Country: United States
Ticker Symbol: ALV (NYSE)
Industry: Manufacturer – Occupant Restraint (Light Vehicles)
Current Price: $55.82 a share (represents $4.98 billion in market cap)
Periods analyzed: 2001 to 2010
Date started: 20 Jun 2011
Date finished: 25 Jul 2011
Report written by: 5 Aug 2011
A corporation whose roots can be found in entrepreneurship, when Swedish businessman Lennart Lindblad started a dealership and repair shop for motor vehicles in 1953. Three years following its inception, the company produced its first seat belt, marking its initial entry into the occupant restraint market. In 1968, twelve years into the seat belt business, the company was renamed Autoliv AB to embody its vision of saving lives (“Liv” is “Lives” in Swedish).
Autoliv Inc. (NYSE:ALV) is the merger of this renamed company and the American company Morton ASP, whose global headquarters is located in Stockholm, Sweden. It is presently the world’s largest automotive safety supplier with all leading auto manufacturers as its customers, the likes of which include GM (NYSE:GM), Ford (NYSE:F), Volvo (VOLVY), Volkswagen and Toyota (NYSE:TM).
With over 80 manufacturing facilities, 11 technical centers, 20 crash test tracks and 43,800 employees in 29 nations, ALV is in the business of developing, marketing and manufacturing passive and active safety systems for light vehicles, having maintained a minimum 30% market share of the global occupant restraint market since 2001 — in other words, there is an ALV product in every three of ten cars and light commercial vehicles seen plying the road. (If that is not arrogant enough for the reader, then allow me to point out that the company itself claimed “statistically, there were almost two seat belts and 1.2 airbags from Autoliv in every vehicle produced globally in 2010…”)
Vision-Mission and Core Values
ALV’s ultimate vision is the substantial reduction of traffic accidents, fatalities and injuries across the globe. The company intends to achieve it through the creation, production and sale of automotive safety systems.
In order to accomplish this mission, ALV has elected to exemplify the principles of a passion for life, customer satisfaction and value, innovation, talent development, ethical behavior and a diverse culture.
Within the world of automotive safety, there are two technology classes enabling Autoliv — and its competitors — to fulfill its vision and mission: passive and active.
Active safety systems are designed with the intent of preventing crashes, or at the very least, lessening their severity. Autoliv employs a combination of night vision, radar systems of short, medium, or long range and forward-looking cameras for applications such as speed sign recognition, collision warnings, pedestrian detection and identification of dangers lurking in blind spots.
However, the company recognizes that perfect prevention of crashes and vehicular accidents is, like an ideal world of values and characteristics unattainable in practicality, asymptotic. It is an immutable fact collisions will occur. Hence, passive safety systems are eponymously aimed at mitigating the injuries arising from these mishaps.
Passive safety typically includes airbags, seat belt systems — whose load limiters and pretensions contribute the bulk of their efficacy, along with crash electronics, pedestrian protection and anti-whiplash systems.
Airbags are at the forefront of reducing fatalities, designed to fully inflate in 50 milliseconds (literally in the blink of an eye) and, through adaptive output inflators, can self-calibrate depending on the severity of the crash. As of December 2010, there are currently seven airbag classes out in the market:
- Traditional passenger/driver airbags: reduces fatalities among belted drivers by 25%, serious head injuries by 60% and belted passenger deaths by 20%.
- Curtain airbags: decreases risk of lethal head injuries from the side. Covers whole upper side of vehicle.
- Side airbag — single chamber: protects the chest.
- Side airbag — dual chamber: protects both pelvis and chest.
- Rear-side airbags: protects rear occupants
- Knee airbags: defends the hip, knees and thigh, as 23% of active-life years can be lost to vehicular accidents.
- Anti-sliding airbags: installed in the seat cushion, developed to prevent the occupants’ sliding under the seat belt. Improves efficiency of traditional airbags and further lowers risk.
Autoliv has never forgotten the people outside the vehicle and how unprotected they normally are during accidents. To preserve their lives (or diminish injuries), the company has designed schemes enabling the hood of the car to act as a head cushion. Nonetheless, the crudest method available has and always will be, in my opinion, the employment of exogenous airbags.
Autoliv claims to spearhead the frontier of passive safety, declaring itself accountable for “virtually all major technological breakthroughs within passive safety for the last 20 years.”
Source: 2010 Annual Report
II. EXECUTIVE SUMMARY
Any reasonable investor in the securities market would gravitate towards all potential opportunities whose underlying businesses: (a) possess the tenacity to endure the costs of debt, (b) have gained and maintained splendid efficiency in its daily operations, (c) continuously accrue profits well above its expenses, (d) sustain an invaluable position in its macroscopic environs, (e) display the potential to pursue value-adding growth over the long-term and most importantly, (f) whose market prices are far, far lower than their estimated value.
After thoroughly scrutinizing the processed maelstrom of raw information at its purest, I have determined that Autoliv Inc. (NYSE:ALV) represents a low risk to the long-term investor, translating to a weighted average cost of capital (WACC) of 6.92%.
I justify this evaluation by pointing to ALV’s manageable level of credit, strong levels of efficiency, relatively consistent bottom-line profits (and moreover, returns above the cost of capital), a distinct economic moat arising from the company’s production process along with the immense barriers to entry natural to the automotive safety industry and finally, reasonable potential for growth as indicated by: (i) low safety content values per vehicle in the markets beyond Japan, North America and Europe and (ii) increasing regulatory decrees in favor of its business.
The only hazard faced by an investor in ALV is the permanent decline in the consumer demand for light vehicles, which is natural considering the products it manufactures and distributes. The needs of this downstream market are shaped by the confluence of individual aesthetic preferences, costs of transportation, costs of maintenance and any threatening alternatives to cars and the like for the standard modes of transportation. An analysis of this triumvirate has lead me to the conclusion that rising costs of fuel and increasing concerns for the natural environment are presently driving the growth of the automotive industry.
ALV’s current price of $55.82 a share is cheap in terms of book value and multiples of earnings accrued during the 2010 fiscal year (particularly net income and net operating profits after taxes).
The intrinsic value estimates propagated by my financial models signify margins of safety commensurate to the risks assumed by the long-term investor. The gradual corrosion of the market to date — no doubt a product of the uncertainty revolving around the United States’ debt ceiling negotiations — proffers an excellent opportunity to jump in and exploit the widening discrepancy between ALV’s stock price and the appraised value.
III. RISK ASSESSMENT
As stated in the executive summary, I have deemed Autoliv to represent a low risk for capital losses to the long-term investor. This is justified by manageable levels of debt, sustained strength in operational efficiency, encouraging profitability (and returns in excess of the cost of capital), an economic moat formed by distinct competitive advantages and immense barriers to entry and rather alluring prospects for the future, with the only threat being permanent declines in auto demand).
This level of risk effectively translates into a WACC of 6.92%. I based the after-tax cost of debt on the 5% average rate on all interest-bearing liabilities and the median effective tax rate of 31%. Autoliv’s cost of equity, meanwhile, was computed using a modified version of CAPM, assuming the July 2011 T-Bond coupon rate of just about 3% as the risk-free rate of return (Yield Curve for July '11) and seven basis points above 8% for the market return, drawn from the equity risk premiums computed monthly by Aswath Damodaran (Damodaran Online).
Adjustments to the Financial Statements
Autoliv disclosed neither the financial reports of its significant equity investments or the owned portions of these associates from 2001 to 2007, preventing me from determining whether adjustments to the balance sheets and income statements are needed.
However, I have performed several amendments to the format of the income statement, fine-tuning their receptivity for scrutiny. Thus, any ratios and figures I derived from the recast income statements and then presented here on this report will be slightly different from what one may calculate using the financial reports as originally exhibited by Autoliv. From what I have observed so far, the differences directly affect gross profits, operatingincome and EBIT.
Autoliv’s debt ratio has been, for lack of a better term, modest. I’ve observed debt ratios never higher than 60% of total assets — the company has done an excellent job with its financial activities, ensuring the debt ratios meander close to the median 53%. The most recent fiscal year saw an immense improvement, posting a debt ratio five percentage points lower, having increased current assets, specifically cash and net receivables.
Currently, 67% of Autoliv’s liabilities are current (higher than the average 57%), almost all of which rested on accounts payable, accrued expenses (and those wonderful reserves for restructuring and product-related liabilities) and other current liabilities. Trade payables dominated ALV’s debt situation and aren’t likely to pose a significant threat to the company’s solvency.
Speaking of which, ALV’s solvency ratios did not fail to impress me. OCFBWC, Adj. GAAP EBITDA, Net OCF and NOPAT are all above 20% of total liabilities as of 2010 year-end, posting results greater than the 10-year averages. That none of these took a dip below 60% of these figures more than once lends weight on the company’s strength.
Altman’s Z-score, one of the more traditional litmus tests for ascertaining the possibility of bankruptcy, has grown from the borderline 1.80 in ’01 to 3.67 on ’10. As one can see from the graph, the Z-Score has never dropped below 2.0 since ’02 — the financial crisis of ’08 and ’09 brought down the company but failed to deliver the killing blow, permitting it to rebound exactly one year later.
Liquidity and Earnings Coverage
Buttressing the robust long-term financial strength is Autoliv’s exceptional ability to cover current obligations. I observed that cash alone can pay for over 30% of current liabilities since ’08, over 2.5× better than the median. Once net receivables are introduced, only a miniscule amount of the current debt remains, that is if it wasn’t eliminated already.
Current ratios throw in the rest of current assets into the fray: net inventory, income tax receivables and other current assets. Alongside cash and net receivables, they exceed the enemy by 22% at a minimum. Anything else that somehow survived would be crushed by net operating cash flows, which amounted to 38% of current liabilities (and 21% of total) on average.
The margins of safety — above interest expenses, yearly operating lease obligations and principal payments of debt — enjoyed by ALV last year range from a mediocre 21% to an amazing 88% depending on one’s choice of profitability: EBIT, NOPAT, OCF, FCF, or OCFBWC. However, the strength of this protection went wild during the past decade.
* Note that interest has been added back into OCF here
Obviously, the current figures are promising, being 30 to 88% higher than the long-run averages. However, the coefficients of variation for each profit metric question the sustainability of its present level of financial protection — excluding the dismal ’09 performance (more on this in the section on profitability) is a pointless endeavor, its impact on the variability measure laughable. A joke.
Nonetheless, a careful analysis of Autoliv’s long-term debt took this ratio one step further by projecting the required interest, operating lease obligations and principal payments, as well as commitment fees necessary to maintain part of the astronomic credit facilities on reserve to the next nine years.
I estimated that, barring fresh infusion of debt or managerial whimsy, an average of $113 million must be paid every year. The 10Y medians of the same profit metrics in the table above are all at least twice the value of these estimated requirements across all three scenarios. This in itself suggests a satisfactory level of protection and further contributes to Autoliv’s financial strength.
Of course, I can’t help but worry a bit over this ratio’s historical volatility...
If there’s one thing I can put my confidence in, it would be the high level of operating efficiency achieved by Autoliv in the middle of the decade and then sustained it for the years to come. ALV’s turnover ratios over the past ten years indicate this. Starting from ’01, the airbag manufacturer produced about $1 per every unit invested in assets ($1.33 per unit of NOA). This jumped to 1.19 (1.82) in ’05 and strode forward by several paces to 1.32 (2.26).
Both ’05 and ’10 figures achieved or surpassed the long-term averages for the year and over the ten-year history I scrutinized, none of the ratios have ever banked towards 60% of these averages, let alone plummet beneath them.
As I am indubitably aware turnover ratios may not exactly be a perfect indicator of efficiency, I shall provide key figures derived from the annual reports (if not directly lifted from them) so the reader may verify the incredible achievements the underlying business obtained.
* The information involving ISO certifications, the consumer reject index and the “share in global market” are estimates, as Autoliv presented the data in graph form without reference to the specific values.
As seen above, ALV’s key performance indicators have been improving. ALV embraces its culture of innovation and values the inputs of its employees, receiving an increasing number of suggestions from them and investing in more training days every year. Both injuries and absenteeism has decreased despite the steady growths in headcount, which I would infer as an indication of something being done right.
Furthermore, the company’s products have grown in quality, its rejection rates dropping from 50 for every million produced to a mere 5. Autoliv, naturally, pins the medal of distinction on its production process. The management calls it a “strategy of shaping a proactive quality culture of zero defects” (2010 Annual Report). I would call it an increased emphasis on carping.
Previous annual reports by the company also proffered two additional insights into ALV’s production process:
- Sales contracts are typically awarded three years prior to the commencement of vehicle production and are valid for the 4-5 year production period of the platform/vehicle model under contract (2005 Annual Report)
- The company strives (or insists, as I’d like to put it) for the customer to immerse themselves in the project as early as possible in order to “reduce… financial risk” (2004 Annual Report).
The manufacturing portion of the system has been quite efficient. Rarely does Autoliv retain over 10% of its goods available for sale as inventory by the end of the fiscal year. Yearly production represents 90% of cost of goods available for sale and of what has been manufactured, only 0.4% are expected to be obsolete or excess — I observed that actual write-offs were far less than the provisions themselves, leaving me with the idea Autoliv’s business operations exude conservatism.
While there is only so much more Autoliv can go as far as improvements are concerned, by looking at these facts and estimates, I am inclined to believe the company is going to remain operating efficiently for the years to come.
To commence my comprehensive profitability analysis of Autoliv Inc., the first thing I looked at were its sales figures. After all, every dollar of profit and loss — or most of it, at least — are ultimately products of Autoliv’s ability to sell its goods.
Historically, North America and Europe were the greatest contributors of global sales, accounting for 90% of sales. As the years passed, Japan and “The Rest of the World” (this dismissive name is not a result of my own ruminations) stole shares once owned by the predominant regions, owing to stellar compounded growth rates of 16.3% (Japan) and 25.7% (ROTW) versus the mature areas’ 3.8% (America) and 2.9% (Europe). As of 2010 year-end, sales have been evenly divided between Europe, North America and Japan/ROTW.
Autoliv identified two factors crucial to the development of the industry, a third of which it dominates: (a) safety content value per vehicle and (b) global production of light vehicles (2010 Annual Report). Government regulations also have an influence on ALV’s sales.
The stacked area chart I have provided clearly shows how much dependent Autoliv is on its airbags. Sixty-seven percent reliant, on average. The reasons behind the existence of this balance probably lie not in the question of which sells more, but in the fact that seven kinds of airbags are being installed on light vehicles. Eight if “pedestrian protection” is included.
Finally, despite their heavy reliance on airbags and crash electronics, ALV’s customer mix is a sight to behold. Since 2001 the company has been catering to the needs of the most prominent companies of the auto industry. Better yet, not a single one was responsible for over 15% of a given year’s sales.
Autoliv’s very existence is not subservient to a small number of customers, or to any one region for that matter.
As seen in the graph, ALV’s operating profits have been within the $500 million range. At worst, it has achieved merely $200 million and at best, slightly less than $900 million. These results represent 4% to 12.4% operating margins (in contrast to the reported financial statements’ 1.3% to 12.1% range).
That costs of goods sold take up so much space goes to show how of sales is swallowed up by ALV’s manufacturing processes. COGS has never gone lower than 74% or greater than 80%, even during the financial crisis of ’08 and ’09. I find it notable for Autoliv’s COGS margins to have risen above 77% only four times: twice in ’01 – ’02 and twice again in ’08 – ’09, years succeeding the bursts of economic bubbles.
In my opinion, what little data I have can mean two things: One, volcanic eruptions in the economic sense aren’t expected to materially affect gross margins; and two, should the underperforming years be utterly discarded, gross profits have never deviated far from 24% of sales, speaking for the efficacy and the limitations of ALV’s cost-saving initiatives.
SG&A expenses have been just as stable. While normally 5% of sales, operating expense still siphons a material portion of what little remained for the company’s earnings, leaving behind 78.6% on average —with very little variability. It should stand as a testament to the sheer difficulty ALV has in curbing the growth of its rising costs.
With innovation as one of Autoliv’s core values, as well as a crucial aspect of its business operations, I’ve come to understand R&D is the backbone of its life and the prime driver of the innovations it leads the industry with. R&D has never dropped below $300 million for the last six years and moreover, not one year from ’03 onwards did the annual R&D expense go beyond one standard deviation of its average ($311 million).
Vertical analysis shows R&D did not vary much from 5.4% of sales, with its highest being 6%. Going further by designating 2001 as an index, the value dispensed under R&D for 2010 was 85% above the value of what was invested in R&D nine years earlier.
It speaks for Autoliv’s perennial and unwavering commitment to innovation. What I find interesting here is the fact ALV maintained its control over 30% of the global automotive safety market without making drastic leaps in R&D investments.
Returning to the “overall picture,” the processing of COGS and SG&A often results to margins around 18%, ALV’s staunch devotion to R&D and the immobile behavior of D&A have thus been observed to reduce these margins by no less than 40% (more commonly, 60%), leaving with very low operating margins.
Moving on to the portion of the income statement after operating income, the impact of items considered either nonoperating or operating but infrequent and/or unpredictable has been relatively small, typically a 10% reduction on operating income. Much of this siphoning has been traced to restructuring provisions, an unpredictable operating expense larger than most items under this category.
In fact, it was also the item responsible for nearly zeroing net income for ’09. Killing off this bastard, for example, pulls up ’09 net profits by approximately $300 million, raising the bottom-line margins from zero to six percent.
Interest revenues don’t have a very strong effect on the company’s EBIT, raising it by rather negligible amounts. ALV’s financial statements and its footnotes do not disclose its sources, although I am operating under the impression it is coming from its excess cash and cash equivalents and a long-term interest-bearing deposit.
Interest expenses are a different story. They have consistently been 5% of interest-bearing liabilities and its value never strayed far from $56 million a year — one reason why interest expenses floored the sum of operating income, nonoperating and unusual items and interest revenues by as much as 93% on ’09.
ALV’s rather creative tax management resulted in a median effective rate of 30.8%. This sounds just about right in light of that six of the eleven adjustments it has used in the past are reasonably predictable and can be expected to produce a 4.6-point absolute deduction in the effective tax rate — barring any anomalous years such as ’09, when all income tax adjustments had egregiously abnormal figures.
Out of courtesy for the reader, I took the liberty of summarizing my findings in the table, which can be compared with the 10-year median and the coefficient of variation.
So did Autoliv do well in reining its costs?
My response here would be a clear-cut yes.
With the margins at the bottom-line being rather low on an average basis (despite the 8% NPM posted for 2010 year-end), an important aspect to consider here are the profits retained by Autoliv, after subtracting for both minority interests and dividends distributable to the shareholders.
Historically, the retention rate has been swinging madly. In the past decade alone, the company has had 18% for ’02 and 84% for ’10… but that’s considering dividends were compared to net profits alone.
After peering at this chaotic mesh of numbers for an awkwardly long period of time, anyone would be able to see some level of predictability (ignoring the lack of reliability for free cash flows to either the firm or the equity). I could be reasonably certain that dividends are rarely expected to drop below 17% of NOPAT or owner earnings. Neither would it fall beneath 10% of net OCF, operating profits, EBIT, or adjusted EBITDA.
However, note the company opted not to distribute any dividends at all during the dismal year of ’09, when the net margin was virtually zero (culprits behind this: D&A, Restructuring Provisions and Interest Expenses and to a lesser extent, R&D and COGS). This gives me the impression Autoliv values its survival and would rather retain earnings than squander it on shareholders in times of economic turmoil — I see this as a positive trait, an indicator of the company’s honesty, choosing to admit it is in a pinch rather than pretending like nothing is wrong, allowing the distribution of dividends, financed by either debt or its own cash reserves.
One item that got my interest here is what I interpret as the “dividend potential” of the company. While Autoliv’s management can theoretically proclaim the distribution of dividends equivalent to 100% of their retained earnings, 100% of profits for the year, or perhaps even more so — no matter how suicidal it might be — as far as sustainability is concerned, there is always an option to retain free cash flows after principal payments and debt arrangements in cash, equity investments, business acquisitions and other assets, dispense them, or simply both.
The graph above displays compares the amount of distributable dividends to the amount of free cash flows earned by the company’s equity (inclusive of working capital or not). Dividends have always, always been less than either profit metric. FCF to Equity have always been greater than twice the value of dividends declared, with the exception of 2009 and 1-2 more years. This highlights the capability of the company to double its dividends at any given year, without any detriment, or much of it, to the amount thrown back into the system.
2010’s dividend declaration of $93.3 million represents a 1.72% yield on the 2010 average market cap of $5,421 million (computed through the average of closing prices at the end of every quarter, multiplied by the number of shares outstanding less treasury). Doubling this to $186.6 million results in a 3.74% yield on the present market cap of $4,985 million.
Returns on investment
Essentially, by virtue of maximized efficiency, low but fairly consistent profits and a reasonable level of leverage, Autoliv in theory should have compelling returns on investment.
The terrible profit margins Autoliv has posted year after year are bumped up slightly (by 15% to 20%, usually) through the clever utilization of its assets. As debt hovered around 50% of all assets, any returns on assets earned are practically doubled. Long-run returns on equity are centered around 13%, excluding the years of ’01, ’02 and ’09. Precluding merely ’09, of course, lowers the average to 12%. Last year’s performance was exemplary, mostly due to high net margins resulting from splendid gross profits and low impact from all operating expenses.
Although returns on net operating assets (RNOA), another ROI metric, were never greater than historical ROE’s, that they always contributed over 70% of ROE values have lead me to insinuate that economic returns are predominantly operating, rather than financial management — and that’s a good thing.
However, what I find most intriguing is not its returns, but on the variance between that and ALV’s cost of capital over time.
RNOA has grown from 3% to 21% in the past nine years, incurring a long-term average of 10%. My estimates of ALV’s cost of capital has risen from 5.7% in ’02 to 6.5% in ’10. Autoliv has earned less than this in the beginning and now posts returns with margins of safety above 50%. This gap between ROI and cost of capital supports Autoliv’s ability to create sustainable value (more on this in the next section, Inherent Stability) as it continues to exist and grow.
Reliability of indicators
Before moving on to identifying the qualitative facets of Autoliv’s manufacturing business, the first thing I had to look at was the reliability of the statistics I just presented. To supplement this part of the analysis, I included the C-Score and F-Score system concocted by James Montier and Joseph Piotroski, which were designed to be litmus tests of falsified accounting records and wellsprings of value, respectively.
Beginning first with the layout of the industry, the key thing to remember about Autoliv is that it and all of its competitors are heavily dependent on the auto industry. If the auto industry screws up one way or another, then we are bound to see a shocking impact on Autoliv’s business.
To answer the question of “why,” I point back to the very products Autoliv is manufacturing: airbags, seat belts, steering wheels, electronic safety systems. Only an idiot would fail to see the synchronized connection between this business and the auto industry, especially in light of the fact all of Autoliv’s major customers are auto manufacturers.
This industry is mature and consolidated. Autoliv only recognizes two other companies as major competitors: the American TRW’s occupant safety division and the Japanese Takata, whose market shares have been estimated by Autoliv to be 19% and 20% respectively. As for the “other” competitors, of all of them, the Indian company Delphi has been assimilated into Autoliv’s business thanks to strategic acquisitions (2010 annual report). As for the rest, they are most probably fighting each other, vying for the table scraps (21% market share) falling from the massive buffet feasted on by the “Big Three.”
Looking at the average of all absolute changes in market share can assess the likelihood of sustainable value creation (Maubossini, "Measuring the Moat"). Working with the figures in the table above will produce averages of an absolute 2.5 (’02 to ’06), 3.2 (’06 to ’10) and 5.1 (’02 to ’10). These are rather high values and can signify the industry’s shaky partitioning among the major players, although I have to say it’s been favorable for Autoliv.
* As another reminder, Takata does not have any publicly-available information for the years ’02 and earlier.
As it can be seen here, returns on net operating assets have been generally increasing for both Autoliv and TRW, while Takata’s fell from 10% to 5% in the four years from ’06 to ’10.
While TRW looks like a possibly better investment, I must stress that TRW’s occupant safety segment represented only 26% of its total assets on 2010. These haven’t been broken down, so I would have no idea how much of TRW’s $4.1 billion in net operating assets would fairly embody this business division. Furthermore, ALV’s larger control over the market ensures it earns more than TRW does as far as the absolute numbers are concerned, rather than percentage figures.
Summarizing what I have on the industry so far, we have reduced rivalry across the three firms, but not decreased enough to keep the market shares stable over time. In addition, the profits of the industry have been flooding into Autoliv and TRW, producing returns far greater than their costs of capital (using this graph makes the assumption that TRW’s WACC is the same as ALV’s.).
Obviously, the enormous profits raked in by TRW and ALV would be alluring for many new entrants. However, several walls bar their invasion.
- Incumbent dominance: look again at the table of market share. ALV is dominating the industry in terms of sales, snatching the diamonds straight out of TRW’s and Takata’s hands.
- Investment costs: over the past ten years, ALV has spent approximately $3.11 billion on R&D and technical/engineering expertise. Capital expenditures on fixed assets totaled to $2.70 billion. These figures total to $5.81 billion. Seems daunting enough.
- Patent protection: Autoliv files safety patents every year and its protected intangibles have a remaining life of six years on average, as of 2010 year-end. These are probably patents on its production processes and perhaps its actual products, adding yet another significant barrier to entry.
- Asset specificity: not less than 70% of Autoliv’s depreciable assets have been invested in machines and equipment. The company has technical centers in ten countries and manufacturing facilities devoted to airbags, seat belts and steering wheels in 11, 15 and 8 nations. I would expect something similar from either TRW or Takata.
A PDF sample of an industry research report on the airbag industry (which I think was prepared during the year 2005) written by Flatworld Solutions Pvt. Ltd. also adds other potential weaknesses for the industry:
- Suppliers of the industry can actually expand their business and begin competing with those who used to be their customers.
- Customers have plenty of power due to the fact they buy in bulk, as government regulations in developed nations ensure all light vehicles are equipped with airbags and seat belts. Adding to their bargaining power is the capability of corporate customers to arrange in-house suppliers for components — a common practice in China, Japan and South Korea (2010 annual report, 25).
For those who are interested, this report can be downloaded here: An Industry Report on the Airbag Industry.
To stave off the threats of competition, their suppliers’ potential expansion and their customers’ possible independence, Autoliv has attained several qualities that serve to tilt the playing field towards its favor and preserve its ability to earn profits well above the costs of capital.
Thanks to its large market share (40% in terms of firm revenues vs. industry sales, but ALV pinned its estimates at a more conservative 35%), it has attained an impressive scale economy.
From an industry that has produced no less than 54 million light vehicles (LV) in the past ten years (OICA, website), Autoliv’s products have captured at least 17 million LV per year during the entire analyzed period.
Sales generated per LV stabilized around $290, while all costs per unit have either increased slightly or took a backstep or two, when they would have gone up tremendously had ALV’s pool of captured vehicles remained constant since ’01. Take R&D for example. The company spends about $11 in research and development for every vehicle its products went into; this value hovered close to $16 from ’03 onward —yet had the company apprehended the same amount of vehicles annually, the amount spent on R&D would’ve risen to $20.2.
Taking that into consideration, Autoliv’s costs are strongly mitigated by the sheer volume of light vehicles using its airbags and seat belts — the quantity of its market clearly permit the company to spend more for R&D and other improvements and dilute this across each vehicle. However, any weakness in LV production may affect the efficacy of this mitigation; therefore it is important to look at the other sources of competitive advantage…
Such as its production process.
As mentioned earlier in the section covering “efficiency”, Autoliv’s production process is meticulous in terms of quality control and, thanks to constant streams of R&D expenditures, is subject to multiple improvements over time. Most, if not all, of its facilities are ISO-certified. Furthermore, many of its complex innovations and products in “automotive safety and key supporting technologies” are protected, holding over 6,000 patents on 2010 year-end, all of which expire on various dates from 2011 through 2030.
Strategic acquisitions have also added value to ALV’s production process. On 2009, ALV acquired Delphi’s European and North American assets for airbags, steering wheels and seat belts, effectively consolidating the industry. On 2010, the company bought the Estonian Norma (a top supplier of the Russian market), acquired the automotive radar business of Tyco and Visteon. Delphi’s Asian operations were virtually absorbed into Autoliv, “significantly strengthen[ing] our (Autoliv’s) position in the expanding Asian market, particularly in South Korea and with Hyundai/Kia” (2010 Annual Report, 36).
Though related somewhat to scale advantages, diversity is another key element to Autoliv’s dominance. The company’s operations are spread over 29 different nations, 17 of which are considered countries of “low costs”. R&D is spread over ten of these, providing maximum flexibility in terms of critical thinking and mindset. Plus, the massive number of nations its manufacturing facilities are based in provides a significant defense against the effect of natural calamities on the production process.
Although the apparent lack of differentiation from one company’s airbag/seat belt to another’s enables any customer to, quite literally, pick any one leading supplier and be done with it, Autoliv banks on its stalwart reputation and customer mix. Its dedication to innovation and quality all but ensures products well worth every penny spent on them; furthermore, its range of clients prevents the scenario of absolute dependency on any single one.
Despite these low search costs, these are somewhat offset by the accepted industry practice of locking in clients three years prior to production through contractual obligations.
An overwhelming majority of ALV’s competitive advantages lies in its production, covering both scale and process. It is diversified across multiple corporate clients and it is an accepted practice in the industry to lock them in for the medium-term. All four, thus, contribute to the immense market share controlled by Autoliv, since 2001 to present day.
The growth of Autoliv — and the occupant safety industry itself — are driven by three factors: (a) Safety Content per Vehicle, (b) Supportive Government Regulations and (c) Global Light Vehicle Production.
Safety content per vehicle is the average value of a given vehicle’s safety systems — both active and passive. The global average for the year 2010 was $250 per unit, 20% higher than $210 (the 2001 average and the costs of goods sold spread across every captured vehicle for ’10).
As the graph indicates, the global average did not deviate too much from $250, most historical values coming up on the $20 interval between $240 and $260. North America and Europe possessed the highest safety content value in all ten years, exceeding even the global average. Japan joined these two since the year 2008, hitting $280 and going up since then.
What I find intriguing here is the immense gap between the “Rest of the World” averages and the global average, or for that matter, the average safety content value for the so-called Big Three (Japan, Europe and North America). Look at the purple line at the very bottom of the graph and compare it to the blue one in the very middle.
Automotive markets beyond the three primary sales regions have had safety content values at steep discounts to the global average: almost 50% on ’01, then down to 28% on ’10. This is only suggestive of an opportunity. Sniff it out on the management’s discussion of its growth prospects and two countries apparently pervade its discourse: India and China. India, whose safety content values are less than $60; China, less than $200.
Lest I forget it, the amount of money spent on costs of goods sold, spread across every vehicle statistically captured by Autoliv, is lower than every number posted for the global average. Not only is that another clear indication of how effective Autoliv’s cost-saving initiatives are but also implies the possibility of it dropping as more investments are made into the regions beyond the Big Three — a strong one, too, considering the fact that global LV production has become increasingly concentrated in the Asia-Oceania region.
Escalating government regulations in favor of safety — and the industry, inadvertently — also play into the immense profits earned in this life-saving business. I did my best to unearth the latest, specific vehicle safety mandates from the Federal Motor Vehicle Safety Standards (US), the ECE Vehicle and Equipment Regulations (World Forum for Harmonization of Vehicle Regulations) and other reputable sites across the Internet.
Unfortunately, this eluded me and all I have to present is the outdated information provided in the 2010 annual report:
1. Side curtain airbags will become mandatory in all vehicles produced for the US market starting 2013.
2. Brazil ruled that all light vehicles will have frontal airbags beginning 2014.
3. Europe is in the process of phasing in more stringent crash tests into its standards.
Nonetheless, this led me to the expectation of governments eventually considering the implementation of higher safety standards for local vehicles.
The last source of growth, however, is something neither the company nor its industry can control: downstream opportunities, i.e., consumer demand for cars and light vehicles. It is a double-edged blade, capable of inciting either tremendous growth or an appalling decline.
Global production of light vehicles — passenger cars and light commercial vehicles — lifted straight from figures provided by the international association of automobile manufacturers (oica.net) indicates a 3.4% geometric growth rate for the nine-year period between ’01 and ’10.
It can be seen on the table that production in Europe and America has been falling, while the Asia-Oceania region is rising, even during the financial crisis (when EU & NA production fell by 8 million cars in concurrence to Asia-Oceania production advanced 1 million). Asia-Oceania’s strong 9.3% nine-year geometric growth contributed significantly to the expansion of automobile industry.
Given the industry’s intrinsic dependency on auto manufacturers, the next question that I had to ask myself was: What factors shape LV production?
Common sense dictates three:
• Consumer preferences, including environmental footprints
• Mileage: the cost of fuel
• Cost of maintenance
Consumer preferences are, like the stock market as a collective whole, generally fickle. It is a pointless exercise to analyze these.
However, “going green” is a trend that has long been recognized by the manufacturers — otherwise they would not be producing hybrid and pure electric vehicles today. These two 2007 articles, one by professional automotive journalist Mike Bartley (German Car Manufacturers Going “Green”) and another by Tamara Holmes of bankrate.com (Automakers See Green Across Their business), wouldn’t have been published either with certainty in their voices.
Mileage, or rather fuel economy, has a profound influence on consumer behavior and for a very good reason.
Raw data mined from inflationdata.com. 2011 data is merely partial, for obvious reasons.
The average price a barrel of crude oil would cost has risen from $16 on the year 1998 to at least five times that amount on 2011: roughly 13.7% a year. Consequently, costs of gasoline have also gone up, considering the fact crude oil is responsible for over 60% of gasoline prices (US Energy Information Administration, Gasoline Explained, 19 May 2011).
This insinuates, if not confirms, gasoline is presently at its highest regions, affecting nearly every consumer. In concept and in practice, auto manufacturers would be hard-pressed to develop vehicles of superior mileage, through refinement of fuel-injected systems or technology such as electric vehicles, gas-electric hybrids, hydrogen-powered cars and the like.
Roland Hwang, Transportation Program Director of the Natural Resources Defense Council (the NRDC), asserted in his May 10, 2011 article on the Green Car website “tougher pollution and fuel economy standards [ensured] American automakers are not just making world beating, competitive products, [but] they are [also] doing fuel economy.” Fuel efficiency is a matter of survival, he wrote. “With gasoline prices pushing $4/gal., consumers are flocking to fuel-efficient cars, shunning SUVs and snatching up hybrids.” (“Fuel Economy is Key to Automobile’s Future” in Green Car).
Finally, the last of the triumvirate affecting LV demand would be the cost of maintenance and/or repairs. Data lifted from Autoinc’s industry research on the two business categories for the US region indicates at least 200 vehicles are being serviced every month by specialized shops nationwide, generating revenues not less than $300 per order. Shops capable of providing collision repair receive fewer repair orders monthly (an average of 90), each one worth about $1,900 more or less.
These numbers have shown sticky consistency over the 2002-2010 nine-year period: little variation and little growth/decline.
* Note: no data was available for the average value of service tickets for ’07 and ’08. The reports were unfortunately too vague on the subject.
My point with automotive maintenance is simply that maintenance and repair costs also affect the production of a specific vehicle platform and any signs of growth or stability (rather than decline) are bound to play a role in the purchasing decisions of Autoliv’s downstream consumer.
So far, Autoinc’s data does not appear to indicate anything detrimental to the auto industry.
Given the decent growth prospects in regions beyond the Big Three (in terms of global LV production and safety content value per vehicle), not to mention mounting discernment of value in safety and an incentive for auto manufacturers to constantly improve mileage and reduce or maintain the costs of regular maintenance, what has Autoliv done so far to pursue these opportunities?
According to the 2010 annual report, Autoliv’s management intends to finance plant extensions and manufacturing facilities construction in China, India, Brazil, Poland and Thailand by increasing capital expenditures to $300-$350 million yearly (roughly 4% of sales) in anticipation of “continued positive vehicle model mix”, “strong order intake from prior years” and higher expectations from its radar, night-vision and vision cameras.
Furthermore, strategic partnerships and/or acquisitions are definitely going to be utilized. Within the past two weeks alone, ALV has established cooperation with Great Wall, a leading manufacturer for SUV and pickups in China (Business Wire, “Autoliv becomes strategic supplier to great wall”, 24 Jul 2011). This partnership called for technical cooperation in the areas of active and integrated safety along with passive safety, enhancing the business relationship Autoliv has had with the Chinese manufacturer since 2003.
IV. Valuation Analysis
I had a great initial impression of the company. Everything about it spoke of cheapness, even when the market was pricing it at $69.11 a share last week. That price was worth 2× the book value, 5× the tangible book value and 10× the net income of year 2010. Furthermore, when compared to the “predictable” level of maintenance owner earnings (the value capitalized to produce the unadjusted figure in Greenwald’s Earnings Power Valuation model), the July-end price was merely 12.8× that amount.
When the price took a significant hit today from the worries over the fate of the U.S. economy despite what I think was a half-assed resolution of the explosive Republican vs. Democrat debt ceiling negotiations, it became even more attractive!
At a market capitalization of $4.88 billion, it dropped to 1.7× book value, 4.1× tangible book value, 8.4× net income of the year 2010. The P/E multiple for maintenance owner earnings FELL by two whole numbers, from 12.76 to 10.30.
The more Autoliv plummets, the more attractive it becomes as an investment. Of course, could there still be an appropriate estimate on its intrinsic value?
Net Asset Value
Assessing the costs of liquidation is not appropriate for Autoliv, not when its products have virtually no substitute and its salability is intrinsically tied to that of the automobile. Cars are not likely to vanish from the face of the economic world in the near future and even if robots had somehow replaced every human driver on the planet, airbags and seat belts aren’t going to go away.
Aside from zeroing reserves for bad debt, restructuring costs and inventory excess and/or obsolescence, to be frank, not every asset underwent an adjustment. Only fixed assets were adjusted.
Under fixed assets, the following were applied:
- A 10% increase on land and land improvements, reflecting my belief a new entrant is likely to pay higher for all the land needed to construct buildings and operate.
- A 20% leap for machinery and equipment, as the equipment a new entrant would surely purchase must be state-of-the-art.
- Buildings were padded with a 15% increase to their gross values. Manufacturing plants and other major operating facilities are likely to be more expensive, reflecting better equipment and layouts.
- A 10% increase on construction in progress, basing it on the idea the new entrant would face prices different from whatever ALV spent on them.
- $1,200 of ALV’s goodwill came straight from acquiring a significant chunk of Delphi back in the late 1990s. Now, I have absolutely no idea how much this same portion of Delphi would be worth now, but seeing as how Autoliv did not bother reducing this goodwill (or at least, it gave me the impression it didn’t), then I suppose ALV until now still gets its money’s worth from an acquisition made ten years ago. In this case, a new entrant that would “reproduce” the Delphi acquisition by purchasing another major supplier in the industry is likely to pay more for it. I’ve decided to peg 20%.
- The remaining $412.3 million in goodwill obviously came from ALV’s strategic acquisitions, but unfortunately, I don't know where it specifically came from. Just to be safe, I padded this by 10%.
- Finally, I made no adjustments to the amortizable intangibles. Filing for patents, I think, are likely going to reap similar costs and the value of creating the items they protect are already embedded in R&D.
With everything else held constant, the unadjusted net reproduction costs of Autoliv Inc. stand at $4.03 billion. However, further adjustments have to be made for: (a) dilution, (b) value of customer relationships and (c) the value of R&D.
Dilution is roughly equivalent to $178.8 million, arising from dilutive shares of 328 thousand (options), 361 thousand (RSU’s) and 5.7 million (Equity Units through Purchase Contracts).
The value of customer relationships (marketing/functionality operating expenses, as termed by Greenwald) and R&D were determined in the same manner: by taking in the relevant expenses and capitalizing it, subjecting it to a 5-year straight-line depreciation.
I assumed that 8% of COGS and SG&A — low by my own subjectivity, but possibly not in the industry — represent marketing and functionality operating expenses. Capitalized and subsequently dispensed over time, as of 2010 the depreciable estimate was about $1.25 billion. Turning towards the value of its R&D, under the same principle, the depreciable level of R&D was estimated at $1 billion.
These three, when applied to the unadjusted net reproduction cost, raised the total to $6.1 billion, a number higher than Autoliv’s current market cap but lower than both the value of stagnation and growth.
Value of Zero Growth
The value of zero growth, or “earnings power value”, in the words of Bruce Greenwald, is merely the net present value of maintenance owner earnings, capitalized over WACC and further adjusted as if it was a plain DCF financial model.
Rather than using 2010 figures and taking it as what the company could possibly accomplish at the very least over the next few years to come, I walked down the path of conservatism and applied the following assumptions in projecting the income statements — note that I tend to favor medians. I see them as more reliable than averages whenever the base numbers are too volatile to be useful.
- $277 sales per vehicle captured in the global market, representing the 10-year average. A little close to 2010’s $280.
- 62 million vehicles produced worldwide, signifying the median level. About 15% lower than 2010’s 73 million.
- Estimated market share of 33%. Median of ALV’s own estimates and significantly lower than market share derived from percent of industry sales (40%)
- Median COGS margin of 76.7%
- Median SG&A and average R&D margins, both of which experienced low variation over past ten years.
- Used median D&A margin, which underwent moderate variation due to its number being relatively immobile. The $285 million assumed is in line with what has been posted in the past.
- Growth R&D and growth SG&A expenses were based on the median depreciation charges, which resulted from estimating the values of customer relationships and R&D for net reproduction costs.
- Effective Tax Rate of 30.4%, arising from the statutory 35% lowered by 4.6% due to reasonably predictable tax adjustments.
- Maintenance capex is estimated to be 95% of actual capex (based on estimates using number of light vehicles captured). Excess depreciation was signified by the remaining 5%. Number used was the 10Y median of the yearly estimates from 2001 to 2010, all calculated using number of light vehicles captured.
These assumptions resulted in operating margins of 7.85% (lower than median 7.9%), actual NOPAT margins of 5.53% (just above the median). My estimate of maintenance owner earnings was pinned on $484 million. As I have written earlier, the market cap of $4.88 billion ($54.64 a share) is just a bit above ten times this amount.
Capitalized via WACC, I arrived at a nominal earnings power value of $6.99 billion. After adjusting it for excess cash (+$304 million), dilution (–$178.8 million), underfunded pension assets (–$136 million) and interest-bearing debt (–$566 million; the present value of total principal payments, interest expenses, commitment fees and rent expenses, given a pessimistic outlook, capitalized with WACC), the final estimate of earnings power value — the value of zero growth — was computed to be $6.42 billion.
This $6.42 billion indicates a 22% margin of safety over the market price. In other words, current prices are so low there isn’t even a premium for additional growth!
I also took the liberty of playing with the core assumptions and found several interesting points:
- If Global LVP was reduced to 54.11 million (the lowest number for the entire decade), the final EPV becomes $5.85 billion (↑20% over market cap.)
- If all cost controls are minimized except the D&A margin, holding it constant, which I personally think is highly unlikely to become permanent considering all the cost-cutting initiatives it pursued in the past, operating margins would fall to 6.3%. This will result to a final EPV of $5.02 billion (a 2.9% margin of safety).
- What if composite sales per car and global LV production were reduced to $238 (never seen since ’02) and 54.11 million vehicles? Final EPV would drop to $5.31 billion (↑8.85% over market cap). Throw in the 6.3% operating margin and it plummets to $4.61 billion: a 5.6% overvaluation. Still acceptable.
Here’s another kicker I think the readers would find interesting: The earnings power value of $6.42 billion is higher than the net reproduction cost estimate of $6.1 billion, which highlights qualitative advantages. Possible sources of the $320 million discrepancy would be the very competitive advantages already brought up in the section on Inherent Stability:
V. Personal Choice of Action
It seems to me Autoliv Inc. is an excellent choice for a long-term investment. Whatever risk it assumes is throttled by the brutal combination of quantitative and qualitative analysis. Decent leverage, sustained efficiency and positive profitability, plus great competitive advantages in a fortified industry as well as geographic diversity in its operations more than offset its single, greatest weakness that is the complete and utter reliance on the auto manufacturing business.
If at all, the only threat I am seeing would be the effect of macroeconomic forces, not on Autoliv’s business fundamentals (its longevity over the tumultuous decade of 2001 to 2010 imply amazing resilience), but rather, its stock price and its dividend policy.
Keeping these in mind, with its high margins of safety and excellent protection from permanent losses in economic prosperity, ALV is presenting itself as an excellent buying opportunity, at least for the week. I would personally take any signs of decreasing stock prices as a traffic light telling me to wait… and buy at even better prices.
1. I currently hold a few shares of this stock, having purchased it the week after S&P downgraded the US.
2. The report was written in early AUGUST, so obviously the current market price of Autoliv would be different from what it was during the time of writing. However, the most recent market price was $54.78 as of August 30, 2011, slightly lower than the $55.82 on month-start.
3. This report has been slightly truncated for the sake of space, although there was no effect at all to the impact of its message.
4. DCF valuations have been taken out, but they have been performed and at an excessively pessimistic scenario, the company is trading slightly above the fair value of $53.76. Slightly brightening the growth outlook hurls fair value all the way to about $97 a share (42% margin). Terminal value, however, accounts for 60% of these figures. The as-of-writing price of $55.82 assumes a 10.3% yearly decline in free cash flows over the next nine years considering zero terminal growth.