|Shares Out. (in M):||93||P/E||0||0|
|Market Cap (in $M):||5,253||P/FCF||0||0|
|Net Debt (in $M):||3,325||EBIT||0||0|
High level thesis:
Temporary operational headwinds and cyclical concerns have depressed ADNT share price, giving us an attractive entry point into an industry-leading auto supplier.
Hawkeye901 previously wrote up the company a year ago. His writeup and comments thread is worth reading to get up to speed.
ADNT is the largest global manufacturer of automotive seating, producing 1 of out every 3 seat systems worldwide. ADNT spun out of JCI in late 2016. The company has 86,000 employees operating in 250 plants in 37 countries worldwide. In addition, ADNT has a 50% interest in 19 JVs in China, employing an additional 33,000 workers at 73 plants. ADNT also has a 30% interest in Yanfeng (YFAI), the largest automotive interiors business in the world.
Seating suppliers compete on price, technology, and reliability. Seat suppliers benefit from high switching costs as they become entrenched in the OEM’s production process. For this reason, incumbent suppliers almost always win the next generation of the vehicle program.
The global seating market is fairly consolidated. ADNT (~33% share) and Lear (~20% share) are the two largest global suppliers. ADNT is #1 in the Americas (34% share), Europe (36% share) and China (45% share). Regional competitors include Magna (Americas), Faurecia (Europe), and Toyota Boshoku (Japan).
Key issue: Production issues in SS&M (Seat Structures & Mechanisms)
SS&M is the metal components division of ADNT. Until recently, it had not been reported as a separate segment. In SS&M, ADNT is making the frame of the seats as well as metal components such as recliners, tracks, height adjusters, latches and locks. The division has $2.8b in revenue (excluding 2 China JVs), 28 global plants and 18,500 employees. 55% of sales are internal. ADNT’s global market share in these product categories range from 14%-34%.
In 4Q’17, ADNT ran into production issues associated with the wide-scale launch of a new product line of metal components. These new components, called the 3000 series, are a meaningful improvement over the prior generation of products (the 2000 series) because they are stronger, lighter, and provide improved functionality. Production headwinds intensified throughout the winter and caused management to reduce FCF guidance from $525mm to $225mm. The stock dropped from the low $80s to the low $60s within a month of the guidance cut. The company subsequently reduced it’s 2020 margin targets and the stock sold off further to ~$56 where it is today.
The root cause of these production issues was an overambitious launch program coupled with an overly complex footprint and supply chain. It didn’t help that the company was somewhat starved of capital over the last few years of JCI ownership.
As a result, ADNT experienced production issues at number of its SS&M factories. For example, ADNT’s new stamping equipment produced below the expected production rate and experienced issues with output quality. This created a domino effect of inefficiencies. ADNT had to pay exorbitant prices for outsourced stamping to meet demand. ADNT also had to staff hundreds of extra people to monitor quality at multiple production facilities. Due to the backup in production, ADNT also had to air freight significant content (over $40mm YTD) to lessen liquidated damages since ADNT was creating line-stoppages at its customers. In addition to the equipment issues, ADNT’s European supplier of specialty alloys failed to perform. This led to on and off raw material shortages creating further production inefficiencies and forcing ADNT to pay import tariffs while it qualified other suppliers.
1) Headwinds in SS&M are temporary:
From a high level, there is no reason why ADNT’s SS&M segment should not earn an acceptable rate of return on capital deployed. They are the largest global player in the category and benefit from substantial internal demand. In addition, ADNT’s two Chinese SS&M JVs are a $900mm business earnings mid-teens EBIT margins. This shows that the business can be nicely profitable if run properly.
To fix the operational issues, ADNT has replaced the senior management of SS&M and has provided the resources and capital needed to turn the business around. ADNT has also formed a steering committee to report SS&M progress on a weekly basis to the board. KPIs such as production rates and quality metrics have already shown meaningful improvement. Going forward, SS&M will be reorganized as a standalone unit to ensure proper management focus.
ADNT has also undertaken a strategic review of the business to try to reduce its complexity by potentially divesting and outsourcing certain non-strategic components and functions. In the short term, ADNT has forecasted sequentially lower quarterly losses in SS&M between now and the end of FY’18. SS&M margins will likely trend towards breakeven by the end of FY’19 as the operational issues abate.
In the medium term, ADNT’s management still thinks they can achieve mid-to-high single digit SS&M EBIT margins (just not by 2020). This will be achieved through component standardization, plant rationalization, and product mix. For example, margins will structurally improve as several high cost plants in Western Europe are scheduled to close in FY’19 and FY’20. That volume will migrate to ADNT’s newer, underutilized, lower cost facilities in Eastern Europe.
2) SS&M losses are obscuring meaningful SG&A improvements
When ADNT first became an independent company, the business was inefficiently run and overstaffed. This was best exemplified by the 210 bps difference in SG&A as a % of revenue compared with its primary competitor, Lear. However, there are few structural reasons why this margin gap should exist besides a modest level of extra overhead needed to support a greater number of Chinese JVs.
Management committed to close this SG&A margin gap by 150 bps by lowering headcount in key SG&A functions (Finance, Legal, IT, HR, etc.) and implementing more efficient systems and processes. So far, management has done an admirable job right sizing the cost structure and has delivered 160bps improvement. While this impact is currently being overshadowed by losses in SS&M, over time this will result in sustainably higher margins for ADNT through the cycle.
3) Fears about U.S. auto cycle are overstated:
U.S. auto sales have recovered nicely from the ’09 recession and remain somewhat above trend at ~17.3mm SAAR. This is concerning to prospective investors in the auto supply chain. However, I think views that current sales are meaningfully above normalized levels are somewhat misplaced because on a per capita basis current sales levels do not appear abnormal and miles driven continue to grow at a healthy pace.
In addition, ADNT’s U.S. business is only ~30% of profit. Auto sales in the rest of the world (in aggregate) are not overextended and require minimal adjustment to normalize.
In my base case I am assuming that mid-cycle U.S. SAAR is 16mm. Below is a table calculating the adjustment needed to bridge from FY’17 results to more normalized operating profit levels. The company claims decremental margins of 15%, I use 18% for conservatism.
4) ADNT is a durable business that is well positioned to benefit from key secular trends in the auto industry.
Mix shift to SUVs: Consumer preferences have shifted significantly over the past several decades to favor SUVs (including crossover vehicles) and pickup trucks over passenger cars. This change has been aided by substantial improvements in engine fuel efficiency. ADNT benefits from this transition because SUVs have more seating content per vehicle. Absent significantly higher fuel prices this trend is likely to continue, particularly outside of North America where SUV penetration rates are growing off a much lower base.
Growth in Chinese consumption: China’s rapidly expanding middle class is driving a transition to a more consumer driven economy. Despite massive growth over the past several decades, auto ownership rates remain very low compared with the developed world. For example, China’s car ownership rate is ~180 per 1,000 people vs. ~820 per 1,000 in the United States. ADNT has the relationships and infrastructure to benefit as China continues to catch up to the developed world.
Light-weighting: Increasingly stringent fuel mileage regulations continue to cause OEMs to demand lighter components from their suppliers. Setting aside product launch issues, ADNT’s new metal components lineup is a step change in performance vs. prior generations and is advantaged vs. much of the competition.
Safety regulations: Emerging markets such as China are following the lead of developed markets by implementing more stringent safety regulations. This increases the seating content per vehicle and encourages developing market OEMs to partner with global suppliers with better safety capabilities like ADNT.
Electrification: Unlike many auto suppliers that sell components related to the internal combustion engine, ADNT is agnostic to electric car share gains.
Autonomous: A move to self-driving cars would very likely increase the seating content per vehicle as the car interior is reimagined. ADNT has committed substantial resources to develop prototypes for this potential transition.
ADNT is trading at 6.5x my normalized EPS of $8.62 per share and 9.1x EV/normalized NOPAT of 912mm. This takes into account normalized U.S. SAAR and adds back all losses from SS&M.
I value ADNT in my base case at $92/share using an unlevered DCF. This is 64% upside from today’s price. I use an 8% discount rate on cash flows and a 13x NOPAT multiple (which implies 11.5x P/E) to calculate my terminal value. This seems conservative for a growing, durable business generating low-teens tangible returns on invested capital.
Over my forecast period I model 60bps of margin contraction in China to be conservative given the opacity of the JVs. I assume $100mm of annual restructuring expense to account for future plant rationalizations. I assume modest margin contraction in ADNT’s core business to account for a normalization of U.S. SAAR. I conservatively assume no value for the recent commercial seating JV with Boeing.
Global recession: Global new auto sales are cyclical. ADNT’s earnings would decline materially in a downturn due to the high fixed cost nature of its business.
Execution issues persist: SS&M manufacturing issues could continue to snowball, leading to further operating losses and damage to customer relationships.
Competition: Rivalry between existing players could increase. This would be most impactful to ADNT if it occurred in China.
Rising input costs: Historically ADNT has been able to recoup raw material inflation with a 6-month lag.
Sharply higher gasoline prices: Hurts demand for light trucks and SUVs.
Trade wars: Some exporting on SS&M side. NAFTA repeal could strand some assets.
|Entry||06/01/2018 05:34 PM|
Thanks for the write-up. Many people point to the better execution at their Chinese JVs as proof that Adient managment has what it takes to turn this around. However, my experience with these types of JVs has been that the foreign partner has very little real input on running these units in China and the unit economics are very different. Does Adient have a carve-out that allows them better control of these Chinese JVs?
The thing i struggle with on Adient is their inabilty to execute on basic stuff. SS&M is a core part of seating and it's not really something that should be separated. Most auto guys know that the other things that Adient does (away from SS&M) generates nice cash but isnt the reason why custiomers stay with you.
|Subject||Re: Chinese JVs|
|Entry||06/02/2018 05:15 AM|
the JV profitability is not “proof management has what it takes” it is merely an anecdote that indicates that good profitability is possible in the mechanisms business. i don’t think anyone expects adnt’s SS&M business to achieve anywhere near those level of margins for a variety of reasons. When I discuss normalized earning power today - I am just adding back SS&M losses to breakeven (among other adjustments). In my base case DCF I capitalize a 3% SS&M margin 5 years out.
I too share your concern about management’s ability to execute. However, that’s what gave us this opportunity. I’d like to think the business isn’t rocket science and they can figure it out and get it back on track.
|Subject||Re: Re: Chinese JVs|
|Entry||06/04/2018 03:06 PM|
Got it. Thanks for the reply.
|Subject||Re: Guiding down again ...|
|Entry||06/11/2018 10:20 AM|
This is not the news I was hoping to wake up to on a Monday morning. However, the thesis remains that their operational challenges are temporary and fixable. I'm a buyer on weakness here.
|Subject||Re: Re: Guiding down again ...|
|Entry||06/11/2018 10:32 AM|
was there a view the seating/interiors business was also experiencing operational issues? the vagueness in the release makes it sound like it is more than just hiccups.
|Subject||Re: Re: Re: Guiding down again ...|
|Entry||06/11/2018 10:41 AM|
here is outlook from the press release. I bolded the part about seating. This is all the info I have at present.
Revised Outlook for Full Year 2018
Today, Adient also announced that it is revising its outlook for the full fiscal year 2018. Despite an anticipated increase in FY2018 revenue to approximately $17.5B, operating performance is running behind plan and thus the company’s outlook for Adjusted EBITDA is now expected to be approximately $1,250M. Continued challenges impacting the Seat Structures & Mechanisms segment drove approximately half of the shortfall versus previous expectations while weakness in the company’s Seating segment and Interiors drove the remainder. The primary drivers impacting Seating related to lower than expected operational conversion, primarily in North America, and to a lesser extent, economics and the negative impact of foreign exchange. As a result of the lower earnings, increased cash restructuring, and a negative working capital trend, free cash flow for the fiscal year is expected to be approximately $0 to $(100)M. Further details of Adient’s revised FY2018 outlook will be provided during the company’s fiscal Q3 earnings call.
|Subject||Re: Re: Re: Re: Guiding down again ...|
|Entry||06/11/2018 11:15 AM|
yes, saw that ... but I am wondering if this is "new news" on seating. Was there an awareness of operational issues on seating and interiors before... i thought it was only SS&M. Thanks for all the prompt replies.
|Subject||Re: Re: Re: Re: Re: Guiding down again ...|
|Entry||06/11/2018 11:35 AM|
Fx, raw material inflation, and softness in interiors JV were previously communicated. This is the first time i'm hearing about operational issues on the seating side of the business (although the SS&M & Seating businesses are somewhat intertwined).
I wish I had a better explanation for why the magnitude of the issues are more than previously communicated. Perhaps the previous CEO was hanging on to unrealistic expectations because he knew he was on thin ice. Perhaps management took their eye off the ball on the seating side while they were putting out fires on the SS&M side. If anyone talks to IR/CFO, I'd be curious what they are saying.
My thesis is predicated on the operational challenges being temporary. I still believe that to be the case. If so, normalized, mid-cycle earnings power is unchanged and my fair value estimate is only slightly lower.
|Subject||Re: Re: Re: Re: Re: Re: Guiding down again ...|
|Entry||06/11/2018 01:26 PM|
Thanks for the reply rhuabarb. so now we are sort of left hanging re the new operational issues in seating until they report in July... that's an enternity with this co.
|Entry||10/03/2018 06:36 AM|
At 38 / share this looks very interesting. Anyone that have a strong reason not to buy it, excluding cycle arguments?
|Entry||10/03/2018 05:13 PM|
The other argument against owning it is that it goes down every day.
|Subject||Re: Re: Re: Updates?|
|Entry||10/04/2018 09:47 AM|
it may not be crazy, but i think it's premature to worry about financial distress.
the trailing leverage is 2.3x. the cap structure is very well balanced between secured and unsecured. the bonds are termed out until 24 and 26.
while the total leverage covenant is only 3.5x, there is a ton of room to negotiate that higher if it becomes a problem.
there is over $1b in net cash at their subs in china. roughly half of that is due to ADNT at some point.
if they really needed to burn the furniture, they could sell any one of those ~20 JVs to their partner. the interiors JV (70-80mm EBITDA) comes to mind as the most logical since it isn't even in seating.
the cash burn should be modest this year (~$100mm) and next year should be positive FCF. a little macro softening in NA or Europe will help them because the crux of their issues is they took on more business than they could handle which has led to inefficiencies.
the JIT seating side of the business is generating FCF. while they had a difficult launch with Chrysler, that issue is likely to improve sequentially.
it's the SS&M side that is burning all the cash. However, you can see from their latest investor presentations that EBITDA in the segment was -82 in Q1, -34 in Q2, and -18 in Q3. that seems to be moving in the right direction. on 9/27 there was a positive UBS note discussing operational progress after touring a formerly troubled plant. that is encouraging.
this fiscal year is the last year of spinoff related expenses (for example, YTD $50mm of becoming adient that rolls to $0 next year). That is additive to FCF sequentially. i expect a couple hundred $million next year of FCF.
also capex is running > D&A partially due to growth capex. in the near term, they've been quoting less new business (particularly in SS&M which they are deliberately trying to shrink) so FCF will pickup in time.
I've also asked the CFO about his level of concern about the potential for financial distress 1 to 10. He said he has been at 10 at past jobs, but currently is a 1 or a 2 out of 10. obviously he is biased, but the long dated unsecured bonds trade at a 6.7% YTM, so the credit markets aren't too panicked.
|Entry||10/04/2018 10:36 AM|
The whole sector is on sale so why not buy higher relative quality?
|Subject||Re: Re: Updates?|
|Entry||10/04/2018 10:54 AM|
Which ones would you recommend dutchballa.
|Subject||Re: Global SAAR Thoughts/GTX|
|Entry||10/04/2018 08:08 PM|
Agree with your musings cnm3d . The last downturn was historically bad for autos. The odds are low that the next slowdown will be anywhere near that magnitude. If we are right on that, most of the sector is likely a buy across the board.
What I like about the seating guys in particular is that you don’t have deal with the internal combustion uncertainty that will likely limit multiple expansion in ICE suppliers. And while the OEMs are cheap as well, they are having to invest gobs of money in electric and autonomous R&D which has a very uncertain payoff.
|Entry||10/05/2018 09:49 AM|
CNM3D - would love to get your take on GTX. I looked at it and passed after meeting with management twice (once during analyst day and at a group lunch).
Personally, I came away unimpressed. Management couldn't answer simple questions regarding the negative asp mix from diesel to gasoline and competitive positioning vs BWA in gasoline.
I also think their exposure to diesel could be a noose around the Company's neck for years.
Growth drivers - cybersecurity for cars?
I'm definetly open to change my mind though given the move down from 22 on WI to 16 today.
|Entry||10/05/2018 05:24 PM|
Does the liability decrease each year with the principal payments or will they be paying $175m per year forever?
|Subject||Re: Re: Re: Re: Is this a 0?|
|Entry||10/18/2018 01:07 AM|
If you think it is a 0, how do you value the equity income and cash left on associate's balance sheet?
|Subject||Re: Is this a 0?|
|Entry||10/18/2018 02:20 AM|
See comment 16.
|Subject||Re: Re: Is this a 0?|
|Entry||10/18/2018 02:43 AM|
Mip, see comment 16 for my response to a similar question.
(edit - accidental double post)
|Subject||Re: Re: Is this a 0?|
|Entry||10/18/2018 09:36 AM|
No dog in this fight, but I'd be curious to see your (or mip14's) assumptions on the cycle and what it means for the financial results of this business.
|Subject||Re: Re: Re: Is this a 0?|
|Entry||10/18/2018 10:36 AM|
both LEA and ADNT have indicated decremental margins are 15-20% all variables equal. they claim the earnings impact would be lower if they adjusted their footprint (to take out fixed costs).
for ADNT, there is a tremendous opportunity for self help (the crux of my thesis). it wasn't that long ago (11/17) they guided to 525mm of fcf for '18 (going to 750+ in '19 and beyond). Earnings would be even higher than FCF given some of their chinese JV earnings (30-35%) are retained for growth.
Therefore, they can absorb some cyclical weakness and still generate plenty of FCF if they can just operate the business better.
|Entry||11/09/2018 02:24 PM|
The company had already preannounced (so there was no "miss"). They also did not give any guidance (and previously communicated they wouldn't on this call). So neither of those data points are new information.
Cutting the dividend and amending covenants is not a "blow" to the long thesis. Shoring up the balance sheet is a positive.
I agree that the macro is uncertain. That was the case yesterday though.
Don't get me wrong, I'm not jumping up and down at the results and the tone of the call was cautious. But I don't think things have changed that much vs. yesterday.
|Subject||Re: Re: Re: Earnings|
|Entry||11/09/2018 04:07 PM|
Have to hand it to Molinaroli. He under-invested in seating throughout the upcycle, gave the malnourished business to investors, and played into investors' favorite activity of comparing margins of comps and assuming the lower one catches the higher one for easily explainable/blocking and tackling reasons and they make a ton of money. Shoot the guy convinced a lot of smart people that seating is actually a good business.
I can't remember the book, but the quote is around passing on the market leader in a sector due to higher valuation and buying the #2/3 player at a "discount"when the economy is expanding. It turns out the leader's higher margins actually expand faster than peers during the expansion and when the inevitable downturn comes their margins also hold up much better than their weaker competition. Feels like a good analogy for this.
|Subject||Re: Re: Re: Re: Earnings|
|Entry||11/09/2018 04:44 PM|
dutchballa I think the book you are referring to is Common Stocks and Uncommon Profits (great read)