[ADNT – Adient] Self-Help Margin Expansion Opportunity, 4-Year Double

In a quick blurb from last month, I flippantly wrote: “I don’t think 10x/1x EPS/BV for a moatless auto lender at or near the peak of the auto cycle is all that cheap.”  Well, how about a sorta-moaty auto supplier trading at 7x?  My sense is that auto stocks – their single digit earnings multiples superficially cheap in a market bereft of sane valuations – are in vogue among investors these days (I’m looking at you, FCAU!), and ADNT, both cheap AND a spin-off, is likely no exception.  I don’t love hopping on this increasingly crowded bandwagon, but whatever, it’s an interesting idea.

As a spin-off, ADNT gets the obligatory glance from every event-driven hedgy attracted to putative forced selling and post-spin incentives.  In this case, post-spin shareholders of JCI – a diversified industrial with $30bn of revenue across commercial and residential HVAC, electronic security systems (via recent Tyco acquisition), and battery technology and a $30bn market cap – were also left holding the stock of a ~$5bn-ish market cap automotive seating supplier with $16.6bn in revenue and a levered balance sheet (JCI loaded ADNT with $3.5bn in debt while booting it).  The fundamental reason to own JCI is to participate in the “total building solutions” (or something) enabled by the Tyco acquisition, with megatrends of urbanization, energy storage, and sustainability and various Tyco synergies fueling top-line growth and margin accretion.  Holding onto a automotive seating supplier was certainly incongruent to that theme.

Adient is the #1 automotive seating company in the world, participating up and down the seat stack from subcomponents (foam, trim, fabric, metal structures) to complete seating systems.  With a global market share of 34%, the company is 50% larger than the next largest competitor in North America, and 2x and 4x-5x the #2 player in Europe and China, respectively.   Customer concentration is an industry-wide reality for auto suppliers who derive a substantial portion of their revenue in the US given the consolidated state of the industry, and while ADNT is no exception, relative to its peers, the company has less exposure to any single customer, greater geographic diversity, and a out-sized exposure to the secularly growing Asia-Pacific market.

(While neither Magna nor Lear disclose the percentage of sales coming from their largest customer, we can deduce that given the highly consolidated auto OEM market in North America relative to Europe and Asia and both suppliers’ heavy exposure to North America, customer concentration is greater than it is for either Adient or Faurecia).

Income from unconsolidated JVs represent a substantial part of the company’s value.  In China, where the company has partnerships with all the major auto OEMs and greater penetration relative to other seating competitors, ADNT operates through 17 soundly-capitalized JVs who collectively hold $1.1bn in net cash and have generated a steady, growing stream of equity earnings and dividend payouts (over 60% of equity income recognized by ADNT is converted to cash dividends) over the last 5 years that today constitute around 30% of the company’s total EBIT (as you likely know, this equity income is already taxed at the JV-level before it makes its way to ADNT’s income statement and is included in the total pre-tax and after-tax profits reported by the company).

One of these unconsolidated Chinese JVs, a 30% owned entity called YFAI (created in July 2015 and pronounced “wi-fi”), represents ADNT’s interiors segment (instrument panels, floor consoles, door panels).  For background, JCI’s auto the interiors business had a solid base of customers outside of China, especially among premium German OEMs.  Under ADNT’s ownership, the prime cuts of this business were combined with Yanfeng’s automotive interiors business (mostly APAC), and the cost base – engineering, in-house tooling, and equipment manufacturing – was moved to China to create YFAI, a JV entity with global scale and a competitively advantaged cost structure.  On a standalone basis, YFAI does about $8bn in revenue at 6% EBITDA margins (this margin includes cockpit assembly, without which margins would be 2pts higher), generating returns on invested capital of over 20%.  Given the current mix of cockpit assembly in the backlog, management sees 100bps-120bps of margin expansion through 2020 that drives ROIC into the 30% range.   Like the other 16 JVs, this one is well capitalized with around $300mn in net cash.