Lear Corporation (LEA) Earnings Call Transcript & Summary

From a global light vehicle production recovery. And I think it's important at times like this to remember that we've been at the trough for the past 2 years. We were running north of 90 million units a year in 2019 and prior, we were at 75 million in 2020 and again something like that in 2021. So a lot of recovery still in front of us. We're still at the bottom. And there appears to be some additional torque here at Lear, based on the company's exposure to secular trends as well as the operational improvement and margin expansion that we've been seeing. So Ray and Jason, thanks for joining us.

Yes. Thanks for having us, Rod.

It's great to be here.

So to kick things off, Ray and Jason, I was hoping just to get your latest views on the production environment and what you're seeing. So there is some expectation of recovery. There's obviously a bit of nervousness about what that is really look like -- looking like. Some suppliers are a little bit more optimistic than others. You were assuming something like 6% growth for this year. Can you talk about broadly what you're seeing here just in the first beginning parts of the year and what you've got some visibility into?

Sure. Yes. I think our midpoint -- the midpoint of our guidance was based on industry growth of 6%. I think on a sales-weighted basis it's more like 10%, because Europe and North America are growing a little faster than what we assumed in China. And as we look at how the year has started, certainly the first week or so was a bit bumpy as the OEMs tried to resume production, and the supply base did as well, coming out of Omicron and dealing with absenteeism and things like that. It was a little bit slow first week or 2. But I would say the last 4, 5, 6 weeks have been pretty strong, a little bit better than what we experienced in the fourth quarter. And so I'd say that the year thus far, holding the kind of geopolitical issues and macroeconomic issues aside for a moment, what's happening, I see some opportunity in the first quarter to maybe do a little bit better than we had anticipated. We had the industry down 5% in the first quarter, and I think we'll be a couple of percent better than that as we look out at the first quarter in terms of the production environment, Rod, specifically.

That's good to hear. Hopefully it continues. I'd like to maybe talk a little bit about the outlook here for 2022 and 2023 and beyond, just to frame things. So -- but first, maybe just to recap your recent history. If we go back to 2019, Lear was a mid-6% EBIT margin business. Last year was 4.3%. This year, you're looking for 4.9%. So improvement despite some of the cost headwinds. If we pencil out what the company would look like if you hit your target margins, 8% for seating, which is 75% of your business, 10% for E-Systems, which is 25%, it comes out to a blended average of about 8.5%, right? Subtract corporate overhead, you'd be kind of a low to mid-7% margin business. Obviously, if E-Systems grows faster than Seating in the future, that's upside based on mix. Can you talk a little bit about what's happened here over the past 2 years? How much of a drag has production been? How much have you seen from commodities? What's happening behind the scenes in terms of performance and it ultimately starts to come through as the industry recovers?

Yes. Let me -- I'll start it, Rod, and just give some general thoughts and then Jason can kind of follow up with some of the numbers, because as we've discussed, there's a lot going on. And I think it's important to take a step back. And to your point of 2019, we really put a tactical plan in place, a strategic plan around the trajectory and improvement of margins in E-Systems. And what we discussed and what we outlined was, one, we're going to -- and we've been through this before. Jason and I went through a very similar situation in Seating back in 2012 and '13. If you recall, we had really looked at the business, relaid the business out organizationally, structured on, focused on, driving accountability within the different business segments, looking at each one of the businesses independently and making decisions based on our right to win. And we spent tremendous time over the last 2 to 3 years really assessing where we're positioned, what type of returns we're getting in different regions and by product lines. And we've made some changes even to our product portfolio from that period of time, and vertically integrating was something we talked about as being key to driving margins and moving forward and customer diversification in growing the business. And so if you look back to '19, we laid that plan out, and you fast forward to today -- before we get into some of the numbers -- we've been very successful. We have one hell of an organization in place, and it is aligned around driving accountability in the business, starting with Carl Esposito we brought in to run the business, and then setting up business groups within power distribution, connectors and electronics. And so really driving that financial responsibility within the organization with great leadership. Then you look at the vertical integration and how successful we've been. We've partnered with some of the best companies to continue to vertically integrate. You think about Shinry, Hu Lane, IMS in respect to getting at some of the capabilities and enhancing our connectors technologies and building our business with these partnerships. And the most recent acquisition with M&N Plastics. We're already at full capacity, and that business makes double-digit returns. And so we talk about the need to vertically integrate with engineered components, that was a key acquisition, and like I said, we're already at full capacity, and that's North America primarily. We're already looking at investments in Europe and Asia to continue to vertically integrate, and those are components that we can source ourselves. And so it's a matter of how fast we can deploy capital and engineer the components that will be fully integrated into our harness business. And then most recently, you've seen the announcements on growth in electrification. And so you look across the board and what we've done with low voltage, high-speed data, high-voltage wiring electrification, we're doing a nice job of diversification of our product mix and also doing a really nice job of our product strategy within the areas that we want to participate in long term. And so I step back with E-Systems, everything is on track strategically and tactically. I'll talk a little bit more about the margin and some of the headwinds we've seen that don't really represent that clearly today. And I think the second element you talked about is Seating. Well, we've done a really nice job there. It wasn't that long ago, we were 19% market share. We're 25% today. We had over $1 billion of conquest wins, really, really strategic wins, against some of the most fierce competitors in the marketplace today. And in addition to that, we continue to strengthen not just our investments within our JIT manufacturing capabilities with Industry 4.0, automation and other technologies within our manufacturing plants, but the technology in components, this thermal comfort is something that we've talked about, priceable features. We've done a nice job. The Kongsberg acquisition, which we're hoping to wrap up here really quickly, continues to put us in a position of integrating components in a very unique way with technology. And our customers couldn't be more excited. We're getting incredible positive feedback from our customers on how we can really look at the product longer term, much more technical, much more innovative. And then the reconfigurability within the vehicles. We've done a nice job of creating technologies within our ConfigurE+ capabilities. And so a lot going on in Seating, but I think it results in growth. And like I said on the earnings call, that's one of the best compliments we can get from our customers, and continued growing both parts of our business. And so -- when you step back aside from all the things that are somewhat out of our control, we've done a really nice job of executing our strategy that we defined very clearly back in '19. And Jason, I'll let you go ahead and kind of explain some of the numbers.

Rod, I think it was a good question the way you framed it here. So looking at '19 and fast forward through the last 2 years, it's hard to see the underlying performance improvements because they've been obscured by the impact of lower industry volumes, commodities, COVID premium costs. So if you just look at the math, industry production is down about 14% over that 2-year time period. Our platform volumes on existing platforms down 14% over that time period. On a sales-weighted basis, the industry is down 19% over that period of time. So we have offset some of the industry reduction with favorable mix. But nonetheless, revenue due to volumes off $2.8 billion over that 2-year period of time. And we've offset about a little more than half of that with our backlog rolling out about $1.7 billion of backlog, but if you look at sort of the combined impact of that on operating margin, so volume rolling off at your variable margin level and then backlog rolling on at or slightly above our set margins, the combined effect of that is a 225 basis point reduction in margins over that time period. You add to that what's happened with commodities and COVID, you've got another 150 basis points of margin contraction. And so those things taken together lowered margins by 375 basis points. Our operating margins over that time period are down about 230 basis points. So we have 145 basis points of net performance improvement. So we had positive net performance in 2020. We had it again in 2021. We've signaled that again in 2022. So the things that we can control, whether that's the operating improvements we're making in our plants day-to-day, our commercial negotiations, our CTO and VAVE activities and our restructuring program, all those things taken together, coupled with what Ray described in sort of redefining how we're going to run E-Systems, focused on improving margin of every program, every product, the combined effect of that is showing itself in that net performance line. And so absent these kind of macro issues that have weighed on margins, you could see a path to clearly back into the 7%s and even beyond that in terms of the total company margin potential in a more normal volume environment, a more normal commodity environment, and one absent of this sort of staffing and starting of production around the semiconductor shortages.

Great. That's really helpful to frame it that way, because I would think that a lot of the things that you guys have done will stick around, and when the production comes back at any level of production, you're going to be more profitable. Talking about this year, at the midpoint you're expecting margins to increase by 60 basis points to 4.9%. Very modest production improvement and a pretty stiff headwind from commodities and labor. Could you just talk about the puts and takes that we're looking at for -- looking at for 2022?

Sure. And we sort of laid this out on the earnings call. I'll walk through kind of the big pieces of this. So we have revenue up at the midpoint $2.3 billion or roughly 12%. And that's on an industry volume increase of 6% and a sales-weighted industry volume increase of about 10%. As you mentioned, operating margins are up 60 basis points at the midpoint. But we do have a fairly wide range in the full year margins, as low as 4.3% and as high as the mid-5s. If we -- if the industry volumes are more aligned with IHS and we have successful negotiations with both our suppliers and our customers on some of the inflationary pressures, you could see margins in the mid-5s this year. I think it's also important to highlight some issues around the cadence of earnings this year. And so we didn't really get a chance to talk about that on the earnings call, but for 2 reasons: the first quarter is sort of the trough margin for us at Lear this year because we have both a little bit lower industry volumes than we will expect to see in the subsequent quarters and also just the way our contracts are laid out on some of the commodity pass-through agreements. So particularly in our leather business, where there's a lag on the recoveries, that will weigh on Seating margins a little bit in the first quarter. And then we'll see the benefit of that in the second half of the year. And so you'll see a little bit lower margin perhaps than you would have expected in the first quarter and then sort of building from there into Q2 and into the second half of the year, driven again by volumes gradually recovering, steel costs have started to moderate. We'll see some benefit from that in the second quarter. And then just these contractual pass-through agreements on things like leather hides. And then lastly, our commercial negotiations around the noncontractual inflationary pressures that we're dealing with in the supply base and in our own business that we're working to pass through. We're not going to sacrifice the quality of a deal commercially just to maximize the first quarter margin. So if we have a path to a better agreement that may benefit the business longer term, we may sacrifice a little bit of Q1 margin to see some benefit in subsequent quarters, just depending on how these negotiations play out, which, as I'm sure you know, are very complex given the very dynamic environment we're faced with.

And can we talk about these recoveries in negotiations? So it's a huge headwind in 2022. I think it was maybe 70 basis points or something like that on the margin from commodities. And that's after another -- after an impact you had last year. It sounds like it's coming from maybe less commodity and more other inflationary factors like costs that are being passed on from Tier 2 suppliers. Can you give us a little bit of insight into how the negotiations with OEMs work? Are you locked into pricing? Is there room to adjust for, some of these things that are not typical, like labor or Tier 2 components? But -- by the end of the year, what's kind of the whole that you still need to cover, the cumulative headwind that you've been absorbing?

Maybe I'll walk through the numbers, and Ray can add a little bit of color on the negotiations themselves. So '22 is a little bit different than 2021. So last year, it was predominantly or almost exclusively raw material buy on our end that drove the headwind. So primarily steel and copper was about 70% of it and then 30% chemicals and leather hides. As we look at 2022, a little less than half of it is those same raw material inputs that we're buying, the 4 that I just described. And then the other little bit more than half, or 55% of it, is component cost related as well as sort of these nonlabor-related inflationary pressures we're seeing on things like ocean freight and other items like that. Utility costs, for example, in Europe are another issue. And so within -- but within the rest of that sort of component bucket, it's driven by the same things that impacted us last year. So it's -- on the E-Systems side, it's suppliers trying to pass through the effects of higher copper costs and higher resin costs on engineered components, connection systems, things like that. Most of those are directed contracts, and so there are more 3-party negotiations. On the Seating side, it's things like steel, that are embedded in parts that we're buying where we had some contractual protection. But over time, just the significance of the steel increase has weighed on our supply base. But it's also things like yarns and other components that we're seeing some inflationary pressures on. And the most significant impact is certainly in the first quarter, and it gradually dissipates as you work through the year, partially because of the mechanics I described earlier and partially because of the nature of the commercial negotiations with our customers. And so you get to the end of the year, I think that the impact at that point in time may even be positive on a year-over-year basis, looking at '21 to '22. And so the negative impact is really concentrated in the first half of the year, just mechanically.

Yes. I think this might be a blessing in disguise, but our E-Systems business has been entrenched with working through some of these issues, starting with the chip situation well over a year ago. And so what we've done in both Seating and E-Systems, and it started with E-Systems and dealing with the cost increases relative to chips, is put together a very thorough process. And one thing that we understand with our customers as we bring different costs forward, it has to be auditable, and you have to audit it down to the cost relative to what the request is. And so we have one heck of a process in place that really combines engineering, our purchasing groups, our commercial teams, our finance teams, to really bring those issues forward. And I think of last year as more temporary in nature. We negotiated under, let's say, a quarter or a half year type solution to resolve. And what we're looking at this year from our suppliers is more of a fixed request that's more longer term. And so you have to have the data in place to really put in front of the customers because there are suppliers that have multiple different platforms or multiple different customers that we put material in that have to get resolved. And so we've been working and we've been successful with the majority of our customers last year. This year, I would say the change is more into the Tier 2 in respect to price lifts and also more fixed. And so far, we've had some really good conversations with our customers. And Rod, I think if you recall, it's not just the requests for inflationary costs. It's also ways that we can work because we do have the productivity agreements in place where we can help offset some of the cost in a particular period of time, or what we call CTO or VAV, where we have hundreds of millions of dollars in the pipeline right now with different customers where we can use those savings as offsets for particular requests. And then in some cases, when you think about Seating, depending on the platform, 75% to 80% of the seat could be directed. And so those are just 3-way conversations that we have with our customers, with expectations that the price will change once the customer approves it. And in E-Systems, it can range from anywhere from 30% to 40%. And we do have more flexibility with some of our ability to get at some cost savings through VAV. So a lot of different ways we go at it. And then just from our operational, we did a really nice job of efficiencies gained within our operational plans, getting very aggressive with how we're going to manage our plants under this new environment. So far, last year went extremely well, I think. I think the team did a nice job. This year, slightly different because of the fixed nature of some of the requests. But so far, the customers have been working with us and talking to us about ways to solve it.

So just to clarify this. So the impression of investors is that you have a contract with GM or BMW or whoever it is, and there's a seat set that's $700 and that's spelled out in the contract. Does it not really work that way? Is it sort of -- are there brackets around that? Is there -- what is the latitude that you typically build into these contracts to adjust for things like labor, energy or Tier 2 component costs?

Go ahead.

I mean every customer is a little bit different. But as Ray just described, oftentimes in Seating, you'll have between 75% and 80% of the bill of material that's directed by the customer. And so if there is a request for a price increase on a component that's directed, it's a 3-party discussion. So what you're really dealing with is the residual piece, the portion of the bill material that you're responsible for sourcing, or if you're manufacturing individual components, it's your responsibility as well. Oftentimes, there will be volume clauses in these agreements. There may be direct pass-throughs on certain commodities. Certain customers have steel resale programs where they're effectively buying the steel for you or you're using their leverage to buy the steel. So it varies depending on customer and commodity, but there is a sort of joint ownership [indiscernible] issue contractually and practically with our customers.

And that's why it gets back to the point, Rod, you have to have a very thorough process because it is going to be audited at the end of the day. You are bringing in a directed supplier in some cases, that has an agreement with the customer, and our contract with them that has to be modified either up or down. We are not allowed to change directed components up or down without the approval of our customers. And then there's cases where we have the responsibility of sourcing that is a little different discussion. And so when I talk about the complexity, and Jason is right, every customer is different and every platform is different. And so that process that you follow, it will be very defined and thorough when you go in and get these issues resolved. It isn't -- we can have a supplier that can supply parts across 24 different platforms, 7 different customers. And so you have to get very definitive in what the request is, and in some cases, how you're handling it. Some of it could be, like I said, you could -- it could be a temporary relief and then you modify the contract longer term once things get back to a more normal cost, and then some of them are a little bit longer term fixed. And so every one of these are slightly different. It does take an amount of detail to go in and negotiate and talk through. But like I said, we have different ways of offsetting it: one is the productivity, and what we're doing there is how we negotiate the productivity with our customer, given the circumstances; two is the offsets through VAV or suggestions that we believe will lower the cost, that we can take the benefits of in the short term; and the third one is flat out price changes that are required to [indiscernible] a supplier, in some cases, to ship parts.

What's the -- it was interesting earlier, I think J.C., you said that by the end of this year, it's possible that you actually might have a tailwind from some of these recoveries, net-net. What's kind of the whole that you'd still need to recover when we're at the end of this year looking out to 2023 and 2024. Do you have a rough idea of what that might look like?

I think you can look at sort of the combined effect of commodities that we experienced last year, $185 million, another $140 million this year. Over time, all of that unwinds. Now some of it may be 4, 5, 6 years out as programs change over and those higher input costs are reflected in customers' models. And some of it is nearer term. And it's -- at this stage, there are so many moving parts that I think it's difficult to put a pinpoint number on say, what is the 2023 implication of that and 2024. But based on all the variables that I'm looking at, I would expect '23 to benefit relative to '22, both because we see commodity costs easing, particularly steel this year relative to what we experienced at the end of last year, and because of our ability to either offset these increases through CTO and VAV or commercial negotiation or simply the contractual terms that allow that to unfold in reverse over time. So sitting here today, it's very difficult to put a pinpoint number on it, but I would say it's positive in '23 relative to '22 at this stage.

Great. That's helpful. Let's talk about just the upside for a Lear shareholder. Can you maybe just touch on additional steps you're taking to strengthen the business. You're a cash-generative business and will become even more so; what are the priorities for excess cash generated from the business?

Yes. Maybe start with the second part of that question first. I think that if you look at 2021, that provides a pretty good blueprint of how we are prioritizing capital deployment. First and foremost, we're investing in the business. We continue to invest around 3% of revenue in CapEx to support our strong and growing backlog in both segments. We had 2 small sort of tuck-in acquisitions with M&N Plastics in our E-Systems business and Kongsberg and our Seating business, which we were able to finance the larger of those 2 transactions with pretty low cost, attractive debt. And so we returned all of the cash we generated last year, and more so, to shareholders through both share repurchases and dividends. We've reinstated the dividend to pre-COVID levels, which was really important to us. We restarted our share repurchase program earlier in the year last year when things had improved a little bit. We'd like to get back to that if industry conditions warrant it. And we are committed to both a steadily increasing dividend and an aggressive share repurchase program, taking advantage of the value we see in the stock price as it sits here today, particularly now it's down even more this morning with what's happening in Europe. As we look out further, I think we continue to focus on tuck-in acquisitions that strengthen our core businesses, particularly Seating componentry to -- as Ray had described a little bit earlier, and then in E-Systems around power distribution primarily, connection systems and acquisitions that may strengthen our core wire business. In terms of how a shareholder benefits from our game plan here, as you highlighted earlier, we're sitting at trough industry volumes. So I think you've got 4 or 5 years of a nice kind of recovery in industry volumes. And you get the additional tail benefit -- tailwind benefits from us of the strong backlog, a near record backlog that we announced at the beginning of the year that we're launching and launching profitably. I see, over time, a normalization of the production environment, which really weighed on cash flows and working capital last year. As that unwinds itself this year and next year, I think we can get back to the sort of our historical free cash flow conversion rates of closer to 80% or maybe even a little bit beyond that in a particular year, whereas this year free cash flow conversion is more like 70%. So we see opportunities to improve the underlying profitability of the business, to grow well above the market and to continue returning cash to shareholders aggressively through share repurchases over time as well.

Great. I want to see if I can slip in 2 more here. We've got about 5 minutes left, but let's just talk about Seating a little bit, because you mentioned this again today, Ray, about the market share growth, and it's kind of surprising. It never really seemed like there's that much market share shift within the Seating business. Is that largely mix, because companies like GM protected their richest mix products, or are there some shifts that are going on sort of behind the scenes? And how does that -- if there is, how does that change over the next couple of years?

Yes. Well, obviously, we've done an incredible job. And it's a combination, Rod, and Jason can talk a little bit more on the details of it. But we have had conquest wins of $1 billion. And if you look back, it wasn't that long ago we were at 19%, 25% -- you know where our aspirational goals are to really drive to 28%, and I don't see that changing as far as a target. And for a lot of good reasons. One, we've done an incredible job over the last 10 years, and this doesn't mean you just turn it on a switch and you kind of get to where we're at. We've done a great job of building what I consider to be the benchmark of our operations around operational excellence and really having a superior system in place that drives efficiency. So even the conquest wins that we're going after are not businesses that we're trying to buy just to get to the market share. I think you know, Lear Corporation is focused on profitable business, profitable growth, return on invested capital, all the things that we think are important to continue to invest in the business long term and for our investors long term as we look at margin expansion, too. So I think that's going to continue. I think we've got some great opportunities moving forward. And I look and I think it's important to look at how we're really differentiating ourselves. I mean we have the operational excellence, we continue to invest in Industry 4.0, be the leader in just-in-time manufacturing. But equally as important, look at how we're really differentiating ourselves. The thermal comfort is important. We see areas that we create a modular efficient system that is going to be much better for the customer as we integrate the components into a system and then obviously ship those systems into a JIT facility and we've done a remarkable job already. We've been already aggressively looking at how we can engineer and reengineer the system today because I do believe it's very inefficient. And we've talked to customers about how we can add components like bags and blowers and sensors and mats and pneumatic bags into an integrated system. One, lower cost, much more better from a customer's perspective as far as time to sensation, which is very important to them. It's a modular component, so it cuts down on the amount of work that goes into the manufacturing facility itself, quality, et cetera. So that's really our focus. And really, we're the only ones out there looking at that differently. And I do think that's going to be a big opportunity for us. If you look at IHS, they talk about 2% growth over market in respect to those type of features, priceable features. We think it's much, much higher than that. We think that they're limited in how they're looking at rear seats and if you get that packaging right and the efficiency and what that could really do. And I think the second example is this ConfigurE+, it's important. It's the $100 million right now of contract wins we've won with our customer. We own all the patents. It's a powered rail system. We're developing systems that can incorporate airbags and other features that would really allow for customers to reconfigure their interior vehicles differently. And we have a design development contract right now with a major OE in Germany that's looking at proliferating that across multiple platforms, not just cargo vans, but within passenger vehicles too. And so we see those technologies and innovations that we've been investing in as ways to get us in early, it helps capture what we continue to see as growth within the JIT facilities, but on a CPV level, helps us really gain market share within the component and content and features arena.

Just one important point, too, Rod, yes, we did benefit last year from mix in seating, particularly GM's full-size trucks and then our strong luxury portfolio just generally. But as you look out to this year and subsequent years, the market share gains come more from, as Ray described, the conquest wins, programs like the BMW 5 and 7 series that launches at the tail end of this year; the GM -- the Chevy Colorado and Canyon, which we took from a competitor, that's launching this year, business we took in China with BMW on the X5. And then a growing business with Volvo, which we launched a couple of years ago here in North America, but we've won additional business there as well as in China. And so we're seeing growth in market share through those conquest wins as being sort of that next leg up. And $1 billion of conquest wins is 1.5 points of market share by itself. So if our platforms hold up consistent with the market outside of that, we're already halfway to our goal of 28% here just based on what's coming in the 3-year backlog.

Yes. That's really interesting to hear about the differentiation that you've got there. Just one -- we're a minute over, so unfortunately, I'm running out of time here, but -- just no one has a crystal ball, but look, this year you're expecting 60 basis points of margin improvement despite 70 basis points of commodity headwind and despite 10 basis points of labor inflation. Just conceptually, as investors are thinking about the things that you can control and the rate of improvement, does that -- do you think that that kind of gives us a sense or it's an appropriate way to think about the rate of improvement that you're achieving? Because if you didn't have those inflationary pressures, you would be doing like 100 basis points a year or more of margin improvement.

Yes. I think that that's generally a fair way to look at it, and there's a pretty clear pathway for us to get this business back in the 7% plus range overall. And you sort of laid out the building blocks of that with your first question, and looking back over the last 2 years I think there's a pretty clear path. I can't -- sitting here today with all the moving parts, it's difficult to say that's '23. But certainly by 2024, some of this some of these issues dissipate, there's a pretty clear path into the 7%s for this business. I think that's a fair assessment, Rod.

Right. I want to thank you again for taking the time to talk to us. It's always a pleasure to catch up. And I always learn a lot despite all these years of doing this. I learn a lot every time we have a chat. So Ray and Jason, thanks, again, and thanks, everybody, for...

Thanks, Rod.

Thanks, Rod. Great seeing you.