Adient's Trading as if It Will Never Get Better

We think this sell-off is an excellent buying opportunity for the long-term investor. We consider Adient’s problems to be primarily from poor execution and therefore fixable. Also, we do not consider the company to be heading toward financial distress, and we think it can even maintain its dividend as it restructures. Adient still has selling, general, and administrative expenses to cut from its Johnson Controls days and manufacturing to move from high-cost countries to low-cost countries. Its seating EBIT margins trail those of top competitor Lear LEA, and we don’t see why that difference must be permanent.

Adient also dominates seating in China, with nearly half the share of the world’s single-largest auto market. The company’s 20 seating joint ventures are accounted for under the equity method, but their unconsolidated revenue is about $9 billion. We see Adient remaining the top seating company in China because U.S. and European customers operating there want a company that can supply seats globally, and very few companies can do that. Sourcing is not purely a price decision. Adient also bought Futuris in September 2017 partly to increase its business with Chinese automakers, so we think it is well positioned in China with healthy joint ventures that are self-funded.

Option value comes from Adient seeking $1 billion of nonautomotive revenue by fiscal 2022, which for now may come mostly from business-class airplane seats thanks to a newly formed joint venture with Boeing BA. Autonomous vehicles also bring upside potential because Adient owns 30% of the world’s largest automotive interiors company, Yanfeng Global Automotive Interiors. This ownership is in another joint venture with an additional nearly $9 billion in unconsolidated revenue. Interiors have long been thought of as a commodified area of automotive design, but we think they could become much more critical to vehicle appeal in a fully autonomous world. We see Adient having a bright future in seating and autonomous vehicles, but we do think a turnaround will take well into calendar 2019, so investors will need patience.

First in a $60 Billion Market Automotive seating is a market of about $60 billion globally, and Adient is the number-one company with 32% share, according to its estimates, including unconsolidated Chinese joint venture business. Lear, Faurecia EO, Magna MGA, and Toyota Boshoku are the other sizable players. Adient and Lear alone have roughly half the market.

Customer concentration does not look like a big risk to us because Adient’s automaker exposure is 30% of fiscal 2017 GAAP revenue to the Detroit Three, 36% to European automakers, 29% to the Japan Three and Hyundai-Kia, and the remaining 5% to other automakers, such as Tesla. The largest customers were Ford and Volkswagen Group, each at 12%, with Nissan and Fiat Chrysler next at 10% each, and Adient’s largest platform contract made up about 5% of revenue. On the joint venture side, Adient data for 2016 indicates the company’s share in the low and upper 70s for Europe- and North America-based original-equipment manufacturers and in the low to mid-30s for each of the Japanese, Korean, and Chinese automakers in China. In September 2017, Adient acquired Futuris Group partly to increase its exposure to local Chinese OEMs.

We do not think Adient is up to full speed because it identified plenty of SG&A to cut once it became a stand-alone company, and comparisons with Lear’s seating division show that Adient should be doing better. For example, Adient’s EBIT margin trailed Lear’s seating segment EBIT margin by 300 basis points in 2017. This difference is a sign of inefficient manufacturing and probably also the result of problems integrating various acquisitions Johnson Controls made in 2011.

Adient management planned to narrow this gap with Lear by fiscal 2020 via cost cuts and various growth investments in new nonautomotive channels. It expected to improve operating margin, excluding equity income, by 200 basis points relative to the 4.5% level Adient would have achieved as a stand-alone company for the 12 months ended June 2016. However, cost headwinds of $300 million in the seat structures and mechanisms group forced the company in May to say it could not meet this goal. No update on timing has been given, and we may not hear anything until Adient hires a new CEO. Before SS&M’s problems started hurting results, Adient was making progress on better leveraging its costs. On a trailing 12-month basis, SG&A as a percentage of revenue had fallen to 3.8% at March 31 from 5.0% at June 2016. Adjusted EBIT margin, excluding equity income, in the trailing 12 months peaked at 5.2% in September 2017, up from the June 2016 starting point of 4.5%, but fell to 3.8% by March 2018 and fell further to 3.0% by June 2018.

What Went Wrong in SS&M? A lot of the seat structures and mechanisms group's issues initially seemed to be focused on moving work from high-cost countries to low-cost countries, but there are additional troubles to address now. Steel prices rose more than the company expected when it first gave fiscal 2018 guidance, resulting in at least a $35 million cost headwind relative to original fiscal 2018 plans. Management also cited capacity shortages from European specialty steel, forcing Adient to seek new suppliers outside Europe, which slowed production and raised costs. The segment also saw numerous design changes from customers (one vehicle program had 650 design changes before it launched, for example), and management told us that Adient did not seek sufficient price increases on these changes because it wanted to keep customers happy and incorrectly thought that some changes did not require price increases. SS&M also suffered some of its own supplier problems and tooling issues that forced it to add workers and weekend shifts at a cost premium.

The business also recently began launching its new mechanisms portfolio, the 3000 line, which required new technology investment and, in some cases, resulted in unspecified machine utilization problems that forced Adient to use expedited freight to deliver to customers on time. In addition, SS&M saw about triple the number of launches in 2017 and 2018, and it sounds to us from talking with the company that its resources were spread too thin and too focused on putting out fires, so to speak, rather than on proper execution. These headwinds led total company adjusted operating income for the quarter reported on July 26 to fall year over year by $127 million, or 38%, and adjusted EBIT margin including equity income to fall 370 basis points to 4.6%. Long term, we think the segment can be turned around, but it will take more than a few quarters. SS&M has lost money every quarter of fiscal 2018, but its losses have narrowed to $18 million in the third quarter from $82 million in the first quarter.

Change Is Coming The new 3000 mechanism line sounds to us like a critical part of SS&M's turnaround even though its recent start caused some problems. Management expects the new product line (recliners, height adjusters, latches, and tracks) to see returns on sales by fiscal 2022 often more than double what the prior-generation mechanism portfolio generated. The rollout will take time as plants are retooled and as old vehicle programs at customers expire. Recliners is furthest along, with the 3000-line recliner making up 25% of fiscal 2017 recliner business. The company expects that ratio to be 94% by fiscal 2022. Adient said in May that a completely new mechanisms portfolio is a once-every-20-30-years event, so we expect a long run of economies of scale once the portfolio is 100% switched early next decade.

The company is also revamping various manufacturing processes to reduce changeover time and increase output in stamping and welding. Six of nine key leaders in SS&M have been replaced and seven of 21 plant managers are new. Some vertical integration is expected to be replaced with outsourcing. SS&M also does plenty of Tier 2 supplier business, where it supplies seat structures or various mechanisms like recliners to a Tier 1 supplier such as Lear, Faurecia, or Magna, which then provides a complete seat to an OEM. About 45% of SS&M’s $2.8 billion in revenue (including intercompany sales eliminated in consolidation) is Tier 2, and management said in January that it wants to reduce this exposure to decrease the segment’s capital expenditures and weed out unprofitable vehicle programs. The reduction would come from the Tier 2 structures business and then the new mechanisms lineup will run for 20-30 years, eventually generating scale. Strict platform profitability thresholds will be adhered to, and some products may be dropped to focus on new products that have lower cost or more upside potential. Finally, there are plants in Europe losing money, and Adient has agreements with the work councils there to close the largest of them in fiscal 2019.

The vision at spin-off time was to make this business, excluding China’s SS&M business in the joint ventures, a 5%-10% EBIT margin business. We calculate that in fiscal 2017, SS&M’s EBIT margin, excluding China, was negative 3.6%, down from “roughly break-even” for the trailing 12 months ending June 2016, CFO Jeff Stafeil said in January. It is possible that the new CEO will want the target changed, however; we see no reason Adient cannot turn SS&M around, as a lot of factors are within management’s control. It certainly should not be losing money or barely profitable. The Chinese joint venture shows that Adient can run a profitable SS&M business. Chinese SS&M EBIT margins are in the mid- to high teens, and the businesses there generated SS&M net income of $72 million in fiscal 2017, a 9.7% net margin, of which Adient received half via equity income. Chinese SS&M is far more profitable than the rest of Adient’s SS&M businesses because the joint venture sells only mechanisms instead of mechanisms and seat structures, and the joint venture there started life in December 2013 without the inefficient legacy European business that Adient’s consolidated SS&M results have.

Pessimistic observers may scoff at these change initiatives and suggest exiting SS&M because it loses money while consuming about 45% of total company capital expenditure. But there are also benefits, such as SS&M enabling Adient to be involved with vehicle design early in the process, which in theory allows Adient the best design flexibility to minimize cost for a vehicle seat. It also helps Adient get its foot in the door on a program. This matters because seating is a very sticky business. Once a supplier is on a program, it tends to stay on it even for the next generation of a vehicle. We also think it is too early to give up on turning SS&M around when management has plenty of fat to cut. Although Adient’s stock has fallen hard in 2018, it is not in distress, and we do not think selling SS&M at a likely very depressed price makes much sense.

Moats Matter--and Give Us Comfort Seating is one of our favorite sectors of the auto supplier world. It is an oligopoly, and we expect it to remain that way, because it is hard for an upstart supplier to usurp an incumbent seating provider. We think Adient's narrow economic moat is safe despite the company's recent troubles. The company has moat aspects from four of our moat framework's five sources: intangible assets, cost advantage, efficient scale, and switching costs.

Seating is not a commodified business. It requires patents, decades of trust built up with customers, and an ability to service a customer all over the world with just-in-time manufacturing. This consistent reliability is not something that just anyone who can get a loan to start a seating company could do easily or quickly. Automakers’ move to more global platforms is very good news for Adient because a supplier must be able to service the OEM consistently all over the world. A regional player cannot do this, and we think a small company would be hesitant to borrow lots of money to add new facilities and overhead all over the world without any guarantee of winning new business. Automakers want the same supplier on a program globally because of scale benefits for them and reliability with a vendor that knows the vehicle program. Therefore, seating is a sector likely to remain best served by a limited number of companies for a long time to come, yielding an efficient scale benefit to Adient.

Adient’s expertise has won it many awards, both from customers such as GM and Toyota for supplier of the year or design, and for highest seat quality from J.D. Power. It takes trust from customers to even get on a vehicle program; then suppliers can keep the business with their technical expertise with technologies such as weight reduction via materials expertise in steel composites as well as using new materials such as magnesium or aluminum. Seating and interiors also matter for safety and heavily influence the overall appeal of a vehicle to a consumer. Longtime seating companies such as Adient have decades of knowledge of what automakers and consumers want in a seat or interior, a helpful intangible asset in keeping new entrants out. Another intangible asset comes in the niche performance seating area, where Adient owns the Recaro automotive seating business, which management is now trying to leverage into business-class airplane seats with transaction prices well over $100,000 and EBIT margins in the high teens. These metrics are dramatically different from Adient’s auto seating business, where content per vehicle ranges from about $500 to over $1,800 (the company’s global average is about $700) and EBIT margins around 8% may be the best to hope for.

Once the supplier is on a program, it will be asked to develop seats for a new-generation vehicle program sometimes years in advance. This planning means the supplier gets into planning a vehicle early enough to offer the best design and integration into the vehicle’s floor to reduce weight while also lining up its own supply chain to offer the best cost savings to the OEM. This integration and ability to offer an improved product at a good price make for a sticky relationship with a customer, creating a barrier to entry not only for the current vehicle program but for future programs as well. Once a supplier has the business, it is extremely rare to lose it, especially during a vehicle program, because automakers then must remove tooling from the supplier, which can cost millions. An automaker would also have to incur expensive validation testing of a new supplier, all while the production line is not making any vehicles and decimating an automaker’s ability to recoup its fixed costs.

The stickiness of the relationship with the automaker and Adient’s ability to innovate also help cost advantage by protecting Adient from the relentless annual pricing reductions automakers expect from suppliers, because automakers will be willing to pay up for new technology. Also, seating is a less capital-intensive business than other areas of the automotive supply world. Adient’s capital expenditure as a percentage of sales is one of the lowest in our supplier coverage. The seating assembly process cannot be automated as easily as, say, Gentex GNTX making auto-dimming mirrors or a stamping company producing doors or hoods. We think Adient’s cost advantage has the potential to improve as the company moves certain production to low-cost countries such as China and Mexico from high-cost countries in North America and Europe.

Our Valuation Assumptions May Prove Conservative Our fair value estimate is primarily driven off midcycle EBIT margins, excluding equity income, as well as value creation in stages II and III of our discounted cash flow model rather than what Adient will do in the next one to two years. For example, a 100-basis-point decline in our midcycle EBIT margin of 5.5% would lower our fair value estimate by 17% to $60, all else constant. We think our 5.5% midcycle EBIT margin is conservative, given that Adient is not done restructuring, we do not yet model any benefit from management's plan for $1 billion of nonautomotive revenue by fiscal 2022, and the company posted a 5.2% EBIT margin in fiscal 2017. We do not even model noteworthy margin levels until fiscal 2021, when we model 6.5% before falling to our 5.5% midcycle. For fiscal 2018-20, we assume a mid-2% range this year, about 3% next year, and then 4% in fiscal 2020, which we think is conservative.

We also think the market is pricing in expectations that this company will hardly improve. We think that view is unrealistic, but the market for now likely has little confidence in the story until Adient’s numbers say otherwise. If we modeled our fiscal 2018 2.4% EBIT margin as a midcycle number, our fair value estimate would be only $35, which is lower than our bear-case fair value estimate of $41, which assumes a 3.5% EBIT midcycle margin. Our bull-case fair value estimate of $111 has midcycle margin of about 7.5%, which is not a ridiculous number, given where Adient is today versus Lear’s seating group. By our math, Lear posted an 8.2% operating margin in 2017 for its seating segment, excluding restructuring and excluding equity income. Metrics like this make us think that Adient’s stock today has more upside potential than downside risk. However, if the market began pricing in a recession soon, we would not be surprised if Adient fell into at least the $30s.

Financial Leverage Increasing, but Debt Looks Manageable Management told us at spin-off time that getting to investment-grade was a top priority for capital allocation even ahead of share buybacks. Buybacks have only totaled $40 million since the spin-off, all of which came in fiscal 2017, and we do not expect any soon, given that cash will be required to fund restructuring. First-half fiscal 2018 cash restructuring outlays totaled $100 million, and management said it expects about $200 million for the full year. Management expects normalized average ongoing annual cash restructuring of $100 million after fiscal 2018, but the actual amount depends on OEM footprint changes. Once SS&M and seating are performing better, we'd like to see buybacks because we believe the stock is cheap, but we expect term loan prepayments are more likely. Prepayments are probably on hold while the company restructures. At the spin-off, Adient took on about $3.5 billion of debt, mostly to fund a $3 billion one-time distribution to Johnson Controls.

The company’s net leverage ratio, which is net debt/adjusted EBITDA, increased to 2.29 times at June 30 from 1.73 times at Sept. 30, 2017. Management has prepaid $300 million of term loan debt since the spin-off, but we think further debt reduction may be delayed as a result of the CEO change and cash needed to turn the company around. We think Adient has time to turn itself around before major maturities come due in 2021.

We also think the dividend, which is payable quarterly and currently annualized at $1.10 per share, is safe, but we do not expect it to grow until fiscal 2020 because of restructuring and the U.S. may be late in the economic cycle. The dividend requires about $102.7 million to service annually (93.37 million actual shares outstanding at June 30), so we think Adient could service it via the credit line for a year if it had to. If fiscal 2019 or 2020 free cash flow does not improve from the guided possible burn of fiscal 2018, then the dividend could be at risk, or the risk of a cut could be an overhang on the stock. We think the last thing management wants to do is send the stock down hard further by cutting the dividend. We calculate that if net debt of $3.1 billion increased by, say, $100 million for a dividend, net leverage goes to 2.36 times adjusted EBITDA from 2.29 times. That seems manageable to us relative to the company’s net debt/adjusted EBITDA covenant requiring a ratio of equal to or less than 3.5 times.

New Chairman and CEO on the Way Bruce McDonald, a longtime Johnson Controls executive who was Adient's first CEO and chairman, resigned in June. He will remain an advisor until Sept. 30 to interim CEO Fritz Henderson, who is also on Adient's board. Henderson is the former president, CFO, and CEO of General Motors.

Adient’s board is a mix of Johnson Controls directors and new directors. We like that the board has several people deep in automotive experience but has enough nonauto people to bring some balance to strategic discussions. McDonald had plenty of credibility to chair Adient’s board since he was CFO of Johnson Controls and later became vice chairman. We think it’s possible the next Adient CEO could come from outside the company because two of the three directors coordinating the search never served on Johnson Controls’ board. Given the current state of Adient after a CEO from Johnson Controls, we also think an outsider may be the preferred path. However, Adient executive and Johnson Controls veteran Byron Foster, former head of seating and now head of SS&M, is a possibility because we think the next CEO will have an operational rather than financial background. Henderson, 59, is another possibility but was vague on the July earnings call as to whether he wanted the job.

New Aerospace Joint Venture Holds Appeal Adient formed a joint venture with Boeing, announced in January, called Adient Aerospace, for which management expects regulatory approval this year. Adient will own 50.01% and consolidate the joint venture within its seating segment. The business will sell to airlines and airplane leasing companies for installation on planes made by Boeing and other aircraft makers. Adient Aerospace is headquartered in Germany, and manufacturing will be there because Adient has an aircraft seating test center there in use since the early 1990s. Customer service will be based in Seattle. Adient and Boeing will each contribute $28 million initially to form the venture, and through 2019, the total cash contribution split roughly 50/50 will total about $100 million.

Retrofit is about two thirds of the airplane seating industry’s $4.5 billion market, and management expects this to grow to about $6 billion by 2026. What’s appealing to us about Adient Aerospace is that management sees the sector as ripe for disruption because it’s an oligopoly mostly controlled by B/E Aerospace and Zodiac. Adient’s management in January called out on-time delivery rates of less than 65% in the industry; we think Adient, as a just-in-time manufacturer to autos, should have no problem beating this service. Our aerospace analyst notes that the 65% on-time delivery rate is artificially low because of large increases in Boeing and Airbus production. B/E and Zodiac have both recently been acquired by larger aerospace companies, and our aerospace analyst thinks this will help these incumbent companies clean up their act. We think the key for Adient is to move quickly once it gets regulatory approval, as we think there is share to take and room for a new player. But the competition is likely to get tougher.

We suspect airlines are looking for more reliability from a supplier, and the relationship with Boeing should give Adient credibility to gain share. Also helpful for credibility and airline connections is Ray Conner, an Adient director, who is the retired CEO of Boeing Commercial Airplanes and retired Boeing vice chairman. On the new aircraft side, Adient may have an advantage over suppliers if Boeing changes its interiors catalog to airlines to highlight Adient’s seats. Profits will take time, because once Adient wins a contract it could be two to three years before there is revenue, but with EBIT margins in the high teens, we are OK with the investment and the wait because the profits will be worth it if the company can win business. In April, the company brought demonstration lie-flat business-class seating to the Aircraft Interiors Expo in Hamburg, so aerospace is not just ambitious talk by management. We won’t start modeling airplane seating business explicitly until we see some contract wins, but we think expansion beyond autos in this form is a smart move.

Autonomous Vehicles Bring Opportunity and Option Value Adient is working on new seating technology for an autonomous ride-hailing world. We expect these products will initially be sold to fleet companies such as GM's Cruise or the likes of Uber and Lyft, but they could also be sold for private autonomous vehicle ownership. AVs give automakers the ability to make the inside of a vehicle in many different configurations compared with traditional vehicles because not having to drive creates free time, which means the interior can have multiple functions such as talking, relaxing, or working. In an AV world, there won't be a fixed driver's position, like there is today, so the person can move about the cabin. This change brings opportunity for a large seating company such as Adient; we think in an AV world the interior of a vehicle will perhaps become less commodified than it is today, so Adient's 30% Yanfeng stake could be far more important to the market than today. Features such as more storage, wireless charging, displays in the ceiling or in a seatback, and pullout tables are likely to be common. Screens could be used to shop, have a video chat, or watch media on a screen bigger than a mobile device.

Form and function are likely to change. For example, Adient has a partnership with Autoliv, the leading safety supplier, to integrate seat belts directly into the seat as opposed to the B-pillar of a vehicle presently. Futuristic capabilities--involving seat-to-seat communication (so a seat knows how far to recline or pivot for example), seat-to-cloud or to a mobile device so a ride-hailing customer can have seating preferences automatically waiting for them, biometrics, and perhaps e-commerce or media on demand via onboard computers integrated into a seat, door panel, or window--will be normal. Biometrics would likely include sensors in the seats that could automatically communicate with emergency responders or a rider’s physician in a health emergency. Sensing technology would also have to automatically tell a vehicle and a fleet cleaning service that the seat needs cleaning, repair, or replacement. Adient has expertise in system integration, such as integrating safety systems with seats to determine airbag location or how seat belts and airbags keep someone safe regardless of the seat’s position, so we think it can effectively incorporate new technology such as seat-to-seat communication. Adient also can serve OEMs globally, unlike smaller players, so we think it will successfully work with partner companies, such as electronics companies in Asia, to make new products that will appeal to OEMs and their customers.

Adient has told us that it owns the intellectual property for algorithms around seat-to-seat communication, but we also expect partnerships in electronics. We think partnerships with mobile device providers such as Apple or other large tech players such as Microsoft or Samsung to optimize needed capabilities are not unreasonable. These arrangements could provide a positive catalyst, especially considering a depressed stock price. The exact presentation and capability will only be known with time, but we see Adient as a key player in the user experience aspects of an AV. Drivers will no longer have to drive, and their comfort and ability to meet, sleep, relax, or interact with family members are all going to be shaped by how companies like Adient design seats and interiors.

In January at the North American International Auto Show in Detroit, Adient displayed its AI18 concept vehicle, which features five different seating layouts: lounge, communication, cargo, family, and baby plus modes. A vehicle could have all five modes, and rear seats would be able to automatically retract into the trunk in cargo mode. Seats can rotate 180 degrees in communication mode; this movement occurs with the passenger still seated rather than before the trip begins. Sensors in the seat also analyze pressure placed on the seat from a person and can automatically optimize comfort. We see these configurations ultimately allowing more of a vehicle’s features being controlled from anywhere in the vehicle rather than in the center stack or steering wheel. Adient is not yet discussing specific dollar content per vehicle but has told us that it is significantly higher on these new seats than on today’s products, which makes sense given the new technology and innovations such as headrests weighing 20% less than present headrests because of fewer components and new pivot systems so the seat can be comfortable even when reclined.