Posted on the Value Lab 04/06/22
AB Volvo (OTCPK:VOLVY)(OTCPK:VOLAF) is a company we haven’t given much thought to. We all knew the automotive industry had been struggling in recent years due to shortages of semiconductors (although Volvo no longer manufactures its brand of cars than trucks and equipment), so we have given space to the sector because of these shortages with horizons that are difficult to trace. Indeed, our thoughts on Volvo focus on the weaker forecast for 2022 due to these shortages, returning to more optimistic expectations expressed at the FY conference. Additionally, Volvo is grappling with issues related to China’s economic woes. Nonetheless, we have noticed its valuation declining significantly and are starting to wonder if Volvo could be an attractive exposure as prices have returned to pre-COVID levels.
A look at AF
Volvo did very well on an FY basis. The environment has shown a strong demand for freight vehicles with such high freight rates, of course contributing to demand being ahead of supply, hence the shortages. However, due to the changing commodity environment, exercise results are a bit of a red herring. We are more interested in the fourth quarter results, which are beginning to show the impacts of higher pricing on gross margin, and revenue growth being held back by supply shortages versus a strong fourth quarter of 2020. when the demand for cars accelerated.
During the year, marketing dollars were better spent thanks to exogenous growth in the automotive market, contributing to higher operating profit. Although this decline in marketing spend was also seen in the fourth quarter year-on-year development, gross margins began to reduce profitability as operating profit and gross profit fell. While trucks were in higher demand due to freight, supply shortages caused industry inefficiencies affecting gross margins and also caused drop in orders.
Additionally, there have been increases in nickel pricesaffecting stainless steel, aluminum components, and we are also worried about the situation in the rubber markets, which could be the next source of shortage.
Exhibition in China
Further on the earnings issue, the joint venture with Dongfeng Motor (OTCPK: DNFGF) had also turned its profits into losses thanks to China’s economic difficulties, affecting the performance of the joint venture and the associated line in the income statement. In fact, China was an important theme for this quarter. While a drop in demand for trucks was evident as the cycle turned back there, partly linked to the huge housing bubble it bursts therethere was also a decline in demand for construction equipment, which, despite being the only geography in which such declines were occurring, caused the entire segment to tumble.
For construction equipment, while China is currently the main source of problems, we also highlight lower year-over-year orders in Europe and Latin America, as governments begin to take their foot off the fiscal pedal.
Volvo is therefore exposed to construction machinery, mainly in China, and trucks. Additionally, supply shortages caused a 22% drop in sales in March and are why the company is heading for flat sales growth in 2022 compared to 2021, and inflation is affecting margins. . What are the puts and takes here relative to the valuation?
- Freight is in high demand and trucks are valuable commodities. While long lead times create lag, price increases are possible to preserve margins from cost inflation. This demand is expected to persist and is exposed to businesses unlike demand for cars, which may be more sensitive to economic headwinds associated with inflation, including retail fuel prices.
- Service revenues are also growing and account for about 20% of the revenue mix. Here, inflation is reflected very quickly, and these revenues are essential and recurrent. It’s also less affected by supply-side issues, and it’s likely to rise in the mix due to the stable forecast for increased production despite demand, which should improve the company’s margins, as service is a higher margin business.
- China receives a promise from its government to clean up the economic mess. The Evergrande (OTCPK:EGRNF) disaster and its impact on the real estate market and the general economic outlook will be part of the area that China will have to deal with. Perhaps they will eliminate production caps for steel mills as part of the stimulus, also lowering steel prices for Volvo, and they will also support the markets on which the equipment business is based. Equipment represents 20% of turnover against 69% for trucks.
- The bus segment is expected to strengthen as the reopening progresses, but this only accounts for 4% of revenue.
- Despite stimulus, equipment end markets will deteriorate in coming years in China, and likely in the rest of the world as fiscal stimulus eases, due to lower shipments in Europe and in Latin America.
- Inflation will put pressure on margins with price increases lagging behind these input increases, so the fourth quarter results are the best estimate of the current situation for Volvo.
Given all of this, we use fourth quarter financial data to calculate the execution rate figures. Let’s work with the P/E numbers to consider the valuation. On a TTM basis, Volvo’s P/E is around 10x, which is very low given its fine end markets, relatively resilient margin profile thanks to price flexibility and services likely to increase in the mix. In reality though, a running P/E is best estimated by annualizing Q4 EPS, so let’s call it SEK 12 per share. That puts us at a P/E of 14x, and it’s based on the conservative assumption that the joint venture continues to make losses in China, and that price increases don’t really happen with margins hurting at current levels. Additionally, it is a P/E multiple that anticipates margin improvements and resilience related to service revenues that will rise in the mix associated with lower production rates due to semiconductor shortages.
A P/E of 14x still implies a fairly high earnings yield despite conservative assumptions. In addition, Volvo is offering a nice dividend of 3.8% on an ordinary basis to shareholders which has been proposed to the board of directors. While a change in direction from growth to flat moves is a disappointment, markets have responded appropriately with prices back to pre-COVID levels.
Overall, we like end markets, and we think China will do what it can to restore its economy as its zero COVID policy, among other things, begins to unravel around them. This should help the JV as well as the equipment business. In trucks, while semiconductor shortages are an ongoing issue, we like the market odds as demand for the goods will remain sustainably high. We should also see some contribution from the buses as the reopening takes root better. The service business provides margin resilience as units sold become less relevant to the mix, and we appreciate the economics of service and the value provided by trucks in today’s freight environment. Overall, a conservative multiple of 14x gives a nice margin of safety despite headline risks, and we look favorably on Volvo as a buy.