|Shares Out. (in M):||94||P/E||7x||6x|
|Market Cap (in $M):||6,320||P/FCF|
|Net Debt (in $M):||2,623||EBIT||0||0|
After a recent pullback, we believe shares in Adient represent an extraordinarily compelling investment at current levels with the potential to more than double your money from the current price in the next few years.
Bruno677 had originally written up Adient (ADNT) last November after its spin-off from Johnson Controls. Now that the initial spin-related dynamics are behind us and the company has reported three quarterly earnings reports as a standalone company, we wanted to share a more detailed write-up regarding our thoughts on Adient and the progress the company has made thus far on its financial targets.
Brief Background on the Company and Last Fall’s Spin-off
We would encourage anyone interested in the company’s history under Johnson Controls and how the spin-off dynamics have led to a dramatic undervaluation of Adient’s shares to review Bruno677’s write-up and our remarks in the comments section of his write-up. The company is the world’s largest automotive seating manufacturer with an estimated global market share of ~33% (including China through joint ventures). Adient has 36% share in the Americas, 38% share in Europe, 44% in China and 13% in the rest of Asia. Other competitors include Lear, Faurecia, Toyota Boshoku, Magna, in-house operations and other smaller players. To put Adient’s market position in key markets differently, it is roughly 50% larger than its closest peer in the U.S., double the size of its closest peer in Europe and four times the size of the closest competitor in China.
Despite the dominant market shares discussed above and associated scale advantages, Adient’s operating margins have surprisingly lagged those of its closest competitor, Lear. The source of this margin gap stems largely from (1) higher overhead vs Lear and (2) underperformance of the company’s metal structures and mechanisms business, which accounts for roughly 18% of Adient’s sales but fails to generate any operating profits today. We believe the margin opportunity afforded by the restructuring of these two areas represents a tremendous potential for cost reduction and earnings growth over the next several years.
Phase One: SG&A Reductions to Drive Earnings Improvements in FY 2017 and 2018
At the time of the spin-off, Adient’s SG&A as a percent of sales was roughly 200bps higher than Lear’s even though Adient’s larger scale should arguably result in better operating leverage. As one former competitor stated in our research, “From an SG&A standpoint, I always believed [Adient] was a lot fatter than we were… I went to customers and they showed the [Adient] org chart vs ours on similar programs and we’d have half as many people on the program.”
We think much of the cost difference can be reduced through basic restructuring initiatives that will be completed in the near-term (within two years of the separation). Importantly, we believe the company is already executing on these cost savings faster than even the most optimistic expectations, giving us confidence in the management team’s ability to continue to deliver on their profit improvement goals. For example, in the fiscal year ended September 30, 2016, Adient reported adjusted SG&A of $817 million. In fiscal Q1, Adient reported $176 million in adjusted SG&A ($704 million annualized), which represents a 14% reduction from the prior fiscal year. In the recently reported fiscal Q2, Adient’s adjusted SG&A was down to $153 million ($612 million annualized), representing a further 13% reduction sequentially and a cumulative 25% reduction from FY 2016. In the fiscal year to date, Adient’s adjusted SG&A as a percentage of sales has been 4.0% vs last year’s 4.9% and Lear’s 3.1% over the same period. In other words, we believe Adient is about halfway to Lear’s overhead levels in just two quarters as a standalone company, with significant earnings contribution from continued execution on this plan (and the potential for Adient to over-deliver on their targeted SG&A levels).
Phase Two: Metals Business Restructuring to Drive Earnings in FY 2019 and 2020
Adient’s other key margin improvement opportunity relates to its $3 billion metals business, which accounts for ~18% of Adient’s sales but currently generates no profits. We believe improvements in this business will provide the second phase of margin improvement starting in late FY 2018. While we acknowledge that there is some execution risk in the metals turnaround, our industry research and discussions with management about the business gives us confidence that they can achieve enough improvement in the metals business to deliver on their overall margin improvement plan.
Management is confident that improving the metals business is not reliant on customer wins or works council approvals to shut a plant, but is simply a timing exercise as they phase out their highest cost/less efficient production. They expect improvements to pick-up in late 2018 as they close a couple of big money losing plants in Western Europe. As an example of the restructuring opportunity highlighted in their 2016 pre-separation Analyst Day, Adient has a plant in Germany that is currently losing $40 million annually. The closure of this one plant should improve the margin of the metals business by 130bps and the overall company margin by 25bps.
We have spoken to numerous industry participants and there is broad agreement that the metals business should earn a double-digit margin over time, which would imply 200bps of margin improvement potential for the company overall. Management is targeting margin improvements from the metals restructuring of 100-200bps, indicating they believe they can get to at least mid-single digit margins over the next few years, which we view as a reasonable target.
China JV Value
Furthermore, we believe Adient’s Chinese joint ventures are being undervalued by the market and the analyst community. Many sellside analysts value these ventures at 8x net income, a considerably lower valuation than publicly-traded Chinese auto suppliers, which on average trade at ~13x earnings for H-shares listings and ~24x earnings for A-shares listings. Moreover, sell-side valuations do not account for the significant net cash balances sitting at the China JVs. Since the spin-off, management has provided more detail regarding the proportionate net cash at its China JVs and we believe there currently is over $700 million in proportionate net cash attributable to Adient at the JVs (representing ~$7.50 per share and ~11% of the current share price). Said differently, sellside analyst price targets based on 8x earnings value Adient’s dominant China franchises, which control almost half the market, at just 6x earnings net of cash. We think this is simply too low.
While we have assumed 4-5% growth in China over the next few years, we would highlight that management believes they have significant opportunities in China in the coming years. Adient believes that, due to its dominant share and scale advantages, it has much better product quality and higher margins than competitors in the market. Based on customer discussions surrounding upcoming product launches and a mix shift towards more expensive vehicles (where Adient has a higher share), management believes they have a real line of sight to increasing their market share in China over the coming years from today’s 44%. Internally, they have dubbed this the “Drive for 55 [% market share].”
Further, in 2015, Adient sold most of its interiors businesses to Yanfeng Automotive Interiors (YFAI), where Adient now owns 30% of the company. Management has indicated that YFAI is expecting meaningful margin improvement over the coming years, as they complete their own restructuring activities and due to strong growth in backlog that management claims is at higher margins than the business is currently earning.
While we are hesitant to assume significant upside to a Chinese auto supplier, we think there is a reasonable probability that Adient’s Chinese joint venture income could meaningfully outperform expectations in the coming years if they are able to deliver on some of the opportunities highlighted above.
While we expect that many reading this write-up will have an instant fear of Adient’s exposure to U.S. SAAR, we think those concerns are overstated as Adient’s exposure to U.S. SAAR likely represents ~25% of Adient’s total earnings, given its significant exposure to Europe and Asia. Further, we believe Adient’s meaningful self-help initiatives will help offset a significant amount of potential SAAR headwinds.
To explain what we mean by this, we believe North American sales will total ~$7.3 billion this year out of $16.2 billion in total consolidated sales (ex-China). Therefore, every one million unit decline in SAAR represents ~6% impact on North American sales (and ~2.5% for the consolidated business ex China given Adient’s significant Europe/Asia/Latin America business). Assuming 17.5% incremental cash gross margins (management has stated incrementals/decrementals are in the high teens), a one million unit decline in SAAR would be a revenue impact of ~$420 million, a profit impact of ~$75 million and ~35bps of overall margin headwind. With approximately 125bps remaining after FY 2017 on Adient’s margin improvement program, they could theoretically absorb a decline in SAAR of more than 3 million units and keep earnings flat, assuming zero growth from either the non-North America business or China equity income.
Electric Vehicles / Autonomous
Further, we expect that some investors may also wonder what happens to this business assuming the rapid adoption of electric vehicles and/or autonomous driving. In the case of Adient, the global leader in seating, we think if anything, they could be a beneficiary of these trends. As the market potentially shifts to autonomous vehicles, there is a logical argument that seating manufacturers could see higher content per vehicle (more flexibility, potential to swivel or fully recline may be demanded by consumers). But at a minimum, we think it is highly unlikely that a quality, comfortable seat would become less important in the future.
Aircraft Seating Opportunity
Adient is also working on entering the aircraft seating market. While it is still early days, the company has announced a collaboration with Boeing, has recently demonstrated a business class seat to customers and expects to have a production seat finished by September of this year at which time they expect to “go to market with a ready to sell product.” We think this could represent a $3 billion market opportunity with mid-teens margins potential. At a 20% share, we believe this could contribute $0.80 per share of earnings that would command a mid-teens multiple (due to higher margins than auto seats), which could add $12 per share of value or nearly 20% of the current price.
Other Developments Since the Spin
With its recent earnings announcement, management raised its expectations for EBIT by over 6% from its original guidance, despite a weaker revenue outlook (down by 4% due to FX and weaker passenger vehicle production outlook). In addition, management’s free cash flow guidance for the year was increased by 60% and the Board approved a $250 million share buyback (~4% of the current market cap).
Assuming a 16.5 million SAAR (down meaningfully from the peak), ~1% annual production growth ex-US and mid-single digit growth in China with EBIT margins of 6.9% (excluding equity income), we believe Adient can generate ~$14.75 in FY 2020 EPS (which begins in October 2019). To put that margin assumption in perspective, Lear’s seating business (with fully allocated corporate), generated a 7.1% operating margin over the past 12 months.
Assuming Adient trades at approximately 10x forward earnings, the stock would be worth $150 including dividends, a gain of 125% from the current share price in 2.5 years, an IRR of ~40%.
As a separate note on valuation vs. Lear, some might argue that Lear’s higher margin electrical business (which accounts for 35% of LTM adjusted EBIT) might indicate Lear should trade at a premium to Adient. However, we would highlight that Adient’s high growth China business represents a similarly-sized earnings contributor (~40% of total earnings) and would itself almost assuredly trade at a higher multiple as a standalone public company in either Hong Kong or the A-shares market. In addition, we believe Adient’s dominant global position in auto seats actually warrants a premium valuation to that portion of Lear’s business.
|Entry||05/31/2017 01:01 PM|
Thanks for the idea hawkeye901 - the one fundamental question I have is why does this opportunity exist? why is the stock mispriced? has the market basically overlooked the magnitude and feasibility of the margin improvement opportunity? if so, why?
|Subject||Re: Why mispriced?|
|Entry||05/31/2017 02:02 PM|
Regarding the opportunity and why it exists, we think Adient has faced: 1) a former JCI management that constantly talked down the auto business, 2) a spin-off that occurred shortly after the JCI/Tyco merger, leaving Adient's stock in the hands of shareholders who had little interest in, or in the case of former Tyco shareholders, little knowledge of, the comparatively small and noncore automotive supplier, 3) large ETF/index fund holders forced to sell their shares following the spin-off, and 4) a new company that is unknown to the investment community. In our experience, these spin-related dynamics can take a long time to dissipate and for the stock to fully close its valuation gap vs peers.
In addition, we think concerns over U.S. SAAR have held the stock back but as stated in the write-up, we think the true exposure is less than probably many investors appreciate. Last, we think the unconsolidated China JVs have created some confusion in valuation. First, few people appreciate the net cash at those entities and management has just begun providing more details in the past few months. And as a further example, Goldman's price target is based 50% on a 4x consolidated EBITDA valuation. However, the after-tax JV net income is part of Adient’s EBITDA, so Goldman effectively values these entities at 4x fully-taxed earnings (or roughly 2x net of cash).
Based on the above, we believe significant confusion remains surrounding the company and the opportunity. However, given the low starting valuation of just 7x earnings, we think the passage of time and the company continuing to deliver on its targets will cause the share price to take care of itself.
|Subject||Re: Re: Why mispriced?|
|Entry||05/31/2017 02:38 PM|
Got it, thanks. So you think Adient suffers from the "baby bathwater" syndrome re the US SAAR overhang? I think the damage from the expected decline in US SAAR has been relatively contained to the OEMs...other tier 1 suppliers such as DLPH, VC and LEA haven't been hit. Also is it possible to get the financials for the China JVs? Curious how much free cash those JVs generate and what the capital structure looks like at the JV level.
|Subject||Re: Re: Re: Why mispriced?|
|Entry||05/31/2017 03:16 PM|
Just to be clear, we don’t think U.S. SAAR is the only overhang, but is just one of a number of possibilities we suggested in response to your question on why this opportunity exists. That being said, I would highlight that Adient’s stock fell 7.9% on May 2nd when April SAAR was released, so it does seem like some people are concerned about the issue.
For the China JVs, as part of the Form 10, Adient provided detailed 2013-2015 financials for the largest JV, YFAS (formerly called YFJC and representing close to half of total equity income). Since that time, for YFAS and the other JVs, Adient has provided quarterly summaries of key income statement and certain balance sheet items. Adient has also stated that the 12/31/16 YFAS financial statements will be filed on or before June 30th (within six months of the end of the JV’s fiscal year).
|Subject||Re: Net income vs. Cash flow|
|Entry||06/06/2017 01:38 PM|
Given the noise from historical pro forma financials and the restructuring / separation costs the business had taken prior to becoming public, I think the best way to analyze Adient's current FCF is to start with their FY 2017 guidance and some of the one-off items that are in this year's results. First, Adient has guided to $400m of free cash flow this year, which includes $230m of cash restructuring expense ($280m original guide less $50m shifted to next year), $100m of “becoming Adient" expenses to get its infrastructure in place, $75m of elevated capex related to stand up costs, and $20-30m in lower JV dividends from YFAI (not reflective of full year run-rate). Adjusting for these items, Adient's FY 2017 normalized free cash flow generation capacity would be ~$830mm, just over 90% of their net income guidance.
Going forward, there are a couple of items that will affect the bridge from adjusted net income to free cash flow: (1) We expect capex in the near-term to remain above D&A, (2) we budget for $100 million in ongoing annual restructuring costs and (3) the China JV distributions will be below net income.
|Subject||Re: Recession Scenario|
|Entry||06/06/2017 01:40 PM|
As a starting point, in my opinion, the 20% drop in SAAR that you highlighted does represent a substantial decline in SAAR. To put it in historical perspective, a 20% decline from last year's 17.5mm SAAR would be just under 14mm. While SAAR was below 14mm from 2008-2011, the last time it was below 14mm prior to that period was the early 1990s (and the US population is 27% higher today than it was back then). So we do think what you’ve suggested is more than just a garden variety recession case.
However, even in the 20% SAAR decline, we think the EBITDA decline is more manageable than what you're suggesting (unless accompanied by similar auto sales declines in Europe and China). We have discussed decrementals with the CFO numerous times and he has been consistent that he believes decrementals are in the mid- to high-teens. Based on this guidance, we tried to address what we believe is Adient's sensitivity to SAAR relative to their remaining SG&A and metals margin improvement opportunity. Based on the company's remaining margin opportunities, we think they can roughly handle a 3 million unit decline in SAAR with EBITDA/earnings remaining flattish.
|Subject||Re: Re: Recession Scenario|
|Entry||06/12/2017 09:31 AM|
Can you talk at all about what pushed Lear into bankruptcy in 2009, recognizing that there was a historic drop in units at that time? But was Lear too highly leveraged, or can this business just not withstand a severe global recession? How does ADNT's leverage compare to Lear's at that time?
Also, what is the pricing position of suppliers vis a vis OEMs at this point? Is this a two player business where Lear and Adient can hold price, or are there tons of smaller producers who the OEMs can use as backups and continue to squeeze margin?
|Subject||Re: Re: Re: Recession Scenario|
|Entry||06/12/2017 05:18 PM|
We think Lear's four-month trip through bankruptcy in 2009 is a bit of an extreme comparison. GM and Ford accounted for 50% of Lear's 2007 sales, at least 50 auto suppliers went bankrupt in 2009, and the auto supply chain was operating at approximately mid-40% capacity utilization. In addition, Lear did head into the financial crisis levered at just around 2x (end of 2007) with a fairly significant unfunded pension/OPEB liability. Given that backdrop, by the end of 2008, Lear had breached its debt covenants and filed for bankruptcy in July 2009. But to your question on whether the business can’t survive a severe recession, we think this was really a function of the severe decline in volumes than anything uniquely concerning about the auto seating business. From 2007 to 2009, Lear’s seating sales fell by 36% and adjusted EBITDA fell by 53% for decrementals of ~12% over the period.
Regarding Adient’s leverage, it currently stands at 1.64x and they expect to be ~1.5x by the end of their fiscal year (September 2017). We think management's rapid execution on its cost opportunity will help bring the headline leverage ratio down much more rapidly than people are expecting (in fact, even the current ~1.6x leverage level is overstated on a run-rate basis when you consider the progress management has made on cost reductions in the past few quarters). Longer term, Adient's target is to run at ~1x leverage, which they should reach next year. Moreover, Adient’s headline net leverage figure does not represent true economic leverage as it excludes the significant cash held at the JVs and does not account for the JVs’ full profitability (since consolidated EBITDA includes after-tax equity income rather than proportionate EBITDA). Adjusting for these JV-related items, net leverage would fall to 1.1x. Further, Adient's customer concentration is much lower than Lear’s, which we think helps mitigate risks. Ford and GM together accounted for 50% of Lear's 2007 sales (and remain 42% today), while Adient's largest customer accounts for just 12% of consolidated sales (and its top 2 customers combined are just 23% of sales). Importantly, if you consider Adient's significant non-consolidated China business, the customer concentration is even lower than it appears (as JV income accounts for 25% of EBITDA).
Regarding your question re seating manufacturers vs the OEMs, we are not going to argue that Adient is the highest quality business or that it operates in some cozy duopoly. However, we do think industry pricing dynamics appear stable based on our research and LEA/ADNT financial reports. Further, in the past, OEMs did shift from buying a full seat from one manufacturer to disaggregating the purchase of seating components in order to increase pricing transparency and pressure suppliers. Consequently, we believe the OEMs have already pulled that lever and it is reflected in the financials of both Adient and Lear. While there are smaller players, with the top 3 suppliers accounting for 75% share in the Americas, 72% in Europe and 54% in China, we do think it’s a fairly stable and consolidated market.
|Subject||Re: Re: Re: Re: Re: Re: Recession Scenario|
|Entry||06/13/2017 12:40 PM|
The company’s China JV margins benefit from 2 key differences vs other regions globally: (1) a highly profitable metals business and (2) lower SG&A. Adjusting for the SG&A and metals differences, the China business does not earn excessive margins vs seating businesses in other regions. We would also highlight that the company has a very strong market position and is four times larger than the next largest competitor in China.
Regarding the China metals business, management has stated that it earns margins approaching 20%, compared to the consolidated metals business, which is currently breakeven to slightly negative profitability. Adient’s China metals business benefits from a high portion of local content, whereas competitors import much of this content and therefore must contend with import duties.
On the SG&A point, the China JVs have lower SG&A due to more efficient operations and a certain amount of overhead that is borne by the consolidated Adient business. On this last point, we think looking at the ~10% operating margins on the China JVs somewhat overstates the level of profitability as there is a sizable China support function that sits at Adient corporate.
In addition to the points above, we think Adient’s China JVs have some nuances vs traditional suppliers due to the fact that the OEMs share in the JV economics. While your point on potential margin compressing offsetting some of the consolidated business improvements is a potential concern, we have tried to take a relatively conservative view on the JV earnings (with growth of 4-5% per year) to reflect these risks, even though (1) recent performance has been much stronger and (2) the YFAI JV has significant company-specific tailwinds over the next couple of years.
|Subject||Re: Re: Re: Re: Re: Recession Scenario|
|Entry||06/13/2017 12:43 PM|
We certainly acknowledge that SAAR can drop 20% from here in a recession. There do not appear to be many other areas of the market that are indicating a recession is likely on the horizon although of course we need to consider the possibility for any stock. As we indicated, we believe the company can still hold earnings flat (assuming stability in other regions) due to the substantial margin opportunities and the geographic diversification of its revenue base. In this case, ADNT would be trading at 7x EPS on depressed earnings at current levels, which we think would make it a very attractive investment.