BorgWarner Inc. (BWA) Earnings Call Transcript & Summary

Good afternoon, everyone, and thank you to those who have joined our earlier fireside chat sessions and those just tuning in now. My name is Fitz Middleton. I am the U.S. sector specialist for industrials and materials at BofA. I work alongside John Murphy and his team closely, and I'll be moderating this fireside chat with BorgWarner. A couple of reminders. First, as a reminder, through the course of the discussion, we will be receiving audience questions. You can submit them through the Veracast system. The option to do so is at the bottom corner of the interface portal. And if you have any problems with the webcast audio, please e-mail [email protected], and someone will get back to you with assistance in pretty short order. Okay. Let's get started. I'm happy today to have BorgWagner joining us. As many of you know, BorgWagner is a leader in engine and drivetrain technology. Over the course of the past several years, BorgWagner has positioned itself uniquely as a propulsion company with a broad product portfolio across combustion, hybrid electric vehicles. From BorgWagner today, I'm happy to welcome Fred Lissalde, the company's President, CEO. He's been in the role since 2018 and had a long career across several divisions, drivetrain systems, transmission, turbo systems. Also joining us is Kevin Nowlan, the company's CFO, who was appointed to that role back in 2019; and Patrick Nolan, Vice President of Investor Relations. Thank you guys for joining us. We appreciate your time.

So if we just kick it off, I think.

We could begin.

Great. I think that we'll start with some of the things I think are most topical with clients and investors right now. Where the industry stands and what a return to normal is most likely to look like? So if we think about kind of restart dates for Europe, it seems like early May is not a bad bogey. North America, mid- to end of May, not a bad bogey. So within those markets and the restarts as we ramp back up, are you seeing them pretty coordinated between countries and states? Or do you think that there's some dislocations, maybe even disruptions, emerging as we take on that process?

Yes. I think the good thing is that it restarts. The pace of the restarts vary by customer region. Europe has begun and North America is following. So it's positive. However, there are still a lot of uncertainty as to what the pace of these ramp-ups will be. And therefore, I think it's -- we think it's really important to stay in very close contact with our customers and our suppliers for securing a seamless production restarts. I mean we're ready at Borg. We are -- we have implemented a slate of clean restart processes, and we have pressure tested some of those, and we're happy where we are. We've just built from what we learned in China and adjust it to some of the local areas, but we're ready to go.

Great. I mean -- and I think that's interesting. You bring up what we've learned from China. Can you just expand maybe a little bit on china's ahead of maybe the rest of the world, what lessons you can take from there, maybe what lessons don't apply to North America as China has ramped up ahead of the other regions?

Yes. We've lived through the ramp-up of China. So we can apply best practices from there. I don't see a lot of what has been done in China that can't be applied. Now we are leaving to our local plant managers some room to tweak how they want to restart their own production. But we're ready. We've done a lot of work getting ready and putting health and the safety, our people first. In addition to China, I think we've seen a lot of innovative safety solutions developed in China and also outside of China. And this is that cross -- sharing of ideas that really I'm very proud of because it fosters and promote collaboration and focusing on health and safety of our employees.

Makes sense. That's helpful. So -- and then maybe if we think about some of the customer releases. If you have any visibility on customer releases in Europe or North America, kind of post 2Q, maybe that would help frame what the velocity of a recovery might look like in the second half on production.

Yes. We -- I think what we see right now is a focus of all of the players on the restart and the ramp-up. The demand outlook for the second half will most likely remain a recurring questions for us for the next several months as, ultimately, the demand will be driven by end customer confidence. So we are focusing on what we can control. What we can control is our readiness to restart with very open communication with the broader supply base, i.e., customers and suppliers.

Right. Okay. And then I think that one of the other topics that seems to be getting a lot of attention is sort of the Tier 2, Tier 3 supply chain and how that supply base looks in terms of liquidity levels and how well they're kind of weathering through the market turmoil and recent pressures that have come up as well as their ability to support production when it comes back online broadly, and then sort of geographically as well. What do you think the state of the Tier 2 to Tier 3 supply base is as you look out right now?

So there is pretty clearly some stress in the supply base. And it is absolutely Tier 4, Tier 2s and Tier 3 suppliers to be able to fund production restart. Therefore, we're staying very close to them and we're monitoring the situation. To date, we've not seen any disruption. We're ready to go. And we've also applied some of the risk management best practices of supplier distress that, as you may remember, we've seen in the past in some regions. But clearly, this is a different scale, and we are all hands on deck to work with our supply base and secure restarts.

Great. And then I kind of have one more that I put into the bucket of like most recent themes. So in terms of near-term operations and the production ramp, have you seen any launch delays, cancellations from the automakers that are on your radar as we stand today?

Yes. So we have not seen -- we have not seen cancellation. We've seen a little bit of delay, but I wouldn't rate those delays are significant, especially in the world of electrification where we see a momentum that is not slowing down in -- even within this COVID-19 crisis. The push for electrification in those launches, programs and RFQs are really not much impacted by what we see as a current market disruption. And one thing maybe that is here to remember is that 50% of our backlog is in China, which is right now a little bit -- has restarted and that's where we see the least disruptions at this point in time.

Great. That's helpful. I think that China exposure is a key area of focus for the market right now. So thank you. And then if we kind of move on to the next kind of bucket, impressions around the financials that we saw last week. I think it was a pretty good decremental margin of 26% in Q1, if I got that right. That's despite some production stoppages. So -- and you kind of cited cost restructuring actions that you've executed on over the past year. If I could just ask you to kind of look out to 2Q, do you think the decrementals are much worse than Q1 given that there'll be production kind of volume weakness and the capacity utilization impact? Or do you think that those will kind of remain contained and there's still stuff you can do on rightsizing the cost structure to help in Q2 as well?

You're right. The decrementals were 26% in the first quarter, and we're pleased with that result. And it was a function of a couple of things. I mean first, we did, as you've mentioned, execute on some cost restructuring actions over the course of the last year, particularly in our engine segment which is why we were able to manage the decrementals in that segment down to about 20%. And we achieved that overall company result while we were also increasing the investment in R&D dollars in our Drivetrain segment to support our electrification program. So that is why we are pretty happy with the result we delivered in the first quarter. But to your question, then, as we look ahead, with the pace at which production is coming down on a year-over-year basis, it's really challenging to manage the decrementals that's something that's less than the 30% range. Particularly because it's hard to get cost out fast enough to offset the impact of the loss contribution margin. And then as you think about this environment, we have the risk of the operational inefficiencies that come into the supply chain into our plant environment as we ramp up production from a pretty severe shutdown. So that can make managing the decrementals even more challenging. So I think as we look ahead Q2 and beyond, we think the right way directionally to think about us is decrementals in the 30% range given some of the inefficiencies and given how quickly production has come down. But then as production starts to rebound and starts to approach a more normalized looking levels or a more normalized looking environment, let's say, I think we would expect to start to see the incrementals come back more consistent with the historic guidance we've given, caught in the mid- to high teens.

Right. Okay. That's helpful. Appreciate it. And then so kind of sticking there on the cost reduction and cash conservation actions. What have been some of the areas within your cost structure that you've gone after first? Where are some of the areas that may be untouched a little bit or less touched on the cost side? And then I'd have a follow-up to that, which is, are the cost saves -- if we try to bucket them, how much are kind of sticky to permanent? Is it more of a short-term trough type of effort?

Yes. You mentioned the term, I think, cash conservation. I mean keep in mind that even in this challenging environment, we still expect to generate positive free cash flow for the full year 2020 and that's even in scenarios where we're talking about global production being down as much as 30%. And so with that and our strong liquidity profile and our strong leverage profile, we don't think about it in those same terms as cash conservation. But then with respect to your question about cost management, we have taken certain actions in the near term to manage the costs. But where our plants have been shut down, we've been executing temporary layoff strategies, we've also executed certain salary pay cuts, including like Fred and me and others in our leadership team taking pay cuts as much as 20%. So those are some of the near-term temporary actions we've taken. But then one of the things we haven't done is focus on reducing our longer term investments, our investments in R&D and CapEx, which you've seen some of the peers do. With our R&D, for example, our current planning and assumption is that we're going to maintain our investment dollars at approximately the same rate that we had last year because we're going to continue to leverage as a competitive advantage our liquidity profile, our free cash flow generating profile to maintain our level of investment in those future electrification programs. And from a CapEx perspective, as long as our customer launch cadence remains intact, we'll continue to invest our CapEx dollars accordingly to support those launches. And it's those things that support the ability of our company longer term to deliver that 400 to 500 basis points of outgrowth. So that's something that we are focused on in the near term. But of course, we'll continue to look at ways to manage both of those areas, make sure we're investing the right amount of dollars of supporting those long-term needs. The last point I might touch on in terms of what are those stickier things that you asked about is you have seen us proactively talk over the last 14 or so months about 2 restructuring programs focused on both SG&A and cost of goods sold. A year ago, we announced one more focus on SG&A, and we started to see some of the benefits of those actions in Q1 even, helping our decremental margins. But then what we announced back in Q1 in January, these are actions that we're executing over the next 2, 3, 4 years to improve our long-term cost profile. So those restructuring plans, particularly what we announced in January, are going to take several years to implement, but they remain on track with no delays at this point. And we're pleased that we got out in front of this in terms of executing some of these risk mitigating strategies.

Great. Yes. That's well -- point taken. And then you talked about a little bit about incrementals kind of coming out of this. Maybe if you could just expand a little bit, Kevin, on kind of how you think about costs coming back into the system as volumes ramp. Are there buckets where we should expect to see that where it makes most sense? Or how should we think about that?

I think from a cost perspective, in the near term, we think our decrementals are going to run in that 30-ish percent range simply because in this type of an environment as we're restarting plants, we think there's inefficiency in the system. We think there will be inefficiency in terms of the production ramp-up, even right now, we're back in the bulk of our plants operating, but at not high levels of production, let's say. So there is some inefficiency that comes with that. There's inefficiency with restarting in a social distancing environment. And so we're working through some of those inefficiencies that are undoubtedly going to come into the system as we restart in this environment. And then even on the supply chain side, as Fred alluded to, there are likely to be some challenges there that could create some headwinds as we look forward from a cost perspective. At the same time, as we see some of those challenges coming forward, we'll also look at what other actions we should be taking internally to manage our cost structure accordingly. So those are some of the puts and takes as we look out over the coming quarters from a cost perspective.

Great. Thanks. And you made a good point on the kind of the free cash flow, and I think you ended the quarter with $900 million in cash. So could I just ask a little bit about the balance sheet? And over the longer term, kind of how you view capital structure, what it should look like on a sustainable basis? Kind of what do you think ideal leverage level should be and maybe a minimum cash balance to kind of weather other cycles? Are there any frameworks on how we should best think about that?

Yes. Starting maybe with that cash balance. We think about it more in terms of liquidity, which is cash and committed undrawn revolving credit facilities. What we do is when we assess how much liquidity we need as a company, we look at severe downturn scenarios, not too different from the type of scenario we're experiencing right now and we model out how much liquidity we would need to manage through that environment if it were to remain in place for a 2- to 3-year period. And what that's taught us in some of the modeling actions is that our liquidity, cash plus undrawn revolver, should be about 16% or so heading into that type of an environment for us to feel like we can really manage effectively through that environment. Right now, when you look at the cash, like you said, $900 million of cash, let's call it $1.5 billion of the revolver right now, $2.4 billion. We've really started into this environment with well over 20% liquidity. So we feel really good about the liquidity of the company as we're operating in this environment. So that's the liquidity question. From a capital structure and leverage perspective, similarly, we went into this environment with a pretty conservative leverage profile. I think we are gross debt-to-EBITDA of about 1.2x. I think we could -- we anticipate we would continue to operate at strong BBB credit metrics, probably have a little bit of flexibility from a leverage perspective to go a little higher than that. But we do think it's a competitive advantage, maintaining a leverage profile that's at the more conservative end of the spectrum of the peer group. So we feel good about our liquidity profile and our leverage at this point.

Great. And then I'll just briefly take a moment to remind anyone that's on the BofA Veracast system, you can submit questions online if you have any. So please feel free to do so. And then so I was thinking maybe some other kind of bigger picture or less balance sheet related questions maybe. You recently did rework the acquisition agreement with Delphi Technologies for the company's recent revolver draws. Could you just remind us of your current expectations and thoughts on the transaction? And maybe specifically, kind of some of the financial and operational covenants that are in this new agreement and that you'll be looking to at closing?

Okay. I mean, first and foremost, we continue to believe in the strategic merits of the transaction. I think that's important for all of us to recognize. And so we're excited about getting to the finish line of the transaction. The purpose of the amendment that we executed last week was to really make sure we were balancing providing Delphi Technologies with the flexibility it needs to execute its current financial plan in this environment while also protecting us from further unanticipated downside risk. So that was the challenge that both companies faced, and that's what the deal was that we struck last week, giving them the flexibility, giving us the protections. And so your question about what are those new covenants? There are actually new conditions to closing that we have, and there's 3 of them. The first is that at closing, the outstanding revolving credit facility borrowings for Delphi can't exceed $225 million. So you remember, they drew the full $500 million revolver. They need to pay back, at least on a gross basis, $275 million of that back by closing. Second, the revolver, net of any cash balances on Delphi's balance sheet, can't exceed $115 million at closing. And third, there is a net debt-to-EBITDA ratio that gets measured at closing that can't exceed a specified threshold. So those are the conditions that we'll measure at the time of closing. And as long as Delphi executes on its current financial plan, we'll close on the transaction once we get regulatory approvals.

Great. And maybe on the same topic, but from maybe a more operational standpoint. Can you maybe walk us through some of the integration work that you're pursuing? In the current market, have you encountered any new opportunities for cost reductions? Any new opportunities for synergies? Anything that you're finding or you're working on versus your initial expectations or what may have been anticipated?

Yes. So we remain on track, as Kevin alluded to, to close the transaction in the second half, most probably the regulatory approval will be the determiner of the final closing date. As far as integration planning, actually integration planning teams is concern, I am very, very pleased with what I've seen. You have a very, very engaged integration team from both sides. We have match payers. I would say that we are including, I'd say about 200 people to work on this integration. I'm very pleased with what we've seen so far.

Great. Helpful. We did have an audience question on the similar topic, so I'll go ahead and throw that in now, which is, could you just -- with regard to the amended deal, any color on expectations around kind of the path or trajectory of a recovery? Is your base case for rebound to begin in 3Q or does it look further out than that? How are you thinking about the passive recovery from here?

Yes. I'm sorry, is that a BorgWagner specific question you're asking about or just more generally? I mean, from a more general perspective…

Yes.

Yes. I mean on our earnings call a week or so ago, we gave an expectation on how we think the year is likely to play out. And I think the big uncertainty, as we look at the year, is really more so around Q2 than anything else. And it's the pace of the restarts and what levels of production ultimately come into the system. And you saw from our guidance a week ago that we expect in the second quarter, we could be down anywhere from 50% to 75% on a year-over-year basis. So we see that being the most challenged period, and then we start to see recovery in the back half of the year. But even then, there's going to be uncertainty around what is consumer confidence, consumer demand and ultimately the pace of consumption in the marketplace. But right now, we're very focused on Q2 and the pace at which we see production restarts ramping back up. So overall, though -- to answer the question, overall, we're expecting the market to be down 25% to 30% on a full year basis for us based on our weighted average volume.

Okay. Okay. And so then maybe over the longer term, around same topic, but M&A, but much over a little longer-term horizon within the industry. Do you think that it's likely to be more driven by smaller vertical integration acquisitions, Tier 2, Tier 3 suppliers? Is it more likely to be horizontal M&A that create larger or more global footprints? How do you see that playing out if we look out longer term?

What I would say is that technology, as mentioned many times before, will continue to be the primary driver of our M&A strategy. And the main focus will be, and has been, will be adding system capabilities so that we can offer complete solutions for all types of propulsion vehicles. That's the -- and I feel very, very good where we are right now. And what we do with Delphi Technologies is just exactly that. And one thing I would say is also that we have a significant work in front of us, and we will absolutely focus on the flawless integration of Delphi Technologies for the time being, and we don't want the organization to be distracted from this major task, if I may say.

Understood. And then maybe moving on a little bit. Have you seen any of the market volatility, maybe some dislocations out there, that have created opportunity for you to win share or to take over business from other suppliers? Any notable shifts in your win rates or bookings with customers that you've seen or that you think may play out over the rest of 2020?

So I would say it's rather early to talk about changes related to new business win rate. We believe that our financial strength and discipline is a competitive advantage right now, where we are able to protect all R&D and launch money to make sure that we are meeting our mid-term growth prospect despite the changing environment. So more broadly, we don't see any slowdown on electrification programs. Some of them might be delayed by a few months, but if you go -- if you start with China, actually, you can see that what is being done right now is promoting new energy vehicles, which accelerate growth for us. If you move to Europe, what we see is that the clean -- the green deal is being confirmed. And what we see is that 2025 and 2030 regulatory on CO2 and emission has not been questioned. So what you can see, if you look at some details, in some country's programs that were focusing on electrification of propulsion, actually they are deemed essential. In the U.S., electrification might take a little bit more time. But that is why we are absolutely at ease with our strategy of being agnostic across combustion hybrid electric, because I think our customers in the U.S. will benefit from great technologies that we have from a combustion standpoint, making engines cleaner and more energy efficient, which is what we do for a living, either combustion hybrid electric. And so the world is moving at different speed. But as far as we're concerned, we're supporting all customers with propulsion architectures, wherever they want to go.

Great. And that brings up, I think, an interesting question around if some of the OEMs become a little bit more capital constrained, if they alter their investment efforts, is this something where they become more beholden to your powertrain technology? Is there a way that you win here if the OEMs become increasingly reliant on your -- on you to offset some of the investment burdens, whether it's electrification, autonomy, connectivity or anything else that would fall into that mobility solution?

Yes. We are able to do whatever they want us to do. We are able to support the customers with first system engineering discussion to help them defining and ring-fencing their propulsion road map. And for sure, we'll be one of the suppliers uniquely positioned to be able to support our customers from a system standpoint. We are also not -- we are also happy enough to support the customers with subsystems. We don't have the sales systems over the years. Everyone has realized that you need to serve the customer with technology, but at the end of the day, their decision on make or buy, they own it. And we are, at BorgWagner, positioning ourselves to serve them whatever they want either a system or not. But we understand the system, and that's a competitive advantage.

Right. Right. Interesting. Thank you. That's good. I know that I have to let you go so that you can dial into your next meeting, but I want to sneak one more in. Your current outlook for 2020, I think, has revenue outgrowth versus the market of 400 to 500 basis points. It's pretty solid in a volatile macro backdrop. Do you view this as a reasonable benchmark to use over the long term? When we look at 2020, are there things that suggest outperformance is elevated or that BorgWarner's revenue growth should accelerate over the next few years with new business wins? And thank you for letting me sneak that last one in.

Yes, sure. Well in our world, we outsource business about 3 to 4 years ahead of production. And therefore, our ability to move the needle from a growth perspective or outgrowth perspective in a short-term standpoint is fairly limited. So the new business launching over the next few, 3, 4 years are fairly locked in. And what we see from a new business backlog standpoint is supporting an outgrowth of -- within the 500 basis point range over the next several years. And the current market conditions have not changed that.

Great. I'm getting flagged to let you go, so you have time to dial into the next one-on-one. So I think we'll leave it -- have to leave it there. But I did want to say thank you to the BorgWagner team. Fred, Kevin, Patrick, thank you for being here. On behalf of BofA, we appreciate it very much. Hopefully, next year, we'll see you at the BofA Auto Summit in person. And for all of those on the audience line, the next session will start at 3:00 p.m. sharp with GM. So again, thank you to the whole BorgWagner team for your time today and participation.

Thank you.

Thank you, Fitz.

Thank you.