Spotlight On: Lear

July 22, 2016 |

Lear (LEA) is a mid-cap auto parts maker that sells premium vehicle seating and automotive electrical power management systems to automakers around the world. In this article, we’ll be discussing why we are partial to this stock, which is in our Dividend Growers portfolio.

Performance

Despite being in the auto parts industry and consumer cyclical sector, both of which have solidly underperformed the market for the last 2 years, LEA has outperformed all 3 benchmarks. Below is a 2-year price chart with dividend-adjusted return. LEA is in dark blue.
 
performance

Clearly this outperformance comes with a fair amount of volatility (the beta 1-year is 1.25, meaning the stock moves up or down with 25% more force than the S&P 500), but you can see that the stock has stayed above benchmarks for most of the ride. Plus, as we’ll see later, the valuation has come down in this same period.

Innovation in a Competitive Environment

Within the highly competitive auto parts industry where suppliers are often contractually obligated to lower prices annually, LEA has managed to increase margins, court long-term customer relationships, and retain a modest amount of pricing power. This is due in large part to the company’s constant innovation as well as the nature of the relationships between automakers and parts suppliers, which tends to favor the incumbent supplier for vehicle programs.

Lear’s customer base helps speak to its product quality. Ford, General Motors, and BMW collectively account for about half of Lear’s revenue. The other half comes from a wide range of customers, including an impressive roster of sport and luxury vehicle makers such as Alfa Romeo, Audi, Cadillac, Ferrari, Jaguar Land Rover, Mercedes-Benz, and Porsche.

As evidence of its “culture of continuous innovation” (from a Morningstar analyst report), Lear has over 2,000 patents pending, an “Idea Portal” on its website where anyone can submit product ideas, and a Center for Craftsmanship where designers and engineers put their heads together early in the product design stages. The company’s orientation toward innovation and quality will help it continuously serve and adapt to auto industry trends for technological sophistication and luxury.

Industry Trends

The auto parts industry is nested in the consumer cyclical sector because of its cyclical nature, which is highly sensitive to economic shifts and consumer confidence, plus is subject to some seasonal cyclicality. For a detailed outlook on the industry, see this report, which defines three broad categories that materially affect auto companies: “macroeconomic forces, a new era of personal transportation, and stricter regulations.”

The macroeconomic climate presents some key challenges. The strong dollar continues to hurt profitability abroad, which affects globally integrated companies such as Lear. Global economic sluggishness is also suppressing demand worldwide, including in previously-hot emerging markets. However, China, the world’s largest market, is still growing, and the Middle East and Africa are also expected to grow as they become increasingly motorized. In the US, vehicle sales hit record highs last year, although sales are expected to flatten out in the next two years. All in all, despite cyclicality and some significant macro headwinds, the global auto industry is expanding in the long term.

While the macro picture is mixed, automotive design trends appear to be directly favorable to Lear, providing new opportunities for margin increases. In its 10K report, the company highlights 3 “mega-trends” that are driving vehicle design: connectivity (i.e., mobile communication and the regrettably-named “infotainment” systems), consumer safety, and energy efficiency. Longer term, these are expected to persist as industry drivers (excuse the unavoidable pun)—eventually converging toward fully autonomous vehicles. In short: vehicle content is increasing, so content providers such as Lear are set to benefit.

Higher fuel economy standards and consumer demands for vehicle safety likewise represent an opportunity for Lear. The need for more fuel efficient and electronically controlled powertrains offer a “significant incremental content opportunity” for Lear’s electrical segment. Additionally, Lear notes that seating is a critical part of a vehicle’s safety system, so its continued innovations in seating design and materials are pertinent.

Lear sums up the industry trends for which they are competitively positioned like so:
 
industry trends

We believe vehicle design trends will allow quality parts makers like Lear to capture more revenue per unit sold, allowing revenue growth to exceed vehicle unit sales growth.

The Numbers

Lear’s financials provide quantitative support for the qualitative story. First, earnings, sales, and cash have all grown since 2009, when the company filed for bankruptcy. Below is a chart of EPS (in orange) and sales (in blue) with dotted lines representing average analyst estimates for the current year.
 
growth

Disregarding the EPS spike in 2012, both lines have progressed steadily upward. EPS is expected to grow 32.4% for the current year and 7.8% next year. It is worth noting that Lear has reduced its shares outstanding by 35% since 2011, but its EPS has doubled since then, meaning the increasing EPS growth is due to both increasing earnings as well as contracting share counts.

The table at the bottom of the above image shows increasing yearly cash flow per share, which confirms the positive earnings and sales trends. Here are further details on cash flow over time:
 
cash flow

Operating cash flow has increased year over year, as has capex, but at a slower rate, as evidenced by rising free cash flow (FCF). Also nice to see, FCF as a percent of sales and FCF as a percent of net income are increasing, meaning the company translates more and more of its revenue into cash.

This growth appears to be managed in a sustainable and financially responsible way. Lear scores a B from Morningstar for financial health. Both its debt/assets (0.2) and debt/equity (0.6, which is average for industry peers above $2B market cap) have slowly crept up since 2009, but its interest coverage ratio has also increased to a healthy 15.0. This alongside rising FCF tells us that the company is able to easily afford its level of leverage.

Now, for profitability. As you’ll see in the following tables, Lear has gradually increased its profitability, but there is room for improvement.

Below notice that the gross margin, net margin, and operating margin, as well as the ROE, ROA, and ROIC, all have a rising trend. Meanwhile, the SGA margin (selling general and administrative expenses as a percentage of sales) has remained fairly steady. Sales per employee have hovered in the same general range for the past 5 years, while receivables as a percentage of current assets has actually come up.
 
profitability

While the current figures are decent and the trends are generally good, you’ll see below that, when compared with notable peers, Lear’s margins do not stand out.
 
profitability

It does however have the lowest SGA margin, which speaks positively of management’s ability to keep overhead low. Compare that with larger peer Delphi (DLPH), another strong company that also sells automotive electrical equipment, which has more than double the SGA margin, but also has better margins and capital efficiency.

Management keeps a close watch on these figures, particularly ROIC. In their most recent earnings call, CFO Jeff Vanneste stated, “return on invested capital is one of our key financial measures and drives most if not all of our investment decision.” Given this statement and management’s track record so far, Lear should continue to hone its operational and capital efficiency in the years to come.

Dividends

As mentioned at the top of the article, Lear is in our Dividend Growers portfolio. Although its current yield is fairly low, 1.1%, we believe that Lear’s commitment to it growing shareholder return will result in long term dividend growth. As shown below, the dividend increases have averaged about 20% per year, and the payout ratio and FCF payout ratio are both very low, indicating that the company should have no trouble continuing its strong pace of dividend growth.
 
dividends

In fact, considering its FCF and low payout ratio, we would rethink our commitment to this company if itdidn’t continue raising the dividend at a fairly brisk pace.

Valuation

Even as Lear’s price is up 19.6% (excluding dividends) in the last 2 years, the P/E has come way down, as shown in the bottom chart here:
 
p/e chart

Additionally, at 8.1 its forward P/E is even lower than the trailing P/E, and both the PEG forward and PEG trailing at 0.6, suggesting that the stock is priced low for both its historic growth as well as its expected growth. The stock is also on the low end of its 5-year P/FCF range.

The entire auto parts industry appears to be discounted right now, but LEA’s P/E multiples and PEGs are lower than the industry averages. Only its price/book is higher than the industry average. The stock’s valuation metrics also compare favorably to the peer group we looked at earlier:
 
valuation

One could argue that all of these stocks are inexpensively or at least fairly priced. Yet Lear is still on the lower end of this group in most measures.

Final Thoughts

Lear’s management team has done a terrific job of turning the company around since its bankruptcy, and we have faith they will be able to continue to steer it in the right direction, especially by increasing profitability. The challenging macro climate and the cyclical nature of the industry will provide headwinds for Lear and contribute to the stock’s future volatility. At the same time, industry growth and design trends will favor innovative, high-quality suppliers like Lear.

The company had a bangarang first quarter in 2016, beating the EPS expectations by $0.63. Management also increased guidance, so analysts have revised upward accordingly, as seen below. The bottom row shows the percent change of the current average estimate from the average estimate 90 days ago:
 
estimates

This provides another vote of confidence in the company’s growth trajectory.

On top of it all, the price is relatively low, both compared to industry peers and historical valuation. We also expect solid dividend growth from the company based on its financial health, low payout ratio, and history of dividend increases. All of this has us cheering for Lear.





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