Description

Who wants to buy the lowest quality business in autos competing for the highest valuation? Meet Adient, ~1/3 garbage can (seat frame stamping and machining), 2/3 problem plant whac-a-mole (seat assembly). The stock has just ripped 100% into a guide down - it is clearly time to buy. Top problem solvers and go-getters from all over the country are dreaming to land a job at Adient Global HQ, sandwiched in between a trailer park and a correctional facility. Do you blame them? Who wouldn’t want to work at the most depressing looking corporate office in the industry with crash tests co-housed within the corporate office (yes, it is loud. yes, it keeps employees from falling asleep at their desks). While some folks may give them a thumbs-up for cost saving, let’s remember the company just offloaded their G550 (insert spin-off costs here) for a fraction of what they bought it for. The good news is all of the bad people, err people, are leaving the company. I recently spoke with a large private supplier who noted he was getting flooded with resumes from Adient, and from high level folks. He said the last time he saw this was from folks at Takata leading up to their bankruptcy. So at least they have that going for them. Not good enough? Did I mention they are turning the business around? Just listen to the public lender call pump-job that sent the stock up 100% (not the most recent public earnings call which sent it down 10%). They’ve been working to close the margin gap vs peers since 2016, so they have it all figured out now. I know they’ve guided to a 2H recovery for the past 2 years but this time is different, it’s happening this time… And besides, we’re getting paid. From now until 2022 we’re getting a whopper of a check - $479mm cumulative FCF (according to sellside; they are never wrong), that’s an annual 2.3% of current EV. Not sure what else you could want. Interested? Please, keep reading.

I’ve said this on VIC many times. The only reason we look at earnings is because they are proxy for FCF. Since FY 2015 Adient has generated $3.5bn in adjusted net income. Over that same time period the company has generated NEGATIVE $1.4bn in FCF. Since FY 2017 the company has generated $1.46bn in adjusted net income. Over that same time period they have generated $100mm in FCF. These are not typos. This stock is worth $5 per share.

Over the course of the past couple years, China exposure has gone from a positive, to a negative, back to a positive. I think China exposure is now clearly a negative. Putting aside the fact that forward-looking consumer sentiment in China is now horrible, I think the market is misinterpreting the 2018 slowdown. While demand for autos slowed in 2018, it also slowed across a number of household goods. The best explanation for the rapid growth and subsequent slowdown in demand is the S-Curve. When products go from 20-60% penetration investors typically underestimate the growth, while in later periods analysts continuously underestimate the declines rates (though total units continue to grow). I think we are currently seeing this in China, with passenger vehicles currently at 50-60% penetration on a per-household basis. The fertile fallacy in my view is that compared to the US, penetration in China still has a long way to go. This however completely misses the cultural difference in car ownership in China. Chinese use public transportation during the week (communist country = great public transpo apparently) – cars are for weekend trips with the family. Combine this with US / China decoupling and related deglobalization and I think you have plenty of reason to believe continued declines in China auto sales for the next few years is our base case (setting aside a global slowdown along the way – don’t be so negative). Adient has the most exposure to China of any auto supplier. China is important because every auto supplier has the highest margins in China, by far. For example, Adient’s EBITDA margins in Asia were 10.7% this past quarter vs 1.8% in the Americas and 3.3% in Europe. Lear’s Europe margins have historically been negative to LSD, while their North America margins have been only slightly better. So while there is upside to NA margins (if it happens, this will take 5-10 years due to double-dip programs) if they can get their act together, there is likely downside to Asia margins as growth slows. Lastly, Ford is currently shifting away from western suppliers in an effort to save money. Given Ford is 12% of Adient’s revenues this is going to be a problem.

Europe is currently a disaster. If you’re an auto supplier and you’re not selling products that help OEMs meet emissions requirements your business is going to face headwinds in Europe. Regulators are requiring OEMs to hit emissions targets which are impossible to achieve. OEMs are going to try their best to meet them through a number of technologies, as well as altering the product offering to things consumers do not want (barbie / GI Joe electric vehicle anyone?). It’s important to highlight that the European economy is exposed to China through Germany, and I would expect continued trade friction to weigh on the EU economy. Lastly, Ford is effectively exiting their Europe passenger vehicle business. Ford is 12% of Adient revenue globally.

Adient clearly has margin issues. While the bull case believes they will be able to turn around this business in short order, this is going to be extremely difficult due to the nature of Adient’s business. Seat structures and mechanisms are the highest level ASIL rating, or safety rating. New products and designs require extensive crash testing, validation and approvals – this is not cheap and it takes time. Oftentimes OEMs allow suppliers to redesign their products to reduce costs. This allows suppliers to offset annual price downs. The problem with being a Tier 2 supplier into the seat and seat structure is that the content is safety critical, making this process extremely costly. As a result, price downs are not as bad here. Unfortunately Adient’s problem isn’t price downs, it’s mispriced business. The next point is important. The average contract life for Adient’s seat structures business is 10+ years, as business is typically awarded on a dual platform basis, which each platform being 5-6 years. This means the time it is going to take to fix this business (ie the time to let loss-making business roll off, which is still rolling on, thanks to now departed management) is going to be much longer than investors expect and it’s going to require a lot of engineering expense.

OEMs are also not in the business of handing over their profits to suppliers. In cases where OEMs botch a new launch, they typically reimburse suppliers by giving them new business on future launches and in some cases one-time payments. Adient’s case is different, and it’s helpful to understand the history. When Adient spun out of Johnson Controls it’s executives were compensated on backlog growth, and so grow backlog they did. They underpriced business to drive backlog and then left current shareholders holding the bag. This is evident in Adient’s filings and from talking to industry. Historically Adient would get into a program and then every time an OEM had to change something in the design of the vehicle, Adient would jam them on pricing, knowing that replacing them would be very difficult, and while also knowing they could nickle and dime them over time to get their margins up. OEMs have now caught on.

I commonly hear investors ask the company if volume declines will help the company lose less money in their SS&M business. The company will tell you it is not, but the reason why is more informative. Unlike seating plants which are set up next door to customers, seat structures and mechanism facilities are not. Adient’s, for example, are located in Europe, with each plant making a handful of parts that when combined with the parts from other plants, supply auto programs all over the continent and world. While two plants might manufacture the same component, they are going to be designed differently and going into different programs. So when Ford ultimately exits Europe or global production legs down 5-10%, the fixed cost deleverage is going to kill this business, which is effectively a metal bender with high fixed cost.

Appendices   

Catalyst

Earnings misses, valuation re-rating, continued operational issues.