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We See Accelerating Growth for Mobileye

The firm’s narrow moat is evident in pricing power that generates ROICs in excess of 40%.

We think

Given its higher scalability, Mobileye more closely resembles a software business than an auto-parts vendor. Its high revenue growth does not require an investment in bricks and mortar or tooling and equipment like a traditional capital-intensive auto-parts supplier. Mobileye designs its own microprocessors and develops proprietary algorithms, but outsources all of its manufacturing, including microprocessor fabrication.

Without a high fixed-cost base, profitability is high as research and development for chips and software plus selling, marketing, general, and administrative costs are the company’s only major operating expenses. In 2015, this cost structure enabled Mobileye to generate a gross margin slightly in excess of 75%, EBITDA margin of approximately 52%, and an adjusted ROIC near 43%. Because of the substantial growth we forecast, we think that scalability will drive the EBITDA margin to an average of 62% over our 10-year Stage I forecast.

New-car assessment programs are used by governments around the world to provide an independent vehicle safety rating. Legislators, especially in the United States and in Europe, have set guidelines that will progressively require the addition of active safety and autonomous driving features as standard equipment through the end of this decade. As a result, new model introductions over the next several years should incorporate Mobileye technology, which enables the safety features being driven by regulators.

Intellectual Property and Customer Switching Costs Are Advantages Mobileye's narrow economic moat is derived from the intangible asset of its intellectual property and high customer switching costs. The company's sticky, market-leading share results from its long-term highly integrated customer relationships, a voluminous dataset built over 15 years of research, and the time and investment required to switch to a competing technology. In the past eight years, the company has won 85% of the contracts for a prospective customer requested a quote. Steep switching costs result from incremental engineering costs, preproduction validation, and higher prices for competing technologies.

Pricing power exists for suppliers like Mobileye, which have generated an innovative technology that has substantially changed the market. Because of the company’s highly scalable business model in which it outsources chip production, pricing power has been especially noticeable in the past three years as revenue has grown disproportionately much faster than costs. As a result, we forecast Mobileye will generate sustainable excess returns on invested capital for more than 10 years. However, due to the highly competitive automotive industry, the potential for competitors to meaningfully encroach on the market after 10 years, and Mobileye’s heavy reliance on camera-based vision technology, we cannot say that it is more likely than not that the company will maintain economic profits beyond 20 years.

Pricing power is one of the key attributes of an economic moat. Generally, automotive-parts suppliers are contractually obligated to reduce the price of their products annually and must use lean manufacturing practices just to prevent margin erosion. Even so, a continuous flow of technical innovation has enabled most of the auto industry’s suppliers to maintain moderate pricing power in this highly competitive sector.

Mobileye is highly specialized in vision-based technology, which could limit the flow of future innovation relative to other suppliers with broader product portfolios, putting at risk the pricing power of their intellectual property. However, with its single-camera (monocular) technology, the company has a substantial lead against the competition. Competitors have developed dual-camera, stereo-vision systems that cost more, consume more power, use more windshield space, have less range, have more difficulty distinguishing objects from background, and provide less effective warning for active safety and advanced driver-assistance systems. While some competitors have initiated monocular system development, it will be several years until they amass the dataset already in use at Mobileye and another several years before their systems could appear on a production model.

Mobileye has 15 years of research and development behind its vision technology. In the process, the company has collected a massive dataset from millions of miles of on-road testing. Data was sourced from road experiences in 40 countries, in multiple scenarios, around the clock, and on hundreds of vehicle models. This deep and wide dataset trains and optimizes the company’s proprietary algorithms such that safety functions are fully validated while false positive readings (for example, one that would cause erroneous deployment of automated emergency braking) are avoided.

In our view, Mobileye’s technology head-start and dataset result in a service that will be difficult for competitors to replicate. One of the eventual steps necessary for complete self-driving vehicles will be the implementation of vehicle-to-vehicle and vehicle-to-infrastructure communication. This technology will allow vehicles to become part of an ad hoc computer network that--when combined with GPS, radar, lidar, and sonar sensors in each vehicle--provides exact relative vehicle positioning. In this context, Mobileye’s technology adds incomparable detail to the ad hoc network where real-time vision and data collection create instantaneous roadmaps that give autonomous vehicles greater predictive capabilities, enabling efficient traffic flow in congested metropolitan areas.

Additional evidence of an economic moat lies in the high costs that customers would have to pay to switch to one of Mobileye’s competitors, especially during the production phase of a vehicle program’s lifecycle. Automakers require suppliers’ technical expertise very early in the development process, especially when engineers are working on critical areas of the vehicle such as active safety and advanced driver-assistance systems for which Mobileye provides vision technology. Total development time for any given passenger vehicle can take 18 months to three years. During this period, suppliers’ personnel work on teams alongside the automaker customer and, in many instances, are located at customers’ development facilities. Programs have total life spans that are generally 5-10 years. As long as a supplier is in good standing with its original-equipment manufacturer customer at the end of the vehicle program, the supplier is usually considered to be incumbent on the successor program.

It is rare that an OEM decides to drop a supplier of a critical component or system, and if it occurs, it should be viewed by investors as indicative of a much larger problem with the supplier than might readily be apparent. To switch to one of Mobileye’s competitors midprogram, an automaker might incur such costs as initial development engineering, sourcing new computer chips, preproduction validation, the higher cost of a shorter production run for the successor supplier, and the higher price of competing vision-based technologies. Total costs for switching to another supplier of this technology could run into the hundreds of millions of dollars.

Dependence on Auto Industry Brings Risk Even though Mobileye's business model has low operating leverage, high scalability, relatively expansive margins, and impressive returns, the company still operates in the global automotive sector. The automotive industry suffers from growing overcapacity, capital-intense operations, fierce competition, and high cyclicality. In our opinion, Mobileye's head-start on the competition, long lead times for vehicle product development, lengthy product lifecycles, and the drawn-out growth curve of active safety and advanced driver-assistance technology penetration provide the firm with a healthy buffer to the industry's vagaries. However, at some point, given the nature of the auto sector, Mobileye's pricing could come under pressure once the technologies reach a mature level of penetration. We see this as only a very minor risk in the near term.

Although Mobileye designs and develops its EyeQ microprocessor technology in house, it depends on ST Microelectronics for chip fabrication. The microprocessors come from a single plant in France. Given the reputation of French labor, disruptions could be an issue in the future, although we see no immediate risk of a shutdown. Natural disaster, equipment failure, and/or logistical issues are also risks to Mobileye’s single-source supply of microprocessors. While we do not believe the company will insource chip fabrication, we think that at some point, the fast-growing pace of Mobileye’s sales volume will warrant serious consideration for a second microprocessor source.

Mobileye’s headquarters and research and development center are in Jerusalem. Even though Israel has entered into several peace accords, unrest and terrorist activity plague the country and the region. While the company does not have production facilities in Israel, it faces the risk that hostilities could have a material impact on administrative offices and R&D operations.

We think Mobileye is in vigorous financial health. The only criticism would be that the company has no financial leverage, eliminating the tax benefit of interest expense and increasing the weighted average cost of capital being solely equity funded. However, we struggle to see a potential use of any debt capital raised by the company.

With substantial growth for the foreseeable future, one might think that debt capital may be required. However, the scalability of the Mobileye’s business model dramatically reduces the need for capital investment to meet future sales volume growth. Mobileye generates substantial operating cash flow that is adequate to meet the needs of the growing organization. Cash generation is substantial enough in our discounted cash flow model that not only are operations adequately funded, but we have to assume substantial share repurchases and initiation of a dividend to keep balance sheet cash and equivalents in check through the second half of our 10-year Stage I forecast.

We cannot completely rule out merger and acquisition activity, but we do not include acquisitions in our forecast 20% annualized revenue growth rate. Mobileye operates in a very specific space within the automotive sector, which limits the potential for bolt-on acquisitions. Any M&A that might develop may be used to quickly increase engineering staff, expand information technology staff, or enter an adjacent market like commercial or off-highway vision systems but would probably not include any manufacturing capability.

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