Lear To Expand Seating Division By Acquiring Eagle Ottawa

-10.25%
Downside
145
Market
130
Trefis
LEA: Lear logo
LEA
Lear

Global automotive interiors supplier Lear Corporation (NYSE:LEA) is closing on a deal to acquire Eagle Ottawa, the world’s largest supplier of premium automotive leather, for over $800 million. [1] The company’s revenues increased by 67% between 2009-2013, as annual global automotive production rose by 25 million units during this period. With most European economies returning to growth, U.S. sales slowly rebounding to pre-recessionary levels, and continual strong demand in China, global production is expected to grow by 21 million units by 2021. [2] Lear’s business depends on the performance of its automaker clients, which in turn depends on the global vehicle demand. Flush with cash, the company is looking to further expand its seating business and gain from the rising vehicle demand, especially in the luxury segment, owing to Eagle Ottawa’s expertise in premium seating supplies.

We estimate a $98.92 price for Lear Corporation, which is roughly in line with the current market price.

See our full analysis for Lear Corporation

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Demand For Premium Vehicles Remains Strong

Global vehicle production rose 4% in the first half of the year to 43.1 million units, but the premium segment has been growing at a faster rate, bolstered by higher proportion of high net worth individuals and increasing disposable incomes. BMW, the world’s highest selling luxury automaker, is also Lear’s largest luxury client, constituting 10% of the net sales in 2013. Retail sales for BMW have risen 10% to almost 1.03 million units through July, reflecting strong luxury demand worldwide. [3] In addition to BMW, Lear also supplies seating and electrical interiors to other premium automakers such as Volkswagen’s Audi, Daimler’s Mercedes-Benz, Chrysler and Jaguar Land Rover. In fact, Lear is the exclusive seating provider for some of the compact models made by the German automakers BMW, Audi and Mercedes in Europe. Compact vehicles are volume models for these automakers, as consumers look to trade-in their large sedans for entry-level premium vehicles, especially in emerging economies. Recent trends in some of the markets around the world signal how luxury vehicle sales could remain strong, going forward.

  • China: Fastest Growing Emerging Economy

China is our example for high premium vehicle growth in a market where the automotive industry is, in general, flourishing. China is the world’s largest automotive market, accounting for 28.6% of all passenger car registrations or sales last year, and is expected to form 30% of all global volumes by 2020. ((“New PC registrations or sales“)) Although the country’s economic growth is expected to slowdown in comparison to the double-digit growth rates seen in 2010-2011, it is still the world’s fastest growing major economy and continues to attract large-scale investments in the automotive sector. The country’s auto market is projected to grow by around 8.3% in 2014, which although is down from last year’s 13.9% volume rise, will outpace the estimated rise in global vehicle volumes. [4] The luxury segment, which presently constitutes around 7% of the net vehicle volumes in the country, is expected to spearhead China growth. The luxury car market in China is still immature, unlike in the U.S. and some European markets, and is expected to grow at a CAGR of 12% through 2020, due to increasing disposable incomes and strong consumer preference for luxury brands.

  • Brazil: Slightly Slowing Emerging Economy

We take Brazil as an example of an emerging market, where due to weak economic conditions this year, the automotive industry has been slowing. South American vehicle production declined 17% year-over-year to 1.8 million units in the first half of the year, dragged down by slow sales in Brazil, Argentina, and Venezuela. Vehicle demand in Brazil, the fourth largest vehicle industry in the world, has taken a hit this year due to tighter credit availability, lay-offs resulting in unemployment and lower consumer spending. However, despite the decline in overall auto volumes, the luxury segment of the Brazilian vehicle market is growing at a steady pace.

Brazil is one of the most unequal countries in the world. Despite having a small proportion of high net worth individuals (HNWI), which form the target base for luxury vehicles, Brazil’s combined HNWI wealth of around $4 trillion is the third largest for any country. [5] Interest rate hikes, which have affected overall automotive sales, are expected to benefit the more affluent customers, who would generate larger returns from their investments. In addition, Brazil luxury car sales represent a very small portion of the overall vehicle industry presently, and are estimated to constitute only around 1.7% of the net sales by the end of this year. The government has also offered tax breaks on imported cars from automakers such as Mercedes-Benz and BMW, who have vowed to begin local production within the next couple of years. Premium vehicle sales could continue to remain strong in Brazil, despite declining sales in the country’s overall automotive market.

  • U.S.: Saturating Developed Market

U.S. is the world’s largest premium vehicle market, and our example of a somewhat saturated developed market where the proportion of luxury vehicles has hovered in a narrow range of 10.5-11.5% since 2008. [6] The automotive market in the U.S. is regaining momentum after the economic downturn, and vehicle production volumes are expected to surpass the previous record of 17.3 million units in 2000 by the next couple of years. Although the North American vehicle market is relatively mature, growth lies in potential upgrades to luxury vehicles and/or replacement of ageing vehicles in the region. In fact, the average age of a passenger car in the U.S. reached 11.4 years in 2013, while the average age stood at 8.4 years in Europe and below 5 years in China. [7] In addition, as some of the emerging economies have become more volatile, and the European countries are still trying to rebound from the double-dip recession, investments in the relatively stable North American market could be beneficial for automakers.

The seasonally adjusted annualized vehicle sales rate in the U.S. stood at 16.5 million in July. ((Sales climb 9% to 1.4 million vehicles, autonews.com)) According to IHS Automotive, light-vehicle production is expected to rise by 3.8% to 16.8 million units this year in North America, and grow to 17.5 million units by 2016. [8] [9] This means that even if luxury vehicles form a stable 10.5-11.5% of the net volumes in the U.S. going forward, growth lies in the overall growth of the country’s automotive market.

New Business Could Boost Seating Division’s Bottom Line

Lear’s seating division constitutes just over 50% of the company’s valuation, according to our estimates. Eagle Ottawa generates around $1 billion in revenue, and is the leather supplier for over 50% of all cars in the U.S., including many for GM and Ford, which together constituted 44% of Lear’s 2013 sales. Inclusion of new business would not only boost Lear’s top line, but due to Eagle Ottawa’s expertise in premium leather, the company could also gain additional contracts from luxury automakers. Luxury vehicles require higher seating content per unit, and thus will boost Lear’s average content per unit. In addition, Eagle Ottawa’s acquisition underscores Lear’s strategy of expanding its seating operations, as well as adopting environment-friendly and cost-effective methods of production. Eagle Ottawa introduced a process to recycle the scrap hide into a traditional leather alternative for automakers, investing $3 million into its Rochester Hills plant to manufacture its recycled composition leather line. Lear’s earlier low-cost seating initiatives include:

  • The 2012 acquisition of Guilford Mills, an auto-fabric supplier. Guilford Mills has provided low-cost seat cover solutions to Lear, and has also helped the company expand its seating-fabrics offerings.
  • Lear also expanded its seating systems business this year with the opening of its fourth facility in Romania. [10] A new seating plant at Iasi, known as one of the major centers for the textile industry, aims at providing low cost seat-cover solutions for Lear with emphasis on seating surface materials, including cutting and sewing capabilities.

As Lear looks to produce standardized seat structures and mechanisms, which can be adapted to multiple segments, developments and investments costs might fall in the coming future. The company’s seating division saw a decline in operating margins last year, with the figure falling to 4.8% from 6% in the previous two years. This was mainly due to manufacturing and launch inefficiencies in the Americas. However, margins are expected to rebound to 5.5-6% this year on the back of higher sales and improved efficiencies. We currently estimate the seating division’s long-term margins to remain relatively stable at around 6%. In view of Lear’s strategy to acquire new high-margin businesses and expand sales, particularly to premium automakers, profitability could further rise for the seating division. If margins grow steadily to around 6.5% by the end of our forecast period, there could be a 7% upside to our current price estimate for Lear. Taking into account the possible increase in Lear’s global seating market share following the Eagle Ottawa acquisition, the upside could be around 10%.

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Notes:
  1. Lear to buy leather supplier Eagle Ottawa in 800m plus deal, crainsdetroit.com []
  2. Global vehicle production to increase by 21 million by 2021, polk.com []
  3. Mercedes S-Class helps July sales beat gains at Audi, BMW, bloomberg.com []
  4. China’s auto-sales projection lowered, marketwatch.com []
  5. Sales of luxury cars boom in Brazil, June 2014, ft.com []
  6. Luxury share of U.S. auto market remains in 10-11% range, polk.com []
  7. Average age of vehicles on the road remains steady, June 2014, wsj.com []
  8. Lear 10-k []
  9. Auto demand prompts suppliers to expand, rubbernews.com []
  10. Lear corporation plans to open automotive seating plant in Iasi“, lear.com []