Description

Adient – the world’s largest automotive seat maker – is a turnaround situation that represents a high-skew investment opportunity. The company has made significant progress on its multi-year turnaround, and has now survived the worst crisis to hit the automotive industry in decades, thus significantly de-risking the chances of complete failure, and increasing the odds it will eventually attain normal industry margins. If it does, the stock has at least 300% upside to fair value. 

Congrats to chatham123 for his short sale pitch (May 9, 2019 to March 11, 2020), which generated a 23% return if traded on those dates.

While that trade made money, I would argue that the last year has added multiple pieces of data supporting the view that the company is succeeding in its turnaround. This progress has been obscured by the macro environment, with a global, cyclical slowdown in auto sales in 2019 getting overshadowed by the COVID-19 pandemic, resulting in a total expected decline of some 20% from the 2018 peak to the bottom this year. Yet, despite this massive headwind, the company is adapting, and further cutting its cost structure, with a target of being cash flow breakeven even in a down 20% market. (In the month of June, when sales were down 25%, the company generated nearly flat EBITDA, evidence they can deliver on this target.) When global volumes do recover, ADNT will be in an operational and cost structure position to deliver significant profits.

Brief background:

As chatham notes, ADNT’s management team had a horrible incentive structure after the 2016 spin-out from Johnson Controls, which motivated them to grow their backlog without regard to profits. They did a great job at this over the next year, and saddled the company with many years of low or negative returning contracts. On top of this commercial issue, the company had operational issues in 2018, as it tried to launch a new type of seat frame at the same time as it had numerous new vehicle launches. When it couldn’t deliver the new frames on schedule, it was forced to pay for third-party stamping factories and premium freight, resulting in massive losses on some new business wins. The overall disaster at the company led to the hiring of Doug Del Grosso as a new CEO in October of 2018. Doug was a former executive at Lear, Adient’s number two competitor, and the benchmark for where ADNT has long hoped to take its margins one day. Here’s the slide from Doug’s first earnings call as CEO:

In that call, Doug said there was nothing he’d seen in his first 100 days at ADNT that made him believe the company couldn’t one day reach those margins, and he laid out a multi-year plan to get there. 

The whole reason to be long ADNT is that if the company can do this over the next several years, earnings power can return to ~$8-9 a share, last seen in FY2016/2017. I estimate that they can achieve this in 5 years, with an upward bias assuming auto industry sales return to steady growth, market share is maintained, and debt paydown reduces interest expense. Putting a discounted forward multiple on this earnings power gets you to a fair value of at least $75, or roughly 300% upside to fair value today (see valuation below).

Up until COVID hit this spring, ADNT had put together the following track record of improvement, establishing credibility for Del Grosso’s plans:

• Positive trend in profitability
  • The December 2019 quarter was the company’s fourth consecutive improvement in ebitda, and the first year-over-year improvement since Q4 of 2017
  • The March 2020 quarter extended the progress in core margins (excluding equity income) to a 5th consecutive quarter
• Positive trend in new vehicle launch management
  • As of Dec 2019, launch costs were down 40% for the US and 14% for EMEA, yoy 
  • Containment costs for launch issues were down 36% for the US and 19% for EMEA, yoy
  • Premium freight costs were down 85% yoy
  • Multiple “flawless” launches executed: zero safety incidents, zero customer rejects, 100% on-time delivery, and 100% achievement of financial targets within 90 days from start of production
• Positive trend in commercial issues, without loss of market share
  • Company has renegotiated low return contracts with over 5 critical customers, and is walking away from non-profitable programs 
  • Over the past 12 months, company has replaced over $700 mm of negative returning business with new contracts that meet their return hurdles
  • Company has continued to maintain high win rates, despite higher return hurdles, and expects to actually gain market share going forward (comment from Jan 2020 earnings call)
• Positive trend in losses at the Seat Structures & Mechanisms (SS&M) business, the segment which has caused the most problems for ADNT 
  • Segment FCF losses have been cut from $450 mm a year in 2018 and 2019 to about half that this year
  • Management believes they remain on track to hit breakeven by 2021, which is the same target Del Grosso issued in his first report in February of 2019
• Positive trend in FCF
  • The company posted a loss of FCF in 2019 of 160 mm, and initially projected breakeven FCF for 2020
  • Then at the FQ1 2020 earnings call, the company revised its expectations from break-even to positive FCF for 2020
  • For the first half of FY2020, ADNT nearly achieved FCF breakeven, with an improvement of $210 mm of FCF over the same period in FY2019
  • COVID headwinds will now prevent achieving positive or breakeven FCF this year, but the company is working to adjust its cost structure to achieve positive FCF even in a down 20% market

All these pieces of data increase my confidence that Adient was on the right track prior to COVID, and that it could indeed close the margin gap it has with its peers. 

When COVID hit, ADNT quickly took action to increase its liquidity to over $1.2 bn and reduce cash burn (down to $175 mm a month) to ensure it could survive the crisis. Since the low point when auto industry production was nearly shut down in April, production levels and revenue have rapidly improved. With the sequential improvements seen over the last few months, which are expected to continue, it seems clear that surviving the pandemic is well assured. 

While the onset of COVID has impacted the company significantly, it is using the time to accelerate its turnaround, with plant closures and consolidations and additional cost cuts, and is working to achieve positive FCF even in a significantly down environment. When production returns to normal, these cost reductions will help it achieve its margin improvement targets.

Valuation:

The bet with ADNT is that it will continue its path of internal improvements, and eventually reach industry margin levels, driving significant earnings improvement. I believe that global auto industry production levels will rebound and return to a normal trend, but this is not the key bet with ADNT. If it reaches its margin targets, there is a lot of upside in a variety of end-market scenarios. While the future is uncertain, the success the company has seen over the last year and a half under Del Grosso’s leadership increases the likelihood it will achieve its targets. Precision in valuing this company is a fool’s pursuit, but here’s how I look at it simplistically:

I assume revenue returns to 2019 levels of ~$16.5 bn. I assume the company reaches the bottom of its targeted core ebitda margin range, of 8.5%, driving ~$1.4 bn of annual ebitda, up from pre-COVID expectations of ~$900 mm this year. I assume equity income from the China joint ventures returns to ~$280 mm (2019 was $286 mm, 2018 was $385 mm, but the company divested part of one JV, which will reduce equity income by $30 mm/year). The company plans to use proceeds from the divestiture to reduce debt, and analysts have interest expense going from $200 mm down to $160 mm over the next several years, which is what I assume. I assume depreciation of $280 mm, consistent with current levels. I assume a tax rate of 38% (the company states that a high 30s % effective tax rate is appropriate). With current share count, this results in a “normal” earnings level in the low $8 range. I apply a terminal multiple of 9x these ~five-year forward earnings (essentially a discounted market multiple), and arrive at an estimate of fair value of ~$75, or 300% upside from here.

Risk:

Clearly, there are significant external and internal risks to achieving fair value for Adient, but that’s why there’s potential upside of 300% or more. In investing, there is a tradeoff between opportunity and clarity. The greatest opportunity for Adient was when it had the least clarity. Over the last two years the company has consistently delivered on the initial turnaround plan Doug Del Grosso issued at his first earnings call in Feb of 2019. Up until the COVID pandemic, the company remained on track for this plan, despite headwinds from a cyclical downturn in auto sales, especially in its highly profitable Chinese market. Then with COVID, the company has further adapted, accelerating its turnaround actions, and targeting positive cash flow even in a down 20% market. This track record has increased the likelihood it will eventually succeed. In my opinion, the opportunity-clarity tradeoff remains extremely attractive for this situation, where if the company continues on track, there should be another 300% upside to fair value from here.

Catalyst

Continued progress on turnaround objectives.

Earnings and FCF improvement.

Auto industry rebound post-COVID.