Lear Corp (LEA) 2018 Q3 法說會逐字稿

Good morning, and welcome to the Third Quarter 2018 Earnings Call.

I will now turn the call over to Alicia Davis, Vice President of Investor Relations.

Good morning, and thanks for joining us for Lear's Third Quarter 2018 Earnings Call. Presenting today are Ray Scott, Lear's President and CEO; and Jeff Vanneste, Senior Vice President and CFO. Other members of Lear's senior management team have also joined us on the call. Following prepared remarks by Ray and Jeff, we will open the call for Q&A. Please note that you can find the presentation that accompanies these remarks at ir.lear.com.

Before we begin, I'd like to take this opportunity to remind you that as we conduct this call, we will be making forward-looking statements to assist you in understanding Lear's expectations for the future. As detailed in our Safe Harbor Statement on Slide 2, our actual results could differ materially from these forward-looking statements due to many factors discussed in our latest 10-K and other periodic reports. I also want to remind you that during today's presentation, we will refer to non-GAAP financial metrics. You are directed to the slides in the appendix of our presentation for the reconciliation of non-GAAP items to the most directly comparable GAAP measures.

The agenda for today's call is on Slide 3. First, Ray will provide a business update and review highlights from the third quarter. Jeff will then review our third quarter financial results and provide an update of our 2018 financial outlook. Finally, Ray will offer some concluding remarks. Following the formal presentation, we will be happy to take your questions.

With that, I'd like to invite Ray to begin his presentation.

Thanks, Alicia. Great job. And good morning, everyone. It's a pleasure to speak with you today. Earlier this morning, we released our third quarter financial results and updated our full year 2018 guidance. As you can see on Slide 5, we reported quarterly sales of $4.9 billion, core operating earnings of $399 million and adjusted EPS of $4.09 per share. In the face of a number of macroeconomic and customer-specific challenges, the Lear team performed exceptionally well. As a testament to our strong operating capabilities, our core margins were flat at 8.2% for the quarter, outpacing a 2% decline in sales over the third quarter of 2017. We also grew adjusted EPS by 3%. A 12.1% E-Systems operating margins were lower than our recent historical average due primarily to production volume declines on key profitable platforms. However, in Seating, operating margins were 8.6%, up 50 basis points up year-over-year. Unfavorable industry conditions impacted the results in Seating negatively as well. By doing things like targeting cost reductions helped us offset these factors and expand operating margins year-over-year. I'm very proud of what the team has accomplished in this very challenging macro environment.

As you know, the automotive sector has been under pressure for the past few months due in a large part to macroeconomic conditions outlined on Slide 6. We have concerns about trade and tariffs, rising interest rates, foreign exchange risk, the North American auto cycle and declining production volumes in China and Europe, the industry looks very different today than it did at the beginning of the year. Despite these headwinds, we remain very bullish on our business prospects and take that we are -- there are many reasons to be positive about the macro conditions going forward, particularly in North America. The U.S. economy remains very strong. Leading economic indicators are positive. A new NAFTA deal has been negotiated, and given our footprint, we have experienced only minimal impact from tariffs. Though we continue to see softening demand in Europe, we hope to be through WLTP-related delays by early 2019. We believe this increased focus on the environment is a positive one for our business long term. We expect this trend to continue as we move forward, leading to increased demand for electric vehicles and supporting our strong and growing position in the vehicle electrification.

Regarding China, despite near-term concerns about slowing growth rates and broader questions surrounding trade and macroeconomic policy, we remain very optimistic about the long-term potential for Lear in this critical region. As the largest auto market in the world, China represents a tremendous growth opportunity for us. There are numerous opportunities for us to increase our market share in this region.

As I've mentioned before, we're launching a significant number of new programs. Slide 7 and 8 highlight some of our key launches in Seating and E-Systems. We are very excited about several major new programs in key vehicle segments. Many of our most important programs are transitioning to new models, including GM's full-size pickups in North America and the Ford Focus in Europe and China. We are launching significant backlog with several premium vehicles like the Mercedes GLE, the BMW X3, various Audi models and Jaguar I-PACE, which is Jaguar's first all-electric vehicle. As we told you on our last earnings call, we ended production on the BMW X5 in June. This is a program we elected not to pursue because the return profile did not meet our internal thresholds. We are using this capacity to launch the all-new Volvo S60. Additionally, we are launching 2 new vehicles in North America, the Ford Ranger and the Chevy Blazer. We are excited about these new product launches because they contain some of the complex technologies we have ever produced.

As you can see, these launches extend through 2019. As is typical, we will experience some downtime in advance of the start of production as OEMs reconfigure their assembly plants in preparation for the new vehicles. On a couple of our large North America Seating programs, we expect 13 weeks of downtime through the first 3 quarters of 2019, with 8 of those weeks occurring in the first quarter. And after changeover, these next-generation programs tend to start at margins lower than those associated with the previous programs. Though these launches will have short-term margin effects, we couldn't be more excited about this business because these are some of the most coveted platforms in the industry. This is really good business that will allow us to continue to build on our success for the long term.

Though we've had some macro challenges in this quarter that will continue into the near term, we remain very optimistic about our future. The current environment, though not where we're expecting it to beginning the year, gives us an opportunity to separate ourselves from our competitors. Our highly experienced and capable management team built this company to thrive in challenging times. We couldn't be better positioned as we look to the future.

And with that, I'd like to turn the call over to Jeff to provide more detailed review of the third quarter and our financial review -- results for the revised 2018 outlook.

Thanks, Ray. Slide 10 highlights our financial results for the third quarter. Overall, sales in the quarter were $4.9 billion, down 2% from last year, as the strong black backlog growth was offset by significant production declines on key Lear platforms and the negative impact of foreign exchange. While our core operating earnings were down compared to last year due to lower revenues, overall company margins were flat at 8.2%, driven by continued strong operating performance. Our earnings per share was up 3%, driven by a lower effective tax rate and the benefit of our share repurchase program. Equity earnings were $3 million in the quarter, down from $12 million in 2017. The decrease was primarily related to the consolidation of wire harness joint ventures in China, the weaker production environment in China and the short-term impact of Section 301 tariffs on certain wire harnesses imported from China. Third quarter free cash flow was $107 million, down $76 million versus 2017. Free cash flow in the quarter was primarily impacted by increased working capital associated with the timing of customer payments and higher levels of inventory due to the sporadic changes to customer schedules. In the third quarter, we increased our pace of share repurchases, investing $195 million to buy back over 1.1 million shares.

Slide 11 provides the third quarter year-over-year sales and adjusted operating margin walk for our E-Systems segment. Third quarter sales were up 9% compared to 2017, driven by strong backlog and the impact of the consolidated China wire business, somewhat offset by lower production on key Lear platforms and the negative impact of foreign exchange. E-Systems third quarter margins were 12.1%, down 230 basis points from 2017. Roughly 2/3 of the margin decline in the quarter was the result of lower production on key Lear platforms. Given the specific programs impacted and the sporadic nature of the production cuts, the downward margin impacts was more significant. The impact of volume and mix was somewhat mitigated by strong operational performance, which includes the negative impact of supply disruptions on certain key electronic components. During the quarter, we continued to invest in launching our backlog as well as spending on advanced engineering to support further growth in electrification and connectivity.

Slide 12 explains the year-over-year variance for sales and adjusted operating margin in the Seating segment for the third quarter. Third quarter Seating sales were down 5%, driven by lower production on key Lear platforms and the negative impact of foreign exchange, somewhat offset by strong revenue growth from the backlog. Despite lower sales, third quarter Seating margins improved 50 basis points to 8.6%. The margin improvement was primarily driven by continued strong operating performance, a strong backlog with overall margins accretive to segment margins, somewhat offset by the lower production on key Lear platforms.

Slide 13 summarizes our history of returning cash to shareholders. Since 2011, we have returned over $4.7 billion to shareholders in the form of share repurchases and dividends. As a result of these actions, we have reduced our total shares outstanding by nearly 40% and increased our dividend by an average of 30% per year over this time period. We have approximately $1 billion remaining on our share repurchase authorization, which extends through the end of 2020. This represents approximately 11% of our total market capitalization at current market prices.

We have updated our full year 2018 financial look -- outlook to reflect the current production and foreign exchange environment. Slide 14 shows the global vehicle production and currency assumptions supporting that revised guidance. Our vehicle production estimates are based on the October 2018 IHS forecast as well as our most recent customer production schedules and internal estimates. IHS is now forecasting 2018 global industry production of 94.1 million units, down 1.3 million units or 1% compared to estimates published by IHS in July. Second half 2018 production estimates in North America, Europe and China are down 2% 4% and 5%, respectively versus IHS' July second half estimates. From an FX perspective, all major currencies have weakened versus the U.S. dollar. We are forecasting average full year euro of $1.18 per euro, which implies an FX rate of $1.15 per euro for the fourth quarter. Additionally, we are forecasting an average full year Chinese RMB of RMB 6.6 to the dollar, implying an FX rate of RMB 6.87 to the dollar for the fourth quarter.

Slide 15 provides a summary of our updated full year financial outlook based on our year-to-date results through the third quarter and our outlook for the fourth quarter. Our revised sales outlook is $21 billion to $21.2 billion down, down $800 million at the midpoint, driven by lower volumes on key Lear platforms and the impact of weaker global currencies versus the U.S. dollar. Core operating earnings are now expected to be in the range of $1.73 billion to $1.75 billion, down $60 million at the midpoint driven by the lower sales, somewhat offset by operational efficiencies. Our free cash flow outlook remains strong at approximately $1 billion, down from our prior guidance due to lower forecasted earnings, slightly higher CapEx, increased working capital and higher restructuring costs.

Slide 16 shows our 2018 financial outlook compared to 2017. Despite flat production levels in our key markets, Lear is forecasting another year of solid growth with sales up 3%. We continued to deliver profitable growth as core operating earnings are forecasted to increase 1% versus 2017. Also, we continued to convert earnings to cash as full year free cash flow is forecasted to be approximately $1 billion.

Now I'll turn it back to Ray for some closing thoughts.

Thanks, Jeff. As I've already said, despite the near-term headwinds, we have never been in a better competitive position, and I've never been more excited about our longer-term opportunities.

Slide 18 outlines why we think we will continue to be successful in the marketplace. We have industry-leading talent with deep experience and a track record of operational excellence. We have 2 high-performing business segments that supply critical systems to our customers. As a company, we are well diversified by region and customer and are well positioned through our backlog to continue to improve that diversification. We also have one of the strongest balance sheets in the industry and investment-grade credit ratings. We have never been in a better financial position or had more financial flexibility than we have today. Over the past several years, we've executed a very deliberate strategy of shaping our product portfolio and geographic footprint to gain market access and capabilities in key areas. The steps we have taken have created leadership positions in key product segments and allows Lear to continue to achieve strong operating results.

Both Seating and E-Systems are perfectly aligned with the major global automotive trends of electrification, connectivity and shared mobility. We have leading market positions in electrification and connectivity, and both areas represent tremendous growth opportunities for us. As I've mentioned before, we are quoting significant business in these areas. We are also well positioned to take advantage of increased shared mobility via our Intelligent Seating capabilities, that allow for the seat to -- for reconfigurability, personalized seating and cooling and individual seat-based control.

Our new Chief Technology Officer, John Absmeier, is leading the creation of a new dedicated innovation team, pursuing strategic partnerships with leading tech companies, startups, incubators and accelerators and exploring potential venture capital investment opportunities to give us access to the best technologies and the most current thinking. We're also developing new strategy to monetize our software in a way that supports our customer needs while pursuing quotes in vehicle positioning software, services and data.

From a capital allocation perspective, our first priority is to invest in the business for profitable growth. We then pursue strategic M&A opportunities that allow us to enhance our capabilities and strengthen our market position. Finally, we returned excess cash to our shareholders through our dividend and share repurchase programs. We are committed to maintaining investment-grade credit.

To sum it up, we have tremendous capabilities and innovation in technologies and 2 business segments that are perfectly aligned with industry mega trends. We have consistently outperformed our peer group across every major financial metrics. This level of performance doesn't just happen. It is the result of having the best team in the industry, investing in the business over the long haul and continuing to focus on our customers, our operational excellence in achieving profitable growth.

And now with that, I'd like to turn it over for your questions.

(Operator Instructions) Our first question comes from the line of our Armintas with Morgan Stanley.

Given the macro headwinds that we're seeing from China and Europe, maybe you could talk about what you're seeing on the ground in China with regards to production schedules and in your conversations with the local regulators around the potential for stimulus as we think about '19?

Yes, that -- it's a good question. Obviously, given the production environment right now in China, we have seen a softening. And I think some of it was due to some changeover of some products, we had the peer-to-peer lender issue related to the consumers getting at the ability for credit. And we saw some inventory, I think the customers have done a nice job of taking some of the days on hand down. So with that we, obviously, saw some softening that I think is -- we saw in the third quarter, we'll see that probably into the fourth quarter too. But I do believe that there will be stimulus that will be put in place. I don't know exactly when that will occur. Maybe the first part of 2019, but I do believe from what we're hearing, there will be potential stimulus that will be put in place to drive the market up.

Got it. And then just as we're thinking about the puts and takes for '19, at our conference, you mentioned some of the transitions with the Ford Explorer, the K2XX, T1XX transaction still being in focus. Anything you want to highlight for 2019? I know margins are holding in quite nicely despite the launches, and what should we expect around production growth over market and margins for '19? Just some high level puts and takes there?

Yes, we'll provide more color when we release our '19 guidance as we always do in January. But here's what I can tell you right now. From a top line standpoint, IHS, at least as of October, is forecasting global production up 2%. 1% in North America and Europe and 4% in China, at least that's their current estimate. We've got $1.4 billion in backlog that's rolling on next year. And of that backlog, about 40% is related to E-Systems, a disproportionate amount given E-Systems mix of the overall Lear business today. I think with respect to currencies, if we go into next year, in the current FX environment, sales will be down. The euro I heard earlier this morning it was like at $1.14. So that's a bit challenging for us on the foreign currencies. Ray alluded to this in his review of the launches that the first half of next year is a significant launch cycle for us. There's 13 known customer down weeks next year, 11 of which are in the first half of the year. Most of them related to the transition of the K2XX to T1. So as a result, what we'll see next year from a cadence of sales is we'll see the back half sales higher than the first half as we get through these launches, we get through the downtime in the first half, and we realize the full volume levels of those launch programs as we get in the second half of the year.

And then just to preempt the question that's going to be coming is with respect to steel and tariffs, we've alluded to steel in the past as it relates to both the impact on '18 and '19, suggesting that for '18, we really didn't have a significant impact on the tariffs because -- or the inflationary impact of the tariffs on steel because we have purchased our complete steel requirement for '18 in November of '17, so when prices -- the preinflationary buildup. We're going through the process right now of securing our steel for 2019, and given the current steel price environment, it's likely that our year-over-year cost of steel is going to be higher. On the tariff side, to the extent that we source the business, we tend to source it locally. And as a result, the impact that we are having or will have on tariffs is somewhat small. To wrap it up, those 2 together, as you look at '19, as it relates to what we're seeing right now on steel and what we're seeing as potential tariffs, I put the impact to the overall business next year and company margins of about 10% to 15%. The other thing is with respect to E-Systems, we see this as a huge growth opportunity, a secular growth story for us. So we will continue to invest in that business, and you'll see some small impact of margin impact given that investment, but we think that given where we are with the trends and our positioning, it makes all the sense in the world to further invest in that business.

Just to clarify that 10% to 15%...

Oh, basis points. I'm sorry.

Basis points, not percent.

Yes, just to clarify that. Somebody kick me...

You we on a roll. You we on a roll.

Did you get that? Not 10% to 15%, 10 to 15 basis points.

Your next question comes from Itay Michaeli with Citi.

Jeff, maybe just a follow-up on that. You mentioned $1.4 billion in backlog next year. Is that sort of a fresh number for some of the industry changes? Or do those not yet reflect some of the pressures we've seen in second half the year industry-wide?

I mean, there may be some impact to it, but I don't know that the impact of some of the volume changes is that significant. And to that point, Itay, we'll be coming out in January in addition to giving our 2019 guidance, we'll be updating that backlog as well. But I don't see a major change with respect to that number. I think that $1.4 billion is still a good number.

And I think -- and we've mentioned this before, what's exciting is -- specifically in Seating is 90% of our backlog is on these CUV, SUV crossover. So it's perfectly aligned with some of the trends we're seeing and the move from pass cars to more to CUV, SUV. So some of them are the hot products that there is a demand for.

Absolutely and that's very clear. And then just on the fourth quarter outlook, just want to sure I can kind of square your guidance with IHS. You can maybe share what you're assuming for China auto production or at least kind of Lear's China revenue in the fourth quarter? And maybe preliminarily how you're thinking about next year for China?

Well, I think with respect to the fourth quarter, certainly, IHS suggests that quarter-over-quarter from Q3, fourth quarter is going to be up relatively significantly in China and to some extent in Europe, less so in North America. But if you look at our top programs, our key programs, in each of those regions, they're either not up nearly to the extent as industry IHS volumes or they're down in some cases. For example, our Lear China volumes are forecasted to be down in Q4, maybe unlike what the industry is saying in general. So I think what we'll see in the fourth quarter is sales that are generally flat with the third quarter, given that mix of business versus overall industry. I will say this that as we look at production schedules and customer releases, what we've seen really over the last three or four months is very sporadic, impromptu production scheduling declines taking days or weeks out of the schedule. So there is some factoring into our top line guidance associated with what may be still to come. One may call that conservative. I would call it probably consistent with what we've seen recently. But what we're seeing is as a result of all of that, sales that are likely to be flat between Q3 and Q4.

That's very clear. And then just lastly wanted to touch on free cash flow and, particularly, the working capital component of guide down. I think typically in the past, sometimes when supplier revenue comes under pressure, working capital could become a source of cash. And maybe just walk us through that a little bit and kind of how you think about that into next year as well?

Yes. So there is a few key themes that have affected both our Q3 and Q3 year-to-date free cash flow, all of which are tied to a higher level of working capital that we've seen in the business, primarily driven by a couple of key things. One, given the sporadic nature of the production cuts that we've seen, it's been very difficult to react to a few of those. And as a result what we've seen is some embedded level of inventory as a result. The second thing is, what we normally see, given our non-calendar close, we have a fiscal close, we're always seeing some timing issues related to the end of our quarter. We saw that this time. But also in the quarter, we've -- we have some new payment terms with some of our customers that have affected the timing of when we'd anticipate those payments. And lastly and certainly from broader perspective, given the change that we've seen in our customer sales mix, more historic customers' volumes being down and some new customers, primarily in China, going up, but the payment terms on each of those customers is a bit different. So what we've seen as a result is a somewhat elongation of payment terms with the mature -- the quicker-paying customers sales down and the longer-paying customers slightly up. So as a result what we've seen in both the quarter and the full year is a buildup of working capital associated with that. Now the assumption that we have in the fourth quarter that supports our full year guidance of $1 billion is about $475 million of fourth quarter free cash flow. Fourth quarter is typically our best free cash flow quarter this year being no different. Now that's in comparison to last year's fourth quarter, which had free cash flow generation pretty consistent with what we're estimating our fourth quarter to be this year. The difference being we have a much more significant buildup of working capital going into the fourth quarter, and we expect some of that working capital to come down, and as a result, generate free cash flow as a result. So that's a long-winded way of saying that we're very confident in our free -- full year free cash flow guidance and what it will take in the fourth quarter to get there.

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

Just a first question on volumes going forward. I mean, given sort of the volatility and slippage in schedules and IHS estimates during the course of the quarter, I mean, how confident are you in schedules, in IHS schedule, IHS numbers or estimates in the fourth quarter and going into 2019? It seems like the world is shifting faster than IHS can keep with up and the customers are kind of scrambling. I mean, how do you get a read on these near-term numbers and even 2019?

Well, it's certainly a slippery pig right now, it's hard to catch. As I said before, the production decline come quick and sometimes deep. I mentioned that, John, in my previous response that what we're seeing in the fourth quarter, if you look at what our internal forecast says today, we would probably be at the high end of the new sales guidance range. So we've baked in some element of conservatism with the belief that there's more to come in the fourth quarter. What we do as well in the context of our guidance is we don't necessarily take specifically IHS numbers and run with them, we have the benefit of seeing customer releases now through the end of the year. We have our own internal conversations with the customer. So we take all of that into account when we come up with the guidance. And as I said, there's some level of conservatism right now based on a belief that there may be more production downtime to come.

Okay, that's very helpful. And the slippery pig is a very vivid image in understanding how this works. Yes, I appreciate that. Really it does help. Yes, it might be in a title someday. But the second question is, as we look at Page 11 and 12 on E-Systems and Seating that walks year-over-year, you have volume and mix as negative to revenue, but also particularly on E-Systems, I think it's 150 basis points, if I'm looking at my notes correctly, negative volume and mix and on Seating with negative 40. Is there a way to parse out in that op margin decline? Or should I say pressure from volume and mix? What's volume and what is mix? I'm just trying to understand what the mix impact is there and what really went on?

Well, let me try to size up. Let's talk about E-Systems for a moment. Let me try to size it up. If you look at it regionally, in E-Systems, our key platforms were down in each major region. North America, the primary component was the build-out of the Focus after the second quarter. In Europe, we've seen a number of programs be down and then some of our backlog programs like the Focus is building up. So it's going through a ramp there. And in China, our overall key platforms were down fairly significantly on a year-over-year, one customer, in particular. And if you look at the customer stratification, that one customer plus JLR announced some downtime, for example, in the third quarter and into the fourth quarter. And then if you look at it on a product basis, which I would put a lot of this into the mix element, given the issues with WLTP in the E-System segment, we were disproportionately impacted on our Ts and Cs business, which carries -- given the investment thesis there, carries with it a higher-margin benefit. So we were disproportionately impacted in Europe there on Ts and Cs. So that's kind of overall story, but it's some mature programs that had the lion's share of the volume declines and the mature programs in our case tend to be the ones with the margins incremental to the overall segment margins.

And just -- John, just to add, I mean, E-Systems is fundamentally the same high growth, high margin business, it's always been. We are rolling on some new customers, which we're excited about. What Jeff mentioned was we had some older programs, more mature programs that were accretive to margins, that because of production stoppages and delays impacted us in the quarter, but in addition to that, and we've said this before, as we build up these relationships with these great customers and it's really diversifying our customer base, they are coming in lower than what would be the historical margin, but very healthy, good programs. And during a time that we want to protect the launches and secure the launches and build our reputation with these customers, in some cases, there is a time element here as we build the profitability back up on those programs. I think in addition to that, in the quarter, Jeff will talk a little bit more about it, but we continue to invest. We're not sitting here looking at this particular time and saying, let's don't invest, let's cut back our investment. We actually think now is the time to invest. We're -- like I said, we're going to separate ourselves, and it is the right time to take advantage of some of the issues we're dealing with and be opportunistic. And so we didn't stop spending relative to new growth programs. And so we think that's very important that we are looking at this longer term as opposed to trying to work out a quarter short term. We are very positive on the long-term play in E-Systems, and like Jeff talked about, we had some swings within the quarter, but we're more optimistic now than ever.

Okay. And then just one other question on raws. I mean, the way you were discussing the steel was interesting, I mean, it sounds like you sidestepped the pressure by buying in November of '17. But it sounds like you're indicating there might be some pressure from steel going forward in 2019 as you're working through, you know, the buy right now for 2019. I was under the impression that steel was largely a pass-through or directly indexed to the OEM customer. So I'm just curious if you can kind of explain what's going on there? And then also as we think of the petrochemical sort of derivatives like plastics, resin and foam, what's your ability to kind of pass that through to your customer as well?

I'll take the latter first. The foam and chemicals is a relatively small exposure to us. On the steel side, I think the way to look at the year-over-year variance, let's say, from '18 to '19 is, what did the -- what does the steel environment look like today versus it did a year ago because we're securing next year's buy based on whatever steel prices are really up in the next couple of weeks. The -- on the exposure, part of our plan to mitigate some of the steel price increase impact is to get additional coverage from some of our customers that we're not necessarily on the steel buy program with today. Just to give the overall view on steel, we buy about 3 billion pounds of steel each year, of which 90-plus percent of that is under some steel resale or buy program or recovery program from the customer. So of that 3 billion pound buy, we're only exposed to roughly 10%. And we're trying to further mitigate or increase that coverage of customers by getting on some steel buy programs that were not currently on. So the impact that I referred to is really on that 10-or-less percent of our exposure.

And just there a little bit more, John, if I could just, this is something we talked about in the past too. Relative to our competitors, we're a smaller player, and we have strategically not grown that business at all cost just to grow it, and so we've kept it relatively specific, smaller because we want to have capabilities but not have a large chunk of our business in structures. And when we negotiate these deals, and just to kind of give you some more insight, there is a lot of directed components that go into our structures business. We don't manage our directed suppliers. We manage only the components that we can control and we have sourcing control for. And so when we get in these type of situations, we do have particular contracts with our customers. In other situations and we're doing it right now, we're very aggressive on the levers that we can pull. And if that's substitute materials, design changes, VAV, we have a queue built up that we can go into our customers and offer them alternatives. And so we're taking a very aggressive approach, not just burying our head in the sand and hoping some of these things will go away, but being out in front of them and saying, "Listen, heading into '19, here's some optionality for you, here's some ways that we can continue to reduce our cost and mitigate what could be a potential problem." And then at the end of the day, we obviously have productivities and things that we negotiate with our customers to hopefully mitigate this or net it down.

Okay, that's helpful. And then just lastly on Page 15, we're looking at revenue midpoint up $633 million, but core operating earnings only up $21 million. So I'm just curious if you can kind of illustrate what the pressures are in 2018 that have led to only a small increase in core operating earnings with a reasonably large net sales increase? And then as we think about 2019 and to put you on the hook, if you're willing go there, if we look at 2019, just hold everything else equal and just say the backlog rolls on, revenues up $1.4 billion, I mean, should we see sort of a same kind of increase next year on a linear basis? Or the reasons that 2019 sort of on -- incremental margin and realization should be much better than what we saw in 2018?

Well, I think that what we've seen in the year in general is pretty consistent with what we originally thought the year was going to look like. Obviously, it turned downward in the second half of the year, so the impact of volume and mix is more exaggerated than what we have initially thought. But what we said at the beginning of the year is that we're going to have, in Seating, for example, a very significant level of program changeovers that are going to have an impact on margins. We also indicated that commodities was going to be a challenge, albeit we've been kind of immune thus far in 2018 from the impact of tariffs. The pricing on the steel that was secured in '18 was higher year-over-year from 2017. So we had continued to attribute roughly 20 basis points of margin decline associated with that. And on E-Systems, obviously, what happened in the third quarter, the different industry and macroeconomic environment that we have now versus what we thought before, you can see the impact on margins as a result. But we had also said during the course of the year that a couple other things were impacting margins in that segment. One, the wire harness business, the China wire harness business that gives us a broader footprint in China, it's fantastic business, it's north of 10% margin, but it's dilutive to the overall segment margins in E-System. And also that given the backlog, the significant backlog and the launch costs will be up year-over-year, but the investment that we're pouring into that segment to support our ability to grow is no different than what we saw before, and to Rays' point, we're going to continue to invest in that business because we think the growth potential is very significant there. So it's really lot of the things that remain consistent from what we originally guided, but the level of production declines and specifically declines on our key platforms is really what created the change.

So if we were to look forward to 2019, a lot of those factors seem like things that you've kind of elucidated or illustrated so far. So I mean, is it really just sort of the stability in schedules and your understanding of maybe the volatility and managing around that which would drive potentially higher incremental margins of what you saw in 2018? Or do you think that there's still kind of the same kind of pressures you saw in 2018 that will come from these factors in 2019?

Well, I think that if the industry and macroeconomic environment is the same, I can speak to E-Systems, we could see margins in that 12% to 13% range. Now what can change that? Obviously, volume recovery on some of the key platforms, the -- getting through this WLTP that disproportionately affected Ts and C business and the margins in that segment as well, further growth. So I mean, there is a pathway to improve margins. But as we look at it today given kind of the industry positioning, I think we'll be in that 12% to 13% range on an annual basis going forward. And obviously, longer term, as the business grows and the growth is going to be not primarily, but I mean, there is going to be more electronics, electrification, connectivity programs, which command higher margins, we should see mathematically margins continue to improve.

Yes, John, I think our earnings growth is tied to our revenue growth, and we have very strong revenue growth. And we talked about the backlog, and in that backlog, I mean, one of the key drivers in our backlog is E-Systems and is disproportionately higher in E-Systems relative to the overall business today. So E-Systems is -- even though both divisions are growing, E-Systems is growing faster relative to Seating. And looking at that business too, the split between the electrical portion and the electronics, where the investment is going is in electronics, that electronics is higher-margin profile. And that's why we're so -- the opportunities are so big is that we're changing not the profile -- not just the profile of the company relative to E-Systems and Seating, which is great, but the profile with electrical and electronics, and we're really taking off when we look at the electronics, but that's the investment, but that's also the growth engine where the electrification and connectivity. And so we're putting ourselves in a really good position and that grows the earnings.

Okay, that's very helpful. And just one really last question -- quick question. The $1.4 billion backlog roll on next year, what's the split between E-Systems and Seating, just to remind us?

40% E-Systems. 60-ish...

60/40, Seating. And our current mix of business is like 75%, 25%, so that gets to Ray's point that we're growing faster in E-Systems.

The next question comes from the line of Colin Langan with UBS.

I think we probably covered this, but I'm going to make sure my math isn't off. It imply -- I think your guidance for the full year implies sales roughly flat into Q4, but margins get worse. Is that correct? And what should we think about as the deterioration to Q4 for margin?

Well, I think that part of it is with respect to the Seating margin in the third quarter. There was some commercial issues that were resolved in the quarter, that had some level of tailwind there, about 20 basis points of what we see in Seating in Q3 was really related to the timing of those settlements. But other than that, it's kind of the same flat level of sales and generally speaking, earnings levels that are maybe in Seating more around traditional 8% range and on E-Systems in that similar territory that we saw in Q3, which is the 12% to low-12% area.

Got it. And you mentioned that 12% to 13% looks like the right range for E-Systems. I mean, how should we think about Seating at this point? I mean, is 8% the right sort of full year type margin? Should we think about some of commodity, maybe launch costs into next year, putting a risk to that, I mean, any guidance there?

Ye, Colin, I think that 8% range is that more -- the annual number. And I highlighted and I did it intentionally to give you some idea of what the cadence are of launches from quarter-to-quarter. I mean, in the first quarter, we're really going through some great launches. And I wanted to -- everyone understand the cadence, but yes, on an annual basis that margin is 8%.

Yes, and I think just to add a color then and to add on to Ray's point is, that 8% or in and around that 8% is an annualized number, but given the cadence of what we see in launches and in volumes, we're going to be probably below 8% in some and above 8% in others. So that's annual view. And given that launch, we'll probably be higher in the second half and lower in the first half.

Got it. That makes sense. And just circling back lastly on the China issue in terms of IHS, if it's a bit too optimistic for Q4. Any sense of the sensitivity if China is down 1 more percent, I mean, how should we sort of gauge that if we see weakness in the quarter for the overall market?

Yes, I guess, we've look at it and you have the overall market, but our position with customers. I mean, we're growing with Geely and Geely is one of the customers -- domestic customers that's outgrowing -- outpacing the market. And so the way we look at it is there is the industry -- or China and then there is the specific platforms or programs we're on, and that's why we've been very selective, not only with the domestics with some of the products that we're launching in China on where those product placements are and what's the growth, what do they look like as far as demand. And so even though Jeff alluded to and talked about it, there is IHS, we study a lot of different things relative to volumes and what's going to happen, not just in fourth quarter, but heading into next year. And we're excited because, one, we're smaller player that's growing fast, and we're well positioned with the exception of one of our major customers there in China today, but there is the growth with Geely right now and the launch of Audi and other programs that we're going through launch cadence with it.

The next question comes from the line of Rod Lache with Wolfe Research.

I was just hoping you can clarify a few things. Your comment about the downtime during the first half of next year, what's the magnitude of that from a revenue perspective for you because there was actually fair amount of downtime this year as well?

Rod, we give our -- we'll give our guidance in January. I'm not going to get into those numbers at this time. But what we did want to point out and it's not unlike a typical year that we have downtime and we do. I mean, we've had this year, we had in the third quarter. But we did want to highlight the fact that there was -- and what's probably significantly different is the amount of downtime in that first quarter. That's the significance of it, but we'll give more insight in January.

Maybe I would offer you this to you, Rod, with respect to first and second quarter. In the first quarter, there is 8 weeks of known customer downtime, 4 of which relate to the couple of GM pickup and SUV plants going down, and the other 4 related to Ford in Chicago, and one of the vehicles there is the Explorer and that's going through a launch. And then in the second quarter, the 3 weeks of downtime that the customers have announced, all relate to GM pickups and SUVs. So they're obviously on high-contented SUV truck-type vehicles.

Yes.

But again the thing Rod is that we'll have the GLE up and running, we'll have the Blazer up and running, the Ranger up and running. So there is downtime in some of these key platforms, but these programs that we're launching right now will hopefully be up and running at full run rates heading into the first quarter and second quarter.

Okay. Yes, it just seems like your tone about the reacceleration has changed a bit, and we're just trying to size that up. How should we be thinking about launch costs next year versus this year? You had 2 GM plants go down this year, you've got 2 -- actually 1 -- the heavy-duty is going down in the middle of the year and then it's not until very late in the year that Arlington goes down. So is there -- should we be thinking about launch costs being higher?

I would say this Rod. I said we're going to give a very fulsome level of guidance in January when we come out. So we'll be much more -- we'll give much more information at that time.

Okay. You're giving sort of half -- sort of hints about things here. So we're trying to work around what you're providing. You guys have talked about $1.4 billion of backlog. You typically do about negative $400 million of price, just based on your historical price deflation. So you've got about $1 billion of tailwind just from those factors next year versus this year excluding any changes to production. And it sounds like you're suggesting that the production will be lower in some instances.

No, that's not what we're saying at all, Rod. I think what we're saying is -- you're picking out the pieces which I think is -- I don't disagree with anything you said. So $1 billion of backlog, we got industry production up 2%. I think you're a little bit heavy on the customer LTAs, the FX environment in its current situation probably would be down. But what I'm -- what we're trying to point out is I think you can draw a top line conclusion for the year. What we're trying to draw everybody's attention to is the cadence by which we're going to see the sales roll out during the year. It's going to be more disproportionate to the second half given what we're talking about in terms of launch schedules and announced customer downtime. That's the message that we're trying to get across.

Okay. So that's a big important clarification. So you're not trying to suggest that, as you're looking at things today, that your earnings will be flat or down versus this year. Is that a fair...

Again, Rod, we're not...

I know you are not saying what guidance is, right?

Yes, we're not going to say what guidance is on earnings today. That's going to be reserved for January in Detroit.

Okay.

Yes.

And your...

I think, Rod, there is not anything that isn't public information that we're trying to put out there, it was just more the timing of it. We've had down weeks before. Like I said, we've had in this year. I can't remember historically having this type of downtime in the first quarter was the only point we're trying to mention.

Okay. And then lastly, just any additional color on how we should adjust free cash flow for -- based on some of the things you hinted at, just the different -- the differences in terms that you've got with customers, and you also alluded to restructuring this year? So we think about extrapolating from what we see right now into next year, is there any kind of color that you can give us on the free cash flow generative power of the business and how that's changing?

I don't see it changing dramatically. I don't see that there is any cause for alarm that all of a sudden that there is a sudden change in the ability to generates significant cash flow. I think we will continue to generate significant cash flow, the earnings power and the cash generation power of the business has -- is not changing, in our opinion, it's never been stronger.

Okay. But your -- I mean, you changed the EBITDA by about $100 million and you lowered your free cash flow by almost -- or I guess, the EBITDA was actually $60 million lower and your free cash flow was $200 million lower this year. And it sounded like there were some changes to terms and there were some adjustments to restructuring that contributed to that?

Because a lot of times these customer payment are one-time events. You deal with it and then that's what -- that's the new norm, if you will, it doesn't mean that we're not getting paid. It means that what it initially happens, when you pinpoint it at a period of time, it could be less, but over the course of time, it doesn't change.

Okay. So that's not something we should not extrapolate prospectively.

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

We got 2 simple questions for you. E-Systems backlog, revenue up $155 million, margins down. Can you tell us what's going on with the operating margin of that business that you bid and why it came in as a headwind to the segment?

I'm sorry, specific to the backlog?

I'm looking at Slide 11, and I see your sales walk has backlog up $155 million and...

Yes.

And the adjusted earnings and margin right below it, it's 15 bps headwind. And I'm trying to understand why that came in worse than segment margin?

Yes, here's the story on that. So it's -- we said this a number of times that backlog typically comes in at a margin profile that's lower than the overall segment. This business that came on board, that $155 million came on board with margins of approximately 12%. So that's intuitively less than the 14% that we saw last year in the third quarter. So it's a great business. Those margins will improve, but day one from the backlog, they're slightly under segment margins.

Yes, I think that, David, we mentioned it just -- I mean, we talked a little bit about this, we're really expanding our diversification of customers. And so we're launching new business, like I said, with Geely and Volvo, and Audi and Mercedes. And so as we're launching these business, even though they're great performing -- performance from a profitability standpoint, there is some time element here as we start to work the programs, and we work and build relationships with these customers. So we're building a great diversification of customer base than launching some great products that are profitable, but not at the historical rate of what you've seen.

Yes, I think it's important that, that slide or that graph, if you will, is meant to depict the implications of those items against the baseline of 14.4% margins. And that is great business. It just happens to be 12% as opposed to 14%.

Understood. And it piqued my interest, you were speaking about inventory earlier and some of the production choppiness, product changes. How do you feel your inventory levels are both on your balance sheet versus the inventory levels at your customers today for your products?

One, there was a significant cut like you said, and some of that was timed, so we can actually adjust quicker. In some cases, it was intermittent and quick. And so our inventory levels right now is something that we're attacking very aggressively. In some cases, we're protecting our customers because of launches that are going to occur over the next 3 to 4 weeks or occurring right now. So we have held some excess inventory to protect their launches. In other cases, we're taking much more aggressive steps because of how quickly they came at us. In some cases, like I mentioned, they're intermittent. And so there is commercial resolution and actions we have to take internally, but that's something we're attacking aggressively right now, David.

So there is an opportunity to work that down and you have a little bit too much inventory?

Yes.

Yes.

Yes, and historically, we do. The -- our year-end inventory is typically the lowest inventory level we have because we have a chance to adjust down inventory levels given the Christmas downtime and whatever. So that is a historical fact that inventory levels at the end of the year is at the lowest point of the year.

The next question comes from the line of David Leiker with Baird.

Just 1 question. I'm looking at Slide 8 for your E-Systems launches, and I think they're like 12 launches on there. Almost all of them have wire harnesses and about half of them have something more than a wire harness. Can you give us any characterization of how that mix might look in terms of your contract wins in your booking business? How much of your new wins are something more than a wire harness?

Right now, what we're looking at is -- and I could give a backlog update, but just -- the wins are heavier in electronics given our book of business today. And so electronics, we're looking at the range of 35% to 40% of the business we're winning is in electronics.

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

I know you talked a little bit about the free cash flow and some of the timing this year. I guess, I just wanted to relate that back to your downturn free cash flow analysis because -- and whether the sort of the experience you've seen here at the end of the year sort of changes that at all? Because I think in that scenario, right, you sort of showed a like down 10% globally, $300 million lower operating income, about $400 million lower free cash flow. We didn't get anything sort of -- if we annualize it, we don't get anything close to that, but it does seem to be well in excess of that. So is it really all timing? Or have you learned anything else in terms of how the business will react?

Again, I think that we're trying to paint a picture within a defined period of time, as of the end of December. And the customer payment terms, the timing of customer payments all gets equalized over time. And as a result, no, I don't see any major change in the business associated with working capital. Over the long haul, I do see it and that's what we're indicating, as of 12/31, given that, yes, there is going to be see some implications as of that date, but on a long-term basis no major change at all to the company ability to generate a significant amount of free cash flow.

The next question comes from the line of Anthony Deem of Longbow Research.

Just a quick question on your capital allocation priorities. I'm wondering what your appetite for share repurchase is at these levels or with group valuations reset materially lower? Is Lear prioritizing M&A or share buyback?

So I went through the priorities. Our first priority is invest in the business for profitable growth. Second, obviously, is M&A. And then the last one is returning excess cash to our shareholders. And as we look at the valuation right now of Lear, I mean, obviously, we'll have meetings with our Board of Directors even -- as soon as November, and so we'll discuss those type of things. But as far as our priorities go, our priorities have remained very consistent and those are our priorities.

Yes, and I'll add one thing and gets back to the questions that we've had on free cash flow. We feel extremely confident in our ability to generate significant amount of free cash flow. And as a result of that and as a result of what we've seen in our share price and our evaluation, we were opportunistic in the quarter, and we elevated our share buyback as a result.

And I had just one last question. We've heard of week-to-week incremental customer order cuts from other suppliers throughout the third quarter. And it sounds like through October here, you're trending near the high end of your expectations, but -- obviously, lowered expectation. But I'm wondering if you're seeing incremental week-to-week order cuts happening in October? I assume you saw in the third quarter as well.

Yes. Well, Monday is always the start of it. It seems recently, every Monday we come in, there has been changes to the schedules. And I know how you described what's been going on as a greased pig, but yes, we've seen those cuts and I think that's one reason why we've been, con -- not conservative, but looked at everything and looked at what the customers are doing, inventory levels, the days on hands, what's going on with the releases, what even most recently historically that's changed, to really look at the guidance going forward in the fourth quarter.

Can I ask one more follow-up there? I assume that's mainly China and Europe, just wondering if there's any incremental customer order cuts in North America too?

It's been primarily China and Europe. Yes, that's a good way of categorizing it. Yes, it's been China and Europe.

And our final question comes from the line of Chris McNally with Evercore.

I'm going to try to re-ask -- I know everyone's asking the same question over and over again. But maybe from a qualitative standpoint, listening to the call and discuss the electrical margin outlook, I've written down, I think, you said 5 headwinds: 3 from China production; China customer mix, 3 01; the fourth, you mentioned WLTP to customers this year; then the fifth, you discussed some of the higher margin business either rolling off or lower production and then the headwind of new backlog rolling on. With -- I know you restricted how you're going to talk about 2019. But can you just sort of rank order those in terms of which is dragging the margins down the most? Q3 is down about 200 basis points year-over-year.

Well, I think that -- let me think about that a second. I would say in terms of ranking, the volume declines on our more mature key platforms by far was the biggest impact. The significance of the declines on some of those key platforms they were very significant. I would say that not necessarily next, but the Focus build-out in North America, that was a pretty significant program for us in North America. And then I would say that the impact of some of the European OEMs and specifically, European OEMs where we have T and C business was also very significant. But I would say key platforms, primarily in China. Europe -- North America Focus and European customers/Ts and Cs business.

And I do want to point this out as a one-timer, but we continue to invest like we said, we -- our investment in electronics was up year-over-year, quarter-by-quarter. So that was a factor within the quarter. And there is smaller issues, there is a lot of supply issues relative to some chip manufacturers that are having trouble supplying parts, that was disruptive in the quarter. But I think just looking at, if you want to say prioritizing it, those would be the big issues.

Okay. I mean, that's really helpful. I think, because one of the questions that people will probably continue to ask post the call is, if you look at the margins of 12%, 13% or 12.5% in -- basically implied in the second half and talking about sort of this, I think, new norm for 2019, when we look at those 4, you would think the Focus build-out, less year-over-year WLTP, is obviously not going to be as much of a headwind in 2019. And then, obviously, there is a low visibility around this, the key platforms in China. I think people are going to want to know, particularly, if China gets better, and that's a huge if, as you mentioned, could we reverse some of that downward move that we've seen in second half?

Yes, I think there's a lot of factors. And I think, the way we look at, in the current production, in macroeconomic environment that we're in today, we believe in the near term to mid-term, E-System should perform at or around 12% to 13% annual margins. And there is a lot of factors that will persuade that and -- just like you mentioned. I mean, if China snaps back, that's not what we're looking at, we're looking at what we see right now, that would be a big factor for us, absolutely. If some of these volume -- or some of the volumes go up relative to some of the products that we're producing that are accretive to margins, that's a bit snap back. It's a pretty sensitive range when you talk about E-Systems given the size and the quarter. So it doesn't take much to move it either, both up and down. And I think that's something -- in the big picture, we're doing everything that is right for the long-term and building that business and not looking at it specifically in a quarter, we're looking at much longer-term what that business can do, and we're very optimistic on where that business is going.

Okay, that's great. And so essentially the 14% type margins that you talked about for the medium term in your previous targets, that assumes that clearly probably that number one, the platforms and the growth in some of the key growth markets comes back and some of your backlog margins actually mature. Is that a good way to think about the bridge between the near-term and sort of the 14%?

Yes, that's the great way of looking at it.

Okay. Well, I think probably the only people left on the call right now are the Lear employees, and I just want to say a few things. One, I want to thank you for all your hard work. Right now, there are some challenges in front of us, but I can tell you, I've never been more excited because this is -- we know how to operate in these type of the conditions. And we've built a team, and I know the team and how well we can -- things that we can do in this situation. We've put the operational excellence and the manufacturing plants in place. We've invested in this business over the last 10 years. We have 2 great business segments and businesses that are running extremely well. And I just want you to know that I'm excited, I'm looking forward to what we can do because I know without a doubt we can separate ourselves from our competitors. Our competitors are having some serious issues with launches. We don't have that. And we're built for success right now. So thank you for everything you're doing, and I'm looking forward to what we're going to do in the future.

Thank you. That concludes the conference call. You may now disconnect.