Lear Corp (LEA) 2017 Q3 法說會逐字稿

Good morning. My name is Alex, and I will be your conference operator today. At this time, I'd like to welcome everyone to the third quarter 2017 earnings call. (Operator Instructions)

Joel Elsesser, Vice President of Investor Relations, you may begin your conference.

Thanks, Alex. Good morning, and thank you for joining us for our third quarter 2017 earnings call. Our press release was filed this morning with the Securities and Exchange Commission, and the presentation for our call is posted on our website, lear.com, through the Investor Relations link.

Today's presenters are Matt Simoncini, President and CEO; Jeff Vanneste, Chief Financial Officer; Ray Scott, President of our Seating Division; and Frank Orsini, President of E-Systems. Also participating on the call are several other members of Lear's leadership team.

Before we begin, I'd like to remind you that during the call, we will be making forward-looking statements that are subject to risks and uncertainties. Some of the factors that could impact our future results are described in the slide titled Investor Information at the beginning of the presentation and also in our SEC filings.

We will also be referring to certain non-GAAP financial measures. Additional information regarding these measures can be found in the slides labeled Non-GAAP Financial Information at the end of the presentation.

Slide 3 shows the agenda for today's review. Following the formal presentation, we will be pleased to take your questions.

Now please turn to Slide 5, and I'll turn it over to Jeff.

Thanks, Joel. Lear's positive momentum continued during the quarter with record third quarter results across all key financial measures. Sales, core operating earnings and free cash flow all experienced double-digit growth compared with 2016. Adjusted EPS improved by 24%, reflecting our strong operating performance, the benefit of our share repurchase program and a lower effective tax rate. As a result of our strong year-to-date performance and our positive outlook for the fourth quarter, we are again increasing our full year financial outlook.

Slide 6 shows the factors driving our strong revenue growth in the third quarter. Sales grew 10% in the quarter, well above industry growth of 2%, reflecting our record sales backlog, the acquisition of Grupo Antolin's seating business and favorable foreign exchange, partially offset by lower production on certain Lear platforms in North America.

Slide 7 shows our core operating earnings for the quarter compared with a year ago. Core operating earnings increased 12% to $408 million with a margin of 8.2%, up 20- basis points from 2016. The improvement was driven primarily by the addition of new business.

From a segment perspective, seating margins increased 20- basis points from 7.9% to 8.1%, reflecting favorable operating performance and the addition of new business. Margins in E-Systems remain strong at 14.4% but were down slightly from a year ago, reflecting the timing of commercial resolutions as well as development costs associated with our growing sales backlog.

Slide 8 provides our updated financial outlook for 2017. Our outlook is based on the latest IHS production forecast and a euro assumption of $1.17 for the fourth quarter. Based on these assumptions, we are increasing our revenue guidance by $400 million to $20.4 billion. The revised forecast reflects higher European production as well as the strengthening of most major currencies compared to the U.S. dollar.

We are increasing our outlook for core operating earnings by $50 million to $1.7 billion, reflecting the increase in sales and continued strong operating performance.

We are increasing our guidance for capital expenditures by $25 million to $585 million, reflecting increased investment to support recent new business awards and launches at Grupo Antolin as well as latest foreign exchange assumptions.

We're also raising our guidance for free cash flow by $50 million to $1.15 billion.

Our effective tax rate is now expected to be approximately 25% for the full year.

Now I'll turn it over to Frank Orsini, President of our E-Systems business, who will provide an overview of some of the growth drivers in the E-Systems segment.

Thanks, Jeff. Please turn to Slide 10. We often describe our E-Systems business as providing the neural network of a vehicle. Our E-Systems portfolio consists of our wire harnesses, terminals and connectors and electronic modules that support traditional and high-power electrical architectures as well as connectivity applications. We expect electrical content per vehicle to increase by approximately 3% to 5% per year on our traditional products driven by growing consumer demand for additional features in the vehicle that require power and signal management. Additionally, we are well positioned for accelerated growth with emerging industry trends that I will cover over the next few slides.

As you can see on Slide 11, industry penetration rates over the next 10 years are expected to reach 75% or more for connected vehicles and approximately 40% for electrified vehicles. These 2 trends, followed by the trend of autonomy, represents a significant content growth opportunity for Lear. This year alone, new technology associated with these industry megatrends has accounted for approximately $200 million in incremental new business awards spread across 35 vehicle nameplates with 6 customers serving 3 continents.

Slide 12 provides some additional details on the opportunity with high-powered vehicles. As this slide shows, we have a complete high-power product portfolio with scalable power technologies in each of our core product segments. This represents a significant incremental content per vehicle opportunity as high-power electronics are additive to traditional electrical power distribution systems. Our range of capabilities position Lear to capitalize on vehicle electrification trends from 12-volt Start-Stop to 48-volt and, ultimately, to full electric vehicles, with growing content opportunities as the level of electrification increases. We presently have been awarded 48-volt contracts on 29 nameplates across 6 customers with a number of these programs launching next year. Currently, high-powered business awards represent approximately $150 million in new business over the next 3 years, and quoting for new programs is increasing rapidly.

Slide 13 shows the growth opportunity for connectivity. In 2015, we enhanced our E-Systems product portfolio by adding vehicle-to-vehicle and vehicle-to-infrastructure connectivity capabilities with the acquisitions of Arada Systems and Autonet Mobile. We now have a complete connectivity offering, including advanced capabilities in cellular, V2X, DSRC, Wi-Fi and Bluetooth RF communication protocols. These product offerings position Lear to grow with the rapidly increasing connectivity trend.

Our connectivity offerings are highly synergistic with our traditional electrical distribution capabilities and industry-leading electronic modules. Lear's connected gateway modules with over-the-air software upgrade capabilities will launch in 2018 on 9 nameplates in Europe, representing Lear's first major production connectivity platform.

Lear has the leadership position in V2X infrastructure with more than 26 global deployments across 10 states and 5 countries. We continue to see increased quoting activity for connectivity solutions with our global customers.

Now I'll turn it over to Ray Scott, President of our seating business, for an update on growth drivers in seating.

Thanks, Frank. Over the next few slides, I will provide some insight into Lear's strategy and actions to continue to profitably grow our seating business. We believe that our value proposition to our customers is unmatched in the seating segment. We possess the most comprehensive seating component capabilities in the industry. We're also committed to delivering the highest quality products at the lowest possible costs.

Our world-class, low-cost manufacturing engineering footprint provides a competitive advantage and, together with our unique product capabilities, is driving market share growth. We're dedicated to both near- and long-term innovation to meet our current, future customer and consumer needs.

With that as background, please turn to Slide 15. The megatrends that Frank discussed of autonomous connectivity electrification have an impact on nearly every component of the vehicle, and seating is no exception. This slide shows key seating market trends that Lear is addressing as part of our product strategy. Over the last 5 years, Lear has taken significant steps to expand our seating innovation. We have dedicated resources to innovation and developed methodologies, processes and tools to identify specific opportunities and accelerate development timing. In short, we are investing more time, resources and energy than ever before on innovation.

Some key examples are listed on this slide. I'd like to highlight 3 major initiatives: Crafted by Lear, Drop & Go; and INTU, which is our Intelligent Seat system. As you know, we launched Crafted by Lear to take our unmatched seat capabilities to our customers' design teams to help bring their vision for their brands to life in the showrooms. Crafted by Lear aims to develop beautiful, compelling, cutting-edge seat designs using the most advanced surface materials and -- with an executed premium level of craftsmanship.

Drop & Go is a reconfigurable seating solution that provides ultimate flexibility, specifically for CUVs, SUVs and passenger vans. The next-generation of Drop & Go will advance this product into a complete system that includes electrification, drawing on our capabilities and expertise in E-Systems. Enhanced reconfigurability, cargo management and other functionalities will also be benefits.

Finally, you may be familiar with some aspects of INTU, which we believe will be the world's most innovative and intelligent seating system. Based on advancements in electronics, electric systems and sensors embedded in the seat and the rest of vehicle, we have created seating modules and features that provide personalized comfort in user experiences like never before. The seat will become the center of occupant information and connectivity. In all of these areas, we are already engaged with customers on meaningful co-developments for future vehicle applications.

Slide 16 shows how we have dramatically increased our capabilities, making Lear the most vertically integrated seat supplier in the industry. The acquisitions of Guilford fabrics, Eagle Ottawa leather, combined with our trim cover expertise, give Lear an unmatched position in service materials. Other complimentary investments and acquisitions have also broadened our seating capabilities, including our investment in Tempronics for seat heating and cooling and our recent acquisition of the seating business of Grupo Antolin. Not only does this full component capability provide opportunities for vertical integration, it also supports the innovation activities highlighted on this page. Many of these innovations are only made possible by the significant capabilities of our E-Systems business. The next generation of intelligent seating systems requires significant and sophisticated electronics and software, which E-Systems provides. No other seating supplier has all these capabilities under one roof. Lear's seating is leveraging its E-Systems capability, particularly as we innovate for the next generation of seating systems.

Slide 17 focuses on our future growth opportunities in seating. Since 2012, Lear has delivered seating sales growth 5 percentage points above the industry and has become the fastest growing and most profitable automotive seating company in the world. We have achieved market share gains by leveraging both our superior product capabilities and our industry-leading cost structure. As we look at the next 5 years, we project that our seating business will continue to have very similar growth pace. We also anticipate that the market trends and innovations that I discussed earlier will drive average seating content per vehicle higher. This growth will be driven in part by the emerging markets, which we believe will add features and content, consistent with the mature markets. Lear's total product capabilities position us well to participate in and benefit from this growth.

Longer term, we see that the seats will continue to evolve, adding additional features and becoming safer and more connected. These trends will require a significant increase in electrical and electronic contents in seating, driving a substantial increase in CPV.

In summary, Lear's segment-leading component capabilities, low-cost infrastructure and product innovation will drive continued profitable growth. We have the most talented team delivering the best seats at the lowest possible cost every single day.

So thank you, and I'd like to turn it over to Matt.

Great. Nice job, guys. Slide 19 highlights the huge strengths of Lear's product portfolio. Both of Lear's business segments are high-performing, with sales growing faster than the industry production and segment-leading margins. Both business segments are complementary. We believe that having both of these together under the Lear umbrella will provide the best opportunity for continued profitable growth.

In summary, Lear had another great quarter, again, reporting record financial results. The investments that we have made in this business have positioned us to continue to build on this success. We have again increased our full year financial outlook for 2017 and expect our profitable growth to continue due to our unique product capabilities and record backlog. We have a track record of performance and a balanced strategy of capital allocation that are delivering superior returns to our shareholders. Our strong free cash flow and financial flexibility allows us to continue to invest in the business while consistently returning cash to shareholders.

Now we'd be happy to take your questions.

(Operator Instructions) And your first question comes from the line of Itay Michaeli from Citi.

Why don't we just start off real quick just on the fourth quarter? I think you kind of implied margins a little bit lower year-over-year, so hoping you can walk us through some of the puts and takes around the walk into Q4.

Yes, it really comes down to mix, Itay. We're getting a little bit of headwind on the changeover that we're starting to see on the large SUVs, the GM, large SUV and pickup truck platforms. We're also seeing some weakness in certain pass cars going into the fourth quarter. Other than that, it's a pretty clean quarter. If the macros hold, we expect to outperform.

That's very helpful. And then as we think about kind of preliminary into 2018, Matt, just how are you feeling about the overall outlook of -- I think, previously, maybe actually on the Q3 call last year, expectations of Lear kind of outgrowing the market by 5 points each year. How are you feeling there? Just maybe are there big picture puts and takes as we think about 2018?

I feel great about 2018. The industry is strong. It's continuing to grow on a global basis. Both our businesses are doing well. We're continuing to win more than our share of business, so share continues to grow. I think the operating teams are doing an outstanding job of running hundreds of facilities around the world. The macros, I think, are setup pretty well heading into next year. When you look at the major markets, whether it's Asia, China specifically, Europe and North America, even if we see a plateau or a flat line, it's flatlining at a pretty high level. Again, we would expect the cars that we're on to do well. The rotations through the CUV is actually benefiting Lear. So yes, I'm a bull.

Got it. That's very helpful, Matt. And then just lastly, maybe on Slide 10, I appreciate the color on E-Systems. Could just talk a little bit more about the win rates you've had in high power and connectivity? Kind of how -- what's the competitive landscape look like? And how do you feel your win rates are tracking there relative to other components within the E-Systems?

We're doing well in that product segment. One of the things we want to do with the slide, we show some of our capabilities and highlight some of the things that are happening in the marketplace that can benefit Lear. Frank, can you show us a little more color to Itay on this?

Yes, absolutely. So Itay, in this particular area, high power, in general, all 3 of our product segments benefit from the ability to scale up in power. So 12-volt architectures, 48-volt architectures and all the way on to electrified full 400- to 800-volt architectures are right in our wheelhouse. So from a competitive standpoint, we're competing very well. We're winning a lot of business, as we mentioned. In terms of the growth prospects, we just see it continuing. The margins are great on the business we're winning and the business we're winning exceeds our expectations on capital investment and everything that we're working on. So right now, we really like the position we're in. The technology is doing very well for us, and we see future growth coming as well.

Your next question comes from the line of John Murphy from Bank of America.

Just a first question, kind of wrapped in sort of backlog growth, CapEx and sort of developments there. I mean, obviously, the ramp-up in CapEx is -- it's not major -- but I mean, it indicates you're winning more business than you maybe have --had expected before. So just wondering if you can give us an update on the backlog and what kind of growth you're seeing there. And also, very simplistically, if we saw -- Matt, this sounds like a very simple question, but if we saw volumes flat next year, you would expect your revenue to grow at about 5% based on what you know about your backlog right now?

The last answer is yes. As far as CapEx, what you're seeing in the near-term CapEx is the business wins, some of the business that we're winning is near term, if you will, John. So it's a quicker kind of a launch case than the normal 3-year advance, and I'd expect our backlog to be bigger next year than it was this year. Does that make sense? Like the 3-year backlog, which we'll announce with full details and color in the January Deutsche Conference in Detroit. But the capital intensity of business, high 2%. I think we've been running at about 2.8% of sales. I don't think that trend is going to change meaningfully.

And Matt, does that mean that you will have 1 new business or some of the programs that you're on are sort of expanding in size and scope because it's untraditional the way...

It's both.

It's both. Okay. That's helpful.

Yes, it's takeaway -- it's takeaway business in the near term, John. There was also some capital associated with the recent raise, some capital associated with Grupo Antolin, that acquisition. As we got into those plants, we saw some things that we think we needed to do as well as consolidating some of the subtiers into Lear to improve the performance, and that's driven a portion of that capital raise that you just -- we just announced in the guidance.

Okay. That's helpful. And Frank, just on Page 12, I mean, it sounds like this is a huge opportunity as sort of you get to more high-powered trains and ultimately, to EVs. You mentioned there's about $150 million in the backlog over the next 3 years. The next 3 years should have some increasing penetration on these kind of high-power trains out there, but it's really probably beyond that window as we get out to sort of 2020 to 2025 and maybe even beyond where there's some real ramp-up. Where do you see the opportunities beyond the next 3 years for this business? And could it be significantly more additive to the backlog than what you're talking about over the next 3 years, which is good. But it does sound like there's going to be a lot more opportunity well beyond that because we're thinking about powertrains, you might have some visibility into that already.

Yes, absolutely. You couldn't have said it better. The opportunities are tremendous. The 3-year backlog's not even completely done, there's still some sourcing that we're working on in this area, as well as some programs that are still out for bid. So we think that this is, a, a very near-term opportunity for us because when you think of the ACE technologies and what's coming our way, electrification is going to be tremendous in terms of CPV. So we see opportunity there beyond the 3-year backlog. The CPV opportunity we put on, on this slide for you, give you some indication, as I mentioned, we have opportunities in each one of those areas. So it continues to get better for us in this area. We really believe this is a trend that's going to benefit Lear long-term as well.

Your next question comes from the line of Brett Hoselton with KeyBanc.

Can you talk a little bit about M&A? How the deal flow valuations and areas of possible interest for your company?

Yes. At any given time, we're looking at numerous opportunities, Brett, to grow the business, something that would increase our capabilities. We're fairly happy with our capabilities in seating. It's hard to think of something we don't have that we would need, considering our component capability is already the best in segment. So our primary focus has been in our E-Systems division, things that can help us deliver higher power, software, cyber are some of the areas that we've been looking at; positioning of the vehicle, that's an area that we continue to look. At a lot of times, the investment from [made-like, from] auto -- Arada and Autonet last year, is to provide intellectual property. They're smaller, but they provide a big value and intellectual property and technicians and software engineers. More of that area, so I think similar to those types of acquisitions. Valuations in this space, at times, have been silly. Everything is more -- has a higher multiple than Lear, which I find to be ridiculous, Lear's multiple to be ridiculously low. That being said, we understand that the valuation on a lot of these acquisitions are going to be quite high, and in order to play in that space to get to technology needed, at times, you're just going to have to swallow hard and do it. So yes, I think that's it.

Very good. And then, can you -- given the recent announcements from Delphi and Autoliv that they're going to split their companies, I know you addressed and have consistently said that you think there's value in the combination of the electronics with the seating business. I was hoping you could maybe elaborate on that for us a little bit more, simply because, again, given the Delphi split and given the Autoliv split, we're getting significantly more questions on how the 2 benefit one another.

Right. The Autoliv and Delphi splits are different situations than Lear, whether you're taking a business that you don't want to fund continued losses or basically breakeven; in the case of Autoliv or in Delphi where you have a high growth in a flatline business. In our business, the DNA of our business is, quite frankly, quite a bit different in both segments where we are both outgrowing the market, both generating cash and both leveraging the technology on a product that benefits both product segments. From us, first and foremost, we think the capabilities are growing our E-Systems business. It's best when it's underneath Lear's umbrella. And by that, we mean not only our infrastructure, our shared infrastructure and the fact that these products are starting to have overlap, and I'm going to come back to this point, but also because of our capital structure, and our investment-grade capital structure allows us to invest. And finally, the last piece of it is, I think customers are more willing to source on electrical electronics firm that actually has $20 billion of revenue and the financial wherewithal and the management team that we have as opposed to a stand-alone E-Systems business. Now as far as the product convergence, what we wanted to show on the slide is that most mechanical subsystems of a vehicle, over time, have become more intelligent. If you take the steering systems, for instance, that's not a largely electronic-based, we see the same thing happening at seating: it's becoming higher power; there's more features; more electronics; and it's becoming intelligent and will become even more so as we see a penetration of more autonomous vehicles. So it's the first line of connectivity. And when you look at the capabilities of Lear, we're in the sweet spot because a lot of the developments that we've done in our Intelligent Seat has come from the software engineering capabilities that we have in E-Systems. So we see that. Now all that being said, if we received a compelling offer that would create long-term sustained value creation for our shareholders, we'd consider it. We understand our fiduciary responsibility for the shareholders to do -- to create value as a leadership team of this corporation. But we believe the best way to do that right now is to keep these 2 businesses together.

Your next question comes from the line of David Tamberrino with Goldman Sachs.

Matt, one of the things that you guys have acquired into is the V2X platform, and I think you've noted that you have the most installed applications globally. What does the medium-term opportunity look like for increased deployments there? And on the back of that, how is that business currently being monetized? You just selling the hardware? Or is it ongoing service revenues? And then from there, what opportunities do you really have in a country like China that's looking to roll out smart infrastructure? So not necessarily just tied to vehicle production but actual infrastructure installations, and how do you think about that growth?

David, one of the side benefits and I'm going to turn it over to Frank in a second, but one of the side benefits, quite frankly, is what we learn by doing these deployments. It helps us develop our gateways and our modules from learning how to deploy these things and how they -- the data is being collected, if you will, through these modules. But Frank, can you talk about the specific revenue streams and opportunities?

Yes. Absolutely. So for the V2X topic, specifically vehicle infrastructure and vehicle-to-vehicle, what we're seeing is the global deployments that we have are really translating into knowledge and information for direct-to-vehicle applications as well. So as we mentioned on the call, we're a leader with 26 global deployments. To answer your question, there is opportunity to expand that position. We're actively quoting right now with certain states in the U.S., and we're actually quoting work in other countries as well. We're already in India in terms of Asia, but China is another country that we are speaking to actively right now for this technology. And that can be said for every space in the world right now. We're working with South America. We're working with Europe as well. So there's a lot of opportunity we believe to continue to expand that. But where it really -- really becomes important, as Matt said, is taking that knowledge from the infrastructure and then deploying it into vehicle applications. Your question regarding, yes, it's hardware and software. Today, services is something that we are looking to provide as an opportunity to monetize these capabilities as well. So the option of putting this technology directly in the vehicle is very important to us in the future, and it's something that we're quoting actively with certain customers around the world.

And from a penetration standpoint within the vehicles, I mean, where are we at today? And where do you think that starts to ramp up for the next 3 to 5 years?

Well, there's some proposed rule-making that's in play right now with NHTSA that hasn't fully been adopted yet, and that will relate to DSRC or some cellular method of providing data between the vehicles. Lear is prepared for either technology. So in terms of penetration, it's right in the connectivity stats that we've been looking at. We believe that some of this technology will allow for the vehicles to communicate between each other. And we're seeing our fair share of quoting right now. We do believe that in the next few years, you'll start to see these applications on vehicles.

Understood. And then just a second question for me, we noticed raw materials from a copper standpoint continue to come up. Can you remind us what the indexation clauses you have and how much of a lag there would be for the raw materials?

So on the copper side, you're right, we have seen an increase, certainly, recently on the price of copper. On copper, we're about 90% insulated via the index agreements, which tend to run very quickly. So it could be a matter of a month to a quarter in between the timing of the fluctuation and the impact on our pricing with the customer. On steel, about 90% of our buy on steel is either covered through a purchase agreement with the customer or comes into Lear in a fabricated form from a supplier of adjusters or frames or what have you. And on hide market or leather, about 60% is covered directly by an index agreement, which has a longer tail to it, and the other 40% is generally handled through commercial discussions on productivity and other type of commercial issues.

Your next question comes from the line of Chris McNally from Evercore ISI.

I was going to focus on, I think, the same slides that everyone seems to be focused on today, which is the -- this great opportunity within the electrical, really, on the higher voltage systems, which is increasing focus of The Street right now, and you gave some big numbers out to 2027. Can you sort of put the couple of drivers together and help us understand for the industry and not just for Lear, what type of CAGR do we think we could kind of expect? Because this has been a 3- or 4-point outgrow over the last couple of years, but we're clearly waiting for that inflection for when it could be sort of high single digits and some of the back of the envelope math that this could be sort of 10% as you start to get out to the higher forms of electrification. So anything that you can add to sort of put the trends together so we can see the long-term growth of what electrification would be very helpful.

Yes, it's hard, Chris, to give you a specific point. I know IHS has it in the high single digits penetrating in over the next 5 years. The wild card in all of this is legislation, starting with China, specifically, but every major city seems to now have an initiative or a legislation or regulations regarding internal combustion engines in their greater metropolitan areas, right? So we're not really sure what it's going to come in. We know the rates that we pegged have always been exceeded. So if we would have been here 3 years ago, I would have told you probably 3%. Then it starts getting to 5%, and now we're running at 6%, and IHS has it approaching 10%. And I think that might be the most realistic guidelines we can point to. But the wild card, again, appears to be legislation as people try to or regions try to manage the CO2 emission issue.

And then, maybe, Matt, if we just use that sort of 10% with the multipliers that you gave, some of the multipliers, obviously, on [inaudible] with the content going to 2,000 per vehicle, what type of CAGR could we expect if we blend that in for your electrical division? Understanding that either you will not have as much growth in traditional wiring, plus you'll have some of the growth in connectivity. Can we see electrical as an industry? Obviously, let's just say for now that your share remains the same, could growth here, as we get into the 2020s, move towards the production plus high single digits, plus 10%? I'm just trying to get an idea for what the outlook of that division is in terms of the acceleration.

Yes, 10% might be optimistic. I probably wouldn't quite go that. Could it be? Yes. If you do the math, it could be that. I would be more comfortable with a number more like 7%. And I think (inaudible) our share of that, but I would probably use that from an investment thesis standpoint.

Your next question comes from the line of Brian Johnson of Barclays.

A couple of questions around E-Systems, sort of a housekeeping near-term one and then a longer-term one. First, could you maybe walk through the puts and takes on somewhat of the uncharacteristic slight decline in margin for the quarter? Was it product mix? Was it just the production and currency? Was it the copper timing?

Yes. I think the main driver here was there was a mix, an erosion with the mix with the pass cars. But really, last year, we had a benefit of recovery. 14.8% was the margin in 2016 in the third quarter, which was unusual. This normal seasonality, Brian, would have locked that margin down to like the lowest margin for the year of the 4 quarters. The third quarter with the shutdowns in Europe and, in certain cases, in North America, is usually the weakest quarter. Last year was one of our stronger quarters because we had picked up, I want to say, Jeff, about 4 -- 40 basis points.

Yes.

40- basis points in margin last year on commercial recovery. This year, we've had the incremental costs associated with development costs with a growing backlog. So we've had to step-up our engineering and development costs in that segment. But that was almost secondary to the kind of one-timers in last year's number, which inflated last year's number. I would tell you, 14.4%, that's a pretty good number for the third quarter when you take into consideration normal seasonality, Brian.

Right, and the production mix.

Right.

On the E-Systems content opportunity for high-power, could you give us a sense of -- a couple -- few things around that, what you see is the strategic environment there, competitive environment, in terms of is it the usual [ease] other electrical architecture players. Does that change with one of your major competitors sending power electronics one way and wiring and harnesses another? And then you have a lot of players out there coming in from the powertrain mechanical side and motor side who bundle power electronics into e-Drive modules. So just, what do you think the competitive environment is, where do you have strengths, and what it's going to mean for margin in that business?

Well, I can tell you, Brian -- this is Frank. We are seeing very similar competition to what we've seen over the last couple of years, similar players, because where we're competing, we're competing for the electrical architecture, in many cases, for these product lines. So the 48-volt systems that we're providing can range from high-powered terminal connectors all the way to a full system where we're doing the wiring, the terminals, electronic modules as well. So in many cases, we're seeing similar competition. The competition is similar in terms of the scope that we've experienced in the past in terms of competitive pressures and things of that nature. So nothing new there. We don't see any outside entrants today that we're quoting, and we're quoting very actively all over the world with every customer. So -- and we're successful with the business growth and the wins that we're experiencing, and we expect that to continue as well.

Okay. And is the relationship with the Tier 2s in terms of where the value is at, is there anything different than in your normal thing? I'm thinking of the infinians of the world and debates around silicon carbide and so forth. Are you different set of upstream partners or players you're used to dealing with?

Players we're used to dealing with. In the case of high-voltage or high-power, it actually spins to our advantage because we can use more of our Lear terminals and connectors on our products. So it's actually an internal opportunity to apply more of Lear's technology. But we lead the industry in power-to-size ratio on our terminals and connectors, and we're selling our terminals to even our competitors and other customers for that reason. So for us, we see it as an opportunity but very similar structure in terms of Tier 2s that we experience today.

Your next question comes from the line of Emmanuel Rosner of Guggenheim.

Just -- first, just a couple of follow-up questions on the backlog. It looks like it was particularly strong in this quarter. I think if I just multiply it by 4, it would be like close to $1.5 billion. So I was curious if you could update us on where the backlog for this year is shaping up to be. And then, just making -- wanted to make sure I understood your earlier comments correctly when you said that you expect the 3-year number to -- when you -- disclose it - in January to be higher. So you had $2.8 billion over 2017 to 2019. What you're saying is that we'll have a higher number than that over '18 to '20?

We'll have -- to start with the '17 number, Emmanuel, your math is pretty correct. We're running at about $1.4 billion, $1.5 billion for the quarter, and yes, we'd expect it to approach the $2.8 billion. The comment I was making is we expect that the 3-year backlog will be higher in the years '18 and '19 than what we've previously discussed. But that number is pretty consistent overall.

Okay. Understood. Okay. Now I guess, second question would be on the -- your slide on the content per vehicle opportunity in seating. You highlighted some very favorable market trends. But then, at the same time, when I look at your Slide 17 and then some average CPV growth projection, going from $710 in 2017 to $750, in 2022, it's just a 5% increase over 5 years, which would be like 1 point of growth a year. So to get your 5% growth a year in seating, do you basically need market share gain?

Yes, we need market share gain. We also sell components within the market share. In many cases, we're selling leather to folks that we don't make -- that we're not -- our competitors that are making the seats. So I think it's both, and I also think it's the content opportunities. Ray, any more color you can provide?

Yes, I think you hit on it, Matt. I mean, it's the market share gain. We think we're going to have some opportunities in Asia with the split of business there and the continued market gains we've seen. I mean, I think if you look back historically, we're at 19%. We're at 22% of the market today, and we see a very similar trend going forward.

Understood. And I guess, just a quick final one. I noticed you no longer have your customary slide showing how undervalued Lear stock is. Does it mean that you are comfortable with the market value?

Well, we thought about putting it in, but we thought we're getting long-winded with that. But I try to make that point clear, I think, when we talk about the valuations. But yes, if you want me to give you my feel on that?

Quite frankly, I think we are incredibly undervalued. At what is the 6th turn we're being valued as if we're just Adient, which, obviously, we're more profitable and growing faster. And we also have an electrical/electronics business that is one of the sweet spots of some of the major trends. So yes, I find it ridiculously low and plus, by the way, we have a huge track record of performance and the most experienced and stable management team in the industry. Is that okay? I would have put a slide on it but...

I think he's writing.

Yes, just wanted the [truth], you're saying that you're happy with the current valuation, but...

I'm happy with the current valuation here. I think that at a minimum -- and you've heard me say this, and we had it on a slide before, we are at a minimum one turn too low. And when you look at the EBITDA of over $2 billion, you can do the math, it's 68 million shares outstanding. It's a significant value upside.

Your next question comes from the line of Colin Langan from UBS.

Kind of circle back on the question earlier on the potential split of the businesses, you've got a lot of questions from investors on that. Have you -- I think in the past, you've talked about stranded costs, if you were to split the 2. Any color around how large that would be? And I think in the last quarter, the tax leakage was $400 million. Is that still the right number, might have changed in the quarter, but just want to check there as well?

Yes, it is. And with respect to the redundant costs, we've estimated that historically at roughly $150 million. So I think your facts are pretty accurate.

And then the tax is...

So the tax is about $400 to $500 of tax leakage.

Okay. And in the quarter, the K2 effect was pretty weak, but your margins held in pretty well. How should we think about that as we go into '18? Because I remember the last change-over, it seems to have had an impact on your margin. Do you think you can manage it now since it's a smaller part of your business? How should we think about that risk next year?

Well, I think the last point that you made is probably one of the most important, which is it's become a much more balanced product portfolio. I think the seating teams have done an outstanding job managing the headwinds. A little bit early to talk about 2018, but we think we can manage it. Ray, can you talk a little bit about what your team is doing to offset those headwinds?

Yes. We're in a different place than we were prior to the previous launch. The disciplines that we put in place, the capital, the investment we've made in the business, the team that's on the ground, going through all of our launches, we're in a different place. So we're much more confident as we head into '18 on our launches.

And just lastly on the tax guidance. I mean, this year is trending at 25%, I think it was 28% the prior 2 years. I mean, is there anything unusual this year? Should we think of 25% as the new rate? Or should it go back up?

I think what we've seen in the last 2 years is in-and-around at 26% to 27%. And the 25% revised guidance now for the full year really reflects some of the tax planning strategies, coupled with where we see the mix of earnings by country versus maybe what we saw earlier in the year. But on an ongoing basis, I think you'll continue to see it in that, absent tax reform, which is a huge wildcard, obviously, but continue to see it in that 25% effective tax rate range.

Your next question comes from the line of Adam Jonas of Morgan Stanley.

So Matt, what do you think is more overhyped? EVs or AVs?

I think they're both hyped appropriately.

Any one more hyped -- appropriately hyped than the other one.

I think there's levels of autonomy that are in the marketplace today. I think, nearer-term, you're going to see the penetration of EVs. I think in time, you will see AVs, but you'll still have guys like me driving old cars around. So I don't need a full autonomous anytime soon, but you look at that Cadillac CT6, which by the way does not have our seats, so I shouldn't be telling you this, but it's really -- it's a really cool feature, and I think leading the industry on autonomy right now. So that's an aspect of autonomy, it's in the marketplace today.

Got it. And just a follow-up, the topic of vertical integration. I mean, you've been in this industry for few decades, maybe. And over that time, you've had this...

Thanks for pointing that out 5 years.

I know it's at least as long as I have and I've been here too so, I'm a baby. But over this time, we've had this trend of vertical integration, the OEMs kind of become, if I'm exaggerating a little bit more like marketing and design shells and financing companies, where a lot of the value-added has been coming from the supply base and to your benefit. And I'm just -- the question is, at a time when we're kind of reinventing the powertrain of the software and architecture and all of the things that are going on with the next cycle or a couple of cycles, a lot of OEMs are looking in the mirror and saying, jeez, I got tens of billions of invested capital in architectures and internal combustion that need to be written down overtime or have a lot less longevity, and I might have unionized employees sitting around saying, what do we do? I either pay them to go away or put them to some other use. The quest -- that's a setup for could we see a slowdown of the trend of vertical integration and the potential for some of your OEM customers to become competitors for some systems? Maybe not seats, maybe not full electrical architecture, but just at the margin trying to capture some of what they got hollowed out and shelled out over time?

Yes, I come at it slightly different. It's a great question and one that we get from time to time. And I think there's some confusion out there. One, I mean, we're assuming that they could do it, meaning they have the technical capability to do it and the knowledge how to do it. I think a lot of those skills are gone. Certain OEs do still make seats, for instance, certain OEs are touting their design seats. But the way we look at it is capital and the need to invest in this business to participate in mobility and autonomous is going to be huge. This is not where you want to be spending your capital and engineering dollars. And I think that ultimately will speak to the trend of further outsourcing. In fact, what we're seeing is the folks, for instance, that do make their seats are looking to monetize that asset to free up the capital and generate revenues so they can, in turn, put that investment into where they really need it, which is the design of autonomous and full powered vehicles. So we think it's actually an opportunity, not a risk.

Your next question comes from the line of Rod Lache from Deutsche Bank.

Just first in the quarter, you had an $8 million EBIT impact from $130 million decline in volume and price. And that's really good. I was wondering if you can clarify if that has any implications going forward. For example, if volumes were flat next year, is there an opportunity for margin expansion or should we be thinking about development costs and launch costs that would mitigate some of that for next year?

So I think inside that number, Rod, is the impact of the North American volume in the quarter, and obviously, the mix therein with what happened with the K2XX in the quarter. Some of that was mitigated by the benefit we got in Europe, where volumes were actually up in the quarter. So I think the read-in there is that the downside impact of that overall volume change was mitigated by some of the performance that we saw in the quarter. And I think maybe that's the take away that you can take to a level of volume environment next year, let's say in the third quarter or beyond. The run rate of the business beyond the volume issue seems to be performing quite well.

Right. So you'd have some performance, actually more performance that'd actually be flowing through in a flatter production environment?

Yes. Obviously, we were on -- it's much as anything, it's what car lines sell within the performance number or the production number.

Right.

Car lines selling that would help. But we've always got abilities to take cost out of the business.

Right. .

Flat would be okay. Flat would be okay.

Yes. And I think maybe 2 questions for Frank, first is could you just clarify what your market share is roughly in high-power?

You're scrambling those stats, I don't know, if we actually have that number, Rod, to be quite frank.

I don't know.

it's pretty consistent with our market share in electrical distribution. As it is, although I do think our capabilities are better than even some of the larger players in the space.

Yes, and it's our fastest-growing segment right now, too.

So we don't have that number.

Maybe (inaudible) okay.

Well, I would think so. I mean, from a standpoint that there's 4 major players in electrical distribution; us, Delphi, Sumitomo and Yazaki. And I think our capabilities are -- rivals, at least all of them, and not better than probably 2 of them.

And right now, we're selling all 3 of our segments in high-power. We've got wire business and high power distribution and connectors and electronic models in the higher power range so it's...

Something in the -- I would go mid-teens, just to be conservative.

Yes. And I'm wondering if maybe you could just address the kind of a higher level question, so how will companies in E-Systems be differentiated do you think in the longer run? Just broadly, in electrification ADAS connectivity, where would customers regard you guys as stronger? And are there disadvantages in not having things like domain controllers or broader capability in software and electronics as some of your peers have suggested?

So, Rod, I would tell you that I think a lot of it boils down to signal and data management. And that's where we're experts. When we put together systems for our customers, we're going well beyond wire now. We're putting systems together as a system-level approach. And we're doing wire boxes, domain controllers are part of our product offering. We do them for customers today, and we'll continue to do them in the future. Where we've been ramping up is software capabilities on top of that hardware offering to even further optimize content feature adds and things of that nature. So as you start thinking towards autonomous vehicles and what those trends are going to look like, we're positioning ourselves, as Matt mentioned earlier, as V2X positioning, vehicle positioning being able to provide the signal and data management and movement of those signals throughout the vehicle. And that's going to come through incremental box content with hardware and software in the vehicles. And right now, we're actively quoting DSRC modules. We're actively quoting connectivity modules that will allow the vehicles to speak between each other and back to the infrastructure. So we see ourselves in this great opportunity and this great spot where as these added systems come on to the vehicles, a, the baseline is going to be higher powered architectures in connected vehicles, which plays right into the slides that we presented today, plus now you layer on top of that incremental functionality of vehicle positioning, the signal and data management to pull signals in and out the vehicle, that's exactly where we position ourselves with the acquisitions and where we're going. So for us, it just represents added CPV content as we move forward, whether they're autonomous vehicles, there's a role for us there, electrified or connected, we're going to be a player in all 3 areas.

So there's no area at the moment that you'd say you'd need to really augment your capability to be at the benchmark level?

Well, as Matt mentioned, Rod, we're looking at it every day in terms of software capabilities to continue to layer on. We want to get better in vehicle positioning, we want to get better in vehicle-to-vehicle type software communications. But right now, we have a baseline that allows us to participate in these trends. We're going to absolutely continue to look to increment our capabilities in those areas.

Your next question comes from the line of Joseph Spak of RBC Capital Markets.

Just wanted to start with, I guess, 2 housekeeping items on the back, on the walks you provided. Is the backlog still coming in roughly that 80-20 split you talked about earlier on or is it coming a little bit differently? And then just on the flow-through on the acquisitions, I'm assuming that's because there's still some deal costs and maybe some writeups, and does that -- the flow-through on that get better in the coming quarters?

Let me start with the last part of the question, and then I'll hand it over to Jeff on this part of the backlog. The Grupo Antolin acquisition had some headwinds this quarter. Yes, because some of the transition costs, but really the main reason there was premium costs associated with some difficult launches in Europe, which we expect to correct itself. We think that business is going to perform at the CE margins overall once we get it sorted out and some of the premium costs that we incurred in the quarter.

Yes, and on the backlog, Joe, I think for 2017, I think it's still running at that same 80-20 seat to E-Systems mix. I think what you'll see even in the backlog that's currently published, and I think you'll see it likely when we come out in January, is there'll be a mix shift going the other way starting in 2018. Not to say that these systems would be larger than seating, but it's not going to be 80-20, it's going to be more geared towards E-Systems than the 2017 year.

It will be more proportionate, just like the lion's share there or a large portion will be seating, it will be disproportionate as it relates to the current revenue split.

Okay. By the way, does that -- in $118 million also include AccuMED?

No, that is specifically Grupo, Grupo Antolin.

Okay. Okay. And then Frank, if we look at -- I'm sorry, Ray. If we look at Slide 16 on the next generation intelligent seating and all the functionality, I was just curious to get your thoughts on the integration of seats with traditional passive safety, especially as we move more towards autonomous vehicles, whether you think that's something that's necessary or even likely to occur?

Yes, that's a good question. And a couple of different points. One, we've been integrating belts and bags forever with our customers in all of our seats, and we still do that today. The customer is focused on that integration from a safety system, from a vehicle architecture standpoint. So we obviously work with our customers today. We've kind of seen some ebbs and flows with all belts and seats and those types of safety devices being integrated into the seat, and we're working with our customers on those different applications with a number of different suppliers. Where we see the real opportunity, and I do believe that when we look at the passive seat today becoming much more dynamic and smart, it's in the dynamic safety features within recliners and tracks. And that's what we're doing as we have a couple of development programs with our customers on how the devices themselves that have been passive have become smart. And so we're spending a lot of time and effort with our customers on really generating a seat system that is intelligent. And just going through the whole system and it's tied directly to what Frank is working on with biometrics, health and wellness, the seat is actually being able to read your anthropometric measurements and get data that is meaningful to that occupant, personalizing the seat for -- we're not going to -- no longer have a center stack if you have mobility and other ride-share device or vehicles where you can individualize your seat for audio, for picking up your smart device. And so that's really where our focus is. We're still working with our customers on passive restraints and bags, but we see a change going to much more smart devices within the seat systems themselves.

Your next question comes from the line of Ryan Brinkman of JPMorgan.

This is Samik on behalf of Ryan. Thanks for all the color today and the detailed discussion on the content opportunity and the incremental content opportunity on both the segments. What I wanted to get your thoughts on is where do we stand in terms the organic research and development spend towards supporting that growth and being able to successfully leverage that growth? I think there was a mention that E-Systems had slightly higher investments this quarter as well contributing to the decline in margins. So how should we think about where you are right now in your research and development expenses? And does that need to change materially from here to be able to leverage this content opportunity that you're outlining?

Not materially. It is a more engineering-focused business that requires more engineering development focus or costs, quite frankly. You might see a couple tenths and you'll notice it in the SG&A lines of the business overall as we move forward. So, yes, it is a little bit more engineering-intense business and it requires a little bit more work upfront, but it's not a meaningful change. It's probably, I don't know, 20- to 30- basis points overall, but not meaningful overall to Lear Corporation.

Got it. Got it. And just to follow -- second and final question. Can you provide us with an update on Eagle Ottawa? I know, at the time of the acquisition that was sort of thought to be a product that's more directed at the luxury market. Have you seen automakers in more -- in the mass market segment as well adopt that -- adopt the leather products, et cetera, quite well? And is that driving sort of above-industry growth for you as well?

Yes. In respect to Eagle Ottawa, I think one thing that was important with Eagle and Guilford in our own capabilities, we have an in-house design group that can go and work with our customers in the clay studio so. And what we are seeing as far as trends to answer your question is a significant opportunity as far as a well-crafted, executed seat that really pushes the envelope of design to really give the customers a specific brand and look that they're looking for. But more importantly, we're seeing all kinds of exotic materials and luxury type materials within the interior. We know that that's a big opportunity for our customers to continue to differentiate their products. And so, yes, we absolutely are excited...

And leather continues to penetrate into the baseline vehicles as well as cars become more contented. Leather is the trend that we would expect to continue. It is growing, it is penetrating, not just in the seat, but in other components. So the Eagle Ottawa acquisition has been an outstanding acquisition for Lear Corporation. Not only does it complete our building of craftsmanship, it's the people that we gained and the expertise and design that we gained from that acquisition. So it was great from a financial standpoint, it's great from a penetration standpoint and from an organization standpoint. So it was an outstanding acquisition for us.

Your next question comes from the line of David Leiker from Robert W. Baird.

Two quick questions here. Matt, some of the smaller players in the space, particularly, over in Europe seem to be losing some contracts in the premium space. That's a pretty big area for you and that you dominate. Is that business that's coming your way? Or is that going somewhere else?

We're winning pretty much from everybody, but we are getting our share of it and it's -- we are getting our share of it, David. I think what the car company is starting to see, we had a question on it a little bit earlier, which is they get the best quality and craftsmanship when they source in a holistic manner, right? By sourcing Lear both to the assembly, but also the foam and the scrim and the seat covers, right? They get a better executed seat. I think some of the smaller companies are stumbling on the launch, and that's an opportunity. The other thing that's happening, and specifically in Europe, where there's still a lot of prominent privately-held organizations, is the need to have the world-class quality systems and global footprint is also creating an opportunity. These cars sell in multiple geographic locations, right? In many cases, multiple continents. So, yes, that's an opportunity. I won't say it's all coming to us, but we're getting more than our share.

Great. And then just one last one. As we look at the E-Systems portfolio, and you have a split between the traditional and the emerging markets. And then you list some market opportunities, 2022 to '27 for the high power and the connectivity. Do you have a similar number for the traditional electrical products group in A grade and what that market opportunity is in that growth?

Yes. As we said a little bit earlier today, 3% to 5% on the traditional products and the emerging market trends are going to create an opportunity beyond that.

I was more interested if you had the dollar number there?

No.

By any chance? Okay. We'll follow up. We'll follow-up on that one.

Sure, you had to say that dollar.

I heard the growth number, I heard the growth number, I was -- I'm curious on the dollar number. But it's great quarter.

Your next question comes from the line of Shawn Kim with Gabelli.

Just quickly to follow up. You guys -- you mentioned a lot of the opportunities content-wise over the next few years. I wanted to focus on some of the OTA updates. I know a lot of players don't have that capability. A lot of folks are investing a lot of their time and efforts into that. Can you potentially size that up for us? And just to give you some context, there's some reports recently going around that, OE companies were spending anywhere from $40 million to $50 million in expenses, working expenses each year, and last year was the first year where it was greater than 50% number where a lot of those expenses could have been fixed POJ software. So I was wondering if could just help us size up that opportunity. How are you guys planning to monetizing that over the next couple of years?

Well, the way we're going to do it is we have our traditional core products, and we're making them connected products. So we have a gateway product portfolio today, and we are making those connected gateways through over-the-air software capabilities. The companies that we bought back in 2015 have both given us the capabilities to do that. So the opportunity, as you mentioned, by making the components upgradable over the air for software is the ability to do a couple of things. Yes, you can reduce the dealership costs because, yes, you can flash the vehicles for warranty problems or things that might be happening. It can also provide content opportunities for instrument costs or upgrades, radio upgrades in the infotainment area. And our connected gateway sits over top of all of the vehicle domains. So we can interface with any one of the vehicle domains, including powertrain infotainment. So that's where you really get the benefit of working with Lear. The other thing is you can also pull vehicle health information off the vehicle and provide that to the customers so they can better develop the vehicles in the future. We're entering the space heavily in 2018 with our first product launch. As I mentioned, it's going to be on 9 nameplates in Europe as we continue to launch that product platform. So for us, it's a very big opportunity. We're very excited about it because it's a combination of our core products that we're now making connected through software capabilities. And we think it's going to be not only a CPV driver for us as we've captured on the connectivity page, but it'll also be a big growth opportunity for us in the future.

Got it. And just a quick follow-up to that question. Obviously, a lot of companies in Detroit are focusing on software development, can you maybe comment a little bit about how you guys are going about retaining talent, going out and finding talent, especially as you're competing with companies out in Silicon Valley. Are you seeing more of a shift towards engineers coming towards Tier 1 auto, in general? And would just love your comments on that whether you guys are going about it through acquisition or if you guys are getting some good pipeline activity as it relates to the talent?

We have no problem attracting talent to Lear Corporation for a lot of reasons. I think everybody wants to play on a winner, and we're that. Two, the industry, it's a great time to be in the industry, and when you have this convergence of tech and auto, it's the biggest industry in the world, and by the way, we design really unique product and we provide jobs. Then you couple this with -- it's hip to be in Detroit again, where we're headquarted, we have no problem getting talent from anywhere in the United States to come work for Lear Corporation. It is a competitive landscape, and I think the type of demographics that we're looking to attract are attracted by companies that win, that are community-minded, that have opportunity and good HR practices and policies, which we put a ton of effort into and that's why we have no problem recruiting.

Your final question comes from the line of Jeff Osborne of Cowen and Company.

Just one quick one. A lot of discussion on E-Systems. And I was just curious if you can quantify roughly what the margin premium would be as the backlog moves from the traditional wire harnesses and T&Cs over towards the high power and connectivity that you talked about?

Probably, on average, we say on average, the backlog comes in typically at an incremental margin of about 10%. A little bit slightly higher for more capital and engineering-intensive business. So maybe low- double digits would probably be my estimate.

And does that change, though? Just as the mix over time over the next 5 to 10 years switches more towards high power and connectivity?

It will really move up, it's more a function on return on investment. Traditional wire harnesses are not as capital and engineering-intensive, so they require a lower margin to exceed your cost to capital. Electronics and connectors are more capital-intensive than engineering-intensive, so they would require a higher margin. So as we shift there was more type of intelligent products, to the software-driven products, the margin profile would increase over time. So you are correct, Jeff.

Great. At this point, I think probably the only people on the phone are Lear employees and the Lear team. I want to start by thanking the finance team for pulling together all the information that supports a call like this. Secondly, I want to thank the broader team for the outstanding work and dedication and focus that it takes to post these type of numbers that allow us to have a call as pleasant as today's call. We have headwinds, we all know that, the industry isn't easy, but I know if we work together as a team and we communicate, and communicating with honesty and transparency and work as a team, there's nothing that can stop us. We have the best team in the industry. Continue to kick ass, guys. Thank you.