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Edited Transcript of ADNT.N earnings conference call or presentation 6-Aug-19 12:30pm GMT

Q3 2019 Adient PLC Earnings Call

DUBLIN Aug 9, 2019 (Thomson StreetEvents) -- Edited Transcript of Adient PLC earnings conference call or presentation Tuesday, August 6, 2019 at 12:30:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Douglas G. Del Grosso

Adient plc - President, CEO & Director

* Jeffrey M. Stafeil

Adient plc - Executive VP & CFO

* Mark Oswald

Adient plc - VP of IR

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Conference Call Participants

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* Aileen Elizabeth Smith

BofA Merrill Lynch, Research Division - Analyst

* Brian Arthur Johnson

Barclays Bank PLC, Research Division - MD & Senior Equity Analyst

* Colin Langan

UBS Investment Bank, Research Division - Director in the General Industrials Group and Analyst

* Emmanuel Rosner

Deutsche Bank AG, Research Division - Director & Research Analyst

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Presentation

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Operator [1]

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Good morning and thank you all for standing by. (Operator Instructions) Today's call is also being recorded. If there are any objections, you may disconnect at this time. I will now turn the call over to Mr. Mark Oswald. Thank you. You may begin.

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Mark Oswald, Adient plc - VP of IR [2]

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Thank you, Christie. Good morning and thank you for joining us as we review Adient's Results for the Third Quarter of Fiscal Year 2019. The press release and presentation slides for our call today have been posted to the Investors section of our website at adient.com.

This morning, I'm joined by Doug Del Grosso, Adient's President and Chief Executive Officer; and Jeff Stafeil, our Executive Vice President and Chief Financial Officer.

On today's call, Doug will provide an update on the business, followed by Jeff, who will review our Q3 financial results.

After our prepared remarks, we will open the call to your questions.

Before I turn the call over to Doug and Jeff, there are a few items I'd like to cover.

First, today's conference call will include forward-looking statements. These statements are based on the environment, as we see it today, and therefore, involve risks and uncertainties.

I would caution you that our actual results could differ materially from these forward-looking statements made on the call.

Please refer to Slide 2 of our presentation for our complete safe harbor statement.

In addition to the financial results presented on a GAAP basis, we will be discussing non-GAAP information that we believe is useful in evaluating the company's operating performance.

Reconciliations to these non-GAAP measures to the closest GAAP equivalent can be found in the appendix of our full earnings release. This concludes my comments. I'll now turn the call over to Doug. Doug?

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Douglas G. Del Grosso, Adient plc - President, CEO & Director [3]

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Okay. Great. Thanks, Mark. And thanks to our investors, prospective investors and analysts joining the call this morning, spending time with us as we review our third quarter results.

Turning to Slide 4. First, just a few comments on recent developments including certain of our key financial metrics, which are called out at the top of the slide.

Although, our third quarter results are down year-over-year, Adient's financial results improved sequentially for the second consecutive quarter as benefits related to turnaround actions implemented earlier this year more than offset significant industry weakness in China. No doubt a good outcome and evidenced, the turnaround is tracking in the right direction. Sales and adjusted EBITDA for the quarter totaled $4.2 billion and $205 million, respectively. Sales were in line with our internal expectations. Continued operational headwinds within the Americas and European segments, combined with significantly lower vehicle production in China, were the primary contributors to the $113 million year-over-year decline in EBITDA.

Adjusted earnings for the -- per share fell $0.38 in the most recent quarter, as the lower level of operating profit dropped right to the bottom line. We ended the quarter with just over $1 billion of cash on hand at June 30.

Important to note, the adjusted results covered -- excluded certain charges that were -- that we view as onetime in nature or otherwise skewed trends in the core operating performance of the company.

Jeff will discuss these items and provide additional details on our segment performance, cash flow and balance sheet in just a few minutes.

Outside the financial results, other recent developments include a number of customer events that were completed across Asia, Europe and North America. The events showcased our current and future product offerings, and equally important, highlighted a number of opportunities to increase program profitability for both Adient and our customer through innovative VA/VE initiatives.

Feedback has been overwhelmingly positive with more events planned for later this year. Speaking of customers, Adient was pleased to have won the Quality First award from PSA Group at the annual Supply awards ceremony in June. Adient was recognized for delivering outstanding achievements in product development and operations, while meeting PSA's quality requirements in supporting its business transformation.

And finally, we were awarded a number of product wins during the quarter.

Slide 5 provides a few examples of the recent wins.

As you can see from the examples highlighted, the recently awarded programs include both replacement and new business wins. It includes a great mix of truck, SUV and luxury platforms such as Ford Ranger, Porsche Macan, Buick Envision and VW Amarok, to name just a few.

Given the customer mix, geographic mix, platform mix of these and other recent business awards, we expect Adient's leading market position to continue to strengthen in the coming years, definitely one of the many reasons we're excited about the future as we look forward.

Win rates are tracking as expected and in line with historical performance, for example, replacement business is being won at a greater than 90% rate across total Adient.

If you drill down further, the replacement win rates for our seating business, year-to-date, in China and North America, is running at 100%, and Europe is also showing strong results at 90%.

Likewise, our new business wins continue to track in line with past performance and internal expectations.

Of course, winning business is just the first step. Once a program is awarded, it's imperative to develop and launch the programs flawlessly. It goes without saying this has been and continues to be a focus area for the team after falling short of our high launch standards and historical levels of performance.

The increased focus is translated into improving launch performance, which we experienced in Q3.

Slide 6 illustrates programs that were successfully launched in the most recent quarter, including Daimler A class Sedan, the Jeep Gladiator and the Renault Captur.

On the right-hand side of the slide, you can see various actions the team is executing to stabilize and improve our launch performance, such as ensuring adequate on-time staffing, increased focus on change management, enhanced readiness and program reviews and early escalation of potential issues.

I think you'll agree, these are not new concepts, rather concentrated efforts focusing on the basics.

Although we are making progress, more work is needed to ensure ongoing future launches return to best-in-class standards.

Turning to Slide 7. I'd like to provide some commentary on the turnaround and share a few tangible proof points on the progress we've made over the past few quarters.

First, the team has made solid progress on improving the operating performance at our underperforming plants.

As mentioned previously, the number of troubled plants is limited to a handful across seating and SS&M. However, the losses at the plants have had a significant impact on Adient's financial results.

The team continues to execute against detailed work plans designed to eliminate operational wastes and improve utilization rates.

One of our critical JIT plants at Sharon, Michigan, has made significant progress due to successful execution of variety of operational and commercial actions with the most recent being the ability to reduce headcount to align with our customer broadcasts and production requirements.

Since October, the plant run rate has improved significantly. One step that stands out relates to the required production labor, which, in the first quarter of this year, ran at approximately 606 team members, today, due to actions implemented and improved operating performance, we're running at approximately 528 team members.

Second, we're achieving significant reductions in premium freight and containment costs. As you might expect, this is very much linked to stabilizing and improving the overall operating environment. On this front, we're driving more timely closures of issues and pursuing recoveries on supplier- and customer-related issues.

The benefit of reduced containment, premium freight and ops waste contributed to sequential quarter-on-quarter improvement in Q3 results reported today.

Year-to-date, premium freight is down 65% across the company: down 70% in the Americas, 50% in Europe, and we expect this trend to continue into Q4.

Increasing program profitability is another area we've progressed. It starts with the commercial discipline, making sure you're bidding on the right programs at the right price and taking advantage of change management to walk margins higher where possible.

Similar to the previous focus areas discussed, progress was made on the front during the quarter as we resolved the backlog of open pricing issues with our final customers.

As mentioned on our last earnings call, resolving these issues was the first step intended to stop the bleeding on certain programs. Additional efforts in the area of VA/VE initiatives, change management and focusing on returns through product life cycle are moving forward to improve program profitability. It's encouraging to see our efforts translating into improved operating and financial performance.

As you can see by the chart in the lower right-hand side of the slide, Adient's EBITDA margin with and without equity income has improved sequentially since Q1, as the turnaround actions implemented gain traction. A very good result, especially considering we've achieved, despite downward pressure on earnings from a variety of macro headwinds, particularly weak industry conditions in China.

Two additional comments before moving on. First, expected earnings growth driven by the company's self-help initiatives is not dependent on improved macro environment. I'd point to the quarter just completed as a good proof point. And second, despite the progress demonstrated in Q3, we continue to stress turning around the operations and achieving acceptable levels of profitability will be a multiyear journey. We've made good progress, but a lot of work lies ahead.

Moving on and flipping to Slide 8. We included this slide as a reminder how we expect the pacing of the turnaround to progress.

The plan is on track as efforts to stabilize the business this year are taking root and having a positive impact on our operations and financial results. We continue to expect further stabilization and reaffirm this morning within our earnings release, H2 EBITDA and EBITDA margins will improve versus H1 of this year, despite weaker-than-expected H2 market conditions in China.

As we exit fiscal '19 and progress through 2020 and 2022, we expect our continued focus on operational excellence, commercial discipline, the reduction of overall launches and the rightsizing of SS&M will drive a large improvement in margins but more importantly, an even greater and more tangible benefit in free cash flow.

We are currently finalizing our fiscal year '20 assumptions and plan to share our expectations once finalized.

Before turning the call over to Jeff, let me conclude with a few comments related to the China market and overall macro environment.

Starting with China, the China economy, especially consumer sentiment, remains weak. Passenger vehicle sales and production continue to be significantly impacted by the overall economy and industry-specific factors such as the pull-forward of the GB 6 emission standards.

As cautioned on our Q2 earnings call in early May, signs of stabilization were not materializing heading into Q3 as we originally expected.

In Q3, Adient deliveries were down significantly due to aggressive inventory reductions at certain of our main customers. In fact, a few of our customers experienced production declines between 30% and 40%.

Based on current production schedules, including extended down weeks that occurred in July, we are expecting limited upside in Q4 fiscal year '19. However, the lower level of inventories could set the stage for a fiscal year '20 recovery.

More on our 2020 expectations once the fiscal year '20 plan has been finalized.

In addition to headwinds coming from China, other macro factors such as tariffs and the weakening U.S. dollar have placed downward pressure on earnings, which, as you expect, the team is working hard to offset and mitigate.

And despite these added pressures, we continue to expect our significant self-help initiatives will drive further earnings growth and cash generation.

With that, I'll turn it over to Jeff, so he can take us through Adient's financial performance for the quarter and what to expect in the remaining of the fiscal year.

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Jeffrey M. Stafeil, Adient plc - Executive VP & CFO [4]

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Great. Thanks, Doug. Good morning, everyone.

Starting my comments on Page 11. And before jumping into the financials, I'd like to point out that there were several onetime noncash charges that significantly impacted Adient's Q3 GAAP results.

The biggest charges are financing, tax-related items. As a result of the new debt arrangements, the incremental interest expense and the repositioning of our intercompany financing, it became difficult to support the full utilization of our deferred taxed assets in certain geographies. Therefore, we recorded valuation allowances against these balances. These valuation allowances impacted our net loss by about $250 million in the quarter.

It should be noted, this will result in an increase in our current and future effective tax rate, but it will not negatively impact our future cash tax payments.

As a result of these items, we were required to adjust our fiscal '19 effective tax rate, which resulted in an additional tax expense of approximately $50 million related to the first half of 2019.

Outside of taxes, restructuring charges, a U.K. mark-to-market adjustment and a deferred financing fee also impacted the GAAP results.

The total of these items impacted Adient's GAAP net loss by $334 million in the quarter.

Turning to Slide 12 and adhering to our typical format, the page is formatted with the reported results on the left and our adjusted results on the right side. We will focus our commentary on the adjusted results.

These adjusted numbers exclude the onetime special items just discussed. Complete disclosure of the adjusting items are called out in the appendix. Sales were $4.2 billion, down about 6% year-over-year. FX accounted for about half of the decline. Adjusted EBITDA for the quarter was $205 million, down $113 million or 36% year-on-year, largely explained by a decline in business performance in the Americas and EMEA along with lower volume in equity income in our Asia segments. I'll cover this more in detail in a few minutes.

Finally, adjusted net income and EPS were down approximately 74% year-over-year at $36 million and $0.38, respectively.

Now let's break down our third quarter results in more detail. Starting with revenue on Slide 13. We reported consolidated sales of $4.2 billion, a decrease of $275 million compared to the same period a year ago.

As mentioned just a moment ago, the negative impact of currency movements between the 2 periods, primarily in Europe, accounted for just over half of the decline.

Lower volume mix in Europe and Asia, with a partial offset in North America, impacted year-over-year results by approximately $125 million.

While this result in North America and EMEA was consistent with internal expectations, the sales and earnings in China was worse than expected.

Moving on. With regard to Adient's unconsolidated revenue, our Q3 results were significantly impacted by the much lower levels of vehicle production in China.

Unconsolidated seating and SS&M revenue, driven primarily through our strategic JV network in China, was down about 17% when adjusting for FX.

As mentioned earlier on the call, aggressive inventory reductions at certain of our main customers, combined with the balance out of certain programs, resulted in underperformance compared with vehicle production in the quarter.

Sales for our unconsolidated Interiors segment -- or business, recognized through our 30% ownership stake in Yanfeng Automotive Interiors or YFAI, were down approximately 21% year-on-year when adjusting for FX.

Moving to Slide 14. We provide a bridge of adjusted EBITDA to show the performance of our segments between periods. The bucket labeled corporate represents central costs that are not allocated back to the operation, such as executive office, communications, corporate finance, legal and marketing.

Big picture. Adjusted EBITDA was $205 million in the current quarter versus $318 million last year.

The corresponding margin related to the $205 million of adjusted EBITDA was 4.9%, down approximately 220 basis points versus Q3 last year.

The primary drivers of the year-over-year decline is attributed to negative business performance, largely launch related, the negative impact of lower volumes and mix, primarily within EMEA and Asia and a $23 million FX-adjusted decline in equity income.

Macro factors including negative impact of foreign exchange also weighed on Q3. I will point out that despite being down year-over-year sequentially, compared to Q2 2019, results improved by $14 million. This is the second consecutive quarter of improvement and demonstrates the operating environment in Americas and EMEA has stabilized and has begun to improve, albeit at unacceptable levels.

Also worth noting, SS&M progressed positively versus Q2 2019, as global results improved by about $13 million sequentially.

Similar to past quarters, we've included detailed bridges for our reportable segments, which consist of Americas, EMEA and Asia, on Slides 15, 16 and 17.

Starting with Americas on Slide 15, adjusted EBITDA decreased to $69 million, down $30 million compared to same period a year ago. The drivers -- the primary drivers between the periods include an approximate $27 million in unfavorable business performance, including approximately $17 million of operating performance, higher freight and negative net material margin.

And I note that we did see improved launch and op waste performance and lower premium freights.

Also included in the business operating performance was a $9 million year-over-year decline within the SS&M business, primarily associated with unfavorable mix. Other headwinds included a $14 million increase in SG&A cost, which is more than explained by temporary SG&A benefits last year related to the elimination of the company's 2018 incentive comp accrual.

Additional headwinds related to an increase in Adient's Aerospace spending, partially offset by reduced engineering cost and the year-over-year decline in equity income.

Partially offsetting the headwinds just mentioned, were lower commodity prices of about $9 million and benefits associated with higher volumes, call it, $5 million.

On a sequential basis, compared with Q2 fiscal '19, results for the Americas improved by $37 million, primarily driven by improved labor and overhead, a decrease in operational waste and premium freight. Definitely a positive sign and evidence that actions taken to improve the business earlier this year are gaining traction.

One last point on Americas. Our CapEx for the segment was approximately $39 million in the quarter.

Turning to Slide 16 and our EMEA segment performance. For the quarter, adjusted EBITDA was $53 million or $44 million lower compared with Q3 2018. The primary drivers between Q3 this year and last year's third quarter include negative business performance, call it a $23 million headwind including launch-related cost and inefficiencies associated with the common front seat architecture we have discussed several times in the past. Lower volumes and mix impacted the segment by roughly $9 million. And finally, FX resulted in an approximate $8 million headwind in Q3 versus the same period last year.

I'll point out that although the SS&M business in Europe was down $12 million year-over-year, results were $12 million better versus Q2 2019, as actions taken to stabilize the business gain traction.

CapEx for EMEA was approximately $51 million in the quarter.

Finally, turning to Slide 17 and our Asia segment performance. For the quarter, adjusted EBITDA was $110 million or $36 million lower compared with Q3 2018.

Headwinds from lower volume and a decline in equity income resulting from a significant reduction in China auto production totaled $18 million for each and were the primary drivers of the year-over-year decline.

In addition, business performance was also a modest headwind, call it, $4 million, driven in part by the lower volumes due to the higher fixed cost nature of the manufacturing business. And finally, but to a lesser extent, macro factors, namely foreign exchange, weighed on the quarter by approximately $6 million. Partially offsetting the headwinds were positive contributions from lower SG&A cost and lower commodity prices.

Asia's CapEx for the quarter was approximately $8 million.

Let me now shift to our cash and capital structure on Slide 18. On the left side of the page, we break down our free -- our cash flow. Adjusted free cash flow, defined as operating cash flow less CapEx, was $168 million for the quarter. This compares to $252 million last year.

And important to remember, last year's launch and initial sale of accounts receivable financing facility provided an approximate $94 million benefit to free cash flow.

Excluding the factoring program, free cash flow in Q3 2018 totaled $158 million, essentially flat with our Q3 results.

Lower capital expenditures, an increase in customer tooling recoveries and a decline in restructuring cost essentially offset the lower earnings when comparing the 2 periods.

I'll also point out during the quarter, cash dividends received from our China JVs totaled approximately $165 million.

Capital expenditures for the quarter were $98 million compared with $138 million last year.

As you can see in the footnote, we continue to break out CapEx by segment.

On the right-hand side of the page, we detailed our -- we detail our cash and debt position.

At June 30, 2019, we ended the quarter with just over $1 billion in cash and cash equivalents.

As mentioned upon the completion of the debt refinancing, we intentionally increased our liquidity and capital structure flexibility to further enable the turnaround and protect against uncertain macro risks such as softening end markets.

It's early days since completing the refinancing and gaining traction on the operational turnaround. So rest assured, we'll continue to monitor and assess our cash position with debt pay down being a priority.

Moving on, gross debt and net debt totaled $3.777 billion and $2.752 billion respectively at June 30. And worth mentioning, no near-term maturities, thanks to the refinancing completed in May.

Moving on to Slide 19. Let me conclude with a few thoughts on what to expect for the remainder of fiscal 2019.

Based on current vehicle production plans and expected movements in foreign exchange, we continue to expect revenue to settle in the $16.5 billion to $16.7 billion range, implying Q4 revenue of approximately $4 billion and consistent with what we would expect as a result of our normal seasonality.

This would result in revenue being down approximately $150 million year-over-year or $200 million from the quarter just completed.

With regard to adjusted EBITDA, we continue to expect second half results and margin to surpass first half performance despite weaker-than-expected market conditions in China, as actions taken to improve the company's operating and financial performance gain traction, especially as it relates to the self-help initiatives within Americas and Europe.

Included in our EBITDA assumption is equity income of approximately $265 million, down from our earlier expectations given the continued weakness in China.

In fact, based on our current expectations, the weaker-than-expected China market will likely result in equity income in H2 being down approximately $25 million compared with the first half.

Our assumption in early May assumed flat to slightly better performance.

If we combine consolidated results in China, China performance is expected to be down approximately $35 million in the second half compared to the first half. The decline is more than explained by volume.

Combining the expected drop in sales due to normal seasonality with the expected decline in equity income partially offset by self-help initiatives in the Americas and Europe that are gaining traction likely translates to an adjusted EBITDA in Q4 slightly below the $205 million posted in Q3.

Moving on, based on our expected cash balance and debt, we continue to expect full year interest expense to be approximately $175 million.

With regard to taxes, the establishment of valuation allowances in several jurisdictions over the past few quarters has significant impact on our adjusted effective tax rate and variability of the rate between quarters, as evidenced with Q3's approximate 39% adjusted effective tax rate.

As a result, we'll continue to focus more on our cash tax estimate for the year, which continues to be approximately $105 million to $115 million for the year based on our expected earnings and composition of those earnings.

This outcome would be about $30 million less than fiscal '18.

One additional point on cash taxes. Important to remember, more than 50% of our cash tax payments relate to consolidated JVs and withholding taxes on dividends from JVs. One last item for your modeling, based on the performance through the first 9 months of 2019 and given our intense focus on cash flow, we now expect capital expenditures to settle in the $500 million to $525 million range.

At the lower end of the range, Q4 capital spending would be about $150 million. This level of spend combined with a reversal of temporary working capital benefits experienced through the first 9 months of the year, essentially driven by quarter and timing, will result in a free cash outflow for the year likely in the range of $200 million and somewhat better than earlier internal forecasts.

As a reminder, and as we called out on Slide 18, one factor that can influence the cash outcome is Adient's trade working capital, which is highly sensitive to quarter end dates.

Before opening the call to your questions, just a quick comment on the tariffs as this topic resurfaced last week.

As a reminder, we had anticipated a headwind of about $20 million for fiscal '19. This was primarily associated with Section 301 duties impacting our electric motor drives, and to a lesser extent, Section 232 duties impacting certain of our steel and steel tubes.

The elimination of Mexico and Canada steel tariffs in late May was positive news, however, last week's tweet calling for a 10% on all other goods beginning September 1 will partially offset the benefit. Based on what is known today, it appears Adient's total exposure or headwind in fiscal '19 will be approximately $15 million.

We'll continue to monitor the situation and provide you with updates as potential outcomes become clear. The team will continue to focus on customer recoveries and additional mitigation actions to help lessen the impact going forward.

With that, let's move to the question-and-answer portion of the call. Operator, can we have our first question?

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Questions and Answers

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Operator [1]

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(Operator Instructions) Our first question comes from Brian Johnson of Barclays.

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Brian Arthur Johnson, Barclays Bank PLC, Research Division - MD & Senior Equity Analyst [2]

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A couple of questions. First, just vis-à-vis the pace of customer discussions given the OEMs are having their own issues. When you say increased program profitability, you've talked in the past about 5 critical launches that were, sounds like, money-losing. Last quarter, you indicated that those were perhaps on the path to become breakeven. Is that still your goal? Or could they actually get to a point where they're contributing profitability?

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Douglas G. Del Grosso, Adient plc - President, CEO & Director [3]

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So first of all, Brian, let me take a shot at answering it, maybe not the most direct way because I think about it not so much in terms of breakeven. I think what you're referring to, we had a couple of customers where we had a backlog of open commercial issues, and we were trying to get to an immediate cash neutral position with those customers on those issues. That's what we referred to as stopping the bleeding. We've essentially achieved that this quarter with those particular customers. I wouldn't characterize that as all of the customers that we had open issues or certainly our objective is to far exceed a breakeven settlement. That was, I think, unique to that particular situation. And to that particular situation, I think it now sets us in a position that allows us then to use a number of, I'll say, commercial tactics to then enhance the performance of that business.

And I think what we're seeing with all of our customers right now, particularly with the sensitivity of volume and the situation in China is they're much more open, and that's why we keep underscoring, emphasizing our activities around value engineering and just cost reduction proposals. And we've had some really good discussions on a wide base of customers and that's accretive to our performance, some of which you're now seeing reflected in our Q3 results.

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Brian Arthur Johnson, Barclays Bank PLC, Research Division - MD & Senior Equity Analyst [4]

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Okay. Second question, sort of building on that. In prior slide decks, you talked about the margin gap to the peers, which is fiscal '18 was about 400 basis points. Since now we've combined the business and, yes, I guess, we can do the work to back out SS&M, but how -- can you give us an update on how much of that gap has been closed so far? And then given the timing you're talking about on Page 8, how that gap would close over that time period?

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Douglas G. Del Grosso, Adient plc - President, CEO & Director [5]

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Yes. We haven't specifically spelled out how much of the gap is closed arguably. It's opened slightly since we compared to fiscal year '18 results, and we've had deterioration in our fiscal year '19.

That being said, what we've tried to outline is this is a multiyear plan, and this year has been really focused on stabilizing the business, stopping the bleeding and arguably going after low-hanging fruit, but really attacking operational inefficiencies, a premium freight containment with a level of commercial resolution mixed in on that. We looked at it and said this is a multiyear program, we've laid out that 2022 timeline that says when we have high confidence, we could completely close that gap. How we step through it, I think you'll have to wait until we start to provide some vision on 2020, which we're now just starting to finalize as to what the next increment in improvement is. On today's call, we're really not prepared to target a specific number yet.

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Operator [6]

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Emmanuel Rosner of Deutsche Bank.

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Emmanuel Rosner, Deutsche Bank AG, Research Division - Director & Research Analyst [7]

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So first question on the operational improvements. It's obviously nice to see overall EBITDA traction on a sequential basis. Would you be able to point us to, more specifically, where -- by segments or subsegments -- where we should be able to track them in the numbers? Obviously, America's improved quite a bit, SS&M as well, I guess where are sort of the pockets where the strongest, more noticeable operational improvement is happening? And where we could expect more of this to come in the quarters coming?

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Jeffrey M. Stafeil, Adient plc - Executive VP & CFO [8]

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Yes. Good question. I think we've seen improvements, in particular, in North America and Europe. North America more pronounced this quarter. There's been a number of launches that, as you know, have caused us problems. And, at some degree, as those launches have -- we've worked past some of the initial issues. It's been harder to bring back to the margins we had on the programs that they had replaced. So that's been one of the primary focus of the team.

They've been chipping away at it. I think if you look at just our overall operational waste, our launch cost, premium freight metrics, they're all improving in those regions. And we're definitely seeing it in the numbers.

The things that are kind of coming against us a little bit obviously, China is such a big portion of our earnings, all of Asia is a big portion of our earnings. With that being down as much as it was, it's masked a lot of it as well as you've seen some elements of sales and mix pressure in the U.S., in particular, but also in Europe, as some of our higher profit -- most profitable vehicles have had some reductions in their volume. But I'd say overall, in the things that we can control, we're seeing significant improvements. And I'd say, more importantly, building momentum that gives us some promise that there's more opportunity to run, as we go forward.

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Emmanuel Rosner, Deutsche Bank AG, Research Division - Director & Research Analyst [9]

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Yes. That's helpful. And then I guess zeroing in specifically on the fourth quarter. So I think you were mentioning maybe it's shaking out a little bit softer sequentially than the third quarter. Can we speak a little bit about the puts and takes over here? From a high level, I could see that your equity income expectation is quite a bit weaker into the fourth quarter. Curious what you're seeing there? Obviously, the normal seasonality of revenue as well, which is down. But I would also have expected offsetting this to see further progress in the operational turnaround, maybe further benefit. Can you maybe just put a little bit of a finer point of how these are expected to shake out?

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Jeffrey M. Stafeil, Adient plc - Executive VP & CFO [10]

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Yes. It's a good question. And obviously, it's -- there's a lot of volatility that can happen in the numbers as we go forward, as we're still sort of early days in the turnaround here. But I would say a couple of things. One is revenue is going to be highly impactful to us. Q3 -- our calendar Q3, our fiscal Q4, is the time volatile production schedules, and it's even more volatile in these days. So we've seen a lot of downtime in the customers from a normal perspective, and then there's been some downtime that hasn't been necessarily planned or contemplated, which has played -- has a difficulty here because you can imagine that our margin is roughly 2x -- or I should say, our contribution margin is roughly 2x our EBITDA margin. So that revenue falls, it has a bigger impact. We are still seeing improvements. We are still seeing all those things I just talked about on operational waste, launch performance, et cetera, but it's counteracting some uncertainty in the market and that really what -- is what drove our numbers.

As it relates to China, our fiscal Q3, we think was probably the low water point from a production schedule, primarily due to the emissions change, as the market was close to a 20% down in production. But we still are seeing roughly a 15% down production environment in China, in our fiscal Q4. That will drive our numbers and that's been contemplated in the numbers I talked about earlier.

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Emmanuel Rosner, Deutsche Bank AG, Research Division - Director & Research Analyst [11]

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So but just to be clear -- that's very helpful. Just to be clear, there's -- should we expect further benefit from operational improvement in the fourth quarter beyond what was seen in the third?

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Jeffrey M. Stafeil, Adient plc - Executive VP & CFO [12]

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I don't -- maybe I didn't catch your question, Emmanuel. Can you say it again?

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Emmanuel Rosner, Deutsche Bank AG, Research Division - Director & Research Analyst [13]

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Just curious if offsetting these headwinds that you spoke about, are they also a step function increase in the operational improvement between the third...

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Jeffrey M. Stafeil, Adient plc - Executive VP & CFO [14]

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Yes, yes. I think we're still seeing -- all those things we talked about, it's just that's what they're fighting against I guess is the point here. So the improvements in what we are seeing in launch performance and premium freight and just all across-the-board of better execution, I would say better relationship with the customer, finding more opportunities where the customer and us can have win-win situations, our VA/VE group, which essentially Doug formed when he came here in a much more meaningful way than had existed, is really starting to gain traction. All those things are helping offset some of those headwinds I just articulated.

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Operator [15]

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Colin Langan of UBS.

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Colin Langan, UBS Investment Bank, Research Division - Director in the General Industrials Group and Analyst [16]

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I'm not sure if this is similar to Brian's question earlier, but I think in the past that you had mentioned renegotiating commercial renegotiations of about 40% of the issues that you're facing, impacting margin, I think it was 60%, 40% pricing. I mean are you saying that those pricing negotiations are completed? And if not, where do you stand on trying to kind of set new pricing on certain contracts?

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Douglas G. Del Grosso, Adient plc - President, CEO & Director [17]

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Sure. First of all, thanks for the question, Colin. When I think about my initial comments, when I first arrived at Adient, I was characterizing things as a renegotiation. I think as I spent time and got more engaged with the team, what turned into a renegotiation really was more a backlog of open commercial issues. So I would characterize it different SS&M business that was underbid, and we had to go in and completely reprice. You know as products like seating that are engineered products as they go through the development cycle, there's a number of scope changes that have commercial impact. And because the company was experiencing distressed launches, the customers really weren't particularly interested in having any commercial discussions until we resolved their operational issues.

So just adding a little bit more color, I think the characterization of 60%, 40% is, at a macro level, a pretty good assessment. Though I would say, how you resolve the issues, you can capture them as operational or not, the one example we illustrated in the earnings deck today was a way to solve a commercial issue through operational improvements. And that is kind of getting what the customer recognizing what real run rates are going to be out of his operation, they're different than the contractual agreement that we're forced to support from a capacity standpoint.

Once they essentially relieve us from that contractual obligation, we can then flex down our labor and pull that cost out.

Do you call that commercial or do you call it operational, you can bucket it either way. The way it buckets in our numbers internally that shows up more operationally because our pricing didn't change, but labor against pricing has gone down significantly. So some real great progress made there.

Going back to the first question, I think about some of the commercial issues in terms of weights. We had some really tough issues on a global SS&M project had a huge backlog of open issues. We will solve that through kind of waves of commercial and operational activity. We had a huge success in the first wave, which, on a kind of a normalized run rate, got us to a cash neutral position. That's a big step up for us on a program of that magnitude in the SS&M group. And it sets the stage for us to have further discussions with the customers and introduce kind of value win-win opportunities for them.

One of the ways that we do that is just completely changing, I'll say, the environment with our customer. So by executing on future launches with them, that creates a completely different relationship with them, where we're now allowed to bring in ideas to further take cost out.

So there's a second wave that you'll start to see that comes forward in Q4 and what we think we'll do in fiscal year 2020. So again, I'm trying to provide you kind of more detailed in how I think about the business today versus my initial impression when I first got here.

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Colin Langan, UBS Investment Bank, Research Division - Director in the General Industrials Group and Analyst [18]

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Got it. That's helpful. Any color on the operational issues. I mean is it -- can you boil it down to the ones that are purely operational where there's no contractual issue? I mean is that a -- I think in the past, you've said a handful of plants, are you down to 2 or 3 plants that are driving some of that? And how quickly can those pure operational issues be fixed?

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Douglas G. Del Grosso, Adient plc - President, CEO & Director [19]

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Yes. I think -- well, what we've done is we've got -- we've now changed the approach. Initially, it was really a handful of plants in a few regions that were deeply distressed, and they were in the midst of launch. That, to a certain degree, is stabilized, I would say, just by approach to the way we run in the business. In every region we will always have a top 5 focus plant initiative, plants that we think are underperforming operationally. And so each, Americas, Europe and Asia, have a top 5. We'll constantly be working those. I think you can see some of the performance gains we're making in premium freight, containment cost, which is end-of-line inspection, good progress there. The real, I'll say, inflection point in the -- in our performance will be as we go through our next phase of launch activity and the way we capture launches, is really all inefficiencies, SOP plus 90 days.

If those inefficiencies are still in place, it moves in -- we capture it with operational waste, containment and things like that.

The launches that we're having now are going quite well, and what I'm anticipating is that as we transition those projects out of the launch phase into standard production phase. We'll be operating with a lower level of cost structure, inefficiencies that have been really killing us over the past couple of years. So again, as you -- as we come out with our '20 numbers, we will probably put brackets around that so you can anticipate the year-over-year improvement in those areas.

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Operator [20]

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John Murphy of Bank of America Merrill Lynch.

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Aileen Elizabeth Smith, BofA Merrill Lynch, Research Division - Analyst [21]

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This is Aileen Smith on for John. First question, you've commented in the past that your China joint ventures have largely been self-funding in nature, and as we understand it, this has been a reason why that business had been holding up better than the consolidated business until more recent quarters. As the market has deteriorated, how much control does Adient have on pulling cost out of its JVs? Is it tougher than the consolidated business to be decisive and surgical on cost reduction given the JV partners?

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Douglas G. Del Grosso, Adient plc - President, CEO & Director [22]

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I'll start out answering the questions. Jeff can certainly provide some more detail. I think less about -- I mean indirectly, it's our JV partner, it's really our relationship with the government that if there's anything that presents a barrier to our ability to flex on the cost side, it's maybe what the government's position within the region, the city that, that plant operates. I would say for the most part, the vast majority, we have a lot of influence consolidated, obviously, unconsolidated at driving that down. I would say our partners have a huge vested interest in those operations remaining profitable and conserving cash.

I've been actually quite impressed to see the reaction in China, considering that's not been the mode of operation for the last, whatever you could argue, 20 years. And so we've really flexed down our cost aligned with volume. And if you look at the performance of the region against that volume drop, you can see, basically, they're maintaining a level of profitability, and there's a small footnote and even if you look at the non-consolidated, that net performance is pulling through. So I don't -- there's really not huge barriers to us to influence that.

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Jeffrey M. Stafeil, Adient plc - Executive VP & CFO [23]

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Right. And fortunately, our JV partners are very aggressive with it. We were somewhat concerned as we went into this because China hadn't experienced a downturn of any significance in a long time. And as a result, we were working with them closely, but they were quite aggressive. If you look at our margin performance in the quarter, year-to-date, we have adjusted extremely well in the region to the sales environment. And if you think that contribution margins are roughly 2x EBITDA margins, they've held margin despite the sales decline and despite a pretty significant sales decline. So I would say that they've performed extremely well and should be poised when the market recovers to probably have a little bit of a rebound or a pickup in margin as that happens.

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Aileen Elizabeth Smith, BofA Merrill Lynch, Research Division - Analyst [24]

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Great. That's very helpful commentary. And then a bit of a follow-up question. It's the same that have been asked already on pricing dynamics. Doug, in the 9 to 10 months that you've been on the job, if you could perhaps qualitatively comment, have commercial discussions with customers been more or less challenging in recent months as the industry environment remains really tough? And asked another way, are you seeing your customers push back more so now than they perhaps did earlier this year when I think there was an assumption that some of the industry pressure might be more transitory?

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Douglas G. Del Grosso, Adient plc - President, CEO & Director [25]

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It's always pretty challenging. I can't think of any time that pricing discussions with our customers have not been challenging and expectations high. When volume is strong, there's high expectations. When volume is low, there's high expectations out of more a sense of desperation.

I think what's really changing right now, and this is very much specific to the seating business, in a -- I make these comments against the backdrop of not being in the business for a while and coming back to it. I think over the last few years, our customers have moved to controlling a lot of the supply chain and controlling a lot of the engineering of the product. And when the market was a strong, that worked relatively well. I would argue there was a lot of inefficiencies with it, but the strength of the market overcame the inefficiencies. What we're seeing right now is, as the market weakens or there's concern that the market's weakening, our customers are not really equipped to find ways to reduce cost as effectively as they have had in the past. And it's -- and every single customer that I've met with has an initiative right now to engage with the supply base to find ways to reduce cost.

I consider that a great opportunity, and one that didn't exist over the last few years because there was a sense that they could control this more effectively than the supply base.

We're not going back to the days of full-service supplier and things like that. But over the course of the last, I'll say, 2 months, we've had executive-level meetings with 4 of our major customers, and I'm expecting to have with all of our major customers, where they've really opened up the door and said, "Look, bring us our ideas. We need to find ways to benchmark our vehicles against our competition to look for value creation opportunities." And what I like about it as well as -- because it's happening at a high level, we're not bumping into the normal bureaucracy of and resistance to change. Those executives are taking it on, they're directing new organization to go after these ideas if you bring them forward and you've really done your homework and you can present them with all of the insight of why this is a good thing for them to do and what the risk assessment is. I see a window of opportunity here for us to get some things done that, up until recently, we haven't been able to do it. So always a lot of pressure, always high expectations. But if we can link it to actually pulling cost out and then sharing some of that, then it's a win-win.

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Aileen Elizabeth Smith, BofA Merrill Lynch, Research Division - Analyst [26]

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Great. That's very helpful. And last one, if I may, for Jeff. In terms of thrifting and actions taken to reduce CapEx spend that you cite on Slide 19, can you detail where this is coming from? Is it maintenance CapEx and restructuring actions that you're getting a bit more efficient on? Or is it growth CapEx that you're pulling back on in any way?

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Jeffrey M. Stafeil, Adient plc - Executive VP & CFO [27]

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I wouldn't characterize it as growth CapEx at all. I think it's smarter utilization of our capital. I mean there's examples of reusing equipment instead of buying new welding lines, looking for opportunities there. We -- I'd say lots of efficiencies in how our program teams are going about capitalizing a new program. So that's one, the timing of it's two. We also, I think, compared to some previous years, we've really thrifted down on, we'll say, the unnecessary CapEx that had been in the business or stuff that really wasn't focused on the business, an example might be, our old headquarters building that we had spent a fair amount of money on. We've directed, really, our capital towards things that really provide the best returns and making sure we do not jeopardize any programs or any launches as a result, so that's another thing. Just in the sequence of thrifting, we've also made sure that we don't leave any programs in disarray as we thrift that capital.

So I'd say a good balance, just a lot of discipline, a lot of team members really thinking creative ways. And remembering, we do have a pretty substantial asset mix in the company also, which will drive our CapEx down in the future, just to kind of give a forward look on this. It won't -- doesn't impact too much in '19 or even '20, but as we take a little bit of focus away from growth in the SS&M business, that is where a large majority or a large portion, probably half of our capital, has been dedicated in the past. There's some significant opportunities to reduce the spending in that area.

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Mark Oswald, Adient plc - VP of IR [28]

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Christie, it looks like we're at the bottom of the hour, so that will conclude the call today. Again, I know we did not get to a couple of the questions that were in queue. I'm available this afternoon, this morning for a follow-up call. So please feel free to give me a call and reach out. Thank you, everybody, for participating.

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Douglas G. Del Grosso, Adient plc - President, CEO & Director [29]

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Thanks everyone.

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Jeffrey M. Stafeil, Adient plc - Executive VP & CFO [30]

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Thank you.

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Operator [31]

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Thank you. This does conclude today's conference. You may disconnect at this time, and have a good day.