Lear Has Some Explaining to Do

In a letter to Lear's board, money manager Richard Pzena, who owns 10% of the company's stock, called Icahn's $36-per-share bid "horrendous." He said that the value of Lear is closer to $60 per share and that the company has earning power of $4 per share in a couple of years. As I'll explain below, my analysis of Lear indicates that Pzena's valuation is reasonable and his earnings estimates are conservative.

Lear should be valued based on normalized earnings. Valuation should not be based on an extrapolation of Lear's trough years (2001 and 2005), nor its peak years (1997 and 2004).

When normalized operating margins of 6% are applied to the $12 billion (revenue) seating business and normalized operating margins of 7.5% are applied to the $3 billion (revenue) electronics business, the reason for Icahn's attraction to Lear becomes clear. On a normalized basis, Lear generates about $1 billion per year in operating cash flow.

Because Icahn already owns 17.8% of Lear's shares, he will only have to pay an additional $2.27 billion for the right to own that $1 billion operating cash flow stream. It's worth noting, too, that Icahn is getting a high-quality business. For example, Lear dominates the seating market, with a 40% market share. This is a solid non-commodity business that earns 25% on invested capital.

By my calculations, Pzena's earnings-per-share estimate of $4 in a couple of years appears low. Normalized net margins for this business should be at least 2.1% to 2.2%. A net profit margin at these levels implies $4.40 to $4.66 in earnings per share in 2009.

Why Did Lear Accept Icahn's Offer?

Last Friday, Bob Rossiter, Lear's chairman and chief executive officer, said in a press release: "We believe that the transaction price, which represents a multiple of about 9 times our forecasted 2007 core operating earnings -- excluding the Interior business -- provides shareholders with significant value."