Emerging Market Slowdown Could Hurt Lear Corporation
Lear Corporation (NYSE:LEA) is one of the leading suppliers of automotive seating and electrical interiors in the world. The company has come a long way since filing for bankruptcy in 2009, in the thick of the recession. Net sales increased 82% from 2009 to 2014, reaching $17.7 billion last year, three-fourths of which was formed by the seating segment. Lear supplies interiors to some of the largest automakers in the world, including GM, Ford, and BMW, which together formed 54% of of net sales in 2014. Naturally, the company’s business depends on the performance and automotive production of its clients, which, in turn, is driven by global vehicle demand. In 2014, worldwide vehicle production rose 3.4%, and could grow again by a similar percentage this year. However, the rise last year was bolstered by an increase in demand in mature markets, as the U.S. witnessed the largest automotive demand since 2006, and Europe returned to positive growth. However, vehicle ownership rates in developed markets is already relatively high, and once the automotive industries in these countries replenish sales lost during the recession and weak economic conditions, vehicle production growth could return to a more normalized figure of 2-3% in the near to mid term in North America and Europe.
In this scenario, automakers and parts suppliers will look for growth in emerging markets. However, the increased volatility in some of the economies, such as Russia and Brazil, poses a threat to sales. In addition, although vehicle sales in China are expected to continue growing by a mid to high single-digit percentage in the near term, demand in the world’s largest automotive market has slowed down from previously seen high growth levels. Lear, just like other companies in the auto sector, has looked to make the most of its operations in low-cost emerging countries, where vehicle demand is growing due to steadily increasing disposable incomes and low current penetration levels. In addition to benefiting from higher demand in developing markets, Lear has looked to leverage the low costs of manufacturing in these countries to boost profitability. More than 100 of Lear’s manufacturing engineering facilities, out of a cumulative 219 facilities, are located in low-cost countries. The company has 25 production facilities across China, Brazil, and Russia.
We estimate a $113 price for Lear Corporation, which is slightly above the current market price.
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A slowdown in vehicle demand in emerging countries is detrimental to Lear’s clients and, in turn, to Lear’s business. Automotive companies tend to have a high degree of operating leverage, and are thus sensitive to fluctuations in sales growth. Assuming that operations in low-cost countries such as China, Brazil, and Russia are more profitable for Lear, a declining proportion of sales from these markets will not only drag down revenues, but also negatively impact operating margins.
What’s In-Store For Automotive Industries In China, Brazil, And Russia
- China-
China’s automotive market grew by only 6.9% year-over-year in 2014, down from the 13.9% growth seen in 2013. This market is expected to grow by 7% again this year. In isolation, an annual growth of 7% seems robust, and should reflect strength in the automotive market. However, in China’s case, this reflects slowing vehicle demand in a slowing economy, which is expected to grow by 6.5-7% this year, down from a 7.4% growth rate in 2014, hurt by a weakening real estate sector and industrial overcapacity. Vehicle sales are expected to grow 7% this year and cross 25 million units mainly due to government vehicle scrap programs and fast-growing dealership networks, particularly in tier-2 and 3 cities. Luxury vehicles are expected to witness the most growth, and could cross annual sales of 2 million units in China in 2015, especially owing to the anti-trust policies of the government, which drove down product prices, especially of imported premium vehicles.
However, sales could further slow down going forward. Air pollution and excess traffic have prompted China to limit vehicle purchases in recent times. Cities such as Beijing, Guangzhou, Shanghai, and other cities have limited the availability of license plates, with Shenzhen capping the number of new available license plates at only 100,000 for this year. [1] According to a survey by Bain & Company, approximately 30% of mainland car owners would consider giving up their cars if oil prices rise rapidly or traffic continues to worsen. Slowing vehicle sales in the future will hurt Lear’s clients, and, in turn, Lear, which generated 12% of its net revenues from China last year, its fourth largest market. In addition, although higher premium vehicle sales in China should technically boost Lear’s average revenue per unit, this might not be the case, as an industry-wide downward adjustment of premium parts/vehicle prices, fueled by the government’s anti-trust campaign, will reduce average unit pricing.
- Brazil-
Vehicle sales declined for the second consecutive year in Brazil last year, down 7% to less than 3.5 million units. Brazil is the fourth largest automotive market in the world, and should present a solid growth opportunity to automakers as vehicle penetration is still low in the country and disposable incomes are rising. However, high interest rates and inflation rates have choked the country’s growth in the last year or so. Lay-offs resulting in unemployment and lower consumer spending have hurt demand for vehicles in Brazil. This slowdown is expected to hamper sales for automakers such as GM and Ford, the two biggest clients of Lear, and leading automakers in Brazil. Lower vehicle demand will lead to lower production levels and could subsequently contract Lear’s business going forward.
Brazil’s GDP grew at only 0.15% in 2014, while annual inflation is running near 6.5%. Vehicle demand might remain subdued again this year in the country, as vehicle prices are expected to rise between 4.5-7% due to the expiration of a consumer tax break on new car purchases at the end of last year.
- Russia-
As the Russian economy continues to struggle amid geopolitical issues with Ukraine and collapsing oil prices, the ruble has lost approximately half its value against the U.S. dollar in the last 52 weeks. Negative consumer sentiment amid high prices and interest rates has also impacted the country’s automotive market, which was already in decline before the Crimean crisis. After declining nearly 5% in 2013, annual vehicle sales in Russia fell 15% last year, and continue to fall this year. [2] Low demand and negative currency translations in Russia have also prompted automakers such as GM, Ford, Volkswagen, and Jaguar Land Rover to halt or slow down vehicle production in the country from time to time last year and this year. Lower production for Lear’s clients in Russia will impact the company’s top line.
Emerging markets have been the growth driver for automakers in the past, and local production in these markets has also bolstered profitability for auto companies. However, with major markets such as Brazil and Russia witnessing slowdowns, and China under the threat of potentially slowing vehicle sales in the near to mid term, Lear’s business could face headwinds in the future.
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