Lear Corp Q2 FY2020 Earnings Call

Good morning and welcome to the Lear Corporation Second Quarter Earnings Call. All participants will be in listen-only mode. After today’s presentation, there will be an opportunity to ask questions. Please note this event is being recorded. And now, I would like to turn the conference over to Alicia Davis, Senior Vice President, Corporate Development and Investor Relations. Please go ahead.

Thanks, Paul. Good morning everyone, and thanks for joining us for Lear's second quarter 2020 earnings call. Presenting today are Ray Scott, Lear's President and CEO; and Jason Cardew, Senior Vice President and CFO. Other members of Lear’s senior management team including Frank Orsini, President of our Seating Divisions; and Carl Esposito, President of our E-Systems Division also have joined us on the call. Following prepared remarks, we will open the call for Q&A. You can find a copy of 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 review highlights from the quarter and provide a business update. Jason will then review our second quarter financial results and the key factors impacting the second half of 2020. Finally, Ray will offer some concluding remarks. Following the formal presentation, we would be happy to take your questions. Now I'd like to invite Ray to begin.

Thanks, Alicia. Good morning everyone. I’ll be proud to begin the formal presentation and take a moment to say that I hope everyone is staying safe and healthy. Our thoughts and prayers are with all those who have been impacted by COVID-19. Now if you could please turn to Slide 5, which provides some news and business highlights. The second quarter was among the most challenging in Lear’s history. Our financial results were significantly impacted by the COVID-19 pandemic, which resulted in extended production shutdowns and a 46% year-over-year decline in global vehicle production for the quarter. Despite the challenging environment, we successfully executed on the near-term priorities we set forth on our first quarter earnings call. We demonstrated both our financial strength and resilience of our business model. We safely and effectively restarted operations, maintained ample liquidity, effectively managed costs, and continued to position the Company to take advantage of growth opportunities. We had another quarter of strong business wins, including additional Conquest business in Seating. I am very proud of what the Lear team accomplished. During the quarter, we received a PACE Award for Xevo Market, a testament to our regulation and industry leadership. I am also proud of the fact that Lear was named GM Supplier of the Year for the 19th time in the third consecutive year, and we continue to be recognized by many of our customers for safety and quality. As we discussed last quarter, we developed the safe work playbook, which provides a standardized approach to safely operate our facilities and includes health and safety information related to plant operating protocols, employee education, and facility assessments. On April 6th, we published a playbook on our website. It has been downloaded almost 35,000 times and the response from our customers as well as manufacturing and non-manufacturing firms around the world has been overwhelming. We are particularly proud that we have played a role in helping keep people safe around the globe. I want to take a moment now to discuss an important new initiative at Lear. I have been deeply affected, on a personal level, by the recent events that have highlighted the ongoing racial injustice in our society, and I am not alone. It has affected the entire Lear family. At Lear, we have a long-standing commitment to a workplace that is diverse, equitable, and inclusive. However, following these troubling events, we knew we had to do more. So, building on our strong foundations in diversity, equity, and inclusion, we launched the drive, educate, fund initiative. Through this initiative, Lear will drive change by developing impactful ways to help end racial injustice in society, educate by accelerating our in-house training to ensure that we as an organization continue to foster diversity, equity, and inclusion within our own community, and fund by providing both financial and non-financial resources to nonprofits devoted to achieving racial equity. As a team, we are committed to helping drive change in this important area. Now, if you could please turn to Slide 6. During the quarter, our business was impacted by production shutdowns in our two major markets, North America and Europe. Almost all of Lear's operations outside of China were closed for all of April and a portion of May. After manufacturing restrictions were eased, we concentrated our efforts on safely and efficiently restarting operations. As production resumed, our plants came back online gradually, and we saw weekly improvements in capacity, utilization, and business performance. Then in June, we reached a turning point; we started the month at similar levels to May, but by the end of the month, most of our plants in our major markets were operating at or near pre-COVID levels. Slide 7 provides an update on the Seating business. In Seating, we achieved solid growth over market of 3 percentage points. Our solid growth over market was driven in part by strong performance of the key platforms in North America including GM’s full size trucks and Mercedes and Ford SUVs. In addition, we enjoy a strong market position in luxury brands in China, and the premium market outperformed the overall market in China during the quarter. Detrimental margins year-over-year were 20%, despite significant incremental costs in the quarter. Our ability to flex our cost structure in the current volume environment and aggressively manage variable costs and overhead lessened the financial impacts of the severe production disruptions we experienced, which allowed us to continue investing in the business during the downturn. Now I want to provide an update on the innovation efforts in Seating. We have made investments in technology that enable us to grow and capture market share. We have used our unique capabilities in seating engineering, design, and electronics to create a broad portfolio of innovative solutions, featuring intelligent seats of the future. Two examples of our advanced product technologies include the Intu intelligent seating system that provides advanced solutions for wellness, comfort, sound, and safety, and ConfigurE+, a PACE award-winning patented state-of-the-art rail system that is configurable, electrified, and ideal for shared mobility applications. Even though the Intu technologies are still in the early stages of development, we have been awarded three advanced technology production contracts and have ten engineering development programs underway with seven different global OEMs. We are very encouraged by these development programs because such programs often lead to production awards in the future. ConfigurE+ is also in the early stages, but we have achieved some commercial success. It is slated to launch with two global automakers in 2021 and 2023. Just two years ago, this technology was in development, and now we expect to generate more than $100 million of annual revenue by the year 2023. We're very excited about the opportunities here because we believe there will be a number of fast followers as other customers adopt the technology as we move toward production. We believe we will be able to continue to increase our market share in Seating not only because of our quality and operational excellence, but also because of our unique ability to innovate and offer creative value-enhancing solutions to our customers. In the second quarter, we again achieved significant new business wins, including conquest wins. On our last earnings call, we announced that we had almost $500 million of conquest awards in the first quarter. In the second quarter, we secured an additional $200 million in net conquest awards. I'm very proud of what the team accomplished, as we continue to focus on quality, execution, and driving value for our customers. Slide 8 provides an E-Systems business update. During the second quarter, E-Systems achieved growth over market of 11 percentage points. The strong growth over market was driven by a combination of launching products in our electrification portfolio, strong volume on the Ford F-Series Super Duty, and our position with luxury brands in China. We’re beginning to see the benefits of our growing electrification portfolio and the increased diversification of our customer base. To better align our operations with the production environment, we accelerated restructuring actions during the quarter. We optimized global capacity and our footprint through plant consolidations and other repositioning actions, particularly in Asia. Through these actions, we were able to lower our cost structure, driving improved margins, and positioning ourselves for future growth. During the quarter, we continued to focus on electrification and connectivity with approximately 40% of our year-to-date awards coming in these two high-growth business areas. As we've discussed previously, increased vertical integration in our wire harness business is a key component of E-Systems' improvement plan, and our efforts have been very successful thus far, as we have exceeded our internal targets in this area. Year-to-date, we have vertically integrated approximately $50 million of previously external purchases, with 80% of these products launching by the year 2021. This success is helping drive margin improvement in E-Systems segments. Now please turn to Slide 9. On our second quarter 2019 earnings call, we laid out a detailed plan to improve E-Systems performance and position it for profitable growth. We intended to provide a comprehensive review of E-Systems business and strategy at our Investor Day, which was scheduled for June 9th. We unfortunately had to postpone Investor Day because of COVID-19. So, we thought it was important to provide a brief update on the improvement plan and describe E-Systems' strategic direction on today's earnings call. Over the past year, we have successfully executed our improvement plan. We have built a strong management team, stabilized the business, restructured operations to better align capacity with production volumes, and improve visibility in profitability by customer, product, and region. We've improved margins on existing businesses through customer negotiations and cost optimization. We continue to make strategic and highly targeted investments in fast-growing industry segments where we can earn returns that exceed our cost of capital. And we are aligning our product portfolio to industry megatrends by accelerating expansions of our terminals connections business, increasing vertical integration, and expanding our footprint in high-growth businesses with a focus on electric vehicles, 5G connectivity, and software. We have conducted an extensive study of the markets in which we participate. We examined the competitive dynamics, growth prospects, and the future architecture of the products we supply. As Slide 9 demonstrates, we have expertise in complete vehicle architecture. We are narrowing our electronic product portfolio to those areas where we can leverage our expertise in electrical distribution systems, body electronics, and vehicle architecture, thus allowing us to make selected value-creating investments. We're focusing our product segments where we believe we can be most competitive, such as battery charging power management with electrification, where we have demonstrated that we can be successful, and in areas like software that enables us to move beyond being a component specialist to heavy systems and domain expertise. We believe pursuing these very targeted areas of business will allow us to leverage synergies and drive further margin improvement. And now, I'd like to invite Jason to review our second quarter financial results.

Thanks Ray. Slide 11 shows vehicle production and key exchange rates for the second quarter. In the quarter, global vehicle production was down 9.9 million units or 46% compared to 2019, as the industry was significantly impacted by extended shutdowns related to the COVID-19 pandemic. The majority of the production declines occurred in North America and Europe, where production was down 69% and 63% respectively, as plant operations in these regions were closed for all of April and a portion of May. When they restarted, there was a gradual ramp-up of production over several weeks. These two regions normally account for over 75% of Lear sales. Global production declines on a Lear sales weighted basis were approximately 55%. Industry production in China recovered in the second quarter, growing by 7% year-over-year. From a currency standpoint, all major currencies weakened against the U.S. dollar compared to last year. Slide 12 highlights Lear's growth over market in the second quarter. Sales grew above market in both Seating and E-Systems as well as in each of our major markets. Total company growth over market was 5%, with E-Systems at 11% and Seating at 3%. Growth over market in North America of 6% reflected the strong performance of GM full-size trucks, the Ford Explorer, and Mercedes SUVs. China's 8% growth over market reflected strong relative demand for luxury vehicles that benefited both Seating and E-Systems. Slide 13 highlights our financial results in the second quarter which was significantly impacted by the COVID-19 pandemic. For the quarter, sales were $2.4 billion, down 2.6 billion or 51% from last year. The decline was driven primarily by lower production in all major markets, except for China. We did see a meaningful ramp-up in sales in the last few weeks of June, and as a result, our financial performance in the quarter was better than expected. Adjusted operating losses were $248 million, compared to core operating earnings of $352 million in 2019. The decline in core operating earnings from a year ago reflects a significant decrease in sales as well as incremental costs associated with the restart of production and operating plants in the current environment. I'll provide more detail on both these incremental costs as well as the actions that we have taken to offset their impacts later in the presentation. Second quarter free cash flow was negative $611 million compared to $268 million in 2019. Negative free cash flow reflects lower earnings and higher working capital related to the restart of production, partially offset by lower capital expenditures. We expect that the working capital will decline in the second half of the year and be a source of cash flows. Slide 14 explains the second quarter year-over-year variance in sales and adjusted earnings in the Seating segment. Sales in the quarter were $1.8 million, down 54% from the second quarter of 2019. Seating adjusted operating losses were $102 million compared to adjusted earnings of $315 million last year, reflecting lower volumes and net COVID-related costs. Slide 15 provides the second quarter year-over-year sales and adjusted earnings walk for E-Systems segments. Sales in the second quarter were $690 million, down 41% from the second quarter of 2019. E-Systems adjusted operating losses were $91 million. Adjusted earnings declined from last year due to lower industry volumes and COVID-related costs. Please turn to Slide 16 where I will describe in more detail how COVID-19 has increased our operating costs as well as the actions we took to mitigate the impact on our financial results. In the second quarter, we faced significant non-recurring costs related to setting up our plants for safe production. The biggest cost headwind we faced in the quarter were semi-fixed labor costs. In certain locations, we were obligated to continue to pay some of our employees while they weren't working. This occurred in the first quarter in China as well. While a portion of these costs are offset by local government incentives, the net impact was significant. Inefficiencies at our plants as they restarted operations also drove higher costs during the quarter. There were other costs that impacted us in the second quarter that we expect to continue for the foreseeable future. These costs include personal protective equipment and other costs associated with lower plant efficiencies due to social distancing protocols we have put in place. Consistent with our expectations, we incurred incremental costs related to COVID-19 in the first half of the year of approximately $150 million, net of customer reimbursements for certain of these costs. Now that our production is running closer to pre-COVID levels, we expect the net costs going forward to be considerably lower in the second half of the year. As we noted on our last earnings call, we took aggressive actions to offset these additional costs with programs that were designed to carefully balance the need to reduce costs while also protecting our world-class operating performance and the longer-term value creation potential of both our business segments. Our cost reduction plans, which were split into three distinct phases to provide flexibility, were designed to operate in an environment where revenue was down 25% to 30%. As industry conditions continue to improve, we will reverse some of the non-return spending reductions that we've put in place. Likewise, if industry conditions worsen, we'll implement additional cost reduction actions to preserve our liquidity and protect the enterprise. Slide 17 highlights assumptions that are driving our expectations for the second half of the year. While our visibility is somewhat limited under the current circumstances, we wanted to provide some insight into how we are thinking about the rest of the year. The situation is still very fluid. The number of increasing COVID infections and the potential for additional shutdowns could have a significant impact on our financial results. Other factors that could impact the second half include the underlying mix of production, changes in foreign exchange rates, and ongoing customer demand. IHS is projecting global industry production to decline by 11% in the second half compared to 2019. Given the uncertainty surrounding the COVID-19 pandemic and the possibilities for government-mandated shutdowns, our internal projections are based on a range of 10% to 15% for production declines. Our production estimate also reflects uncertainty with respect to consumer demand given the challenging economic environment. Despite the significant drop in revenue in the second quarter, detrimental margins improved somewhat on a sequential basis to 23% from 25% in the first quarter. Looking ahead to the second half of the year, we expect detrimental margins to improve further to about 20%, with the fourth quarter anticipated to be better than the third quarter. Factors driving the improvement in detrimental include one-time production ramp-up costs that will not reoccur, higher production volumes, and the continued benefit from cost reduction programs. Detrimental margins in the fourth quarter will also benefit from the non-reoccurrence of the GM strike. For the full year, we expect detrimental margins to come in at approximately 23%, consistent with our prior public comments. Looking at our margin performance on a sequential basis, we expect incremental margins to be above 20% for the third quarter. Restructuring costs for the remainder of the year are expected to be relatively consistent with our first half run rate, as we continue to realign our manufacturing capacity with industry demands. We expect free cash flow to turn positive in the third quarter and expect additional sequential improvements in the fourth quarter, reflecting our working capital. Capital expenditures are expected to increase in the back half of the year to support new programs coming online in the second half of 2020 and throughout 2021. Please turn to Slide 18 where I will discuss our financial position. Lear entered the pandemic with a strong balance sheet and ample liquidity. As a result, we didn't need to raise additional funding or seek covenant relief when the auto industry shut down for two months earlier this year. In today's uncertain economic environment, it is critical to have ample liquidity in case production is impacted again or if industry conditions worsen. At the same time, it’s equally important to have the wherewithal to continue to invest in the business to further improve our competitive position and create long-term value for all stakeholders. While the second quarter was among the most challenging we have ever faced, we ended the quarter with $2.5 billion in total liquidity, a low-cost flexible debt structure, and no significant near-term debt maturities. We have investment grade credit ratings from all three rating agencies, and Fitch recently initiated Lear with a BBB rating in July and Moody's affirmed Lear's investment grade rating in June. Our capital allocation plan remains unchanged. Our first priority remains investing in our core businesses through capital expenditures. We'll consider both acquisitions but believe our businesses are well positioned in and out looking for any transformational M&A, and we remain fully committed to maintaining investment grade credit metrics. We have been consistent in our commitments to returning excess cash to shareholders and look forward to continuing discussions with the board about restarting these programs once we have greater certainty regarding the sustainability of our cash flows. Now, I’ll turn it back to Ray for some closing thoughts.

Thanks Jason. Now turning to Slide 20. In summary, the second quarter was among the most challenging in our history. Our solid performance in the quarter demonstrated resilience in our financial strength in the face of the previously unimaginable scenario, involving a global shutdown, leading to a 50% decline in revenue in the midst of the pandemic, with many of our employees working remotely. Never in the history of the automotive industry have we seen nearly simultaneous relaunch of plants around the world following an extended shutdown with extensive new health and safety protocols in place. I usually close earnings calls with a thank you to the Lear team after the Q&A is done, but I think it's important I take time now while everyone is still on the line to say thank you to the team. I cannot ask for more talented, committed, or loyal teams. What we have accomplished is incredible, and I'm extremely proud of how we are performing during this trying time. When the crisis began, we focused on three near-term priorities: ensuring the health and safety of our employees, preserving liquidity, and aligning our operations and strategic priorities with industry changes. Over the last few months, the team has worked tirelessly to implement the necessary protocols to safely and efficiently restart operations, effectively manage our costs, preserve Lear’s financial flexibility, and position the Company to continue to take advantage of growth opportunities. We have now transitioned into the second stage of our COVID-19 response. The economic environment remains highly uncertain, and we do not know exactly how the pandemic will continue to affect our industry. However, with today's challenge comes opportunity. This crisis has brought clarity about what matters in our business as it relates to our strategy, competitive positioning, product portfolio, our cost structure, operations, and our team. We are committed to executing against our strategic goals while balancing short-term challenges with long-term priorities. We will continue to make targeted strategic investments that position Lear for continued market leadership and drive long-term value for our shareholders. And with that, we would be happy to take your questions.

We will now begin the question-and-answer session. Our first question today will come from Joseph Spak with RBC Capital Markets. Please go ahead.

First question is. Maybe you could talk a little bit more about the 8% margin commentary, excluding COVID? Is that just backing out some of the volume impact you associated with it as well as the cost in each of the segments?

Yes, Joe, that's exactly right. It's the net COVID costs that we talked about impacting both segments as well as just adjusting for volume, and the way we measured as we looked at what we were anticipating in terms of revenue in the quarter prior to COVID, when we set guidance at the beginning of the year, relative to where it came out and the way we've measured that.

And then as we think about each of the segments headed to the back half of the year, in Seating, is that right levels, that 8% level to think about, especially since you're lapping the GM strike in the fourth quarter? And then E-Systems, you talked about showing improvement going back to the back half of last year, and you mentioned some of these systems initiatives today. Should we think about 8% as the new sustainable target here as volume stabilizes for that segment?

I think, ultimately, it’s really a question of where volumes stabilize. We have seen an improvement in production rates, heading into the third quarter in July; we’re around 90%. Now, that's still a 10% difference from our historical run rates. If you just look at the math on that, the variable margins in Seating at 20% and E-Systems at 30% trim about 135 basis points off the seating margins and about 250 basis points off the E-Systems margin, so at a 10% lower volume overall. I think that's probably sort of the right starting point, as we look to the third quarter. Now, if the volume environment improves, and it's down less than 10%, then I would see upside to those numbers. If the volumes were flat year-over-year, then I think you've got the right idea on where we would end up, but I'm a little ways away from that, and there's still a great deal of strain in the whole supply chain right now. In particular, if you look at what's happening in Mexico, where you're not able to have the full complement of employees in the plant yet. There's still a reasonable risk of disruption that could impact that. So, even if the demand is there and the OEMs are trying to replenish inventory levels, it's uncertain whether they're going to be able to continue running at the rate they want to throughout the quarter. If that all works out, then certainly we would be back on track in terms of three operating margins for the business, but I think the volumes will be a little bit lower than what you're suggesting there, Joe.

Maybe I could just sneak one last one in. I know that your businesses are just in time, but did you see any of your customers take a little bit of excess inventory to gauge against any supply disruptions?

No, I think the initial wave was just filling the pipeline and getting inventories back to a level where we could resume production. I am not really seeing any buildup of inventory at all.

Our next question will come from Rod Lache with Wolfe Research. Please go ahead.

Two topics, one is just electrification, obviously, it is inflecting in terms of demand and also awards. Can you just give us a little bit of an updated view on what you currently expect growth of the market to be for E-Systems and the impact of electrification? And when you say that you're focusing on a few specific products within that, what is the content per vehicle associated with that?

So in terms of growth over market, Rod, we're still expecting six points plus in E-Systems, and that really is underpinned by the growth potential in electrification and connectivity. We have 450 million in new business awards in those categories last year. 600 million of a 900 million backlog that we had announced in January was in electrification and connectivity. Even though the quoting activity slowed down a little bit in the first half of the year because of COVID, we still had 170 million in awards in that space. We see a tremendous growth opportunity. The two biggest areas of growth within electrification for us are really high-voltage wiring and connection systems, and then onboard chargers and battery management systems. Those are sorts of, if you had to split the portfolio, it's nearly 50-50 between those two categories. That's where we're winning business today, that's what we're rolling on in the backlog, and we see great potential with both those sub-segments of electrification heading out over the next several years.

Yes. I think just to add a little bit to that, Rod, why I think we're so optimistic and positive about the future growth prospects with E-Systems is that we talked a lot about being customer-centric with maybe one or two major customers. The need to really differentiate our customer base, and COVID, obviously, one benefit is we talked to our customers quite a bit. I talked to them quite frequently on everything that's going on with respect to what they see as far as current volume, long-term, and even their product portfolio and some of the opportunities for investment. We built up that customer base. We talked about the need to invest with those customers. With Audi, Jag Land Rover, Geely, and Volvo, we are investing in those companies and those customers over the last several years. Those are starting to gain traction and present growth opportunities. So, I'm positive regarding our growth and our ability to grow within electrification, because one, I’m hearing it from our customers, the need that they're looking for our products, but the actual awards that we're getting within that area.

Just to clarify, I know you've said before that you have about $500 of content or addressable content in internal combustion. When you look at high voltage systems, wiring terminals, connectors, and chargers, what does that come up to?

Yes, I would say on the low-voltage side, it's more like $700 would be the average globally, with North America being a little bit higher, Asia being a little bit lower. And on the high-voltage side, in the areas that we're participating, we've got $1500 to $2000 of content opportunity per vehicle.

Okay. And just lastly, could you clarify, I believe at Slide 16, when you put $130 million on the right, it includes both non-recurring and ongoing costs. What is the ongoing component, and how should we be thinking about that? Is that just more or less to offset the incremental COVID-related costs? Or are you actually coming up with additional cost savings that would allow you to get to these margins, or long-term margin targets at lower levels of revenue?

Yes, so I would say 75% of that $130 million is in the non-recurring categories of salary deferrals and pay cuts, the lower incentives caps, and temporary reductions in discretionary spending. The other 25% is recurring, and the biggest driver of that is we've increased our restructuring investment by about $50 million this year, and we expect to see about $40 million of savings from that as I look out for next year. That investing is in two areas; one, lowering our SG&A costs. We've done a lot of work in that area over the years, but we found an opportunity to lower costs at some of the administrative functions, centralizing some functions in lower cost regions, reducing headcount, and doing this on a more permanent basis in program management and sales to realign to the lower volume environment. On the manufacturing side, there are really two areas of emphasis: one is getting the footprint right in Asia and E-Systems. We're closing three facilities over the next six to nine months to better align our footprint with the business there, improving the cost structure and capacity utilization. Then on the Seating side, there are a couple of facilities that we're going to close in North America to improve an already strong footprint here. So, you take those pieces together, it's about a quarter of that cost reduction program we see continuing and helping offset both the ongoing costs of operating in this post-COVID-19 environment and ultimately helping offset some of the impact of the lower volumes.

Our next question will come from John Murphy with Bank of America. Please go ahead.

Good morning, everyone. First, good morning, Ray. My first question is about the North American content number, which was 528 this quarter, representing a 20% year-over-year increase, showing strong performance. I understand that the mix has contributed to this, but I would like you to clarify how much of this growth is due to the mix versus new business wins. Looking ahead to the second half of the year, with the anniversary of the GM strike in the fourth quarter and the launch of GM's SUVs, I expect there could be an improvement in that CPV number as we progress. What are your thoughts on that number for the latter half of the year? Additionally, how sustainable do you believe this number is?

Yes, starting with the second quarter, really, it was driven by the strong mix in the region that was the biggest factor. Also, last year, Ford was going through a changeover in the Explorer, and GM was finishing up their changeover on K2 to T1 on the pickup side. We benefitted from relatively strong volumes on those platforms compared to the market. If we look out for the second half of this year, we do expect our growth over market to continue, not nearly at the sort of 6% sales weighted adjusted basis that we enjoyed in the first half or maybe a little bit less than that. Again, underpinned by the same thing that you described there, John, in terms of the strong mix in North America being particularly strong and weighted towards trucks and SUVs, where we have a lot of content and a good book of business. We also see the luxury market in China continuing to do well into the third quarter. We saw that in the first quarter and again in the second quarter where luxury sort of outperformed the broader market, and both our business segments were overweight luxury, and maybe more so in Seating and E-Systems both of which segments benefit from that.

Okay, that's incredibly helpful. And then just a second question around these Conquest wins in Seating. I think you said they were 500 million in the first quarter and 200 million in the second quarter. Just curious how fast those roll on? Are they faster than your typical new business wins because they're conquest? I mean, just how do those work? And how do those roll on over time?

Those are more traditional in that it's three to four years out.

Okay, gotcha. And just lastly, you talked a lot about M&A opportunities on the E-Systems side. But is there anything that you're seeing on the Seating side that would either be a tech acquisition or vertical integration or anything that you might do on the Seating side or M&A?

We look at all kinds of different things, but there's really nothing of any significance on the Seating side. There may be some smaller type of opportunities that might make sense for us to stabilize some of our businesses, but they're smaller.

Our next question will come from David Kelly with Jeffries. Please go ahead.

Hey, good morning, guys. Appreciate you taking my questions. And appreciate the breakout of segment level net COVID cost. I'm just curious how you see the moderation cadence there impacting the second half? Or are you expecting more steady PPE-related costs and efficiencies through the fourth quarter? Or is this more of a wind down with a greater impact expected in the third quarter here?

Yes. The costs were disproportionately in the second quarter. The biggest piece of that was the semi-fixed labor costs due to contractual or statutory requirements to pay employees that weren't working, plus the ramp-up production. We’re largely through that unless, of course, there’s another wave of shutdowns. So that was the vast majority of the cost; about 80% of the costs were non-recurring and in that category. The other 20% include the PPE cost, and some ongoing inefficiencies that we're going to see because of social distancing in the plants and having to make some modifications to our processes. We see those costs continuing into the second half of the year, sort of at a $25 million a quarter rate. Just like anything else, like commodities or foreign exchange or inflation, that’s going to be part of our commercial discussions with our customers. We’re working collaboratively with them to try and find offsets, and when appropriate include that in the cost models going forward. I think it's reasonable to assume that we can offset or pass through about half of that, but that will be applicable across the board, not just in the second half of the year, but likely into next year as well.

And then maybe switching gears, you’ve referenced expected CapEx uptick in the second half. Can you just talk about what you're seeing as it relates to planned customer launches in the back half of the year? Are you seeing any significant delays or cancellations?

No, we're not seeing any major cancellations, just some small delays. Some of these are directly related to the downtime we experienced due to COVID, but there are no significant program delays or cancellations.

And most of that we saw in advance of the first quarter earnings call when we talked about a sort of a shifting of a month or two, but there's nothing new since then.

Our next question will come from James Picariello with KeyBanc Capital Markets. Please go ahead.

Just going back to the restructuring savings and what are the permanent actions. I thought the last break you guys provided was maybe 60 million in incremental savings for this year with an additional 15 million for next year. Is that 60 million now 40 for 2021?

Yes, in the first quarter, we adjusted our initial $100 million investment in restructuring to achieve more savings this year. As a result of some plant closures I've mentioned, we anticipate a higher level of savings next year than we did three months ago.

But would those savings be in addition to your normalized incremental margin or would this help offset the uptick in engineering spend and spillover from PPE costs and the like?

That’s difficult to sort of bucket that. It's an incremental savings that we will enjoy next year. We haven't done our 2021 plan, and it’s obviously a better way to try and guide to next year. We're still trying to work our way through the balance of this year, but it will be a benefit to next year. As I mentioned a minute ago, we do expect to see some ongoing costs related to PPE that will linger into next year as well as some inefficiencies. You have some pluses and minuses heading into next year that are sort of unique outside of what we've described in the past in terms of just sort of our goal to have a net performance positive where we're funding our customer pricing each year and then the incremental investments that we may have for engineering to fund the backlog that's rolling on. Those would be independent of the more recent developments.

That one, like I said, we're really excited with what we've been able to achieve in such a short period of time. To answer your question, it’s a number of different engineered components, including T's and C's. Those are legacy programs or programs that are in production today. So, when we described our ability to go after the vertical integration, the harness itself is probably 60% of the overall cost and 35% to 40% would make up these engineered components. We have a right to play, and it's an opportunity for us to increase our margin. When we set out, it was more on just programs that are in production. We have a much higher number internally that we're tracking that we can go after. The early indications on how successful we were, so quickly were surprising. Those are current programs. Now, I will say this, and I think I said it before, those types of programs we have to validate, we have to test, we have to get approval. That can range from any timeframe from six months to a year or longer, but boy did they do a nice job of accelerating those things, getting those parts approved quickly, and getting them vertically integrated into our harnesses. The longer duration of time takes will take place when we have a program that we're engineering. We've reached out to a number of customers, and I’m going to tell you that the early feedback from our customers has been overwhelmingly positive. There are programs we're discussing right now that are in development that we can replace components either directed components from our customer or engineered components outside of Lear’s engineered portfolio. Two things are going on: one, the ability to quickly get at what is the legacy program or current program surprisingly quick, and where are we getting great traction right now; two is the amazing feedback we've gotten from our customers when you have a full-service type capability where you can source it yourselves and the flexibility that we're allowing our customers to create value. Those things are going extremely well, and we talked about those being a key to continue improving our margin within our E-Systems business.

Our next question will come from Brian Johnson with Barclays. Please go ahead.

Hi, team. This is Jason Store on for Brian. I appreciate all the color today. The new initiatives in E-Systems, I was hoping to maybe drill in a little bit on electrification. I guess one question, as we think about win rates in 2019, which I think you've mentioned was around 40%. How does that compare to your win rate in the first half of this year? And I guess, as we go out to 2022 and 2023 timeframe, does that business approaches near $1 billion? Given your win rates, are your ambitions to perhaps be a number three or even number two player in high voltage electrification because it seems like if those continued, that might imply that?

Yes, well, first of all, yes, we do target to be in the top three. That's one thing that when we did this extensive study of our product portfolio, we mentioned it as an 18-month project where we really went into detail about our ability and our right to play within a product segment. What type of market share do we believe we could capture? Can we obviously outgrow the market but also get really good returns? We have set internal targets where we want to be in a position to be one of the top three players. We looked at where we wanted to emphasize our investment and focused on the areas of growth, where we do believe we've been very successful. I think it's important to note as I mentioned earlier, E-Systems was primarily two customers of ours and we talked about the need to diversify our customer base. That is so important and we have incredibly strong relationships with our customers. We've extended to Audi, Volkswagen, Jag Land Rover, Geely, and Volvo, and their platforms are starting to build momentum with growth. Our investments were the right things to do over time. Even though we had to sacrifice margin, we had to build up our reputation and our ability to supply high-quality components and products. That’s really starting to set the seeds for growth. Yes, we are targeting to be in a position to be one of the top players.

Understood. That's very, very helpful. And then maybe just following along a similar theme, in Seating, I know there's been a lot of discussion around Conquest wins in the first half of this year, which has been very constructive for shareholders of Lear. Should we think about any incumbent business that you may have lost as well as the Conquest business that you've won? Or are we really talking about the shared win rate here, exceeding your current market share such that there might be some upside to proceeding growth in three to five-year time frame?

Yes, one, we said net new business awards. We’ve selectively chosen not to aggressively go after certain businesses or for reasons that logistically or just competitively don’t make sense for us. So yes, we consider everything when we talk about Conquest wins, and the way we look at our backlog is net new business awards. We've been successful within Conquest wins, but there are others that we don't think fit with our strategy long-term. We’re comfortable with our growth over market in that area, and we have done a nice job gaining market share from 18% to 23% during a time when there was a lot of irrational players out there that positioned us well today. We have an incredibly recognized team and incredible talent. That’s very important and it’s also important when going through a crisis like this. Then operational excellence – we’ve been investing in that business for 10 plus years, making targeted investments that create a moat around our ability to execute our products. We are recognized for quality by our customers, and that process takes time. Lastly, we embed technology into our seat systems, and that’s exactly what we’re doing. We have capabilities for these systems and our manufacturing within Seating allows us to embed technologies that create value for customers. We position ourselves in a way with operational excellence and technology to differentiate ourselves, and that's why we've been successful.

Our next question will come from Emmanuel Rosner with Deutsche Bank. Please go ahead.

I wanted to just follow up on the free cash flow outlook for the rest of the year. Could you give us some early sense of how much of the working capital drag you think you would be able to recapture in the back half? And I guess overall, very encouraging that you expect positive cash flow in the third quarter and substantially in the fourth quarter? Any early sense on whether on a full year basis that would enable you to be free cash flow positive?

Yes, so in regards to the third quarter, we expect to be sort of working capital neutral, maybe slightly positive. Our outlook for production and earnings generation will lead to cash flow in the quarter. In the fourth quarter, we see most, if not all, of the working capital use from the second quarter reversing itself and benefiting the fourth quarter. In terms of whether we can be free cash flow neutral or positive for the full year, ultimately, that's going to depend on the level of production in the second half and the timing of that production. If that production ramps up in the last couple of weeks like we saw in the second quarter, that revenue will be sitting in receivables and collected down the road 30 to 45 days; it could weigh on that working capital opportunity I just described. However, in a 20% revenue decline for the full year, we expect to approach free cash flow positive or neutral. The better end of that range would align with revenue down roughly 20% year-over-year and give us a reasonable chance of getting back to that.

Okay, that's great color. And I guess secondly, focusing on your outlook for second half growth over market, I was hoping to focus on the backlog outlook for the second half. Obviously, you had three bros above market this quarter despite a negative backlog. How should we think about – what does the backlog look like in the second half?

Yes, so the backlog was pretty weak for the first half of the year and negative in the second quarter. That was a function of the business that rolled-off and then seeing some delays and programs rolling-on at lower volumes. The second half backlog is considerably stronger. We're expecting somewhere between $500 and $600 million of full-year backlog, and the vast majority of that is going to hit in the second half of the year. That will be a significant factor in the growth over market where the first half was more driven by mix than anything else.

Any breakdown by segments that you could provide?

In terms of the relative breakdown for the second half of the year, it will be more focused on E-Systems due to their size within the company today. In absolute dollar terms, Seating will constitute a larger portion. However, we anticipate stronger growth from the backlog in E-Systems during the second half. This growth will largely come from electrification platforms, including electric chargers and other products expected to progress in the latter half of the year.

And the next question will come from Chris McNally with Evercore. Please go ahead.

If we just put together the couple of different points you've made on marginal over the course of the conference call. If we look at the underlying that you're calling out for both Seating and E-Systems being 8%, obviously, there’s puts and takes to next year. But is it fair to say that once we are at either pre-COVID revenue levels or maybe just global production that is pretty close to pre-COVID, that 8% is sort of a margin level that you would hope to achieve? It may take some time with one or two years, but the underlying unit cost comes back once we hit that revenue level?

Yes, I think I'm seeing that that's definitely the case in E-Systems. The other factor is to think about is the mix of whether that revenue comes back by production volumes or whether it’s backlog. Typically, you've got this detrimental margin, variable margin on the lower volumes at 30% and then you're rolling on backlog since segment margin, let’s say, 8% to 12%. You can see a little bit of dilution as a result of that. So, it depends on how the mix of revenue shakes out looking out into the future. But generally speaking, as volumes get back to 2019 levels then what we said is in Seating. We're comfortable with the long-term margin range of 7.5% and 8.5%. That’s where we've run this business for the most part of the last five years. In E-Systems, we still see a longer-term trajectory toward 10%. It’s sort of troughing in the middle of last year at 7.6% and we've been working our way up after this COVID setback. We still are on our way toward driving that incremental margin improvement over the next several years.

Okay, that's really helpful. And then just on a shorter term basis, you gave incremental margin from Q2 to Q3, and I think you mentioned in the 20% plus range. That's very helpful, obviously, maybe we're in this COVID environment with extra cost for longer than we realize. Is that sort of low to mid-twenties, all things being equal as production gets better? Can we use that as a sort of a sequential incremental margin or at least a rule of thumb or just a checkmark to kind of keep the quarterly numbers, as you think about the next four to six quarters?

To the extent that revenue increase is driven by volume recovering, yes, that's a good number to use. The other factor is to think about in the third quarter, you had the weakening recently of the U.S dollar. We may see a revenue tailwind in Q3 and Q4, but it's going to roll on our European segment margins overall. Call it 5% or so in today's volume environment. That will be a little bit diluted to that sequential, incremental margin. The other factor is whether that revenue comes back by volume or again by backlog and so there's the sequential incremental margins vary depending on the mix of volume versus backlog as well.

Great. If I can sneak in one quick second one on E-Systems, you've had great success with some of the big customers in Europe. Without even giving any names, could you please talk about whether you've made any progress with some of these super early stage start-ups that may not have huge volumes, but predominantly in North America, where we're seeing a lot of activity in launches? Has that business been awarded for their electrical?

We've had some good conversations, but nothing of significance that we would report as far as backlog. We're having good dialogues and discussions, so we remain cautiously optimistic, but a lot more work is needed there, good conversations.

And the next question will come from Itay Michaeli with Citi. Please go ahead.

I was hoping you can share on a total company basis what Lear’s net new business wins look like in the first half of this year relative to the first half of last year? Just maybe, Ray, how you're thinking about growth over market longer term for the Company? I think back in 2018, it was about five points over market at the Investor Day: how do you think about that in light of some of the Conquest wins as well?

Yes, I think it's a little bit early to provide the full backlog update at this point, Itay. When we report Conquest wins, it is net of any losses. You can use that as a proxy for backlog and what’s just a bit unusual about the last 12 months is the extent of backlog we're seeing come through Conquest where historically, it was more about customers introducing a new program and winning your share of that. I think it points to some market share opportunities in seating beyond what we anticipated. We had an ambitious target of going from a 23% to 28% market share, and I think this helps us get there. If we achieve that, it helps us get to the four to five points above market targeted growth opportunity we've talked about in Seating. In E-Systems, more of the new business wins are coming in electrification and connectivity, so it's not a lot of Conquest because this is new content to the market, and that's the biggest driver of the business we're winning right now in E-Systems. Yes, to Jason's point, we're very comfortable. We haven't changed our numbers. I believe as we continue to be successful in our growth, our trajectory will still be on track to what we committed to, and I don't think there's anything in front of us right now that would tell us otherwise.

It’s very helpful. And just lastly, going back to the free cash flow discussion for the year, Jason, I was hoping you can share roughly what you think CapEx might come in 2020, and then given the new business progress, maybe directionally, how we should think about that in absolute terms or as a percentage of revenue over the next couple of years?

Yes, I think our original guidance this year was $600 million. We're targeting around $425 million of CapEx for the year at this stage with a heavy weighting to the second half of the year with Q2 being so low. I think sort of 3% of sales on a normalized basis is still a pretty good figure to use for the combined business going forward.

And our final question today will come from Armintas Sinkevicius with Morgan Stanley. Please go ahead.

Great. Thank you. Appreciate you taking the question. I'm just trying to think through how does Mexico look like? You have significant exposure. You mentioned that as something you're watching here into the back half. Could you provide us with how things have gone since reopening in mid-May and how they look now?

That's a good question. I think to quickly say we are pleasantly surprised overall with the performance in how we look at our business within our manufacturing facilities. It's gone extremely well. We do a nice job of being able to contact trace, minimize any type of exposure, stunted spread, and the number of issues that we have had have been external to our facilities. We haven’t gone through what I thought we'd see as a lot of stop-start, start-stops. It’s been relatively smooth from that perspective. Now on the supply side, we study both. We have detailed reviews of how each plant is doing internally at Lear. But on the supply-side, it’s gone extremely well, better than I expected, still somewhat fragile because all suppliers are not equal. We are seeing different locations that are having different types of hotspots or incurring significant increases in cases, even outside the manufacturing plants. Although we monitor our facilities very closely on a daily and weekly basis from an audit standpoint, we also keep a close eye on our suppliers. I would say that Mexico and I think I said it on the last call, Mexico unfortunately doesn’t, in some respects, possess the infrastructure that the U.S. might have. In some respects, they're probably six to eight weeks behind us. We have some concerns around the world in different pockets based on different information and intelligence we're gathering. Even though we're running well, we are pleasantly surprised at how well the overall supply chain is running, there's still pockets that we have a lot of concerns around, and we keep those under close monitoring to minimize any potential issues within our supply base. Overall, somewhat surprised at how well things are going but cautiously concerned.

And then the other question I have is around incremental margin. Once we get through COVID, you mentioned some of the detail around what the volume situation does with your margins. But once we get through this, should we be looking at this 20% to 30% variable margins for Seating and E-Systems? Or do these incremental margins start a bit slower as you're starting to put costs back in the system as volumes pick-up? If you could help us think through that? I know it's a little bit early to think that far ahead, but just conceptually when COVID does come under control.

Yes, I think if you get to a point where those incremental costs are behind you, then you can think about the incremental margins being more in line with the segment variable margins. Again, our discussion on the split of whether that revenue is coming back by production volumes or whether it’s backlog. Therefore, the incremental margin on variable margin on lower volumes at 30% would roll on backlog since the segment margin say 8% to 12%, and you can see a little bit of dilution as a result of that. So, it depends on how the mix of revenue shakes out looking out into the future. But generally speaking, as volumes get back to 2019 levels then what we said is in Seating. We're comfortable with the long-term margin range of 7.5% and 8.5%. That’s where we've run this business for the past five years. In E-Systems, we still see a longer-term trajectory toward 10%. It’s been troughing in the middle of last year at 7.6%, and we’ve been working our way up after the COVID setback and still probably on our way toward driving that incremental margin improvement over the next several years.

But no reason to think it'd be any different than your variable margin today?

The volume piece of it, no.

Great. Thank you for taking questions.

Thanks. The only ones left on the line at this time are Lear employees. As I said earlier, thank you for everything you've done. It’s been absolutely impressive. I appreciate all the great work you've done; what we have accomplished is incredible. I'm extremely proud of how we're performing during this trying time. We have more work to do, but I appreciate everything you're going to do as we move forward and continue to separate ourselves. Thank you for everything you're doing.

The conference has concluded. Thank you for attending today's presentation. You may now disconnect your lines at this time.