Lear Corporation: Recent Drop Unwarranted After Recent Results Illustrate Improving Fundamentals

| About: Lear Corporation (LEA)

Approximately 3 months ago, I wrote an article on Lear Corporation (NYSE:LEA) suggesting it was undervalued although not egregiously so. Immediately after, the stock rose significantly, preventing one from establishing any major positions. However, in recent weeks, the price of Lear has gradually come down, culminating with a nearly 6% drop after the recent earnings call. However, I believe that not only was the decline overdone, but that the fourth quarter results and other recent developments are quite positive. They have provided further evidence that Lear is poised to take advantage of a rebound in seating and significant growth in the electrical business. The results and outside events also provided some unexpected positives to further add onto the original thesis. Thus the recent drop presents a buying opportunity for a firm that appears to have about 34% upside.

This article will not rehash the original article but provide analysis on the recent results.

1) Revenue for the quarter exceeded my estimates ($16.2B vs. $16.1B). More importantly company estimates for 2014 are quite robust at $17.15B at the midpoint. This represents almost 5.7% growth even though IHS is predicting cars to grow only 3%, and Lear typically has to reduce prices to customers yearly. This continued strength illustrates that Lear continues to take market share, and that the strong performance this year was not an anomaly but rather a base.

Source: Lear 2013 Q4 Presentation

2) The story of margin expansion within electrical has continued. They have guided for electrical margins between 10.5% and 11% which agrees with my original model. Seating margins are still taking time to improve. However, 2 out of the 3 factors affecting seating margins in the original thesis showed improvement as described in the 4th quarter conference call. Europe is stabilizing and potentially improving as Lear European sales for 2013 were actually up 4%, and total European production was up 1%. Second, Lear is another quarter closer to finishing production ramp up, and have the cost inefficiencies behind the firm. The South American business remains weak. The rhetoric about the production inefficiencies and the effect of South America has remained consistent, indicating in my opinion that management is accurate in its description of the levers affecting the business. In spite of some remaining headwinds, Lear has guided to seating margin improvement for 2014, and likely 2015, as they believe seating margins will improve throughout the year according to the recent call and presentation:

"On the seat side, I still think that through the first half of 2014, we'll be seeing headwinds on the product changeover, as well the launch costs, which are, in many cases, 2 separate things. Product changeover we define as just the kind of profit profile of the business that's coming online versus the profile that it replaces. Launch costs are really the inefficiencies associated with ramping up the plants and training the workforce on a new product. The launch costs would be heavier in Seating through the first half and then diminish as the year goes on. And that's one of the drivers on what we expect at segment, with a steady improvement in margins as we start off the year, a little bit lower than we expect to finish the year."

Source: Lear 2013 Q4 Presentation

3) Cash balance has increased from $841MM to $1.14B. This provides more financial flexibility and opportunity to return cash to shareholders.

4) In fact, they are likely to use this cash for an accretive transaction. The most recent conference call indicates Lear is actively looking to add onto the firm to participate in industry consolidation. For example:

Brett D. Hoselton - KeyBanc Capital Markets Inc., Research Division

"Since you're in discussions, and back to the prior question about capital deployment, earlier in the call, you kind of talked about the idea of feeling comfortable going up to 1.5x net leverage for it sounds like a transaction, an acquisition or an opportunistic acquisition of some kind. What are your thoughts on the capital deployment side? You've got the $750 million authorization. That's potentially going to kick in after March 2014 here. That seems to expend over a 2-year period of time. Your free cash flow, you've got net debt cash neutral, $1.2 billion in EBITDA. It kind of seems like you've got $1 billion, $1.25 billion, almost $1.5 billion to do something with. What are your thoughts there?"

Matthew J. Simoncini - Chief Executive Officer, President and Director

"Our comments have been along the lines that we're comfortable with the 1.5 turns of gross leverage as opposed to net leverage. From our standpoint, we do have wherewithal to take advantage of any potential opportunities, whether it's organic with the business growth or expansion of the footprint, which has been very good for us, and you've seen the results of it in Electrical. Two, we would look to participate in any significant consolidation in the space, particularly in Electrical and also in the components and in Seating."


John Murphy - BofA Merrill Lynch, Research Division

"Okay. That's incredibly helpful. Then just a second question as we look at the potential for consolidation in the Seating business, particularly North America, as maybe one of your large competitors exits. You probably wouldn't be the buyer of that big a deal on the Seating side because you'd run into antitrust issues. But could you be a buyer of seating assets in North America if they weren't that big-bang JCI deal, if somebody else was forced to divest assets? Is that something that you've thought about, as being part of the industry consolidation but obviously not the big consolidator?"

Matthew J. Simoncini - Chief Executive Officer, President and Director

"Absolutely, we would. It's not our primary focus though, John. I mean, we're very strong in North America, both in the just-in-time assembly in our mix of business and our components. We would more be interested in a market that maybe we're less represented such as Asia or in components that we could possibly get stronger in such as leather. If a niche acquisition, if you will, brought us further customer diversification in North America, we would strongly consider it, quite frankly. But for the most part, we're pretty happy with what we have here in this market."

And finally

Brett D. Hoselton - KeyBanc Capital Markets Inc., Research Division

"From an acquisition standpoint, a lot of what you've done up to this point is in bolt-on acquisitions. Is there the potential for a more significant acquisition? I mean, with, let's say, $1 billion plus $1.5 billion in capital, that's quite a significant acquisition or war chest, so to speak. Are you thinking that that's a possibility?"

Matthew J. Simoncini - Chief Executive Officer, President and Director

"I don't see anything out there that would fit strategically at a valuation that would make sense to our shareholders. If it was out there, we do have, obviously, the financial flexibility to execute something like that. I don't see it out there. I don't see something that fits strategically at that size, at a valuation that makes sense to our investors, our shareholders. So I don't think it's likely, but yes, if it was out there and if it fit and it was the right valuation and we could execute it and get the synergies that would justify the investment, we would do it. But I don't think it's probable, Brett. I think what's more probable is more along the lines of what you saw us do with Guilford, which has been an excellent acquisition for us. It's increased our capabilities, and it's providing nice financial returns. I think what you'll see is more along the lines of Guilford. And with that, I think that concludes the Q&A. No? There's more? I thought they said that was the last one?"

Lear is not only actively searching for an acquisition to bolster its position, but has been for some time as evidenced by the discussion that current valuations are not attractive to shareholders. It appears a transaction could happen in the next 6 to 12 months.

5) According to its earnings release, Lear will continue its $750MM buyback. This illustrates that Lear remains committed to returning capital to shareholders and the swing towards being more shareholder friendly is likely permanent.

6) Given Lear's projected earnings, it trades at less than 5X EV/EBITDA 10X PE, 7% FCF yield. This FCF yield is likely even artificially depressed due to upcoming negative working capital changes as discussed by Lear:

Jeffrey H. Vanneste - Chief Financial Officer and Senior Vice President

"Yes. Just setting the parameters, our 2013 free cash flow was $367 million. At the midpoint of our 14 guidance, we're at $375 million, $8 million to $10 million or so. Earnings is up $100 million on a year-over-year basis. You're right, John, that the primary issue is working capital, and there's certain lumpiness in that working capital rationale. One of them is the timing of customer payments. We had anticipated getting paid by a couple of customers in 2014. They accelerated some of those payments into 2013. That created a good guy, if you will, for 2013 and a corresponding bad guy and '14, which is part of the reason. Additionally, we've got some working capital buildup associated with the growth of the business in 2014. Restructuring cash will be slightly higher, roughly $10 million higher in '14. And then there are some other compensation-type payments that will be funded in 2014 that is a little bit greater than the expense that we're incurring through the course of 2014. So there's an imbalance there between the expense that's in the OI number and the cash payout related to the 2013 performance."

These ratios are quite cheap - growing earnings at 10+%, possesses a strong position in strong industry, and has proven to be shareholder friendly.

7) Marcato has increased its stake recently by almost 15%. Often after an appreciation of over 40% since beginning the position in early February 2013 would cause a fund to take some chips off the table to lock in gains. However, Marcato still feels strongly about the investment. And now, one can invest at a lower price than Marcato doubled down, and after revealing a strong quarter.

8) Johnson Controls (NYSE:JCI) has exited the electronics industry. This reduces the number of competitors in the industry, likely providing an improved pricing environment through consolidation.

Given these facts I have updated my model, and provided a few tweaks which better reflect the business. These tweaks include:

1) Raising the model cash tax rate to 25% for 2014-2017 and 30% for 2018 (for final period calculation) to be conservative. Although they do expect cash tax rate for 2014 to be 20%, and the cash tax rate to remain below the effective tax rate for several years.

2) Increasing revenue base to reflect 2013 results and 2014 guidance

3) Increasing seating costs slightly in case seating margins remain low

4) Updating cash balance and shares outstanding.

5) Reducing 2014 CAPEX but not other periods CAPEX to be conservative

6) Increasing restructuring expenses, but not reducing them each year.

With these tweaks and increased conservatism, I calculate a per share value of $97.50, representing an upside of about 34% from the recent share price of $72.33. This updated model can be found on dropbox.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in LEA over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: The author has presented his findings to the best of his knowledge. He encourages potential investors to perform their own due diligence.

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