As Lear Corporation (NYSE: LEA) investors know, the automotive industry is cyclical and closely tied to GDP growth. Additionally, many economists use global auto sales growth as a leading indicator of global growth, reasoning that there is a strong positive correlation between the two. With much of Europe mired in a recession and most of the developed world experiencing slow, if not zero, growth for at least the next year and emerging markets slowing as well, a major risk to the industry is weak demand. However, with more flexibility, via less leverage and pension liabilities, Lear should avoid the massive failures it experienced in 2009, even in the event of a significant slowdown in the economy. Let's look into Lear Corporation and its sales figures to get a better understanding of this automotive supplier.
Two of Lear's biggest success factors are its high quality products and strong positioning in its product segments (seating and EPMS). The seating segment is a cash cow in a mature market and the Electronic Power Management Systems (EPMS) segment is positioned in a growth market. Also, Lear has been able to innovate and retool products to meet clients' needs and therefore maintain its market share. Lastly, Lear is able to source inputs from low-cost countries, keeping its Costs of Goods Sold (COGS) as low as possible.
The automotive industry is cyclical and is tied to global and domestic GDP growth. As a result, the company's share price will likely be highly influenced by shifting expectations for the global economy. A significant global slowdown may weigh on the stock. In a deteriorating economic environment, investors tend to shun names with a high degree of cyclical exposure.
- Warranty Liabilities: Lear claims to be insured against liabilities and have the bargaining powers to pass on some of the claims to its suppliers. However, the extent of this insurance and pass-through ability is not disclosed and is too difficult to estimate to cause any changes to my forecasts.
- Share Buyback Program: Last year, Lear initiated a share buyback program, which acts as a dividend. This is accounted for in the forecasts by lowering cash and shareholder's equity. Eventually, this would increase EPS, but would not cause much distortion on the actual financial statements. In order to reflect this within eVal, I paid close attention to the dividend payout ratio.
- Capitalized E&D: Some contracts state that the buyer reimburses E&D costs, so while Lear capitalizes some of the E&D costs it can only expense the amount that is not contractually reimbursable. Hence, the capitalization of E&D costs would only impact the cash balance of Lear without affecting the income statement. This could create confusion to investors as it is often hard to forecast the amount of contracts rewarding reimbursement. Although E&D costs are relatively small compared with the company's other expenses, they still can eventually impact the tax expenses and add more uncertainties to forecasting net income.
- Restructuring: There are incremental costs associated with the company's restructuring through Chapter 11, notwithstanding the one-time item of restructuring cost in 2009. Items to look at are impairment of long-term assets and pension costs, but it is also difficult to estimate these directly without further management information.
Financial Ratio Analysis
Lear Corp has lower gross and EBITDA margins than its major competitors, but actually has higher EBIT and net income margins. Part of this discrepancy comes from the different input costs that each company uses as well as how it classifies the different costs such as depreciation and R&D (or E&D for Lear). Lear capitalizes its reimbursements when the E&D costs are contractually guaranteed and fully recoverable by its customers.
Lear's ROE is approximately in line with the mean and slightly higher than the median versus comparable companies. This is most likely due to the share buyback program, which was approved for an increase earlier this year. Comparing leverage ratios, in this case total debt-to-EBIT, Lear has on average, less debt than its competitors. The lack of debt can be attributed to the recent emergence from bankruptcy and the ability for Lear to keep leverage off of its balance sheet in the short-term. Lear turns over its net operating assets on an average basis and turns over its net working capital faster than the average.
Breaking down Lear's ROE through the basic Dupont decomposition, I can see that due to Lear being less levered than its competitors, ROE is forced lower than the average. However, because Lear has higher turnover than its competitors, the decrease caused by the low leverage gets offset. Lastly, due to higher than average net income margins, ROE is further boosted. One reason for higher net income margins is that the lower levels of leverage causes less interest expense, providing Lear with slightly lower than average gross margin, with higher net income margin. Thus, Lear generates significant ROE without the excess leverage risk of some of its competitors by having slightly higher margins and more efficiently extracting value out of its assets.
Forecasts for global auto sales for 2012, by calculating the 10-year Compounded Annual Growth Rate (CAGR) of global auto sales, is about 3.8% per year. If I apply this growth rate to 2011 global auto sales, I calculate a 2012 global auto sales forecast of about 70.5 million units sold.
I then calculated the average selling price of a vehicle by dividing historical auto industry revenue by the total number of cars sold. Next, I calculated the total level of dollar sales resulting from this level of vehicle production by multiplying the 70.5 million forecast for production by the ASP. I conservatively forecast a flat ASP, over time, because of weak demand in European and North American markets.
From there, since auto parts industry sales can be thought of as COGS of the automakers, I derived a simple logic to find Lear's segment sales: [(total auto sales) x (% of auto parts sales) x (% of interior parts) x (Lear's market share on seating and EPMS segments)]. I assumed that the percentage of auto parts and interior parts are fixed from 2011 to 2012, because the auto industry is a manufacturing industry, and the COGS ratio would stay relatively stable over this period.
To forecast Lear's segment earnings in seating, I noted that Lear's market share in the seating segment had been increasing rather steadily since the financial crisis. I determined that the increase in market share would continue in 2012 as Lear continues to implement large CAPEX towards the seating segment. Considering the overall competitive market situation, I determined that Lear's market share in the seating segment would slightly increase to 8% from 7.8%. Thus, we arrive at forecasts that Lear's seating segment sales would be about $11,786 million.
In the EPMS segment, similar calculations were used. Lear's market share in this segment is growing much faster than the seating segment, mainly due to its technology in hybrid car power management systems and the government incentives that have been put in place. With Lear's focus on developing the EPMS segment, the company has been able to capture consistent share within the newly growing market. Thus, I determined that Lear's market share in this segment would continue to grow rapidly as Lear invested almost twice as much CAPEX toward EPMS segment than last year. To adjust for the risk of the EPMS being a growth segment, I forecast that Lear would be able to grow its market share at least at the same rate as last year's 0.3% and capture overall 2.1% of the market. This is a conservative estimate because the CAPEX investment itself implies a higher market share gain than the forecast. Thus, the analysis derived that segment sales would be $3,981.9 million in 2012, creating a total sales forecast of $15,768 million.
It is expected that with a slowing economy in Europe, softening economic indicators in the U.S., and structural headwinds in the global economy, it will take years for Lear's industry to fully recover. Therefore, a conservative stance toward the stock seems prudent, and if more risks arise, it might imply further downside in LEA, which has already lost nearly 32% over the last 52-weeks.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.