BorgWarner Inc. (BWA) Earnings Call Transcript & Summary

Okay. It's 8:00 sharp. We're ready to kick things off. On behalf of Wolfe Research, I'd like to welcome everybody to our 2020 Auto Tech -- Auto and Auto Tech Conference. We think it's a particularly interesting time to be gathering here not only because of questions about the threats like China and coronavirus and European regulatory pressure, we think that there's something even bigger underway. We think that right now, in 2020, we're at the edge of some very disruptive changes that has been in the works for decades. Until now, the investment community has kind of viewed these changes as down-the-road issues, really not very relevant for stock picking, but that's all now changing. And it's changing because it's going to be in this decade that EVs will inflect. In June of 2008, Pat Nolan, who is now Head of Investor Relations at BorgWarner; Dan Galves, who's my partner covering auto 2.0 research, and I wrote a report in which we predicted that by the mid-2020s, battery electric vehicles are going to reach cost parity with internal combustion vehicles. And that report obviously predated Tesla, predated Rivian and all the things that we see today. At the time, I think one of the most exciting cars was the Hummer, which was getting about 10 miles per gallon. Now GM is planning to produce a very different kind of Hummer. But we said mid-2020s. And now we are in 2020. So that's obviously not very far away. Over the next 2 days, we think you're going to hear that it's relatively soon that fully autonomous vehicles are going to become a reality. First, limited to dense urban centers, but this is going to be huge. It's going to be very disruptive to transportation as we know it today. And it's also within this decade that we're going to see relatively less expensive and less constrained AVs that will be sold to private individuals, which will lead to investors starting to question whether we've reached peak auto, where auto demand peaks for good. And it's over the next few years that we're going to start to see automobiles sold online from retailers like Amazon, Carvana and Shift with cost advantages versus today's business model. And over the next few years, we're going to see an explosion of new markets for suppliers, a $30 billion market for Level 2+ semi-autonomous driving systems, a $50 billion market for automotive central compute systems. And McKinsey believes that there's a $750 billion market coming for connected car data. The amount of disruption that we're talking about here has the potentially -- potential to profoundly change the auto competitive landscape, both for automakers and for suppliers. And I think most of you in this room are aware that if you've been reading our dailies or thematic pieces of the effort that we've been putting into addressing and assessing some of these trends. And I hope that over the next 2 days, you'll be able to identify some very interesting, hopefully, alpha-generating opportunities from the agenda that we pulled together. And if there's any way that we can help any of you, please reach out to any of us. In the front of the room, we've got Dan Galves from our team; Harry Nikel; Shreyas Patil; Tatjana's sitting outside at one of the desks; myself; Brittany Amoroso who is also outside. And really, we all agree to have her to thank to because she pulled together all of this, all of your conference schedules, your meetings, all of the logistics, did a phenomenal job. Our CEO, Ed Wolfe, will be floating around here as well. And we've got our crack sales team also floating around and here to help you. We're here to -- for your service. So any kind of questions or things that you'd like to do, please reach out to any of us. Now with that, I'm going to click over to the first slide on BorgWarner. We had a different slide, but that's okay. BorgWarner has a long history of capitalizing on automakers' need to improve efficiency of their propulsion systems. For decades, the biggest opportunities came from technologies that enhance the efficiency of internal combustion engines and drivelines. The company dominated turbochargers, timing systems, dual-clutch transmissions. In the past 5 years, the company is taking a series of steps to position themselves equally well for vehicle electrification. The idea was that the company wanted to be agnostic to these trends. And BorgWarner's management team believes that this is achievable -- so I think you can keep it there, Fred. BorgWarner believes that this is achievable. And because many of the electromechanical technologies that they have in-house within the company are also going to be critical for electric vehicles. Every EV needs a gearbox. And BorgWarner has the most sophisticated gearboxes on the market today. Every hybrid needs a clutching mechanism to disconnect and connect the electric driveline from the internal combustion driveline. BorgWarner is the leader in clutch packs and actuation of clutches. In the years since they described this goal of being agnostic to combustion, hybrid or electric, BorgWarner made a number of important acquisitions. In 2015, they acquired a proprietary electric motor company called Remy. In 2017, they acquired the commercial industrial power electronics business called Sevcon. And then in January 28, BorgWarner -- of this year, BorgWarner announced that it will be acquiring Delphi in what they've described as a game changer with respect to their electrification platform. We talked about before the business that Delphi has built up over time. In the first half of 2019, they talked about having won $3.5 billion of lifetime business in power electronics. BorgWarner -- Delphi is a $4 billion revenue company. So clearly, this company has some big opportunities for growth ahead of them. But obviously, this acquisition also comes with some challenges. So what are investors hoping to hear from this discussion today? They want to know whether organic growth for BorgWarner is going to reaccelerate. Will the company's acquisition of Delphi contributed to competitive advantages? Or does it come with baggage? And with that as an introduction, I'm very pleased to welcome the management of BorgWarner. Fred Lissalde, who's sitting to the left of me, CEO; Kevin Nowlan, CFO; Hakan Yilmaz, CTO. And as I mentioned, Pat Nolan, is in the audience. And now I'll pass it on to Fred for some opening remarks.

Thank you. Thank you, Rod. So we -- thanks for the introduction. We are a company that constantly outgrow the market by, on average, 500 basis points per year. And we do that because we have the right product to do so and we do that independently to the propulsion mix shift. From a financial performance, we ended the year at 12.1%, the op. We generated close to $700 million of free cash flow. And this is the position of strength and financial discipline that allows us to now execute the proposed transaction with Delphi Technologies. I have 3 slides that I wanted to go through that gives you a little bit of the highlights of the transaction. So it seems that everywhere I go, I need to carry that today, which I'm now going to read to you. The high level, first and foremost, reason why we are extremely excited about the transaction with Delphi Technologies, because it accelerates our positioning very, very uniquely into the world of electrified propulsion architectures. It accelerate actually the position of both companies to be uniquely positioned in the world of electrified propulsion architectures. Who else in the world has at scale mechanical, rotating electrics, software and control? This is the equation that you will always find when you move towards electrified powertrain. In battery electric vehicle, in hybrid or for an eTurbo, you always need mechanical at scale, rotating electric at scale, power electronics, electronics software and control at scale. This is the execution also of our strategy that we've announced a number of years ago and that you alluded to, Rod, around being agnostic across combustion, hybrid and electric. And then we run to you the -- I will run the pie chart of the product from Delphi Technologies, and you will see that we're getting great assets from a combustion standpoint that also positions us absolutely uniquely in the world of combustion and hybrid. Again, who else in the world understands and make at scale all the air paths, turbo, EGR, EGR cooler, VCT, the fuel path and the engine control unit and transmission control units plus all the assets that we have in transmission? It's not only that strategic fit that excites us, it's also the financial compelling element of this transaction. This transaction is meaningfully accretive and generate meaningful synergies, bottom line synergies. And you will see in 2 slides from now that we think that we can generate very meaningful top line synergies, bring those 2 companies together. Let's go around the Delphi Technology portfolio, and let me do it step by step. So we -- I talked about the electronics and the power electronics, about 20% of their revenue growing. This is a great fit for both companies, again, bringing under one roof mechanical, that's our roots; electronics, their roots; and rotating electrics that we brought 5 years ago with the acquisition of Sevcon. And we have great product leadership and great technology in those 3 fields. Aftermarket. Delphi Technology is a great player in aftermarket field, about $800 million of aftermarket. Borg has about $600 million of aftermarket. When you combine those 2 companies, it's a $1.4 billion aftermarket, which is very relevant in the marketplace. One of the biggest aftermarket play in the propulsion area. They have a business unit called PTP, growing less than the other business unit, as you've seen in the pie, but generating a lot of cash, very profitable. And we like the product that we have in this field. It matches very, very nicely the other products that we have in the propulsion area. Then we have injection, commercial trucks and trucks injection, about 12% of the revenue, pretty stable, very high product leadership, good market share, a great technology. This thing is going to be here for a long time. And then what do you have? You have light vehicle injection. As you can see on the slide, diesel is going down. And by 2022, 2023, the diesel exposure for Delphi Technologies is going to be minimal. And GDI is going up. And we've assessed their technology from a GDI standpoint. We're very, very pleased with what we saw. Their launches are ongoing, and we are very pleased with what we've been able to see during due diligence. GDI goes hand on hand with our turbo business. Like the turbo product, GDI is still in growth in combustion and in hybrid. In combustion, about 50% of the engines right now are GDI, growing north of 70% in the future. So it's a growth market. You don't have too many players, great technology for us at BorgWarner. This is what we are good at: bringing good technology, commercialize it, bring it to scale around the globe. So during due diligence, we've assembled a team of BorgWarner people and Delphi Technology people, and we looked at -- all right, in the field of electrification, and I'm going to focus on the field of electrification. You could think about other synergies in the field of combustion. But here, we looked at the field of electrification. We looked at all the customers that wanted to go into modular purchases, both in hybrid and electric. And we boiled down that list to the customers that were ready to source within the next 24-month programs systems from a hybrid and electric standpoint. And what you see here is both the size of the list that shows us that the electrification is accelerating globally and the amount of revenue that those 15 top programs are generating in 2023 and beyond. It's both the size, the acceleration and the amount of revenue generating -- potentially generating with the coming together of Delphi Technologies and BorgWarner that really, really is important. So I'm really, really confident about the fact that bringing BorgWarner and Delphi Technology together, we bring both short-term value to shareholders and long-term value to shareholders with leveraging synergies and leveraging revenue synergies down the road, positioning us very uniquely from a -- in the world of electrification, but also very uniquely in the world of combustion and hybrids. Back to you.

Thanks, Fred. So I'd like to ask you a number of questions about your outlook longer term and Delphi as well. But before I get into some of those, I was hoping you can give us a little bit about your perspective on what the market looks like today. As we go around the world, the nexus of concerns is largely in China and in Europe nowadays. China is roughly 17% of your business. Obviously, a lot of disruption happening right now. And then not a day goes by where we don't read something about an automaker that is facing a lot of pressure in Europe as a result of CO2 mandates and the need for them to adopt more expensive technologies. Maybe they'll hit these targets, maybe they won't. But what are you seeing today from these customers in terms of their production schedules, their response to these things and in terms of your operations?

Yes. We think that 2020 is going to be a challenging year from a market perspective. Our hypothesis is at midpoint of our guide, market is down 3%. And that excludes any impact, any potential further impact of coronavirus. So down 3%. We are seeing all markets down. U.S. I think at midpoint is down 1.5%. Europe, at midpoint, down 3.5%. China, down 3%. So we feel it's going to be a challenging year. This is also one of the reason why we are proactively embarking into our own restructuring efforts. We've announced in April our first wave of restructuring effort, touching SG&A. And we've announced 2 weeks ago a second wave of restructuring effort. We are looking at cost of goods sold. We want to be proactive and make sure that we position the company in the best possible position to withstand the strong margin profile that we have. That's why I would say it's going to be a challenging year.

Your China operations now, are they up and running? Or are things shut down today?

So we have 10 plants in China, 9 of them are up and running. One we're supposed to open March 11. First and foremost, we want to keep our people safe wherever they are. The 9 plants are open, they are running. Some of them have been opened for quite some time and only closed for the Chinese New Year week. And we've adjusted our output to the customer demands there.

And you alluded to a restructuring that you've got underway, and there's been -- we've had a lot of questions from investors about what exactly is happening and what's the payback. This is the BorgWarner internal restructuring, but it sounds like this is in order to sustain a targeted margin profile. Can you just talk about what you're doing there?

Yes. It's a restructuring that essentially touches areas of the business that are literally really impacted by the integration of Delphi Technologies. And it's a restructuring that we want to be proactive, making sure that we know things are going to happen and we want to make this restructuring in the position of strength rather than making it too late.

Makes sense. Let's talk a little bit about the adoption of new technology and contract awards that are being made right now. So all we hear nowadays is about electrification in the industry, and it's obviously reflected in the valuations of some companies that are out there, good and bad. You mentioned on your conference call that 100% of your net business wins basically were electrified, hybrid or electric. Does that mean that nothing is happening in traditional combustion technologies like turbos and timing systems? Can you just elaborate on, from your perspective, what do you mean when 100%?

Yes. So $2.1 billion of net backlog, 2021 to 2023, is all hybrid electric. It also -- it's -- it also hides the fact that we are outgrowing combustion. We're outgrowing combustion by about 400 basis points and that combustion is down 6% year-over-year, between '21 and '23. So the net new backlog of $2.1 billion is 100% hybrid electric. We're outgrowing the combustion sector, which -- by about, yes, 300, 400 basis points, which also enables us to outgrow the hybrid sector by 10% and the electric sector by 17%. So again, to my remarks earlier, we are outgrowing the market. Wherever it is combustion, hybrid electric, for sure, we're outgrowing the market way, way -- bigger way in hybrid electric. And that's why 100% of net new business backlog is H&E, which is a good thing.

But is it -- are new timing systems and new turbocharger awards and things like that, are they still being awarded by customers?

Yes. They are. They absolutely are part of the backlog. Yes.

Okay. Now let's switch to Delphi and this concept that this is a game changer for you. So you obviously want to have something that's differentiated for BorgWarner just like you had with turbos or I think in timing systems, you might have something like 60% of the world market for timing chains, some amazing market share. And you want to have something like that for electric vehicles as well. So could you talk about how exactly is acquiring the power electronics of Delphi a game changer for you in electric vehicles in general? And there's 3 leaders, just so that everybody's kind of level set, the 3 leaders in power electronics in automotive in the world are Bosch, Denso and Delphi. So how does that affect you and give you a competitive advantage?

The ability to have under one roof, at scale, mechanical, rotating electrics, promoters and the motor controller software is going to be positioning us very uniquely in the marketplace. This allows us to design a system smarter than anybody else, right? Because we understand all the connections, interaction, mechanical motor software. We are going to be able to do a better job in term of developing those mechanical, motor and software systems from an efficiency standpoint. And I'd like to turn it over to Hakan just right after for him to talk about the importance of efficiency in electric propulsion architectures. This is what is going to be differentiating us in the marketplace, being able to have those 3 elements under one roof. Not that we need to sell systems, we're happy to sell subsystems, but being able to talk to customers with having those elements at scale is very, very important. Also from a competitive positioning standpoint, being able to make those 3 key elements: mechanical, motor, electronics software, in-house, manufacture them at scale, purchase components and electric -- electronic component at scale is absolutely differentiating. Do you want to talk a little bit about efficiency and what that means from an efficiency standpoint?

If you can maybe just bring into this. And also just to give everybody a perspective, a electric vehicle drive module, you guys have said is about $1,500. About $750 of that is the power electronics. So why do you need to have that in-house? Why couldn't you just partner with somebody and, say, we have access to this.

Let's start with the efficiency. There is -- I always hear this myth about electric cars being 95% efficient. Well, that's not true. The electrical motors are 95%-plus efficient. But you don't only have an electrical motor on a battery electric vehicle. If you follow the path that the electrons follow from plug to wheel, you have to take the electrons from the plug, they have to go through the onboard charger, which is about 95% efficient. So basically, half of your fuel you're leaking out when you're filling up your battery pack. Then you store them in your battery pack. The battery pack has charging, discharging efficiencies, especially at cold temperatures. If you leave your car overnight soaked at cold temperature at minus 20-degree Celsius, minus 10-degree Celsius, you're almost losing half of your charge. Your range is shrinking. Then you take the electrons out of your battery pack, put them into your inverter in your electrical drive module and convert them into a magnetic field to turn your electrical motor and create your torque at your wheel. And in that whole process, you lose another 5%, 10%. If you look at the average battery electric vehicles sold today and look at the Department of Energy estimates, a battery electric vehicle, in total, on average, on a nice sunny day, about 60% efficient. So a lot of your efficiency is actually getting lost, all your energy is getting lost from plug to wheel. This is why saving any efficiency on battery electric vehicle is priceless because any percentage efficiency gain you have is going to help us reduce your cost exponentially on your battery pack because battery packs are heavy. If you save 1% of your efficiency, you're basically saving maybe about 1.5% to 2% of your battery pack because you're making it also lighter. The entire vehicle is getting lighter as you reduce your battery pack. So efficiency matters a lot. And OEMs are willing to pay a lot more on percentage efficiency gains on battery electric vehicles than conventional combustion vehicles. Having the power electronics in-house matters a lot because, as Fred explained, the electrical drive unit is one of the most dominant parts on your vehicle that controls your torque, speed and efficiency of your overall system. And the development process requires cross-functional teams from gear system, from thermal management, from packaging, manufacturing processes, electrical machine winding and magnetic field technologies, power electronics, smart controllers and software. Bringing all of those functional teams under one roof is the key because it's an iterative development process. If you split your brain of your development system from gearing, from motor, from inverter, the power electronics into multiple suppliers, you can never build that effective iterative system integration, system development engineering processes effectively. To maximize the efficiency, having those under one roof is the key and having them work together as one team is the key to get the best efficiency points.

But you can't say, "Look, I'm working with Delphi. You're a separate company. Here is the contract that we've won from this automaker. We're working on the motor and the gearbox. And you guys are working on the power electronics that are integrated into this, and we'll collaborate together." That's not practical?

That would be a reactive approach. Consider the fact that building an electrical drive module with all 3 in 1 requires 100 to 150 engineers for 1 product and half of that software, roughly. If you have a reactive approach and try to develop a new platform with a partner, you're reacting to the -- you're already late in the game. The key is to have your off-the-shelf, scalable electrical drive modules ready to quote to customers when they come in with the best efficiency and best cost.

There is another key. If you have the motor, I have the power electronics, you have to tell me in order for me to control your motor the good, the bad and the ugly of your product. I have to do the same with my controller, no product is perfect. And as for transparency and the openness of having the controller or -- yes, the other controller and the motor, and I'm even leaving the transmission aside, but it's -- to the 3 -- among the 3, you have to collaborate. And that under one roof is priceless.

Yes. And what is it about Delphi specifically that you think gives them a competitive advantage? I think you've mentioned at one point that they're more vertically integrated than most of the other players in that field.

Now Delphi Technologies, what we like about them is their innovative culture, and they have these decades of electronics and software capabilities that they have built their network with the national labs, with the universities, the R&D tech centers, their heritage that they brought in from General Motors' times. And they were really looking at the future of electrification, and they've started developing the core technology that you need for inverters, for power electronics, for integrated drive modules already more than 2 decades ago. They worked with Department of Energy, ARPA-E. They worked with national labs, and they developed this core technology named the Viper power module, which is in the center of your inverter design. If you're building power electronics and inverters for electrical drive units, you start your power electronics with the power module. The power module is basically a switch. It takes -- what you do is you take your electrons from your battery pack, you put them in a small reservoir called the capacitor. The capacitor can discharge electrons very quickly at rapid pulses that goes through your power module, the switch, which is a semiconductor with IGBT or silicon carbide, maybe you heard about it from the semiconductor industry. The key is taking those electrons out of the capacitor and releasing with small pulses to create this sinusoidal wave to generate the magnetic field in your electrical machine. The magnitude of that sinusoidal wave is your torque at your wheel. The frequency of the sinusoidal wave is your speed of the vehicle. So that little switch is the core of your performance and the efficiency that you create out of your electric drive unit. And it has to match perfectly the customer specification and the electrical motor that you have under one roof. So Delphi Technologies developed these power modules in the last 2 decades. They're in production with it and they are chip-agnostic. They have high scale in power electronics production. They can buy these power module switches, IGBT or silicon carbide, from semiconductor companies. They have a great supply chain established. They can scale up. And that's perfect technology that we need to match with our mechatronics and electrical machines in the mechanical side to have the most cost-competitive and efficient electric drive units in the market.

And that's what we saw during the discussion with Delphi. And that's one of the reason why the structure of the deal -- one of the reason the structure of the deal is made as -- so that shareholders from both sides can benefit to the upside. It's a 100% stock deal. One of the reason is also to preserve a very strong balance sheet. But the fact that the both -- shareholders of both companies are going to be able to enjoy that revenue synergies.

Okay. I'm going to open it up to questions here in a minute, but I've got one more that I wanted to ask you. So tell me whether this criticism is fair. Delphi is 20% electronics. And the rest of it is a bunch of fuel injection and valve timing and things like that that you bought Delphi for the 20%. But the other 80% really isn't that important to you or maybe something challenging that you need to manage down the road of internal combustion declines. So what's your reaction to that?

Absolutely unfair. 20% electronics going to 30%. 20% aftermarket fits perfectly with our aftermarket. About 20% powertrain product, we're finding homes into 2 existing business units that are going to match perfectly, generating a lot of cash and very profitable. 12% of truck injection. We love that. We love our truck business. This is going to be around for a long, long time. And the GDI, the GDI is in growth mode, both in combustion and hybrid. The technology leadership is clear. You don't have too many players. It's still in growth mode. For us, we like all of what we see.

Any questions? Okay. Let's talk about -- and feel free to -- if anything comes to mind, I'll pause here in a little bit. But can you talk a little bit about the process post the transaction? First of all, are there businesses that may be divested? And there certainly have been businesses that have been a bit weak within Delphi, and they're going through a restructuring of that. So what are the challenges that remain in looking at those businesses? And how do you intend to avoid disappointments in -- operationally within that acquisition?

Yes. So during due diligence, we looked in great detail at what they call the Project Pioneer, which is essentially focused into the rationalization of tech centers and the adaptation of engineering workforce through the demand, especially into diesel. And we feel very comfortable about what we saw. This is certainly something that we will carry on past closing. We've done a lot of work there. This is focused on engineering. And the synergies that we will capture are independent from Project Pioneer. They're essentially more on SG&A and purchasing and a little bit of IT. Do you want to add anything to that?