Adient Starts to Deliver on Turnaround

Automotive seating supplier Adient’s ADNT fiscal third-quarter results support our thesis of a long-term turnaround story moving in the right direction, so we are leaving our $53 fair value estimate in place. Adjusted diluted earnings per share of $0.38 beat consensus of $0.34, while a 6.1% year-over-year decline in revenue (down 2.8% excluding foreign exchange) to $4.2 billion beat consensus of $4.1 billion. Free cash flow of $168 million declined from the prior-year quarter’s $252 million, but last year included $94 million of proceeds from factoring receivables.

The quarter showed that operational challenges remain but also revealed improvement in execution, requiring less expedited freight. Through June for the year, premium freight costs have fallen about 65% versus fiscal 2018, but continued manufacturing problems in the Americas and the Europe, Middle East, and Africa segments, plus large volume declines in Asia from China, led to all three geographic segments posting year-over-year declines in adjusted EBITDA. Adjusted EBITDA improved sequentially for the second straight quarter.

Management confirmed its outlook for second-half adjusted EBITDA to exceed the first half’s $367 million, but it also expects the fourth-quarter figure to be slightly below the third quarter’s $205 million. Adjusted EBIT and EBITDA include equity income from China, and the company’s more than 20 joint ventures are suffering from the large volume declines in that market that are hurting the whole auto industry. It does not surprise us that fiscal 2019 equity income guidance was lowered to about $265 million from $290 million-$300 million. The third quarter in China faced headwinds not only from volume as many automakers sought to reduce inventory, but also from a pull-ahead of sales to clear inventory in advance of new emission rules that started July 1. Management expects the worst to be over for China, but we don’t expect rapid growth there anytime soon. Adjusted equity income in the quarter fell 30% year over year to $66 million.

Adient’s turnaround story is a long-term one that’s still in the early stages. We expect improvement because Adient can eventually roll off underperforming vehicle programs that prior leadership probably underbid to get, and it has a higher quantity of early-stage discussions with customers to prevent launch problems that often lead to scrapped production and premium freight charges. CEO and president Doug Del Grosso sounded pleased during the earnings call that automakers are having more broad-based mutual discussions with suppliers on how to cut costs for the first time in several years, as opposed to just dictating pricing and production terms.

Management’s turnaround plan, which will last well into the next decade, calls for at least $425 million in free cash flow improvement through fiscal 2022, which we think is reasonable. We continue to believe there’s no structural reason that Adient’s margins cannot one day be comparable with those of Lear’s LEA seating segment, which in 2018 were 8.3% before equity income and excluding restructuring charges. For conservatism, however, our Adient midcycle EBIT margin before equity income is 5.5%. Management also said during the call that the company’s ability to improve doesn’t depend on the macroeconomic environment improving. This makes sense to us, since most of its problems appear to be structural.

Two pieces of good news for investors is that customers are not giving up on Adient, which we’ve never been worried about, and the tariff headwind for fiscal 2019 is now expected to be about $15 million (from $20 million previously) due to the removal of steel and aluminum tariffs on Mexico and Canada, a benefit partially offset by President Donald Trump’s Aug. 1 announcement of a new 10% tariff on Chinese imports. On the customer front, Adient won a quality award from Peugeot in June, and fiscal 2019 renewal win rates on business have been 100% in China and North America and 90% in Europe. This stickiness is a key reason Adient has a narrow economic moat: Switching suppliers is difficult because of factors such as extensive validation testing and removal of tooling. Adient also has wins this year on a new Cadillac sedan and crossover, the CT5 and XT6, Jeep’s new Gladiator pickup, Volkswagen’s Amarok pickup in Europe, and the Ford Ranger midsize pickup in Asia and EMEA, and earlier in the year it announced the contract for the new BMW 7-Series and next-generation Ford F-150, the top-selling vehicle in the United States, due in 2020.

With customers standing behind the company and no major debt maturities until 2024, we remain confident in Adient’s ability to turn itself around and eventually generate cash flow appropriate for the largest seating company in the world. Even after the market’s positive reaction to the earnings report, we believe the stock is drastically mispriced. In our opinion, a conservative normalized annual equity income balance of $350 million multiplied by 7 is $2.45 billion, which is greater than Adient’s market capitalization as of the Aug. 6 market close. This math means that investors are getting the consolidated seating business (everything outside of China) for free.