Dowlais: Undervalued Global Auto Supplier With Market Leading Positions And EV Tailwinds, Strong Buy

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Investment Thesis

Dowlais (OTCPK:DWLAF) is the #1 global supplier of drive systems, serving >95% of global OEMs, and its products are contained in >50% of all light vehicles (both ICE and EVs). Dowlais' globally diversified revenue base is supported by a vertically integrated / low-cost manufacturing footprint across 17 countries. In my view, Dowlais is well-positioned for the EV transition, with ~70% of Auto product sales either agnostic or benefitting from electrification. In addition to taking market share as the industry transitions, Dowlais has significant margin expansion opportunities from company-specific initiatives to increase operational efficiency, as well as from the recovery in global light vehicle production volumes (GLVP) to pre-COVID levels (expected by 2026).

Despite the robust forward earnings growth outlook (+10% EPS growth p.a.) and strong competitive position, Dowlais trades at a meaningful discount to the listed global auto supplier peer average. I believe this mispricing is likely driven by an overhang on the stock post its spin-off from Melrose (OTCPK:MLSPF) in April 2023. Based on my conservative base case sum-of-the-parts (SOTP) valuation estimates, the underlying value of Dowlais' shares is ~£1.50 (US$1.90). This implies a significant upside of >100% compared to the current share price of £0.73 (US$0.92), and a wide margin of safety, leading to an attractive asymmetric risk / return profile. Management's robust shareholder return policy of ~10% of current market cap p.a. (dividends + share buybacks) further de-risks the equity story and should eventually help to close the gap between the current share price and underlying business value.

Business Highlights

Dowlais, headquartered in the UK, is a specialist engineering group that is focused on the global automotive sector. It is listed on the London Stock Exchange with a market cap of ~£1.0bn (US$1.3bn), and trades over-the-counter in the US [DWLAF].

Dowlais has three segments: Automotive, Powder Metallurgy, and Hydrogen:

The Automotive business is the world leader in drive systems (e.g. sideshafts, propshafts, and ePowertrain systems). Automotive serves >90% of global auto OEMs, and >50% of all light vehicles use Dowlais technology. Currently, only ~30% of the Automotive segment's products have exposure to ICE vehicles, with the rest being either agnostic or net beneficiaries of the EV transition. Therefore, I believe the steady decline in ICE volumes over time should be more than offset by growth in EV-specific components and higher required content per vehicle in EVs. The transition to EVs is widely anticipated, but the pace of change may be slower than expected ~12 months ago, especially in regions such as the U.S. While Dowlais will be a net beneficiary of the transition to EVs, management noted during the recent Q4 2023 earnings call that a slower than expected EV roll-out will be a slight tailwind to Dowlais given its exposure to ICE. FY2023 Results Link.

The Powder Metallurgy ("PM") segment supplies sintered products and metal powders for the automotive end market as well other industrial applications. The PM segment is more vulnerable to the EV transition, with ~50% of products having ICE exposure. However, growth in EV-specific products, industrial applications and innovative new products in the pipeline, should at least offset the decline in ICE-exposed products over time. In my view, the PM segment can be thought of as the "cash cow" within Dowlais, that generates large / stable profits that can be re-invested / returned to shareholders.

The Hydrogen segment is a small "start-up" business within Dowlais. It is the leading provider of metal hydride hydrogen storage technology. While this business is relatively early-stage, I understand that the technological / commercial progress made to date has been compelling. Therefore, in my view, this business carries solid option value, however is likely not a major factor in the valuation of Dowlais today.

Selling Pressure Post-Spin-Off Drives Mispricing

Dowlais was spun-off from Melrose Industries [MLSPF], a British industrials company, in April 2023. I believe the rationale for the spin-off was that Melrose believed its main asset, a large aerospace business, wasn't being fairly valued given the lower relative multiple of the automotive business. Given this differential in relative valuation / size, most of Melrose's shareholders were invested in Melrose for the aerospace, not the auto business. As a result, once Dowlais was spun-off, many of Melrose's shareholders proceeded to indiscriminately sell their shares in Dowlais. Since the spin-off in April 2023, Dowlais' share price has fallen by ~45%, whereas Melrose's share price has increased by ~9% (see share price chart below). For reference, global auto supply industry bellwether Magna's (MG:CA) share price is down ~20% over the same period. Therefore, I believe the sell-off in Dowlais' shares is largely due to the technical headwind of Melrose shareholders selling Dowlais and buying more Melrose stock, not based on Dowlais' underlying fundamentals.

Significant Margin Expansion Opportunity

Dowlais' Automotive segment EBIT margin of 6.9% in 2023 is expected to increase significantly to 10%+ in 2026, which appears achievable. There is high visibility on ~2/3 of this ~300bps of total margin expansion, which will be driven by "self-help" initiatives including moving select manufacturing facilities to low-cost countries, which is in progress (U.S. -> Mexico, Germany -> Hungary), as well as other procurement, productivity, and operational efficiency measures. ~1/3 of this margin expansion is expected to come from revenue growth driving operating leverage as global light vehicle production volumes returns to pre-COVID levels (expected by 2026). Based on my calculations, the self-help initiatives alone would imply ~£90mm of incremental EBIT (25% increase in group EBIT) off of the current revenue base. FY2023 Investor Deck

Key Value Drivers

The key drivers of relative value in the global auto supply sector include 1) scale and geographic / product diversification, 2) forward revenue growth expectations (supported by positioning for the EV transition), 3) current margin profile, 4) forward margin expansion / EPS growth opportunity, 5) capital structure and return of capital.

Dowlais has global market leading positions in its products, but with revenue of ~US$6bn, it is smaller than the global auto supply public peer average of ~US$19bn (see comparable companies table below). Dowlais' revenue growth should outperform the expected industry average of low- to mid-single-digit % growth going forward, given its strong positioning in EVs. Dowlais' 2023 EBIT margin of ~6.5% is broadly in line with peers. However, Dowlais has significantly higher margin expansion opportunities driven by its company-specific operational initiatives. Analyst consensus forecasts for Dowlais' 2025E EBIT margins are ~8.5% vs. ~7.5% for the industry median (management predict 10%+ in the medium term, which is achievable in my view). Strong margin expansion and operating / financial leverage are expected to drive a ~13% 2023 to 2025E EPS CAGR. Dowlais' current financial leverage, including a net pension deficit of £459mm, is ~2.5x Net Debt / EBITDA. This is slightly higher than the global auto supply average leverage of ~1.9x, but Dowlais should deleverage rapidly over time due to its strong earnings growth and free cash flow generation. Dowlais' dividend policy of paying out ~30% of net income is broadly in line with peers. Dowlais also announced a £50mm share buy-back programme as part of its FY2023 results, which signals Dowlais' strong excess cash flow generation, focus on shareholder returns, and signals management's belief that the shares are undervalued at current prices.

Attractive Price Levels Result in Wide Margin of Safety

Dowlais currently trades at ~4.0x EV / 2024E EBITDA, and ~6.5x EV / 2024E EBIT vs. ~5.0x EV / 2024E EBITDA and ~8.0x EV / 2024E EBIT for the global automotive supply sector average. I believe this ~1.0x EBITDA / 1.5x EBIT multiple discount to peers is fundamentally unwarranted given Dowlais' strong positioning with respect to the key value drivers mentioned above. Given there is also a clear correlation between margin profile and trading multiple for the auto supply sector, Dowlais' go-forward margin expansion is likely to be accompanied by multiple expansion, which should drive further value creation. Dowlais currently pays an attractive ~6% dividend yield, and has a 2026E levered free cash flow yield of >20% once the current one-off capex / restructuring initiatives contemplated in 2024 and 2025 are completed.

Base Case Valuation

Given the differences in Dowlais' business segments, in my view a SOTP valuation is the most appropriate (see below for my detailed base case valuation calculations). For the Automotive segment, I assume an 8.0x EV/EBIT multiple (in line with the global auto supply average), after giving credit to the ~200bps of self-help automotive margin expansion (but using the current revenue base). For the PM segment, I assume a 5.0x EV/EBIT multiple, given this business is more vulnerable to the EV transition. I ascribe no value to the Hydrogen business, given its early-stage. This SOTP valuation implies a share price of ~£1.50 (~US$1.90), or a premium of >100% to the current share price of £0.73 (US$0.92). This SOTP valuation implies a blended multiple for Dowlais (pro forma for 200bps of margin expansion) of 7.6x EV/EBIT, 4.8x EV/EBITDA, and 7.3x P/E, which I believe is reasonable on a relative and intrinsic basis.

I believe this base case valuation is conservative and does not account for additional upside opportunities including: 1) GLVP volumes returning to pre-COVID levels (and resulting margin expansion), 2) broader auto supply industry re-rating as volumes recover and uncertainty over EV transition diminishes, 3) Dowlais market share gains from transition to EVs, 4) a value-surfacing event for the PM segment, and 5) value for the Hydrogen start-up business.

Downside Valuation Scenario

I have also contemplated an extreme downside scenario, where none of the margin expansion initiatives are successful, industry volumes do not recover to pre-COVID levels, and Dowlais' revenue stays flat. In this scenario, there would also likely be some industry-wide multiple compression, so I have taken down the target EV/EBIT multiple for the Automotive segment from 8.0x to 7.0x. In this downside scenario, the SOTP implied price is ~£0.80 (US$1.00), which is still slightly higher than the current share price of ~£0.73 (US$0.92). This demonstrates that the current price is below even a pessimistic downside valuation. This results in an attractive asymmetric risk / reward ratio, with limited downside risk and significant upside opportunity.

Shareholder-Friendly Capital Allocation Policy

Dowlais currently has a robust policy to return capital to shareholders through a 2023 total dividend of £57mm (targeting ~30% of adjusted net income) and a £50mm share buyback program, which was recently initiated along with Q4 2023 results. This implies a strong total return of capital yield of ~10% on current market cap. On the recent Q4 2023 earnings call, management stressed its "strong focus on shareholder returns", and the share buyback program announcement was unexpected and signals management's view that the company is undervalued at current share price levels.

The company also has a long historical track record of shareholder-friendly initiatives. Melrose, Dowlais previous parent company, was consistently focused on ways to optimize its asset base to create shareholder value, including disposing of non-core segments and separation of different segments. I believe this culture of shareholder value creation has carried over to Dowlais and the Dowlais management team will be focused on ways to surface value in its various segments in the coming years.

In 2023, Dowlais generated £93mm (US$119mm) of adjusted free cash flow, which is expected to ramp up to ~£240mm (~US$300mm) by 2026 according to analyst's consensus, as the current capex / restructuring program are completed. This will significantly increase the amount of free cash flow management can allocate towards dividends and share-buybacks.

Key Risks & Mitigants

As a global auto supplier, Dowlais' revenue is dependent on end consumer demand for light vehicles across its regions, which can fluctuate depending on many factors including interest rates and consumer sentiment / purchasing power. Dowlais is relatively underweight in China / Rest of Asia, which are growth markets, and overweight in the Americas / Europe, which are more mature. Revenue is concentrated on a relatively narrow range of products (e.g. sideshafts, propshafts, and AWD systems). Potential supply chain issues could impact global light vehicle production, which could (temporarily) impact OEM demand for Dowlais' products. The global light vehicle market is undergoing a massive transition towards electrification, and there is significant uncertainty as to the pace of change as well as outcomes for all players.

These risks are mitigated by Dowlais' 1) strong market leading positions, 2) global footprint and low customer concentration, 3) mostly propulsion agnostic product portfolio, 4) high visibility on margin expansion initiatives, and 5) the wide margin of safety implied by current share price levels.

Dowlais' revenue is globally diversified across regions with the Americas / Europe / China / Rest of Asia representing 40% / 34% / 12% / 14% (Source: Dowlais FY2023 Investor Presentation). Dowlais also has low customer concentration, with its top 5 customers only representing ~25% of total sales (Source: Dowlais January 2023 Capital Markets Event). Dowlais is also focused on expanding its product portfolio into new and EV / industrial applications, which enhance its growth and margins over time.

Bottom Line

The sell-off in Dowlais' shares post spin-off has created a compelling opportunity to buy stock in a market leading global auto supplier that is poised to benefit from the EV transition, at a deeply discounted valuation.

Dowlais' trading multiple discount to peers should close and potentially turn into a premium as the significant self-help margin expansion initiatives take effect, and Dowlais captures incremental market share as the industry transitions to EVs.

Our conservative base case SOTP implies a value of ~£1.50 (~US$1.90) per share, or a premium of >100% vs. the current share price of £0.73 (US$0.92). Even under a pessimistic downside case, underlying value is still above current share price levels.

Therefore, Dowlais' shares represent a "Strong Buy" in our view, given this asymmetric risk / reward profile and wide margin of safety.

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.