The Long Case For Adient

| About: Adient plc (ADNT)
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Summary

ADNT is a classically undervalued spin-off; with its independence from Johnson Controls, it has significant opportunities to re-accelerate top-line growth and expand margins given several self-help cost-cutting opportunities.

Despite these significant opportunities and the company’s superior scale, it trades at a discount to its closest comps.

Catalysts include technical overhangs related to spin-off subsiding, company executing on cost saving opportunities, and new business wins.

Target Price and Rationale

Our price target is derived by applying a 9.5x P/E multiple (in-line with the company's closest comp Lear (NYSE:LEA)) to Adient's normalized 2020 earnings.

Relevant Comps

LEA, EO.PA, MGA

Catalyst

Technical overhangs related to spin-off subside, company executing on cost saving opportunities, and new business wins

Summary

Adient plc (NASDAQ:ADNT) is a classically undervalued spin-off. With its independence from Johnson Controls (NYSE:JCI), ADNT has significant opportunities to re-accelerate top-line growth and expand margins given several self-help cost-cutting opportunities. However, despite these significant latent opportunities and the company’s superior scale, Adient paradoxically trades at a discount to its closest comps as a result of unusual spin-off dynamics and several underappreciated value drivers. At its current price, Adient shares present investors with the opportunity to buy an industry leader with durable competitive advantages and several significant levers for earnings growth at a discount to peers. Moreover, the company’s discounted valuation provides a margin of safety even if expected cost cuts and other opportunities fail to materialize.

Company Overview

Adient is the world’s largest automotive seating manufacturer. The company holds a dominant position in its industry, with 36% market share in Americas, 38% market share in Europe, 44% market share in China. The company is ~50% larger than the #2 player in the United States, twice the size of the next player in Europe and 4x the size of the closest competitor in China. Our conversations with industry participants confirmed that the company enjoys durable competitive advantages not only related to its scale but also its product quality and service. Adient’s revenue is also relatively balanced across geographies and OEMs, with the company having exposure to nearly all major OEMs and no single customer accounting for more than 14% of sales.

Spin-Off Dynamics

Adient was spun-off from Johnson Controls following its merger with Tyco. Johnson Controls shareholders received .1 shares of Adient for every share of JCI. The nature of the spin-off is worth noting in that Johnson Controls shareholders essentially received shares in a company that is much smaller (~10% the size) and operates in a different industry from Johnson Controls. This, combined with the perception of Adient as a cyclical, low-margin business like other auto suppliers, resulted in significant selling pressure and unfavorable technical overhangs.

Under Johnson Controls’ ownership, Adient was capital-constrained, as Johnson Controls was unwilling to invest in the business and instead prioritized other segments of its business. This limited Adient’s ability to bid on new contracts and invest in necessary restructuring and cost-cutting activities. With its independence from its parent, Adient is now positioned to capitalize on these opportunities.

Investment Thesis

Self-Help Cost-Cutting Opportunities Drive Significant Margin Expansion

Despite its superior scale relative to peers and the high fixed-cost nature of the business, Adient’s margins significantly lag those of its peers for no structural reason. We believe that this is largely the result of Adient’s former parent underinvesting in Adient as it prioritized other segments of its business.

Much of this margin differential is a result of bloated SG&A expenses. Specifically, there is a ~140bps gap between Adient and Lear’s (Adient’s closest competitor and the #2 player in the automotive seating business) SG&A as a percentage of sales. Going forward, the company has an opportunity to significantly expand margins by merely closing the SG&A gap with Lear. Moreover, given Adient’s superior scale and lower mix of just-in-time business (which is lower margin), Adient’s normalized margins could arguably be higher than Lear’s.

In addition, Adient has further significant cost-cutting opportunities related to its metal seating assembly business, which represents ~18% of the company sales but is currently breakeven. The metals business consists of several acquisitions that have not been fully integrated as a result of Johnson Controls’ unwillingness to invest in the necessary restructuring. The business also has excess capacity; for example, Adient has a plant in Germany that is currently losing ~$40 million annually, which alone represents a 130bps drag on metal business margins and a 25bps drag on consolidated margins. With the company now independent and able to address these issues, metal business could ultimately reach an 8-10% margin, representing a further 140-180bps margin improvement.

Our calls with former Adient employees who worked at the company during its ownership by Johnson Controls confirmed that Adient has significant low-hanging fruit in terms of cost rationalization opportunities, giving us confidence in the long-term runway for cost cuts. In addition, it’s worth noting that Adient’s management has a track record of executing on cost saving opportunities. Adient’s CFO, Jeff Stafeil, was previously CFO of Visteon. In 2014, during his tenure, Visteon acquired Johnson Controls' automotive electronics business. In less than two years, Visteon grew this business’s EBITDA from $58mm to $150mm, significantly exceeding initial guidance for cost savings.

Assuming the company is able to increase margins 140bps related to SG&A and 150bps related to the restructuring of the metal business, which does not give full credit to either of these opportunities, executing on these self-help cost-cutting opportunities alone would drive EPS from the ~$9.5/share expected in fiscal 2017 to at least $13/share over the next two to three years. This would translate to a 5.3x P/E multiple, a substantial discount to Lear’s ~9.5x P/E multiple. Furthermore, this is before giving the company any credit for growth in top-line revenue or JV income.

Underappreciated Value Drivers

Lower Corporate Tax Rate

Most analysts base their valuation of Adient’s core business on peer EV/EBITDA multiples. However, this ignores the valuation impact of Adient’s lower corporate tax rate. While Lear’s tax rate is 28%, Adient is domiciled in Ireland and thus should pay a tax rate of 10-12% going forward. As a result of this advantaged tax rate, Adient should be valued on after-tax metrics such as EPS or NOPAT.

Chinese JVs

Valuation models used by sell-side analysts undervalue Adient’s Chinese JVs. Adient and its JVs were first movers in the region and currently have a ~44% of the market. These JVs are also highly profitable and are growing considerably faster than the company’s overall earnings given growth in the region. Over the past five years, equity income from Chinese JVs has grown at a 12% CAGR.

Sell-side analysts that separately value Adient’s JVs in an SOTP model apply 8-9x multiples to Adient’s JV earnings (which are after tax). In addition to these multiples being a considerable discount to the 10-11x multiples that Chinese auto suppliers trade at, this approach implicitly overlooks the significant net cash position of these unconsolidated JVs. For example, Adient’s largest Chinese JV, Yanfeng Johnson Controls (YFJC), had a net cash position of $586mm as of the end of 2015 (likely higher now given additional cash build-up since then). While there isn’t disclosure for the company’s remaining JVs, we believe that these JVs have similarly overcapitalized balance sheets. Assuming that this is the case, Adient’s Chinese JVs could have collective net cash of roughly $1.4 billion, or $700mm ($7.50 per share) attributable to Adient. This excess cash alone represents 11% of Adient’s current market cap. Viewed another way, the 8-9x multiples that analysts apply to JV earnings represent 6-7x multiples net of cash.

While it is difficult to ascertain the timing, a potential one-time distribution of excess cash would realize the considerable embedded balance sheet value of these JVs. Furthermore, it is worth noting that Jeff Stafeil’s tenure at Visteon saw the company monetize its 50% stake in an automotive interiors JV by selling its share to the Chinese auto supplier Huayu Automotive Systems (which, interestingly, is now a part of Adient’s Yanfeng Interiors JV).

Reacceleration in Top-Line Growth

While Adient can generate $13 in EPS by 2020 through cost cuts alone, the company also has several opportunities to grow revenue and JV income on top of earnings growth. Although concerns over peaking North American SAAR dominate the investment narrative for many suppliers such as Adient, the company generates a significant portion of its earnings outside of the U.S. In particular, ~50% of the company’s net income comes from its Chinese JVs, where despite concerns over a slowdown, auto sales are still expected to increase at a reasonable rate going forward. Furthermore, Adient has a benefit of increasing seating content per vehicle in many segments of the market. In addition, Adient should be the beneficiary of several idiosyncratic drivers.

New Business Wins

Prior to the spin-off, Johnson Controls underinvested in Adient, resulting in a lack of business wins and market share loss over the past several years. With its independence, Adient has already begun to make progress towards regaining share. In our discussions with former Adient employees and employees at several OEMs, our primary research contacts indicated that Adient possesses significant competitive advantages across several market segments and regions and should be well-positioned to add new business wins given its independence from Johnson Controls. While the lack of business wins over the last few years should continue to weigh on near-term revenue, the company’s already-underway progress at restoring the pace of business wins should re-accelerate revenue over the medium to long term.

Chinese JV Income Growth

Unlike other areas of its business, Adient’s Chinese JVs have not been significantly affected by underinvestment from Johnson Controls. Over the past five years, equity income from the company’s Chinese JVs has grown at a 12.2% CAGR. Despite recent concerns over slowing growth, light vehicle sales are still expected to grow at a 4.5% CAGR between 2017 and 2020E per IHS. On top of unit growth, Adient’s Chinese JVs should benefit from increases in content per vehicle given that they are well-positioned with respect to the continuing shift from sedans to SUVs. Growth in the company’s JV equity income would also translate into further margin expansion given the higher margins of these JVs compared to the rest of the company.

Expansion Into Non-Automotive Markets

Another opportunity that Adient was unable to capitalize on during its ownership by Johnson Controls is the opportunity to be making and selling seats in non-automotive markets, such as trains and aircrafts. Indeed, the company recently announced that is collaborating with Boeing (NYSE:BA) to explore aircraft seating and interior solutions. Of note, a possible reason for this partnership could be the fact that Zodiac, the second largest aircraft interior supplier, has been experiencing operational issues and several delays in deliveries over the past several years. Given Adient’s proven supply chain and execution capabilities (in many ways, the seating business is more akin to a just-in-time logistics provider than a traditional manufacturing company), as well as the fact that Adient already operates an FAA-certified plant, the company has the ability to begin to take share in the industry over time. While we do not ascribe any specific benefit from these opportunities in our model given uncertainty regarding their probability, timing, and magnitude, opportunities in these areas nonetheless represent a potentially significant free option (particularly given the significant size of these verticals, e.g. the aircraft interiors market is $15bn).

Valuation and Estimates

Despite the company’s dominant market position and significant opportunities to grow earnings through cost cuts, top-line growth, and JV income growth, Adient paradoxically trades at over a 2x discount to Lear’s 9.7x forward P/E multiple.

Our estimates assume that the company is able to realize 140bps of margin expansion related to SG&A cuts and 150bps related to the restructuring of the metals business, partially offset by 125bps of margin headwinds related to growth investments and pricing pressure. We assume modest top-line growth over the medium term given recent business wins, as well as a 4% CAGR in JV income (conservative given that this is below growth estimates for light vehicle sales in China, and Adient’s JVs should gain share given their outsized exposure to higher-growth vehicles such as SUVs). We also expect the company to deleverage given significant free cash flow generation over the next several years, reducing interest expense.

Our base case price target is based on applying a 9.5x multiple to Adient’s 2021 earnings and implies nearly 100% upside and a ~19% IRR. Crucially, even if the company doesn’t execute on cost cuts, we think downside is limited.

(Editors' Note: This is a republication of an entry in the Sohn Investment Idea Contest. All figures are current as of the entry's submission - the contest deadline was April 26, 2017).

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.