Description

Executive Summary:

Lear was last discussed on VIC in 2009.  I was writing this up at the end of last month when the stock was $58/share and now is up 11% since then.  But I still think the risk/reward is compelling. 

Lear is a Tier 1 automotive supplier, which manufactures seats and electrical distribution components for almost all major automotive manufacturers globally.  Today, Lear is set to grow EBITDA by 2015 25% from its 2012 level while shrinking its share count 25% over the same time period through buyback programs announced in April 2013.  Lear is currently trading at 4.8x 2014E EBITDA, which is a discount to its long-term average of 5.5x.  Based on 2015 figures, Lear shares should appreciate by almost 50% in 2014 based on the reduced share count, improved EBITDA and the restoration of its long-term valuation multiple and 75%+ by 2015 based on 2016 figures.  By 2015, the company will have a meaningful net cash balance again and be in a position to initiate another accelerated return of capital to shareholders.  Further upside is achievable if Lear’s two businesses were separated and its electrical business was sold.  Downside risks are manageable given the likely bottoming of European automotive production, the steady continued improvement in US automotive production, and Lear’s continued progress with the launch/changeover of an unusually large number of its vehicles platforms. 

Business Description:

• Seating: Lear is the #2 supplier of seating in a $55bn global market (2012) with roughly 20% market share. Seating is generally a just-in-time manufacturing operation, and the market is reasonably consolidated between those auto manufacturers who produce the product in-house and four other major competitors (Johnson Controls, Magna, Fauercia and Toyota Boshoku). 
• Electrical Power Management Systems –Lear has a 7% share in a $51bn (2012) market.  While its business is sub-scale, Lear has greatly improved the profitability of this segment by growing rapidly over the last few years.  Major competitors like Delphi and TE Connectivity have much larger operations and are consequently more profitable. 
• Lear filed for bankruptcy in 2009 and emerged that same year. 

Structural Improvements since 2009

• Balance Sheet – Prior to bankruptcy, Lear operated with a levered balance sheet.  Lear emerged with a substantial net cash balance, and after the recent $800mm Accelerated Share Repurchase (ASR) program, has a modest amount of net debt. 
• Cost Structure – Lear’s restructuring allowed it to reduce its cost structure and improve its profitability even at current revenue levels below the levels reached prior to the financial crisis.  While margins have stagnated over the last few years, this masks a substantial improvement in the electrical business offset by challenges in the seating business.  As discussed below, Lear is now positioned to resume its margin improvement.  In addition, Lear has adjusted its footprint and today has more than 80% of its facilities in low-cost countries.      
• Customer Concentration – Today Lear serves a diverse customer base and no customer accounts for more than 25% of its sales.
• Geographic Concentration – Likewise Lear has expanded its footprint globally and experienced strong growth in emerging markets further diversifying its franchise. 
• Growth Markets – Lear’s electrical division benefits from long-term secular growth in the use of technology in vehicles. 
• Capital Management – In the past, Lear pursued a strategy of large acquisitions entering new segments with little true strategic rationale.  Today, Lear is returning capital to shareholders and considering only tuck-in acquisitions. 
• Healthier Industry – After the bankruptcies of General Motors and Chrysler in 2009 along with a large number of automotive suppliers, the industry has reduced excess capacity, has improved balance sheets, is competing rationally and is focused on profitability.  In addition, the US OEMs have improved their relationships with their supply base viewing them as partners and focusing on their long-term financial health. 
• Improved Management – Management is focused on returns on capital and returning capital to shareholders. 

Margin Improvement

From an operating perspective, 2013 will be the low point for the Company’s business and I forecast a material improvement in earnings by 2014 and 2015 accompanied by continued top-line growth. 

• Seating
  • In the Company’s seating business, EBIT margins have declined from 7.5% in 2010 to management’s forecast of 5.5% margins in 2013. 
  • 2013 should be the seating margin nadir in my opinion as margins are being negatively impacted both by a low point in extremely depressed European production and by  launch costs occasioned by the change-over of GM’s truck platform (representing approximately 10% of Lear’s sales) to a next generation model. 
    • Lear estimates the 14% decline in European production over the last two years has caused seating margins to decline 100bps
    • In addition to the GM truck platform changeover, 2/3 of Lear’s products are undergoing some type of changeover, which is further depressing margins (For instance, a changeover to a new product often requires new tooling and new line configurations, which tend to be more expensive in the initial phase of implementation before costs are reduced over time). 
    • By 2014, these headwinds should begin to subside and margins should expand by at least 100bps by 2015 and possibly 150bps by 2016. 
• Electrical
  • In the Company’s electrical business, margins have improved from 4.3% in 2010 and management is forecasting 8-8.5% margins in 2013. 
  • Q1 2013 results showed margins in this segment were 8.4% underscoring my confidence in margin improvement for both segments.
  • Lear’s electrical margins (7.3% in 2012) are still well below peers (Delphi 11.1%, TE Connectivity 14.1%, and FCI 15.0%).  While Lear’s product mix is less profitable than those of its peers, there appears to still be further opportunity for margin expansion as the business continues to grow. 

Capital Allocation

• In April 2013, Lear announced an accelerated and expanded share repurchase program including the implementation of an $800 million Accelerated Share Repurchase (ASR) program and the commitment to repurchase an additional $750 million of stock after the conclusion of the ASR.  This is in addition to the $702 million of shares repurchased from 2011 through q1 2013. 
  • At the time of the announcement, the $1.55 billion of repurchases represented 32% of the shares outstanding at the prevailing market price.
  • At today’s price, Lear could repurchase 26% of its shares outstanding 
• Despite this aggressive repurchase of shares, Lear will likely have no net debt by the end of 2014 and over $300 million of net cash by 2016
  • Lear will be well positioned to again enter into another accelerated return of capital in the future
• Lear today has no debt maturities until 2018, a $1 billion undrawn revolver and approximately 1x gross leverage.  Lear could easily add another turn of leverage, which would allow it to repurchase an additional 18% of its shares outstanding.  At this point, management is not willing to do that, but the company could clearly tolerate the additional leverage 

Free Cash Flow

• Capex
  • From 2010 through 2012, Lear invested $300 million adjusting its footprint to lower cost countries.
  • Lear has noted that longer-term, its capex should be between 2-2.5% of sales while it is spending around 3% in 2012 and 2013. 
  • A 0.5% sales reduction in capex will increase FCF by almost $80mm annually or more than $1/share
• Per share improvement
  • We estimate FCF for 2013 will be slightly under $300mm or $3.33/share taking into consideration the ASR.
  • Between the additional buybacks, margin improvement and lower capex, we forecast FCF/share to reach $6.75/share in 2015 and almost $8 by 2016. 
    • Removing growth capex and only including maintenance capex in the FCF calculation would add up to $1/share to FCF
    • Investors are purchasing Lear shares today with a very attractive FCF yield and growth prospects  

Asset Sales

• The seating and electrical business operate independently and there is no benefit from these businesses being together
  • Automotive components are purchased independently by the automotive OEMs, so they do not give credit to a seating supplier for also supplying electrical components
• The electrical business lacks the scale of key competitors and requires significantly more capex compared to the seating segment
• The electronics business is only 25% of consolidated EBITDA and thus Lear gets no credit for this higher value business
• The most recent sale of an electrical business was  Delphi’s purchase of FCI at 7.4 x EBITDA
  • A sale of Lear’s electronics business would likely raise $2.4-2.8 billion and allow the company to repurchase 40-45% of its shares outstanding at today’s price
• Prospective buyers of seating are unlikely to want to purchase the electronics business

Risks:

• Europe
  • European production has been a large concern for global automotive suppliers since Europe’s financial crisis began.  Q2 production ended only down 2% and signs of stability have emerged.  While it will likely take time for Europe production to rebound, the crisis in production has likely subsided. 
• Future capital allocation
  • Lear’s board was slow to adopt an accelerated share repurchase program and made a questionable acquisition in buying Guildford Mills.  However, they are now firmly committed to the repurchase of $1.55 billion of stock. 
• Execution risk from launches in seating business
  • With the launch of the GM new truck platform and changeovers in the majority of its products, 2013’s seating operations face unusually high operational risk. Our checks indicate this is going smoothly, and while margins are depressed, 2014 should experience a strong rebound in performance.
• Pension/OPEB offset by NOLs and JVs
  • Lear has pension and OPEB liabilities of $440 million (on an after-tax basis).  These plans are mostly closed to new entrants and should decrease in value as interest rates rise in the future
  • In addition, Lear has JVs with $21mm of equity earnings, that likely are worth $250 million and NOLs that will offset $3 billion of future taxable income, which are probably worth $350 million today  
  • So on balance Lear’s other liabilities and assets would add to its enterprise value instead of subtracting from it.

Conclusion:

Benefitting from margin improvement, share count reduction, future free cash flow growth, and a return to Lear’s historical valuation of 5.5x EBITDA, investors should achieve a return of 50-75% from Lear’s current price. 

Catalyst