Lear Corporation (LEA) Earnings Call Transcript & Summary

Welcome back, everybody, and thanks for joining us again. Next up, we have Lear, which is a leading global supplier of seats and electronics. I think a lot of you are familiar with. Lear has been gaining market share in seating for years now and honing its electronics strategy with a focus on growth. We expect that to be augmented potentially by acquisitions. We'll hear a little bit more about that from Jason today with a focus on technology and those acquisitions. To discuss all of this and much, much more, we're very happy to have Jason Cardew, SVP and CFO at Lear. Thanks for joining us today, Ed, I mean, sorry, Jason. I have Ed on my screen as well. Ed Lowenfeld was going to be on before us. So sorry about that, but thanks for joining us, Jason. We really appreciate your time.

Yes. Thank you, John. I'm happy to be here. I appreciate being able to participate in your conference today.

Well, maybe to kick off, Jason, there's obviously a lot going on in the industry, foam shortages, semi storages, all sorts of supply chain disruption just from ICE to EVs. What are your kind of, can you give us some general opening comments on what's going on at Lear and the industry and your view on 2021?

Sure. Yes. So it's, obviously, it's been a choppy start to the year in terms of supply disruptions. And you're in the second day of this conference, I'm sure you've heard quite a bit about supply shortages and the impact on customers' production. But despite that, our businesses, both Seating and E-Systems, are off to a really good start and not just in terms of execution on the financial plan for the year, but also really execution on our strategic plan. We took advantage of the downtime last year to really refocus our strategy. And we've built that strategy around 4 key pillars. And first, really extending and building on our advantages in Seating. It's a great leadership position we have in that business. We see an opportunity through technology and innovation to invest in priceable features, both organically and inorganically, would give us a chance to extend that advantage. In E-Systems, it's really a transformation that's focused on accelerating growth through connection systems and electrification. And then in Industry 4.0, there's a chance for us to really leverage that to further build on our strong heritage and operational excellence. And then the fourth pillar is around sustainability, investing in products and processes that benefit the environment and investments in human capital management. And so we're really executing across those 4 pillars, very focused on that, while at the same time meeting or exceeding our financial commitments for the year. Ultimately, that's what will allow us to fund the strategy that we're investing in. In terms of the industry and our financial outlook, as you mentioned, there's lots of challenges right now. When we started the year and really coming out at the end of last year, we anticipated the first half of this year to be pretty challenging. Because of our E-Systems business and the relationships with the microchip suppliers, we had a pretty good line of sight on some of the challenges there, the shortages and baked that into our outlook. So our industry volume assumption was a little bit more conservative than what IHS was projecting at the time. And so I think that's given us a bit of some breathing room as the industry struggled here at the beginning of the year. If you look at IHS sort of as a gauge of what's happening with the industry in terms of lost production, I think if you look at their January outlook to their March outlook, they've cut production by 4% and 3%, respectively. I think the impact, when all said and done, it's going to be a little bit worse than that in both the first and the second quarter. And I think the effects of this, the shortages really linger into the second half of the year, particularly in the third quarter. I think by the time we get to the fourth quarter and into '22, that will largely be behind us. But I think it's going to be a little bit bumpy straight through the second and third quarter. So really, what we're focused on in the first quarter, and it's really been an extraordinary effort by the operating teams in both Seating and E-Systems given all these challenges with part shortages. Our purchasing and operating teams have been working around the clock to secure production. We haven't disrupted customer production. And I think there aren't many suppliers, particularly on the electronics side of the business, that can make that statement thus far. And I think ultimately, though, the shortage situation will affect everyone, particularly in the second quarter. I think that's going to be the kind of the peak of the problem in terms of the shortage. Despite that, again, because of the cushion we had in the volume assumption in our guidance, we're very comfortable with our range, both on the revenue side and earnings side for the business. I've lost your audio there.

There you go. Can you hear me? Sorry about that. We still have technical difficulties. So I mean, I appreciate you guys are operating and executing well, and you're not interrupting any launches. But are you seeing any launch timing change or anything pushed out? And does that help or hinder your, I mean, your outlook? And also, when you're talking about maybe the stress sticking around through the end of this year, will that be relieved in a big way in '22? I know you're not giving 2022 guidance. But I mean, will this volume just be gone or will it pop back up and bounce back up at some point in the future, whether it's the third quarter or the fourth quarter or into 2022? So any launch delays and then when could you actually, could you actually see a recapture of some of this lost volume?

Yes. I think perhaps as early as the fourth quarter, you could see recapture some of that lost volume. We haven't really seen any meaningful changes in the timing of launches with our customers. So I think by the time you get to the fourth quarter and certainly into '22, there's a setup for a nice volume recovery, maybe even similar to what we went through coming out of the 2008, '09 downturn. We had nice volume growth from 2010 through 2017. It sort of feels to me like there's a setup for '22, '23, '24 for a really nice volume recovery, particularly in North America where demand is really, really strong. And China has recovered, Europe maybe to a lesser extent, but we feel like the setup for industry volume is really, really strong heading into the end of this year and into next year.

And then the other question we have on the input cost side is raws are inflating in many ways. I mean, that's going to be a challenge. It is what it is. You can't control raw material pricing, but you can control how you deal with it. So if you could just remind us how your contracts or in the industry are pass-through or directed buys all work? Obviously, you got a number of different materials that you're dealing with, with your customers, maybe steel, resin, foams. How does that all work and how should we think about that?

Right. Well, the 2 biggest commodities for us are copper and steel. So starting with copper, we've seen about a 40% increase from last year's average price to current pricing. So it's been a pretty meaningful move in copper prices. We buy about 175 million pounds of copper a year. 90% of that's on an indexing agreement and is pass-through. The other 10%, we typically buy 3 to 6 months ahead, and so we have a bit of a cushion there heading into this year. We had some of that locked in. But we do expect higher copper prices throughout this year. I think it's a bit of a short-term phenomena. Copper sort of peaked a little bit above $4. It's come back down to $4. And I think over time, it will stabilize and come back maybe closer to where it's run 2016 to 2020, somewhere in that $3 a pound range is what we're anticipating. On the steel side, steel has probably doubled if you look at the CRU index from last year to this year. We typically lock in our steel the year prior on the portion that we're responsible for. So we buy about 3 billion pounds of steel. 15% of that is raw steel that we buy for ourselves or our suppliers and the balance is on either an indexing agreement or it's in a component where the supplier may be responsible for it. And so that increase in steel has been significant, but it hasn't had a meaningful impact on the first part of the year because we locked in last year. In the second half of the year, we do expect to see increases there. And we factored most of that into our outlook. In terms of the kind of the margin impact of both of those, thinking about copper, again, first, because we have pass-through agreements, that does insulate us on the operating income side for 90% of it, but it does lead to higher revenue without earnings, so there's some margin dilution. And that, coupled with the higher copper costs, it's about a 50 basis point headwind for us year-over-year. We had about half of that factored into the guidance. So there's a little bit of risk to that. On the Seating side, we had 30 basis points of margin headwind for steel and chemicals factored into the outlook. It's probably 10 basis points worse than that. We have a lot of levers to pull on the Seating side. And I think we're very comfortable we're able to more than offset that on the seat side.

That's helpful. Then maybe if we take a step back and think sort of more strategically about the Seating business. First, I mean, you guys have been competing incredibly well, gaining market share. One of your big competitors has been pulling back and retrenching a bit and trying to get its house a little bit more in order, doing a pretty decent job there, but that's created some real opportunity for you. So I mean, how do you think about the competitive landscape going forward with existing companies? And is there opportunity, there's still room for outsourcing in seating, where you might get an opportunity to make more seats for some of the companies that are doing it in-house as they have to focus their actual capital and human capital and R&D dollars on AVs and EVs that are going to chew up a lot of their investments. So I mean, competitive standpoint and potential for even more outsourcing for you.

Yes. So we're very excited about our position in seating. We're a leader in seating. We have the #2 market share at 23% of that global market, but we have the highest margins, the highest financial returns and a solid track record of growth. And it's really, if you step back and compare us to all the other large seat makers, we're the only ones that have been fully focused on this over the last 20 years. We've just methodically executed in that space. Over the last 10 years, we've made considerable investments on the inorganic side, rounding out our capabilities on the components. We're the most vertically integrated seat supplier and the only supplier of leather fabric, the cut and sew seat covers, foam and structures. That, coupled with the electronics capabilities we have, really uniquely positions us in seating. And despite our strong position now, we're even more excited about the growth potential of that business and our ability to continue to differentiate ourselves in the marketplace. So we're really focused on additional vertical integration opportunities. We think there's more there than outsourcing opportunities per se or additional consolidation of JIT suppliers. I think the real value creation potential for us in seating is on technology and innovation. The best example I can offer on that is our ConfigurE+ patented technology allows the customer to put power to a seat without having to connect it to a wire harness. So there's all kinds of applications for that. We have the first program launching this year with that, second customer launches in 2 years. So in '23, that's a $100 million business for us. We see that as potentially a $500 million business if you look 5 or 6 years out. We're seeing tremendous interest from other customers now that we have that product entering the market. And even beyond the traditional automotive, we see applications in commercial vehicles, last-mile delivery vehicles. We're just scratching the surface on what we can do with that technology. So I think the investments we've made in technology and innovation are allowing us to further build out that competitive advantage that we've established in seating. We really like our position there. We've targeted 28% market share longer term on the JIT side, but we also see growth on the component side. We have a $5 billion-plus component business that is profitable and does well for us, sort of underpinned by acquisitions of Eagle Ottawa on the leather side, Guilford on the fabric side. It's a really strong business for us. So we're really excited about our potential in the seat business. And you mentioned what some of our competitors are doing. I'll tell you, from our standpoint, that separation of Yanfeng and Adient in China is a positive for Lear. They had a really dominant position in China. The 2 of them together had nearly half of the market. Now what you have, you have 3 seat makers that have about 20% of the market each. And we really like our ability to compete in that environment. And we think that, that kind of diminishes some of the scale advantage that they had. And we see great growth potential for our business in China as a result of that and as a result of our investments in technology and innovation.

So Jason, one of the things that you just mentioned there was the vertical integration. And I'd admit when we first heard about Eagle Ottawa, it seemed like a single. But then a year or 2 later, it seemed like a double and then a triple and then almost a home run deal financially, right? I mean, it just got better and better over time. What other opportunities are there for acquisitions, that, Guilford? Is there stuff on the structure side, on the foam side? I mean, what do you mean by vertical integration? And how much further do you have to go to be "fully vertically integrated"? Like I said, I mean, that Eagle Ottawa deal was amazing over time. It took a little time to play out, but I mean, it played out well. What are the opportunities there?

Yes. I think about the other priceable features that we're not in. You think about the joint development agreement we have with Gentherm is an example where we can bring a better heat and cool experience to the occupant through a collaboration with Gentherm and products that we've developed. So I think comfort features in general is an opportunity for us. I don't want to tip our hand specifically on what we're looking at there, but we do see some near-term opportunities, both organically and inorganically, on componentry within seating. It's not going to be in structures. We're not looking to grow there unless there's a very targeted opportunity. We did have a very small transaction we did last year. We took over a company called Gill that made structures for the T1 programs, strategically important for us. That's been a nice little tuck-in deal that we haven't really talked about. But we're not looking to grow in structures per se. We like the size of our business as it is today. It's modestly profitable. It's a challenging business. There's work to do there still, but we're not looking to expand there. It's more on the, I would describe it as comfort-related features in the seat where we see an opportunity.

Got you. And you mentioned before that there's opportunity in China the way that the competitive landscape is shifting a bit. Just curious if you can comment on anything else maybe in China that's either making it look even better because of more and more new entrants. But then also South America is another region that's in flux. And you got a number of competitors, I mean, sorry, customers backing away like Ford to some degree. And what is that, what are the issues and opportunities in South America as well?

Yes. Well, starting in China, our business is really underpinned by the Western OEMs operating in China, particularly on the luxury OEM side. So we have a great business with Daimler, with BMW, with Audi, also a nice business with General Motors in China on the seating side specifically. We see opportunities with the domestics. We have a business we're launching this year with Great Wall. We see opportunities for further growth with Great Wall, Changan. Volvo Geely is a tremendous opportunity for us in China. So we're not necessarily looking to target some of the new entrants in the market. We're going to be taking a bit of a wait-and-see mode with most of those new entrants. But on the stronger Chinese domestic OEMs, we definitely see an opportunity. In South America, that is a tough market. We've been very disciplined in that market. We actually kind of retrenched, go back 5 or 6 years ago. We exited a couple of programs selectively there and took a step back and have now restored the profitability on the seating side in South America. We have the #1 market share in South America in seating. It's a good business for us, but it requires super discipline. On the E-Systems side, it's a relatively small business for us in South America. It's modestly profitable. But we like that market. You just have to be very disciplined in your investment decisions there.

Got it. So maybe switching gears to E-Systems. You guys had a great session last week, so we appreciate that. E-Systems has kind of gone from a connected car to much more focused on EVs, right? There's been somewhat of a shift over time in the strategy or at least the focus, right, at least from my perception. And there's tremendous opportunity for you as we switch from more ICE to EVs because there's just going to be more, there's going to be more content. So can you talk about how that portfolio has shifted over time if I'm correct or maybe incorrect? I know you're still focused on the connected car, but it really does seem like the greater opportunity might be in high-voltage wiring harnesses, the connectors and power electronics and any BMS stuff that you're developing. How has that portfolio transitioned and what is the real big opportunities there or what are the big opportunities?

Yes. Electrification is a tremendous opportunity, as you pointed out, in E-Systems. And we had an event last week where we talked about that in some detail. So if you look at an electric vehicle compared to a traditional ICE vehicle, there's about $1,900 of incremental addressable content for us in that space, and that's really broken down into 4 partitions. You have high-voltage wire and connection systems, which is $200 to $400 of content. You have the battery disconnect unit, which is $600 to $800. Battery management system is another $150 to $350. And then lastly, the integrated power modules, which includes onboard chargers and DC/DC converters. And that's another $600 to $800 content opportunity for us. So we are very focused on that. It's the single biggest growth opportunity we have in E-Systems. The growth we're anticipating there at $270 million of revenue in that space last year. $385 million is our projection for this year. Looking out to 2025, we see that as a $1 billion business. Most of that is awarded. 2026, it's a $1.4 billion business. So that's a business that's going to grow 30% CAGR over the next 5 years and drive 3 points of growth over market for E-Systems overall. The mix of that business is a little bit different than our traditional E-Systems portfolio. So today, we have 75% of our business is in wire and connection systems, 25% of it is in electronics. If you look at electrification specifically, 40% of that business is in wire and connection systems and 60% is on the electronics side. So that's part of what's kind of driving a mix shift of our portfolio and our business in E-Systems overall. We've got a long track record of success in that space. We were on the Chevy Volt program going back 10 or 12 years. We've invested heavily in technology in that space. We really like our ability to compete there. We do see growth opportunities in connectivity. I know we haven't focused as much on that of late. But it's about a $200 million business for us this year. We see that business more than doubling over the next 5 years. So telecommunication units and gateway domain controllers are both good products for us and provide some growth potential, but not to the extent you see on electrification.

I mean and I look at the portfolio right now, it's pretty robust, but there could be some spots that you might want to fill in. So I mean what would those spots be? What would you be going after to augment your EV product portfolio? How available are they? And because of this crazy SPAC craze that we're having right now, are valuations just prohibitive because there's so much capital chasing? I'll leave it at that.

Yes. So I think our focus on the M&A side within E-Systems is more on the connection systems side of the business. We had a small transaction we announced last week with M&N Plastics. And that, coupled with the organic investments we're making there, is really going to strengthen that business. And that will also impact the high-voltage side of connection systems over time. Within electrification, we like the portfolio we have. We have all the capabilities that we need. We're not necessarily looking for M&A to supplement that. If something became available, we wouldn't shy away from it. But that's not an active emphasis for us on the M&A side right now.

Got it. And when you look at the EV bidding process as you're going out and you have RFQs or RFPs, how competitive is the environment? Who are you running up against as you're trying to win business? Is it the usual suspects or are there new folks showing up? I mean, we have a lot of people that are fearful, like all of a sudden, the incumbents are going to get crowded out and take out of the equation and all of a sudden, they're going to be out of the game. Seems a little bit misguided. I think your incumbency plus your technology gives you, at least, in my opinion, a pretty damn good advantage versus anybody else that would come in new. But who are you running into in this process of going after business? And is it new players?

Yes. So it depends on the product. So on the wire, the high-voltage wire and connection system side, it's the usual competitors, Aptiv, Yazaki, Sumitomo, Leoni maybe to a lesser extent. On the power electronics side, it's a kind of a fragmented market, and we're the only one, and we think there's one other market participant that has that complete capability between battery disconnect units, battery management systems and integrated power modules. And so typically, we're competing against people that make one component or another. And what we're seeing increasingly in quotes from our customers, the bundling of multiple products together. I think our breadth of products gives us an advantage there. We can choose to make something or buy it. So you have a cost advantage potentially, but having the knowledge and capability of that, coupled with the electrical distribution side really uniquely positions us as someone with the deepest domain knowledge and expertise in electrification of anyone in the competitive landscape.

Okay. Got it. Maybe on to some straight financial questions for you as CFO to get into some numbers here. What do you think that normalized margins are for Seating and ultimately for E-Systems? I mean, E-Systems is going to go through ebbs and flows as the product develops. So it's kind of hard for us to understand whether that's 8% or that's 12% or maybe it's 15%. I mean, so Seating might be a little bit easier to predict and talk about. But I mean, on both segments, what do you think "normalized margins" can be?

The way we look at both businesses is more on a return on invested capital basis. And so the margins are sort of an output depending on the level of capital intensity, investment intensity of the products that we're in. In Seating, I think 7.5% to 8.5%, that range gives us a nice spread between our cost of capital and the returns that we're targeting. And so that range is designed to capture the whole kind of scope of businesses that we're targeting. So if you're going after a JIT program, if you're a 5%, 6% in a JIT program, you're going to earn a nice return. You have a fully vertically integrated program with structure, leather, cut and sew, trim and foam with JIT, you need to be at the higher end of that range or even beyond that. And so that, I think, is the right range that allows us to continue growing the business, but at the same time, generating significant returns well in excess of our cost of capital. On the E-Systems side, our target is 10%. One, because we believe that's the right target for the product segments that we're participating in. And two, that's the margin that gets us to the return targets that we've established. And we think the portfolio we've put together and the goals we have in terms of growing in connection systems and in power electronics to supplement our existing book of business today will allow us to get to 10%. And so both businesses at those margin levels return well in excess of our cost of capital.

Okay. And then when you think about the 2 segments, I mean, you got 2 mouths to feed almost or 2 segments you're treating. I mean, how do you decide on where major capital commitments or incremental capital commitments go? Because there's growth opportunity in both segments, you might argue E-Systems has more blue sky than maybe Seating, but Seating has got great cash flow or return prospects that investing there you get great cash flow to invest in E-Systems. How are you deciding between capital? Is it old school return on invested capital, where I get the best bang for my buck or do you think about it with some sort of thought about what happens in 5, 10, 20 years and where the growth could be greater?

Yes. Yes. I think the answer to that is, it's both. We do start with return on invested capital as sort of the filter that we're looking at investments, whether those are organic or inorganic, so internal capital decisions or M&A. For some of the E-Systems products, we may take a longer time horizon. Think about some of the products that we're investing in where you have an initial R&D investment that's going to benefit you for not just the current generation but successive generations. You may have a longer planning horizon as you evaluate those investment decisions. But both businesses today are generating free cash flow and self-sustained. And so it really isn't an allocation issue between the segments. They're both performing well. And so for us, the only thing we're doing is maybe restricting capital within the segments in particular areas. So again, in structures, for example, on the Seating side, we're not looking to grow that business. It's a $2 billion business for us today. We're going to grow there. It's in products with patented technology like ConfigurE+ or it's with a customer where we have a proven track record of earning a return or in a region where we know we can earn a return and we're not looking to expand and put more investment beyond that. On the E-Systems side, for example, in electrification, we've chosen to sort of exit or de-emphasize inverters. We looked deeply at the competitive landscape across power electronics and felt like that wasn't an area that we could be competitive and generate returns longer term. And so we're not putting any more capital to work there. And so ROIC is the lens that we're looking at the business through, but we also look at it over a longer time horizon as well for some of these nascent technologies.

Okay. Doug, I think you had some questions.

Yes. So I'm kind of representing the credit on the call. So I think on target leverage, right? Leverage has been very manageable. On a net basis, less than 1. Where do you think the sweet spot for leverage is, how do you view the ratings, could you consider maybe a high yield or are you comfortable in the mid, low?

Yes. So we worked hard to get to our investment-grade credit ratings. And so it's important for us to maintain that investment-grade balance sheet. And so our gross leverage is 1.2 turns, something like that this year based on our outlook. We're comfortable going a little bit above that. We've talked about 1.5 turns in gross leverage being our target for the right transaction. We could certainly go above that with a pathway back down into that range. But I think our investment-grade balance sheet really served us well last year, thinking back to the pandemic. We didn't have to go out and and restructure our debt. We don't have to raise money. We didn't have to. We had no constraints to operate the business in a very, very difficult market. And I think longer term that's a competitive advantage for us. And so we we're committed to maintaining that.

Yes. We are getting towards the end of the session here. So I have one more question for you. The capital markets are reasonably wide open in many ways to anybody that's got a solution for a problem. Obviously, E-Systems has a lot of solutions. Seating is more of a volume play. But is there any potential for you to consider raising capital maybe with a focus of saying, hey, we're going to invest maybe more heavily in E-Systems and get access to a lot of this low-cost capital that seems to be floating around might allow you to return more value to shareholders over time if you do it from a credit standpoint, maybe consider a convert? Or maybe, I mean, I don't think, I mean, I think your stock's got -- we're neutral in it right now, but I mean, it's not super high multiple. So I mean equity probably wouldn't be in the cards unless your multiple doubles from here and then maybe you'll take that low-cost equity. But I mean, there's an opportunity here. And things are pretty robust in access and cost of capital. Would you ever consider doing that to accelerate growth?

Yes. We certainly would consider it if it was necessary. For the right transaction, we're not afraid to take on a little bit more leverage, again, with an eye towards getting back down to that sort of 1.5x gross debt over time. Based on what we're seeing in the landscape here, it's more tuck-in acquisitions that we see being able to fund with the free cash flow we're generating in the business. Larger transaction, we would definitely access capital markets. And I agree, they are certainly wide open. And so we would gladly take advantage of that for the right transaction, John.

Okay. With that, we're getting down to the last minute here in the session. So we're going to tag out, Jason. Thank you so much for the time. We greatly appreciate it. We appreciate the time your team gave us last week on the E-Systems day. Once again, if you guys have not listened to that, you should listen to the replay because that was a really great session that the Lear team put on, on E-Systems. So Jason and the Lear team, thank you so much for joining us today. We appreciate it.

Thank you, John. And thank you, Doug.

Thank you very much. Bye-bye.