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Morningstar | Lear's First-Quarter Results Disappoint but 2019 Guidance Remains Unchanged; Maintaining $122 FVE

Narrow-moat rated Lear, supplier of seating, electrical, and electronic systems to the global auto industry, reported first-quarter diluted earnings per share before special items (EPS) of $4.00, disappointing the market with a $0.11 miss compared with the sell-side consensus. EPS was $1.10 lower than the prior year. Revenue of $5.2 billion, representing a 10.0% drop compared with 2018. Adjusted EBIT plunged 22.9% to $378 million for a year-over-year margin contraction of 120 basis points to 7.3%.

Given the uncertainties of global trade conflict and Brexit as well as increased spending to support launch activity this year, management's 2019 guidance contains wider-than-usual ranges. Lear's unchanged guidance includes revenue between $20.9 billion-$21.7 billion, core operating earnings in a range of $1,600 million-$1,700 million, and free cash flow in a range of $850 million to $950 million compared with $1.1 billion in 2018. We estimate consolidated 2019 revenue at $21.2 billion. At a 7.9% adjusted EBIT margin, in line with management expectations, we estimate $1,670 million adjusted EBIT, representing a 40-basis-point margin contraction and a 4.4% decline versus 2018, respectively.

Unfortunately, the investment community is very well aware of Lear's impressive growth potential and margin expansion. Consequently, the market has bid the shares up to a 16% premium over our $122 fair value estimate. At a 2-star rating, we view the stock as being overvalued relative to our expectations for economic profits and future cash flows.

Our investment thesis on Lear remains intact. Lear's above-industry growth rates are supported by a growing global premium-vehicle segment and increasing penetration of automotive electrical and electronic content. A culture of continuous innovation at Lear enables regular and consistent product and process development, commercializing technology that generates solid margins and returns on invested capital. Automakers' growing use of common architectures benefits Lear because of its global footprint.

However, the market has become enamored with several stocks in the auto supplier group that possess technologies that will participate in the growth in automotive electronics and electrical systems, including Lear. These stocks have been trading as though the economic cycle will never hit a downturn. For our DCF model fair value to reach the sell-side’s $175 consensus price target, one would have to believe that Lear could generate a normalized, sustainable, midcycle EBITDA margin of 10.9%. Compare this to the 2018 EBITDA margin of 10.6% (10-year peak in 2017 at 10.7%), our midcycle assumption of 8.6%, plus the 10-year historical median of 7.5%, and then one can begin to see how the sell-side consensus price target has valued Lear stock as though economic cycles no longer exist.