Description

 

Introduction

 

Lear Corp. (LEA) is one of the world’s leading suppliers of automotive seating systems and interiors. With over $18 Billion in annual sales and a market cap of about $1.66 Billion, the stock is very cheap. Over 2/3 of Lear’s revenue is from seating systems. Inspite of being in the automobile parts industry, this is a fantastic business. Lear is a market leader in a mostly oligopoly-type supplier marketplace for seating systems. A series of mostly one-time events have depressed earnings and led to a collapse of the stock price from $60 in January ’05 to about $24 today. Intrinsic value is easily over $3.4 Billion and possibly as high as $5.8 Billion by 2009. This compares quite nicely with a current market cap of under $1.7 Billion.  Holding Lear for 2-3 years is likely to yield a 100-400% total return.

 

Liquidity

 

With 67 million shares out, a market cap of over $1.6 Billion and daily trading volume often exceeding a million shares, one can build a decent sized position fairly easily.

 

Business Background:

 

Lear was founded as American Metal Products in 1917. In 1988 management led a leveraged buyout of Lear Siegler seating. Lear came public again on the NYSE in 1994. The company has made numerous acquisitions as well as had considerable organic growth over the last 12 years. They have evolved from a seat supplier to a systems integrator to a strategic partner to the major automobile manufacturers with the capability of doing complete interiors for a given automobile.

 

Lear has three major divisions:

 

1.                 Seating Systems

2.                 Electronics and Electrical

3.                 Interior Products

 

Lear’s original seating business is a fantastic business. For the 10-years ended Dec. 31, ’04, Lear generated a 13.3% average annual sales growth and averaged a 28.3% return (after tax) on tangible capital employed. In the auto business, that is a stunning statistic. Part of it is due to their 40+% market share in the seating business. Lear does some $18 Billion in sales annually with just $2.5 Billion in fixed assets like plants etc. In 2004, they generated about $440 Million in net income – which implies a P/E of less than 4 based on the current market cap.

 

They share the seating market with one major competitor, Johnson Controls. Lear is regularly rated as the #1 seating systems supplier on a variety of metrics. Lear’s seating business has a solid moat around it. Seats have gotten vastly more complicated over the last few decades. Historically Lear has generated just a 6% operating margin on its seating business – and that is with over $10 Billion in annual volumes. The good news is that, even with that slim operating margin, its return on invested capital is off the charts.

 

The slim operating margin and the specialized know-how serves as a strong deterrent to would-be new entrants in the space. To get even the 6% operating margin, one needs several billion dollars in annual volume. And with a total world-wide market size under $50 Billion, that is very hard to do. Any new entrant would lose money for years on end and still not get to $10+ Billion in sales or get to 6% operating margins. Plus they wouldn’t have the know-how or the brand or credibility to get any traction. Neither can the auto manufacturers do it cheaper themselves. The result is that seating systems is likely to remain a cosy oligopoly – generating high returns to shareholders. While auto manufacturers are constantly beating up supplies over price, Lear’s already slim margin and limited competition means that manufacturers do not have that much clout to drop their margins much lower than they have historically been. They are better-off collaborating to get better seats as consumers care a lot about seat comfort and features.

 

The Electronics and Electrical division is an okay business while Interiors has proved to be a terrible business. Lear management is very cognizant of this and has already spun off the European Interiors business to Wilbur Ross’ International Automotive Components Group. Lear did this in exchange for a 34% interest in Ross’ company. Thus Lear owns 34% of a business with $1.2 Billion in sales and $300 Million in assets. To the extent Ross is able to pull off what he did with International Steel Group, it represents further upside for Lear. Lear has also announced that a definitive plan for the rest of the interiors business will be executed by the end of 2006. It would not be surprising to see another deal like the first Ross deal.

 

What went wrong?

 

Lear hit a perfect storm of four events in 2005 that decimated its cash flows and stock price.

 

First, raw material and energy prices skyrocketed very quickly in 2005. With their locked-in prices and contracts the company was stuck with absorbing some of the differentials which clobbered its margins. As these contracts have run out, the company has renegotiated pricing and surcharges with its customers. As this time, much of this painful episode is behind the company.

 

Second, Lear had an unusually large number of new model introductions to deal with in 2005. New models mean significant one-time engineering and launch expenses – which again clobber margins. In the next few years this is not expected to be as pronounced.

 

Third, it saw significant declines in sales of vehicles (like large SUVs) which have “lots of Lear content.” This is likely to be an ongoing trend, though much of the pain is behind Lear.

 

Finally, Lear has been negatively impacted with the production cuts that Ford and GM are undergoing. With 44% of total sales going to GM and Ford, the company is directly impacted when GM and/or Ford cuts production. However, these cuts have a much lower impact than one is led to believe by the headlines. On Sept. 21, the company quantized the hit as being a $300 Million reduction in 2006 sales and a $60-65 Million reduction in operating earnings. That’s quite manageable on $18 Billion in annual sales.

 

The good news is that Lear’s business in Asia with Asian manufacturers is growing rapidly. This business has been growing at a 30% annual clip for the last 2-3 years and is expected to grow to $3-4 Billion in the next 2-4 years (up from $800 Million in 2002).

 

One does not need to be bullish on GM and Ford to invest in Lear. On the contrary, even if one is quite bearish on the future for GM and Ford, this investment still works. In 10-15 years, GM and Ford may well be much smaller than they are today. As they shrink, Lear’s business with them will shrink as well. However, global demand for cars is rising and the aggregate number of cars produced worldwide is rising. Lear is growing its sales very rapidly to the dominant Asian manufacturers (albeit from a small base) and I expect the $$$ sales increases from all Lear’s customers excluding GM and Ford will more than offset any future declines at the big two. Net net, Lear is unlikely to see it seating sales decline over the next several years.

 

If one factors in all the announced production cuts at Ford and the positives of the rising sales in Asia, the stock is still very cheap. Even if GM and Ford undergo further cuts in production, Lear is moving aggressively to scale up its business with Toyota, Nissan and Hyundai on a worldwide basis. And they keep getting design wins with new ones. In the last few years they started supplying seating systems to India’s Mahindra & Mahindra. They recently became a supplier to Tata Motors in India. Both are likely to get much larger over the next decade and Lear will ride their coat-tails and grow along with them.

 

The Numbers

 

Historically, sales have been broken down as:

 

Seating:                 65%

Electronics:             17%

Interiors:                18%

 

Since interiors is being spun off, let’s assume Interiors is zero in 2007 and beyond.

 

Seating:        80%

Electronics:   20%

 

Lear has been restructuring its business to deal with the lowered GM/Ford volumes, increased Asian volumes and increased use of low-cost locales for more of its production. This restructuring cost the company $100 Million in 2005 and about $120-150 Million in 2006. The company expects a quick 2.5 year payback on these initiatives in increased profitability.

 

The company expects to be back to its historic margins and profitability in 2008. While managements can say all sorts of things, I believe they have a sound basis for their projections. The management team is the same that did the LBO etc. They have a lean and mean approach to business and they do have the luxury of absolute market leadership in 80% of their product mix (seating).

 

Seating is at a $12 Billion run-rate. GM and Ford make up $5.3 Billion of this number. Let us assume conservatively that this declines to $4.2 Billion by 2008. Asian sales are expected to increase by atleast $800 Million by 2008.

 

Total Seating Sales in 2008: $11.7 Billion

 

The company expects to return to historical 6% margins on seating by 2008.

 

Seating Operating Income: $700 Million

 

Electronics Sales are expected to be $2.8 Billion (after GM/Ford decline). Margins for this business have historically been between 7.5 to 9%. Let us assume 7% margins.

 

Electronics Operating Income: $200 Million

 

Total Operating Income:   $900 Million

Interest:                          ($200 Million)

Capex:                             ($300 Million)

Taxes                              ($100 Million)

 

Free Cash Flow:                $300 Million

 

This cash flow is worth atleast a 10-15x multiple or a market cap of $3.0 - $4.5 Billion. In 2007, free cash flow might be atleast $100 Million. Thus by the end on 2008, there is expected to be excess capital of atleast $400 Million ($100 + $300). Now our market cap range is $3.4 to $4.9 Billion at the end of 2008.

 

In addition, there is the 32% stake in Ross’ IACG for the European interiors. In addition Lear is likely to get something similar for the rest of its interior business. What is the interiors business worth? I don’t know. But I like the deal they did with Ross with taking an equity stake. If they do a similar deal for the rest of the interiors business, that’s pretty sweet. Interiors is over $3 Billion in annual sales. If Ross can get this business turned around in 2-3 years to generate even a 2% Free cash flow margin, that would be $60 Million in FCF – which would be worth $600 – 900 Million.

 

So, let’s give the interiors business a valuation range of $0 to $900 Million.

 

Thus Lear’s intrinsic value is a range of $3.4 - $5.8 Billion in 2008-09.

 

That is $50.74 to $86.57 per share (versus a present stock price of about $24).

 

Lear has had a long history of doing stock buybacks. If Lear used it’s excess cash to buy back stock, it could spend upto $400 Million by the end of 2008. And if it bought back stock at an average price of $35/share, it could buyback 11.4 Million shares.

 

Now intrinsic value would be $3 Billion to $5.4 Billion with 56 Million shares out.

 

That is $53.57 to $96.43 per share.

 

Thus Lear’s range of intrinsic values in 2008-09 is $51 to $96 per share. This is a 2-4x return from current levels. The range of annualized returns is 28.5% to 100%.

 

The Cast of Characters Involved with Lear

 

Richard Pzena’s fund owns over 14% of the company (9.6 Million shares). He presented Lear at the 2005 VIC conference and also discussed it in Value Investing Insight. Anytime a fund manager is willing to own over 10% of a company, they have to have very strong conviction. As you all know, all sorts of onerous rules kick–in once you own over 10%. He’s treated as an insider and has to file even the smallest changes to his position immediately.

 

Joel Greenblatt (some of you might know this nice fellow) owns some 505,000 shares, but I would not be surprised if he owned a lot more Lear LEAP options. Joes loves LEAPs and discussed them at length in his first book. The telling thing about Joel is that he founded VIC and has access to all our identities. VIC has to read all ideas posted every week to select the $5000 winner. Thus it’s reasonable to assume that either Greenblatt himself or someone in his shop goes through all the VIC postings. He’s famous for holding very concentrated positions. On gurufocus.com and EDGAR, the data indicates that Greenblatt owns just 6 stocks:

 

Walmart, Lear, American Express, Ameriprise, Auto Zone and Live Nation

 

So, after full access to 500+ ideas a year on VIC for the last several years, the aforementioned names are what Greenblatt seems to have honed in on. Lear apparently ranked much higher for him than several thousand other VIC ideas. That is a very compelling piece of data. His interest in Lear is not surprising. Greenblatt and Pzena are close friends (he talks about Pzena in The Little book that Beats the Market). He loves spinoffs and Lear kinda has a couple of spinoffs built-in (Interiors). His buddy Pzena has the ear of management, there is virtually no downside and a massive upside.

 

Other interesting holders of the stock are Bill Miller and Carl Icahn. Miller also owns over 10% of Lear (7 Million shares) and Carl Icahn owns 4.2% (2.8 Million shares).

 

Disclaimer

 

This is not a solicitation to buy or sell stocks. Please do your own independent analysis before buying or selling LEA (or any other stock). We have a long position in LEA at the time of this writeup that can change at any time without notice. There are no plans to provide future updates on our LEA buying or selling activities.

Catalyst

Value is its own catalyst. However, we have a few tangible catalysts with Lear. In 2007, the interiors business will be mostly sold/spun off and by 2008 the restructuring will be complete, propelling the stock higher as the core business gets its stride back and Asian sales continue to rise.