Lear Corporation (LEA) Earnings Call Transcript & Summary

And this is Joe Spak, lead automotive analyst at RBC Capital Markets. Very pleased to have with us Lear. From Lear, we have Jason Cardew, the CFO. The format, again, just to remind everyone for this session, is fireside chat, but we do want the audience and investors on the line to get involved, and we urge you to do so. It's quite simple. There should be a box on your Web application that says questions. You type it in, it pops up on my end, and I can integrate that into the conversation. So with that, Jason, thanks for joining us this morning.

Yes. Thanks, Joe.

I guess, just to get started, obviously, when you reported second quarter earnings, you provided an LVP, global light vehicle production outlook of plus 6%. At the time, that was certainly, I think, below some third-party estimates and may be viewed a little bit conservative. I think, since then, we've seen a ton of OEM downtime announcements and probably some revisions to those third-party estimates as well. So it's looking more like prudence now that you did that. But I'd be curious to hear from your perspective, how you're seeing your schedules and your call-offs progress versus sort of your expectations that you laid out in the second quarter. And if you can, obviously, maybe comment on some specific automakers or programs that may be impacting your outlook for the year.

Sure. Yes. So Joe, the short response for that is, the production environment remains extremely challenging. And we anticipated that, as we issued our guidance on the second quarter earnings call, as you mentioned, we're a little bit below some of the other estimates out there. I think IHS, at the time, was calling for global vehicle production to be up 10%. We used 6%. Since then, they've lowered their estimates to 8% or 8.5%. And they also provide a weekly update of the production shutdowns. And if you [ go over ] like that, they're probably closer to our number, maybe even a little bit below that at this point in time. But it's really difficult to say where we're going to end up for the full year. But what I can talk about is that -- with a little more specificity is the third quarter since we're most of the way through that. And at the time we issued the guidance, we've talked about the revenue in the quarter being $4.66 billion. And since then, we've seen continued production cuts. The assumption we made at the high end of our range was for revenue of $4.85 billion, and we've seen about $100 million of production cuts announced on our platforms in each of the last 5 weeks. So if you sort of roll that forward, with [ 3 ] weeks to go, we're sitting at $4.35 billion in the quarter, so below that midpoint that we issued on the second quarter earnings call. I think the other important point, and maybe a point of the departure from what we saw in the second quarter, is the production cuts are coming with a little bit less notice than they were previously. And I think it's indicative of just the uncertainty that our customers are dealing with and the unpredictability of the schedules that they're trying to work through as well. So the third quarter we knew was going to be worse than the second quarter. It's turning out to be much worse. The good news is the demand backdrop remains exceptionally strong. And so if we see some progress on the chip shortage and customers are able to resume more normal levels of production, the fourth quarter should improve from there. And certainly, as you look out further maybe into the second half of next year, where there's a little bit more clarity on supply of chips, you see a real strong backdrop for global vehicle production growth. And so we're excited about the longer-term prospects, but it is really choppy here in the near term.

And maybe between the 2 segments, like you talked about sort of being below the midpoint, is it pretty broad-based between the 2 segments? Or is one of your segments getting hit a little bit harder right now with some of this choppiness?

Yes. We're seeing it pretty consistently in both segments. The reductions are more pervasive in the second quarter and to a lesser extent, the first quarter. Customers were able to sort of pick and choose the platforms that they ran. They were running their most profitable, most in-demand platforms, and to the detriment, maybe, of some others, that have benefited us a little bit in Seating in the first part of the year. Now it's pretty much across the board, we're seeing reduction. So it's impacting pretty much every customer in some way, and it's impacting both segments in a similar fashion now.

So last quarter, you talked about -- to think about normal decremental margins on sort of the lower volume in each segment. Is that still sort of the right way to think about it for the third quarter? Because you mentioned some of the mix is a little bit different. It also sounds like maybe some of the volatility, if anything, increased, which would suggest that it might be a little bit maybe more towards the higher end of what you've witnessed historically.

Yes. Since we've been dealing with this for a while, we have taken steps to try and offset that maybe richer conversion on the [indiscernible]. And both business segments are doing a great job in that regard. So I would expect, if you think about the guidance that we issued for the third quarter, the downward conversion would be similar to our normal decremental margin, so somewhere between 22%, 24% on a blended basis between the 2 segments. And really, that's volume converting at something richer than that and then performance offsetting that in both segments.

Okay. And that encompasses your latest view and thinking on other costs such as commodities. I know that was sort of called out a little bit in the past, and we've seen some commodities level off, but other -- maybe there's some other inflationary areas. And I guess, 2, maybe while I give you the opportunity to talk about inputs would -- that I'd be curious to get your point of view on are, one, given what just happened with the hurricane here in the United States, whether you're seeing any impact on petrochemicals needed for foam and whether you're seeing any increase there. Because I know earlier in the year, there was a little bit of a foam issue. And then secondly, freight, which doesn't seem to be abating at all. And I don't know how much you sort of get on ocean containers, but even trucking, I think, is pretty tight. So maybe you could just talk about both of those inputs.

Yes. In terms of the foam chemical pricing, we did factor in some increases into the second half of the year in our Seating business in the guidance. And we haven't seen any change in that regard. We are watching it very closely for exactly the reason you just described. And we did a really remarkable job of navigating that tight supply condition earlier in the year and didn't shut any customers down as a result of our relationships with the foam suppliers and ensuring that we had adequate supply. I wouldn't expect significant changes in commodity costs in the second half of the year relative to what we expected. I think we're pretty well locked in contractually. In terms of freight, we are seeing certainly higher ocean freight costs. But most of our material in both segments is sourced in the markets that we operate in. So North America is generally sourced within North America; Europe within Europe; and Asia within Asia. We do have some material moves on the ocean, but it's limited in both segments.

So that -- I think you talked previously about a $95 million half over half, both plus or minus, that still seems valid. And did that -- was that just straight commodities? Or did that include some sort of logistics number as well?

Yes, it contemplated logistics, but it's primarily commodities.

Okay. And then can you just -- because this is a question we get a lot from investors. I'm sure you do as well. But just to again level set the conversation, talk about the pass-throughs and the recoveries you can get on some of those headwinds and maybe even how we should think about some of this trending as a sort of maybe very early look into '22. Because it would seem like, at the very least, if you thought that these inputs were going to level off, you'd have a similar $90 million, $95 million headwind in the first half of next year that you'd have to contemplate.

Yes, Joe, I think that's the right way to think about it. But just taking a step back, our major commodities are copper and steel, and about 90% of our copper is on an index or in a pass-through agreement. Most of that is pass-through within 3 to 6 months. And so next year, we shouldn't see -- absence of further elevation in copper, we shouldn't see much impact year-over-year. On the steel side, about 85% of that buy is on an index, in a pass-through agreement, or it's the responsibility for the supplier we're buying it from in a fabricated form. And so that's probably the trickier one right now. Since we issued guidance, we have seen that spot prices increase another 9%, just looking at the hot-rolled spot price. I think it was $1,750 or so at the time of the guidance. It's over $1,900 now in North America. And so it's difficult to say where that's going to settle in. But what I can say about next year is you'll see some lag benefit and recovery of the steel increase from this year that will benefit next year that will help offset for that full year increase in the higher steel prices. This is really unprecedented, what we're seeing in steel. And so we're going through our usual playbook and then maybe a couple of steps further in terms of how we think about offsetting this. First and foremost, we want to continue the dialogue with our customers to improve that pass-through relationship. And I think we're in a very strong position relative to the [ contract ] in that regard in contractual terms that we have with our customers. But we're also doing a lot more with CTO, in our cost technology optimization and VA/VE, hosting calls, same events with our customers. And I think we do that as good or better than anyone in the space. And I think we have to help our customers find ways to offset this, not just look to pass through this cost, so that we'll do it in that fashion. And in addition to that, we'll soon be entering our customer pricing negotiations for the next year. And as commodities remain at this level, certainly, that's got to be part of the dialogue there. And then lastly, I'll just point out both business segments, we had strong net performance. And so that the we measure that is it's all the plant, commercial and purchasing performance relative to what we pass back to our customers and price reductions and commodities. And we were able to offset that fully in both segments. We had about 100 basis points of net positive performance in E-Systems this year and a little less than 40 in Seating despite the commodity costs that were elevated. We would look to try and replicate that next year. I think it's a little bit harder if you have another year of this level commodity increase. But that's the game plan as we sit here today.

Yes. Maybe let's talk about some of the business highlights. The growth over market in the second quarter was really strong. I think 11% overall, 19% in Seating. E-Systems was down, though. And I know that's a very sort of -- that can be a very choppy figure quarter-to-quarter. For the full year -- for the second half, you sort of indicated that it's more like 5%. So maybe you could just talk a little bit about that sort of deceleration. Is it just some of the choppiness because of the comps? Is there some program-related stuff going on? And then one of the other things that I always sort of get a little bit concerned about is, I guess, the best way to describe it is the convexity of the outgrowth to changes in vehicle production. So when it's more extreme when you have a big sort of drop-down, is that outgrowth truly independent? Or does it get impacted a little bit more? So maybe you could talk a little bit about how you guys think about that.

Yes. I think as you mentioned at the beginning, growth over market, that metric can be very choppy and in a normal environment. And in this environment, where it's really driven by the customer's ability to get chips on particular platforms, it's a difficult metric to really rely on to see what the real secular growth potential is of both segments. And so in the first half, we benefited in Seating because GM protected the full-sized pickup trucks and SUVs. And luxury, globally, held up better than the market itself, and so that really drove that outperformance in Seating and E-Systems. Ford is a great customer of ours. They're a little bit more than 1/4 of our E-Systems business, and they saw a pretty significant reduction in production across the -- their whole portfolio really in the second quarter. And so that drove sort of the negative on the E-Systems side. Looking out to the second half of the year, now what you're seeing is a little bit more pervasive reductions across all customers, all programs. But again, it's difficult to see the secular trends in both segments when you have -- it's not really the customer -- end customer demand that's determining volume. It's supply, supply of components, that's determining volume. So I think you have to kind of look past this year and even parts of next year to see what the real secular growth potential is for both of our business segments.

Okay. Yes. I mean, just to maybe just sort of bring back to sort of the comments you brought earlier, and I'm not sure if you even saw these edges, but sort of GM is sort of updating some of their semiconductor adjustment, and now they're talking about some of their full-sized SUV plants going back to full production next week. And so this sort of like choppiness, like maybe you were sort of privy to that information, but like how much in advance are you sort of getting some of these updates from your customers? You don't need to sort of call out GM specifically, just in general. And how difficult does that make it in terms of loading up the plants to deliver what your customers need?

Yes, I'll tell you, it's extraordinarily difficult. And really, it's based on the relationship we have with each customers. So you have the traditional communication through the releases that the plants receive each week. But what we're dealing with right now is more daily communication with most customers. And in the case of E-Systems, 3-party discussions between the chip supplier, the customer and us. And so it is changing on a daily basis, literally. And that lack of visibility makes it very difficult to plan the workforce needs in our -- particularly in our component plants and inventory levels for that matter. So it is a challenge. And what we're doing is really relying on the strong relationships we've built with customers to have the earliest possible insight to their thinking and their plans so that we can adapt and adjust accordingly. That's really all you can do at this stage.

Yes. And maybe just to sort of finish the conversation on the growth over market conversation. I think you've talked about greater than 4% Seating and maybe greater than 6% in E-Systems over time. Is that still the right way to think about that over a multiyear period as we think more towards the middle of the decade?

Yes, absolutely. Yes. I think in Seating, there's 3 primary drivers of that 4 points or so of growth over market. CPV growth in that space, we talked about -- historically, it's about 1%. It's been running a little bit more than that, 1.5%. I think this year, it will be even higher just because of that first half of the year, the mix skewed to luxury and some richer platforms generally. So that's one driver. Second driver is growing our JIT market share. We continue to take share in that space. We see a reasonable path to being the largest seat supplier over the next 5 years. And I think growing that market share from 23% to 28% that we've targeted is very achievable. In fact, we had $1 billion of net conquest awards in '19 and '20. We've got nearly $100 million again now this year so far. That by itself is almost 2 points of market share that we'll see come online over the next 4 or 5 years. So that's the driver. And then technology and innovation is really a key driver for us. So ConfigurE+ is our best example that we have 2 production awards, one is launched now, one we'll be launching in 2023. We just won our third program, a development contract with the third customer with ConfigurE+. It's not going to launch until 2026, but very excited about the growth prospects there. And then just our component business more generally. I think we don't talk a lot about it publicly, but it's a nearly $5 billion business in Seating. The combination of structures, cut and sewn trim covers, leather, fabric and foam. We see opportunities to continue to round out the component capabilities, capture more of that share on the component side, particularly in priceable features, comfort systems are interesting for us, both organically and some of the investments we've made and potentially inorganically as well. And so I think that will be the sort of last driver on the Seating side. In E-Systems, the 6% growth over market is driven by electrification, first and foremost. If you look at our backlog in electrification, $450 million of our $900 million backlog that we announced in January of this year, that drives 3 points of growth over market by itself. And our electrification business is growing by about 40% this year, 60% next year. That's a business that will be over $600 million in revenue next year after being around $250 million or $275 million last year. So that business is growing rapidly. That's a key driver of the growth. And then gaining share in low-voltage wire and connection systems. We're continuing to win business there. We see -- we're at about 8% of that market now. We see a path to getting to 10% or 11% as we look at high-voltage wiring. We think we can do better than 8% on the low-voltage side. And then on the connection systems side. It's a business that historically the $450 million business. We've talked about a path to growing that to $900 million. That's going to be a $600 million business for us next year. So just based on what we've been awarded, the benefit of the M&N Plastics acquisition and then new business that we've in-sourced to ourselves where we can -- that the combination of those 3 things has already driven the first $150 million of growth in that space. And then lastly, on the E-Systems side, CPV growth in low-voltage wire. I know the longer-term trend towards zonal controllers and new electrical architectures may reduce wire content. In the meantime, we're seeing significant increases in content. In fact, even with zonal controllers, we see the potential for low-voltage wire harness content to be higher than it is today. And so those are the 3 main catalysts for growing the E-Systems business at 6 points above market.

Yes. Maybe sticking on E-Systems, and I appreciate the drivers of outgrowth there. One of the other things you've talked about for a while in that business is the vertical integration that you sort of expect. And I think in your -- and I think last quarter, you put out a slide which showed that being a little bit of a positive next year and a larger positive as you think out to '23. Can you just, again, go through that process? What exactly you're doing? Where are you in that process? And what is it about sort of next year that seems to cause an inflection in that vertical integration?

Yes. So last year, we talked about in-sourcing parts that we currently buy on the outside where we have the ability to manufacture them. So that was sort of the first stage in growth, the sort of low-hanging fruit. The second stage is acquiring new capabilities like we did through the acquisition of M&N Plastics. And so not only do we get the revenue benefit of that acquisition, which is not a -- you get the capability to replicate that in other regions. So it's a North America footprint today. We see an ability to duplicate that in Europe and Asia to grow the business there. And then the last piece of it is the customer awards in connection systems. So we've been investing in that business, building our capabilities, both on the high-voltage side and low-voltage side. We've built the team out. We've brought in some outside talent over the last couple of years. We've built partnerships in that space that are giving us access to a catalog that we didn't previously have access to. All those things taken together are driving the near-term growth and even more so, the growth that we expect if we look out 4 or 5 years. And so I think we're well on our way to that $900 million target we've talked about. Just the fact that we've gotten the $600 million for next year is a good indication that we can do those.

Great. Maybe just on the margins then. You talked about -- I think, previously, you talked about somewhere around 3% in E-Systems for the quarter. Obviously, now with the volume and revenue coming in lower, it seems like there's a little bit of downside to that or maybe at least the lower end of the range. If I do some sort of quick math, I think the lower end was sort of more in the mid-2s. And I think you talked about something not quite 7% but a little bit south of 7% in the fourth quarter. How has -- sort of how the production has developed here changed that view at all? And then building on top of that, I guess, look, it is what it is. This is sort of out of your control or like for the balance of this year. I think what investors really want to understand is, what can we take from sort of the second half margin rate as we begin to think about 2022 that can take the margins higher so that, over time, we can get to that 10% target?

Right. Yes. And I think that it's difficult to draw conclusions from what you're seeing in the third quarter, just given how low the volume levels are. I think, on an annualized basis, it's something like 68 million units or 70 million unit global production level. So this is a business that needs value, that has higher fixed costs and higher variable margins, and so it is more sensitive to volume. I think of maybe a better kind of launching point for that discussion, maybe if you look at what we did in the second half of '20 and the first quarter of this year, and you annualize that, that puts that business at about $5.2 billion of revenue and a little less than $400 million of operating income, about 7.5% operating margins. And that's with some level of COVID premium costs and other inefficiencies that are a bit unusual as well. So it doesn't take you much to get to sort of an 8% number in normal circumstances with that volume level. That would equate to an industry volume run rate of about 84 million vehicles if you just look at global production over that time period. And then if you take a step back and look at, say, 2017 where volumes peaked at 93.5 million units, that's about 10% higher than the run rate I just described. A business with 25% to 30% variable margins with another 10% volume, you pick up 150 basis points in margin right there. That puts you at 9%, even with these inefficiencies that we're dealing with. So that's sort of the real, I would say, run rate potential of that business as we sit here today. So I think the lower volumes, the COVID cost, the chip shortage is really masking the improvement that we've made. As I mentioned earlier, we've seen 100 basis points of net performance improvement in that business this year. It just -- it doesn't come through because of what's happened with volume. So I feel very confident, even more confident in our ability to get to 10%, again, with some reasonable level of volume. And if you look out, I think what we said before, 10% by 2024, if we can get back to sort of that historical peak global industry volume, you only need 100 basis points margin beyond the volume piece of that equation to achieve that target. And although we've made a lot of progress, we're just at the beginning stages of seeing the benefit of the vertical integration that we talked about in connection systems, so margin expansion through that. We've improved margins on some of our newer lower performing customers, so more of that over the next couple of years, and the scaling effect of our electronics business as it grows into sort of the engineering investments that we're making right now. I think those are the 3 catalysts that take us to that next step.

Yes. It's a good point on sort of the annualized volume level. And maybe as we sort of think about the sort of same factors for Seating, obviously, the margins are a little bit higher, maybe not as high a fixed cost, maybe not as much sort of R&D investment and some of the other things you sort of mentioned. But as we think about -- I think you've talked about 7.5% plus sort of being more normalized. Like is it really just about volume in Seating? Or is there anything else we should think about to sort of get thinking about those margins over time?

Yes. In the Seating business, we've talked about 7.5% to 8.5% being the normalized margin range in that business. I think that's still the right range because the commodities and lower volumes price is at the lower end of that over the next year. But as we see the benefit of some of the proprietary technology launching that has a better margin profile, additional growth on the seat component side has a better margin profile. Those things taken together put us back to the high end of that range, and maybe even a little bit beyond that, we see a reasonable path to that level and beyond with that combination of maybe normalized steel or finish passing that through normalized volumes and then the effects of the mix of that business shifting a little bit in our favor in terms of the component side and growth that we see in that part of the business over time.

Okay. Maybe one -- a couple that sort of come in from investors, and I'll sort of try to put them together there. I know you mentioned the $4.35 billion for the third quarter. I know I -- you said that's sort of broad-based between -- they're kind of sort of broad-based between the segments. Is there -- I guess, maybe put it a little bit differently, like do you think this is -- I'm trying to sort of combine a couple of questions here. Is this timing such that maybe the third quarter is a little bit lower than you would have thought? Or what customer -- or what sort of came in different from maybe what you thought about a couple of months ago when you talked about the back half of the year?

Yes. I think we were seeing reductions in the schedules that were in the sort of $30 million to $50 million a week in terms of the impact prior to establishing our guidance. And we talked about our guidance at the time, the high end represented everything we knew at that point, and the range was intended to cover additional reductions. We saw an acceleration in the last 5 weeks to the sort of $100 million a week of new reductions all in the third quarter. It's hard to say if any of that would be made up in the fourth quarter. I think perhaps it's more likely that gets made up next year and beyond. And it's difficult to say whether that $100 million pace per week continues on. We're hopeful it doesn't, but I think that there's more uncertainty with customer production generally right now than there was 5 weeks ago. And it's -- so I think that's going to weigh on us here in the near term.

So that -- just to put a final point on it, and then we can sort of wrap up. The whole sort of back half of the year guidance assumes something in that $30 million to $50 million a week. It's more recently gone to that $100 million a week. If that persists, then obviously, there's still a little bit more risk even to sort of the fourth quarter as well. That's the way to think about it?

I think that's a fair way to think about it. And what we have to sort out is whether the recent reductions are -- in order for the customers to maybe clear some of the partially built vehicles and then production comes back, or if it's indicative of something, a greater level of shortage. And only time will tell on that. And I think it's also dependent on whether there are further government mandated shutdowns in places like [indiscernible] that would put pressure on supply.

Yes. Okay. Well, I think, Jason, with that, we're out of time. So I want to, again, thank you for your continued participation in our conference. Really appreciate it, and thanks for all the color. Thanks to all the investors who joined in as well. And that will conclude the session. Thanks again to the entire Lear team for your participation. Really appreciate it.

Yes. Thank you, Joe. I appreciate you hosting the event.

Take care, everyone.