|Shares Out. (in M):||94||P/E||4.8||4.8|
|Market Cap (in M):||4,208||P/FCF||5.5||18|
|Net Debt (in M):||2,948||EBIT||873||795|
Adient is the recent spin out of Johnson Controls and began regular trading this past week. JCI shareholders received 0.01 shares of ADNT for every 1 share of JCI creating approximately 93.5 million shares of ADNT. We think the company exhibits many of the characteristics that frequently cause spins to outperform including the fact that the company was capital constrained within JCI and the new-co should be free to bid on new business helping the topline grow beginning in FY 2019. We also think the valuation is somewhat obscured by the fact that FY 2017 (beginning Oct 1 2016) is a transition year with only $250 mn of estimated free cash flow due to two large one-time items but which we expect will be meaningfully higher higher in FY 2018
Background: Adient is the largest automobile seating supplier with a 34% global market share in an industry where size and scale are an advantage due to high fixed costs. The automotive seating industry had been under pressure approximately four years ago as OEMs began cutting costs in seats - an easy and indentifiable target since they are one of the most expensive outsourced part to the auto manufacturing process. Margins in the industry for companies such as ADNT and LEA were under pressure although margins have since improved with supplier attempting to move up the value chain to end markets such as fabrics, leather and metals. The industry continues to trade at low EBITDA and P/E ratios due to constant pressure by OEMs but our sense is that the market appears to have reach an equilibrium and expect margins to remain stable for the foreseeable future.
Chinese Joint Ventures: One of ADNT's competitive advantages is that it is the largest suppler of automotive seats in China though its 17 joint ventures which have grown at a 26% CAGR since 2000 compared to industry-wide growth of only 2%. The company has a first mover advantage in China and currently has a 45% market share which generates about $7.0 billion in sales with an estimated 12% EBITDA margin. As an aside, the reason for the perceived drop-off in FY 2016 sales is related to the deconsolidation of the Chinese JV YFAI in FY 2015.
Valuation: An initial valuation of ADNT yields and equity price of $47-$56 based on 4.75x-5.25x FY 2017 EBITDA of $1.575 billion which is an inline multiple to best comps Lear and Magna. However, we think this is only a baseline view and that there could be significantly more upside when investors begin to value the company on FY 2018 financials and on either a P/E of FCF basis which reflects the value of the company's low 10%-12% estimated cash tax rate. We think FY 2017 is likely a transition year for the company and that FY 2018 could show 50 basis points of EBIT margin improvement (based inpart on management's guidance of 200 bps of increased margins by 2020) and lower capex due to reduced cash restructuring charges at the end of one-time IT start-up costs. At current prices, we estimate the stock is trading at 4.4x FY 2018 estimated earnings of $10.15 per share, and at a 14% free cash flow yield compared to comps trading at a 10% yield or lower. We estimate that an inline 10% yield with LEA would generate an equity price of ~$62.00 per share. Alternatively, we think investors could value the company's EBITDA ex-china at a 5x multiple and place a P/E multiple on the higher margin and higher growth Chinese-based JV earnings. In this case, we estimate FY 2018 EBITDA ex-China of $1.279 billion which by itself equal an equity value of approximately $36.00 per share after the $2.9 billion of net debt. We estimate that Chinese/Hong Kong based auto companies (Ningbo Huaxiang Electric, Weichai Power, Fuyao Glass, Weifu High Tech, Huayu) are trading at 8x earnings and assuming an inline multiple on the estimated $380 mn of Chinese earnings would equal additional equity value of $29.00 per share for a total value of $65.00 per share.
Risks: We think the main risk is the company's initially high 1.9x leverage ratio although we do think the company can delever relatively quickly. Other risks include potential Chinese margin pressure and potentially peak US SAAR.
1. Valuing on FY 2018 financials
2. Valuing on either a P/E or FCF basis
3. Valuing Chinese JV earnings independantly from non-Chinese EBITDA
4. New business wins
|Entry||11/15/2016 08:42 AM|
We are in agreement with bruno677 and also believe ADNT represents a compelling long opportunity. We were planning on writing up the idea as well and rather than post separately, we thought it made sense to share some of our thoughts in the comments.
Besides some of the key points highlighted in the write-up, particularly around 1) capital constraints at ADNT under JCI and 2) the company’s strong position in China that is likely not being appropriately valued by the market, we thought it might be helpful to highlight some of the areas that we find particularly compelling in the ADNT investment opportunity, specifically: 1) ADNT’s much larger scale in seating vs any global peer, 2) the margin opportunity at ADNT, 3) the technical/spin-off dynamics which seem particularly compelling here, 4) the balance sheet optionality at the Chinese JVs, which are heavily net cash and 5) ADNT’s Irish domicile and hence lower tax rate vs peers.
Adient’s Scale in Perspective
As bruno677 mentioned, ADNT is the leader in the seating industry. But to put its scale in perspective, ADNT 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. Despite its global scale advantages, ADNT’s margins are counterintuitively below peers, particularly Lear (LEA), the next largest global competitor. That brings us to our next point around the potential margin opportunity at ADNT over the coming years…
While the stock is outright cheap on current earnings (5x management’s FY 2017 adjusted EPS guidance), we believe the investment opportunity here is even more compelling when you consider the upside potential around margin improvements that management is targeting for the newly-separated ADNT. Specifically, management has highlighted a 200bps margin opportunity over the next 3-4 years (very impactful for a business that is currently generating ~4.5% core EBIT margins).
In terms of overhead, when we compare SG&A as a percentage of sales for both Lear and ADNT, there is roughly 150bps difference between the two companies, even though ADNT’s larger scale should arguably result in less SG&A (as a percentage of sales) than its smaller competitors. Management has stated that they believe a 25bps improvement will come immediately upon separation as they leave behind a significant JCI overhead allocation and establish a leaner standalone infrastructure.
Outside of the overhead opportunity, ADNT is focused on improving the profitability of its $3 billion metals business (which is currently break-even). Management has been unable to improve the margins in this business to date as 1) JCI was unwilling to let them spend the needed restructuring to fix this business over the past few years and 2) it takes time (largely around vehicle cycles) to move production from higher cost and lower utilization plants to lower cost regions. As an example of the opportunity, ADNT has a plant in Germany that is currently losing $40 million annually. Simply closing this one plant could improve the metal margins by 130bps (and the overall company margins by ~25bps). Our diligence indicates that this business could ultimately earn 10% margins, which represents 180bps of margin improvement opportunity for ADNT overall. Even if they only get part of the way there in the coming years, the tailwind to overall ADNT margins would be significant.
Based on the SG&A and metals opportunities, we believe the potential to reach management’s 200bps margin improvement target seems very possible (and perhaps even conservative).
Technical Selling / Spin-off Dynamics
From a technical perspective, we think it’s important to understand the sequence of corporate actions that resulted in Adient. Current Johnson Controls (JCI) is the result of a merger between legacy JCI (which owned Adient) and Tyco, which only closed on September 6, 2016. Then, less than two months later, Tyco and JCI shareholders received shares in ADNT, an auto supplier worth about 10% of the value of their existing shareholdings. Many legacy JCI shareholders undoubtedly owned JCI for its core industrial franchise and not the auto business. Further, many Tyco shareholders probably had little familiarity with Adient so likely chose to simply sell their shares. With 80 million shares of ADNT having traded since it began trading on a when-issued basis, (out of ~94mm total shares), we think this technical selling pressure is likely largely behind us and is resulting in a particularly compelling / discounted valuation for ADNT.
China JV Opportunity
As a first mover in China, ADNT’s Chinese JVs currently control ~44% of the market. These businesses are very profitable and cash generative. In terms of valuation, many sellside analysts are simply valuing them at ~8x net income. However, we think this simplistic analysis results in illogical unlevered valuations and ignores the significant balance sheet optionality that exists at the Chinese JVs.
For example, ADNT’s largest JV, YFJC, currently has ~$600 million of net cash on its balance sheet (or ~$300mm net to ADNT for its 49.9% share). While we do not have detailed disclosure for the remaining JVs, our understanding is they are largely similarly overcapitalized and net cash. If we assume that all of ADNT’s JVs had a similar balance sheet to YFJC, the ADNT share of net cash would be ~$750 million or over $8 per ADNT share (almost 20% of ADNT’s current market cap). While we are unable to assess the timing or probability, the potential for a sizable special distribution to ADNT is a significant potential value driver that we do not believe is reflected in the current share price.
Even ignoring the ability to get the excess cash distributed out to ADNT, the balance sheet at these JVs results in extraordinarily low unlevered valuations based on analysts’ simplistic “8x net income” valuation methodology. Using YFJC as an example, assigning an 8x multiple to the equity income results in an EV/EBIT multiple of just 5.0x, an exceptionally discounted valuation in today’s environment.
ADNT is Irish domiciled and as such is guiding to a 10-12% tax rate. While that rate is distorted by the JV income, the consolidated tax rate on the core operations is in the 16-17% range, which compares favorably to Lear at 28% and other peers at 29-33%. Therefore, while many analysts are focusing on an EBITDA valuation methodology in the initial days of trading, we think an earnings or NOPAT-based valuation methodology makes more sense over time.
If management can achieve its 200bps margin improvement, we think they can generate $14 of EPS by 2020 (vs 2017 guidance of $9.35 per share at the midpoint). If the stock traded at Lear’s current multiple of ~8.5x NOPAT (which translates to ~8x earnings and ~10% FCF yield), the stock would be worth over $110 in roughly 3 years or more than 140% gain (and 35% IRR) from the current share price. Alternatively, if ADNT simply traded at 10x earnings, the stock would be worth $140 per share, triple the current share price.
|Subject||Re: we agree|
|Entry||11/17/2016 02:14 PM|
· Hawkeye, we fully agree and just wanted to add two points.
Management Has Done this Before: ADNT’s CFO, Jeff Stafeil, was previously CFO of Visteon (VC), and his success in that role draws striking similarities to the opportunity at ADNT.
o Stafeil has meaningfully improved margins of a JCI business before. In mid-2014 VC purchased JCI’s electrical business. In less than 2 years the business nearly tripled EBITDA from $58mm to $150mm far exceeding the timing and cost savings target in the initial guidance.
o We’re confident in Stafeil’s ability to monetize ADNT’s JV’s in China because he has done it before, in fact with the exact same business. In late 2013, Visteon sold its 50% stake in an interiors JV to Chinese auto supplier HASCO, the very same business that is now Adient’s 2nd largest JV.
· Conservative Guidance: We believe Management’s guidance for 2017 to be extremely conservative at all levels. The results ADNT has already posted in the last 12 months are in line with the low-end of their EBITDA guidance, before even factoring in meaningful upside from JV income growth and margin expansion.
|Subject||Re: Re: we agree|
|Entry||11/21/2016 02:02 PM|
We agree as well. I would also add to what has been said that ADNT has very small pension liabilties compared to peers that have significantly more pension liabilities.
|Subject||Re: Re: Re: we agree|
|Entry||11/21/2016 02:06 PM|
Also curious whether you guys are hedging the position and if you do, curious what you are using. We have hedged the position using a combo of auto supplier names (MGA, LEA, TEN, CPS, GM, F, DLPH and DAN in various %). That's why on a relative basis, the absence of penstion liabilties adds to the undervaluation of the name. Thanks.
|Entry||12/07/2016 11:53 AM|
Bruno/Hawkeye - how big are raw materials as a % of COGS and what is their hedge position on this (can they pass them on and if not are they hedged)? Auto supppliers have had a very benign environment the last few years as pretty much all their raw mats fall while the SAAR increases +HSD every year. Going forward, SAAR gains are going to be tough (likely flat/up LSD at best) and raws are all inflecting the other direction for the first time in years (oil/plastic/petrochems/resins, steel, aluminum). I remember from looking at LEA that raw materials are ~85% of COGS and this was a real issue for the industry in the last commodity upswing.
Thanks for any thoughts