Lear Corporation (LEA) Earnings Call Transcript & Summary

Good afternoon, everybody, and thank you for joining us for the session with Lear as part of Deutsche Bank's Global Auto Conference. My name is Emmanuel Rosner, and I'm the senior U.S. autos analyst at Deutsche Bank. Lear is a global leader in the supply of automotive seating and electrical architecture and a fast-growing player in electronics and vehicle electrification and connectivity. We are very pleased to host with us this afternoon, Lear's CEO, Ray Scott; CFO, Jason Cardew; and Head of Strategy and Investor Relations, Alicia Davis for a discussion. The format will be a fireside chat around some of my prepared questions. But before that, I will hand it over to Ray for some prepared remarks. So Ray, Jason and Alicia, thanks a lot for being with us today, and over to you.

Yes. Thanks for having us. And it's great, and I appreciate everyone joining us today. Before we get into some of the more specific questions, I would like to kind of ground everyone on where we're at and what we're seeing. Obviously, we are much more positive than we've been in quite some time for a number of different reasons. But given the change in the landscape, we worked diligently on a plan, while we're down, on safety and protocols within our plants and really focusing on liquidity, reducing our costs, preserving our liquidity and making sure that we had ample liquidity, and keeping an eye open on, not just our strategy that we had in place before the crisis, but keeping an eye on any potential things that could create opportunities as the landscape was changing. And so we did spend a significant amount of time on the first part, making sure we put a safe work playbook in place, standardizing practices, draw up policies within our plants, and the team did an incredible job of what, I believe, setting a benchmark to making sure we're opening our plants officially and safely. And with that, we've kind of transitioned now into making sure we're monitoring our plants. The plants are doing extremely well. We've had minor issues, but no significant issues. So the teams are doing an excellent job of running our operations and getting our operations back up and running. Jason and the finance team, along with the operational team, continue to stay very focused on decremental margins and driving our cost and making sure we're the most efficient company that we can be during these times, and they're doing a really good job there. We'll talk a little bit more about that. And again, like I said, positioning the company to take advantage of any growth opportunities, either Conquest wins or any opportunities that might present themselves as we continue to unfold and really realize what we're going to be looking as far as volume. So with that said, we are in a much more positive position. We've seen some changes in respect to what we're going to see in the second quarter. And kind of give you an overview of where we're at. China and Asia are back to about 95%. Europe is around 60%. And again, Europe continues to improve week after week. Thought that might be a little bit more challenging, given the complexity of the supply chain in the different countries and the different countries in respect to the situation with COVID. But that's been really doing a nice job. In North America, we're at about 60%, 70% in North America. We continue to keep running and continue to keep improving in North America. So we're much more, like I said, positive. We've seen some improvements within our manufacturing processes and plant volumes. And I think we're in a good position or a much better position in respect to second quarter. And so I just want to give everyone kind of a general update of where we're at from a business standpoint.

Great. That was a great state of -- general state of business and very happy to hear the more positive tone. So I was hoping to maybe dig a little bit in more detail into some of these points. You gave us an update on some of your restarts in production at some of your plants. Just curious of a couple of things within that. What are you seeing in Mexico, in particular, and with the supply chain there?

Well, I think I've said this before, Mexico is and has been about 4 to 6 weeks behind where I believe the U.S. was at. And so they're still having significant issues relative to the medical state and the infrastructure within the hospitals and some of the needs that they need just on the ground in Mexico. Now in respect to the manufacturing plants, it's different by state. And so in Puebla, we're still down. That's still the degree, the order is that there's no production or manufacturing within Puebla. It's very limited. In Chihuahua, now, we can produce at 30% production, and they have different codes relative to what states you're in and what volume you can produce. The rest of them are -- were pretty much at 100%. And so those are the 2 limiting factors that we have in respect to production, and those will change as the environment changes around those particular states. And hopefully, over time, those will change quickly to a -- from a red to an orange to a yellow and to a green. And so we still are limited in manufacturing. As far as how the production environment is going from a Lear perspective, it's operating extremely well. The protocols, the procedures we put in place are doing extremely good job of protecting the employees within the facilities. We had some absenteeism issues relative to particular plants, but nothing major. And the team is doing a remarkable job of getting back up and running really quickly. So overall, with the exception of what are the state orders, we're doing a nice job of getting production back up and running. And with that, I don't know, Jason, if you want to mention anything?

I think the second half of Emmanuel's question was in regards to the supply chain. And that's another area we've spent a tremendous amount of time in planning and monitoring, training, working with our supply base during the downtime. And we've been pleasantly surprised by how robust the supply chain has been and how well our Tier 2, the Tier 2 suppliers and our supply base have held up. And while there's of course pockets of issues on balance, that hasn't been a real limiting factor for us as we've ramped back up.

That's very good to hear. And just one more point of clarification on these -- the topic of this ramp up. So in Europe, we've heard different messages from different suppliers around how this ramp up is going. I think a lot of them were quite positive, as you sounded. Some of them complaining about maybe a little bit of a lack of visibility and then some start-stop type of situation, which can make single -- more difficult to manage than usual from a cost point of view. Can you comment, from your perspective, what you're seeing specifically in Europe?

Well, like I said earlier, we've been pleasantly surprised to the positive of Europe. I thought Europe would be a little bit more challenging given, one, the challenges with Spain and Italy and some of the countries relative to where they're at with COVID. But the supply chain has done a nice job of really supporting the volumes that are required from our customers. We haven't seen any issues relative to particular customers. Actually, like I said, I think they've been running extremely well. We seem to see increased volumes week after week, and there hasn't been any significant disruptions or concerns that we've seen within our supply chain. So overall, things have been going relatively smoothly. I don't know, Jason, if you want to add anything there?

Yes. I'd say Europe restarted production ahead of North America and started very, very strong. As Ray said, they've continued to build week after week, and we haven't seen any setbacks, really. I think the bigger question maybe with Europe is going to be on the demand side. There isn't quite the same need to replenish inventory levels in Europe as we see here in North America because sales were down so dramatically in April and May. I think inventory levels in general are a little bit more in line with what they need to be. So that may be a bigger factor as we look forward in Europe relative to what we see in North America.

All right. That's very clear. Maybe shifting gears to your growth profile. Your first quarter growth above market was very strong. What were the drivers of it? And do you view that as -- do you view these drivers as sustainable?

Yes. You're right. The first quarter growth above market was extremely strong at 11%. Now a bit of that is due to the regional mix of industry production. So China was down a lot more than North America and Europe, and our market share in China is lower North America and Europe. So there's a bit of -- that's just the math on the regional mix that helped us. But North America was particularly strong for us in both segments. In Seating, we were 9 points above the market and E-Systems were 12 points above the market. And that's partially because our backlog was very North America-weighted in the first quarter. That's a big factor. We had the benefit of the GLE, GLS continuing to ramp up, and that impacted the Seating backlog. And then in E-Systems, we had the ramp up of the F-150 Super Duty, where we have the upper body wiring harness on that net loss last year. So that drove the backlog there. And then also in North America, it's the flip side of the changeover cycle in our major programs that's helping us -- that helped us really in the first quarter and will help us, I think, throughout this year. We talked a little bit about this last year, where we had GM's full-size truck platform going through a changeover and had some downtime scattered throughout the year last year. Ford with the Explorer is another important Seat program for us. They went through a changeover last year. And so even though the market is likely to be down in North America this year, the Explorer is likely to be flat or certainly positive relative to the market. So those things helped us in the first quarter and will continue to help us as we look out for the balance of the year. China was also a strong market for us, where our growth over market in China is 14%. And I think the main driver of that, and I talked a little bit about that on the earnings -- first quarter earnings call, was the premium market has held up better than the overall market in China. And we saw that continue through May. What I've read thus far, I think the premium market was up 28% in the month of May, and the overall market was up about 2%. So we've seen that -- what happened in the first quarter kind of continue into the second quarter. And our book of business in China is a little bit weighted to the premium side. Almost half of our sales are with Daimler, BMW, Audi and then the premium side of Volvo, Geely. And so that had a pretty significant impact on our growth over market in the first quarter. And I think that will continue at least into the second quarter and perhaps beyond as well.

That's very good color. If I wanted to hone in specifically on the new business piece of that growth above market. So backlog was $130 million in the first quarter. So that accounted only for just 2.5% of revenue outflows. What does the outlook look like for the full year, perhaps versus your initial $825 million backlog expectation? Are you seeing delays, cancellation? Is it just a matter of adjusting for the lower volume outlook? Anything you can tell us on this?

Yes. I think it's a little bit early to give a formal update on the absolute number. But I can, I think, provide some additional color that would be helpful. First, just a quick reminder the way we calculate backlog. It's net new business. So roll ons of new programs are positive, loss programs are negatives. And so I'd point that out because in a year where you have delays in some new program launches, the roll on piece of that will be disproportionately impacted. The roll-off piece won't be because those programs, in some cases, built out last year. Overall, there have been delays, as you pointed out. And I think we've heard from some of our customers on your conference. The delays have been pretty modest. I would say, mostly 2 to 3 months. And I think a lot of that will shift into next year's backlog. Perhaps there'll be some offset to next year's backlog though because industry volumes, at least at this point, it looked like they'll be a little softer than what we had projected for next year. But I'd say the main factor that will impact our backlog this year is really that the formulaic impact of the roll on, roll off. And so some of those programs that were delayed will have a negative impact on the backlog. And it may be a little bit more than just applying what percentage reduction you see in global production to our backlog. The number is likely to be a little greater reduction in the backlog than that, then the math would tell you there. I'm hopeful that by the time we get to our second quarter earnings call, we'll have a clearer picture of what all of our customers are doing in terms of specifics around the launch timing and volumes. And we can provide a bit more complete picture on how we see the backlog as a result of that.

That was actually great color. And so that's, I guess, the backlog piece, but then do you still feel comfortable that some of the earlier pieces like the mix as well, like some of the easier comps versus some of the production last year, those things would still enable you to grow well above market over the rest of the year. Am I correct?

Yes. So in terms of -- are you referring to the changeover in the lower volumes from last year being helpful in growth over market? I think if that's the question, yes, I see that continuing throughout the year on the platforms that I described, in particular, GM full-size trucks relative to the market, Ford Explorer relative to the market and then premium in China relative to the China market.

Understood. What can you tell us about your quoting activity?

Well, it's interesting. At first, back in March, April, we were obviously very concerned, just making sure we're very mindful in monitoring what type of quoting activity was going on, and it did slow down. And I think a lot of that was a function of just purely just everyone learning how to work remotely and trying to do different things in respect to technical reviews and quoting and quoting processes and those type of things. I'll tell you now, I think -- and Jason and I just sat through a meeting this morning, and we continue to monitor this very closely. The activity is back to normal. We seem to work through a lot of the challenges in respect to working remotely and those type of things, and we're much more engaged in a lot of different activities with our customers in respect to quoting activities. And so what was something -- that was something we are monitoring closely has now shifted to what I'll consider to be more normal and back to what we are looking at prior to the crisis.

That's very encouraging. And then specifically, in Seating, you reported $900 million of new business awards in the first quarter, including $500 million of Conquest business, which I think was up massively from just $300 million all of 2019. I sort of asked the same question to Adient earlier, but who are you conquesting this business from? And what are the drivers of these share gains?

Yes. We did have a good quarter. The team did a really nice job. And we worked exclusively, and we can't announce the customer at this time, but hopefully, we'll be to announce it in another time. But I think if you think back about the work that we've been doing, and we've talked about this historically, we've grown our market share from 18% to 23%. And we've done a nice job of Conquest business within that, and again, focused on profitable returns, done a nice job of driving good growth profitably. And that's come across a lot of different competitors. There is -- I won't single out a particular competitor. It's been across a number of different competitors that we've been fortunate enough to put ourselves in a position to win the business. And I think when you think about how you do position yourself to have those type of Conquest wins, it takes time in respect to the capital that we've put in place, the reputation we've built as far as quality, execution, and just making sure we're focused on driving value for our customers because, obviously, we have to make sure we're creating some type of value for our customers. And so I think it's a number of different reasons why we've been able to secure those Conquest wins. And I think it comes across a number of different key things that drive our business and what will drive our business going forward. But the team did have a great quarter in respect to Conquest wins. And I'm very hopeful that we'll have an announcement in the second quarter earnings call that we'll continue that same type of trajectory. So really proud of what the team has accomplished.

That's good color. I mean, I guess, overall, would you see -- obviously, it is a pretty concentrated business, in general, I guess, at the global level. Do you sort of like still see further consolidation around the largest player and like some of the smaller ones are like being squeezed out? Or would you see sort of like a broad, you taking share from a broad number of competitors?

I think our share, when you look at it, it's one that's been really nicely balanced globally. It hasn't been in one specific region. And I think the same thing holds true in respect to the Conquest wins across different competitors. I wouldn't say it's been heavily weighted one particular competitor. It's been a nice balance. And I think we've talked about it, that we're being very selective. We've talked about the patience you have to have in respect to a lot of our customers do not like to resource business mid-cycle. They do prefer to have it at a model year changeover, which allows them time to not add any risk to their current products. And so I think when you have patience and you're looking at it over a longer horizon, and you put yourself in that position where you've invested in a smart way, driving the business and creating value for your customer, we're hopeful that we'll continue to win across the board. And so like I said, gaining market share from 18% to 23% and then having the type of Conquest wins we've had recently, I think, just continues to add credibility to what we're saying. You have to focus on all different facets of the business. You can't ever lose focus because you can lose it quickly. But you got to make sure you're putting yourself in a position of winning business. And so it's been a nice book of business across, not just one region, but all regions, and then a number of different competitors, not one selective competitor.

That's great to hear. Shifting gears to E-Systems. When can we expect to see revenue growth acceleration from your electrification and connectivity businesses in particular? And within that, how do you see the mix of business shifting within E-Systems?

Yes. I think, Emmanuel, you'll really see that happening in 2021. Last year, we quoted a total of $1.2 billion in electrification and connectivity. We won $450 million or about 40% of the business we quoted, which was better than our historical win rates. And $600 million of our $900 million backlog that we announced back in January is in electrification and connectivity. And so that business is relatively small coming into this year. It's about a $200 million business that will be $700 million to $800 million by the time you look out to 2022, depending on what happens with industry volume. So that business alone is really generating 3 to 4 points of growth above market for us, and it's the single biggest catalyst for our growth if I look out for the next 3 to 5 years. In terms of our mix of business, if you look at last year, we're about 75% wire, which includes our terminals and connectors business; and 25% electronics. If we look out to 5 years from now, our target is to see that mix shift to 65%, 35%. And the biggest driver of that increase from 25% to 35% will be in power electronics and connectivity, the electronics side of that. And then on the 65% wire business, we're targeting to double the size of our vertical integration there, which is primarily terminals and connectors. That was about a $400 million business for us last year. We see that business doubling in 5 years to about $800 million. Some of that's going to require a little bit of M&A, some tuck-in acquisitions. But largely, we see some runway to get half of that growth just organically through the portfolio of products we have in place today. So I think there's a pretty clear path to both increasing the growth rate of the overall E-Systems business through electrification and connectivity, and then through that mix improvement, driving accretion to the margins over time as well.

And so the bulk, I guess, the start of some of the new business launching you said is essentially next year?

Yes. I mean, it starts this year. Next year was a bigger piece of the backlog. So it's $600 million of business rolling on over 3 years. When we initially provide our backlog for this year, $150 million of that $600 million was slated to launch this year. That number is going to be lower for the reasons we've discussed earlier with some of the delays in new programs launching. But the $600 million overall is still intact and will be the catalyst for that sort of 3 to 4 points of above market growth coming from electrification and connectivity.

Understood. Let's switch gears to margins. You provided a solid outlook for decremental margins for the rest of the year of just 20% to 22%, a little bit better than your usual 22% to 23%, and that's despite incurring 2 to 3 points of post-COVID operational inefficiencies, which you're more than offsetting by $250 million of planned cost saving. Now that your demands are so post-production restart in North America and even more in Europe, and you have probably a better handle on this, like our inefficiencies, indeed as much as $100 million to $150 million. And do you think they're here to stay? And then on the other -- on the flip side, can you just walk us through the source of the $250 million in expected additional cost savings this year and how sustainable those are?

Yes. So far, what we're seeing in terms of the inefficiencies associated with the ramp up and the PPE costs are largely in line with what we had anticipated. Obviously, when we provided those comments on our first quarter earnings call, there was a lot of uncertainty because we had only experienced that ramp up in China, and we weren't sure exactly how it will play out in Europe and North America. But we've been closely monitoring that. And as we look at the results internally in April and May, we're right on track with what we were targeting and what we've described on the first quarter earnings call, sort of that $150 million number, I think, is a good number for the full year. In regards to how much of that cost continues longer term, I think it's a little bit early to say. But I would be surprised if it's less than $25 million to $50 million as I think about the impact on next year. And at the same time, we've taken a number of steps to reduce costs. And I think it's reasonable to assume that those actions will allow us to offset any carryforward impact. Also, there will be commercial discussions around that cost, if it's a permanent cost. A lot of our business is on cost models. And so that will become an input in the model once you're -- when you're discussing pricing with customers over a longer period of time, if that's a permanent cost. So -- and then in regards to the cost reduction program itself, we're right on track with that. And the biggest drivers of that were around salary compensation. We had some deferrals of salary. We had pay cuts for the top management and the Board. We had lower T&E, R&D and other discretionary spending, which pretty much just was brought down to near 0 here in the second quarter as the activity ground to a halt. We had the benefit of government subsidies. Unfortunately, we likely have lower reduced incentive compensation as a result of the lower earnings this year. And all those things taken together are on track for that $250 million that we targeted. A lot of that will unwind itself as we look out to next year. As volumes come back, we're going to put some of those spending programs back in place. Particularly on the R&D side, we were very cautious and deliberate and any changes that we made there and we did protect our most important investments, particularly around electrification, connectivity and supporting those other strategic growth areas for the business. But you could see some modest tailwind where the cost doesn't come in quite as quickly as the revenue comes back. We're going to want to see that revenue have some sustainability to it before we bring all the costs back. But that essentially is kind of how we're laying out our plan for the balance of this year and into next year in regards to costs.

Okay. And then you indicated in Q1 that excluding the COVID impact, both segment margins would have been above 8%. Obviously, a strong performance there on underlying basis. How long can you take now to achieve these margins? And do you need global production to go back to specifically 2019 levels or early 2020 levels?

No, I think that we were off to a fantastic start. I thought we had a solid fourth quarter and an even better first quarter, absent the -- this pretty massive impact of lost volume that happened at the tail end of the quarter. And so we're -- I think we're still on track to achieve the margin targets that we've established for both segments. But if you think about the impact on margins of that volume reduction, just simple math. A 30% variable margin business like E-Systems, a 10% reduction in volume is 250 basis points of operating margin. So you can't immediately claw all that back. The restructuring investments that we have in place and the cost reduction programs we have in place, I think, will allow us to claw back about 1/3 of that in the first 12 months and then the balance will take likely another year or so to claw back. In Seating, the math is a little bit easier. The variable margins are closer to 20%. So that same kind of 10% reduction in volume would have about 130, 135 basis point impact on operating margins in Seating. And I think with our restructuring investments, we could claw back about half of that in the first 12 months and then the balance, maybe a year or so afterwards.

That's great color. A couple more questions. On longer term, what is the potential for E-Systems margins to recover further and what would sort of be the drivers?

Yes. So similar to what we've described previously, our long-term goal, in which we described as a 3-year goal, was to drive margins in E-Systems from 7.5% to 10%. Obviously, this is a bit of a near-term setback with the lower volumes, but all of the other actions underlying that plan are either on track or perhaps even a little bit ahead of schedule. About half of that 250 basis point margin expansion was -- would result from some of the things we talked about earlier on the call here with vertical integration in our wire business and the shift to more electronics in terms of where that electrification and connectivity business will reside and the higher margins associated with that. The other half of that is really a result of improving margins on our existing business. So one of the catalysts for the lower margins or the margin decline in E-Systems that we've talked at length about in the past, as we improved the diversification of that business, we brought on some new customers, but they brought with it a lower margin profile than the segment overall. And we've already seen some improvement in those customers, the margin profile of those customers. But it's going to take time, I think, to get those margins more in line with our traditional book of customers after you've had the benefit of time working with them, learning those customers, learning how to manage engineering changes and commercial negotiations and to the program development cycle with them. To do all of those things better, it takes time. We've invested in resources. The people we've brought on, the team in Asia and then here in North America, running the global business, are very focused on that as well. And I think all those things taken together give us a high degree of confidence that we can deliver on that plan that we have outlined previously. And really, a lot of that is building on the same plan that Ray and I deployed in the Seating business going back to 2012, '13, 14. It was the same playbook applied to this business. Having that granular understanding of what your margin kind of returns are by program, by product, by segment, building the team to deliver on those plans. And all of those steps are well underway now and give us, again, a high degree of confidence that we can execute that plan over that same time horizon, with the caveat being, of course, the impact of -- on margins of the lower production volume if that were to continue on.

Understood. One just point of clarification before my final question. But -- so on the earlier question on the time line to get back to sort of like 8% segment margin, and you were talking about maybe on the E-Systems side about the sort of claw back in the first 12 months and then the rest after that. This was to get back to 8% or this was to get towards your 10% goal?

Yes. A lot of that -- so you're talking about E-Systems kind of specifically or as you want...

Yes. E-Systems.

Okay. Yes. So I think, again, if there is a 10% volume reduction that's permanent, there's about a 250 basis point margin impact, negative margin impact associated with that. So you're essentially -- if that's the volume that you're looking at going into next year, you're 250 basis points behind where you would have otherwise been. So if we were halfway through our trajectory to 10% at the end of this year, we'll be that minus 250 basis points heading into next year. And then the restructuring investments that we're making this year are intended to claw back roughly 1/3 of that volume-related compression impact on margins.

Understood. And then I guess final question, since I think we're fresh out of time. But on the capital allocation side then, you prudently suspended your dividend and buybacks earlier this year. What metrics or environment do you need to see to resume those?

Yes. First of all, our capital allocation priorities and our general philosophy around that is unchanged. Our first priority is to invest in our business through CapEx, ensure that we're competitive in both segments and to support the growth in our backlog. And the second priority is tuck-in acquisitions to further strengthen our competitive position in both business segments. And then with that, any excess cash that we have will be returned to shareholders. So our priorities are still the same. And I think I would add to that, we're committed to maintaining our investment-grade balance sheet, which I believe served us extremely well in a challenging time like this. In terms of what it will take to resume the dividend and share repurchase programs, ultimately, that depends on having a lot more clarity, both around the economic outlook just generally and auto demand specifically. So we're in a bit of a wait-and-see mode on that. But I'd say the fundamental cash generating potential of our business is intact. And even if volumes don't fully recover, we'll generate enough cash to restart those programs. I just can't put a time frame on it with the uncertainty in front of us today.

Great. Well, I want to thank you both so much, Ray, Jason, for being with us today at our conference for all your insights, detailed answers to all the questions. I want to thank all the investors on the line for your participation. Stick with us, we have American Axle starting in 8 minutes. Ray and Jason, thank you so much again.

Thank you.

Yes. Thanks for your time. Appreciate it.