Lear Corporation (LEA) Earnings Call Transcript & Summary

Okay. We're going to kick off our next presentation today, and our next fireside chat is with management of Lear. Lear's business is essentially 2 divisions. 76% of the company sales comes from vehicle seating and 24% comes from E-Systems. The company's Seating franchise is irrefutably strong. We've seen relatively good profitability, and the business appears to be delivering very strong free cash flow, despite a tremendous amount of volatility that's been existing in the auto industry. Next, you have the E-Systems business, which includes a variety of components that make up the data and electrical network for a car. That consists of wire harnesses, terminals and connectors, electronics and software. And this should be a particularly interesting space over the next few years given the advancement of sensors and connectivity and upgradability that we now see coming into vehicles. All of -- in all these chats, I've been putting up on the screen a little bit about what we believe investors hope to hear. And hopefully, this frames a little bit of our fireside chat. In Seating, we believe that investors want conviction that the strong business that they see with significant free cash flow can maintain that level of performance. Just based on last year's numbers, EBITDA less CapEx, looks like Seating was showing off about $1.1 billion, allocating interest and taxes, something that we would do, just trying to think about how free cash flow generative that business is. It's going to be a $900 million free cash flow business. In E-Systems, investors want conviction that there's a company that's positioned to grow based on all the secular themes that we've been talking about and we're going to continue to talk about and, importantly, achieve the company's margin targets. With that as an introduction, I'm very pleased to welcome the company's CEO, Ray Scott; CFO, Jason Cardew; CTO, John Absmeier. And we have several members of the company's IR staff, Alicia Davis, Ed Lowenfeld, in the audience. So with that, I'm going to just open it up, Ray.

So I quickly hit on my perspective on what we think the investment thesis is for Lear. Was hoping you may be able to talk a little bit about it from your perspective. What are some of the key drivers as an investor in Lear that you would want to point out?

Yes. Thanks, Rod, and thanks for having us today and thanks for everyone attending today. When I think about Lear and, obviously, I have great insight to Lear Corporation, I have been around for a long time. First of all, we have a remarkable team. We have an incredible, talented team. And I think when you talk about the results that we delivered last year through a lot of uncertainty, obviously, the GM strike, other things going on around the world, the seat team did an outstanding job of driving margin and free cash flow. And so -- and it really starts with the team. I think second to that is our operational excellence. I mean we are regarded as a quality supplier that performs extremely well through launches, quality, et cetera, from our customers' perspective. And we're being rewarded for that. There's no question about it. You see the growth that we've earned in Seating, and I think we're in a great position. E-Systems continue to grow over market in both segments. We've been very disciplined, and we talk about our focus on discipline with return on invested capital, how we target new business awards. We don't go after business just for the sake of having business. We are very selective with where we want to grow, how we want to grow. That's paid great dividends. In Seating, we've grown the business extremely well. On E-Systems, we're in a great position with electrification and connectivity. So we believe without -- with a lot of certainty that we're going to grow above market. And we've been disciplined with the balance sheet. We have great flexibility from a balance sheet standpoint. And so we're going to continue to remain disciplined. And so when I think about everything that's going on within Lear despite some of the challenges we have in the environment around us, the business is performing extremely well. We're going to stay very diligent to what we -- has made us successful, and we're going to continue to grow this business profitably above market. And so there's a lot of reasons why I look at Lear and I'd say this is a great company to invest in.

Great. I wondered maybe just before we dive into some of the longer-term strategic questions and outlook, just to kind of get a state of the world from you a little bit. There's a lot of noise, obviously. Daily, we're getting headlines on coronavirus and how that's affecting a variety of different companies. We've got a lot of issues happening in Europe as well from a regulatory perspective. I was hoping maybe you could talk first about what's the state of the world. How do you see it?

Yes. The start of the year has been very challenging, and the coronavirus has obviously been something front and center. And our first priority is and will be our people. I mean, we've done and are taking measures to put in policies, procedures, protective actions to make sure we're protecting our people around the world, even limiting travel, those type of things. And we're working very closely with our customers, too. We have war rooms set up on production schedules, what we're doing with supply chain. And to date, we haven't had issues relative to production or shutting down a customer, but we are working closely with our customers. And so there's a lot going on inside Lear Corporation, not just from protecting our people, but just as importantly, making sure we're protecting our customers. And now, Jason, do you want to mention a little bit about the numbers?

Yes. So first of all, our China business is relatively small. That's about 11% of our consolidated revenue. It's 13% last year, and we've guided to about a 12% reduction on our platforms this year. And so if you do the math, it works out to about $45 million a week in production and revenue in China. And so what we're seeing is the loss of 4 to 5 weeks here in the first quarter. That's pretty well confirmed. And so it's a little more than $200 million in sales and about $50 million in operating income. So it's converting that about 25%, a little bit higher than our variable margin normally would be in the region there, and that's because of some of the fixed costs that are trapped and the nature of how this volume is coming out. In terms of what that means for our guidance, we're still very comfortable with the midpoint of our range. We are seeing a little bit of strength in North America that's helping out. So we still feel quite good about the guidance we've provided in January despite what we've seen thus far. Of course, it's a pretty fluid dynamic situation. If there is an extended impact in China, that would continue to build on that $200 million. Or if there's an indirect impact on the production in Europe or North America, that -- we haven't seen that yet, and that's not factored into those comments.

Okay. So there's some strength that are mitigating some of the weakness now, but that's -- that $200 million impact certainly was not in the guidance when you kind of contemplated that a couple of weeks ago.

That's right.

Great. Maybe we could talk a little bit about the 2 businesses, and starting with Seating and the state of the market. So one of your biggest competitors is obviously now very focused on margin improvement. Presumably, there's price discipline as a result of that. They're a big player, about 34% of the Seating industry. It would seem just from that perspective externally that the competitive landscape is probably pretty good. What are you seeing in terms of the business? And what are your expectations just broadly for pricing, market share? Are there still opportunities for you while within that market?

Yes. I'm very confident in our ability to continue to grow above market. I think last year, we had about $300 million of Conquest wins. And I've talked about this before. We've invested in that business. It goes back, it was -- Jason was a great partner of mine back in '13, '14. If you remember, Seating margins dropped about 200 basis points for a lot of different reasons. But we built that business around a number of different key factors. One, we've built one heck of a team. And I say it goes back, the team. We have very knowledgeable people in the core parts of our business. And two, the discipline we put in, in operational excellence. We invested a tremendous amount of money in capital and people to ensure that we're successful. And so that takes a long time to build that type of infrastructure, and we're continuing to grow on that. So we're working on things. It's not about getting back to basics. I mean we're all over basics. We're moving on to the next generation of technology and innovation in our manufacturing plants and capabilities within our product group. And we've done a great job of growing that business. And then I think about what we've done in innovation and technology. We're very smart about how we're looking at innovation and technology. Like anyone knows who've talked to me, obviously, I'm very passionate about Seating. But the seat is changing. It's becoming much more dynamic, much more smart, much more intuitive. And we have the opportunity as we're still focused on our operational plans, but to really start looking strategically at innovation and technology and how that's going to really shape the world going forward. And we've won some significant contracts. I mean, the ConfigurE+, which was something where we bought from Grupo Antolin, where they had a rail system. But we took the E-Systems capabilities with their sensors and their electrification capabilities and powered the rail system. It's a very unique way of re-configurability within the vehicle. And now we have 2 contracts. We had one major contract with a German OEM, and we have a second contract that we're finalizing the purchase orders and the contracts that we'll announce shortly. But that's the type of evolution that we're talking about. So I see the continuation of growth over market. I mean, the content has increased. We positioned ourselves extremely well with SUVs and CUVs and crossovers. And I've never seen a time like this. It's interesting. We grew our market share from around 19% to 23% when we had irrational players in the market that were buying business, flat out buying business. And we are staying true to our belief that we need a fair return and we still gain market share. I'm seeing more Conquest opportunities today than I've ever seen before. And I've always talked about the customers who have a long-term memory. And so if you're going in for price increase, and I'll call it -- if you care to call it, engineering or scope changes or whatever, the customer still has a long-term memory. And those opportunities will present themselves to us. We're being very selective. I'm absolutely confident we'll beat last year's Conquest wins this year. It gets down to us being, again, very selective. We're not going to go after business just for the sake of winning business. We're going to be going after business that drives profitable growth. And so I look at that business. I'm excited for what the team is achieving and what we achieved last year. And looking forward, I think there's nothing but more opportunities for us. And we're in a position that's very important now too in the automotive cycle. There's changes coming with technology, and we're focused on those changes. And the intuitive seat, the smart seat, re-configurability are all areas that I believe that we're the only ones that can really deliver because we have the capabilities in E-Systems that help us generate those type of smart devices.

So just to paraphrase, there's a lot of innovation that you're bringing in. It's helping you gain market share from that perspective because you continue to invest in some of those areas. And secondly, there's some dissatisfaction perhaps from some of your customers, vis-à-vis some operational issues or pricing then it has had to get adjusted, and that's creating some shifts in share still, prospectively.

Yes. And it's interesting, too. It's not even -- we always have to be mindful of our cost. And we do a great job of still driving the margin that we have been able to deliver the best in the industry in Seating, staying focused on our cost. So when we talk about investment, we invest in the technologies within our manufacturing plants and product. And so it's a combination of that. But right now, yes, the customers, like I said, have a long-term memory. The opportunities are presenting themselves, and they're presenting themselves differently than I've seen in the past. It isn't going out and trying to re-leverage the current supply base. They're being very selective. And they're like -- some of the programs that we're looking at winning from a Conquest standpoint, we're the sole supplier in negotiating with our customers. Now we still have to be mindful of cost and it isn't that they're giving away the business, but what's unique about it is I'm not competing against 3 or 4 other players. It's very unique. And I believe that to be true because of our reputation. We stand behind the product that we deliver. We don't go back and reprice. We put the capital in place so we don't have poor launches. I mean, a number of our competitors have had really poor launches that have cost them new business opportunities. And so -- and we're -- that's kind of surfacing right now. I think the focus this year has been being very selective on the opportunities we want to take forward and working those deals out with our customers.

Let me ask you about the content per vehicle in Seating because it's been awesome, right, the past couple of years. And partly, it's not really your doing entirely because there's been the shift towards SUVs and crossovers, 3-row vehicles. Is that kind of mostly behind us, this growth opportunity of improving mix within the seat and now it's a market share thing? Or is there still content per vehicle growth?

I absolutely believe there's still content per vehicle growth. Jason, do you want to elaborate a little bit on the numbers?

Yes. I think if you just look over the last 2 years, we've seen content per vehicle grow by about $20 globally. A portion of that is because of the mix shift globally, where there's -- China has come down more than North America and Europe. And North America and Europe CPVs are higher than China. So it's about $5 or $6 of that content change. But the rest of it is this continued shift, the CUV, SUV penetration and luxury holding up better than auto overall. In addition to that, we've seen just pure content increases in the underlying markets in North America and Asia over the last 2 years. So at our Investor Day, we talked about expecting 1% content growth per year over the coming 5 years. We've seen 3% just over the last 2 years. So we're right on track there, maybe a little bit ahead.

We've talked a little bit about it when we talk about content growth and the seat is changing quickly. It's amazing how static it's been from a historical standpoint. More technology is going in the seat. We talk about HVAC and heat and cool. We're developing with Gentherm a seat system that will heat and cool the occupant within the seat as opposed to trying to heat and cool the whole cabin. It makes a lot of sense to drive enormous amount of efficiencies. Environmentally, it's much better. I mean, just from an efficiency standpoint on -- the battery drain is better. And that content is going to seat. We talk about smart devices connecting to the seat. Right now, we're working and developing with our customers' devices that -- or technology that will connect from your phone to your text messages to music within the seat itself. Customers want more independence. And so that capability with sensor fusion and algorithms and software are all being built in the seat, and that's what we do and we're delivering. And there's a number of other things with comfort and features that we're developing with our customers. And those are programs that we're actually in development with our customers today. So I see it increasing, right? I mean, we've seen a nice growth in content per vehicle for a number of other reasons just with CV, SUV, but I see the content growing with features and content for individual customers within the space.

Let me talk a little bit about margins and returns in this business, and then we'll switch over to E-Systems. But the margins have been pretty steady, 8% in 2019, despite meaningful volume headwinds, strikes, all these different things that have been happening. And your guidance is a high 7s for 2020. What are the actions that you've been taking that have allowed you to get that kind of stability? And what kind of latitude do you have going forward? Because the market is not going to get any more stable in the future.

Yes. I think it goes back to the things that I mentioned, Jason and I, what we set up in that business. And the business was regionally, geographically situated, and it was based on total returns by, let's just say, a total seat program. And so in some cases, we're willing to accept returns that are not satisfactory to look at the overall JIT business and say it was -- it made sense. We broke all that down. And so every part of our business has to stand alone on its own merit. And so from trim to foam to leather to structures to JIT, all have to have their own individual returns. And we look at that in respect to return on invested capital. And if we're not getting those returns, obviously, we have to make decisions, either you have to go back in and develop some type of program to drive cost out or waste out of that system or we'll exit the business. And so I think it did start with setting the team up so that they're focused on the priorities, which was getting a fair return. And when we broke those down, we started seeing great benefits. And I think that's when we talk about it being sustainable is that we will not win business if it's a trim cover tied to a JIT business and the trim cover is below water. We're not going to win that business. We will turn it down. And so being very selective, we've built a reputation around that. It's amazing how our customers recognize us. When we go in and I talk about the uniqueness right now when we're going after some of this Conquest business, the customers will tell me. They're saying, "Listen, we understand you hold your number and you'll deliver to it." So we'll put the right capital in place. We'll deliver to the number that they've asked, that we've agreed to, and we get a fair return. And so I think it starts there. And I think it's -- the secondary thing is that we've invested a tremendous amount of capital. We have incredible plans. That operational excellence is something that's very important. As you talk about more challenges, having that capability in your manufacturing plants where you can move quickly and you're flexible is a benefit to us. And so we've put the right capital in place globally. And I think it gets back to this discipline. We don't have these big issues that we have to go back out and renegotiate and ruin your reputation over. That's not a place that we're in. And then the smart technology that we're investing in is very selective, and it gives you credibility with your customers, too. So there's a number of different things going on. I don't want to give all our secrets away because I don't want our competitors hearing about it, but there's other things that we do that give us the confidence that, that business is very sustainable long term. I mean -- and you think about it, too. That's for the business where we still have more work to do. What excites me about is a lot more work to do in structures. We're not where we need to be. South America, we'll continue to work our plans. I think there's good opportunities there. We spend a tremendous amount of time what we consider to be waste that we try to get at. So I would say it's good news, bad news. I mean, bad news is we have all this waste, good news is we have all this waste. There's a lot of opportunities for us to get better too and reinvest in the business and continue to grow that business. And so I'm very optimistic about the seat business.

It's interesting that just the level of detail with which you -- in which you break down the business and the analytics that go behind it. Can you share maybe some of the -- we see the overall margins at a high 7s or 8%. But what -- in order to earn your cost of capital, what sort of ranges of margins and how different are the margins in JIT versus foam or structures?

So in order to earn a return in excess of our cost of capital, if we assume our cost of capital is 9% to 10%, overall seat margins need to be 5% to 5.5% in order for us to earn a return in excess of that. If you start out with JIT, it's a little bit lower than that. It could be in the 3% to 4% range. It's not a capital-intensive business. So even at that margin level, you're earning a return in excess of your cost of capital. On the other extreme, you have the structures business, where you need margins north of 10% in order to earn a return greater than your cost of capital, and we're not there. We're profitable in structures, but we have work to do there. And if you look at the other segments within Seating, cut and sew, trim covers, leather, fabric, foam, they're sort of sliding between those 2 extremes of JIT and structures. And all of those businesses are earning returns in excess of our cost of capital today. Now -- so if you look out going forward, if -- what's going to determine our margins as much as anything is, in addition to our ability to continue executing, as Ray outlined, going to be the mix of business we take. If there's more of a shift to JIT business, we certainly we'll look at that at a little margin -- lower margin profile than our segment [ percentage ] overall. But based on our current mix of business, 7.5% to 8.5% is the right target for us. We could grow the business faster if we lowered our return thresholds. We're not willing to do that. We feel like there's enough opportunities to continue growing the business and earn those returns.

Great. Switching to E-Systems. Look, that whole sector had been relatively stable for many years. There were -- there seem to be big barriers to switching for automakers. They didn't really want to switch terminal and connector vendors and that kind of thing. Maybe you can talk to us a little bit broadly about the opportunities that you see in electrification and connectivity. And do you see any evidence that there's an opportunity for growth or share shifting? What are the bidding opportunities that you're looking at now? Because every automaker is talking to us about big changes in platforms and architectures going forward.

Yes. E-Systems took a step back, and there's a number of reasons for that. Primarily, it was volume mix and some big platforms that we had with some of our key customers. But when I think about where E-Systems is right now, I mean, the team that we have in place is incredible. I think everyone knows we hired Carl Esposito, came from Honeywell, incredibly good leader, smart, understands software. So he's bringing a level of sophistication to that group. In addition to that, we brought in Mike Balsei, who ran the Aptiv's wiring and Ts and Cs business, and he's done a nice job. Because we talk about our opportunities, we've done a nice job with wiring, but we have a tremendous opportunity of vertically integrating, very similar to what we did in Seating. And we saw the margin expansion within Seating by vertically integrating, and there's a number of different key areas not just in the terminals and connectors business but other components where we can make a really good return and insource ourselves. And so we've really -- we're walking down that path right now and doing a nice job of sourcing ourselves components and vertically integrated where it makes sense financially. And then we've hired [ Sin Yi ] out in China because one of our issues was China. And he's done a nice job of taking that business and clarifying some of the opportunities. I think one of the fastest-growing regions we had last year was China and specifically with the domestics. And so he's done a nice job of really getting that moving. And so in E-Systems though, electrification and connectivity is a great area for us. And last year, we had significant wins. It's interesting. We talked about having opportunities, and we're very selective on what we quote. And we talked about $1.2 billion was what -- was in the pipeline of quoted business in electrification and connectivity last year. And we won $450 million or 40% of the business that we quoted. Now traditionally, we expect to win 25%, 30%. So that was well above our expectations.

That's in electrification and connectivity.

Electrification and connectivity is the fastest-growing area we have in E-Systems. I think coupled with what we already had as far as business, we're going to see, I believe, very similar results this year. We're quoting about $1.2 billion, a very similar number. We put ourselves in a great position with key customers. We've expanded our proliferation of customers. We're on 6 key customers now in electrification. And so we're doing a really nice job of growing what are the growth engines of E-Systems. And I think coupled with us kind of getting back to the software, we've acquired Xevo, Arada, Autonet, companies that are taking software and really taking our hardware and embedding the 2 together. And John will talk a little bit about it, but on Xevo, for example, I think we're talking -- we're on 25 million different vehicles. And now we're north of 40 million vehicles with Xevo. And right now, it's about getting on the platforms, getting on the vehicles. We're still working through commercializing and monetizing that business, but it's a great platform for us to grow. So we've kind of -- we're looking at wiring and Ts and Cs, body electronics and software are really the core of our business where we have a right to play and we can grow that business above market and get fair returns. So I don't know, John, if you want to elaborate a little bit on that.

Yes. Sure.

Maybe as you do that, just bringing into the conversation what your competitive advantages are. So when the automaker, your customer looks at you, what do they say this company has something differentiated versus the competition?

Sure. Let me frame out what the competitive landscape looks like. So if you think about it in 4 quadrants, on the right-hand side, upper left-hand quadrant would be automotive generalists, folks that are really like Bosch, for example, that do everything; at the bottom right-hand corner, more like electronics generalist, so new entrants like Samsung and so on. The left-hand side is where we play. And on the bottom, it would be component specialists. On the top left would be systems and domain expertise. And so we play between those 2 areas. And I would say over the last several years, we've been investing to move up to the top left quadrant, so it becomes system and domain experts. And we've built the foundation of that business on our body electronics capabilities. And by adding software capabilities and services on top of those, we've moved into the connectivity domain and then, of course, electrification. And so if we take a step back, what is connectivity to Lear? Connectivity to Lear is TCUs, telematic control units. That's basically the cell phone in the car, so connecting the car to the cloud. If you go down into the car, connectivity wired in the car is through what's called the gateway, and the gateway is like a network switch in the car. It's effectively like your router in your house but in the car. It's taking the information that's coming from the cloud or information that's going out of the car and into the cloud and routing it around the vehicle to and from different electronic control units in the vehicle. Lear has a strong position in gateways. And again, that builds from our foundation of core electronics or body electronics. The gateway then sends data signals and power distribution around the vehicle to different electronic control units. And Lear also plays in those things like body domain controllers or general domain controllers. And what we've done over the past several years, through both organic and inorganic investment, is to build the software, as Ray said, on top of those electronics capabilities to be able to differentiate and find higher-margin, new value businesses that are synergistic with our electronics. So in software, you've heard the acquisition of Autonet a couple of times. Autonet brought in WiFi and mobile -- or cellular software capabilities, so the ability for us to take electronics and create connected modules, like TCUs and gateways. Arada brought in V2X capability, V2X software. And it's sort of from the low end up to the applications for V2X, and those are really safety applications and also OEM connectivity or analytics capabilities for that. EXO is another acquisition we made, and EXO is a vehicle positioning software and service capability that adds on to our connectivity electronics. That's really a new space for us, which is getting into that selling software and services directly that can be coupled with hardware or independent of hardware. And then finally, Xevo, which is the next step, which brings in services, user interface and user experience as well as the ability to monetize data. And so that's -- those are the big growth opportunities for us, but where we're playing in software is from the low level or hardware abstraction layer where you're tying the hardware to the software, integrating operating systems and then on top of that applications that run in the car and in the cloud. And we're actually now entertaining real quotes from customers to sell software and services separately from our hardware.