Conti's EV traction goes software, deeply

Continental AG is an insurance company. Its Automotive segment ensures that every carmaker can out-source their lack of costly car software know-how. But, as a good insurer, Continental also reinsures this high-growth low-margin unit with its rock-solid cash machine: Tyres. 

Our last Investment Case on Continental in early 2021 cautiously concluded that the “Mid-term guidance looks sound with profitability, cash conversion and dividend payout returning to their pre-2018 levels while ROCE is expected, at least, at record year levels between 15% and 20% helped by growing service-linked revenues.

This is good to have but we do not expect a linear growth and the next two years’ recovery should look a bit sluggish.” The situation ultimately proved worse than expected as the supply chain broke down due to missing chips. This probably calls for a downwards adjustment to the 2026-horizon plan or, at the very least, a postponement.

“TESLAisation” widens the addressable market, and results in tougher competition 

For the auto industry, the “learning from the past to create the future” methodology translates into “TESLAisation”, a modernized way to describe what Henry Ford built with its Model T in the early 20th century. As such, the electrification of cars rhymes with vertical integration and standardization in order to get the most from battery power at the lowest price. This leaves Continental positioned in an amazingly-growing market, likely to account for 70-80% of the diversification of cars according to VW’s CEO: that market is the software.

As usual, the weak point for generalist auto suppliers is competition from their peers. The current competition from customers, who are now in-sourcing strategic components including software, may lessen and create future opportunities. OEMs looking to develop their own software are meeting with mixed success as shown by VW’s issues with their inhouse software solution designed by subsidiary, Cariad. 

Continental thus acts as an insurance policy 1) for realistic OEMs who know that they are not able to fully in-source the architecture and software of their future EVs and 2) for utopian OEMs who fail to develop their own solutions and gear down their ambitions. To all the above, through its Automotive business unit, Continental can offer a full stack solution of modular hardware and software blocks. This includes radar and ADAS systems for Autonomous Mobility, fleet solutions and cybersecurity for Smart Mobility, displays for User Experience, and sensors and real time computing for Safety and Motion. Such a comprehensive suit leverages the R&D capabilities of the 20k software and IT specialists, a key but scarce asset the company will need to cherish (at any cost?). 

A conglomerate structure out of necessity

In September 2021, Continental finally got rid of its former powertrain division which is now independently listed as Vitesco Technologies (VTSC). The timing was more or less perfect (i.e. ahead of the toughest period in the semiconductor shortage for the auto industry). 

To the chagrin of investors, the day Continental stops being a UFO has yet to arrive. Its conglomerate profile - positioned midway between a historically-thriving tyre activity and the high-growth but razor-thin-margin auto supplier segment - has been much discussed. From a valuation standpoint, simplification would make sense especially when a glance at our NAV-based valuation shows that applying an industry historical 9x EV/EBIT to Continental Tires alone derives a reasonable EV of c. €14bn versus a market cap close to €13bn.

Business-wise, beyond the likely leveraged relations with customers, the synergies between the ADAS development and rubber-based product manufacturing are not that obvious. Spinning off Conti would be at odds with the ongoing consolidation efforts of parts suppliers (Faurecia + Hella for instance). From the Conti management's perspective, it is safer to secure cash inflows from tyres to fund the software push than to risk a spin-off. The question of a split is here to stay anyway.

Dieselgate ghosts still loom at the helm 

The dieselgate scandal resurfaced in late 2021, ringing the departure bell for the now-ex-CFO, Wolfgan SCHÄFER, who was personally targeted by investigations from the public prosecutor’s office of Hannover (on top of an ongoing investigation by the public prosecutor’s office in Frankfurt am Main). However, the financial risk for Continental remains limited by the fact that Vitesco is contractually obligated to indemnify Continental for any sanctions applying to its spun-off unit, if any.

Anyway, it is worth noting that Continental has booked a “high eight-figure” provision with respect to these investigations according to the FY21 annual report. With the 2019-2029 deep transformation to manage (including at least 30k job cuts of which more than a third in Germany) the reputational risk potentially arising from a sanction would make the task of a company-groomed but relatively young CEO-CFO duo much harder. 

Limited upside potential as regards the risk of a cyclical downturn

Ahead of the H1 22 results, our target price derives limited risk/reward appeal. Big unknowns in the market include not only i) the slump in new car demand together with decreasing miles travelled (postponing tyre replacements) as a likely result of lasting inflation, but also ii) further disruption to the supply chain arising either from semiconductors and/or energy rationing in Europe. Indeed, while the individual supply chain players' exposure to gas is hard to assess, it is fair to assume that a pebble in the gears would lead to a complete mess for the highly-interdependent auto industry.

On the contrary, a bullish scenario - removing the overhang of the Russia-Ukraine war - would call for outperformance from the auto suppliers which have been the most affected by the slump in volumes. The time has not yet come when “the content per car” KPI makes more sense that “the number of cars produced”. 

Our valuation is an average of conflicting signals combining into 13% upside potential which leaves no real room for execution risks. The NAV and DCF-based valuations reflect a conglomerate discount coupled with ambitious but reachable long-term prospects. The peer-based metrics offer little support as Conti Tires has done what it does best - act as a shock absorber - while the metrics of pure auto suppliers like Valeo and Faurecia have stumbled.

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