Lear Corp: What To Make From Its Cheap Valuation (NYSE:LEA)

Auto Parts Supplier Lear Accepts $2.8 Billion Buyout

Bill Pugliano/Getty Images News

Introduction

In August of 2021, I wrote an article titled “Lear Would Fly If It Weren’t For The Chip Shortage”. I turned bullish as the company had a great position in the automotive industry with very limited disruption risks. Also, the only thing standing in its way was the semiconductor shortage. Hence, a part of my takeaway was:

If anything, and given the need to produce more cars, the company only suffers from semiconductor shortages. Without that, we would probably be looking at a much higher 2021 EBITDA. Now it looks like 2022 will be the year that gets the company back to normal.

The problem is that Lear Corp. (NYSE:LEA) wasn’t out of the woods – not even close. What followed was an easing semiconductor shortage. However, the war in Ukraine hurt automotive supply chains and new lockdowns in China do a number on shipping. Add to this that high inflation is causing consumer confidence to implode. In this article, I will share my thoughts on the industry and Lear’s dominant position that will help the company to recover – even if it might take longer than expected.

So, bear with me!

So Much Pain And Change In The Industry

As most will know by now, I have a daily European macro newsletter on Intelligence Quarterly. A cornerstone of my research is following the European automotive industry, one of the largest in the world with key brands like Mercedes, BMW, Audi, and the mighty Volkswagen company.

Just like the Americans, they suffered from severe supply chain disruptions. Back in 2020, it was mainly because semiconductors were missing. These problems accelerated in 2021 when sales of electronics went through the roof. Automotive semiconductors have often lower margins, which means available capacity went to non-automotive customers. Automotive producers often used available supply in higher-margin vehicles like expensive SUVs and related. Hence, global auto production remained close to 80 million units in both 2020 and 2021.

Car production: Number of cars produced worldwide 2018 | Statista

Statista

I expected these problems to fade in the first half of this year. That’s not happening now due to new problems. As a result, Lear Corp has not recovered as its stock is down 18% since my August 2021 article and down more than 25% year-to-date.

LEA Finviz Chart

FINVIZ

Before I go into the company’s strengths, we must acknowledge that the company cannot escape automotive weakness. After all, it’s a first-tier supplier that services almost every major automotive company. This means that its decline this year (so far) is justified.

According to the Wall Street Journal, 1Q22 sales are off to a very bad start. All producers except for Tesla and BMW are seeing declines in their US operations.

WSJ auto production chart

Wall Street Journal

The Wall Street Journal wrote:

The overall message is that supply bottlenecks are still putting a speed limit on vehicle production. Deliveries to dealers tumbled in the second half of last year as car makers ran out of key parts, notably microchips, and are recovering only very gradually. Vehicle inventories rose in March, setting the industry up for a better second quarter, but remain very tight by past standards.

Moreover,

There are hints that high gas prices are already having an effect on consumer preferences: In an echo of 2008, U.S. Google searches for electric vehicles hit a record in March. But changing tastes won’t show up in sales numbers that are driven by supply rather than demand. Gas-guzzling pickup trucks and sport-utility vehicles accounted for almost four in every five U.S. auto sales in March, because Detroit has directed the limited flow of parts toward its most profitable franchises.

GM and Ford shares are down 26% and 20% this year, respectively, worse than most peers. That might seem harsh when the companies can still sell every vehicle they can make at record prices. Yet there are also plenty of reasons to avoid Detroit auto stocks right now: Their supply chains have been shown up, raw-material costs are increasing, and-though it is hard to tell-the heavy vehicles from which they make their money could be approaching a rough patch.

I added the comments on EV for one specific reason: Lear has only limited disruption risk. In general, I always prefer suppliers over manufacturers of cars. One reason is the increasing power of suppliers. A cornerstone of my master’s degree (focused on the automotive supply chain) was working on changing relationships. One thing that stood out is the innovative power of suppliers. Suppliers have become the real innovators in the automotive industry, holding most of the patents. Nowadays, suppliers do not come bagging to large manufacturers for their business, large manufacturers look for innovative suppliers. In some areas, it goes so far that large companies like NVIDIA (NVDA) have so much power that observers are ‘afraid’ that manufacturers will become nothing more than just the guys who screw everything together before sending cars to customers. In this case, I’m referring to the chips it delivers. This includes autonomous driving “systems”. Eventually, these become the very core of any car making former niche suppliers powerful players in the automotive industry.

That’s another reason why I like Lear. The company is specialized in seating (75% of sales) and e-systems (25% of sales). The company is, therefore, not that impacted by secular changes in the automotive industry.

So, how does this translate to a cheap valuation?

Lear’s Weathering The Storm

I’m a big believer in simple concepts. I rather have a company that excels at something “simple” than a company that fails in a complex new industry. Lear makes seats, and that’s fantastic. The company is a leader in the business supplying almost every major producer on every continent. This includes EVs like Mercedes’ EQE, Ford’s electric F-150 as well as the new Hummer Pickup truck.

The beauty is that Lear manages to grow despite headwinds. In 2021, sales grew above market in all key regions with strong full-year growth in both seatings as well as e-systems.

LEA 4Q21 earnings presentation

Lear Corp.

The problem is that the numbers above do not put things into perspective. That’s why I added the graph below. 2021 was indeed a better year than 2020. However, both were disastrous compared to pre-pandemic levels, which makes sense given the implosion in car production. 80 million produced cars result in roughly $1.4 billion in EBITDA. This year, the company is expected to do $1.7 billion in EBITDA. In 2024, EBITDA is expected to make it above pre-pandemic levels.

LEA financials

TIKR.com

Headwinds that could slow this trend are:

  • Imploding consumer sentiment
  • High inflation (related to the above)
  • Lasting supply chain issues related to the war in Ukraine
  • Chinese lockdowns

Tailwinds include:

  • Very low (global) auto inventories
  • Improving economic growth
  • Inflation comes down faster than expected

The graph below shows a headwind and a tailwind. The tailwind is that the auto inventory/sales ratio has dropped to less than 0.4x, indicating that there’s not nearly enough supply to satisfy demand. However, the blue line displays consumer sentiment. Consumer sentiment is imploding as consumers cannot stomach inflation anymore. This is hurting automotive producers’ ability to sell higher-ticket vehicles.

University of Michigan consumer confidence, auto sales/inventory ratio

St. Louis Federal Reserve

It’s an incredibly tricky situation. And while I do not own any auto stocks, I am very much involved due to high railroad exposure. After all, companies like Union Pacific (UNP) and Norfolk Southern (NSC) are the ones transporting finished vehicles to consumers.

Union Pacific expects shipments to pick up in the second half of this year. I think that’s likely, but the improvement will be a bit subdued because of inflation and slower economic growth.

And China remains a total wild card. Right now, it has locked down Shanghai. I have zero indication of how long that will take. For now, however, the world’s largest automotive growth market will remain an issue.

Valuation

Lear has a $7.9 billion market cap. The company has roughly $290 million in pension-related liabilities and $165 million in minority interest (interest in companies it does not fully own, but it does recognize EBITDA). Net debt is expected to fall to $950 million next year, which is merely 0.4x EBITDA. These numbers give us an enterprise value of $9.3 billion.

LEA net debt

TIKR.com

$9.3 billion is roughly 4.2x next year’s expected EBITDA of $2.2 billion.

Chart
Data by YCharts

This valuation is too low. Lear is trading like a steel company prior to the bull market in steel. It’s ridiculous. However, it’s caused by investors’ unwillingness to buy anything auto-related.

Lear will start flying once hedge funds and larger players make the decision to allocate money in the auto industry again. At that point, they will see that LEA is way too cheap and start pumping this stock to $200-$220 before a more violent move higher.

In other words, finding an entry is tricky as there could be more downside.

Takeaway

I was wrong last year for one reason: I could not predict that Russia would invade Ukraine, a key country in the automotive supply chain and I did not foresee that we would see new lockdowns in Asia.

As a result, the entire industry continues to suffer – except for Tesla it seems.

Lear continues to be one of my go-to stocks in the industry for a number of reasons. The stock is a leader in seating and e-systems. It is not impacted by secular trend changes that hurt some smaller suppliers. The company benefits from a well-diversified customer base, very low auto inventories, and the fact that the models it supplies grow faster than the industry.

However, the stock price is suffering as investors are not willing to buy any auto stocks.

I think that Lear should be trading between $200 and $220. That price, I consider fair value. If automotive production comes back roaring, the stock should be trading much higher than that.

However, getting there is a problem and I cannot make the case that a rally is imminent. Consumer confidence is low, the Fed is poised to start an aggressive hiking cycle and bonds indicate that the central bank might break something.

If you agree that LEA is too cheap and you’re looking for exposure, please make this a long-term thing. It will likely take a while until your brokerage account shows a nice profit. If you take into account that LEA might fall a bit more and adjust your exposure accordingly, I think it’s a good buying price. Buy some and let it rest until the masses jump on the auto trade again.

(Dis)agree? Let me know in the comments!

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