Lear Corporation (LEA) Earnings Call Transcript & Summary

Great. I think we're live. Thank you, everyone, for joining as we continue Credit Suisse's ninth Annual Industrials conference, the autos track the conference. I'm Dan Levy, I lead autos research coverage at Credit Suisse, and very pleased to have with us Lear Corporation, a leading Tier 1 auto part supplier with solutions both on the seating and the electrical architecture side. We have with us today, Ray Scott, the company's President and CEO; Jason Cardew, the company's CFO. We're going to go through a series of fireside chat style questions. Anyone who has questions, please feel free to evenly [email protected]. I'll do my best to weave in those questions anonymously. But otherwise, Ray, Jason and team, thank you so much for joining.

Yes. It's great to be here, Dan. Thanks for having us.

Great. Well, why don't we just kick off, and I think this is a question we've been asking everyone else is -- maybe you can just give us a flavor for how the fourth quarter is shaping up versus expectations that you laid out a month ago. You could frame that in any way in terms of what's happening with production volumes, whether you're seeing more visibility or better schedules. And then if there's any update that you might be able to provide on the implications for guidance, if that's something you can talk about, that would be great. So why don't we start there?

Okay. Sounds good, Dan. The fourth quarter is playing out about how we had expected when we issued guidance at our earnings call a month ago. So I'd sort of describe it as a hybrid of what we saw in the second quarter and the third quarter. From a revenue standpoint, our sales per week are sort of running in line with what we saw in the second quarter. So a little bit of an improvement in overall production volumes here in the fourth quarter relative to the third quarter. From a shutdown and disruption standpoint, it's a little bit more like the third quarter. So we're still seeing the short-notice shutdowns from our customers. And so it's definitely remain challenging from an operating environment standpoint, driving some additional premium costs and efficiencies in our plants, particularly in our more labor-intensive plants, in our wire facilities, in our cut and sewn trim cover facilities where you have some trapped labor costs as a result of the short notice of the production shutdown. So what that means relative to what we guided to, at the midpoint, our revenue guidance was just over $4.6 billion in the fourth quarter. We're going to come in a little bit better than that as we sit here today, probably between $4.6 billion and $4.7 billion, maybe a little bit closer to $4.7 billion, and so a little bit above the midpoint at this stage. There's still a couple of weeks to go. So I'll put that caveat out there. And then on the operating income side, we're sort of at the midpoint of our guidance, $132 million, I think, is the midpoint. We're right around there, maybe a little bit lower than that as we continue to deal with these operating inefficiencies, premium costs caused by the nature of how the production is being taken out by our customers with short notice. So the conditions are improving somewhat from the third quarter, but they're still challenging as we head into next year. And so we're taking some steps on our end as we have been throughout the year to adapt to a lower volume environment on certain platforms where we see customers signaling to us that they're going to have lower volumes on certain car lines next year. We're continuing to take headcount out to adjust to that lower volume level. We've actually reduced our hourly head count by about 11,000 throughout this year, mostly through attrition, but some of that has come through restructuring. I think that better positions us to adapt to this lower -- or operate in this lower volume environment. And at the same time, we're not taking physical capacity out. So if the volume does come back, it's simply a matter of rehiring people, and ramping back up. We're also working with our customers on recovery of many of the inflationary cost increases, the premium cost, the inefficiencies caused by both the extended downtime taken on certain car lines as well as some of the short notice downtime. And I'd say the last thing that's changed since we issued guidance is we're seeing a little bit of softening in steel prices in North America. Welcome retrieve from that run-up that we saw throughout this year. Not a lot, but it's come down. For example, hot rolled steel, I think the most recent crew index was down around $1,700 a ton. It peaked at over $1,950 a ton at the end of September. And so perhaps the year-over-year commodity headwind, maybe a little bit less as a result of that. I think it's still -- at this stage, it's still a headwind, but it's less so than it was, say, 4 weeks ago when we provided guidance.

Great. And just a follow-up on that. To the extent that the commodities stay where they are, any implications on what this may be for 2022?

Yes. What we talked about on the third quarter earnings call, I think, is that there'd be about $130 million incremental costs year-over-year if commodities remained at what we were seeing in the fourth quarter at the time, and about half of that would be offset through pass-through agreements, the lag of recovery. I mean that was really on the Seating side. So I would say, based on what we're seeing in the most recent crew index, the impact would be a little bit less than that. Steel is one of the bigger components of that $130 million or $65 million net headwind that we saw in the Seating business next year. So at this stage, that's really all we can say about next year. Obviously, there's a lot of moving parts, Dan.

Great. Why don't we pivot to the segments, and let's start with Seating. We know that you had a history of vertical integration actions on the Seating side. And the Kongsberg deal where you're acquiring their interior Comfort Systems business, that's the latest in one of your investments. So maybe you could just give us a sense of big picture how that fits into the overall strategy in seating with vertical integration. And maybe you could say where you are now, how do you think you stack up relative to your competitors vis-a-vis Seating vertical integration capability?

Yes. Thanks, Dan. It's a good question. And kind of, first of all, Kongsberg was a very focused and an intentional acquisition, and we think it's going to be great. And we have other potential acquisitions in the pipeline that we believe will provide similar benefits. But if we take a step back, our strategy has been to extend our market leadership position in luxury and premium seating by investing in what we've described as INTU Seating, and we've been doing that way -- I mean 6 to 8 years, we've been investing in that and designing very specific patents and technologies that are going to be embedded into the seat. And we felt it was at a point in time when it was appropriate that we bring in capabilities in our own house around engineering and manufacturing. And that's really what Kongsberg is going to do. We see the opportunity for growth in priceable features accelerating across all high-volume segments, not just luxury, but there are -- and there are limitations to that going across high production volume in -- particularly in rear seats because of cost and mass and performance and packaging, and we absolutely believe and see a need to develop an integrated modular system to overcome these issues. And we specifically targeted Kongsberg. And we're, like I said, continue to pursue other very similar sized companies that are actionable and that will continue to give us benefits that I described as far as creating a value proposition for not just our customers but the end consumers. And the Kongsberg acquisition was a great fit to help us execute our vision. There needs to be a systems level solution. You just can't solve what I'm describing by supplying a bag and a blower. Today, every single layer, every single component that we can control and design help integrate a much more efficient system. And it's a combination of different components. The way these components are designed and engineered today are independent. And we believe the integration between trim plus pad, foam components and the actual components for pneumatic lumbar or lumbar features or heat and cooling components have to be integrated. And there's a solution there that will create a value proposition for our customers, like I said. So the layered approach or the systems approach that we're really strategically going after is a different way of creating value. And so we believe that this is the right acquisition. We're excited about it. We, like I said, have other smaller acquisitions targeted that will give us innovation and technology that will create a value proposition, will recreate the way we look and design these priceable features so that they not are just luxury end products, but they could go across higher volume models across different segments. And so in the near term, one, it's going to be just integrating and helping Kongsberg. They do a great job from a manufacturing perspective, but seeing where we can help from our operational expertise, utilizing Lear's purchasing scale to support costing synergies. So in the short term, we can continue to have a much more cost-efficient system, and also continue to just develop a much better system in terms to time to sensation. And then that's something that is a big part of customer preferences, and something that we believe we can dramatically change. In the midterm, we've already been talking to the customers is a solution that I mentioned. It's vastly improved complete seat integration, starting from a clean sheet for lower cost. And what we've done is we've targeted all the components within the seat today. We believe we can actually reduce 50% of the complexity within the seat system when we talk about integrating lumbar and heat and cool elements into the seat. We believe that, that type of packaging will allow -- right now, the packaging is a big contributor to not going across multiple different roles within the vehicle. A much thinner profile is exactly what we're working on and designing today. And we believe that the efficiencies will also be attractive to our customers. And so in the midterm, looking at mid-cycle enhancements where we can offer a solution for our customers that is significantly improved. And then longer term, exactly like I mentioned, Dan, there are some other ingredients that we're working on that are inorganic, but also organic that we have in-house to really build a modular concept that can be packaged across multiple rows, and really solving for a customer issue today from microclimate to comfort the packaging to efficiency to lightweight. So it is at the point that we thought bringing in-house was absolutely valuable to Lear Corporation. We love the fact that they have great engineering, great manufacturing capabilities combined with the work that we've been doing for the last 6 to 8 years on improving the overall efficiency of those systems is going to be a very powerful tool in our ability to differentiate ourselves and also continue to work on our path that we talked about growing our seat -- our Seating market share of 28%. So really excited about, Dan, and looking forward to finishing it up hopefully in the early part of the year, so we can really start working on some of the things with our customers longer term.

Great. That's actually really helpful color. Let me follow that up. So you're expanding your capabilities here. I think you're talking [Technical Difficulty] and long-term potential, more modular concept. How does that fit into? I think we all know that there's a lot of changes in vehicle architectures in the vehicle as a whole as we move to an EV world. So an argument could be made that automakers are struggling with the content cost of EV. They're looking for any way that they can cut out other content to save few dollars here, a few dollars there to better fund the EV content that they have. So with all that being said, what's the commercial discussion with customers as you go into the EV world? Does it create a tougher pricing discussion? Or are there ways that you can work collectively to you take out some content, but you get the same, you pass on the saves in that way, it's a win-win. So what's -- how does this all play into the transition to an easy role? EV, good for Seating? Or is it neutral? Or is it negative?

Well, if your so we're approaching it. And again, you're right, our customers are always under pressure. It doesn't matter if it's ICE or EV, and obviously, with some of the cost in EV, there might be obviously more pressure today. But as costs go down, obviously, they're going to see the benefits. But I will say this, what we're doing -- and when we talk about these solutions or these value propositions. One, we do an excellent job from a cost technology optimization. We do a really good job at designing out cost and making systems more efficient. And I think that plays them perfectly with what I'm describing with this modular concept. What we have today is layered independent design components that get packaged into a seat. And there's no question that the customers are going to still want content. I think one of the major OEs just announced the unfortunate lack of heat mats. And I think we saw how quickly the customer said, well, you don't have heat mats, and I'm not buying the vehicles. So these things are very, very powerful with the customers in respect to what they prefer as far as content. And we see that increasing. And with this proposition that we're talking about, literally, we can cut 50% of the content, the parts, have a systems integration solution that is much more efficient from a cost perspective, but also gets the customer what they're looking for in respect to efficiency because this time to sensation is a big issue. And the noise ramifications is a big issue. Being able to cut through the layers of like I said, trim, foam, integrated components is a significant step in the right direction. So they get a lower cost, we get greater value because we get to go across multiple seats. And I think in addition to that, think about the micro climate in seating solution that we have. Right now, the HVAC system pulls about 20% of the battery usage. And our customers are looking for any way to extend the battery usage when we talk about EVs. Well, one of the -- like I said, the big contributors is that HVAC system. They're trying to heat and cool occupants within the vehicle throughout the whole cabin as opposed to just the seat system. So what you do is you cut the cost of the HVAC, you're more efficient in the battery consumption, and you put the features. What we've designed is we have algorithms in very specific software in our modules in the seat that determine when to change the preferences for comfort with the microclimate. In addition to the components are much more efficient. So there's a vehicle savings. There's obviously a cost within the system of the seat. But overall, there's a savings to the vehicle. The same thing holds true with ConfigurE+, what is working out extremely well when we shift to EVs is the floors are significantly flat. And so we have the ability to take out all the harnesses because we power the seats to the rails. It gives you the ultimate reconfigurability of flexibility. The customers are now looking for a way to differentiate their products where they can have passenger seats. And then in some cases, flip those into cargo units or cargo systems. And so we're getting a tremendous amount of traction because the system from a vehicle architecture is significantly lower in cost because you take the harnesses out other connectors, et cetera, and replace it with a rail system that allows you that ultimate flexibility. So I guess the short answer, Dan, is we're using innovation and technology to come up with solutions that are more efficient obviously allow us to gain access into growth areas but are much more efficient from the customer's perspective, and still retaining that ability to give the customers features.

Great. Let's ask a question about margins. Jason, maybe you could give us a sense. For this segment, this segment has been -- you've talked about midterm margin expectations, 7.5% to 8.5%. What entry conditions do you need to return to this margin range? Or is there a new normal given some of the costs that you have. So maybe you could just give us an update on interim margin picture perspective.

Yes. Sure, Dan. So I think if you look back at the second half of last year and the first half of this year, we ran at the low end of that range, and that was despite the fact that we were dealing with some premium costs related to COVID that was before the run-up in steel. So in a normal commodity price environment, absent COVID-related costs, I think, an 80 million unit industry production levels certainly allows us to get into that range. If you look at the elevated commodity costs that we're dealing with today, it'll probably take something closer to 90 million unit production environment for us to offset the impact of commodities and run at 7.5% to 8.5%. I think as I mentioned earlier, that we are seeing steel come back down. And so that will certainly accelerate our path back to targeted margins. And I think even if it doesn't get back to 2020 levels of $500 or $600 a ton, it will be lower, likely in the first half of next year than it is in the second half of this year. And I think 2023 will certainly be lower than 2022. So there's going to be margin expansion through commodities coming back down, particularly steel over the next 18 months. I think combine that with a return to something more normal on industry volumes, and it's -- the path back to 7.5% to 8.5% is pretty straightforward for us. And if you just kind of read in through Ray's comments about what we're trying to do with the modular strategy and the Kongsberg products and how it'll be embedded in Seating. Structurally, that's a higher-margin area of the business than our just-in-time seat business. And so we see that as a pathway longer term to expanding operating margins beyond that 7.5% to 8.5% range. I'm not talking about next year or even in 2023. But certainly, if you look out to 2024 and beyond, there's a path beyond 8.5% in this business based on the opportunities that we now have as a result of that acquisition and some of the other things we're working on with the portfolio.

Just to tack on to that. So you're saying path back to 7.5% and 8.5% as you have commodity prices coming down, volume getting better. That's helpful level of the 80 million versus the 90 million. One more mix to that -- one more to that mix, how does that factor in because you're probably getting some superior mix right now?

Yes. I think that the platforms that our customers have prioritized certainly has benefited Seating, and I think you see that in the growth above market running beyond what it has historically. Over time, there will probably be some normalization of that. But I wouldn't say it's going to have a meaningful impact on operating margins. The bigger impact for us is the level of vertical integration on the platform. So there are a number of highly vertically integrated platforms that customers have cut production in this year that have been very painful for us in Europe, in North America. And so I don't see mix as being a significant factor in the margin equation as you look out into next year and beyond.

Great. Let's -- Jason, same set of questions, but let's pivot to E-Systems. And maybe you can -- obviously, we're seeing the same dynamics, pressure from industry volumes, commodity are in issues there. I mean it's been trending right now to call it, 3% margin. You have this 10% margin target. What -- is 10% still on the table? What needs to happen for E-Systems to get back to 10% aside just from pure industry volume? And if you have any of those similar sort of levels at 80 million or 90 million, that would be helpful.

Why don't I start? Just First of all, I couldn't be more excited about the progress that we have made in these systems. In fact, we are moving at a faster pace than I first would have thought. We really are concentrating on the items that we can control, and we have made good progress on the plan that we laid out a few years ago. We talked about diversification of our customer base. And it's amazing what we've done as far as adding new customers to the mix really led by General Motors, Volvo Geely, Volkswagen and Renault. And we're really growing our connection systems business, not only through acquisitions but organically. And most recently, the acquisition of M&N Plastics has far exceeded our expectations, and that's primarily a North America business that we're quickly accelerating to grow into Europe and Asia. And the partnerships that we've been able to establish. IMS is a great partnership for us to really accelerate our high-speed data connections business and the pending JV that we have with Hu Lane, which is going to give us great access into over 1,400 different components within the [ catalog ]. And so we're really doing a nice job, I think, organically and inorganically in connectors, which we talked about that being a big part of our return back to 10% margins. And we also are improving our Asia business. If you recall a couple of years ago, we consolidated a couple of key customer businesses, one, FAW and SAIC. And we've done a nice job of taking over the management responsibility and improving on those businesses. So that's still going to be some time, but they're doing a really nice job of improving that. So the margins, I think, as we continue to develop these relationships and these customers are going to continue to improve. And I think -- we also are going to keep an eye on any smart acquisitions or partnerships we can continue in addition to the ones I mentioned. So I'm going to turn it over to Jason, so he can give a little bit more detail on the financials, but I am impressed with what we're doing.

So Dan, what I would add to that is if you look back at the second half of 2020 and the first quarter of 2021, you annualize that volume. That's about an 84 million unit global industry production. We ran at 7.5%, and that was with ongoing COVID premium cost. So you call it 7.5% to 8% business. I think that's a better indication of the current run rate of E-Systems as we sit here today. The building blocks beyond that to get to 10% -- there's really 2 or 3 key components. One, continue to grow the connection systems business. That was a $450 million business for us, historically. It's going to be $600 million next year. Every $50 million of growth there is 10 to 20 basis points of margin accretion in E-Systems overall. So we're looking at 50 basis points roughly just based on the growth in that business that we've signaled for next year to $600 million. We see a path to $1 billion business there in 2025, 2026, over $400 million of incremental growth in connection systems. So you're talking another 100 to 150 basis points of margin expansion as a result of that. If copper normalizes to the 2020 levels, you pick up another 50 basis points. And then lastly, as you continue to scale up the electronics business and maybe that engineering headwind diminishes somewhat the pathway to 10% in 2024 is pretty straightforward.

Great. A question on capital allocation. Maybe you could just give us an update there. You increased the quarterly dividend, the $0.77. You've been buying back stock. Just what's the capital allocation strategy now that we've been coming out of COVID? I know there's been some lumpiness in the volumes, but the free cash capabilities of the business are still obviously there. So any comments on the capital allocation side.

Sure, Dan. Yes. I think if you look at this year, it provides a pretty good blueprint for investors on how we're thinking about and how our Board thinks about prioritization of our capital allocation. And so first and foremost, we're going to invest in the business organically, inorganically. You saw that with the M&N Plastics acquisition, in the Kongsberg acquisition, in Seating. We have access to pretty low cost debt. We financed the Kongsberg acquisition through a bond issuance. And we also took advantage of market conditions to improve our maturity profile at the same time. And so if you look at what free cash flow we have generated this year, we've essentially returned all of it to shareholders through our dividend, which is really important to us to get that back to the pre-COVID level. We've now done that, and then the balance through share repurchase. We've returned 100%, maybe even a little bit beyond 100% this year to shareholders. And I think if you look at what we've done over the last 10 years, we bought back 52 million shares, almost $5 billion of share buybacks. And you look at how we've positioned this business to do well during the recovery. We've positioned it for revenue growth, earnings growth and significant free cash flow growth, and we intend to ramp up our share repurchase program as those cash flows improve. We think we can finance some of the tuck-in acquisitions that Ray referred to earlier. We have a clean balance sheet with no near-term debt and then use the free cash flow we're generating to really reduce the share count and create value for shareholders that way.

Great. Just a final because I know we're running up on time here, and I've gotten this question from a few people, and this is just sort of the bridge into 2022. So I'm not going to ask for the full bridge. I'm sure you'll give that to us when you're reporting. But maybe you can just broad strokes, remind us. If we're looking to '21, we're bridging to 2022. Just what some of the large moving pieces are beyond just, okay, industry volume will be higher or wherever you expect? So any big picture -- big moving pieces within that.

I think the 2 biggest drivers year-over-year for us are going to be the rollout of a very strong backlog. I'm not sure if we provided that number on third quarter earnings call. It's well north of $1 billion of incremental revenue next year. Our backlog, our 3-year backlog is higher than it was in the prior backlog we announced at the beginning of this year. So that's a catalyst for revenue growth and earnings growth '21 to '22. And then kind of going in the other direction, you've got the commodity headwind. And so it's just a matter of where does steel prices end up, where do other commodity prices end up as we look into next year, and we're in negotiations with suppliers at this stage. It's just -- Dan, unfortunately, it's just a little bit too early to call that impact. As we sit here today, that looks like it's going to be a headwind heading into next year though. Those are the 2 biggest swing factors outside of whatever happens with the industry volumes.

Great. Okay. Well, we're over time, but we'll leave it there. Ray, Jason and [ entire ] team who isn't in the camera, but I believe is into the [indiscernible]

He's here.

Thank you. Thank you so much. We really appreciate the time, very insightful, and we look forward to hearing more at the narrative unfolds.

Yes. Thank you, Dan. Thank you.

Thanks, Dan.

Great. Thanks.