Lear: In the Driver's Seat
By Efraim Levy
Lear (LEA ) sits comfortably atop the list of the world's largest suppliers of automotive interior systems. We at Standard & Poor's believe that it will benefit as more of its products find their way into the vehicles of its existing customers -- and as it increaes sales to newer customers such as Asian carmakers producing vehicles in the U.S. The shares carry S&P's highest investment ranking of 5 STARS (buy).
Lear supplies every major auto manufacturer in the world. Its products encompass all six interior systems in a motor vehicle: seats, instrument panel/cockpit, door and trim, overhead, flooring and acoustic, and electronic and electrical distribution. In 2001, the U.S. and Canada accounted for 58% of Lear's sales, Germany represented 11%, and the balance came from other countries.
Its sales and earnings are highly dependent upon production volume from the cyclical global auto industry. While we expect lower vehicle production in the U.S. in 2003, we think the adverse effect on Lear will be more than offset by a more favorable sales mix -- a greater percentage of higher-margin products -- and a larger amount of content it supplies for more important high-volume products, such as General Motors' Chevy Silverado and GMC Sierra full-size pickup trucks.
Sales to foreign makers should rise sharply, albeit from a relatively small base. Vehicle production outside North American should be fairly stable compared to 2002 levels. After years of suffering from a strong U.S. dollar against most major currencies, the greenback's recent weakening has helped Lear's performance in Europe.
In addition to higher sales levels, Lear's margins should benefit from restructuring moves. Its current focus on generating cash should help lower debt and cut interest expense. In addition, an expected reduction in the tax rate to 32% in 2003 would help net income. One offset: Lear's decision to expense stock options is expected to reduce earnings per share by 14 cents per share.
Lear had taken on debt to fund acquisitions and other activities, but it has been using its cash flow to reduce the debt. We project Lear's free cash flow (net income plus depreciation and amortization, less capital expenditures) will exceed $350 million in 2003, excluding restructuring-related expenses. It's likely that free cash flow will continue to go toward further debt reduction.
While we find Lear's valuation to be compelling, the stock isn't riskless. If the economy slows or if automotive demand otherwise declines more than we forecast, Lear may not meet S&P's financial projections. Disruptions to production through strikes or violent attacks in the U.S. could also cause it to miss estimates. On the other hand, better-than-expected demand would help Lear exceed our forecasts.
With improving content per vehicle, reduced overhead costs following plant closings and staff reductions, and greater operating efficiencies from improved capacity utilization at its remaining facilities, we see Lear's 2002 earnings per share rising to $4.58, from 52 cents one year earlier (which included about $1.93 of special charges). Also, earnings improvement in 2002 is being helped by a change in accounting, whereby noncash goodwill expense is no longer being amortized.
If Lear's earnings for the first nine months of both 2002 and 2001 were adjusted to exclude unusual items and goodwill expense, the comparison becomes $2.89 vs. $2.23, or a 30% rise. Driven by a more favorable sales mix, restructuring benefits, lower interest expense, and a lower tax rate, we project that full-year EPS will rise a further 12%, to $5.15, in 2003.
Valuing Lear on the basis of price-to-sales and price-to-cash-flow ratios puts the stock in the lower portion of its peer group of automotive parts suppliers, and the p-e ratio is in the middle of the group. Given its expanding share of vehicle interiors and a p-e ratio at the low end of its historical range, we feel that Lear's shares are undervalued at seven times our 2003 earnings per share estimate.
As is normal for shares of cyclical companies when business is going relatively well, Lear's stock trades at a discount to the broader market (companies in the S&P 500-stock index currently trade at about 16 times estimated 2003 earnings). Our discounted-cash-flow analysis supports our view that the stock is undervalued, and it provides an intrinsic value of more than $48.
Given Lear's expanding backlog of new business and its progress at reducing the degree of leverage on its balance sheet, a p-e of 10.5 times estimated 2003 earnings per share is reasonable. This implied target value of $54 also represents a multiple of about 10.5 times estimated 2003 free cash flow per share. Even using the low end of our valuations, our 6- to 12-month target price for the stock is $48, or about 30% above its current level. We expect it to outperform the broader market over the next 6 to 12 months.
Analyst Levy follows automotive stocks for Standard & Poor's