Lear: Sit Back And Relax

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About: Lear Corporation (LEA)
by: Raul Shah

Summary

Lear trades at a significant discount relative to its peers. This presents a potential buying opportunity.

Lear has many competitive advantages that make owning their business far more desirable compared to their competitors.

I will present my viewpoints on some of the big reasons I suspect the stock has fallen this year and if it is a concern for long term investors.

Like I said in my last article, there is no shortage of puns when it comes to titles one can create in regards to Lear Corporation (LEA). However, this title serves a dual purpose. It alludes to the fact that Lear has many competitive advantages which will enable them to win new business, produce higher profits, and enter an era of great growth. As a result, shareholders can sit back and reap the benefits of a wonderful company. I will discuss why I believe Lear is a better company to own than its competitors. Then, I will discuss some of the reasons the stock has been falling, along with some associated risks.

Competitive Advantages

Seating AND E-Systems Company

Lear is one of those companies that flies under the radar. Even on Seeking Alpha, Lear has only about 6,000 followers compared to Apple, for example, which has almost 2 million. Many investors think of Lear as a seating company, but, Lear is far more than that. Lear reports its business in two segments, Seating and E-Systems. In Lear’s E-System segment, they design, engineer, and manufacture electronics, which serve to control various functions within the car. They also have formulated and integrated their own software for their electrical components. They were first to the market with Ethernet and multicore processors. And they are a market leader in smart junction box technology, which includes their Automotive News PACE Award winning Solid State Smart Junction Box™. Here is a list of some of the electronic modules they engineer:

  1. Body control modules
  2. Smart junction boxes
  3. Gateway modules
  4. Wireless control modules
  5. Lighting control modules
  6. Audio domain controllers and amplifiers

As we can see, Lear is far from a company that just designs and sells car seats. In their 2017 10K they clearly state one of their competitive advantages:

We believe that our expertise in consolidating functional controls into integrated modules and integrating these modules into the vehicle’s electrical and electronic architecture is a competitive strength.

On the same note, because of their expertise in electronic systems, many of Lear’s customers allow them early access to their own development teams, which provides Lear with premarket information on their customers’ needs and enables Lear to develop system design efficiencies. Many other competitors fall short in this category and that gives Lear a huge upper hand. Lear believes that this is another competitive advantage they have. They state:

Our ability to design and integrate electronic modules creates a competitive advantage as we support customers with complete electrical architecture development.

Furthermore, their expertise is derived from all over the globe. They have approximately 2,400 engineers across seventeen countries. Having such a large global presence allows Lear to capitalize on business opportunities in foreign markets with foreign companies and provides an overall better/more convenient experience for their customers. Not to mention having a global team facilitates better dialogue, design, and ideas for the future, due to the many different perspectives and experiences of those workers.

The fact that Lear provides electronic capabilities to auto makers helps win their business for Lear. They are already supplying, or will supply, high voltage components and systems for hybrid and electric vehicles produced by BMW (OTCPK:BMWYY), GM (GM), Jaguar, VW (OTCPK:VLKAF), and Volvo (OTCPK:VOLAF), among others. Their expertise in this area will certainly provide additional growth opportunities in the future especially due to the increased need for alternative power designs. Furthermore, as more and more auto makers enter this market, they will consider contracting Lear to assist in their electrical productions. All in all, this opens the door for more collaboration with auto manufacturers for various electronic issues. Lear estimates the global target market for their E-Systems business to be over $90 billion.

Finally, let’s take a look at Lear’s primary competitors. Lear identifies their primary competitors in the Seating Segment as:

  1. Adient (ADNT)
  2. Faurecia S.A. (OTCPK:FURCF)
  3. Toyota Boshoku Corporation (OTCPK:TDBOF)
  4. TS Tech Co.
  5. Magna International Inc. (MGA)

Lear identifies their primary competitors in the E-Systems Segment as:

  1. Aptiv PLC (APTV)
  2. Leoni AG (OTC:LNNNF)
  3. Molex Incorporated
  4. Sumitomo Corporation
  5. TE Connectivity (TEL)
  6. Others

You might see where I am going with this… there is no overlap of companies. This indicates that Lear has no competitor which is in both the Seating and E-Systems industry. This is a huge competitive advantage for Lear as they provide dual functionality to customers. This expertise and broad portfolio greatly enhances Lear’s value proposition and positions them in place to become the standard to which other companies must catch up to in the future.

Seats Will Never Go Out of Style

No matter what happens to cars, they will always need a seat. I can’t imagine a future in which you will have to stand in your car. The fact of the matter is the seat is an integral part of each and every vehicle and thus, will always be in demand.

I wrote in my last article that management has done a great job forecasting future trends. In the past, a seat was a seat. Now, with all the technology we have, a seat is far from just a seat. Car seat manufacturers have to adapt to a changing landscape and Lear is leading the way against competitors.

Lear sees a future involving Intelligent Seats. These seats will be able to take your EKG, read and set your body temperature, absorb energy in a crash, adjust your spine, and make sure the airbags deploy properly. In fact, Lear’s ProActive Seating brand has been endorsed by the American Chiropractic Association, International Chiropractors Association, and World Federation of Chiropractic and Loomis Institute of Enzyme Nutrition. This type of recognition by these influential organizations is a huge competitive advantage Lear Seating has over many other competitors.

Furthermore, combining their expertise in electronics and wireless communication, Lear is designing seats to be able to send the vital signs of the occupant to oncoming emergency workers in the event of an accident. This is a feature which offers incredible value to Lear’s customers (and the ultimate customer, the driver) as it literally could be the difference between life and death. Any auto maker would love to be able to market that safety feature in their vehicles. As a result, Lear’s value proposition is greatly enhanced.

In fact, Lear themselves identify this to be one of their competitive advantages. Here is what they have to say on the matter:

Intelligent Seating (INTUTM Seating):

We believe that we are the only seating supplier with both global capabilities in all major seat components and global electronics development (including software), manufacturing and integration. We believe that intelligent and dynamic seating solutions, which we call INTUTM Seating, will provide future benefits as consumers and automotive manufacturers demand seats that can sense key attributes of a driver and passenger and communicate these attributes within the vehicle network, as well as to external networks. We believe that the seat will increasingly become a more dynamic and integrated system that will actively react to both the driver and driving conditions, particularly with the advent of autonomous vehicles. Such trends will promote increased levels of electrical and electronic integration into the seat, accelerating the convergence of our Seating and E-Systems businesses.

Crafted by Lear

Lear has a long history in luxury and performance seating and places a huge emphasis on its specialized craftsmanship and elegant products, including the world’s best (and largest) supply of premium automotive leather. In order to better facilitate this, they established their Center for Craftsmanship, which is a dedicated studio where Lear’s team of engineers craft entirely differentiated products. Working closely with their customers’ vision, Lear’s team of technicians help bring to life the most creative and boundary pushing designs. This type of customization and attention to detail increase Lear’s value proposition. Further enhancing their value proposition and customer experience is the fact that Lear uses premium materials and textiles, many of which reduce their impact on the environment (which is another trend auto manufacturers are chasing).

Lear themselves, state that this is a competitive advantage:

We believe that our broad portfolio of capabilities, including advanced design and material integration skills, is a differentiating competitive advantage for us. Our unmatched component capabilities, design know-how, global manufacturing presence and our Crafted by LearTM portfolio of enabling and sustainable technologies uniquely position us to bring innovative designs into production with the highest level of craftsmanship.

2018 Connected Gateway Module

Starting with Audi (OTCPK:AUDVF), Lear is introducing the industry’s first and most sophisticated, super connected gateway and communication module (which is a new and improved connected gateway module with enhanced capabilities and a combined secondary communication module).

The connected gateway module manages signal and data onboard the vehicle. Initially, this product performed straightforward tasks such as, provide infotainment system updates and connectivity updates involving Bluetooth or cellular (along with other traditional features of today’s vehicle). However, Lear’s new, super connected gateway, in addition to the communication module, will provide cybersecurity, centralized application processing, and over the air updates which can address all the ECUs in the entire vehicle.

This provides a wonderful growth opportunity for Lear, as this module will continue to take on an increasing role in future vehicles. Lear can use this platform to combine wireless connectivity to extend signal and data management outside the vehicle, which will have significant applications as we move towards autonomous driving.

Relative to their competitors, Lear is second overall in the market for gateway modules. However, given their smart acquisitions such as, EXO Technologies, Arada, and Autonet, Lear is positioned to catapult into first place. These businesses provide Lear with specialized capabilities in V2X, which is shorthand for “Vehicle to Everything” technology which provides data exchanges between a vehicle and its surroundings. Lear’s new super connected gateway and communication module gives them the ability to facilitate updating many issues onboard the vehicle through over the air software updates.

I also want to note that in the Q2 earnings call, CEO Raymond Scott was asked if they would try to monetize the data to earn recurring revenue, as opposed to a one time purchase for their product. His answer was:

As far as getting into those adjacencies, that's not something we're interested in. I think that gets in complete conflict with our customers. And like I said, the opportunities in front of us are enormous and we just have to make sure we capitalize on them.

This speaks volumes to me. Instead of diverting attention and resources all over by chasing any dollar that might float their way, Lear is focused on delivering the highest value proposition to their customer. I spent my entire last article justifying why I believe Lear has a world class management team. This is a company that wants to deliver the best in class products and focus on doing the best job they can to meet their customers’ needs. If you make great products, take care of your customers, and continue to lead in character, the profits will start pouring in. And as time goes on, the cheap, short sighted competitors will fall.

Autonomous Vehicles

As we transition to driverless cars, there will be increased regulation on safety measures. Many of those measures will revolve around wireless communication, occupant health monitoring, and more efficient power consumption. Lear specializes in all three of these areas and is incredibly well positioned to capitalize on these demands. They have acquired wireless communication companies (along with their own proprietary software and communication abilities), are building occupant health monitoring into their Intelligent Seat, and have innovative electronic modules and capabilities. This is a huge growth opportunity and no other competitor matches Lear's ability to contribute in all three of these areas to their customers. As the regulation and the demands of autonomous vehicles increases, weak competitors will falter.

Additional Competitive Advantages

Some additional competitive advantages include:

  1. Smart management team
  2. Consistently high performing operating business
  3. Globalized sales
  4. Differentiated customer base
  5. Currently cheaper than industry peers. Take a quick look at this chart:

Slide 15

Why is the Stock Price Down?

Lear operates in a heavily regulated, global industry and thus, subjects them to numerous risks. I want to discuss some of the biggest reasons why I believe the market is suppressing Lear’s stock price.

Tariffs

With the latest batch of tariffs slapped on Chinese exports, many investors see rising prices for Lear that will affect their competitive price positioning. However, let’s try to take a look specifically at what products will be affected. Back in July, Trump took the leap forward to employ tariffs on many Chinese goods, including one of particular importance to us, resin. Lear makes use of resin in the assembly of end products. Back in 2004, higher costs for certain raw materials, including resin, had a significant adverse impact on Lear’s operating results. However, relative to steel, resin is a much smaller portion of the commodity risk Lear is exposed to. I believe they will be able to pass resin’s higher cost onto customers.

Now, let’s move on to steel. Lear states that:

The majority of the steel used in our products is comprised of fabricated components that are integrated into a seat system, such as seat frames, recliner mechanisms, seat tracks and other mechanical components. Therefore, our exposure to changes in steel prices is primarily indirect, through these purchased components.

Lear has many barriers put into place to mitigate the effects of commodity price increases, such as entering into price index agreements with their customers. Lear utilizes short term and long term supply contracts to purchase key materials.

Lear has stated that in regards to steel:

We buy roughly three billion pounds of steel. Right now, we have got about 10% of that buy is a direct exposure to us. And we are working with one customer in particular to get on their steel resale program. So we would anticipate going forward that our risk would be even lower with our respect to steel buy.

Furthermore, Lear is entertaining the possibility of using different raw materials and commodities if the price of any one they depend on rises dramatically. This isn’t the first time commodity prices have risen and it certainly won’t be the last. Lear knows how to navigate these waters and they have already contemplated entering into discussions with their customers to find alternative solutions. For example, using different materials, different types of steel, or different designs are all ways in which Lear is seeking to provide value to their customers in the most cost effective way. Overall, management sounded quite confident on the latest Q2 earnings call and seemed like they have everything under control and have a dynamic plan for the future.

Honestly, the biggest risk Lear faces in regards to the tariffs, is the risk their customers will face. Auto makers such as Ford (F) and GM, which comprised 36% of Lear’s sales in 2017, are expected to see a large increase in their costs. For example, back in July of this year, GM reported that they incurred about $300 million extra costs due to increased commodity prices. Ford has stated earlier this year that the tariffs resulted in $145 million extra cost and could balloon up to $600 million by the end of 2018. Needless to say, if these companies struggle to sell cars, that reduces the demand for Lear’s business, which will hurt their growth. This is a real threat and is something that will have to be closely monitored.

However, these companies I mentioned should find ways around the tariffs through different methods, such as negotiations, leveraging buying power, vertical integration, finding alternative methods and solutions, and/or differentiating/changing suppliers. These mitigations do not happen overnight though, so there could be some short term pain. That being said, I want to stress that external factors like these do not phase me. Lear is an excellent company with a tremendously strong operating business. These types of distractions tend to sort themselves out – for the long term investor.

New CEO

Matt Simoncini resigned this year after bringing Lear from bankruptcy to record sales. One of the best CEOs in the industry, he orchestrated extremely insightful and profitable acquisitions for Lear over the past decade and has created immense shareholder value over that time period as Lear’s stock price has gone from a low of $25 in 2009 to a high of $206 just this year.

Simoncini praised Raymond Scott, who was formerly the executive vice president of the company, president of Lear’s seating segment, and president of their older electronics segment (which was the basis for their current E-Systems segment). The fact that he has been nominated to the highest title on both sides of Lear’s operations is just what we want – a CEO with expertise in both segments. He has been with the company for a long time and Simoncini would not have left the company in weak hands.

The market equates change in management to uncertainty. And we know that uncertainty can lead to suppressed share prices. It is my belief that this uncertainty is unjustified – we have an in-house CEO who has ran both segments, been with the company for decades, and has the stamp of approval from the former CEO. I see a bright future, not an uncertain one.

Dependence on Customers’ Success

Lear’s profitability is directly tied to their customer’s profitability. If Ford and GM, which represent over 36% of Lear’s sales, start to struggle, then naturally Lear will be affected. Given the enormous pile of debt those companies have, contracting sales, and tariffs, the market is quite uncertain about Ford and GM.

A PE ratio taken literally means Price/Earnings Per Share – but it is more than that. It is symbolic of investor confidence. Ford and GM are trading at very low PE ratios– around 6 for both companies.

In my view, the market has extrapolated those fears to Lear. This is understandable since when those companies went bankrupt in the Great Recession, Lear suffered immensely (due to numerous other factors as well). However, Lear is far more solvent today than they were then, they are producing far more sales than they were then, and they are far more diversified like I showcased in my last article (regionally and customer wise).

If those companies struggle, Lear will too. However, that does not change the fact that Lear’s operating business is incredibly strong and well managed. In my investing strategy, external factors, nonspecific to the core operating business, are not something I tend to worry about.

Ford and GM’s operating business struggles have no influence on Lear’s core operating business– it certainly has an effect on profitability, but the actual core operating business is not influenced by any company, other than Lear itself. As long as core operations are excellent, Lear will find a way to adapt and succeed just like all companies which have excellent core operations do. Short term pain? Maybe. Long term gain? Definitely.

Additional Reasons:

Some additional reasons that the stock price has been suppressed are:

  1. Reports that Lear’s rival, Continental, has stated margins and sales could be under pressure due to higher than expected costs for developing technology. The market has (incorrectly) extrapolated that fear to Lear.
  2. Lingering sentiment over the company’s prior bankruptcy and an interpretation among some analysts that industry trends are similar to around the mid 2000s.
  3. BREXIT – Uncertainty regarding Lear's European Operations. This is an external factor nonspecific to the core operating business.
  4. NAFTA – Although, recently it was reported that the new NAFTA deal will not hurt auto makers as much as initially thought.
  5. Foreign exchange risk

Takeaway

Lear has many competitive advantages that enable them to provide more value to customers than other competitors. The high quality products and expert craftsmanship that Lear offers will allow them to continue to grow the business and create shareholder value. There are numerous reasons why the stock has been pushed to 52 week lows, but I believe those issues are normal in the course of running a business. Lear has a smart and adaptive management team that has insulation against many projected headwinds. Lear trades at a discount relative to its peers and offers a good buying opportunity for long term investors.

Note: There is certainly much more to touch on in regards to the company. I have to discuss in depth their operating performance and then I will present my valuation for Lear. The next couple articles will shift towards being far more quantitative than qualitative. Thanks for taking the time to read my work. Hit that follow button if you so wish and join the DocShah Economics family.

Disclaimer: Neither this article, nor any comment associated with it, is to be taken as financial advice. Investors should always do their own research before executing any financial transaction.

Disclosure: I am/we are long LEA.

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.