BorgWarner Inc. (BWA) Earnings Call Transcript & Summary

Hi. I'm Ryan Brinkman, the automotive equity research analyst here at JPMorgan. Thanks for joining us for the 2020 JPMorgan Automotive Conference Virtual this year. Before we get going with the next presentation, which is from BorgWarner, I just wanted to remind the investors that you can ask a question, submit it via the conference website, and I'd be happy to ask it on your behalf without identifying your name or firm. So with that, I'd like to turn it over. We have with us Kevin Nowlan, Executive Vice President and Chief Financial Officer; also Pat Nolan, Vice President of Investor Relations. Kevin's got some opening remarks and slides to run through and then we'll launch into Q&A. Kevin?

All right. Thanks, Ryan, and thanks for hosting us. We appreciate JPMorgan inviting us to this event this year, even though it is virtual. It's great. I think most of you are probably already familiar with BorgWarner, but just in case you aren't, I thought I'd just give you a quick summary of our business, and I thought I'd start by doing -- taking a look at Slide 3, which provides an overview of really who we are. We are a technology leader in clean and energy-efficient solutions across combustion, hybrid and electric vehicles. If you look at our products, they help improve vehicle performance, propulsion efficiency, stability and air quality, with the advantages that we have customer, geographic and propulsion system diversity and that balanced exposure is key to our business. As I'll show you in a couple of slides, when you look at our Q2 financial performance, I think I'd characterize it as being pretty solid in spite of a really challenging end market environment. And we believe our financial strength, which we helped demonstrate in Q2, combined with our operational discipline, are really key competitive advantages, really differentiators versus others that we see in the market, particularly in this current environment. Another thing about BorgWarner, we are delivering outgrowth. You can see it in the past few years where we've delivered consistent outgrowth, again this year in 2020, and then a backlog that supports 500 basis points of outgrowth annually as we look ahead through 2023. That means above-market growth across combustion, hybrid and electric. And while we acknowledge our business is in transition, it's changing right now as a result of the market, one thing has not changed: The product leadership remains the driver of our business. And to maintain that product leadership, even in this challenged environment, we're continuing to sustain our level of investment in the future. That means in R&D, organic investment as well as through M&A. And so let's -- if you're following along with the slides, flip to the next slide, Slide 4 and I'll give you a little bit of perspective on the industry environment as we see it. As you can see, no surprise to anybody on this phone call, we expect a challenging environment throughout 2020. And Q2 was likely the most impacted quarter, down 50% globally for our global weighted average business. And that was driven by the production shutdowns in North America and Europe that we saw from March through May. So barring another wave of production disruption like what we saw last quarter, the worst would be behind us. But even if that's true, even if the worst is really behind us at this point, we're still expecting the second half to be down year-over-year, call it, high single digits to mid-teens. And that means for the full year, the market decline would be in about the minus 22% to 25% range for us on a BorgWarner weighted basis. So in spite of that ugly industry backdrop, I think it's fair to say that we've generated solid second quarter results. And if you flip to Slide 5, you can see an overview of those results. And starting on the left side of the slide there, you can see we delivered revenue outgrowth in the second quarter of more than 700 basis points and that outgrowth occurred in all major regions. We also delivered a decremental margin of about 28% this quarter on a year-over-year basis, which we are quite pleased with given the suddenness and the significance of the Q2 production declines, again, down 50% globally. You can see we delivered positive free cash flow in the quarter, which is really a testament to the underlying cash flow generating ability of the company. And importantly, as you look ahead to the full year, we expect we'll generate $300 million to $400 million of positive free cash flow for 2020. So as we look at those results and what we've done to date, we're proud of how the entire team has performed and reacted in this challenging environment. We feel like we've managed to manage our decremental costs and our cash flow during this challenging environment, while at the same time, ensuring that we were prepared to supply our customers as production resumed in May. So next, let's flip to Slide 6. I'll shift gears, and we can talk about a significant new business program that Fred announced on our earnings call last week. I'm really excited to tell you that we are building a power-packed Integrated Drive Module, or what we call an iDM, for Ford's new all-electric Mustang Mach-E SUV. The iDM is being supplied by us as a complete system. It includes our thermal management system in gearbox, integrated with the motor and power electronics from other suppliers. And we think it's a great example that showcases our system integration expertise. This iDM is being supplied to power Mustang Mach-E's rear-wheel drive and all-wheel drive configurations. And on the all-wheel drive GT version, we're also supplying the secondary drive unit. So we were able to capitalize on our experience with scalable and modular approaches to iDMs to deliver this customized drive module that met Ford's stringent requirements. And so we're excited to partner with Ford to deliver this high-quality, clean and energy-efficient propulsion solution for high-performance vehicle in the electrification market. It's just another significant milestone for our electric business. But I would tell you, there's still much more to come as we look ahead. And we focused obviously last week in the earnings call on the Ford iDM. But I think there were a couple of other important product announcements that happened this past quarter that we didn't talk about last quarter on the earnings call, but we thought we'd take a moment to comment on in this meeting. So in addition to the Ford iDM in North America, we also announced 3 other eDM programs, or electric drive module, all of which are now in production in China. We started to supply our high-performance lightweight and compact eDM for the JMC-Ford Territory and for 2 other electric SUVs in China. And so these eDM products are a combination of our electric motor and transmission. So along with the Mach-E, these highlight our competitive advantage in electrification. We can supply the entire EV propulsion system complete with transmission, motor, power electronics and thermal controls. We can also supply individual components, or as is the case with certain of these programs, we can supply a combination of the products that our customers require. It's our broad product portfolio and our system expertise that allows us to be flexible and to support the customers in whatever production strategy they choose to pursue and we view that as a competitive advantage at BorgWarner. So let's shift gears. Let me give you a quick update on the pending acquisition of Delphi Technologies. So if you're following along, flip to Slide 8. During the last few months, we achieved a number of significant milestones towards the closing. First, we completed a $1.1 billion senior notes offering, which will allow us to pay off any of the amounts outstanding under Delphi's senior credit facility at closing. We swapped that debt issuance to a euro-denominated debt, which allowed us to drive the effective interest rate to 1.78%, which we view in this environment as a pretty good interest rate on that debt. Second, Delphi Technologies stockholders approved the transaction back in June by an overwhelming majority, which we believe underscores the value that's inherent in bringing the 2 companies together. And then third, we've now received regulatory approval in 6 of the 7 jurisdictions. Importantly, there have been no conditions placed on the regulatory approvals we've received so far. And we expect to receive the remaining approval in the EU in the coming months, which means we remain on track to close in the second half of the year. So in addition to achieving those milestones in the last few months, the integration teams continue to work very well together. There's a high level of commitment and excitement among the teams as we drive toward day 1 readiness and capitalizing on the value-creating opportunities of bringing the 2 companies together. And so I thought I'd wrap up my prepared remarks by hitting one more slide on the Delphi Technologies acquisition on Slide 9, just to remind you of those key strategic benefits of the acquisition. First and foremost, the acquisition strengthens our leadership position in electrified propulsion systems. It gives us scale, expertise and capabilities in electronics at a time when the industry is obviously moving towards electrification. At the same time, though, it does enhance our combustion, commercial vehicle and aftermarket business, driving an even better market balance for us. When we look at the combined company, we'll be able to offer a comprehensive portfolio of industry-leading products and systems across propulsion types. So as we bring our offerings together, we believe we'll be better positioned than before to meet our customers' global evolving needs. So we're confident, at the end of the day, this transaction is going to deliver enhanced returns for our stockholders, both in the near term and long into the future. And so we're really excited to close on this deal later this year. And so those are really some of the highlights that I had in the way of prepared remarks, Ryan. So with that, maybe I'll turn it back over to you.

Yes. I appreciate it. I'm going to start with some questions here about coronavirus. We're trying to ask each of the suppliers what they think the ultimate impact is on industry and their own profitability. So for example, during the global financial crisis, margins compressed, but then they surprised by coming back higher than they were before. And just curious, as you think about headwinds such as possible changes to the supply chain, for example, but also tailwinds in terms of learning to be leaner, how do you think margin ultimately shakes out here at BorgWarner?

Yes. A couple of things I'd say on that, I mean, focusing on BorgWarner here first and foremost. I think one thing as you think about the margin profile of the company heading into a potential recovery, whether that be 2021 or beyond, I think there's been some question we've gotten around what do you think incremental margins are. And traditionally, we've talked about BorgWarner converting incrementally in the mid- to high teens when we deliver on incremental revenue growth. In this environment, we've obviously seen decrementals around the 30% mark in 2020. That's our expectation. I think it's fair to assume that as the market starts to recover, that you should expect the market recovery aspect of volumes -- of revenue growing to come back somewhere in the range of where we had decremental margins in 2020. And I think that's going to be aided by some of the restructuring measures we've already put in place, which will help that incremental margin profile, which means as revenue snap backs from a market recovery perspective, we should see the types of recovery incrementals the same way as which we saw decrementals. I think that's piece one. I think the second thing, in terms of what potential longer-term impact COVID-19 might have on the cost profile, I think that still remains to be seen. Clearly, we're seeing some challenges in the near term driven as much by production volatility week-to-week as anything else. But we'll continue to assess maybe what some of the longer-term structural implications might be. But from a BorgWarner perspective, what I can tell you is we won't accept a structural reduction in our margin profile coming out of the COVID-19 situation. We pride ourselves on having one of the strongest margins in the industry, 12%-plus operating margin for each of the last 7 years. And we drive that through proactive management of our cost structure. You saw it with the restructuring actions we announced last year as well as those we announced earlier this year, even before COVID-19 hit. So if we determine that there's been some sort of incremental permanent impact on our cost structure, which we'll assess in the coming months, you can imagine that we're not going to stop there and just assume that, hey, that's part of our cost structure longer term. We're going to be proactive in figuring out what else we need to do to maintain that top-quartile margin profile.

Great. Thank you. And I'm just curious, too, if the coronavirus crisis causes you to think any differently about capital allocation. For example, about how much capital cushion is appropriate or what the right debt-to-equity level is or what the right amount and timing of return of capital to shareholders is.

Yes. From a long-term perspective, the answer is really no. When we think about the level of liquidity and what our balance sheet should look like as a company, we actually look at significant protracted downturn scenarios, not too different from what we saw in 2009 and not too different in totality from what we're seeing across 2020. And when we run those types of scenarios, what it tells us is we tend to look for liquidity balances of this company of around 16% of pre-crisis revenue and a balance sheet that looks like an investment-grade company. And so as you look at BorgWarner, as we went into this crisis, our liquidity was really strong. We were at 24% of pre-COVID-19 revenue, if you look at the trailing 12 months of revenue and our balance sheet was really strong as well from a leverage perspective. So I think it's no surprise why we've been able to manage through this environment as successfully as we have. And on top of that, even in this environment, we're generating positive free cash flow. So what that means is it doesn't change our long-term outlook as it relates to capital deployment or level of liquidity or balance sheet. And what it means is as we generate positive free cash flow going forward, that cash flow will be available to deploy to support growth initiatives and returning value to shareholders. So whether that's investing in R&D, inorganic M&A opportunities or continuing to pay our dividends, which we sustained through this crisis, as well as our buyback program. Now to the tail end of your question there, what about the near term, one of the things I will say is we are remaining cautious in this environment with respect to liquidity until there's more predictability and stability in the production environment. And so we are remaining cautious in terms of how we deploy capital at the moment. But as we get to more predictability and stability in the market environment, you should expect us to get more aggressive with the deployment of that capital.

Very helpful. And then just lastly on coronavirus. I wanted to ask what impact you think it might have on the type or pace of technological change within the industry. Does coronavirus speed up, slow down or have no effect on pre-existing trends such as vehicle electrification?

We don't see it having any impact on the preexisting trends. The trend we see toward propulsion efficiency and vehicle electrification, we think, is continuing. It's being driven by stricter emissions regulations. And we're not seeing the regulatory environment changing at this point. And that's part of the reason that we are not cutting back on our R&D investments as we continue to invest to support the long-term growth prospects and the backlog of this company, which is, on a net basis, 100% weighted toward -- over 100% weighted toward hybrid and electric programs and we're continuing to see those programs continue.

Okay. And then maybe just turning to 2Q. Of course, the results were a positive surprise across the board. But probably free cash flow was the biggest difference versus expectations, positive $10 million versus consensus, was looking for a negative $100 million. Pretty significant accomplishment when production is down 50%. Can you just talk about what levers you were able to pull there in the quarter to achieve that result? And then maybe also speak to the outlook for the back half and the full year and what gives you the confidence you'll be able to continue to generate cash as working capital will turn into a headwind to support higher production. And I imagine capital expenditures have to rebound from 2Q's low.

That's all fair. Yes, as we look at the second quarter, I mean, as we saw the crisis unfolding in late March, one of the objectives we had as a leadership team was to drive positive free cash flow throughout the year with particular focus on, hey, let's deliver in the second quarter. To deliver positive free cash flow in a quarter like that, that we just saw, you've got to do a few things. One is you've got to manage your decremental margin profile. And so we took some of the proactive cost measures, both temporary as well as converting on our restructuring programs to manage decrementals. That's kind of point one. Point two is you have to manage your working capital effectively, which means a focus on receivables, making sure you're collecting from your customers as well as being prudent with inventory management. And third is prudent CapEx management. You can see our CapEx took a big step down in the second quarter. That was the way we managed to make sure that we were managing our free cash flow generation while continuing to support the customer launch cadence of our customers as we look to the back half of the year in 2021. So that's what you have to do to be able to deliver a positive free cash flow in a quarter like that and we accomplished it. Now as you look to the back half of the year, you're right, a couple of the headwinds we're going to have. One is working capital is going to step back up here, particularly in the third quarter with the sequential ramp-up in production and volumes. We're also going to have a little bit of incremental headwind coming from restructuring cash flows for the programs that we've announced earlier this year. But offsetting that is really the delivery of operating margin. I mean if you look at our guidance, our directional guidance at 30% decrementals on a year-over-year guidance, along with the revenue guidance we've given, it suggests that operating earnings should be stronger in the second half than the first. So those operating earnings are able to more than offset the working capital headwind and the incremental restructuring cash flows and the incremental CapEx that we expect in the second half to deliver $150 million to $250 million of free cash in the back half of the year.

Helpful. I wanted to follow up to your earlier comments on the Ford Mustang Mach-E. Firstly, can you explain which components constitute an integrated drive module? Which of these are you currently sourcing internally in the case of the Mach-E and which components are you capable of sourcing internally in other use cases? And then how should we think about the market trending for iDMs going forward? If you could work into -- I've got a question here from a client, what is the content per vehicle on the Mach-E and how does that compare to your current ICE content per vehicle?

Okay. First, I mean, we're obviously very excited about this program. It's a big win for us in the North American market for an iDM product, which there haven't been many of these in the North American market talked about publicly to date. So we're pretty excited as that's a significant milestone for our business. And in particular, it does showcase our system integration capability, which is I think what Ford and others have come to rely on us for. So to your question about what constitutes an iDM, it's really a combination for us, us providing our thermal management system in gearbox, combined and integrated with the power electronics and the motor from other suppliers. That's what constitutes the iDM that we're delivering. We're supplying a system to Ford at the end of the day. When you look at what we have the capability to supply in an iDM, we can supply any of those individual components. We can supply the fully integrated system. But when we supply components as well, that means because of the Remy acquisition we executed a few years back and now particularly with the Delphi Technologies acquisition, which gives us scale and technology in the light vehicle space, we have much more capability in the power electronics space, we can supply all the components within the iDM. And we're content to supply the system or the individual components as the customer requires. In terms of content per vehicle, I think what we've highlighted in the past is when you look at the opportunity in electrification, it's 3x what it is in the combustion space. When you look at things like an iDM, supplying all of those components as part of an iDM, it's 3x what it is in the combustion space for us.

Okay. Great. And maybe just a follow-up to that. If you could comment on the capabilities that Delphi Technologies offers from an electrification perspective. How does their leadership in inverters fit into the integrated drive module strategy? And then relative to some of the other products that they supply from an electrification perspective, so for example the onboard chargers, the battery pack controllers, is there any synergy there between those products and iDMs such that you could offer like an even larger spot of electrification products or some sort of package deal?

Yes. Starting with the power electronics. I mean, Delphi technologies, as I mentioned, brings scale and leading technology in the light vehicle space and power electronics and electronics. When we acquired Sevcon back in 2017, that started to give us some capability in-house, but Delphi Technologies really takes it to a whole new level. So when you look at an iDM, we've obviously had market leadership when you look at our capabilities on the mechanical side. We have market-leading capabilities when you look at the rotating electric with our Remy acquisition. We now have market-leading capability in the light vehicle space at scale in the power electronics space. So again, we can supply individual components as Delphi Technologies does today on power electronics or we can supply integrated solutions that combine all 3 elements of that, that we can supply from our own internal capabilities or leveraging those components that might come from third parties. In terms of some of the other components you touched on, there are certainly other opportunities elsewhere in EV outside of an iDM. Delphi has some capabilities in onboard chargers and battery controllers. And those could be sold alongside with our battery packs coming out of our Romeo Power joint venture investment that we made a year ago. So we do see capabilities there. But taking a step back, it's just strengthening our position as an overall system supplier in electrification.

Okay. I wanted to ask 2 on hybrids. In the past, you've characterized HEVs and PHEVs as potentially representing a sort of sweet spot for the company, drawing on your capabilities, both to optimize internal combustion and now also to facilitate electrification. What is your outlook for growth in hybrids and plug-ins? And how does that compare over the near and medium term for battery electric vehicles? And what's your latest thinking in terms of how propulsion choices evolve over time? And which do you expect to grow more quickly or comprise a larger portion of your business in the coming years?

Yes. I mean, I'd say, just taking a step back, a key strength of our portfolio is the breadth that we have across combustion, hybrid and electric products. And that balanced approach is a conscious strategy of the company. So we're well positioned as the market migrates to more electrified solution. As you look at our backlog on a net basis, it's more than 100% on a net basis exposed to hybrid and battery electric vehicles. As we look out over the next few years, certainly, we see hybrids as providing a potential content tailwind since they do leverage, as you mentioned, both combustion and electrified products. And so as we've talked about in the past, the addressable market opportunity for us in hybrid is probably about 2.5x what it is in combustion. But even then, keep in mind that as you migrate toward true battery electric vehicles, it gets even bigger in terms of the potential content or addressable market for us. The way we see the market playing out, though, we do see a move in the nearer term toward more advanced forms of hybrids, just like you talked about, some of the plug-in hybrids, and then ultimately migrating more toward battery electric vehicles in the longer term. Regardless, though, as to whether that trend happens the way we think or whether it happens in some other way, that balanced approach we've taken, we think, positions us well to capitalize on any movement in the market, whether it's more aggressive to fully electric vehicles or whether hybrids are here for a longer period of time.

Okay. And then over the last number of years, we've seen a faster adoption of electrification in the light vehicle sector than we have in the commercial vehicle space. Although more recently, there's been a lot of enthusiasm for potential battery electric-driven hydrogen fuel cell commercial vehicles, including after the recent IPO of Nikola, which is also presenting here at the conference today. And I don't know, Kevin, from your time at Meritor, you spent a lot of time thinking about this. So the question is, just given all that BorgWarner is increasingly doing in terms of electrification on the light vehicle side, I wanted to ask what the house view is on commercial vehicle electrification. What are the potential implications for your turbo business? And what electrification solutions or components might BorgWarner be able to provide on the commercial side?

Yes, sure. I mean as it relates to commercial vehicle, obviously, BorgWarner, we think of -- first and foremost, you think of it being a light vehicle company, but 13% or 14% of our global portfolio is in the commercial vehicle space. So it is still a pretty sizable portion of what we do. And as you think about electrification in commercial vehicle, we have seen some initial growth there as it relates to both hybrids and electrics. I mean we've been in production with a high-voltage hairpin electric motor with a major European plug and hybrid CD manufacturer since '19. And we also provide a high-voltage hairpin motor for Scania City licenses. So there's undoubtedly opportunities there and we're already capitalizing on some of those opportunities. And as it relates to turbo, specifically, you mentioned in your question, I mean, turbo, we are a player in the commercial vehicle space. So we have a lot of business across the CV landscape as you look across the globe with a lot of the major CV OEs that you would think of.

Great. And I thought to ask on the thermal business. Can you remind us about the relative size and importance of this business within BorgWarner? And is it also levered to electrification? Because I think batteries with fuel cells may have unique thermal management needs. Is there a content per vehicle difference or opportunity for providing thermal solutions for electric versus combustion vehicles?

Yes, certainly. I mean thermal management is an important part of both batteries and as even you think of the long-term future, potentially fuel cells. And when you look at our new business backlog, the net backlog we talk about, about 5% of that backlog is comprised of cabin and battery heaters, which is really then focused on electrified vehicles. So there is definitely some opportunity there as we look ahead and we're seeing it in our backlog.

Great. And just squeezing a last one here, a follow-up to your comments on the Delphi Technologies acquisition. I imagine that they're benefiting also from the better-than-feared industry conditions such that you expect them to remain in compliance, I would imagine, with the amended terms of the merger agreement, including as it relates to leverage ratio, what's going on there. And then are you thinking any differently about the cost savings or synergies that were announced at the time of the acquisition or the $1 billion share repurchase program just in light of coronavirus and what actions they're taking, et cetera?

Yes. As it relates to Delphi Technologies and the conditions to closing, as you can imagine, when we put those 3 financial conditions into the agreement, it was based on the forecast that we were seeing at the time, and we were trying to make sure that we would give them the flexibility to be able to operate in the current environment. That was put in place back in May. So as you can imagine, just as our scenarios were looking pretty ugly for Q2, down 50% to 75%, production came in actually at the better end of that spectrum. And you can imagine, it probably did for Delphi as well. So overall, our hope and our expectation is as long as they continue to deliver according to their internal plan that they developed a few months ago, that we -- they'll meet all 3 conditions, and we'll close on the transaction, which is our desire. So that's kind of point number one. In terms of the synergies and how we're coming in and the financial performance, we're not going to provide an update today. We'll provide a fulsome update of the financial outlook of the combined companies when we get to closing. But what I will tell you is in our integration planning activities, one of the 14 work streams we're focused on is what we call value capture. And that's predominantly comprised of driving the pipeline of synergies. What I can tell you sitting here today is we're really pleased with the pipeline that we've been building. So we'll give you more of an update on that when we get to closing. And then the final thing on the $1 billion buyback, we absolutely remain committed to that program over the next few years. We are remaining cautious in this particular environment. I mean as we look at the last couple of quarters, we've been -- our hands have been a little bit tied by the Delphi acquisition because we've been subject to more blackouts. But in fairness, the more important issue has been COVID-19. And until there's more certainty and predictability in the market environment, we've been cautious, and you should expect us to continue to be cautious as we look ahead in the coming months with deploying the liquidity. But we do remain committed to that program over the next few years.

Got it. Thanks. And it looks like we're about out of time here. So thanks again so much, Kevin and Pat, for joining us today. Appreciate all the insights.

Thank you, Ryan.

Thank you.