Continental AG Struggling Mightily, And The Market Isn’t Pricing In Much Improvement (OTCMKTS:CTTAY)
September 10, 2020
I’ve often said that investors should be slow to sell the stocks of good companies only because they look expensive. So does it follow that investors should avoid the stocks of lesser companies even if they look pretty cheap? That’s my dilemma with Continental AG (OTCPK:CTTAY) (CONG.XE), as this global giant in auto parts has struggled mightily over the last few years and looks relatively ill-prepared to leverage the transition toward electrified powertrains.
On the positive side, Continental has much better leverage to advanced driver safety (including automation), as well as car connectivity and infotainment, not to mention a profitable tires business that generates attractive margins and cash flow. Low-to-mid single-digit revenue growth and low-to-mid single-digit FCF margin can support a high-single-digit return from here, and the shares likewise look undervalued on the basis of near-term margin recovery potential. Although I have some serious questions and concerns about this business, the valuation already reflects a lot of those issues and I have to wonder if the risk/reward balance skews more toward “reward” today.
Electrification Needs A Lot Of Work
While Continental has been a meaningful player in powertrain, mostly in fuel injection and turbocharging, this business is at meaningful risk from the coming evolution towards hybrid and then battery electric vehicles.
Continental actually put together a strong technology package for 48V “mild hybrids”, and Continental has been one of the leaders in orders for this intermediate phase, but the company hasn’t built up its capabilities in full electrics the way companies like BorgWarner (BWA), Hella, and Valeo (OTCPK:VLEEY) have, and Continental’s capabilities in power electronics and eDrives don’t really look all that impressive. While the company does have decent motor technology, I’m not sure “decent” will get them very far, particularly in the absence of the other components. With that, I’m concerned that Continental will find itself left behind as OEMs transition away from internal combustion engines.
By the time that happens, the powertrain business won’t be Continental’s problem. The company has committed to setting the powertrain business free, where it will operate as “Vitesco”, and will be looking to spin off 100% of the company either later this year or next year (more likely in my opinion). Management had previously expressed an intent to IPO the business, and I suppose that’s still conceivable, but I believe the spin-off is the likely outcome.
Vitesco will be a sizable company with over $8 billion in annual revenue. Unfortunately, about 40% of that is more or less “non-core” and minimally profitable, and businesses like turbochargers and fuel injection will be run off over time. The remainder, businesses like engine sensors, actuators, and electronics will remain, and those generate mid-teens margins.
A lot can change, and time will tell if that plan remains in place. Getting out of turbochargers and fuel injection seems to run counter to trends in internal combustion engine development, and ICE-powered cars are still going to be with us for a while. But if the company can’t really compete effectively with companies like Garrett(NYSE:GTX), BorgWarner, and Bosch in those areas, I suppose it does make sense, and it’s not as though sensors and actuators are going to be less important in the drive toward more efficient ICE vehicles. Still, this is a company that will be weak on BEV-relevant technology, and it will be difficult to play catch-up.
ADAS, Connectivity, And Infotainment Offer More Excitement
Continental is arguably underappreciated as an ADAS/autonomous driving play, particularly given its existing leadership in instrumentation/HMI, ADAS, and related technologies. Continental has considerably more autonomous sensors in the field than its rivals, and the company’s internal software capabilities are likewise quite strong (the company has roughly 19,000 engineers with software experience, out of a total of around 45,000 engineers).
Simply moving to Level 2 ADAS (automated emergency braking, lane monitoring/assistance) represents an almost $200/vehicle potential content gain for companies like Conti, Aptiv (APTV), Bosch, Denso, and so on, and moving into higher levels of automation (Level 3 to Level 5) starts to add thousands of dollars in addressable content. Companies like Aptiv are going to fight hard for this business, but Conti does enjoy a strong reputation in the market.
The opportunities in connectivity and infotainment are likewise substantial. Auto OEMs are going to increasingly be bringing together in-cabin functions like instrument read-outs, communication, navigation, entertainment, and other functions into common platforms, and those platforms are going to require advanced sensing, advanced communication/connectivity, human machine interfaces, and so forth. Again, this is an area where Conti starts off as the incumbent leader, but it’s an area where rivals like Alps Alpine (OTCPK:APELY), Aptiv, and Valeo intend to compete vigorously.
Continental’s performance over the last two to three years has been poor, and a series of profit warnings and downward revisions have seriously damaged investor and analyst confidence in management. Along those lines, while Conti should have a strong incumbent position in advanced driver safety systems, Aptiv has said in the recent past that they don’t really see the company much when bidding on projects.
Those issues certainly make it fair to wonder if Conti is just too big and too cumbersome to compete effectively. Spinning off Vitesco could, perhaps, help, but I believe that decision is motivated more by a desire to not have to invest in BEV-enabling technology. The tire business remains a valuable profit driver (it was literally the only profit-making business in Q2’20 on an adjusted EBIT basis), and I fully expect those profits to be reinvested in the ADAS, connectivity, and infotainment opportunities.
I’d also note that the company is underway with an ambitious cost-cutting program that looks to achieve annual savings of over EUR 1 billion after 2023, and will include some substantial headcount reductions (largely related to plants that produce more mature ICE-driven components).
Management said that they don’t expect auto production to reach 2017 levels again until 2025, and that strikes me as a pretty pessimistic view relative to other companies in the space. It may be that management is trying to establish low expectations, but if that’s the case, it’s likely to have limited benefit as analysts and investors will surely notice other companies outperforming them.
Given the recent performance trajectory, I’m only expecting low single-digit long-term growth after 2020, and I’m expecting FCF margins to hover around the low-to-mid single-digits on a long-term basis. Improved traction in more valuable growth segments (like advanced safety) would certainly help, but at this point it remains to be seen if Continental can reverse what has turned into a multiyear market share loss trend.
The Bottom Line
If there’s a bright side to this story, it’s that even these low expectations can support a high single-digit to low double-digit annualized return on the basis of discounted cash flow and margin-driven EV/revenue. Said differently, the market expects very, very little from this company, even though it remains the third-largest auto components supplier in the world with leading share in a range of markets. As I said in the open, I’m hesitant to invest in companies I don’t think highly of, however cheap they may be, but I do think Continental merits watching as the valuation just seems too low even with a relatively bearish set of long-term expectations.
Disclosure:I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.