Hello. Thank you for joining Lear's third quarter earnings conference call. I will now turn the call over to Alicia Davis, Senior Vice President of Corporate Development and Investor Relations. Please go ahead.
Thanks, Carmen. Good morning, everyone, and thanks for joining us for Lear's third quarter 2019 earnings call. Presenting today are Ray Scott, Lear's President and CEO, Jeff Vanneste, Senior Vice President and CFO, and Jason Cardew, Vice President of Finance. Other members of Lear's senior management team, including Frank Orsini, President of our Seating Division, Carl Esposito, President of E-Systems, and John Absmeier, our Chief Technology Officer, also have joined us on the call. Following prepared remarks, we will open the call for Q&A. You can find the presentation that accompanies these remarks at ir.lear.com. Before Ray begins, 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 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 three. First, Ray will review highlights from the quarter and provide a business update. Jason will review our third quarter financial results. Ray will offer some concluding remarks. Following the formal presentation, we would be happy to take your questions. I'd like to invite Ray to begin.
Thanks, Alicia. Thanks everyone for joining us today. Earlier this morning, we released our third quarter financial results, a summary of which appears on slide five. Sales in the quarter were $4.8 billion. Adjusted operating margin was 7%, and EPS was $3.54. Adjusted operating margins in Seating in E-Systems were 8.2% and 7.6% respectively. For the last six weeks, our largest customer has been experiencing a labor strike. The strike has had a significant effect on North American auto supply chain, including Lear. Despite the impact of the strike and other industry headwinds, we delivered solid financial results in the quarter. While global production was down 3% in the third quarter, sales in our Seating business, excluding the impact of foreign exchange, increased 3% or six points above market.
In E-Systems, third quarter margins, although lower on a year-over-year basis, came in a bit better than what we were forecasting back in July. Slide six provides some recent business highlights. Last month, Carl Esposito, a seasoned executive with expertise in electronics, software development, and connectivity, joined Lear as the President of E-Systems. Carl is a proven leader with the right skills to further enhance E-Systems products and performance. On our second quarter earnings call, we told you we were accelerating our restructuring efforts to respond to the challenging production environment. Driving efficiencies in all areas of our business is not new to us. It's in our DNA. We are executing our plan for further improvement. We will provide a detailed update of our progress early next year.
On our second quarter call, we also laid out the framework for a comprehensive plan to improve our performance in E-Systems and position it for continued profitable growth. We have now the most experienced E-Systems leadership team in our history. In addition to Carl, Mike Balsei, an automotive industry veteran, recently joined the E-Systems team. Mike leads our electrical distribution business, an area in which he has deep expertise and will play a pivotal role in driving improvements and profitable growth in the division. Last month, we welcomed Xin Yi as our new head of E-Systems in Asia. Xin is an accomplished executive with extensive knowledge of the Asian automotive market. He is based in Shanghai and will play a key role in our efforts to enhance growth and profitability in China.
Carl, Mike, and Xin, as well as other recent additions, deepen the already strong management team we have in place in E-Systems and position us well for the future. In addition to having the right people, we also have the right organizational structure. We have reorganized E-Systems to ensure greater visibility into profitability and financial returns by product segment, region, customer, and program. As I said in our last earnings call, we are committed to expanding in areas with high growth and profit potential and exit low return and non-core product lines. We continue to pursue opportunities in electronics, software services, and data that offer incremental sales and margin expansion potential. I'm also very excited about the potential for increased vertical integration of our wire harness business.
The future of our business in terminals and connectors and other engineered components is very promising as we increase our efforts to partner with our OEM customers to meet their sourcing needs and leverage our own manufacturing capabilities. On the technology front, I'm happy to report that Xevo has been named a finalist for the 2020 PACE Award. A prestigious award that is recognized around the world as the industry benchmark for innovation. Hyundai recently agreed to launch Xevo Market in-vehicle commerce platform for Hyundai's Kia vehicles in the U.S. and in Europe. With new partnerships such as the one with Hyundai, that number will only continue to grow. Finally, Lear was awarded the J.D. Power Seat Quality Award, sweeping the luxury vehicle category for the second consecutive year and placing first in two mass-market vehicle segments.
I'm extremely proud of these awards, and they are a testament to our continued focus on operational excellence and quality. Before I hand it over to Jeff, I do want to express my sincere gratitude to him for his 20 years at Lear Corporation, his outstanding leadership, his wise counsel, and most importantly, his friendship. I will miss you, Jeff. We all miss you. We wish you the best in retirement. You absolutely deserve it. Thanks, Jeff.
Thanks, Ray. Thanks to the entire Lear team. It's been an honor and a privilege to serve as Lear's CFO and to have worked with such a great company for most of my professional life. I'm proud and happy to transition the CFO role to Jason, a person I have known and respected his whole professional life. I know that as I enter retirement, I leave the job in very capable hands. Jason, our next CFO, will provide a review of our third-quarter financial results.
Thanks, Jeff. Slide eight shows vehicle production for the third quarter. In the quarter, global vehicle production was down approximately 700,000 units or 3% from 2018. Lear's top programs were down greater than the market in each of our major regions, with Europe down 7%, North America down 6%, and China down 14%. From a currency standpoint, all major currencies continued to weaken against the U.S. dollar in the quarter. Turning now to slide nine. For the quarter, sales were $4.8 billion, down $67 million or 1% from last year, driven by production declines in all our major markets and the negative impact of foreign exchange, partially offset by new business. Excluding the impact of foreign exchange and the acquisition of Xevo, sales were flat, reflecting three points of growth above market. Core operating earnings were $338 million, down $61 million, primarily due to lower production volumes on Lear platforms.
Core operating margins were 7% in the quarter. Third quarter free cash flow was $193 million, compared to $107 million in 2018. Slide 10 explains the third quarter year-over-year variance in sales and adjusted operating margins in the Seating segment. Despite the impact of the strike at our largest customer, sales in the quarter were $3.7 billion, up 1% from the third quarter of 2018. Excluding the impact of foreign exchange, sales increased 3%, representing six points of growth above market. The increase in sales was driven by growth from the backlog, partially offset by lower production on Lear platforms, including the strike-related impact on North American sales. Seating margins were 8.2%, down 40 basis points from last year due to the impact of lower volumes, partially offset by strong operational performance. Slide 11 provides the first quarter year-over-year sales and adjusted operating margin walk for our E-Systems segment.
Sales in the third quarter were $1.1 billion, down 8% from the third quarter of 2018. The decrease in sales was driven by volume declines on Lear platforms as well as currency headwinds. These were partially offset by growth from the backlog as well as the Xevo acquisition. E-Systems margins were 7.6% in the quarter. Consistent with the first half of the year, margins were impacted by lower volumes and unfavorable platform mix on key Lear programs. Net performance in the quarter was negatively impacted primarily by continuing effects from commercial agreements we reached in the second quarter, as well as investments to support our backlog, elevated labor costs and other economics. Slide 12 shows our return of capital to shareholders as a percentage of free cash flow since 2015.
Over the last five years, we have returned, on average, almost 70% of free cash flow in the form of dividends and share buybacks to our investors. Our capital allocation philosophy has not changed. After first investing in the business to support our customers, expand our product and process capabilities, and improve our cost competitiveness, second, making focused strategic acquisitions that add to our product capabilities and offer sales diversification, and third, maintaining investment-grade credit metrics, we are committed to returning excess cash to shareholders. Slide 13 shows full-year IHS global vehicle production volumes, our production assumptions for our top platforms, and our currency assumptions. IHS is forecasting 2019 global industry production to be down 6% year-over-year. This represents a reduction of approximately 1.9 million units or 2% as compared to its July forecast.
We base our production outlook on several sources, including internal estimates, customer production schedules, and IHS forecasts. At the midpoint of our updated guidance, our volume assumption for our top platforms in North America is down 12%, in Europe down 9%, and in China down more than 20%. Slide 14 provides our updated financial outlook for 2019. Primarily as a result of the strike at our largest customer, we are lowering our full-year 2019 financial outlook. At the midpoint of our outlook, sales are estimated to be $19.25 billion, down 9% from 2018, reflecting lower production on their platforms, including from the impact of the strike, partially offset by the addition of new business. Excluding the impact of foreign exchange and the acquisition of Xevo, sales are expected to be down 6% year-over-year. Core operating earnings at the midpoint of our 2019 outlook are expected to be $1.25 billion.
Our updated free cash flow guidance primarily reflects our outlook for lower earnings, partially offset by lower capital expenditures. Slide 15 summarizes the changes in sales and earnings from the full-year outlook we provided in July. Since our July outlook, we have experienced significant lost volume from the strike and other further declines in global vehicle production. These factors, combined with the impact of weakening global currencies against the US dollar, result in a sales decline versus our prior outlook of approximately 4%. Our operating earnings and margins have been impacted primarily by lower production volumes, partially offset by favorable net performance, which includes lower incentive compensation expense. On a segment basis, we now forecast full-year Seating margins in the mid 7% range, down from approximately 8% in the prior outlook, primarily reflecting the impact of the strike.
In E-Systems, our full-year margin outlook is unchanged at the mid 8% range. Though the strike will materially affect our 2019 financial results, we are taking aggressive steps to mitigate the impact, including instituting further reductions in discretionary spending. Our updated outlook reflects the result of these efforts. I will now turn it back over to Ray for some concluding remarks.
Thanks, Jason. Now, turning to slide 17. In summary, we delivered solid financial results in the third quarter, despite the challenging macro environment. I'm proud of what we have accomplished. Without question, challenges remain, but we have an experienced management team that can successfully navigate the current environment. I would be happy to take your questions.
Thank you. At this time, if you do have questions, press star one on your telephone keypad. Your first question comes from the line of Rod Lache with Wolfe Research. Rod, please go ahead.
Good morning, everybody. Thanks for taking my question.
Good morning, Rod.
I was hoping, first of all, you could just clarify the change to your revenue guidance. Your prior guidance for revenue was $19.8 billion-$20.3 billion, and you're now $19 billion-$19.5 billion, so I could see the $800 million taken off, and it looks like FX was probably a $75 million impact, and it looks like you've adjusted some European platforms down about 1% or $90 million. It's a little over $600 million left. Could you just give us a little bit more insight into how much of that is the GM strike or the Hyundai strike and how is that kind of spread between Q3 and Q4?
Sure. Let me first start by just sort of describing the thought process we went through on providing our updated outlook. Obviously, if the vote had been completed on the GM strike prior to issuing our guidance, this would've been a little bit different conversation. Given that GM's our largest customer, particularly in North America, we have kind of a wider range than we ordinarily would at this time of the year. What we've assumed at the top end of the range is that we would lose seven weeks of production to the GM strike, and so that's two weeks in the third quarter and five weeks in the fourth quarter. We're now completing the sixth week of the strike as we sit here today. We expect to hear the results of the vote later today.
What we've assumed at the high end of the range is that there's one additional week of lost production as a result of the time it takes to get ramped up. That's not what GM has told us. That's simply our assumption that we used to set the top end of the range. The bottom end of the range, we've assumed three additional weeks of lost production due to the GM strike. If the vote were to not pass today and the negotiations would continue, we've protected for three additional down weeks. At the middle of the range, we've assumed effectively 8.5 weeks of lost production and rounded up about $525 million of lost revenue. The weekly impact of the strike has kind of grown as the strike has continued on, as more facilities are impacted, as Mexico eventually became impacted.
Each week of the strike now is $70 million-$75 million of lost revenue. That's the missing piece to your walk on the revenue guidance.
Okay. Just to clarify, if the strike is over tonight, you basically lose a month in the quarter, so maybe $280 million of impact in the quarter. It looks like you're assuming quite a bit more than that, even aside from the currency and the adjustments. Am I missing something there?
Yeah. If the vote is passed today and GM is able to resume production next week, that would represent an opportunity even to the high end of our range. We've assumed one additional week of lost production as they ramp production back up at the high end of our guidance range.
Okay. Thanks for clarifying that. Could you just spend a little bit of time talking about the prospects for recovery in that productivity line item in your bridge in E-Systems? How are you expecting that to look here over the next couple of quarters? When would you start to expect that to turn? Presumably, there's going to be some benefit over the next year from the $75 million of restructuring savings and Xevo becoming neutral to earnings. Could you give us a little bit of color on the prospects there?
Yeah. Hey, Rod, why don't I take a step back here and think it through E-Systems. I break this down into near term, medium term, longer term, and there's a lot going on. One, in the near term, obviously, it was establishing a strong management team, and I'll tell you that the team we put into place is, without question, the best team we've ever had in E-Systems from an experience standpoint and the things that they're focused on. The second part of the more near term was putting in place the disciplines which we're focusing on return on invested capital. A lot of these things that we're doing are very similar to what, if you remember back in 2006, 2007, I was asked to go in E-Systems and turn that business around. It was about $1.8 billion in lost money.
Back in 2013, 2014, asked to go turn Seating or improve Seating, and that was down about 200 basis points. Did very similar actions. In the near term, we're definitely on track as far as putting a strong management team, driving discipline, return on invested capital, looking at improving our China operations. We talked about that as being an issue for us, and we hired an expert at looking at that business and staying focused. Our plants are running extremely well. One thing to take note, that the plants are running extremely well, and we're doing a really nice job with launches. Medium term is what we've talked about, the transition to more higher margin products such as power, electronics, and connectivity.
There's a really good opportunity, and we're getting a lot of good traction right now with our customers on just engineered products into EVs within the wire harness business. I'd say one major change there, and we talked about the lack of really being able to get our engineered components on harnesses in the past because of catalogs and other restrictions. Our customers have a completely different mindset now. The doors are open. We're making very good progress. That will take some time because there's design validation requirements that we have to go through, testing, resourcing, that type of stuff. Nonetheless, we're getting and making some very good progress there. The restructuring actions that you alluded to are on track, and we're making some very good progress there.
Longer term in the business, we've done a nice job of looking at the overall product portfolio we talked about. We're going to stay focused on where we can generate really good returns and then obviously exit business that we don't consider to be making the type of returns that we targeted. The continuation of vertical integration. I think the last one is the software and data platforms. We're really doing a nice job. One thing I want to mention is on the Xevo platform, 133 million vehicles. It's up from what was just a short period of time in April, 25 million. Those things are going to start paying dividends longer term.
When I look at where we're at in E-Systems and thinking about the experiences I've had in the two different segments, we're well ahead of where we were in E-Systems prior back in 2007 and then Seating in 2013, 2014, with a strong management team in place. I think these issues that we're looking at as far as improving the overall margin take some time, and the traction will hit at different times, too. I know, Carl, you're in the room, and you kind of go through some of the ways we're getting at some of the differentiation of our product there.
In the medium term, a lot of new product launches, and particularly on the electrification side, really strong portfolio of products. I think something that differentiates Lear is that those broad product offerings will make everything from the outlet to the output of the electronics and the power management become broader systems. As we see further integration of those electronic components and power electronics, then the greater power density, greater opportunity for the customers to have improved vehicles in terms of charging performance. We integrate those things. In the longer term, you'll see a deeper integration of power electronics and subsystems that we make today. In terms of new business, 40% of the wins this year have been around electrification and connectivity. Playing in the right place is clearly where the market's going.
As I think longer term around the software and data services, as Ray mentioned, connectivity is going to really transform automotive like it has in so many other industries. We're there. We're first with the first 4.5G embedded connection. We'll be there with the first 5G embedded connection, and we'll use that connectivity position to help deliver services and software, help enable things like the Xevo services. That goes for software, standalone services applications. In fact, we've received one of the first RFPs for standalone software from our customers. We're seeing the interest there from a software perspective. As we work on the product roadmaps, the portfolio, we're building that not only for hardware, but software and the services aspect. Really excited about both the midterm and the longer-term future for E-Systems.
Yeah.
Good, good team.
Yeah, that's great, Carl. Rod, I want to go through all this because it's important. There's a lot of different aspects that we're going after here. From my experience, and before I turn it over to Jason, kind of into your question in the financials. I don't think we've ever been in a better position. This business, I'm very confident in this business. It's amazing talking to customers, and we've won significant awards recently on some of the things I'm talking about with power electronics and connectivity, and there's an absolute right for us to play in this vertical integration, and the doors are open. It's an opportunity we haven't had, I think, in the past, but now is a real opportunity for us to continue to drive profitable business in E-Systems. With the software that we're developing, it really is impressive.
Every customer I go and talk to about Xevo, what we're doing with Xevo or Rod or all of that with our capabilities is really positive, and we've picked up some really nice contracts. There's a lot of things we're doing, Rod, and why I want to go through all this as an explanation. I've done this twice before. We've never been in this type of position and looking at the product lineup, the team that we have in place, the discipline that we're focused on. I feel really good about the business, and I want Jason to kind of give you an overview of how we see that business playing out over the next several years.
Rod, maybe starting with that, I think part of your question was the net performance in E-Systems in the third quarter. Similar to what we saw in the second quarter, there was a margin compression. There's 285 basis points in the third quarter year-over-year that we attributed to net performance. About 125 basis points of that is related to the pricing agreements that we reached in the second quarter that have a full year effect. Two things have changed in the third quarter that were a little bit different than second quarter. First, our launch costs and engineering costs were higher in the quarter, that was about a 90 basis point headwind year-over-year. Commodity costs were a little bit higher, similar to the second quarter, that was about 50 basis points.
The remaining piece of the explanation is what I saw an improvement on in the quarter. Our ability to offset the contractual price reductions that had been previously agreed to improved. Our performance on cost reduction programs, commercial negotiations, plant cost savings, all improved in the quarter. That was less of a headwind year-over-year. Looking out and putting some numbers around Ray and Carl's comments, and we've said this publicly already, we sort of see the near, the medium term operating margin in E-Systems sort of in that 7.5%-10% range. Looking out over the next 18 months or so, it's likely more in the lower end of that range and gradually increasing as we see the benefit of several things. One, the benefit of the vertical integration that Ray referred to.
Two, as we mature businesses with some of these new customers, we see opportunities to improve margins there. We also see opportunities on some of our more mature programs that have finally finished the changeover cycle. Once you get through the launch cycle and you're able to deploy your cost reduction programs, we see some margin benefit from that. You can't recite the fact that we've digested a massive reduction in production volumes on our core programs in that segment. Our restructuring program was partially designed to take some excess capacity out and improve the margin profile of that business over time. You highlighted the restructuring program. That certainly will help us in the near term, improve margins there.
Looking out longer term, we see this mix of business allowing us to get back to that 10% plus operating margin level, and that's just a bit further out.
Okay. Ray, that's very helpful. I appreciate the detail. Just to clarify, in the next couple of quarters, though, and a lot of these things are kind of longer term and midterm opportunities that look pretty attractive. In the next couple of quarters, in terms of execution, should we be focusing on that 300 basis points or so year-over-year bridge starting to compress as you start to get more internal efficiency, productivity, and restructuring, kind of mitigating some of the headwinds you mentioned?
Yeah. It's a bit early to provide 2020 guidance at this stage, and there's lots of moving parts. We'll get into that in more detail in January on our fourth quarter earnings call when we provide our formal guidance.
Got you. Okay. Thank you.
Thanks, Rod.
Your next question comes from the line of Brian Johnson with Barclays.
Yes. Good morning. Two sets of questions. One, a little bit of housekeeping follow-up on your production guidance. Also recognizing you're not quite ready for 2020. Do you just have a broad sense of how your major customer could ramp up and the potential to catch up on production this quarter versus first half? If so, in first half, is it going to be first quarter inventory rebuilds or spread through the year?
Yeah. As far as the strike and how they're going to ramp back up, obviously, we've been in limited conversations with General Motors. I'd prefer to wait till they announce what they're going to do in respect to call back and accelerating their launches. Jason mentioned how we've kind of looked at it in our guidance. That would be a slower ramp-up. If obviously they come back quicker, that's good news for us. We haven't really gotten into all the details of how they claw it back and how they might get that volume back at this stage.
Okay. Just a related follow-up on that, then I'll ask a Seating question. The SUVs were slated to change over next year. Any sense of how the strikes could affect the timing of that changeover? Go ahead, Jason.
Yeah. We're not expecting a meaningful change in that. We've heard nothing about a change in the launch plan for the SUV. We're expecting that to happen in the second quarter of next year.
Okay. Second set of questions, just really around the seating business and some investors have been asking, given the price negotiations that happened midsummer with a major customer in electronics, are customers approaching Lear, and frankly, your competitors, pushing for price downs in the seating segment, either in just-in-time assembly, which enjoys higher ROIC or in some of the components? Alternatively, is a major competitor still having to walk price up and that's benefiting the industry?
Well, let me start with the activity and the request from our customers for price downs. I haven't seen any changes, both in E-Systems and seating. I know we made some decisions last quarter in E-Systems which have already benefited us in our relationships with our customers and in longer term growth. That was a good decision to make to grow our business longer term and create value for our shareholders. In respect to how our customers are behaving with price downs for some of the pressures they have, I will say that I've seen more of a willingness to look at things differently in respect to VA/VE and cost downs with design. I have had some really good conversations with our customers and how we can look at the whole value chain and reduce cost. Nothing on the price downs.
It's been more of a collaborative, where can we help them? Are there alternatives? Are there things that we can do to really be more efficient as a system supplier? We pride ourselves on that. Something that we're very good at, and we have something we work on internally, which is cost technology optimization, which I believe we are the benchmark, and we've been recognized by our customers for that. I've seen that pick up, and which I think is good for us because there's share programs, there's things that we can work with our customers that help offset volume reductions, those type of things that we're good at negotiating. I think that's a positive sign for us. I do think that, referring to your other point, we have picked up some nice conquest business.
Even this week, we just were awarded some conquest business that I talked about in the Seating area that takes some time. Customers do not like resourcing during a product cycle or product life or during a timing. We're starting to see the next generation of awards coming, and that's been very positive for us. I hope to continue to see that happening.
Okay, thank you.
Thanks, Brian.
Your next question is from the line of Emmanuel Rosner with Deutsche Bank. One moment. Emmanuel, your line is open.
Hi, good morning.
Good morning.
Good morning. A couple of questions on E-Systems. The backlog in the revenue walk was a little bit on the low side at $21 million. Even sort of on a year-to-date basis, I think we're probably only around like $150 million or $160 million. Can you maybe talk about what's sort of going on there? Is it sort of like the impact from the lower global production volume, or is some business being pushed out or delayed into future quarters?
Our backlog for 2019 has come down. We talked about $1 billion for backlog in total for the company back in January, and we've seen that come down by about $350 million for this year. E-Systems has bore the brunt of those reductions. If you look at the composition of their backlog, about 60% of this year's backlog in systems was slated for Asia, which is primarily China. China's been hit harder than any other market in terms of lower production volumes. What we've seen this year is really a combination of lower production volumes, some programs that have ramped up slower, and that's impacted both segments, and some programs that have been delayed and pushed out to next year.
As we look at 2020 and our backlog, we do see that trend sort of continuing, and we do expect the backlog for next year to be a bit lower than this year as a result of some of the same issues that we experienced this year. Lower volume is the main contributor to that, and if you kind of step back and look at what IHS was calling for 2019, 2020 production volumes globally back in December when we established our backlog. They've cut their global outlook by 8% this year and 8% next year. They've cut China by 12% this year and 15% next year. That has had a meaningful impact on the backlog for both years. In addition to that, we've had some programs that were delayed this year, pushing to next year, that will help next year.
Unfortunately, we had further program delays out of 2020 and into 2021. That will help us as we look out into that third year of the backlog when we do formally update that
In January. On the positive side, as Ray mentioned, we've seen two positive developments in the third quarter. We've seen the initial benefit of the commercial agreements that we negotiated in the second quarter starting to result in new business wins on the E-Systems side, albeit much of that is outside of our three-year backlog window, but it's a positive development nonetheless. We've seen a really strong build on the quote pipeline on electrification and connectivity, and the amount of business awarded there. We have talked about $1.2 billion of quote pipeline and electrification and connectivity for this year. That's actually grown to $1.3 billion, of which $1 billion has been sourced, and we continue to win consistent with our targeted share of sort of 25%-35%. So that's extremely positive. As Ray mentioned as well, we're starting to see an uptick in our conquest awards.
We've had over $300 million of conquest awards in Seating this year that will benefit the longer-term growth of that segment. I think as you look at longer term in some of the data services and software aspects, that will also decouple from the OEM production rates as we move to the services that are offered broadly to an already fleet of vehicles. That's, again, another exciting aspect as we look to new areas of growth in E-Systems.
I appreciate all the detail. Secondly on the E-Systems margin. You gave a lot of helpful color before, I think 125 basis point was the impact from the commercial agreements in the quarter. Can you just, for that specific piece, talk to us about how to think about it on a go-forward basis? I understand that it probably goes through at least the end of the year in terms of year-over-year walks or in the fourth quarter as well. Does that carry through 2020 or would that be part of different discussions?
Yeah. The agreements that we reached earlier in the year, those are lifetime agreements, so they've been implemented in the purchase orders this year, and so they will carry on to next year. We've talked about this before, sort of 2%-3% has been the annual price down range in the E-Systems business historically, and we're at the higher end of the range this year. Too early to tell what next year looks like. Yes, there is a carryover effect of that. I also highlighted that in the third quarter, we made some progress towards offsetting that with our cost reduction programs, and we expect that to continue in the fourth quarter and into next year.
Great. Thank you.
Yeah. Thanks.
All right. Your next question will come from the line of Dan Levy with Credit Suisse.
Hi. Good morning.
Morning.
Thanks for taking the questions. Wanted to ask a couple of questions just on decremental or just on margins in general. First, just wanted to start on the GM strike. I noticed in your slide 15 highlighting the margin impact from volume effects, that's a 22% conversion. I believe that that's probably something that's pretty typical. I would've expected maybe larger decrementals given, in this case, the GM strike, the production presumably on your end literally ground to a halt. That's going to be much worse than something where production is going from flat to down too. If you could just give some color on what the decremental margins have looked like on the GM piece of business. Subsequently, as we potentially are looking at higher production in 2020, would you get typical incremental margins on that business, or are there going to be any ramp inefficiencies?
Do you have the capacity to handle that properly?
Yeah. First, in terms of this year, similar to what we've described previously, our variable margins in Seating are 15%-20% and 25%-30% in E-Systems. The GM North America business is some of our most vertically integrated business, so it's going to skew sort of to the higher end of that range as a result of that. In addition, as you pointed out, given the sudden nature of the loss of the volume that pushes our ability to take variable costs out is a little bit more difficult and pushes the number up a bit there. In that bar on the chart that we do have FX, and that's sort of alluded to the conversion as well as volume reductions on other platforms with varying margins.
The way to think about the GM margin is, as I mentioned, sort of in our normal range, and maybe a little higher on the seating side just because of the level of vertical integration. In terms of how we may benefit next year from that, to the extent that volume comes back on overtime, on Saturday or Sunday production, certainly the incremental margin would be slightly less as a result of that. We would have some incremental costs, but I'd say generally should be in line with the variable margin profiles of both business segments.
Great. Okay. Thank you. Just a second follow-up on margins or I guess trying to gauge downside risks as we're looking into 2020. I know you're not providing 2020 guidance. To the extent that we have maybe continued volatility in China or Europe, obviously the question is what may arise related to the CO2 emission regs and how that could flow through to the industry. Just give us a sense of sort of your typical decremental margins by whether it's in Europe or China, and what options you have to mitigate any downside pressure in either of those regions?
Yeah, I think we've talked about in the past that in general, our European margins are in line with our segment averages. Maybe I'm seeing it a little bit lower, a little bit less vertical integration in Europe than we have globally. E-Systems may be a little bit higher because we are a little more vertically integrated, and we have a strong terminals and connectors business in Europe. China, we talked about the effect of lower volumes on some of our mature programs, kind of skewed into the higher end of the range on E-Systems with the loss of the Ford business and other mature business there. What we're doing in response to that is restructuring our footprint and taking capacity out, moving to lower-cost facilities to try and sort of repair or offset the effects of that lost volume.
We'll continue to do that as we look into 2020. We took our restructuring program for this year up to $200 million increase. Our savings outlook's about $75 million annually. We talked about that on the second quarter call, and 80% of that is expected to benefit us next year of roughly $60 million. So we continue to expect that to be the case next year at this stage.
Just to add a little bit more to what we can do, we're taking a very proactive approach to this. You did mention a few different issues that could happen next year. In some respects, we're assuming they can happen, and we're taking those steps to make sure we're countering and driving efficiency. What's great about having the two divisions, both between Seating and E-Systems, for example, we're looking at consolidating in our manufacturing plants where we can drive efficiencies between the two divisions. We're looking at all of our logistics lanes and where we can continue to consolidate in the event that volume gets reduced. We're in negotiations right now with our customers. There's a lever that we have obviously called productivity that we start negotiating in the event that the customers aren't hitting their contractual volumes, and then we negotiate through our productivity.
The synergies that we have between the two divisions can't be overlooked either. We're looking at how we can share resources globally within a region, then down to a platform. If it's program management, sales, engineering, we have a great opportunity for us to continue to drive down our cost. In some respects, having the uniqueness of the two divisions help us in light of any type of reductions. We're preparing for that right now. We have continuous meetings. We put together a team that's dedicated to this. We're looking at every line item within our cost. Jason talked about discretional spending. We're obviously getting at that aggressively, but more mid to longer term, we have some really unique opportunities to drive between the two business divisions, and we're taking advantage of that. There's a lot of different levers we're pulling.
Obviously, we're very sensitive to any changes within volume, and we're reacting quickly.
Great. Thank you. That's very helpful. Appreciate it.
Your next question comes from the line of Adam Jonas, Morgan Stanley .
Great. Thank you for taking the question. Just thinking a bit ahead here, it seems like the conversation around electrification is picking up, and I'm just wondering if that creates an opportunity for you to accelerate the product portfolio transition away from wire harnesses, maybe more towards terminals and connectors as you talked about. That would be helpful.
Right. I think the electrification portion is very complementary, actually, between the wiring terminal connectors, the high voltage wiring content that connect into our onboard chargers and our charging systems is very complementary. When we look at those business opportunities going forward, we look at that very holistically at what content per vehicle can we really capture across the broader portfolio. I think it's very complementary.
In terms of the time frame, too, Adam, this is more in the medium to long term. These programs are typically awarded between two and a half and three and a half years in advance of production. We've had a lot of success this year in winning business in that side, and we would expect the margin profile of E-Systems overall to improve as that ramps up. It's out there a little bit. We're not going to see a meaningful impact certainly next year, maybe a little more so in 2021, we can begin to watch some of that.
Carl just walked in this morning and just gave us a bit of good news, we just won a nice bit of business on the electronics side, power electronics side, that had some very nice returns. But to Jason's point, it's a little bit outside the window, but nonetheless, actually, Carl and I have been out meeting with all the customers, we've had some really good conversations. That's why when I say I'm confident, there's a nice fit for Lear, we are a niche in some respects, supplier that we're not the mega tier with the black box design. They love our ability to be very flexible and agile when we come in with our design capabilities. That's paying off really well. Like I said, we've met with the customer, it's been really positive feedback.
I'm very confident that we have a nice position within power electronics and connectivity. To Jason's point, it does take a little bit more time, and we're very selective. One thing to point out that we don't quote all business around the world. We're very selective with the customers we want to position ourselves with, the vehicles we want to be on, because there's a lot of different quotes out there right now on power electronics. And we're
Like I said, looking at what best position for us to be with the best customers, with the best product. It has been overwhelmingly positive from our customers' perspective.
I've had the opportunity to visit a number of customers with Ray and really impressed with the deep customer relationships that Lear has, and I think the trust in the company. Customers clearly want Lear in their future vehicles and want us to understand our product fulfillment roadmap and how we align with where they're going, and on the software side, our connectivity and deeper levels of integration into the vehicle. It's really exciting.
All right. Maybe near term, you had the commercial agreement therein in last quarter that weighed on E-Systems margins. You mentioned that perhaps that would help the backlog in 2020. You provided some nice color there on the backlog with regard to 2020. It sounds like it'll be lower than 2019. How do we get comfort that the commercial agreement did in fact drive further business?
First of all, let me clarify that the agreements that we put in place this year with our customers were for potential business that are outside of our backlog window. It's not a 2020 effect. It was more of a relationship, if you want to think about it in this near term. It was about continuing that relationship in a positive way to grow the business long term. That's already paid dividends for us. We've already established contracts. Unfortunately, like I said, they're outside the three-year window. There's an element here, though, too, of like Jason mentioned, we are very good at offsetting our productivity, and we do that through a lot of different levers we pull internally. There was a time element of how we were getting at some of our efficiencies.
It also opened the door on VA/VE sharing programs, other things that will impact us more near term and help us improve our margin profile. Those actions are still in place, and we'll work those out with our customer today. That has changed from how we work with our customers, which will impact our margin more short term. Longer term, we're already seeing the benefits of cutting those deals. They absolutely were the right thing to do. Those are paying dividends already.
Great. Appreciate it.
Your next question is from the line of Itay Michaeli with Citi.
Great. Thanks. Good morning. Just had one revenue and one margin question. First, going back to the second half revenue, hoping you can quantify the GM strike effect in the third quarter. Also what your revenue in the third quarter ex of GM strike look like relative to your internal expectations. Also, whether some of the pressure you're seeing in your guidance ex of GM strike, is that from some of it in the third quarter, or is that entirely happening in the fourth quarter?
Yeah. The GM strike impacts both the third and the fourth quarter. In the third quarter is about $95 million of revenue in the third quarter. The margin impact isn't as significant in the third quarter because, in the case of some of the component plants on the E-Systems side, for example, we continued to build some inventory, and so that offsets the impact a little bit. Looking out to the fourth quarter, the impact is much more significant. If you look at sort of the second half impact on margins, it's about 100 basis points impact on the Seating margins, a little bit more than that, and about 50 on E-Systems. Absent the GM strike, we would've been at 8% in the second half of the year in Seating and in the mid to high sevens in E-Systems.
Got it. I guess ask a little bit differently. Out of the $725 million, I think you mentioned earlier about $500 and change is GM. The other kind of $200 million, is that entirely in the fourth quarter or some of that pressure also impacting you in the third quarter relative to your initial internal expectation?
Yeah, that's largely in the fourth quarter. The third quarter actually came in a little bit stronger than we had anticipated. Both the foreign exchange impact and the volume impact are in the fourth quarter. We were a bit conservative in our range, just given all the uncertainty around the strike and how meaningful that impact is per week, and so, we do have built in some additional reductions in volume that have yet to be announced from some customers, have factored into that low end of the range.
That's helpful. I think my last question, going back to incremental margins. If I look at the kind of the backlog incremental contribution margin, it has been declining, I think, in both segments over the last few quarters. Is that just a function of the backlog itself being somewhat smaller? How should we think about that backlog incremental margin perhaps into 2020 and beyond?
Yeah. In general, we've been rolling our new business in line with our segment overall margins. Sometimes in a quarter it can be skewed a bit just because of you have the impact of business rolling off, that we've lost new business that's rolling on, and if the net number in revenue, for example, in E-Systems is $20 million in the quarter, it's not a real meaningful margin look. In general, the business that's rolling on is in line with the segment margins that we have in both business segments today.
Got it. That's helpful. Thank you.
Your next question is from the line of Chris McNally with Evercore.
Hi, guys. Thanks so much for the question. One real quick one. It's been answered a couple times. I just wanted to verify. The backlog comments that you're roughly making for 2020, that's roughly lower than the $1 billion adjusted number for this year, more or less. I know you're not going to give official guidance, just I wanted to make sure it's lower than the adjusted number.
That's correct.
Okay, great. On E-Systems, that's been some of the way that the backlog adjustments have been made. Can you talk about when we think about the push, I mean, we always have a question of are the volumes sort of lost versus moved? In Asia, is it really that basically it's disappointing performance of these platforms, so it's quasi lost, meaning they haven't been pushed to the right into lost backlog this year doesn't go into 2020 or 2021? It's really more around the volume of those launches are just lower.
I'd say generally speaking, it's more that than delays in the case of Asia, but there's been other factors in Asia. There's a program in E-Systems in China that was loss-making, and we've decided to exit that program. That's part of what's impacting the backlog, so that's a negative to the 2020 backlog that will be helpful for the margin profile of the business going forward. There have been a couple of modest programs that have been canceled as well, where there'll be zero volume, and that's impacted the number. In general, I'd roughly tell a third of that is probably just lower volume on a continuing basis on the business that is launching or has launched.
Okay, great. Just on the margin profile in E-Systems, if we take the sort of this base level is in the mid 7%s, it sounds like things are going to be slow going. You talked about 10%, further out, that's multi-year. You do mention some of the things that you're doing, potentially you've got a cost savings program you're going to give us more detail on, some of the discretionary items. Could we expect in 2020 that we get a movement back to even if it's just the low 8% range? Is that sort of still unrealistic and we should kind of think about the restructuring is a year or two out until we get volume, and we're going to stay in this sort of mid 7% range?
Yeah. For a lot of reasons, I think it's too early to try and guide to an operating margin for E-Systems for next year. What we can point to is that I think we've stabilized in the second half of this year. We were encouraged by what we saw in the third quarter and what we see in our fourth quarter abs of the GM strike sort of in the mid to high sevens. You look out to next year, there's a lot of uncertainty on the production environment and I think we would be foolish to try and call the number right now given all that uncertainty.
I think we'll have a lot more clarity in January in terms of what our customers' plans are and maybe even some favorable developments on the macroeconomic side that give us more confidence in what the production environment looks like next year. Also, as I mentioned, we do have some elevated engineering spending in that segment because of our success in growing electrification and connectivity. I think we won more business this year than we had initially anticipated in. There's a little bit of a headwind as a result of that to think about for next year. Just in terms of overall company margins, thinking about next year, one factor that hasn't come up so far in the dialogue, but I'll just point you to that guidance to guidance block that we provided in the formal presentation.
You'll see that we had a pretty significant reduction in discretionary spending and incentive compensation expense. It was about $30 million and half of that in each of those two buckets. Both of those are headwinds as we think about the 2020 margin profile of the company next year as well.
Just the last technical, the Xevo drain on margins in E-Systems in the second half, I think it was something 50 basis points or more, but I don't know, because obviously you get some of that will annualize, but just how much was Xevo a drag on E-Systems margins in the second half?
For the full year, it's about 40 basis points. It's a little bit better than what we had originally anticipated. In the third quarter, we came in a little bit better than anticipated. That's really just the timing of ramping up our hiring on the SG&A side. We did see that the outlook for Xevo improved slightly for this year from what we had initially anticipated.
Okay, great. Thank you so much.
You're welcome.
Your next question will come from the line of Joseph Spak with RBC Capital Markets.
Hey, good morning. You may have sort of just touched on part of my question, but you mentioned on that slide 15, the 15 basis points of improvement within the margin guidance revision from that performance, and I think that's that incentive comp and pullback in discretionary spending. Is that all of it? You also talked about some underlying performance improvement, I think, in E-Systems that's sort of being masked. Is that also part of the 15? I'm just wondering if you could break that down a little bit further.
I would say half of that is incentive compensation, and the other half you could split into two categories. One is performance improvements in the underlying businesses, and the other half is sort of temporary measures that we've taken given the extraordinary impact of the strike with GM and other volume reductions. That portion sort of comes back, I think, next year more so than the other portion of it.
Okay. Another quick one. Mercedes-Benz has had a pretty, I think, visible launch issue with one of their key programs. Has that impacted your profit performance at all on the SUV?
Yeah. The Mercedes-Benz launch is a very complex. It's a great launch for us, but yeah, it's definitely hit us on the cost side.
Is that done, or?
It's ramped up a little bit slower than what we had originally anticipated. Longer term, that's a fantastic platform for us. Very much, it's very complicated, and we have seen a slight elevation of launch costs as a result of the slower ramp-up. We're excited about the prospects for that program next year, once it gets up to full volume.
Okay. Just the last one, bigger picture on Xevo, I know you have one of the customers in the GM Marketplace, we saw this quarter they talked about putting in Android Automotive into infotainment. They struck a deal there. What are the implications for Xevo there?
Yeah, John, do you want to give a look?
Yeah, sure. There aren't actually any implications. If you look in the press release from GM, they actually said they're going to keep their unique services and applications in the platform, one of those being in-vehicle commerce. The underlying platform of that is the Xevo Market. We see it more as complementary services making the ecosystem richer.
Okay. Thank you very much.
Thank you.
Your next question is from the line of David Kelley with Jefferies.
Good morning, guys. Thanks for squeezing me on.
Good morning.
Just a quick question on the seating backlog, which stepped up in the quarter. It's accelerated throughout the year. Was there anything customer specific or unique that's driving the ramp-up this year? Just trying to square that off with your comments related to the step-down in industry volumes and impact on backlog.
Okay. Are you referring, David, to the impact on this year's backlog?
Yes.
Yeah. In Seating, the impact has been a reduction of about $130 million, $140 million from what we initially expected at the beginning of the year. More of the reduction in 2019 is really with E-Systems, but the biggest driver of that, the biggest single driver relates to the ramp-up in volume on some of these new programs in North America that we've talked about historically, where the ramp-ups got off slower than anticipated. Some of that comes back next year. Also keep in mind that we've sort of taken a step back and looked at industry volumes overall, and we're a bit more cautious on volumes globally and in each region specifically and on the programs in the backlog. That will kind of offset the sort of carryover benefit of some of those programs that have had a slower ramp-up this year.
Okay, great. I appreciate it. Last one, and a quick one. Anything to call out from the E-Systems portfolio review, or is that still ongoing?
Well, yeah, that's still ongoing right now. We'll come back with a more detailed plan on the overall product portfolio. I'll tell you that we have discovered, like I said, some great areas that we have right to play in, and one of those big is engineered components in the Ts and Cs. The work's ongoing, and obviously we'll have more at a later date.
Okay, perfect. Thank you.
Thank you.
Our final question will come from the line of John Murphy with Bank of America, Merrill Lynch. John, please go ahead.
Good morning. I just wanted to give a quick congrats to Jeff. It might not seem like it, but we'll definitely miss you. Just a first question. You guys talked about some stress in sort of your tier 2 supply base and with sort of the disruption in the team schedules and the pressure on global volumes. We've been hearing more and more about that in North America and Europe as well. Just curious what you're seeing there, what you're doing there to mitigate risk, and how much things have been going forward.
Yeah, it certainly wouldn't be a surprise to see some distress given how much [insert designs] have come down. We have seen very little impact on our supply base. It's held up very well, even with the massive impact of the GM strike. We've seen very resilient suppliers in our portfolio. We've been pleasantly surprised, I think, by that. We were preparing for distress in the supply base, but it really hasn't been an issue for us.
I think in general, the comment too we've made on E-Systems, we've seen some issues relative to the chip manufacturers, and we work obviously very closely with our customers in getting alternative designs approved, validated, and give us the ability to have alternative sourcing. We do keep a very close eye on any type of distressed supply or other related items within the supply base. In particular cases, we'll obviously take those forward to our customers and find some optional construction or engineered components that we can move quickly to. Let's keep our eye on it. Like Jason said, that significant issue is due to the strike, but probably more just general issues relative and probably more significant within E-Systems on the chip manufacturers.
Okay. That's very helpful. Then just a second question. When you're looking at the 7.5%-10% range, you're kind of talking on E-Systems margins for the next 18 months. I know you're not giving exact guidance, if we were to think about sort of the major swing factors, if we were looking 12-18 months out, why you would have hit 7.5% or why you would have hit 10%, I mean, is it mostly macro or are there some other key factors we can focus on and stay on top of that we should think about?
I think there's three or four factors that are going to determine where we find ourselves on that range over the coming couple of years. One is the success rate on, as Ray mentioned, the vertical integration side. We're already seeing some opportunities there. It does take 12-18 months to ramp that up, and so it'll take a little bit of time. That's going to be a driver. We are seeing an opportunity to improve margins with some of our new customers in the portfolio. That takes time, but the level of success we have with that is going to be a key factor. Our restructuring program is going to be a key factor, combining capacity across seating and E-Systems, as Ray mentioned earlier, taking some capacity out in other cases, specifically in E-Systems, to adjust to the lower production volumes will also be a factor.
Longer term, the penetration in software, the penetration in electrification connectivity or power electronics and connectivity will be a significant factor. Those are the key areas that we're focused on. Maybe a little further out, the effects on the management of the portfolio overall. I mentioned one example where we're exiting a program that's loss-making today. That's going to have a near-term benefit, say, in 12 months out from that goes out. Things like that will lead to improvement. It's going to take a little bit of time. Once again, we had a lot of volume reductions to digest. The first step in the process was really stabilizing the business, and I think we've done that here in the third quarter and feel really good about what's happened so far in the third and early into the fourth quarter with that business.
Great. Thank you very much.
Okay. Is that it? Is it?
Thank you, presenters. Do you have any closing remarks?
Yeah, just real quick. It's probably just the Lear team on the phone now. Hey, Jeff, thank you for your years of commitment, your dedication. I mean, you're a special person. Wish you all the best in retirement. I know you'll enjoy it. I'm sure Donna will send you back to work soon. Well, she's the best. To the Lear team, great job on the quarter. Really outstanding job. We got challenges ahead of us, but one thing I love about this company is we step up and we keep driving. I love what we're doing. I think we have absolutely the right plan in place to continue to drive this business forward, and I thank you for all your efforts. Great job to the team around the table. Thank you for everything. Thanks.
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