Lear’s Q2 Results Review: Profits Grow Despite Currency Pressures
Lear Corporation (NYSE:LEA) announced its Q2 and mid-term results on July 24, and, as expected, the company’s growth outpaced growth in the global vehicle production levels, although negative currency translations played their part in offsetting most of the growth for yet another large U.S. multinational. Net sales were up only 1% year-over-year in Q2 to $4.6 billion, with unfavorable foreign exchange dragging down the top line by 9 percentage points. [1] But what was the standout result for Lear this quarter, was the improvement in its operating performance, and how!
Core operating earnings rose 23% to $337 million– the highest quarterly earnings in Lear’s history, and adjusted margins for the company rose to 7.3% in this quarter, up from 6% a year ago. Why this growth is more pronounced is because it came despite only a 1% rise in net sales. Lear’s low-cost manufacturing footprint and increased operational efficiencies have helped in pushing up the margins.
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. Another testament to this strategy is closing of the seat structure facility in Canada, and moving it to Mexico where labor rates are more competitive. Furthermore, Lear has extended its low-cost engineering capabilities in India and the Philippines, and continues to expand its production capacity in low-cost regions such as Asia, South America, Eastern Europe, and Northern Africa.
We estimate a $108 price for Lear Corporation, which is above the current market price.
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A strong operating performance is why despite the 7.4% year-over-year fall in net sales for the electrical segment, operating income rose. In fact, adjusted segment margins rose to 13.9% in the quarter, up 140 basis points from Q2 2014. According to Lear, the North America business, and the seating business in Europe are still not up to the target margins, and have room for further growth through structural restructuring and cost and pricing solutions. The other two things that boost Lear’s bottom line are Eagle Ottawa and a better mix in China.
- Premium Eagle Ottawa Accretive To Margins
Eagle Ottawa alone added 30 basis points to Lear’s seating division, which saw adjusted operating margins rise to 7.1% this quarter, up from 5.7% a year ago. The acquisition of Eagle Ottawa, the world’s largest supplier of premium automotive leather, which generates around $1 billion in revenue, was completed at the start of the year. Eagle Ottawa formed approximately 6% of the net seating sales in Q2, and is expected to benefit full year seating margins by 20 to 30 basis points, due to its higher price points and premium positioning. Inclusion of new business would not only boost Lear’s top line going forward, but due to Eagle Ottawa’s expertise in premium leather, the company could also gain additional contracts from luxury automakers.
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 includes 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.
But going forward, the company has given a hint that future acquisitions could focus more on technology, seeing the requirement of content per vehicle is increasing at a fast pace due to more connected car features and driver-assisting software. How this could boost margins is through higher average revenue per unit (more content per vehicle), which will, in turn, result in better price and product mix.
- China May Be Slow, But Not Lear’s Business
After only a 2% rise in vehicle production in China this quarter, the outlook for the full-year automotive production rise in the country is down to around 6%. Economic conditions have become weaker in China, over previously seen high GDP growth levels, due to industry overcapacity, and real estate and infrastructure sector slowdowns. This has caught up to the automotive industry in the country too, with passenger vehicle registrations, in fact, falling by ~3% in June in China.
However, despite this downturn, Lear might still be well placed in China, which contributed 12% of the company’s net sales in 2014. This is as the company has maintained strong relationships with foreign automakers in the country, as well as domestic automakers such as FAW, BAIC, Dongfeng, and SAIC. The market share for domestic vehicles increased 3.5 percentage points compared to the previous year through June. [2] Local brands are outpacing growth in foreign joint ventures, but this isn’t a problem for Lear, as a considerable 40% of its seating business in China is with major domestic automakers. [3] In addition, local companies are also looking at suppliers such as Lear to further develop their brand, which should contribute to Lear’s future growth.
What also is a contributor to top line growth for Lear in China is higher content per vehicle, i.e. better mix. The overall market may be down, but the likes of Audi, BMW, GM, and Ford, have all seen solid volume rises in the country this year. This was good news for Lear, which supplied automotive seating and electrical interiors to these automakers. In fact, GM, Ford, and BMW together formed 54% of the company’s net sales last year. Models such as the Audi A4 or the BMW 5 series, Ford Focus and Cougar, and GM’s Buick and Cadillac lines, require more content per unit, which bodes well for Lear.
While revenues rose only 1% this quarter for Lear, this growth is more significant when compared to the flat global vehicle production levels. Also, Lear’s commitment to expanding its low-cost footprint and increasing operational efficiencies has shown how despite a small sales growth, the company’s net income growth remains solid, which means more cash for its shareholders, even when foreign currency translations were as much as a 9 percentage point headwind on the top line. This could bode well in the future for Lear Corporation.
See the links below for more information and analysis:
- Lear earnings preview: top line growth to outpace vehicle production, but currency could play spoilsport
- Large demand for SUVs bodes well for Lear’s seating business
- Lear’s strong growth momentum continues into Q1
- Trefis analysis: Lear Corporation Seating Revenues
- Trefis analysis: Lear Corporation EPMS Revenues
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