Good morning, and welcome to the Lear Corporation second quarter earnings conference call. All participants will be in a listen-only mode. Should you need assistance, please signal a conference specialist by pressing the star key followed by zero. After today's presentation, there will be an opportunity to ask questions. Please note this event is being recorded. I would now like to turn the conference over to Ed Lowenfeld, Vice President of Investor Relations. Please go ahead.
Thanks, Matt. Good morning, everyone, and thanks for joining us for Lear's second quarter 2022 earnings call. Presenting today are Ray Scott, Lear President and CEO, and Jason Cardew, Senior Vice President and CFO. Other members of Lear's senior management team have also joined us on the call. Following prepared remarks, we will open up the call for Q&A. You can find a copy of the presentation that accompanies these remarks at ir.lear.com. 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 two, our actual results could differ materially from these forward-looking statements due to many factors discussed in our latest Form 10-Q 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 three. Jason will begin by reviewing our second quarter financial results and our full year 2022 outlook. Ray will then provide a business update highlighting the industry environment and the steps we are taking to position Lear for success. Following the formal presentation, we'd be happy to take your questions. Now I'd like to invite Jason to begin.
Thanks, Ed, and good morning, everyone. Please turn to slide five, where I will provide a brief overview of our second quarter financial results and other recent company highlights. In a second quarter with ongoing COVID and semiconductor disruptions, cost inflation and a strengthening dollar, the Lear team posted solid results which exceeded our expectations. Sales were $5.1 billion, and core operating earnings were $187 million. Despite lower production volumes than the first quarter, total company operating income and margins improved sequentially. During the second quarter, we returned almost $100 million in cash to shareholders through dividends and share repurchases. Looking forward, we continue to win new business in both business segments with key wins in the quarter, including an electrification award and Connection Systems in North America and multiple awards with domestic OEMs in China in both Seating and E-Systems.
We are continuing to take steps to reduce costs and improve our manufacturing flexibility. Ray and I will both cover this topic in more detail later in the presentation. At the same time, we continue to invest in our core product lines and our manufacturing capabilities to strengthen the business. In May, we announced a definitive agreement to acquire IGB, a leading German supplier of automotive seat heating, ventilation, active cooling, and steering wheel heating. This acquisition, once completed, will expand Lear's product capabilities in active cooling and complement existing offerings in specialized thermal comfort seating solutions that improve vehicle performance and packaging. Our growing expertise in thermal comfort has already resulted in JIT seating contracts that allow Lear to direct the sourcing of these components, and we expect this trend to continue as we design and engineer a more efficient system that reduces complexity and total cost.
Our customers continue to recognize Lear for outstanding quality at our manufacturing plants in both business segments. Over the last three months, we won the Best Supplier in Quality award from Stellantis, as well as multiple plant quality awards from GM and Ford. We released our 2021 sustainability report during the second quarter, highlighting progress on our renewable energy strategy, innovative green products, supplier sustainability, and diversity, equity, and inclusion efforts. Slide six shows vehicle production and key exchange rates for the second quarter. Global production was up 1% compared to Q2 2021, and up approximately 2% on a Lear sales-weighted basis. Volumes in North America were up 12%, while industry production in Europe decreased 5% compared to 2021. COVID-related production shutdowns led to volumes that were 3% lower in China.
From a currency standpoint, the U.S. dollar significantly strengthened against the euro and, to a lesser extent, the RMB compared to 2021. Slide seven highlights Lear's growth over market. For the second quarter, total company growth over market was 6 percentage points, driven primarily by the impact of new business in both segments, with Seating growing 6 percentage points above market and E-Systems growing 5 percentage points above market. Growth over market in North America of 3 percentage points reflected the benefit of new business in both segments, as well as strong volumes on key Lear platforms such as Ford's Explorer and Escape, the Chevrolet Equinox and GMC Terrain, the Hyundai Tucson, and the Chevrolet Colorado and GMC Canyon. In Europe, growth over market was 16 points, driven primarily by strong performance on platforms from Mercedes, Nissan, and Stellantis in Seating and Ford, BMW, and JLR in E-Systems.
In addition, new business was strong in both segments, particularly with Mercedes and BMW. Our China business lagged industry growth by 8 percentage points due to unfavorable platform mix driven by customer production disruptions from government-mandated COVID lockdowns in both segments, which disproportionately impacted the global OEMs. The E-Systems growth over market in China was slightly positive as our strong backlog more than offset the unfavorable platform mix. Slide 8 explains the variance in sales and adjusted operating margins in the seating segment. Sales for the second quarter were $3.9 billion, an increase of $266 million or 7% from 2021, driven primarily by our strong backlog and an increase in volumes on their platforms. Excluding the impact of commodities, foreign exchange and acquisitions, sales were up 8%.
Core operating earnings were $233 million, down $29 million from 2021, and adjusted operating margins were 6%. The decline in margins reflected primarily higher commodity costs, partially offset by higher volumes on Lear platforms and our margin accretive backlog. As we previously communicated, the Kongsberg acquisition is slightly dilutive to current margins, but will be accretive to seating margins in the future as industry volumes improve and we implement our planned growth and cost synergies. Net performance was dilutive to margins, largely due to increased premium costs and higher labor costs that resulted from late notice, customer downtime and the extensive production disruptions in China. Slide nine explains the variance in sales and adjusted operating margins in the E-Systems segment. Sales for the second quarter were $1.2 billion, an increase of 4% from 2021.
Excluding the impact of foreign exchange and commodity cost pass-throughs, sales were up 5%, driven primarily by our backlog and higher volumes on key platforms. Core operating earnings were $24 million or 2% of sales, compared to $41 million and 3.5% of sales in 2021. The decline in margins reflected primarily higher commodity costs and the impact from the strengthening U.S. dollar, partially offset by higher volumes on Lear platforms and margin accretive backlog. The decline in net performance was driven primarily by an increase in premium costs. Excluding premium costs, net performance was positive in the quarter. Slide 10 illustrates our focus on driving operating efficiencies and increasing free cash flow generation in a challenging industry environment. We are working to optimize our footprint and remove any excess capacity while ensuring we can support higher volumes as the industry recovers.
We currently have enough capacity within our existing footprint to support our growing backlog as well as the projected growth in industry volumes over the next several years. We are focused on making our manufacturing footprint more flexible so we can improve efficiencies across both segments within specific regions. We are streamlining our portfolio to focus on our core product lines where we have a competitive advantage and see strong market growth. We are investing in key growth areas such as thermal comfort and Seating and Connection Systems in E-Systems. This focused product strategy will drive revenue growth and higher operating margins in both segments. Working closely with our customers, both business segments are aggressively targeting inventory reductions despite our expectation for continued production disruptions in the second half of this year.
We are also taking a clean sheet approach to our capital expenditure plan, where our footprint optimization will allow us to redeploy existing capital to support growing volumes and reduce the need for new manufacturing facilities to support our new business backlog. We anticipate that this approach will allow us to continue launching our near record backlog while maintaining capital spending near historical levels. Through these actions, we will improve our cash flow generation. Over the next two years, we expect to see our free cash flow conversion rates return to approximately 80%, an improvement from our more recent free cash flow conversion of 65%-70%. In the last two years, we saw opportunities and executed tuck-in acquisitions in Seating and E-Systems to expand our thermal comfort and engineered components capabilities.
We do not expect to execute any significant near-term acquisitions, allowing us to return more of the excess cash generated to shareholders. In the second quarter, we took advantage of the current market conditions and repurchased $50 million worth of shares. We've continued to repurchase shares into the third quarter. Now shifting to our 2022 outlook. Slide 11 provides global vehicle production volumes and currency assumptions that form the basis of our full-year outlook. At the midpoint of our guidance range, we assume that global industry production will be 3% higher than in 2021, in line with our prior outlook. We have reduced our outlook for North America and Europe while increasing the outlook in China. The high end of our outlook remains consistent with IHS's forecast for industry production of up 5% compared to 2021.
From a currency perspective, as the dollar continues to strengthen, we have updated our assumptions. Our 2022 outlook now assumes an average euro exchange rate of $1.06 per euro, driven by a second half assumption of $1.02 per euro. The RMB is expected to be an additional modest headwind as our assumption has changed from flat to down 2%. Slide 12 compares our second half outlook to our first half actual results for sales and core operating earnings. We are forecasting the midpoint of our second half sales outlook to be approximately $10.5 billion, up $242 million from our first half actual results, reflecting higher volumes, a full six months of Kongsberg results, and an increase in commodity pass-throughs, partially offset by changes in FX.
The midpoint of our second half operating income outlook is $494 million, an increase of $123 million from our first half actual results. The improvement in operating income reflects the expected impact from higher volumes and the combination of moderating commodity costs and increased customer pass-through agreements, partially offset by the change in FX rates. Slide 13 provides more detail on our current outlook. While we acknowledge that there remains macroeconomic uncertainty impacting our industry, our strong performance in the second quarter relative to our prior expectations, combined with actions we have taken to improve our cost structure, increases our confidence in our financial outlook. As such, we are maintaining our guidance at the midpoint of our prior range for net sales, core operating earnings, adjusted net income and free cash flow.
Now I'd like to turn the call over to Ray to provide an update on our view of the macro environment and the steps we're taking to prepare Lear to be successful in any scenario.
Thanks, Jason. Please turn to slide 15, which highlights key industry factors and how they might be impacted by macroeconomic and industry-specific conditions. Over the past few years, the automotive market has experienced significant volatility and recessionary industry volumes. Industry production is tracking below 80 million units for the third consecutive year, and for the last three years, production volumes have averaged 13% below pre-pandemic levels. We have been able to partially offset the impact to our business by improving efficiencies in both business segments and working in a collaborative way with our customers and suppliers. Cumulative total company net performance benefited margins by approximately 115 basis points over the past two years, which offset about two-thirds of the commodity headwinds over the same time frame. Looking forward, the industry should benefit from factors such as historically low inventories, an aging fleet, and pent-up demand.
At the same time, however, rising interest rates, inflationary pressures, and other factors are driving recession fears in the broader economy. While it's difficult to predict in the near term, we do know that the shape of the automotive industry recovery will impact industry volumes, commodity costs, supply constraints, and customer production schedules. A slower recovery could bring more stability to the industry as supply constraints are reduced and production schedules stabilize. As we have seen recently, a slowing global economy can have an immediate and significant impact on commodity costs. Whereas North American steel, for example, has declined by more than 50% from its peak, and copper has come down by more than 25%. We would expect oil costs to moderate in a recession, which could lead to lower costs for resin-based products and transportation.
In addition, we expect that our customers would use incentives to stimulate demand if industry conditions worsen. As we weigh these risks and opportunities, we continue to take aggressive steps to position Lear to manage in all scenarios and to improve our competitive position and financial performance. Turning to slide 16, I will describe our key areas of focus and how the actions we are taking are expected to improve profitability and shareholder returns. Since the beginning of the COVID pandemic in early 2020, we have been taking advantage of the downturn to focus and strengthen our product portfolio, our talent and our balance sheet. Over the past two years, we have continued to hone our strategy, which will position the business to generate increasing amounts of cash throughout the business cycle.
We're streamlining our product portfolio to align with our core strengths and are focusing our efforts where we can to add value for our customers. In Seating, we will leverage our growing thermal comfort capabilities to increase market share, improve profitability, and expand our competitive moat. In E-Systems, we are focused on increasing our market share in Connection Systems, battery disconnect units, and wiring to drive revenue growth and margin expansion. We are a leader in operational excellence, and we are leveraging these strengths to position the business to optimize performance. We have recently reduced non-manufacturing salaried headcount by approximately 3% and are identifying additional headcount in SG&A synergies across the two business segments that will further reduce costs. We have frozen salaried hiring except for very critical headcount related to particular projects.
The restructuring actions we are taking in our manufacturing operations will improve capacity utilization and flexibility. We are prioritizing capital spending and investing in Industry 4.0 actions to improve plant efficiencies. In addition to organic investments, we have made two small strategic acquisitions to accelerate our Industry 4.0 efforts. We acquired ASI a few years ago, and in May, we acquired Thagora, which will improve manufacturing operations through scalable, smart manufacturing tools. We returned all of our cash we generated in 2020 and 2021 to the shareholders. Going forward, we expect to continue to return a majority of our free cash flow to our shareholders. Both business segments are well-positioned, and we don't expect any significant acquisitions in the near term. We are concentrating our efforts on improving performance in any operating environment, increasing returns on capital and reducing enterprise risk.
In closing, I wanna thank the Lear team for their continued efforts and for delivering better results than expected this second quarter. Now we'd be happy to take your questions.
We will now begin the question-and-answer session. To ask a question, you may press star then one on your touch-tone phone. If you are using a speakerphone, please pick up your handset before pressing the keys.
To withdraw your question, please press star then two. At this time, we will pause momentarily to assemble our roster. Our first question will come from Joseph Spak with RBC Capital Markets. Please go ahead.
Thanks so much everyone for the update. Ray and Jason, you know, one thing we've heard through earnings season is a number of suppliers getting pricing or recoveries to help offset some of the cost pressures we've seen. I didn't hear you explicitly mention that. I was just wondering if that did help organic growth in the quarter, and if so, by how much, and what's the sort of expectation for the back half?
Yeah. Joe, we strip out commodity pass-throughs from our organic growth. When we talk about growth over market, that's not part of the equation. It was not a factor in our strong growth over market in the quarter.
Okay. Any recoveries for some of the non-commodity inflationary pressures?
Yeah. So, you know, we're on track with the plan that we had laid out on the prior earnings call. We have seen a modest increase in the gross impact, and we've seen a comparable increase in our recovery. The net impact we're expecting from commodities and inflation is still $155 million for the full year. Gross impact's now about $720 million, so up a little bit from what we talked about previously. In terms of the recovery rates for each of the categories, they're generally in line with our prior guidance overall. We are having pretty good success commercially. Ray, I don't know if you wanna add.
Yeah. I think I mentioned this before too. Last year was more of a negotiation by quarter and more of a temporary resolution. This year, as far as the collaboration, it's much more permanent and fixed within the price going forward. I think the success that we've had, and it differs by different area. If it's the sticky labor issue, which is one of the bigger issues that we're struggling with today with the intermittent downtime and start times of the different facilities or our different customers, we have different ways to resolve that. One is obviously we're getting paid for it in a different percentage of what the cost is.
Others, we are able to go and take some of the costs within our own control and derate our plants. That's one way we're solving that, but we have set precedents with the majority of our customers on how we're gonna handle that. We talked about transportation very similar. You know, there's a percentage of what we get recovered, and then what we do is work on different transportation lanes and reduce our costs or consolidate different components to reduce our costs. That's going well. I think generally, you know, we've done a nice job with some of the commodity cost increases across the board. Some of that's a lagging issue, but we've been successful. We are. It's a big focus. We've been focused on it for now two years.
De-risking the company is something that we take as a priority to make sure that we're getting the contracts updated to the increased cost pressures that we're seeing. Also balancing growth. I couldn't be more proud. You know, Jason mentioned earlier, you know, we had the highest level of our backlog during all these different negotiations. There's different ways you can handle it, and I know some of our competitors are talking about 100% recovery. I'll tell you, the majority of the customers are looking at a collaborative share agreement and working in a more cooperative way as opposed to 100% recovery. That's what we've been doing.
I'm very confident that we have all the pieces in place to continue successfully working with our customers and balancing not only the recovery but our growth profile going forward.
Okay. Thanks for that. Ray, just as a second question on your comments on the different, you know, scenarios that could play out, and obviously there's a lot of moving pieces here. Even if you look at, you know, your sort of recessionary scenario, you know, you have commodity costs, you know, coming down, supply constraints easing, you know, more stable production schedules. Obviously volume is a big factor, but as you mentioned, you know, there's some pretty low inventories and volumes are already at low levels. Is there a path here where even if in sort of this, you know, slower growth, environment, that margins actually hold up?
Yeah. I think, Joe, I've heard a lot of different definitions on what recession is, and I think I'm gonna stay with one I heard recently is, if you feel like you're in a recession, you're in a recession. I feel like we've been, particularly the supply base, has been in a recession for two years. Our biggest challenge has been what I referred to as the sticky labor, the intermittent downtime. When you have employees in a plant and you brought them into work, and then you have to send them home. If that issue recedes or dissipates, that's a significant, probably one of the biggest challenges we've had over the last two years. If transportation costs go down, and we're seeing that right now, and we're seeing improvements within our own facilities with labor.
I mean, we were struggling for the last two years with turnover, and we're starting to see that relatively flat to improving. That's something that's a positive sign. The commodity increases, and it's amazing how quickly that's turned around. You know, all these things that were significant headwinds become tailwinds. Yeah, I think even if volumes don't necessarily increase, but we have a more steady, stable environment with decreasing costs could significantly help our margin profile.
That.
Yep.
Our next question will come from Rod Lache with Wolfe Research. Please go ahead.
Good morning, everybody. Ray Scott, just following up on Joe's question on commodities and recoveries. It sounds like most of the year-over-year headwinds is now in the rearview mirror in Q1 and Q2. As things stand now, can you maybe just provide some color if we saw spot rates for steel and other commodities at current levels, how would things kind of flow through into next year?
Yeah, Rod, just starting with sort of the calendarization of the commodity impact. About 95% of the year-over-year impacts is in the first half, so just 5% in the second half, and in the fourth quarter, it should be slightly positive, year-over-year. Now, the benefit of the recent reduction in North America steel in particular and copper, globally, there will be a lag effect to that. We won't see much, until next year in terms of the benefit from that. You know, I think what you could expect over time is if you just look at the negative impact of those two commodities, you know, it was, the steel impacts $130 million net for between 2021 and 2022.
Now that's split between Europe and North America, and Europe's a little bit higher net impact than North America. As North America comes down, we would expect to see that hit that we took over the last two years unwind. Copper is a little less impactful. You know, it's about a $30 million cumulative impact over two years. If it comes back down to 2020 levels, you know, we would see about a $30 million benefit over time. You'd also see some margin benefit as the reversal of the pass-through of higher copper costs, you know, goes back in the other direction. You'd see revenues come down without an operating income reduction for that piece as well.
Are you still expecting that to flow through over the course of maybe two years?
Yeah. You know, in terms of the total impact, we haven't put a specific timeframe. I think we've talked about, you know, perhaps half of that unwinding over the next two years and the balance after that. I think, you know, if commodities were to remain elevated, that was sort of the basis of that comment. If commodities come down, then we could see more of that unwind sooner. That's certainly a possibility. I think there are portions of this that won't unwind, though. You know, higher utility costs, some of the higher component costs that are a result of inflationary increases in the supply base. I think any of the, you know, some of those labor-related inflationary increases may be a little stickier.
I'm not expecting all of that to come back, but I still think it's reasonable to assume that half of the $340 million comes back over the next two years.
Okay. Then I'm looking at the first half to second half bridge on slide 12, and was curious about how you're thinking about net performance from the first half to the second half, 'cause it looks like the incrementals are sort of in the high teens, similar to what we would typically see in seating. I didn't see anything explicitly listed here for performance. Maybe if you, as you're answering that, what are you hearing, if anything, just regarding European production in the back half, as obviously companies are kind of bracing for just some potential disruptions due to natural gas shortages.
Yeah. What we factored into the second half as we look at both businesses sequentially, the biggest driver is going to be volume, and it's more so in E-Systems than Seating. It's, you know, 50 basis points or so in Seating and 150 basis points of margin accretion in E-Systems in the second half of the year. That's because, you know, they were the E-Systems business was disproportionately impacted by some of the downtime in Europe and in China in the first half of the year. In E-Systems, Europe and China represent almost 60% of that business. In Seating, it's just a little bit more than 40%. That's part of the volume differential. Also, the backlog is more back-end loaded in E-Systems than in Seating.
It was a little bit more ratable across the quarters in Seating. That's you know embedded in that 150 basis points as well as the roll-on of the backlog in E-Systems. Commodities will be slightly positive. On the performance side, we are expecting a modest improvement, but offset by slightly higher engineering costs, and so that's sort of a wash as we look at you know first half to second half. Then FX has more of a negative impact on E-Systems than Seating, again, because more of their business and more of their profitability is in Europe and China combined, so they're more exposed to the strengthening U.S. dollar.
Great. Thanks for that. Just lastly, that comment you made on slide 16 about SG&A and overhead synergies between the segments. Is there just additional cost savings that you're alluding to, prospectively?
We took an action in the second quarter that will yield some improvement in SG&A both in the second half of this year and then on a full year basis next year. You know, roughly $35-$40 million in annual savings, with half of that hitting this year and then the balance next year. In addition to that, we do see other opportunities that we're exploring that will
Likely happen if at the tail end of this year or beginning of next year. Ray, I don't know if you want to talk about.
Yeah, I think, Rod, what we're fortunate and gonna take advantage of, the position we're in. We do have some opportunities to scale across both divisions in, you know, redefined in some respects, purchasing, engineering, logistics, even in finance and HR across the two different groups. We took the, what we'll call phase I steps, and then now we're looking at additional actions, administratively. I think more importantly, you know, what we've discovered, and I think we talked about in last call, is the ability because of our vertical integration in the nature of our business, not just necessarily being wiring or just JIT, the ability to, within certain regions, consolidate, manufacturing, products.
We are looking now in Mexico and Morocco at how we can consolidate if there is a continuation or a drop in volume, how we can consolidate quickly within our facilities to gain efficiencies. Even if volumes stay at a relative level at where they're at today or even go slightly up, we're still in a position to take those steps. I think administratively, yes, there's some actions that we can still take to you know, drive costs. But I think more importantly, what we're discovering is there's some flexibility in our manufacturing plants as we look at particular regions to consolidate different products within facilities within a region. We've done a little bit of that work already, kind of proved it out in South America.
Now we're looking at different areas, particularly Mexico and Morocco, to do some further consolidation and still have the capacity if volumes were to snap back and the luxury to supply our customers parts, but just drive more efficiencies within our manufacturing plants.
Thank you.
Next, Rod.
Our next question will come from Itay Michaeli with Citi. Please go ahead.
Great. Thanks. Good morning, everyone.
Morning.
Morning. Just go back to slide 12 and thanks for the second half bridge. How are you thinking about growth over market in the second half of the year? I mean, looks like the volume mix backlog implies about 5% growth relative to H1, with which, you know, sort of similar to I think what you're looking for for LVP second half of the year. Maybe just talk about the puts and takes of you know platform mix and how you think about GOM in H2.
Our growth over market performance in the first half was a little bit better than we expected, and particularly in Seating. I think we ended up at 5.5% in the first half. We do see that moderating a little bit in the second half. You know, we've continued to benefit from our strong portfolio with GM on the full-size trucks and then also luxury vehicles generally. I think that's been a factor, plus the backlog. In E-Systems, we had 3 percentage points of growth over market in the first half. We expect that to be about 2 percentage points in the second half, about 2.5 percentage points on a full year basis. Two things going on there.
One, we see the benefit of a stronger backlog in the second half of the year in E-Systems where, you know, roughly 2/3 of the backlog is in the second half. That's partially offset by some changeover activity on some key platforms, work that Ford's doing with the Expedition, Navigator and Super Duty that will impact volume in the fourth quarter on those platforms. That's kind of how we see growth over market shaping up. You know, it's about 4% total company full year is what we would expect, 3.5%-4%.
Great. That's very helpful. Just as a quick follow-up, apologies if I missed it earlier, any additional color, just the cadence of the second half Q3, Q4. The Q4 should have some benefit on commodities. Anything in terms of the kind of path, on the cadence between the two quarters?
Yeah. You know, as we've seen in the first half this year, you know, we performed a little bit better in terms of the timing of our commercial settlements that helped the first half. So that took a little bit of the, you know, improvement that we were expecting in the second half and pulled it ahead. You know, that's difficult to say exactly how it'll play out again in Q3 and Q4. But what I can say is that margins will be better if conditions and volumes hold up in the third quarter versus the second quarter, and then they'll be better again in the fourth versus the third.
In terms of order of magnitude, it's a bit difficult to call right now, but we would expect, you know, 100 basis points or more of margin improvement in E-Systems sequentially and a little less than that, probably half that in Seating, you know, from Q2 to Q3 as we sit here today.
Perfect. That's very helpful. Thank you.
Yep.
Our next question will come from Colin Langan with Wells Fargo. Please go ahead.
Take my question.
Hey, Colin.
I apologize if I missed this. If you actually slide twelve, sales is going up $240 million, operating income 120 first half to second half or something in that range. If you adjust for commodities, maybe that's a $35 million recovery. I'm looking at with like a 5% contribution margin, been adjusting commodity. What would drive that margin or what am I kind of missing in that math?
Well, sequentially, you know, there's pretty good conversion of volume on the additional sales. You know, what's going the other direction is foreign exchange, taking revenue down sequentially and the margin impact of that. You know, I think the conversion rates are generally in line with our typical variable margin on the volume component of that and our segment operating margins and the backlog component of that. Backlog is a meaningful portion of that $480 million revenue growth first half to second half in that first bar on the chart.
Okay, got it. I think in mid-June you'd got about $5.1 billion in sales, which you obviously hit, but a bit lower on operating income in the $170 million range. It actually seemed like there were more bad news ending the year than there was good news. What has driven this better performance, and are there just some of the customer recoveries coming through at the end of the quarter?
Yeah. The second quarter certainly turned out better than we had anticipated. I think when we provided an update at a conference in June, we talked about $170 million or so of operating income, maybe a little bit lower than that. We came in at $187 million, so you know, almost $20 million higher than we were seeing at that point in time. That really was a result of the timing of some of the commercial negotiations, particularly on the Seating side. Things that we had anticipated happening in the third quarter got pulled ahead to the second quarter. Mix worked in our favor a bit, as well, in Seating again, relative to what we were seeing at the time.
You know, those are the two factors that led to the outperformance from what we were previously expecting.
All right. Just lastly, M&A is a bit of a drag. I don't know, not too big of a surprise, but there's another thermal deal coming. Is that also gonna be a negative contributor? How long would it take to get these businesses to your normal level of profitability?
Yeah. It will be a similar drag. You know, some of the impact of Kongsberg this year is the integration costs. We have about $7 million of costs that, you know, we're investing to integrate those facilities and their operations more broadly into Lear. That reverses itself next year. It's we look out at 2024. At that point, it's in line or accretive to Seating margins with Kongsberg. With IGB, you know, I think it'd be a similar timeline. About two years post-acquisition, we would see that as being accretive to operating margins. One of the benefits of acquiring both is that there will be some synergies there between the businesses and with our existing operations as well.
You know, 2024, 2025, the combined business will be accretive to seating margins based on our plan.
Hey, Colin, just, I think it's important too, to mention the strategic positioning of those two acquisitions. Obviously we can and will continue with the great products that they manufacture today individually. What's been extremely exciting is the customer's response to those acquisitions. The combination, we've talked about it with thermal comfort, is the ability to really create a value proposition for our customers with a combination of lumbar and active cooling and heat. It's a unique position that we hold with the integration of these components into other seat components, such as the foam pad trim and the frame. We were recently awarded two seat programs, big seat programs.
One of the things that we were able to differentiate ourselves on this program and allow for, you know, us to be more efficient from a cost, weight, part number perspective, was the ultimate design, which is the combination of these components into a system or a module. We are getting overwhelmingly positive feedback from our customers. You know, individually, those two businesses and the synergies that those coming together will help drive our margins. What's more important about those acquisitions was the strategic position we're putting the company in. I'll tell you know, we've been with the customers. Frank and I have been flying out, meeting with all the customers at the highest levels, and it is overwhelmingly positive and it's differentiating us right now.
For the first time, we've seen our ability now to source, design, and engineer those components. The two major programs, and I think there's a third one on the way, hopefully soon, where we have full control. That's a significant shift in our customer's behavior as far as product sourcing. We can do that because we are lowering, it is more efficient cost. It's more efficient from time to station. We've been developing this system for, you know, well over eight years. The credibility of having these two powerful companies from a reputation perspective coming in, along with the engineering work that we did to integrate these into seat components, is differentiating our business. You know, our focus is 28% market share. I'll tell you, I'm very positive we keep this type of strategic differentiation.
It's gonna make the difference in us gaining that market share, and it's been overwhelming so far. I couldn't be more happy on where we're at. You know, we got some work to do in the short term to get these things accretive from a margin perspective, but long term, we're getting some real positive feedback.
Great. All right. Thanks for taking my question.
Yeah.
Thanks.
Our next question will come from John Murphy with Bank of America. Please go ahead.
Good morning, guys. Surprisingly, I have a follow-up on slide 15 and slide 12. I appreciate all the information and the answers so far. I was just curious if you can remind us, you know, where your target margins are for Seating and E-Systems. You know, as we look at this, I mean, I think what everybody's trying to get at is it seems like we're at the nadir or the low in margins and as volumes slowly recover and raws ease, we're already seeing some small explosion in your margins, you know, first half to second half. Over the coming sort of 12 to 24 months as things normalize to some extent, you might get a faster return to your target and normal.
I'm just curious if you can remind us where those margins are and if you really do believe, I think we're at this low in margins and you know, crawling out of the gutter and ultimately to these targets pretty quickly.
Yeah. I do see us sort of at trough margins, particularly on the E-Systems side. Seating has rebounded pretty quickly, already. In terms of the target margins for each of our segments, we've talked about 7.5%-8.5% in Seating. I think we are on a nice trajectory to get back into that range, you know, sooner rather than later. I think longer term, the points Ray just made on thermal comfort will allow us to perhaps reach the high end of that range above 8.5%. That's certainly our objective. With E-Systems, we've talked about, you know, structurally that's a 10% business in the right volume and commodity environment.
We're a ways off from that at this point, but as we look at volumes recovering, commodity costs moderating, stability in the production schedule, plus the things that we're doing to control our costs and drive growth with Connection Systems, you know, we do see margins recovering over the next two years in E-Systems, you know, sort of in that 7%-8% range, with some reasonable level of volume at that point in time. Now, that's a little bit lower than what we had expected in 2024, but you know, a lot has changed, you know, over the last two years, certainly.
I think it should be a nice, you know, steady, linear, you know, increase in that margin from where it's at now, through the second half improvement, into next year and then to 2024.
That's very helpful. Maybe then just a second question around volatility and schedules. I mean, you kind of mentioned it, but you know, how damaging has that been to margins here in the short run? Even without a significant recovery in volume, if you just got some you know, better stability in releases, you know, how helpful would that be to margins alone before we even start talking about volume recovery?
Yeah. It's almost $90 million of unrecovered costs that we have embedded in our outlook for this year, for those stop-start, and other premium costs. We have, you know, been in negotiations with our customers. We have recovered a lot. That's the net effect of the negotiations and the, you know, what's taken place in the production environment. You know, certainly, we see some of that continuing in the second half of this year and even into 2023. If you look out, you know, to 2024, I would expect a $90 million improvement in the business, as a result of that, you know, overhang going away.
It's simply just from a normalization of schedules and things actually coming through as they're stated to you. Do you think you get a $90 million bounce back in NOI and operating income?
Yep.
Boom.
Yep.
Okay.
Just running our plan.
Yep.
Awesome. Very helpful, guys. Thank you so much.
Thanks.
Yep. Thank you.
Our next question will come from Emmanuel Rosner with Deutsche Bank. Please go ahead.
Thank you very much. Good morning, everybody.
Emmanuel.
Actually wanted to follow up on one of your last points here around target margins for E-Systems of 7%-8% over the next couple of years. You said that a lot has changed in the last couple of years, which is, you know, obviously very true. Can you maybe just be a little bit more specific in terms of what has changed in terms of the E-Systems outlook? Is it the macro environment, the industry disruptions? Is it the product mix, the investments needed at E-Systems? I guess how much is specific to Lear versus sort of like the sort of environment that you're operating in?
Yeah. I would say that the changes I was describing are entirely industry related. I think if you look at IHS's projection for volumes in 2024 at 88.7 million units, if you go back a couple of years, they certainly were expecting a higher level of global industry volume than that. That's the first factor. The second factor is, you know, higher commodity costs. In what I described, you know, I assume that a portion of that unwinds itself over the next two years and a portion remains.
If volumes, you know, were to get back to where we had anticipated for 2024 when we looked at this eighteen months ago, and if commodity costs were to get back to where they were, you know, eighteen months ago, you know, those two things can, you know, help you bridge sort of from the 8%-9% range. The balance, you know, is work we still have to do. We've seen some nice growth in our Connection Systems business. If I look at, you know, 2023 and 2024, we're expecting that business to grow by 50% over the next two years from roughly $500 million this year to $750 million in 2024, on its way to our billion-dollar target that we talked about.
We had talked about $900 million-$1 billion in 2025. You know, we now see $1 billion as a very reasonable number in 2026, underpinned by this, the Intercell Connect Board award that we had announced on our prior earnings call. That's certainly going to be a factor that allows us to continue increasing margins and scaling of our electronics business, as we've talked about in the past, is a further tailwind to margins expanding in that segment. Then some of the things that we're doing with restructuring and combining certain administrative functions and manufacturing operations across the businesses will certainly be accretive to margins, not just in E-Systems, but in both segments.
I think all of those things taken collectively with, you know, a more reasonable volume environment, commodity environment, sort of gets us back to that 9%-10% that we had talked about as the longer term target for the segment.
That's very helpful. Just a quick follow-up on this. In terms of the engineering spend for E-Systems, has it generally stabilized at where you want it to be as a percentage of revenue? Or do you think that this could still be sort of a headwind to margin as you continue investing there?
I think that it has stabilized and sort of peaked as a percentage of sales. We're relatively flat now this year with last year on engineering in that segment, although the second half is higher than the first half. There may be a little bit of run rate increase in that on that line item heading into next year. I'd say we're generally seeing, you know, what we had expected 18 months ago in terms of engineering spend in that segment.
Okay, great. One quick follow-up on the first half to second half walk again. Could you help me with the commodities bucket in terms of, you know, is it largely—I mean, I guess it's maybe a little bit smaller of a help on sequential basis than I would have expected in the context of not just some of the spot prices coming down, but also obviously some recoveries coming in with a lag and things like that. Can you maybe sort of like talk a little bit about what's behind sort of like this 35 basis points sequential improvement? I know you mentioned some of the recoveries played out maybe faster in the second quarter. Is that a big driver of that?
Yeah, that's the primary driver. We don't see much benefit from the change in the spot price. You know, we've locked in most of the steel for this year. We do have a little bit of upside in North America in the fourth quarter. Copper's basically hedged, you know, through the end of the year. There's a small amount that's still open. That benefit, the immediate benefit is sort of offset by the inventory revaluation. That's why you see more of the benefits next year, early next year from that.
Okay. Thank you so much.
Thanks. You're welcome.
Our next question will come from David Kelley with Jefferies. Please go ahead.
Hey, good morning, Ray and Jason. Thanks for taking my question. Was hoping to follow up on the growth over market discussion and specifically, you know, what you're seeing in China. Can you walk us through if you saw any signs of outgrowth normalization as those lockdowns were lifted and production started to ramp in June? And then maybe if you could give us a sense of how you're thinking about some of the outgrowth opportunities in China into the back half of the year, that'd be great.
Yeah. China growth for us will be better in the second half of the year. You know, if you look at the first half, production, you know, the Chinese domestic OEMs certainly held up better than the non-Chinese or global OEMs. We saw, for example, in Q2, the domestics were up 7% and the global OEMs were down 12%, and that really weighed on our growth over market, you know, in China. If you look at the second half of the year, that normalizes a bit and the growth rates between the two sets of OEMs are more similar. In addition to that, we have some nice backlog rolling on in China. In E-Systems, we have the Volvo XC40 Recharge, the electric version of the XC40.
We have a lot of content on that battery disconnect unit, battery management system, onboard chargers and wire, and a number of other Volvo programs where the power electronics are ramping up. That sort of drives a lot of the E-Systems backlog and growth in the tail end of the year. That's a factor as well. We do see, generally speaking, the global OEMs have sort of resumed normal production rates. Customers for us, like Mercedes, BMW, Audi, GM, have, you know, we see improvements in the operating environment in the second half relative to the first half. You know, certainly, you know, shortage, chip shortage, issues and stop start issues are a risk in that market as they are elsewhere.
We do see more of a normalization of the customer mix in the second half.
Okay. Got it. Thank you. Then maybe a quick question on capital allocation. The share repurchase cadence was stepped up in the quarter. It sounds like that's continued into Q3 and might be an increased focus point as you digest some recent acquisitions. Can you just talk about, you know, the buyback opportunity in the current macro and if you plan to be more opportunistic there?
Yeah, we do intend to be more opportunistic, and certainly, you know, we'll be discussing that with the board at our next board meeting again, and they were supportive of the action we took in the second quarter and here at the start of the third quarter. That's certainly an increased focus for us as we look out over the next 12-18 months. We don't see a need for any significant acquisitions in the near term, and I think that provides us an opportunity to return more cash to shareholders as we see improvements in free cash flow in the back half of the year and into next year. You know, certainly free cash flow has been under pressure because of the stop-start nature of production and the additional inventory that we're holding as a result of that.
We do see some improvements in that in the second half and as we continue to improve there, we will be opportunistic with share repurchases.
Yeah. To be very clear, I mean, our focus is obviously driving our plans. We're focused on that free cash flow, getting our inventory levels back to more normal levels and then returning, you know, our cash back to our shareholders. I don't see any meaningful or significant acquisition on the horizon. We're gonna buckle down and make sure we're driving our business for cash. I mean, we talk about it all the time and focus on our inventory levels and what we can do to improve our free cash flow number and get back to a more normal level of percentage of ROI, but more importantly, make sure we're investing in the right part of our business, which is at this time, returning it back to shareholders.
Okay. Got it. Thanks, guys.
Thank you.
Our final question will come from James Picariello with BNP Paribas. Please go ahead.
Hey, good morning, guys. Just revisiting the second half, would you expect a pretty linear ramp from a top line perspective, you know, 3Q to 4Q, you know, just based on the timing of your backlog and the commodity recovery pass through? And then also from a margin perspective, I just want to clarify for the third quarter, E-Systems up about 100 basis points, 3Q versus 2Q, and Seating about half that. 'Cause just on the E-Systems point, I think it was mentioned previously that, you know, it was maybe pointing towards 4% for the full year from a margin perspective for E-Systems. Is that still the case? Thanks.
Okay. Yeah. Starting with the question on revenue. We see revenues up modestly from the second quarter to the third quarter. You know, you have the stronger dollar weighing on the results. You have a little bit of volume, but you also have, you know, seasonal shutdowns, particularly in Europe, that kind of weighs on the revenue in the third quarter. We see a steeper increase in revenue in the fourth quarter as you get past that normal seasonality. Our strongest backlog quarter is the fourth quarter as well overall. In terms of operating margins, yeah, you've got it basically right.
You know, in the third quarter, while we're not providing precise guidance at this point, just because of the lumpiness of some of the commercial negotiations between the third and the fourth quarter, we do see both segments better, and E-Systems in particular, you know, up about 100 basis points. Seating's probably, you know, anywhere from 25-75 basis points improved from the second to third quarter, assuming the cadence of those commercial settlements happen as expected.
Okay. Just E-Systems for the, you know, for the full year. I think the second half was talked about, you know, in that 4%-5% range for the second half. It seems as though maybe that's coming in a little bit lower. Is that a fair assessment?
We have E-Systems at about 4% for the second half and you know approaching 5% in the fourth quarter is sort of how we see it. For the full year, the math works out to 3.3%.
Understood. That's helpful. Just on the $40 million in annualized SG&A savings, you know, any breakout in terms of the, you know, what that would look like for the segments? Is it, you know, more focused on E-Systems relative to the size of the business or not necessarily?
No, I'd say it's fairly ratable, you know, and including in our headquarters. Not just in Seating in E-Systems, but also some of that shows itself in the headquarters number as well.
Okay. Thanks, guys.
You're welcome.
Thank you.
Sure.
Okay. To the Lear team, I just wanna thank you for a great quarter. Obviously, exceeded our expectations. You guys did a great job. Appreciate all the hard work. We've got more work to do for the remainder of the year, but one thing to note, and I say it all the time, I couldn't be more proud of the team being recognized for all their great accomplishments from our customers, not just with the business backlog, but also the recognitions for quality and other recognitions within our plants. Just shows the great work that you're doing every day. I appreciate all the hard work, and thank you for all your results.
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