Veoneer's Positioned for Growth

We expect global automobile makers’ adoption of advanced driver-assist systems, highly automated driving, and automated driving technologies to support average annual revenue growth for Veoneer VNE of roughly 12% for the next 10 years. We think Veoneer has positioned itself as an integrator of technologies that are required as standard equipment by governments’ new-car assessment programs. Advanced driver-assist technologies enable automakers’ vehicles to receive coveted 4- and 5-star crash test ratings.

In 2016, the National Highway Traffic Safety Administration said that a total of 20 automakers had voluntarily agreed to equip all new passenger vehicles by September 2020 with low-speed automatic emergency braking, which includes forward collision warning, both of which are advanced driver-assist technologies. In a progress report at the end of 2017, NHTSA said that 4 of 20 automakers had made automatic emergency braking standard equipment on more than 50% of their 2017 model year vehicles, while another 5 said that 30% of their vehicles produced in 2017 were equipped with automatic emergency braking.

Veoneer forecasts total addressable market growth of roughly 12%, going from approximately $20 billion in 2017 to $49 billion in 2025. The rapid growth in Veoneer’s market results in high growth potential for order intake within a relatively short time. Current order intake stands at $1.2 billion versus 2018 revenue of $2.2 billion. Management says that $1.0 billion in order intake accumulates to $4-6 billion in lifetime revenue. Once an order is taken, development for a vehicle program takes two to four years. The revenue generation phase lasts between four and six years. Veoneer’s large and growing number of new contracts in development phase versus the lengthy period until revenue generation ramps up leads to estimated net losses through 2023. We estimate positive free cash flow and economic profits in 2025, barring a downturn in the automotive demand cycle.

Full Product Pipeline and Switching Costs Dig Moat Veoneer's narrow economic moat is primarily derived from an intangible asset source and a switching cost source. The intangible asset moat source flows from a product pipeline continuously filled with intellectual property development and the ability to commercialize on these new technologies, as well as contractual long-term, highly integrated engineering relationships between Veoneer and automaker customers. Contractual supply agreements last for 6 years on the low side and as long as 14 years on the high side.

Steep switching costs result from incremental engineering, development, and tooling costs; the need to relocate or even repurchase large, heavy industrial equipment; the risk that the automaker’s assembly line may be shut down during a switch; lengthy time to develop the competing supplier’s product to customer specifications; and preproduction validation to ensure process and product integrity.

Veoneer’s intangible asset moat source is supported by a diversified customer base that enables optimal pricing for new technologies, as well as a diversified geographic footprint that provides a buffer to any single geographic region’s revenue cyclicality and enables participation in customers’ global vehicle architectures. In our view, the extent of Veoneer’s customer base supports the ability to optimize pricing of new innovations should original-equipment manufacturers in one region decide to pressure their supply base for price concessions in the future. While automakers’ increasing global overcapacity is an identifiable, significant, and growing threat to the intangible asset moat source, there is no immediate substantial risk of major value destruction.

Long-term contracts that include both development and production as well as high customer switching costs promote sticky market shares for Veoneer’s products. For the life of a vehicle program, Veoneer collaborates extensively with customer engineers during the development and the production phase, supporting intangible asset and switching cost moat sources between contractual vehicle programs, resulting in a high probability of incumbency for Veoneer from one model generation to the next.

A single innovation in a highly competitive industry represents a temporary advantage at best, which by no means creates an economic moat, as competition can quickly adapt to or in some instances reverse-engineer a competing technology. On the other hand, continuous technical innovation creates a stream of competitive advantages, resulting in moderate pricing power. The company holds 600 patents and 600 additional pending patent applications. Veoneer’s workforce totals approximately 7,700 employees, including 3,700 scientists, engineers, and technicians. Roughly 2,400 are software engineers with an additional 500 software engineers at the Zenuity joint venture. Around 600 software engineers at Veoneer support vision system development.

Some of Veoneer’s patent-protected technologies include autonomous driving technologies, sensors, domain controllers, and related algorithms. While patent protection may not completely deter a competitor, as product solutions sometimes have multiple engineering possibilities, the possession of patented technologies makes competitors’ task of engineering an alternate solution more difficult. Veoneer also actively seeks collaborative technology partnerships; in 2017, it partnered with Velodyne to develop lidar sensor technology for highly automated driving and automated driving system applications.

OEMs are willing to pay a premium to vendors for technology that differentiates their vehicles, reduces vehicle weight, improves fuel efficiency, reduces emissions, improves safety, or lowers costs. However, just one technological innovation does not make a moat. Consistent investment in research and development of products and processes--pumping a continuous flow of intellectual property--along with the ability to commercialize innovations creates a high-pressure pipeline that flows into an intangible asset economic moat and fuels pricing power.

Once an OEM customer and Veoneer initiate the development phase of a vehicle program, OEM switching costs quickly begin to accrue, especially when a complex, highly engineered, and critical vehicular system is being supplied. Costs for switching to another supplier include but are not limited to the substantial lead time and investment to develop and validate a new system; the potential for production disruptions during transition; and the cost of moving large and expensive heavy equipment and tooling in instances where the customer is the owner. In cases where the supplier owns the tooling and equipment, the new supplier would need to develop new tooling and buy the equipment for its own manufacturing process. For Veoneer, software ownership also complicates a customer’s ability to switch to a competing supplier. Adding to the expense, before the vendor begins delivering parts for a customer’s vehicle program, the supplier would need to complete a preproduction validation process.

As part of industry contractual supply agreements, most vendors are obligated to reduce the price of their products annually by 3%-5% on average. This contractual dynamic results in suppliers’ focus on lean manufacturing practices just to partially offset potential margin erosion. Consistent product and process technological advancement enables more favorable pricing relative to many automotive industry suppliers that lack the capability or the desire to innovate. Veoneer’s annual contractual price declines are at the low end of the industry average, providing contractual pricing evidence in support of our narrow economic moat rating.

Commodity Costs and Production Declines Biggest Risks Commodity costs and declines in global vehicle production present the biggest risks to Veoneer. Economic profitability may be at risk if automotive demand were to precipitously drop or if aluminum, steel, copper, and plastic resin prices were to spike dramatically. However, we expect global automotive demand to remain healthy, and commodity cost increases are likely to stay relatively moderate or become a slight headwind due to trade tariffs initiated by the Trump administration.

The company operates in a capital-intensive industry subject to cyclical demand. As a result, Veoneer has a large degree of operating leverage, so sudden declines in volume can have a meaningful impact on profit. Conversely, any increase in sales following large cost-cutting measures significantly raises profits. If trough automotive demand were to be steep and protracted, automakers may postpone model launches that have Veoneer content. The potential changes to profitability brought on by the firm’s operating leverage and cyclical demand result in our high fair value uncertainty rating.

Annual contractual price reductions for OEM customers are an auto industry norm, so Veoneer has to aggressively employ lean manufacturing programs to advance cost savings. To maintain pricing and margin, Veoneer also requires continual investment in innovation. A loss of focus in cost reduction or technological development could result in an erosion of profitability and return on invested capital.

Veoneer was originally funded with a $1.0 billion cash infusion from former parent Autoliv before separation. However, due to weaker global production, especially in China and Europe, cash burn from heavy investment in research and development caused management to raise an additional $627 million in capital: $420 million from common stock issuance and $207 million from a convertible senior note. The company targets an eventual cash balance of $100 million-$200 million versus our estimated $1.3 billion cash balance after the capital raise. However, because we estimate higher new business wins than management’s forecast, we expect Veoneer may need to raise additional capital to fund operations in 2021. The additional funding supports investment in needed R&D staff for the higher volume of development. We estimate that the company could generate enough free cash flow to be debt-free and self-funding by the end of our 10-year Stage I base-case scenario.