Lear Corporation (LEA) Earnings Call Transcript & Summary

On time. Next session is with management of Lear. Lear as all of you know, is a $21 billion supplier. About 75% of their sales are derived from automotive seating where they capture about 25% of the global market. So 1 out of every 4 vehicles, you see anywhere in the world has Lear seats. Over time, that division expects to generate roughly 4% growth over market. 25% of this company's sales come from their E-Systems division, which produces wire harnesses, terminals and connectors that division is expected to achieve something like 6% growth over market over time with a lot of that growth being propelled by vehicle electrification. They just concluded was obviously a very challenging year, actually a challenging couple of years, but where they face massive commodity inflation, which was a 60 basis points of traction from margins in their Seating business, 170 basis points in E-Systems, yet for the full year, overall EBIT grew for this company and the margin was pretty flat despite some pretty meaningful headwinds. And more importantly, the company's performance clearly got progressively better over the course of the year. And by Q4, we saw Seating EBIT margins that were up 130 basis points year-over-year. And obviously, those headwinds didn't go away. And the E-Systems margins were up year-over-year by 180 basis points. For 2023, the company is guiding to another year of earnings growth. Backlog will add at least 5% to top line growth. EBIT margins will expand again 4.5%, and it looks like growth accelerates further into 2024 and 2025 with new business backlog and margins climbing up from 4.5% right now up to 7%. So not only do we get the upside from backlog and an industry recovery, we get that turbocharged by the growth in margins. So sitting -- joining me here on stage, we're very pleased to welcome Ray Scott, Lear's CEO; and Jason Cardew. So I'll join you on the stage.

Okay.

And thanks for coming.

Yes. Thanks for having us, Rod.

So I wanted to start out maybe just dividing things up into the businesses and talking about the Seating business first. So one of the largest seating companies in the world, as I said, 25% market share. And you might think that when this industry is mature as it is with 1/3 of the industry here and 25% there, pretty consolidated. Every auto plant in the world has a seat plant within a couple of miles from it. So you wouldn't think that there'd be a lot of shifting. And also, you wouldn't think that there'd be a tremendous amount of growth in content per vehicle and maybe not that much opportunity for margins at this point. But that's not what we're seeing with Lear, right? You guys are making acquisitions, you're talking about growing market share to 28%. Maybe we could just start out by talking about where you see the biggest opportunities in that business?

Yes. I've been in Seating for 35 years. I think it was August 2, 1988, so a long time. And -- it's pretty exciting time back in the early days of just the cushion room being outsourced to the JIT assemblers. And you're absolutely right. That was a time of growth. But I think today's just is exciting. And you're right, we've had $2 billion since 2020 of conquest wins. And even though there's legacy costs and other things in place, there's done a remarkable job of expanding our market share, which wasn't that long ago, 18% to today's 25%. And we've been shortened the range on when we think we'll be at 28%. And there's a number of things going on in Seating today. And when you think about the tremendous pressure our customers are under with cost, investments in electrification and autonomy and then other areas that they're really trying to change their businesses. We're under that same pressure. But what Lear has been doing for well over 10 years is investing in our operational excellence. And you've seen some of the smaller but important acquisitions with Thagora and InTouch and some of these things that help us really drive our business for efficiency. And that's at the core of what Lear's about is really driving our operations for Industry 4.0, automation and being just very efficient and being the most vertically integrated company that we can create value for our customers on the manufacturing side of the business. On the product side, probably equally as important, the changes we're seeing because you have to create a value proposition and focusing just on assembly of different directed components really doesn't give our customers that value proposition. So we really took a step back well over, like I said, 10 years, 12 years ago and looked at how you can make the seat more smart, intuitive how you create more value for our customers. And you've seen us really driving that thesis around thermal comfort management and the acquisitions that we've made that help us vertically integrate components into modular systems. Because the way the customer is sourcing its individual components. And then that gets shifted over to an assembler to design for manufacturability. Well, there's not a lot of creativity or innovation or really efficiency in that type of design, where you create value for your customer is the integration of these components. And so the acquisition around thermal comfort management products has really, really accelerated. And right now, we're looking at those components. We've taken 50% of the components out. So there's pumps, valves, motors, harnesses, different components that were designed for individual parts, not as a system. Well, that's an easy one. You take out significant mass when we're talking about being able to reduce the mass for our customers. And the time to sensation, one of the things -- the thing about selling to our customers, I say, anyone can sell this product when you're doing these type of things when you're creating value is we're end consumers, too. When you get on an active heat and cool, the time sensation is very long. It's loud. It's ineffective. You have a blower and really a fan that takes all the different bag air around different systems into the occupant. Well, we're designing those components into the trim and through the phone. And so when we talk about sustainability and recyclability, we have a polyethylene material that we're using for foam. We have increased content into the trim cover itself through these technologies we're talking about. So it has been a long road, but I am more excited about the changes in seating than I've ever been. And I think the -- I say the greatest compliment we get from our customers and we get recognition, but as new business awards. And even on the heels of last year, we are contacted by one of our customers we talked about in the earnings call. And we're going to actually take over mid-cycle. This is unheard of, right? I mean we've done mid-cycle changes or when a program is changing over but we're awarded business working in a very collaborative way with our customer on taking that program over. We didn't -- it wasn't a global quote. It wasn't something we had to aggressively buy. They came to us. They audited our facilities. They looked at our technology, and awarded us the business. And so when we talk about fair returns. We have to continue to stay focused on return on invested capital or investments that we're making a fair return, and even our backlog has been accretive to our margins. And so you can see the success, even though we've done a nice job of growing market share, we're being very diligent and disciplined to what is expect to return. If you can create that value for your customer, we believe it's there. So it has been very exciting.

So that example must have been some issue that the automaker had with the existing supplier. But what was more interesting was what you said about this vertical integration and that, that gives you some kind of competitive advantage. The seating industry, as I've known it, is very directed, right? Like the automaker will say we want you to use seat heat from this company and motors from here and that kind of thing. Is that meaningfully changing at this point? Or is that something that you think will change?

No, we're seeing the change. And -- but you have to have the engineering and the in-house competencies. And historically, I think on some of the components that I'm mentioning with thermal comfort management, 30% you might have control over. Bill source yourself and work with another supplier. We have 7 major customers that a 100% direct-sourced our thermal comfort management systems on a business that we've recently won. And so that's moving from 30% to 100%. Now they're not going to give that up unless you have the capabilities. And I think that's the uniqueness is that -- when we acquired Kongsberg immediately gave us credibility. Even though we had been working organically on design and very specific patents and intellectual properties to design these components into other tiered or components that we manufacture. It was when we gained that engineering capability when we had the manufacturing capabilities that, that shifted. And I also think -- from a competitive standpoint, when I say that we're reducing parts 50%, that lowers the cost. And so we can actually create value and expand our margins and then create value for our customers. And so it really is a win-win in respect to us managing our business. And that's why I think about JIT. I was around when the cushion room and then it came out and then it took it over, the concept around some of the difficulties we're having with labor, some of the difficulties we're having with purely the content fitting within the seat, just the size, the amount of content that's going in the seat and solving those problems really is expanding our growth profile and allowing us to go into our customers with a really good value proposition.

What's the seat content today, where do you see that going in, let's say, 5 years with all this additional content is coming in from heating, cooling, all the acquisitions that you're making?

Yes. So it was at 2020, it was to $735 call it, CPV for Seating. And today, it's around $770. And a lot of that is the shift to luxury and high-end vehicles with higher content within the seat system. When you think about the thermal comfort management components, that's anywhere between $2.5 billion to $3 billion, and that's growing today at about 2% over market. And I think the issue right now it's limited by packaging size, cost and complexity because I do think if you look at just massage systems within seats, I think it makes up 3% of the overall market. And candidly, I think it's because these don't work. I mean they just not -- they're not therapeutic in any way. There's no wellness. There's no health benefits to it. You don't walk out of Seating, boy, did that feel good. It's a pneumatic bag that's literally pushing against your back. Well, as we're moving those components closer to the occupant, there's more therapeutic, the more health wellness, more feeling of sensation, I see that accelerating. I think being able to package these things right now, it's limited to -- we've seen this move of heater mats from front rows to second row. And my kids got the back seat and they're like, "Where's my heat mat." It's like once you have it in different seating positions, more customers want it, but you have to create that packaging and allow it to fit from the front row into the second row. And so that's where I see much greater growth over market than what we're anticipating right now at 2%. And I do see that luxury sensation or feeling of content pushing down into lower level vehicles, and we're seeing that today. I mean China is a great example, particularly with the domestic OEs, where a lot lower end vehicles are now pushing up in the luxury market with luxury content. And so we see that continuing. And we talked about this ConfigurE+ technology that we designed that powers a cassette on a rail system within the vehicle. We launched it with Volkswagen, and we're launching the second program with Ford Motor Company. It's about $100 million in revenue today. But you think about that, and it was actually still honest, debuted it in their RAM 1500 BEV truck that they had at the Consumer Electronics Show. We had the rails in the truck. And what that allows is for reconfigurability, a lot more flexibility of the seat systems within the vehicle and their safety elements and content that can be added to the seat. And so we see those type of changes within the seat system really growing content because I think right now, we're looking at $500 content with a rail system with the cassettes. And if you supply the frame structure itself, it obviously could go up to $1,000.

Let's talk about the margins in that business. It was a 7.5%, 8.5% margin business, if we go back to 2017, '18, '19. Past 2 years, you had 190 basis points of pressure from commodities -- so doing a little bit over 6% actually isn't that bad, like in the context of what you've to run for?

I think that's great right now.

Well, there's companies that are doing 2% in your industry. So it's quite good. the improvement, the rate of improvement is modest, right? You're going to do about, I think, 20 basis points this year. Absorbing 25 basis points of engineering. So there's a little bit of pressure there. I see Jason smiling. You were going to remind me. But it's still just 20 basis points. which is small relative to that 190 basis points. So what's the bridge as we want to get back to that 7.5%, 8.5%, can we get there in 2024 or 2025?

Yes, Rod, I think we talked about it on the last earnings call, there is a clear path to 8% in 2025 in Seating that it's really comprised of 2 -- there's 2 drivers. First, the volume in the backlog rolling on over the next 2 years with volume rolling out a 15%, backlog at 10% or greater than that. It's about 60 basis points of margin expansion and then about 100 basis points from net performance. So 50 basis points a year, we would expect from that performance. Our performance this year is a little bit way down as you've talked about, engineering and tooling costs or engineering and launch costs being higher this year. That's really a function of the award of the conquest program that we received in December that launches this year. So a very short development window, very short launch window. And so the costs are compressed into 2023. We would expect those costs come back down a little bit in '24 and certainly not increase. As I look out at '24 and '25, we would expect flat to lower launch and engineering costs. So now you can see the full effect of our performance improvements flowing through to the operating margins as we look out to next year. And all the investments we've made, starting with Lear Ford last year, we've taken capacity out, kind of realigned to the lower volume environment in Europe, for example. The investments we've made in new products that are launching at higher margins than what we've been accustomed to in seeing. I think structurally, the thermal comfort products have a little bit higher margin profile than just-in-time seating and other components within Seating. So the backlog rolling out at 10%. I think you could see that working its way higher over time. So now kind of looking beyond the '25 time horizon. I think there's a path to getting back above that historical range of 7.5% and 8.5% to 8.5% to 9%. And I think if you look back, just as other data point, 2014, the Seating business was at 5.7% and similar kind of volume environment, but much better commodity cost environment. So we're 50 basis points ahead of that right now, and we increased operating margins by more than 200 basis points from 2014 to '17, I think on the heels of volume recovery in the industry, I think you're going to see a similar phenomena here over the next 3 or 4 years. It may take a little longer for the volumes to return to the historical levels. But we're 7.5% below where we were in industry production in 2019. We're almost 14% below where we were in 2017 at the peak, that at some point is going to normalize and come back. And I think that's kind of another tailwind on operating margins in Seating even beyond that 7.5% to 8.5% historical range.

So it sounds like greater than productivity alone is 50 basis points. So greater than that as far as the vertical speed of margin improvement, maybe closer to 100 basis points and maybe get back to the 7.5%, 8.5% in the 2024, 2025 time frame.

Yes. So I think it takes 60 basis points of volume in backlog and 100 basis points of performance that gets you to 8% in those 2 pieces.

Are you anticipating any difference in the pricing environment with your customers obviously facing deflation prospectively, are you back -- are you pedaling softly a little bit in terms of the recoveries because you are gaining a lot of market share and people are still kind of thinking about why are they gaining? Is it because of some kind of pricing dynamic that?

Now we treat those 2 issues separate. I mean, like I said, we're not going to any terms by business. We're going to stay disciplined to what we expect as far as a fair return. When it comes to the deflationary issues that our customers are dealing with or inflationary costs that we're dealing with, we're relentless. I mean we're going after all the costs. And our customers are very sophisticated. This is a process that I think we've discussed it probably back in '21. I think everyone thought it was going to be more of a temporary issue. We are fixing it more with 1 term type solutions in 1 quarter or a one-timer. It's moved to a more of a fixed negotiation. How do you fix it in the purchase order on a go-forward basis, either through indexing or solutions to raise the price. And one thing that we did last year, and I think it's important. I mean, we have incredible transparency because we have the electrical side of the house, and then we have the seating side of the house. So everyone passes through us. We get to see all the contracts for all of our competitors, both on the electrical side and the chemical side. And so we see the negotiations that are being done or completed. In some cases, we're even in because of a third party because of the direct situation where we're bringing them in if there's a particular situation of threat. So we know exactly what our customers are doing. So there isn't any type of advantage to any competitor that might be claiming more of a recovery than we are. What's important is the sophistication that our customers do have in their audits. And in some cases, they even do a third-party audit. You have to make sure that you've done all your work. You have to clean up your own house. When we initiated the Lear Forward plan last year, even though we run our business very effectively and efficiently, what we did was even search for even greater ideas. Can we combined facilities between Seating and E-Systems to utilize our square footage? And can we then not spend the money on a particular plant? Can we some cases, lower our headcount and then utilize the plant differently for across population of different customers? We did that work. We went at it very aggressively last year, and we're still moving that forward this year. And what we found and most recently, we just had an audit from 1 of our customers that came in and reviewed 1 of our plants because they're going to look at you and say, okay, if you're not efficient, I'm not paying anything. So if you have 1,000 people in a plant, and you should be running at 600, you got to go do your work. We did the work. When an audit that came through and they actually suggested they pay us more than what the request was at the time because we were so efficient that they're actually claiming that we should get that based on the model. So -- now where we're relentless, we're working every different way. We talk about -- everyone talks about basket of goods that you can go through from productivity deals to what you're going to do with fixing the contract or renegotiating the pricing or how you can offset with cost savings. We've worked the CTO ideas that we have with VAV extremely hard, and we're negotiating different settlements on a share agreement. And the customer has been very accepting of looking at how they can work other areas of those basket of goods. So we're going to keep pushing. We look at these things in different paths, how they're moving across different customers, and there isn't 1 that we're trying to extend longer. We're just looking at how we're going to negotiate over this year and next year, but we're going to be relentless with that. I mean it's -- it's the right thing to do.

Just to add 1 point on the profitability question you had, are we trading market share for margins. If you just look at the backlog that we launched last year, we converted that at 12% in Seating. So if anything, it's a little bit higher than what it has been historically. And I think you're going to see that going forward.

And objectively, all you really need to do is look at the margins of Lear relative to your peers, and you can see that the margins are actually -- are better. I want to take a couple of questions on E-Systems. So we've known E-Systems to be a producer of harnesses and terminals and connectors and there's a lot of growth in this area as we see more electrification and more data being transmitted within the vehicle. And what is also interesting is the competencies that you're kind of bringing into this by bringing in injection molding and terminals and connectors and other things to make inroads into a variety of other parts within an EV like battery disconnect units and intercell connect boards, who do you compete against your -- and do you see this as a capability that others just don't have?

I think when you look at the low voltage and high voltage, it's some of the similar names that we've competed against in the past with Aptiv or Molex, RT or Yazaki, Sumitomo. When you get into the very selective components, and we've done a really nice job with battery disconnect units and it gets more selective. And you have KDT, you have CATL, you have Panasonic deal. Those type of competitors within that area. And I think within that, you do have a very selective skill set or competency. And so we are very successful on the battery disconnect, and that's where it gets very limited. So we have multiple customers. We have a number of key customers on the battery disconnect. And there's probably only 3 real players that have multiple customers within that area of battery disconnect, probably Panasonic and maybe, Lear.

I mean Lear. So there's really 3 players that have different architectures that they're designing battery disconnect units forward. And within that, and you're right, we have the precision stamping and the capabilities for bus bars, we have the expertise in power electronics and power distribution power with -- through our wiring capabilities. We have the connection systems. And so right now on the battery disconnect units, we have approximately about of the component is vertically integrated. And we have an incredible engineering center and design center that really has helped us. That's really 1 of the big wins that we got with General Motors. And it wasn't a platform specific. It's across their Ultium battery. So we supply that pattern. So no matter how, what volume is doing is it's those batteries that we're supplying the parts to. On the Intercell Connect Board, I mean, that is some of the overmolding capabilities that really is manage the mechanical and electrical system within the cell of the battery. That's our connection systems, our wiring systems, and we're vertically integrated to about 60%. And -- so that allows us, one, to really take advantage and gain margin, but also the compensation expertise to lower cost as we go forward.

It looks like you've got a lot of growth electrification alone could add something like 500 basis points per year to your growth over market prospectively. I want to ask you about the margins in that business. Seating is kind of got line of sight on what we think they're going to get to in the intermediate term. There's a bit of a bigger gap with E-Systems at only 4.5%. I know you've absorbed a lot of margin pressure there, but maybe you can talk through the plan to get those margins back up. What's the plan for commodity recovery and considering that most of the growth that you're going to be seeing over the next couple of years is actually from the backlog, which usually comes in at a lower initial margin. How do we think about the trajectory from here?

Yes. I think you can break it down into the same 2 pieces that we looked at for Seating. So starting with the volume and the backlog, we see that as about a 250 basis point tailwind over the next 2 years. So that's $1 billion of business rolling on at about 20%. And it's a little bit higher than our traditional backlog rolls on. Some of that is because it's production volume going up on existing platforms, which converts to 25% to 30%. The backlog, the mix of backlog that we have is more skewed towards connection systems, which is our highest margin profile subsegment of E-Systems and the new electronic products that are rolling on the battery disconnect unit with that level of vertical integration is going to be higher margin than our existing electronics business. So the 250 basis points from that bucket. And then the other 100 basis points similar to Seating, 50 basis points a year of performance. That performance is a combination of some moderation or recovery in commodities and some benefit from our performance falling through that was this year, offset by higher wage inflation and higher engineering costs.

Okay. And that would get you to?

That gets us to 8%, yes.

8% or so. Any questions from the audience before I do my last 1 or 2? Maybe just really quickly, if you could just give us a little bit of color on the cadence of earnings should be -- that we should be expecting this year because you gave a little bit of a some color on what the beginning part of the year will be and then later on? And then how should we be thinking about $375 million to $525 million of free cash flow this year? Can you just remind us of what your framework is for use of cash?

Yes. So at the midpoint of our guidance, we have $450 million of free cash flow that we expect to generate this year. we really finished strong. In 2022, we generated $50 million more in free cash flow than the high end of our guidance range. It's really a combination of all the investment and effort we put into Lear forward really reducing inventory levels, better capacity utilization, as Ray alluded to. And we've been very focused on returning excess cash to shareholders. We don't see a need for acquisitions in the near term. So that free cash flow is going to be returned in the form of dividends and share repurchases. And to the extent we generate more free cash flow this year than last year, I would look for share repurchases to get ratcheted up a little bit. In terms of your -- the first part of your question on the cadence of margins throughout the year, as we sit here today, we expect the first half to be up year-over-year, but down sequentially from what we saw in the fourth quarter. I think mostly attributed to the normal seasonality of our customer price downs and how those get negotiated throughout the year. And then the second half of the year see sort of flat year-over-year, with what we saw in 2022 at the production assumption that we've used. We have kind of hedged a little bit more in the second half in terms of our production assumption just to be a little bit cautious given all of the difficulties in the macro environment over the last 3 years. To the extent there isn't a pullback in demand or a recession globally, there's probably some upside in that second half production forecast. We've tried to capture that in the high end of our guidance range. And if I look at sort of the exit rates of both businesses at the high end of the range, we could be at 7% in Seating and at or above 5% in E-Systems. And that I think puts us on a nice trajectory towards our longer-term targets or midterm target of '25 of getting both those businesses to 8%.

Great. Well -- yes.

You haven't seem to complain others, I mean you kind of recovery bridge and margin both [indiscernible] you have mentioned less schedule volatility. Like what's -- what are you seeing there? Why has it not been a problem but it hasn't?

It's -- I'd say that it's similar to the fourth quarter, which was an improvement over the third and sequentially throughout last year, it got better and better. So it's still problematic, but no more so and probably no less than how we ended the year. But as the year progresses, we do see more capacity coming online. We do see perhaps those costs alleviating somewhat. So we do see a modestly better environment here.

We do get to see seating and then obviously, systems with chips and some of the other supply shortages. And even though it's better, there are still very selective parts that are short. And our customers are much more sophisticated on their ordering and what they really need versus kind of overinflating to get whatever parts they could get. So that's helped. And I think the combination of this being very selective has helped. But the disruptions are still there. I mean, we're still managing the disruptions. I think to Jason's point, we, in some respects, anticipated some of that to continue. And I think by the second half, we'll see that get better not significantly better, but better.

A quick one.

Yes. I had a question about Chinese OEMs and your exposure to the specifically Chinese EV companies that the fastest-growing carriers globally. I mean just talk about some of your exposures in it.

Yes. Just on the Seating side, we have a growing business with BYD. Historically, they had a joint venture with one of our competitors, it was controlled by BYD.So largely in-house. They've moved away from that model. And -- and if I look at our nonconsolidated backlog, half of that revenue is BYD. And that may be a relatively cautious assumption that we're making there is that relationship is just getting started. We see having something like 1/3 of their seat business, we look 3 years out. Nio is another one that we have had some success with and that does show up in the consolidated revenue. [indiscernible], we've got a nice business with as well and the derivative brands, Polestar is a very good business, both in CNN and in E-Systems, and Lincoln Co as well.

So what's the Chinese domestics as a percentage of your China business?

It's still relatively low. We still are over-indexed to the Western OEMs, but we do see a growing opportunity with the Chinese.

Regionally, we've definitely seen a pickup with the domestic EV players.

Yes. Great. Great. Jason, thanks again for your time.

Thank you.

Thank you.