|Shares Out. (in M):||94||P/E||7x||6x|
|Market Cap (in $M):||6,320||P/FCF|
|Net Debt (in $M):||2,623||EBIT||0||0|
|TEV (in $M):||8,943||TEV/EBIT|
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After a recent pullback, we believe shares in Adient represent an extraordinarily compelling investment at current levels with the potential to more than double your money from the current price in the next few years.
Bruno677 had originally written up Adient (ADNT) last November after its spin-off from Johnson Controls. Now that the initial spin-related dynamics are behind us and the company has reported three quarterly earnings reports as a standalone company, we wanted to share a more detailed write-up regarding our thoughts on Adient and the progress the company has made thus far on its financial targets.
Brief Background on the Company and Last Fall’s Spin-off
We would encourage anyone interested in the company’s history under Johnson Controls and how the spin-off dynamics have led to a dramatic undervaluation of Adient’s shares to review Bruno677’s write-up and our remarks in the comments section of his write-up. The company is the world’s largest automotive seating manufacturer with an estimated global market share of ~33% (including China through joint ventures). Adient has 36% share in the Americas, 38% share in Europe, 44% in China and 13% in the rest of Asia. Other competitors include Lear, Faurecia, Toyota Boshoku, Magna, in-house operations and other smaller players. To put Adient’s market position in key markets differently, it is roughly 50% larger than its closest peer in the U.S., double the size of its closest peer in Europe and four times the size of the closest competitor in China.
Despite the dominant market shares discussed above and associated scale advantages, Adient’s operating margins have surprisingly lagged those of its closest competitor, Lear. The source of this margin gap stems largely from (1) higher overhead vs Lear and (2) underperformance of the company’s metal structures and mechanisms business, which accounts for roughly 18% of Adient’s sales but fails to generate any operating profits today. We believe the margin opportunity afforded by the restructuring of these two areas represents a tremendous potential for cost reduction and earnings growth over the next several years.
Phase One: SG&A Reductions to Drive Earnings Improvements in FY 2017 and 2018
At the time of the spin-off, Adient’s SG&A as a percent of sales was roughly 200bps higher than Lear’s even though Adient’s larger scale should arguably result in better operating leverage. As one former competitor stated in our research, “From an SG&A standpoint, I always believed [Adient] was a lot fatter than we were… I went to customers and they showed the [Adient] org chart vs ours on similar programs and we’d have half as many people on the program.”
We think much of the cost difference can be reduced through basic restructuring initiatives that will be completed in the near-term (within two years of the separation). Importantly, we believe the company is already executing on these cost savings faster than even the most optimistic expectations, giving us confidence in the management team’s ability to continue to deliver on their profit improvement goals. For example, in the fiscal year ended September 30, 2016, Adient reported adjusted SG&A of $817 million. In fiscal Q1, Adient reported $176 million in adjusted SG&A ($704 million annualized), which represents a 14% reduction from the prior fiscal year. In the recently reported fiscal Q2, Adient’s adjusted SG&A was down to $153 million ($612 million annualized), representing a further 13% reduction sequentially and a cumulative 25% reduction from FY 2016. In the fiscal year to date, Adient’s adjusted SG&A as a percentage of sales has been 4.0% vs last year’s 4.9% and Lear’s 3.1% over the same period. In other words, we believe Adient is about halfway to Lear’s overhead levels in just two quarters as a standalone company, with significant earnings contribution from continued execution on this plan (and the potential for Adient to over-deliver on their targeted SG&A levels).
Phase Two: Metals Business Restructuring to Drive Earnings in FY 2019 and 2020
Adient’s other key margin improvement opportunity relates to its $3 billion metals business, which accounts for ~18% of Adient’s sales but currently generates no profits. We believe improvements in this business will provide the second phase of margin improvement starting in late FY 2018. While we acknowledge that there is some execution risk in the metals turnaround, our industry research and discussions with management about the business gives us confidence that they can achieve enough improvement in the metals business to deliver on their overall margin improvement plan.
Management is confident that improving the metals business is not reliant on customer wins or works council approvals to shut a plant, but is simply a timing exercise as they phase out their highest cost/less efficient production. They expect improvements to pick-up in late 2018 as they close a couple of big money losing plants in Western Europe. As an example of the restructuring opportunity highlighted in their 2016 pre-separation Analyst Day, Adient has a plant in Germany that is currently losing $40 million annually. The closure of this one plant should improve the margin of the metals business by 130bps and the overall company margin by 25bps.
We have spoken to numerous industry participants and there is broad agreement that the metals business should earn a double-digit margin over time, which would imply 200bps of margin improvement potential for the company overall. Management is targeting margin improvements from the metals restructuring of 100-200bps, indicating they believe they can get to at least mid-single digit margins over the next few years, which we view as a reasonable target.
China JV Value
Furthermore, we believe Adient’s Chinese joint ventures are being undervalued by the market and the analyst community. Many sellside analysts value these ventures at 8x net income, a considerably lower valuation than publicly-traded Chinese auto suppliers, which on average trade at ~13x earnings for H-shares listings and ~24x earnings for A-shares listings. Moreover, sell-side valuations do not account for the significant net cash balances sitting at the China JVs. Since the spin-off, management has provided more detail regarding the proportionate net cash at its China JVs and we believe there currently is over $700 million in proportionate net cash attributable to Adient at the JVs (representing ~$7.50 per share and ~11% of the current share price). Said differently, sellside analyst price targets based on 8x earnings value Adient’s dominant China franchises, which control almost half the market, at just 6x earnings net of cash. We think this is simply too low.
While we have assumed 4-5% growth in China over the next few years, we would highlight that management believes they have significant opportunities in China in the coming years. Adient believes that, due to its dominant share and scale advantages, it has much better product quality and higher margins than competitors in the market. Based on customer discussions surrounding upcoming product launches and a mix shift towards more expensive vehicles (where Adient has a higher share), management believes they have a real line of sight to increasing their market share in China over the coming years from today’s 44%. Internally, they have dubbed this the “Drive for 55 [% market share].”
Further, in 2015, Adient sold most of its interiors businesses to Yanfeng Automotive Interiors (YFAI), where Adient now owns 30% of the company. Management has indicated that YFAI is expecting meaningful margin improvement over the coming years, as they complete their own restructuring activities and due to strong growth in backlog that management claims is at higher margins than the business is currently earning.
While we are hesitant to assume significant upside to a Chinese auto supplier, we think there is a reasonable probability that Adient’s Chinese joint venture income could meaningfully outperform expectations in the coming years if they are able to deliver on some of the opportunities highlighted above.
While we expect that many reading this write-up will have an instant fear of Adient’s exposure to U.S. SAAR, we think those concerns are overstated as Adient’s exposure to U.S. SAAR likely represents ~25% of Adient’s total earnings, given its significant exposure to Europe and Asia. Further, we believe Adient’s meaningful self-help initiatives will help offset a significant amount of potential SAAR headwinds.
To explain what we mean by this, we believe North American sales will total ~$7.3 billion this year out of $16.2 billion in total consolidated sales (ex-China). Therefore, every one million unit decline in SAAR represents ~6% impact on North American sales (and ~2.5% for the consolidated business ex China given Adient’s significant Europe/Asia/Latin America business). Assuming 17.5% incremental cash gross margins (management has stated incrementals/decrementals are in the high teens), a one million unit decline in SAAR would be a revenue impact of ~$420 million, a profit impact of ~$75 million and ~35bps of overall margin headwind. With approximately 125bps remaining after FY 2017 on Adient’s margin improvement program, they could theoretically absorb a decline in SAAR of more than 3 million units and keep earnings flat, assuming zero growth from either the non-North America business or China equity income.
Electric Vehicles / Autonomous
Further, we expect that some investors may also wonder what happens to this business assuming the rapid adoption of electric vehicles and/or autonomous driving. In the case of Adient, the global leader in seating, we think if anything, they could be a beneficiary of these trends. As the market potentially shifts to autonomous vehicles, there is a logical argument that seating manufacturers could see higher content per vehicle (more flexibility, potential to swivel or fully recline may be demanded by consumers). But at a minimum, we think it is highly unlikely that a quality, comfortable seat would become less important in the future.
Aircraft Seating Opportunity
Adient is also working on entering the aircraft seating market. While it is still early days, the company has announced a collaboration with Boeing, has recently demonstrated a business class seat to customers and expects to have a production seat finished by September of this year at which time they expect to “go to market with a ready to sell product.” We think this could represent a $3 billion market opportunity with mid-teens margins potential. At a 20% share, we believe this could contribute $0.80 per share of earnings that would command a mid-teens multiple (due to higher margins than auto seats), which could add $12 per share of value or nearly 20% of the current price.
Other Developments Since the Spin
With its recent earnings announcement, management raised its expectations for EBIT by over 6% from its original guidance, despite a weaker revenue outlook (down by 4% due to FX and weaker passenger vehicle production outlook). In addition, management’s free cash flow guidance for the year was increased by 60% and the Board approved a $250 million share buyback (~4% of the current market cap).
Assuming a 16.5 million SAAR (down meaningfully from the peak), ~1% annual production growth ex-US and mid-single digit growth in China with EBIT margins of 6.9% (excluding equity income), we believe Adient can generate ~$14.75 in FY 2020 EPS (which begins in October 2019). To put that margin assumption in perspective, Lear’s seating business (with fully allocated corporate), generated a 7.1% operating margin over the past 12 months.
Assuming Adient trades at approximately 10x forward earnings, the stock would be worth $150 including dividends, a gain of 125% from the current share price in 2.5 years, an IRR of ~40%.
As a separate note on valuation vs. Lear, some might argue that Lear’s higher margin electrical business (which accounts for 35% of LTM adjusted EBIT) might indicate Lear should trade at a premium to Adient. However, we would highlight that Adient’s high growth China business represents a similarly-sized earnings contributor (~40% of total earnings) and would itself almost assuredly trade at a higher multiple as a standalone public company in either Hong Kong or the A-shares market. In addition, we believe Adient’s dominant global position in auto seats actually warrants a premium valuation to that portion of Lear’s business.
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