Alicia Davis - Lear Corp. Raymond E. Scott - Lear Corp. Jeffrey H. Vanneste - Lear Corp..

Armintas Sinkevicius - Morgan Stanley & Co. LLC Itay Michaeli - Citigroup Global Markets, Inc. John Murphy - Bank of America Merrill Lynch Colin Langan - UBS Securities LLC Rod Lache - Wolfe Research, LLC David Tamberrino - Goldman Sachs & Co. LLC David Leiker - Robert W. Baird & Co., Inc.

Joseph Spak - RBC Capital Markets LLC Anthony Deem - Longbow Research LLC Chris McNally - Evercore ISI.

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. 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%.

At 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 year-over-year.

Unfavorable industry conditions impacted the results in Seating negatively as well, but doing things like targeting cost reductions helped us offset these factors and expand operating margins year-over-year. I am 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 large part to macroeconomic conditions outlined on slide 6.

With 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 think 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 are launching a significant number of new programs. Slides 7 and 8 highlight some of our key launches in Seating and E-Systems. We're 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 the 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 two 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 most 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 three quarters of 2019, with eight 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 what we were expecting at the beginning of 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 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 a strong 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 above 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 a 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 two-thirds 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 impact 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 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's July second half estimates.

From an FX perspective, all major currencies have weakened versus the U.S. dollar. We are forecasting an 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 China's 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 $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 continue 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 two 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 allowed 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 have mentioned before, we are quoting significant business in these areas. We're also well-positioned to take advantage of increased shared mobility via our intelligent seating capabilities that allow for the seat for reconfigurability, personalized heating 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, start-ups, 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 a 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 did pursue strategic M&A opportunities that allow us to enhance our capabilities and strengthen our market position. Finally, we return 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 in innovation and technologies and two business segments that are perfectly aligned with industry megatrends. 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, and achieving profitable growth. And now with that, I'd like to turn it over for your questions..

Our first question comes from the line of Armintas with Morgan Stanley..

Good morning. Thank you for taking the question.

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 your conversations with the local regulators around the potential for stimulus as we think about 2019?.

Yeah, that'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 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 some 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 2019, at our conference you mentioned some of the transitions with the Ford Explorer, the K2XX/T1XX transition 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 2019? Just some high level puts and takes there..

Yeah. We'll provide more color when we release our 2019 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 of 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 at something like $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 T1XX.

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 into 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 2018 and 2019, suggesting that 2018 really didn't have a significant impact on the tariffs because – or the inflationary impact of the tariffs on steel, because we had purchased our complete steel requirement for 2018 in November of 2017, so when prices – the pre-inflationary 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 two together, as you look at 2019 as it relates to what we're seeing right now in steel and what we're seeing as potential tariffs, I put the impact to the overall business next year on company margins of about 10% to 15% (sic) [10 to 15 basis points].

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 it's not 10% to 15%....

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

Okay. Yeah, that's helpful. Well, great. Thank you. Thank you for taking the questions..

Your next question comes from the line of Itay Michaeli with Citi..

Great. Thank you. Good morning, everyone..

Good morning..

Good morning. 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 changers or that not yet reflects some of the pressures we've seen in the second half of 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 we've mentioned this before. What's exciting is specifically in Seating, it's 90% of our backlog is on these CUV/SUV crossover. So, it's perfectly aligned with some of the trends we're seeing as we move from past cars to more the CUV/SUV. So, some of them are the hot products that there's a demand for..

Absolutely. That's very clear. And then just on the fourth quarter outlook, just want to make sure I can kind of square your guidance with IHS. You could 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 finds 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. Thanks for that. And then just lastly, I want to touch on free cash flow and particularly the working capital component of the guide-down. I think typically in the past sometimes when supplier revenue comes under pressure, working capital could become a source of cash.

Maybe you could walk us through that a little bit in kind of how to think about that into next year as well..

Yeah. So, there's a few key things 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 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 always see some timing issues related to the end of our quarter. We saw that this time.

But also in the quarter, we have some new payment terms with some of our customers that have affected the timing of when we would 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, 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, 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 longwinded way of saying that we're very confident in our full year free cash flow guidance and what it will take in the fourth quarter to get there..

That's very helpful. Thank you for all that detail..

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

Hey, John..

Good morning, guys. 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 and IHS numbers or estimates in the fourth quarter and going into 2019? It seems like the world is shifting faster than IHS can keep up with, 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 to the end of the year. We have our own internal conversations with the customers. 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 a slippery pig is a very vivid image in understanding how this works. So appreciate that. Really does actually help..

Permission to use it..

Yeah, you might be in a title someday. But the second question is, as we look at page 11 and 12 on E-Systems and Seating walks year-over-year, you have volume and mix as negative to revenue. But also, particularly on E-Systems I think it was 150 basis points, if I'm looking at my notes correctly, negative volume and mix and on Seating was negative 40.

Is there a way to parse out in that op margin decline or should I just 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 that 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 buildout 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-Systems segment, we were disproportionately impacted on our T's and C's business, which carries – given the investment thesis there, carries with it a higher margin benefit.

So, we were disproportionately impacted in Europe there on T's and C's. So, that's kind of the 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, 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's a time element here as we build the profitability back up on those programs. And 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. 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 2017. But it sounds like you're indicating there might be some pressure from steel going forward in 2019 as you're working through 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, 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, 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 2018 to 2019 is 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.

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 were not necessarily on a 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, recovery program from the customer.

So, of that 3 billion pound buy, we're only exposed at roughly 10%, and we're trying to further mitigate or increase that coverage of customers by getting on some steel buy programs that we're not currently on. So the impact that I've referred to is really on that 10-or-less percent of our exposure..

And just 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 costs 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's 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 source and 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 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 getting out in front of them and saying, listen, heading into 2019, 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 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 to go there, if we look at 2019, just hold everything else equal and just say the backlog grows on, revenue is up $1.4 billion, I mean, should we see sort of that same kind of increase next year on a linear basis or are the reasons that 2019 sort of on incremental margin and realizations 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 initially thought.

But what we said in the beginning of 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 this deal that we secured 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 in – 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 gets 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-Systems.

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 Ray's 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 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 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 than what you saw in 2018? Or do you think that there's still kind of the same kind of pressures that 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 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, getting through this WLTP that disproportionately affected T's and C business and the margins in that segment as well further grow. So, I mean, there is a pathway to improve margins.

But as we look at it today, given kind of the industry (00:46:24), I think we'll be in that 12% to 13% range at 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's going to be more electronics, electrification, connectivity programs, which command a higher margins, we should see, mathematically, margins continue to improve..

Yeah, 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 it's 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 just the profile, but company relative to E-Systems and Seating, which is great, but the profile with the electrical and electronics.

And we're really taken off when we look at the electronics, but that's the investment, but that's also the growth engine with 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 if you could remind us..

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

Yeah. Yeah..

64% in Seating. And our current mix of business is like 75/25, so that gets to Ray's point that we're going faster in E-Systems..

Okay, great. Thank you very much, guys. Hope you to catch the slippery pig..

Thank you..

Thanks..

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

Great. Thanks for taking my question. I think John already covered this, but make sure my math is enough. 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 had some level of tailwind there, about 20 basis points of what we've seen 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 that 12% to the 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 the commodity, maybe launch costs into next year putting a risk? I mean, any guidance there?.

Yeah, Colin, I think that 8% range is more of 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 want that everyone understand that cadence.

But, yeah, on an annual basis, that margin is 8%..

Yeah. And I think just to add a color 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 an annual view.

And again, 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 one more percent, I mean, how should we sort of gauge that if we see weakness in the quarter for the overall market?.

Yeah. I guess, we 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 outpacing the market. And so, the way we look at it is, there's the industry or China and then there's these 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 and where those product placements are, what's the growth, what do they look like as far as demand.

And so, even though – and Jeff alluded to it and talked about it – there's IHS, we study a lot of different things relative to volumes and what's going to happen, not just in the fourth quarter, but heading into next year.

And we're excited because, one, we're a 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 the Audi and other programs that we're going to launch cadence with..

Got it. All right. Thanks for taking my questions..

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

Hi, everybody..

Hey, Rod.

How are you doing?.

I just was 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 a fair amount of downtime this year as well..

Rod, 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, I mean, it's not unlike a typical year that we have downtime, and we do. I mean, we've had it this year. We had it 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 this to you, Rod, with respect to the first and second quarter. In the first quarter, there's eight weeks of known customer downtime, four of which relate to couple of GM pickup and SUV plants going down, and the other four relate 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 three 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..

Yeah..

But, again, the thing, Rod, is that we'll have the GLE up and running; we'll have the Blazer up and running; we'll have 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 full run rates heading into the first quarter and second quarter..

Okay. Yeah. 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 two GM plants go down this year.

You've got two – actually one, the heavy duty is going down in the middle of the year, and then it's not till 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 give much more information at that time..

Okay. You're giving 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 backlog. You typically do 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 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, I think, an 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....

Look, again, Rod, we're going to come out with....

I know you're not saying what guidance is – right..

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

Okay. And your....

Yeah. And then, Rod, I don't think – Rod, there's 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 them 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 based on some of the things you hinted at, just the differences in terms that you've got with customers and you also alluded to restructuring this year.

As 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's any cause for alarm that all of a sudden that there's this sudden change in the ability to generate significant cash flow.

I think we will continue to generate significant cash flow, the earnings power and the cash generation power of the business is not changing, in our opinion it has 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..

A lot of times these customer payment are onetime events. You deal with it, and then that's the new norm, if you will. It doesn't mean that we're not getting paid. It means that when 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 extrapolate prospectively? Okay. All right. Thank you..

Thanks, Rod..

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

Yeah. We got two simple questions for you. E-Systems backlog revenue up $155 million, margin's 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?.

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

Yeah..

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

Yeah, here's the story in that. So, we've 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 onboard, that $155 million came onboard 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 great business. Those margins will improve. But day one from the backlog, they're slightly under segment margins..

Okay..

Yeah. I think that, David, we mentioned 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 performance from a profitability standpoint, there's 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 and launching some great products that are profitable, but not at the historical rate of what you've seen..

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

Understood. And piqued my interest, you were speaking about inventory earlier and some of the production chop and sporadic 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 three to four 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's commercial resolution and the 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..

Yeah. And historically we do. 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..

Understood. All right. Thank you, gentlemen..

Yeah. Thanks, David..

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

Good morning. Just one question. I'm looking at slide 8 for your E-Systems launches, and I think there are 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 – your booking business? How much of your new wins are something more than a wire harness?.

Yeah. Right now, what we're looking at is – and then I can 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..

Okay. All right. That's all. Thanks so much..

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

Thanks. 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 of free cash flow analysis because – and what is 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 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 really 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 and timing 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 – yeah, there is going to be some implications as of that date, but on a long-term basis, no major change at all to the company ability to generate significant amount of free cash flow..

Okay. Thank you..

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

Hi. Good morning..

Hey. Good morning..

I just had 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 over share buyback..

So, I went through the priorities. Our first priority is to 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..

Yeah. 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 valuation, we were opportunistic in the quarter and we elevated our share buyback as a result..

Thank you. And then 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 expectations.

But I'm wondering if you're seeing incremental week-to-week order cuts happening on October. I assume you saw that in the third quarter as well. Thank you..

Yeah. Well, Monday is always the start of it, and it seems recently every Monday we come in, there's been changes to the schedules. And I know how you described what's been going on as a greased pig.

But, yeah, we've seen those cuts and I think that's one reason why we've been – not conservative, but looked at everything and looked at what the customers are doing, inventory levels, days on hands, what's going on with the releases, what even most recently historically has changed to really look at the guidance going forward in the fourth quarter..

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

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

Thank you..

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

Thanks so much, guys. I'm going to try to rehash, because 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've said five headwinds, three from China production, China customer mix, Section 301.

The fourth you mentioned WLTP, two 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.

I know you're restricted how you want 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 built-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 the European OEMs where we have T&C business was also very significant.

But I would say key platforms, primarily China, Europe, North America-focused, and European customer/T's and C's business..

And I want to point this out as a one timer, but we continue to invest. Like we said, our investment in electronics was up year-over-year quarter-by-quarter. So, that was a factor within the quarter. And there's smaller issues. There's a lot of supply issues relative to some chip manufacturers.

They're 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% to 13% or 12.5% basically implied in the second half and talking about sort of this as a new norm for 2019, when we look at those four, 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's 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?.

Yeah, I think there's a lot of factors, and I think the way we look at it, in the current production and macroeconomic environment that we're in today, we believe in the near term to midterm, E-Systems should perform at or around 12% to 13% annual margins, and there's a lot of factors that will persuade that, 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. Some of the volumes go up relative to some of the products that we're producing that are accretive to margins, that's a big snapback.

It's a pretty sensitive range when you talk about E-Systems, given the size in a 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 in building that business.

And not looking at it specifically in a quarter, we're looking at a 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 this near term and sort of the 14%?.

Yeah, that's a great way of looking at it..

Okay. Thanks so much, guys..

Thanks. 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 have never been more excited, because this is – we know how to operate in these type of conditions. And we've built a team and I know the team and how well we can – the things that we can do in this situation.

We've put the operational excellence and the manufacturing plants in place. We've been best in this business over the last 10 years. We have two 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 this conference call. You may now disconnect..