Description

High level thesis:

Temporary operational headwinds and cyclical concerns have depressed ADNT share price, giving us an attractive entry point into an industry-leading auto supplier.

Hawkeye901 previously wrote up the company a year ago.  His writeup and comments thread is worth reading to get up to speed.

Company/Industry description:

ADNT is the largest global manufacturer of automotive seating, producing 1 of out every 3 seat systems worldwide.  ADNT spun out of JCI in late 2016. The company has 86,000 employees operating in 250 plants in 37 countries worldwide.  In addition, ADNT has a 50% interest in 19 JVs in China, employing an additional 33,000 workers at 73 plants. ADNT also has a 30% interest in Yanfeng (YFAI), the largest automotive interiors business in the world.

Seating suppliers compete on price, technology, and reliability.  Seat suppliers benefit from high switching costs as they become entrenched in the OEM’s production process. For this reason, incumbent suppliers almost always win the next generation of the vehicle program.

The global seating market is fairly consolidated.  ADNT (~33% share) and Lear (~20% share) are the two largest global suppliers.  ADNT is #1 in the Americas (34% share), Europe (36% share) and China (45% share).  Regional competitors include Magna (Americas), Faurecia (Europe), and Toyota Boshoku (Japan).

Key issue:  Production issues in SS&M (Seat Structures & Mechanisms)

SS&M is the metal components division of ADNT.  Until recently, it had not been reported as a separate segment.  In SS&M, ADNT is making the frame of the seats as well as metal components such as recliners, tracks, height adjusters, latches and locks.  The division has $2.8b in revenue (excluding 2 China JVs), 28 global plants and 18,500 employees. 55% of sales are internal. ADNT’s global market share in these product categories range from 14%-34%.  

In 4Q’17, ADNT ran into production issues associated with the wide-scale launch of a new product line of metal components.  These new components, called the 3000 series, are a meaningful improvement over the prior generation of products (the 2000 series) because they are stronger, lighter, and provide improved functionality.  Production headwinds intensified throughout the winter and caused management to reduce FCF guidance from $525mm to $225mm. The stock dropped from the low $80s to the low $60s within a month of the guidance cut.  The company subsequently reduced it’s 2020 margin targets and the stock sold off further to ~$56 where it is today.

The root cause of these production issues was an overambitious launch program coupled with an overly complex footprint and supply chain.  It didn’t help that the company was somewhat starved of capital over the last few years of JCI ownership.

As a result, ADNT experienced production issues at number of its SS&M factories.  For example, ADNT’s new stamping equipment produced below the expected production rate and experienced issues with output quality.  This created a domino effect of inefficiencies. ADNT had to pay exorbitant prices for outsourced stamping to meet demand. ADNT also had to staff hundreds of extra people to monitor quality at multiple production facilities.  Due to the backup in production, ADNT also had to air freight significant content (over $40mm YTD) to lessen liquidated damages since ADNT was creating line-stoppages at its customers. In addition to the equipment issues, ADNT’s European supplier of specialty alloys failed to perform.  This led to on and off raw material shortages creating further production inefficiencies and forcing ADNT to pay import tariffs while it qualified other suppliers.

Investment thesis:

1)      Headwinds in SS&M are temporary:

From a high level, there is no reason why ADNT’s SS&M segment should not earn an acceptable rate of return on capital deployed.  They are the largest global player in the category and benefit from substantial internal demand. In addition, ADNT’s two Chinese SS&M JVs are a $900mm business earnings mid-teens EBIT margins.  This shows that the business can be nicely profitable if run properly.

To fix the operational issues, ADNT has replaced the senior management of SS&M and has provided the resources and capital needed to turn the business around.  ADNT has also formed a steering committee to report SS&M progress on a weekly basis to the board. KPIs such as production rates and quality metrics have already shown meaningful improvement.  Going forward, SS&M will be reorganized as a standalone unit to ensure proper management focus.

ADNT has also undertaken a strategic review of the business to try to reduce its complexity by potentially divesting and outsourcing certain non-strategic components and functions.  In the short term, ADNT has forecasted sequentially lower quarterly losses in SS&M between now and the end of FY’18. SS&M margins will likely trend towards breakeven by the end of FY’19 as the operational issues abate.

In the medium term, ADNT’s management still thinks they can achieve mid-to-high single digit SS&M EBIT margins (just not by 2020).  This will be achieved through component standardization, plant rationalization, and product mix. For example, margins will structurally improve as several high cost plants in Western Europe are scheduled to close in FY’19 and FY’20.  That volume will migrate to ADNT’s newer, underutilized, lower cost facilities in Eastern Europe.

2)      SS&M losses are obscuring meaningful SG&A improvements

When ADNT first became an independent company, the business was inefficiently run and overstaffed.  This was best exemplified by the 210 bps difference in SG&A as a % of revenue compared with its primary competitor, Lear.  However, there are few structural reasons why this margin gap should exist besides a modest level of extra overhead needed to support a greater number of Chinese JVs.

Management committed to close this SG&A margin gap by 150 bps by lowering headcount in key SG&A functions (Finance, Legal, IT, HR, etc.) and implementing more efficient systems and processes. So far, management has done an admirable job right sizing the cost structure and has delivered 160bps improvement.  While this impact is currently being overshadowed by losses in SS&M, over time this will result in sustainably higher margins for ADNT through the cycle.

3)      Fears about U.S. auto cycle are overstated:

U.S. auto sales have recovered nicely from the ’09 recession and remain somewhat above trend at ~17.3mm SAAR.  This is concerning to prospective investors in the auto supply chain. However, I think views that current sales are meaningfully above normalized levels are somewhat misplaced because on a per capita basis current sales levels do not appear abnormal and miles driven continue to grow at a healthy pace.

In addition, ADNT’s U.S. business is only ~30% of profit.  Auto sales in the rest of the world (in aggregate) are not overextended and require minimal adjustment to normalize.

In my base case I am assuming that mid-cycle U.S. SAAR is 16mm.  Below is a table calculating the adjustment needed to bridge from FY’17 results to more normalized operating profit levels.  The company claims decremental margins of 15%, I use 18% for conservatism.

4)      ADNT is a durable business that is well positioned to benefit from key secular trends in the auto industry.

Mix shift to SUVs:  Consumer preferences have shifted significantly over the past several decades to favor SUVs (including crossover vehicles) and pickup trucks over passenger cars.  This change has been aided by substantial improvements in engine fuel efficiency. ADNT benefits from this transition because SUVs have more seating content per vehicle.  Absent significantly higher fuel prices this trend is likely to continue, particularly outside of North America where SUV penetration rates are growing off a much lower base.

Growth in Chinese consumption:  China’s rapidly expanding middle class is driving a transition to a more consumer driven economy.  Despite massive growth over the past several decades, auto ownership rates remain very low compared with the developed world.  For example, China’s car ownership rate is ~180 per 1,000 people vs. ~820 per 1,000 in the United States. ADNT has the relationships and infrastructure to benefit as China continues to catch up to the developed world.

Light-weighting:  Increasingly stringent fuel mileage regulations continue to cause OEMs to demand lighter components from their suppliers.  Setting aside product launch issues, ADNT’s new metal components lineup is a step change in performance vs. prior generations and is advantaged vs. much of the competition.

Safety regulations:  Emerging markets such as China are following the lead of developed markets by implementing more stringent safety regulations.  This increases the seating content per vehicle and encourages developing market OEMs to partner with global suppliers with better safety capabilities like ADNT.

Electrification:  Unlike many auto suppliers that sell components related to the internal combustion engine, ADNT is agnostic to electric car share gains.

Autonomous:  A move to self-driving cars would very likely increase the seating content per vehicle as the car interior is reimagined.  ADNT has committed substantial resources to develop prototypes for this potential transition.

Valuation:

ADNT is trading at 6.5x my normalized EPS of $8.62 per share and 9.1x EV/normalized NOPAT of 912mm.  This takes into account normalized U.S. SAAR and adds back all losses from SS&M.

I value ADNT in my base case at $92/share using an unlevered DCF.  This is 64% upside from today’s price. I use an 8% discount rate on cash flows and a 13x NOPAT multiple (which implies 11.5x P/E) to calculate my terminal value.  This seems conservative for a growing, durable business generating low-teens tangible returns on invested capital.

Over my forecast period I model 60bps of margin contraction in China to be conservative given the opacity of the JVs.  I assume $100mm of annual restructuring expense to account for future plant rationalizations. I assume modest margin contraction in ADNT’s core business to account for a normalization of U.S. SAAR.  I conservatively assume no value for the recent commercial seating JV with Boeing.

Key Risks:

Global recession:  Global new auto sales are cyclical.  ADNT’s earnings would decline materially in a downturn due to the high fixed cost nature of its business.

Execution issues persist:  SS&M manufacturing issues could continue to snowball, leading to further operating losses and damage to customer relationships.

Competition:  Rivalry between existing players could increase.  This would be most impactful to ADNT if it occurred in China.

Rising input costs:  Historically ADNT has been able to recoup raw material inflation with a 6-month lag.  

Sharply higher gasoline prices:  Hurts demand for light trucks and SUVs.  

Trade wars: Some exporting on SS&M side.  NAFTA repeal could strand some assets.

Catalyst

Recovering earnings