coming out of a cyclical trough, at a deep discount to intrinsic value and a large relative discount to peers. Over the last 9 years, Valeo has considerably underperformed peers in terms of profitability, driving its valuation discount and attracting activist investors. This is largely the result of overcapacity and a series of poor acquisitions. Since December 2005, Valeo has reduced employee headcount by 33% (over 23,000 workers) and facility count by over 10%. We believe the earnings impact of these initiatives, combined with a strong portfolio of new product introductions, have positioned Valeo to fully capitalize on incremental demand growth. Furthermore, we believe the strong company positioning is currently underappreciated by market participants. As global automotive demand recovers to more normal levels, we believe Valeo will comfortably operate with 30% incremental margins - out of conservatism, we actually project lower figures for 2011 and 2012 (20% and 10%,  respectively), driving overall EBIT margins of 5.9% and 6.1% over those periods, underpinning our valuation case.

Investors should over time recognize the vastly improved earnings power of the company, and assign it a far less punitive valuation. We believe, over the next 12 months, Valeo shares can appreciate to the EU 45-50 per share level, representing 4.0-4.5x 2011 EBITDA. This represents a conservative target EV/EBITDA as compared to peers, which average over 5.0x on next year's figures. While upside could be significantly higher, we recognize the cyclicality and inherent risks in the highly competitive automotive supply business, and favor these conservative targets.

As some may recall, activist investors Pardus Capital Management and Guy Wyser-Pratte were significant owners of the company and became more vocal in 2007. There appeared to be opposing views with Pardus theoretically supporting a merger with another core holding of theirs, Visteon, and Wyser-Pratte publicly deriding that idea with an emphasis on Valeo undertaking its own restructuring. Soon after (March 2007), it was reported that Apollo Investment Corp had approached the company with the idea of launching a takeover bid, and the company confirmed it was in discussions with unnamed investment funds (the shares were trading north of EU 44 at the time). Pardus opposed the exploration of a sale, preferring management pursue a strategy to improve margins (publicly mentioning the possibility of EU 60 per share if a restructuring was undertaken), and this culminated in a battle for board representation which Pardus initially lost. In 2008, Valeo relented and appointed one Pardus representative to their board, and the expectation at the time was that with the weakness in Valeo's share price early that year, there would be more discussion within the company of the rumored Pardus proposal. Per Bloomberg (reported in April 2008), "under the Pardus plan, Valeo would sell six units, including the headlamp, wiper and transmission divisions, to focus on components for vehicle heating, air-conditioning and electrics...The sale proceeds would fund the purchase of Visteon's climate-control division or Calsonic Kansei Corp ., which makes thermal systems for 41 percent owner Nissan Motor Co., according to the people....Some analysts said the Pardus plan would help Valeo make the most of promising fuel-efficiency technologies such as ''Stop and Start,'' which cuts and restarts the engine automatically whenever a vehicle halts in traffic."

Of course, the global financial crisis intervened, and in 2008 and 2009, as with virtually all auto-related companies, Valeo's top-line declined materially, as did margins (though remaining positive at the EBIT line). The arguably intransigent Chairman / CEO of Valeo at the time, Thierry Morin - who was Chairman for the 8 years starting in 2001, during which the company suffered an operating margin decline from approximately 5% to sub-2% - apparently had "strategic differences" with the Board, and it was announced in March 2009 that he would be departing in favor of Jacques Aschenbroich, who had come to Valeo after serving as the Deputy CEO of Saint Gobain. Since then, Aschenbroich has reportedly suspended tie-up talks with Faurecia (per the French press), reorganized the company around four business groups in order to enhance profitability and efficiency, scrapped plans to sell a substantial amount of assets (specifically mentioning wipers and lighting as assets he did not intend to dispose of), and this June, hired Bank of America Merrill Lynch to evaluate strategic options. Specifically stating that "Valeo intends to actively work to ensure the highest possible value for the group", in our view an atypically strong statement for a large-cap French management team, we are confident that management is aware of their own company's undeservedly low valuation. While we do not anticipate the company selling itself, Valeo's relatively clean balance sheet allows for any number of strategic moves.

Financials

We project Valeo financials using sales growth and incremental margin assumptions. Sales assumptions are based on our views of the global automotive market in addition to recent conversations with Valeo management and the management teams of other auto parts companies (we would also direct you to their recent press release, in late September, raising their internal forecasts of global automotive production growth to 19%, higher than their July forecast of 16%). We believe as demand recovers, Valeo will operate with an incremental margin of 30% in 2010, and at least 20% in 2011 and 10% in 2012.

The key features and drivers of the financial projections (and company targets) include:

- Breakeven point has been lowered by EU 1.1bn, or the equivalent of ~EU7 bn of sales

- Negative operating working capital

- G&A reduced from 4.5% of sales to ~3% by 2012

- 2013 targets of EU 10bn in sales, EBIT margin of 6-7%, and ROCE of >30%

          (The company claims that 82% of its 2013 OE sales are already in its order book, providing it high visibility)

Company Description

Founded in Paris, France in 1923, Valeo designs and produces a wide range of sophisticated components that it sells to automotive OEMs and into the aftermarket. OEM/aftermarket split is 80%/20%. At 18% of sales, Volkswagen is the largest customer, followed by Peugeot, Renault, and Daimler/BMW, who all range from 11-15% of sales. Valeo operates in a highly competitive environment and competes with a number of equally sophisticated manufacturers including Borg Warner, Autoliv, TRW Automotive, Magna International, and Johnson Controls. In order to remain competitive, Valeo must continually spend 6-7% of sales on research and development activities. Valeo products are spread across four categories that we believe will have positive long term industry trends as consumers and OEMs focus on efficiency and safety.

1. Comfort (18%) - parking and maneuvering aids, park assist, cameras etc.; #1 globally in driving assistance, #3 in interior controls

2. Powertrain (27%) - dual clutch transmission, e-Valve, engine start-stop technology; #1 in electrical systems, #2 in clutches

3. Thermal (29%) - air conditioning, air quality management, EGR; #2 in A/C, #2 in engine cooling

4. Visibility (26%) - LED daytime running lights, Xenon lighting, etc.; #1 in wipers, #2 in lighting

In 2009, 64% of revenues came from Europe, 18% from Asia, 10% from North America, and 8% from South America. The Asian exposure is especially attractive to us. We have come to recognize that exposure to the fast growing Chinese market is something that suppliers must plan and invest in for an extended period of time before any results materialize. Penetrating this market requires years of building relationships and a solid reputation within China. We believe Valeo has done an excellent job creating a presence in China and that we are getting involved at a time when they will begin to see the fruits of that effort. Valeo offers one of the strongest China exposures of all western suppliers.

Comparables

EBIT Margin    FR FP ALV TEN TRW    JCI        Avg.

1999                5.2% 9.7% 4.5% 8.2% 5.3% 6.6%

2000                5.3% 8.2% 4.6% 6.6% 5.5% 6.1%

2001                2.6% 6.1% 3.7% 5.6% 5.3% 4.6%

2002                4.0% 7.5% 4.5% 6.7% 5.5% 5.6%

2003                4.1% 7.6% 4.7% 4.7% 4.9% 5.2%

2004                4.6% 8.4% 4.1% 5.2% 4.7% 5.4%

2005                3.7% 8.6% 4.9% 5.3% 4.6% 5.4%

2006                3.2% 8.6% 4.9% 5.1% 4.6% 5.3%

2007                3.1% 8.2% 4.5% 4.6% 5.2% 5.2%

2008                2.2% 6.0% 2.6% 3.2% 4.0% 3.6%

10 year avg.    3.8% 7.9% 4.3% 5.5% 5.0% 5.3%

Valeo has under-performed peers and is aiming to close the gap.

Catalyst