Lear Corporation (LEA) CEO Ray Scott on Q2 2022 Results – Earnings Call Transcript

Lear Corporation (NYSE:LEA) Q2 2022 Earnings Conference Call August 2, 2022 8:30 AM ET

Company Participants

Ed Lowenfeld – Vice President-Investor Relations

Ray Scott – President, Chief Executive Officer and Director

Jason Cardew – Senior Vice President and Chief Financial Officer

Conference Call Participants

Joseph Spak – RBC Capital Markets

Rod Lache – Wolfe Research

Itay Michaeli – Citi

Colin Langan – Wells Fargo

John Murphy – Bank of America

Emmanuel Rosner – Deutsche Bank

David Kelley – Jefferies

James Picarillo – BNP Paribas

Operator

Good morning, and welcome to the Lear Corporation Second Quarter Earnings Conference Call. [Operator Instructions]

I would now like to turn the conference call over to Ed Lowenfeld, Vice President, Investor Relations. Please go ahead.

Ed Lowenfeld

Thanks, Matt. Good morning everyone. And thanks for joining us for Lear’s second quarter 2022 earnings call.

Presenting today are Ray Scott, Lear President and CEO; and Jason Cardew, Senior Vice President and CFO. Other members of Lear’s senior management team have also joined us on the call.

Following prepared remarks, we will open the call for Q&A. You can find a copy of the presentation that accompanies these remarks at ir.lear.com.

I would like to take this opportunity to remind you that as we conduct this call, we will be making forward-looking statements to assist you in understanding Lear’s expectations for the future.

As detailed in our safe harbor statement on Slide 2, our actual results could differ materially from these forward-looking statements, due to many factors discussed in our latest 10-Q and other periodic reports. I also want to remind you that during today’s presentation, we will refer to non-GAAP financial metrics. You are directed to the slides in the appendix of our presentation for the reconciliation of non-GAAP items to the most directly comparable GAAP measures.

The agenda for today’s call is on Slide 3. Jason will begin by reviewing our second quarter financial results and our full year 2022 outlook. Ray will then provide a business update, highlighting the industry environment and the steps we are taking to position leader for success. Following the formal presentation, we’d be happy to take your questions.

Now I’d like to invite Jason to begin.

Jason Cardew

Thanks, Ed. And good morning everyone. Please turn to Slide 5 where I will provide a brief overview of our second quarter financial results and other recent company highlights. In the second quarter with ongoing COVID and semiconductor disruptions, cost inflation, and a strengthening dollar, the Lear team posted solid results, which exceeded our expectations.

Sales were $5.1 billion and core operating earnings were $187 million.

Despite lower production volumes than the first quarter, total company operating income and margins improved sequentially. During the second quarter, we returned almost $100 million in cash to shareholders through dividends and share repurchases.

Looking forward, we continue to win new business in both business segments with key wins in the quarter including an electrification award and connection systems in North America and multiple awards with domestic OEMs in China, in both Seating and E-Systems.

We are continuing to take steps to reduce costs and improve our manufacturing flexibility. Ray and I will both cover this topic in more detail later in the presentation.

At the same time, we continue to invest in our core product lines and our manufacturing capabilities to strengthen the business. In May we announce a definitive agreement to acquire IGB, a leading German supplier of automotive seat heating, ventilation, active cooling, and steering wheel heating. This acquisition once completed will expand Lear’s product capabilities in active cooling, and complement existing offerings in specialized thermal comfort seating solutions that improve vehicle performance and packaging. Our growing expertise and thermal comfort has already resulted in jet seating contracts that allow Lear to direct the sourcing of these components and we expect this trend to continue as we design and engineer a more efficient system that reduces complexity and total cost.

Our customers continue to recognize Lear for outstanding quality at our manufacturing plants in both business segments.

Over the last three months, we won the best supplier and quality award from Stellantis, as well as multiple plant quality awards from GM and Ford.

We released our 2021 sustainability report during the second quarter highlighting progress on our renewable energy strategy, innovative green products, supplier sustainability, and diversity equity and inclusion efforts.

Slide 6 shows, vehicle production and key exchange rates for the second quarter. Global production was up 1% compared to Q2 2021 and up approximately 2% on a Lear sales weighted basis.

Volumes in North America were up 12% while industry production in Europe decreased 5% compared to 2021.

COVID-related production shutdowns led to volumes that were 3% lower in China.

From a currency standpoint, the U.S. dollar significantly strengthened against the Euro and to a lesser extent, the RMB compared to 2021.

Slide 7 highlights Lear’s growth over market. For the second quarter, total company growth over market was six percentage points driven primarily by the impact of new business in both segments with Seating growing six points above market, and E-Systems growing five points above market. Growth over market in North America of three points reflected the benefit of new business in both segments, as well as strong volumes on key Lear platforms, such as Ford’s Explorer and Escape; Chevrolet, Equinox; and GMC Terrain; the Hyundai, Tucson; and the Chevrolet Colorado and GMC Canyon.

In Europe growth over market was 16 points driven primarily by strong performance on platforms for Mercedes, Nissan and Stellantis in Seating; and Ford, BMW and JLR in E-Systems. In addition, new business was strong in both segments, particularly with Mercedes and BMW.

Our China business lagged industry growth by eight points due to unfavorable platform mix driven by customer production disruptions from government mandated COVID lockdowns in both segments, which disproportionately impacted the global OEMs. E-Systems growth over market in China was slightly positive as our strong backlog; more than offset the unfavorable platform mix.

Slide 8 explains the variance in sales and adjusted operating margins in the Seating segment. Sales for the second quarter were $3.9 billion, an increase of $266 million or 7% from 2021 driven primarily by our strong backlog and an increase in volumes on their platforms. Excluding the impact of commodities, foreign exchange and acquisitions sales were up 8%.

Core operating earnings were $233 million, down $29 million from 2021. And adjusted operating margins were 6%. The decline in margins reflected primarily higher commodity costs, partially offset by higher volumes on Lear platforms and our margin accretive backlog.

As we previously communicated, the Kongsberg acquisition is slightly dilutive to current margins, but will be accretive to Seating margins in the future as industry volumes improve and we implement our plan to growth and cost synergies.

Net performance was dilutive to margins, largely due to increased premium costs and higher labor costs have resulted from late notice, customer downtime and the extensive production disruptions in China.

Slide 9 explains the variance in sales and adjusted operating margins in the E-Systems segment. Sales for the second quarter were $1.2 billion, an increase of 4% from 2021. Excluding the impact of foreign exchange and commodity cost pass-throughs, sales were 5% driven primarily by our backlog and higher volumes on key platforms.

Core operating earnings were $24 million or 2% of sales compared to $41 million and 3.5% of sales in 2021. The decline in margins reflected primarily higher commodity costs and the impact from the strengthening dollar, partially offset by higher volumes on Lear platforms in margin of create backlog. The decline in net performance was driven primarily by an increase in premium cost. Excluding premium costs, net performance was positive in the quarter.

Slide 10 illustrates our focus on driving operating efficiencies and increasing free cash flow generation in a challenging industry environment. We are working to optimize our footprint and remove any excess capacity while ensuring we can support higher volumes as the industry recovers. We currently have enough capacity within our existing footprint to support our growing backlog, as well as the projected growth in industry volumes over the next several years.

We are focused on making our manufacturing footprint more flexible so we can improve efficiencies across both segments within specific regions. We are streamlining our portfolio to focus on our core product lines, where we have a competitive advantage and see strong market growth. And we are investing in key growth areas, such as Thermal Comfort and Seating, and Connection Systems and E-Systems. This focus product strategy will drive revenue growth and higher operating margins in both segments. Working closely with our customers both business segments are aggressively targeting inventory reductions despite our expectation for continued production disruptions in the second half of this year.

We are also taking a clean sheet approach to our capital expenditure plan where our footprint optimization will allow us to redeploy existing capital to support drawing volumes and reduce the need for new manufacturing facilities to support our new business backlog. We anticipate that this approach will allow us to continue launching our near record backlog while maintaining capital spending near historical levels. Through these actions, we will improve our cash flow generation. Over the next two years we expect to see our free cash flow conversion rates return to approximately 80% an improvement from our more recent free cash flow conversion of 65% to 70%.

In the last two years, we saw opportunities in executed tuck-in acquisitions in seating any systems to expand our thermal comfort and engineered components capabilities. We do not expect to execute any significant near-term acquisitions, allowing us to return more of the excess cash generated shareholders. In the second quarter, we took advantage of the current market conditions and repurchase $50 million worth of shares. We’ve continued to repurchase shares into the third quarter.

Now shift into our 2022 outlook. Slide 11 provides global vehicle production volumes, and current – currency assumptions that form the basis of our full year outlook. At the midpoint of our guidance range we assume that global industry production will be 3% higher than in 2021 in line with our prior outlook. We have reduced our outlook for North America and Europe while increasing the outlook in China. The high-end of our outlook remains consistent with IHSs forecast for industry production of up 5% compared to 2021. From a currency perspective and as the dollar continues to strengthen, we have updated our assumptions. Our 2022 outlook now assumes an average euro exchange rate of $1.06 per year euro driven by a second half assumption of $1.02 per euro. The RMB is expected to be in additional modest headwind as our assumption has changed from flat to down 2%.

Slide 12 compares our second half outlook to our first half actual results for sales and core operating earnings. We are forecasting the midpoint of our second half sales outlook to be approximately $10.5 billion, up $242 million from our first half actual results. Reflecting higher volumes, a full six months of Kongsberg results and an increase in commodity passthroughs partially offset by changes in FX. The midpoint of our second half operating income outlook is $494 million, an increase of $123 million from our first half actual results. The improvement in operating income reflects the expected impact from higher volumes in the combination of moderating commodity costs and increased customer passthrough agreements partially offset by the change in FX race.

Slide 13 provides more detail on our current outlook. While we acknowledge that there remains macroeconomic uncertainty impacting our industry, our strong performance in the second quarter relative to our prior expectations, combined with actions we have taken to improve our cost structure, increases our confidence in our financial outlook. As such we are maintaining our guidance at the midpoint of our prior range for net sales, core operating earnings, adjusted net income and free cash flow.

Now I’d like to turn the call over to Ray to provide an update on our view of the macro environment and the steps we’re taking to prepare earlier to be successful in any scenario.

Ray Scott

Thanks Jason.

Please turn to Slide 15, which highlights key industry factors and how they might be impacted by macroeconomic and industry specific conditions. Over the past few years the automotive market has experienced significant volatility and recessionary industry volumes. Industry production is tracking below 80 million units for the third consecutive year. And for the last three years production volumes have averaged 13% below pre-pandemic levels. We have been able to partially offset the impact to our business by improving efficiencies in both business segments and working in a collaborative way with our customers and suppliers. Cumulative total company net performance benefited margins by approximately 115 basis points over the past two years, which offset about two-thirds for the commodity headwinds over the same timeframe.

Looking forward, the industry should benefit from factors such as historically low inventories and aging fleet and pent-up demand. At the same time however, rising interest rates, inflationary pressures, and other factors are driving recession fears in the broader economy. While it’s difficult to predict in the near-term we do know that the shape of the automotive industry recovery will impact industry volumes, commodity costs, supply constraints, and customer production schedules. A slower recovery could bring more stability to the industry as supplier – supply constraints are reduced and production schedules stabilized.

As we have seen recently, a slowing global economy can have an immediate and significant impact on commodity costs. Where North America steel for example, has declined by more than 50% from its peak and copper has come down by more than 25%. We would expect oil costs to moderate in a recession, which could lead to lower costs for resin-based products and transportation. In addition, we expect that our customers would use incentives to stimulate the demand if industry conditions worsen. As we weigh these risks and opportunities, we continue to take aggressive steps to position later to manage in all scenarios and to improve our competitive position and financial performance.

Turning into Slide 16; I would describe our key areas of focus and how the actions we are taking are expected to improve profitability and shareholder returns. Since the beginning of the COVID pandemic in early 2020, we have been taking advantage of the downturn to focus and strengthen our product portfolio, our talent and our balance sheet. Over the past two years we have continued to hone our strategy, which will position the business to generate increasing amounts of cash throughout the business cycle. We’re streamlining our product portfolio to align with our core strengths and are focusing our efforts where we can to add value for our customers.

In Seating, we will leverage our growing thermal comfort capabilities to increase market share, improve profitability, and expand our competitive mode. In these systems we are focused on increasing our market share and connection systems, battery disconnect units and wiring to drive revenue growth and margin expansion. We are a leader in operational excellence, and we are leveraging these strengths to position the business to optimize performance. We have recently reduced non-manufacturing salaried headcount by approximately 3% and are identifying additional headcount and SG&A synergies across the two business segments that will further reduce costs. We have frozen salaried hiring except for very critical headcount related to particular projects. The restructuring actions we are taking in our manufacturing operations will improve capacity utilization and flexibility.

And we are prioritizing capital spending and investing in Industry 4.0 actions to improve plant efficiencies. In addition to organic investments, we have made two small strategic acquisitions to accelerate our Industry 4.0 efforts. Required ASI a few years ago, and in May we acquired Thagora, which will improve manufacturing operations through scalable smart manufacturing tools. We returned all of our cash we generated in 2020 and 2021 to the shareholders and going forward we expect to continue to return a majority of our free cash flow to our shareholders. Both business segments are well positioned and we don’t expect any significant acquisitions in the near-term. We’re concentrating our efforts on improving performance in any operating environment, increasing returns on capital and reducing enterprise risk.

In closing, I want to thank the Lear team for their continued efforts and for delivering better results than expected to the second quarter.

And now we’d be happy to take your questions.

Question-and-Answer Session

Operator

[Operator Instructions] And our first question will come from Joseph Spak with RBC Capital Markets. Please go ahead.

Joseph Spak

Thanks so much everyone for the update. Ray and Jason, one thing we’ve heard through earning season is a number of suppliers getting pricing or recoveries to help offset some of the cost pressures we’ve seen. I didn’t hear you explicitly mention that. I was just wondering if that – if that did help organic growth in the quarter and if so by how much and what’s the sort of expectation for the back half?

Ray Scott

Yes. So Joe we strip out commodity passthroughs from our organic growth. So we talk about growth over market that’s not part of the equation. So it was not a factor in our strong growth over market in the quarter.

Joseph Spak

Okay. And any recoveries for some of the non-commodity inflationary pressures?

Jason Cardew

Yes. So we’re on track with the plan that we had laid out on the prior earnings call. We have seen a modest increase in the growth impact, and we’ve seen a comparable increase in our recovery. So the net impact we’re expecting from commodities and inflation is still $155 million for the full year. Gross impacts now about $720 million, so up a little bit from what we talked about previously. In terms of the recovery rates for each of the categories they’re generally in line with our prior guidance overall. So we are having pretty good success commercially, and Ray, I don’t know if you want to add.

Ray Scott

Yes. I think I mentioned this before, too. Last year was more of a negotiation by quarter in more of a temporary resolution. This year as far as the collaboration, it’s much more permanent and fixed within the price going forward. And I think the success that we’ve had, and it differs by different area, if it’s the sticky labor issue, which is one of the bigger issues that we’re struggling with today with the intermittent downtime and start times of the different facilities or different customers. We have ways to resolve that. One is obviously we were getting paid for it in a different percentage of what the cost is. And in others, we are able to go and take some of the costs within our own control and de-rate our plants. And so that’s one way we’re solving that, but we have set precedence with the majority of our customers on how we’re going to handle that.

And we talk about transportation very similar, there’s a percentage of what we get recovered. And then what we do is work on different transportation lanes and reduce our costs, more consolidate different components to reduce our costs so that’s going well. And I think generally, we’ve done a nice job with some of the commodity cost increases across the board and some of that’s a lag, a lagging issue but we’ve been successful. And so we are – it’s a big focus; we’ve been focused on it for now two years de-risking the company is something that we take is a priority to make sure that we’re getting the contracts updated to the increased cost pressures that we’re seeing. And then also balancing growth, I couldn’t be more proud.

Jason mentioned earlier we had the highest level of our backlog during all these different negotiations, so there’s different ways you can handle it. And I know some of our competitors are talking about 100% recovery, but I’ll tell you the majority of the customers are looking at a collaborative share agreement and working in a more cooperative way as opposed to 100% recovery and that’s what we’ve been doing. And so I’m very confident that we have all the pieces in place to continue successfully working with our customers and balancing not only the recovery, but our growth profile going forward.

Joseph Spak

Okay. Thanks for that. And Ray, just this is a second question on your comments on the different scenarios that could play out, and obviously there’s a lot of moving pieces here, but, and even if you look at your sort of recessionary scenario, you have commodity costs coming down, supply constraints easing, more stable production schedules. Obviously volume’s a big factor, but as you mentioned there’s some pretty low inventories and volumes are already at low levels. So is there a path here where even if in sort of this slower growth environment that margins actually hold up?

Ray Scott

Yes. I think Joe, I heard a lot of different definitions on what recession is, and I think I’m going to stay with one I heard recently is if you feel like you’re in a recession, you’re in a recession. I feel like we’ve been particularly the supply base has been a recession for two years. And our biggest challenge has been what I referred to as the sticky labor, the intermittent downtime. And when you have employees in a plant and you brought them into work and then you have to send them home. And if that issue recedes or dissipates, that’s a significant, probably one of the biggest challenges we’ve had over the last two years.

If transportation costs go down and we’re seeing that right now, and we’re seeing improvements within our own facilities with labor, I mean, we were struggling for the last two years with turnover and we’re starting to see that relatively flat to improving, and so that’s something that it’s a positive sign. The commodity increases and it’s amazing how quickly that’s turnaround, all these things that were significant headwinds become tailwinds. And so, yes, I think even if – even if volumes don’t necessarily increase, but we have a more steady stable environment with decreasing cost could significant help our margin profile.

Joseph Spak

Thanks for that.

Operator

Our next question will come from Rod Lache with Wolfe Research. Please go ahead.

Rod Lache

Good morning, everybody. Just following up on Joe’s question on commodities and recoveries, it sounds like most of the year-over-year headwinds is now in the rear-view mirror in Q1 and Q2. Is things stand now can you maybe just provide some color if we saw spot rates for steel and other commodities at current levels. How would things kind of flow through into next year?

Jason Cardew

Yes. Hey Rod, just starting with sort of the calendarization of the commodity impact about 95% of the year-over-year impacts is in the first half, so just 5% in the second half and in the fourth quarter, it should be slightly positive year-over-year. Now the benefit of the recent reduction in North America steel in particular and copper globally. There will be a lag effect of that. We won’t see much until next year in terms of the benefit from that. But the – I think what you could expect over time is if you just look at the negative impact of those two commodities it was the steel impacts $130 million between 2021 and 2022.

So now that’s split between Europe and North America, and Europe’s a little bit higher and that impacted the North America. So as North America comes down we would expect to see that that hit that we took over the last two years unwind. Copper is a little less impactful, I mean, it’s about a $30 million cumulative impact over two years. So if it comes back down to 2020 levels we would see about a $30 million benefit over time. You’d also see some margin benefit as the reversal of the path of higher copper costs goes back in the other direction. So you’d see revenues come down without an operating income reduction for that piece as wealth.

Rod Lache

Are you still expecting that to flow through over the course of maybe two years?

Jason Cardew

Yes. In terms of the total impact, we haven’t put a specific timeframe. I think we’ve talked about perhaps half of that unwinding over the next two years and the balance after that. I think if commodities were to remain elevated that was sort of the basis of that comment. If commodities come down, then we could see more of that unwind sooner, that’s certainly a possibility. I think there are portions of this that won’t unwind higher utility costs, some of the higher component costs that are result of inflationary increases in the supply base. I think any of the – some of those labor related inflationary increases may be a little stickier. So I’m not expecting all of that to come back, but I still think it’s reasonable to assume that half of the $340 million comes back over the next two years.

Rod Lache

Okay. And then I’m looking at the first half to second half bridge on Slide 12 and was curious about how you’re thinking about net performance from the first half to the second half because it looks like the incrementals are sort of in the high-teen similar to what we would typically see in seating, but I didn’t see anything explicitly listed here for performance. And maybe if you – as you’re answering that what are you hearing, if anything just regarding European production in the back half as obviously companies are kind of bracing for just some potential disruptions due to natural gas shortages?

Jason Cardew

Yes. So what we’ve factored into the second half as we look at both businesses sequentially, the biggest driver is going to be volume and it’s more so in these systems than seating. So it’s 50 basis points or so in seating and 150 basis points of margin accretion in these systems in the second half of the year. And that’s because they were – these ecosystems business was disproportionately impacted by some of the downtime in Europe and in China in the first half of the year. So in e-systems Europe and China represent almost 60% of that business and seating it’s just a little bit more than 40%. So that’s part of the volume differential, also the backlog is more back-end loaded in these systems than in seating, it was a little bit more ratable across the quarters in seating and so that’s embedded in that 150 basis points, as well as the roll-on of the backlog in e-systems, commodities will be slightly positive.

On the performance side we are expecting a modest improvement, but foot-offset by slightly higher engineering cost and so that’s sort of a loss as we look at first half to second half. And then FX has more of a negative impact on e-systems and seating, again because more of their business and more of their profitability is in Europe and China combined. So they’re more exposed to the strengthening U.S. dollar.

Rod Lache

Okay. Thanks for that. And just lastly, that comment you made on Slide 16 about SG&A and overhead synergies between the segments; is there additional cost savings that you’re alluding to prospectively?

Jason Cardew

Yes. So we took an action in the second quarter that will yield some improvement in SG&A both in the second half of this year and then on a full year basis next year. Roughly $40 million – $35million, $40 million in annual savings with half of that heading this year and then the balance next year. In addition to that, we do see other opportunities that we’re exploring that will likely happen at the tail end of this year, beginning of next year.

And Ray, I don’t know if you want to talk.

Ray Scott

Yes. I think Rod, we’re fortunate in going to take advantage of the position we’re in. We do have some opportunities to scale across both divisions in redefined in some respects purchasing engineering, logistics, even in finance, in HR, across the two different groups. And so we took the – what we’ll call Phase 1 steps and then now we’re looking at additional actions administratively. I think more importantly what we’ve discovered and I think we talked about in last call was – is the ability because of our vertical integration in the nature of our business, not just necessarily being wiring or just jet the ability to within certain regions consolidate manufacturing products. And so we can – and we are looking now in Mexico and Morocco at how we can consolidate, if there is a continuation or a drop in volume, how we can consolidate quickly within our facilities to gain efficiencies? And even if volume stay the relative level where they’re at today, or even go slightly up, we’re still in a position to take those steps.

And so I think administratively, yes, there’s some actions that we can still take to drive costs. But I think more importantly, what we’re discovering is there’s some flexibility in our manufacturing plants as we look at particular regions to consolidate different products within facilities, within a region. And we’ve done a little bit of that work already kind of proved it out in South America and now we’re looking at different areas particularly Mexico and Morocco to do some further consolidation and still have the capacity if volumes were to snap back, and the luxury to supply our customers parts, but just drive more efficiencies with our manufacturing plants.

Rod Lache

Thank you.

Ray Scott

Thanks Rod.

Operator

Our next question will come from Itay Michaeli with Citi. Please go ahead.

Itay Michaeli

Great. Thanks. Good morning, everyone.

Ray Scott

Good morning.

Itay Michaeli

Just go back – good morning. Just go back to Slide 12 and thanks for the second half of bridge. How are you thinking about growth over market in the second half of the year? I mean looks like the volume mixed backlog implies about 5% growth relative to H1 with which you know, sort of similar to like what you’re looking for LVP second half of the year? Maybe talk about the puts and takes of platform mix and how you think about GM in H2?

Ray Scott

Yes. So our growth over market performance in the first half was a little bit better than we expected and particularly in seating. So I think we ended up at 5.5% in the first half and we do see that moderating a little bit in the second half. We’ve continued to benefit from our strong portfolio with GM on the full size trucks and then also luxury vehicles generally. And I think that’s been a factor plus the backlog. And these systems, we had 3 points of growth over market in the first half. We expect that to be about 2 points in the second half, so about 2.5 for a full year basis. Two things going on there; one, we see the benefit of a stronger backlog in the second half of the year in e-systems where roughly two-thirds of the backlogs in the second half. But then that’s partially offset by some changeover activity on some key platforms work that’s Ford’s doing with the expedition navigator and super duty that will impact volume in the fourth quarter on those platforms. So that’s kind of how we see growth over market shaping up. It’s about 4% total company full year is what we would expect 3.5% to 4%.

Itay Michaeli

Great. That’s very helpful. And just as a quick follow-up and I apologies if I missed it earlier, any additional colors the cadence of the second half Q3, Q4. So the Q4 should have some benefits and commodities anything in terms of the kind of path on the cadence between the two quarters?

Ray Scott

Yes. As we’ve seen in the first half this year we performed a little bit better in terms of the timing of our commercial settlements that helped the first half, and so that took a little bit of the improvement that we were expecting in the second half and pulled it ahead. So, that’s difficult to say exactly how it will play out again in Q3 and Q4, but what I can say is that margins will be better if conditions and volumes hold up in the third quarter versus the second quarter. And then they will be better again in the fourth versus the third.

In terms of order of magnitude it’s a bit difficult to call right now, but we would expect, 100 basis points or more of margin improvement in E-Systems sequentially and a little less than that, probably half that in Seating, from Q2 to Q3 as we sit here today.

Itay Michaeli

Perfect. That’s very helpful. Thank

Ray Scott

Okay.

Operator

Our next question will come from Colin Langan with Wells Fargo. Please go ahead.

Colin Langan

Thanks for taking my question.

Ray Scott

Hi Colin.

Colin Langan

I apologize if I missed this if you actually [indiscernible] Slide 12 sales is going up $240 million, operating income, $120 million first half to second half or something in that range. EV adjusts for commodities; maybe that’s a $35 million-ish recovery. I’m [indiscernible] with like a 5% contribution margin [indiscernible] been adjusting [indiscernible] commodity. What would drive that margin or what am I kind of missing in that math?

Jason Cardew

Well, so sequentially, there is pretty good conversion with volume on the additional sales. So, what’s going in the other direction is for an exchange taking revenue down sequentially and the margin impact of that. But I think the conversion rates are generally in line with our typical variable margin on the volume component of that and our segment operating margins on the backlog component of that. So backlog is a meaningful portion of that $480 million revenue growth first half to second half of that first bar on the chart.

Colin Langan

Okay. Got it. And I think at mid-June, you’ve got about five one in sales, which you obviously hit, but a bit lower on operating income of those [indiscernible] it actually seemed like they were more [indiscernible] ending than there was good news. What has driven [indiscernible] performance [indiscernible] or is some of the customer recoveries coming through at the end of the quarter?

Jason Cardew

Yes, the second quarter certainly turned out better than we didn’t anticipate. I think when we provided and updated a conference in June, we talked about $170 million or so of operating income, maybe a little bit lower than that. And we came in at $187 million, so almost $20 million higher than we were seeing at that point in time. And that really was a result of the timing of some of the commercial negotiations, particularly on the Seating side.

So things that we had anticipated happening in the third quarter got pulled ahead to the second quarter. And mix worked in our favor a bit as well in Seating again, relative to what we were seeing at the time. Those are two factors that led to the out performance from what we were previously expecting.

Colin Langan

Got it. And just lastly, M&A is a bit of a drag too big of a surprise, but there is another thermal deal coming. Is that also going to be a negative contributor? And how long would it take to get these businesses to your normal level of profitability?

Jason Cardew

Yes, so it will be a similar drag. Some of the impact of Kongsberg this year is the integration cost. So we have about $7 million of costs that we’re investing to integrate those facilities and their operations more broadly into Lear. And so that reverses itself next year. And we look out at 2024 at that point, it’s in line or accretive to Seating margins with Kongsberg. And with IGB, I think, it would be a similar time lag. So about two years post acquisition, we would see that as being accretive to operating margins. And one of the benefits of acquiring both is that there will be some synergies between the businesses and with our existing operations as well. And so 2024, 2025, the combined business will be accretive to seat margins based on our plan.

Jason Cardew

Hey, Colin, just I think it’s important too to mention the strategic positioning of those two acquisitions. And obviously we can – and we’ll continue with the great products that they manufacture today individually. But what’s been extremely exciting is the customers’ response to those acquisitions. The combination we’ve talked about it with Thermal Comfort is the ability to really create a value proposition for our customers with a combination of lumbar, and active cooling, and heat. And it’s a unique position that we hold with the integration of these components into other seat components, such as the foam pad trim and the frame.

And we were recently awarded two seat programs, big seat programs. And one of the things that we were able to differentiate ourselves on this program and allow for us to be more efficient from a cost weight part number perspective was the ultimate design, which is the combination of these components into a system or a module. And we are getting overwhelmingly positive feedback from our customers.

And so even though individually, those two businesses and the synergies that those coming together will help drive our margins, what’s more important about those acquisitions was the strategic position we’re putting the company in. And I’ll tell you, we’ve been into customers, Frank and I have been flying out meeting with all the customers at the highest levels, and it is overwhelmingly positive and it’s differentiating us right now. And for the first time we’ve seen our ability now to source, design and engineer those components, the two major programs. And I think there is a third one on the way, hopefully soon where we have full control. That’s a significant shift in our customers’ behavior as far as product sourcing. And we can do that because we are lowering, it is more efficient cost, it’s more efficient from time to sensation. We’ve been developing this system for well over eight years.

And what the credibility of having these two powerful companies from a reputation perspective coming in along with the engineering work that we did to integrate these into seat components is differentiating our business.

And so, our focus is 28% market share. And I’ll tell you, I’m very positive. We keep this type of strategic differentiation, it’s going to make the difference in us gaining that market share. And it’s been overwhelming so far. So I couldn’t be more happy on where we’re at. We got some work to do in the short term to get these things accretive from a margin perspective, but long-term; we’re getting some real positive feedback.

Colin Langan

Great. All right. Thanks for taking my question.

Ray Scott

Yes, thanks.

Operator

Our next question will come from John Murphy with Bank of America. Please go ahead.

John Murphy

Hi, good morning guys. And surprisingly, I have a follow-up on Slide 15 and Slide 12. So I appreciate all the information and the answers so far. But I was just curious if you can remind us where your target margins are for Seating and E-Systems. And as we look at this, I mean, I think, what everybody is trying to get at is it seems like we’re at the, a natter or the low in margins and as volumes slowly recovering raws ease. We’re already seeing some small explosion in your margins you know, first half to second half. But over coming sort of 12 to 24 months as things normalized to some extent you might get a faster return to your target and normal.

So I’m just curious if you can remind us where those margins are and if you really do believe, I think, we’re at this low in margins and crawling out of the gutter and ultimately to these targets pretty quickly?

Jason Cardew

Yes, I do see us sort of that trough margins, particularly on the E-Systems side, Seating is rebounded pretty quickly already. In terms of the target margins for each of our segments, we’ve talked about 7.5% to 8.5% in Seating. So, I think we are on a nice trajectory to get back into that range sooner rather than later. And I think longer term the points Ray just made on Thermal Comfort will allow us to perhaps breach the high end of that that range above 8.5%. That’s certainly our objective.

With E-Systems we’ve talked about structurally that’s a 10% business in the right volume and commodity environment. We’re a ways off from that at this point. But as we look at volumes recovering, commodity cost moderating stability in the production schedule, plus the things that we’re doing to control our cost and drive growth with Connection Systems, we do see margins recovering over the next two years in these systems, sort of in that 7% to 8% range with some reasonable level of volume at that point in time. Now that’s a little bit lower than what we had expected in 2024, but a lot has changed over the last two years, certainly.

And I think it should be a nice, steady, linear, increase in that margin from where it’s at now through the second half improvement into next year and then to 2024.

John Murphy

That’s very helpful. And maybe then just a second question around volatility and schedules. I mean you kind of mentioned it. But how damaging has that been to margins here in the short run and even without a significant recovery and volume if you just got some better stability in releases how helpful would that be to margins alone before we even start talking about volume recovery?

Jason Cardew

Yes, it’s almost $90 million of unrecovered cost that we have embedded in our outlook for this year for those stop-start and other premium costs. We have been in negotiations with our customers. We have recovered a lot. That’s the net effect of the negotiations and what’s taken place in the production environment. So, certainly we see some of that continuing in the second half of this year and even into 2023, but if you look out to 2024, I would expect a $90 million improvement in the business as a result of that overhang going away.

John Murphy

So it’s simply just from a normalization of schedules and things actually coming through, as they’re stated to you, you think you get a $90 million bounce back in NOI and operating income?

Jason Cardew

Yes.

Ray Scott

Yes. Just running our plan.

Jason Cardew

Yes.

John Murphy

Awesome. Very helpful guys. Thank you so much.

Ray Scott

Thanks.

Jason Cardew

Yes, thank you.

Operator

Our next question will come from Emmanuel Rosner with Deutsche Bank. Please go ahead.

Emmanuel Rosner

Thank you very much. Good morning, everybody

Ray Scott

Hi Emmanuel.

Jason Cardew

Good morning.

Emmanuel Rosner

So actually wanted to follow-up on one of your last points here around target margins for E-Systems of 7% to 8% over the next couple of years, you said a lot has changed in the last couple of years, which is obviously very true. Can you maybe just be a little bit more specific in terms of what has changed in terms of the E-Systems outlook, is it the macro environment, the industry disruptions, is it the product mix, the investment needed at E-Systems? I guess how much is specific to Lear versus sort of like this sort of environment that you are operating in?

Jason Cardew

Yes, I would say that the changes I was describing are entirely industry related. I think if you look at HIS’ projection for volumes in 2024, at 88.7 million units, if you go back a couple of years, they certainly were expecting a higher level of global industry volume than that. So, that’s the first factor.

The second factor is higher commodity costs. And so in what I described I assume that a portion of that unwinds itself over the next two years and a portion remains. And so if volumes were to get back to where we had anticipated for 2024, when we looked at this 18 months ago, and if commodity costs were to get back to where they were 18 months ago, those two things can help you bridge sort of from the 8% to 9% range.

And then the balance is work we still have to do. We’ve seen some nice growth in our connection systems business. And if I look at 2023 and 2024, we’re expecting that business to grow by 50% over the next two years from roughly $500 million this year to $750 million in 2024 on its way to our $1 billion target that we talked about, we had talked about $900 million to a $1 billion in 2025. We now see a $1 billion is a very reasonable number in 2026 underpinned by this the interconnect board award that we had announced on our prior earnings call. That’s certainly going to be a factor that allows us to continue increasing margins and scaling of our electronics business as we’ve talked about in the past is a further tailwind to margins expanding in that segment.

And then some of the things that we’re doing with restructuring and combining certain administrative functions and manufacturing operations across the businesses will certainly be accreted to margins, not just in E-Systems, but in both segments.

And I think all of those things taken collectively with a more reasonable volume environment, commodity environment sort of gets us back to that 9% to 10% that we had talked about is the longer term target for the segment.

Emmanuel Rosner

That’s very helpful. Just a quick follow-up on this. In terms of the engineering spend for E-Systems, has it generally stabilized at where you want it to be as a percentage of revenue, or do you think that this could still be sort of a headwind margin as you continue investing there?

Jason Cardew

Yes, I think that it has stabilized and sort of peaked to the percentage of sales. We’re relatively flat now this year with last year on engineering in that segment, although the second half is higher in the first half. And so there may be a little bit of run rate increase, on that line item heading into next year. But I would say we’re generally seeing what we had expected 18 months ago in terms of engineering spend in that segment.

Emmanuel Rosner

Okay, great. And then one quick follow-up on the first half to second half walk again. Could you help me with the commodities bucket in terms of – is it largely – I mean, I guess it maybe a little bit smaller of a help on sequential basis than I would have expected in the context of not just some of the spot prices coming down, but also obviously some recoveries coming in with a lag and things like that.

May be sort of like talk a little bit about what’s behind sort of like this 35 basis point sequential improvement have, I know you mentioned some of the recoveries played out maybe faster in the second quarter, is that a big a big driver of that?

Jason Cardew

Yes, that’s the primary driver. We don’t see much benefit from the change in the spot price. We’ve locked in most of the steel for this year. We do have a little bit of upside in North America in the fourth quarter. Coppers basically hedged. Through the end of the year there is a small amount that’s still open. But that benefit, the immediate benefit is sort of offset by the inventory revaluation. And so that’s why you see more of the benefit next year, early next year from that.

Emmanuel Rosner

Okay. Thank you so much.

Jason Cardew

Thanks. You are welcome.

Operator

Our next question will come from David Kelley with Jefferies. Please go ahead.

David Kelley

Hey, good morning Ray and Jason. Thanks for taking my question. I was hoping to follow-up on the growth over market discussion and specifically what you are seeing in China. Can you walk us through if you saw any signs of outgrowth normalization as those lockdowns were lifted and production started at the ramp in June? And then maybe if you could give us a sense of how you are thinking about some of the outgrowth opportunities in China end of the back half of the year that would be great.

Ray Scott

Yes, so China growth for us will be better in the second half of the year. So if you look at the first half production the Chinese domestic OEMs certainly held up better than the non-Chinese or global OEMs. So we saw, for example, in Q2, the domestics were up 7% and the global OEMs were down 12% and that really weighed on our growth-over-market in China.

If you look at the second half of the year, that normalizes a bit and the growth rates between the two sets of OEMs are more similar.

In addition to that, we have some nice backlog rolling on in China. In E-Systems we have the Volvo XC 40 Recharge, the electric version of the XC 40. We have a lot of content on that battery disconnect unit, battery management system, onboard chargers, and wire and a number of other Volvo programs where the power electronics are ramping up. And so that sort of drives a lot of the E-Systems backlog and growth in the tail end of the year. And so that’s a factor as well.

But we do see generally speaking, the global OEMs have sort of resumed normal production rates. So customers for us like Mercedes, BMW, Audi, GM, we see improvements in the operating environment in the second half relative to the first half. And now certainly chip shortage issues, with stop-start issues are a risk in that market as they are elsewhere. But we do see more of a normalization of the customer mix in the second half.

David Kelley

Okay, got it. Thank you. And then maybe a quick question on capital allocation, the share repurchase cadence was stepped up in the quarter. It sounds like that’s continued into Q3, and might be an increased focus point as you digest some recent acquisitions. So can you just talk about into the buyback opportunity in the current macro and if you plan to be more opportunistic there?

Ray Scott

Yes, we do intend to be more opportunistic and certainly, we’ll be discussing that with the board at our next board meeting again, and they were supportive of the action we took in the second quarter and here at the start of the third quarter. So that’s certainly an increased focus for us as we look out over the next 12 to 18 months. We don’t see a need for any significant acquisitions in the near term. And I think that provides us an opportunity to return more cash as shareholders, as we see improvements in free cash flow in the back half of the year and into next year. Certainly free cash flow has been under pressure because of the stop start nature production and the additional inventory that we’re holding as a result of that. We do see some improvements in that in the second half. And as we continue to improve there, we will be opportunistic with share repurchases.

Jason Cardew

David to be very clear, I mean, our focus is obviously driving our plans. We’re focused on that free cash flow, getting our inventory levels back to more normal levels and then returning our cash back to our shareholders. And I don’t see any meaningful or significant acquisition on the horizon. And so we’re going to buckle down and make sure we’re driving our business for cash. I mean, we talk about it all the time and focused on our inventory levels and what we could do to improve our free cash flow number and get back to a more normal level of a percentage of ROI, but more importantly, make sure we’re investing in the right part of our business, which is at this time returning back to shareholders.

David Kelley

Okay. Got it. Thanks guys.

Ray Scott

Thank you.

Operator

Our final question. We’ll come from James Picarillo with BNP Paribas. Please go ahead.

James Picarillo

Hey good morning guys. Just revisiting the second half would you expect a pretty linear ramp from a top line perspective, 3Q to 4Q, just based on the timing of your backlog and the commodity recovery pass through? And then also from a margin perspective I just want to clarify for the third quarter E-Systems up about a 100 basis points, 3Q versus 2Q and seating about half that. Just on the E-Systems point, I think, it was mentioned previously that maybe pointing towards 4% for the full year, from a margin perspective for E-Systems, is that still the case? Thanks.

Ray Scott

Okay. And starting with the question on revenue, so we see revenues up modestly from the second quarter to the third quarter, so you have the stronger dollar weighing on the results. You have a little bit of volume, but you also have seasonal shutdowns particularly in Europe that kind of weighs on the revenue in the third quarter. So we see a steeper increase in revenue in the fourth quarter, as you get past that normal seasonality. And our strongest backlog quarter is the fourth quarter as well overall.

In terms of operating margins, yes you’ve got it basically, right in the third quarter, well, we’re not providing precise guidance at this point, just because of the lumpiness of some of the commercial negotiations between the third and the fourth quarter. We do see full segments better, and E-Systems in particular, up about a 100 basis points, Seating is probably anywhere from 25 to 75 basis points improved from the second to third quarter, assuming the cadence of those commercial settlements happen as expected.

James Picarillo

Okay. And then just E-Systems for the full year, I think, the second half was talked about in that 4% to 5% range for the second half, it seems as though maybe that’s coming in a little bit lower, is that a fair assessment?

Ray Scott

We have E-Systems at about 4% for the second half and approaching 5% in the fourth quarter is sort of how we see it. And so for the full year of the math works out to about 3.3%

James Picarillo

Understood that’s helpful. And then just on the $40 million in annualized SG&A savings any breakout in terms of what that would look like for the segments, is it more focused on E-Systems relative to the size of the business or not necessarily?

Ray Scott

No, I’d say it’s fairly ratable and including in our headquarters. So not just in seeing in E-Systems, but also some of that shows itself in the headquarters number as well.

James Picarillo

Okay. Thanks guys.

Ray Scott

You’re welcome.

Jason Cardew

Thank you.

Ed Lowenfeld

Okay. To the Lear team, I just want to thank you for a great quarter, obviously exceeded our expectations. You guys did a great job. Appreciate all the hard work; we’ve got more work to do for the remainder of the year. But one thing to note, and I say it all the time, I couldn’t be more proud of the team being recognized for all their great accomplishments from our customers, not just with the business backlog, but also the recognitions for quality and other recognitions within our plants just shows the great work that you are doing every day. I appreciate all the hard work and thank you for all your results.

Operator

The conference has now concluded. Thank you for attending today’s presentation. You may now disconnect.

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