BorgWarner Inc. (BWA) Earnings Call Transcript & Summary

Welcome back, everybody. Thanks for joining us. Next up is BorgWarner, a world leader in powertrain technology that is making a transition to EV tech, at least as fast as any company out there, certainly as fast as any supplier for sure. Last week, the transition was front and center at BorgWarner's Charging Forward Investor Day, which I encourage you to listen to the replay of, that was great, which included news about even further rebalancing of their portfolio towards EVs for a number of strategic actions, which we'll get into today. We believe this puts the company, BorgWarner, at the forefront of the future EV powertrain tech, but clearly, it's really a market leader, but there are some that are skeptical out there still. We're believers. We understand what's going on here. And I think, over time, the market will come around more and more to the idea that Borg is really a leader in EV as well as all other powertrain tech going forward. Today, to present from the company, we're very happy to have Fred Lissalde, President and CEO; Kevin Nowlan, Exec VP and CFO; and Pat Nolan, Vice President, Investor Relations. And before we kick off here, just a reminder, there's some slides that Fred is going to go through. Those are located to the right of your screen. You can pull those up. Once again, it's kind of like an earnings call. You need to pull those this up and follow along. And with that, I'm very happy to turn it over to Fred. Thanks for joining us, Fred.

Thank you, John, and good day, everyone. So yes, last week, we presented our project Charging Forward, which calls for about 45% of our revenue in BEV, battery electric vehicle, either PC or CV, in 2030. And what we've presented, I'm going to try and summarize the Investor Day for you. This is a logical extension of what we've been building over the past years. I remember I was in the leadership team back in 2013, and we started putting wheels in motion, starting with the acquisition of Remy. We did a lot of organic work. We put some of our own products into the market on BEV. We did a lot of inorganic work, terminating to the acquisition of Delphi that closed in Q4 last year, which really gave us -- which really was a cornerstone of that journey towards BEV, gave us a lot of scale, technology, leadership talent across the 3 continents on electronics, power electronics and software. That readiness now will Delphi coincide with the market pool, and that's where we are the strongest. BorgWarner's DNA is to take good products, good technology, commercialize it at the right time and manufacture it to scale. We're built for that. Project Charging Forward has 3 pillars: pillar one, organic and inorganic growth in eLV; pillar two, organic and inorganic growth in ECV; and pillar three, working on our combustion portfolio. Overall, we are self-funding this plan through the free cash flow that is generated from the operation and also, from the additional R&D organically and capital into BEV as well as some disposition at the combustion assets. And those pivots in taking a product at the right time, we've done that before a few times in the BorgWarner history. We've been building to this point, right, steadily since the past 6, 7, 8 years. Kind of quietly, we've been building our portfolio to now be able to accelerate. And you see on the slide here that we've have built those acquisitions step-by-step with Delphi, within AKASOL. We've done a lot of work internally and with this, we've migrated our BEV portfolio, which was about $400 back then in 2014 to now about 6x bigger, $2,640, for HBEV and that's push to them, not take into account battery packs. So we've build that portfolio. It's been -- it's this strategy that we laid out last week is just a continuation of what we've building over the years. So between now, 2021, and 2025, we have different building blocks that we are going to put in motion organically, inorganically. And the way I'd like you to think about it is we laid out the plan for 2030 with 45% of our revenue being in BEVs. The plan is flexible. We know what we're going to do between now and 2025. We know the direction we want to go from an M&A standpoint. We know the direction we want to go from an organic standpoint. We know the direction we want to go from a disposition standpoint. But depending on the different things that can happen in the marketplace, we can adjust that plan, and that plan won't be finished in 2025. So it's a robust plan, built on years of preparation. It's a robust portfolio. That plan is going to generate top quartile margin and free cash flow, and it's a plan that is prudent also and flexible and adaptable depending on what we learn in the next years. Before I turn it back over to you, John, I would say that the company history has been a story of evolution based on a few things. One is what we call product leadership. Technology is good, but you can have the best technology and can't sell it. What we call a product is a technology that is manufacturable at scale that is competitive and that fits a demand. We have those products leadership in BEVs. We have a very agile and decentralized operating model, which is a very important asset that we have in order to move in a coordinated way, leaving top management, the talent to focus on those strategic issues. And the story that made BorgWarner strong, we are just applying those sales, DNA and growth point, profitable growth point to e-products. We've been building for this since quite some time. And we are pretty convinced that we can create significant and sustainable value by aligning our businesses with the strong market tool that we all see towards battery electric vehicle. This was really a summary of last week's Investor Day in a few minutes. And I'll be happy to answer any questions you may have, John.

Okay, Fred. Well, thank you very much for that summary. Maybe to kick off here, there's a lot of organic movement towards EVs in your portfolio. But you have highlighted on the slides here and in the investor slide last week that you're going to have about $2 billion to $3 billion of EV acquisitions for technology, that about $3 billion to $4 billion of divestures on the ICE product side. There is a lot of skeptics that are saying, hey, listen, that's what's driving the shift towards EVs. Obviously, there's a lot going on organically. And as you've outlined here, that kind of activity is stuff that you've been doing for years. So it's not like this is something new, where, all of a sudden, turning the car over and coming up with a new strategy. But just curious out of -- if you can kind of comment on that line of thinking on the skeptic side of saying, hey, this is the key driver of the shift. And also, if you think about that $2 billion to $3 billion of acquisitions, how much is identified and where you're going with that? And then similarly, on the divestiture side, how much has been identified and what kind of progress you're making there? Because I think you're probably more big than most people realize. But if you can comment on that, that would be great.

Yes. So let me start with the acquisition side. The way I'd let you to think about it is the fact that we will be laser-focused on technology and laser-focused on efficiency of moving electrons in a battery electric vehicle. I'd like also for you to think about those acquisitions being more AKASOL like, meaning mono product, BEV-related in those flow of electrons, right? So kind of pure BEV single product assets. We have a pipeline of targets that we're looking at. And that's why you should think about when you look at the acquisition targets. From a divestiture standpoint, we have a proactive portfolio management. And I would say that we're looking at it from 3 elements. One is, is the product growing; is the product generating cash and the right amount of free cash flow; and is the product -- does the product have a path to product leadership. If 1 of those 3 elements from a combustion standpoint don't pass the sense check, then they might be a candidate for disposition. Not that they're bad businesses, but they might be better off being owned by somebody else. That's the way we're thinking about it, John.

And one thing that's going on here with ICE technology is, if you look at your portfolio beyond 2025 or 2030, sorry, it's going to still be 55% ICE, 45% EV. The industry probably won't even be there, right? I mean maybe the industry is around 30% -- 20% to 30% depending on the forecast right now. So you're going to be over-indexed to EVs, but there's still going to be a big chunk of the business that's ICE. So really over the next 10 years, we're going through this transition. Is there the potential that these ICE assets are just much more valuable than anybody realizes right now because maybe we don't shift as quickly towards EVs and the cash flow is -- has a longer and stronger tail and the margins are higher because the automakers are investing in EVs and not ICE and you might be able to get better pricing there? I mean it seems like some of these assets that I'm not saying, don't do what you're doing at all. But I mean some of the stuff that remains in your portfolio might be much more valuable than anybody's even thinking right now. I mean, it's a contrary view. But I mean it's -- cash flow is cash flow when it's value. I mean that's dollars you can invest. That's dollars you can pay back to shareholders. It's real important stuff.

Yes. Maybe let me comment on that. 2 things I'd say. I mean, keep in mind, the bulk of the portfolio on the combustion side we're talking about, we're keeping because it does demonstrate some of the characteristics that all of the characteristics really that Fred talked about, product leadership, leading the market out growth, leading to strong margins and strong free cash flow generation. So that is what's underlying the combustion pieces of the business that we're keeping because we are seeing that opportunity over a period of time. But as Fred mentioned, there are certain businesses that maybe aren't ticking all those boxes, and we think it just doesn't fit with our longer-term financial profile. So they're -- we think they're good businesses, as Fred said. They're just not probably fitting with our longer-term objectives. That's your question then. So is there may be more opportunity than people realize here. Again, these don't necessarily fit with where we expect to be over the midterm and longer term. So we are going to look to exit some of those businesses that don't tick the boxes. And so then as we think about, well, what's the estimated capital flows from this, do you have more opportunity on those dispositions. We did take a relatively conservative view on the potential value of those businesses. And you saw it last week, right? When we talk about greater than $7 billion in sources of capital in our Investor Day slides, only about $1.5 billion is coming from those dispositions of $3 billion to $4 billion in revenue. Now that's a reflection of our assumption of proceeds that we get from the sale, net of the loss of cash flow because these aren't cash flow-generating businesses, but we won't own them anymore going forward. So how did we come up with the value of those businesses? We started by looking at the lower end of the range for publicly traded combustion-focused companies and then applied a discount to the trading multiples and made that the basis of our assumptions. So I think the assumptions that we've made are reasonable, if not possibly a bit conservative. But we took this approach because we didn't want to be over reliant in our capital planning activities on disposition proceeds being the key driver of how we fund the future growth of the company.

Okay. That's helpful. And maybe staying on this kind of line of questioning a little bit. I think it was in 2023, you showed in your deck last week that your EBIT margins will be about 11% or so in 2023, right? And that's the year that your EV product is still losing a little bit of money. I think it's '23 to '24 where it hits breakeven. So we're going to be getting back in your company based on what you know right now to 11% EBIT margins in 2023 and then the EV business is going to start contributing a little bit. So I mean, where do you ultimately see the potential for margins going? And then kind of also kind of to what we're talking about here, ICE product is putting up big margins, if your EV product is still losing a little bit of money in 2023, and you're putting up that 11% margin. I just -- I mean, once again, I mean, just the algebra -- the math here indicates that you're putting up 12%, 13%, 14% margins on the ICE business. And then when EV business kicks in, it may actually be able to lift your aggregate margin there. I mean I know you're talking about low double digits. So we're in that range. But it just seems like there's a real opportunity here on the margin side that may not be appreciated in the aggregate business as we get through this transition.

Yes. Let me comment on a few pieces underlying your question there. You're right. I mean, we are funding that today, right? I mean, when you think of the $200 million to $225 million of R&D in our P&L this year, that's funding revenue of the future. I mean, just by itself, that's a 100, 150 basis point headwind to the total company margins. Yes, we're still delivering 10% to 10.5% this year. So we are funding that in the P&L today. As you look ahead then, as we talk toward 2023, we are on track to delivering that greater than 11% margin in '23, and that's because of our margin improvement plans driven by the cost synergies from the integration of Delphi. It's driven by the incremental restructuring actions that we've been taking and converting on incremental revenue, including that EV revenue. We're converting on that as it starts to come into the P&L. All of that's contributing to getting to that 11% or greater than 11%. So then what happens, to your question, beyond 2023? Well, we expect that the margins are going to start to become increasingly impacted by the M&A activities, the acquisitions and the dispositions. As well as the mix of the business starts to become more heavily reliant on the EV product portfolio. So that's why we say there's a level of uncertainty about the specific margins we would anticipate then, but we do feel really good about the underlying margin performance of the business. And that's why we do believe that we're going to stay solidly in that double-digit range from a margin perspective, and I think that's going to be top quartile among our peers. But in terms of is there upside, that's kind of the nature of your question, I mean when you look at the slide we showed at Investor Day, you probably saw that when we looked at the margins beyond '23, it was intentionally drawn in a certain way. We intentionally drew it to show that we believe there's a floor to this margin profile that we're expecting in the double digit. But there is the potential for upside well above 11% as well. You could see that in the way we drew it. That was purposeful. But with the lack of clarity on the exact path from here to 2025, especially from an M&A perspective, not having great perfect transparency to what those deals are ultimately going to look like, we didn't feel comfortable putting a finer point on that right now.

Got it. Okay. And then maybe just one last financial question, and then I want to get into some near-term dynamics. I mean you're looking at free cash flow, I think, ultimately, of $1 billion in 2025 on sales of $18 billion, so a 6% free cash flow yield on sales, which is pretty good, ROIC probably in the 15% range, plus or minus. I mean if you stripped away the business and just said, "Hey, that's what this company is doing," you got to imagine the investors would be pretty interested, right? But in this new EV world in autos, there's a hyper focus on growth. And to be a little bit of a wise guy, I mean, some of these companies are 100% EV, are being given higher multiples. It's kind of sad. I'm kind of joking. I say this because I mean your financial discipline is fantastic. And I mean, and focus, I think, in shifting the business responsibly in a balanced way, it makes a lot of sense. But do you think you would get even more credit for tilting even more in the direction of EVs? And we're seeing some of these companies that are doing that being rewarded with very low cost of capital. It's helping accelerate their plan. So I'm just curious how do you think about that. I know it's kind of a tough question. But I mean, that's one way, we hear a lot from investors and people are really kind of trying to figure out.

Yes. I think we're trying to drive value creation over the long term for this company. And it's not about addressing what the capital markets might be looking for on a given particular day. It's about making sure we're building a sustainable business that's going to deliver returns to our shareholders, not just in 1 year but over time. And the underpinnings of that are really our capital discipline, which means making sure that we are investing in projects where the ROIC is exceeding our cost of capital. That's ingrained in what we do at BorgWarner, and that's not going to change. And I think that's important because, to your point, I mean, it's easy to grow if you don't have an ROIC discipline. We could do that. We could do it a lot more aggressively if we want it. But if you do that, I think we're going to wake up in 2 or 3 years and realize we've destroyed a lot of shareholder value. And I think we'll all be looking at ourselves in the mirror and questioning that. That is not our strategy. Our focus on ROIC is core to our planning and execution as we accelerate into electrification. It's not at the expense of it. It's core to it. And so I think the thing you have to remember, too, is we're investing in these EV-specific investments. Remember, they do tend to have a longer return profile, and that's okay. That does mean that we are compromising, in some cases, some near-term reported financial metrics, whether it's the margin coming off of 11% TBD, still double-digit and strong; or a particular return on invested capital metric in a given year that might not be as high as what it's historically been. That's okay because the impact of the investments we're making in EV that we're investing a lot in R&D today is, like we talked about, to fund that growth of tomorrow. And that's okay as long as we maintain that ROIC discipline over the life of the programs. But the result of that is that we could see some level of pressure in the near term in any one year's reported metrics. And we're willing to live with that, recognizing that we're driving value creation over the long term. So discipline around requiring returns north of our cost of capital, that's a discipline we're going to continue to maintain as we grow this portfolio more aggressively to electrification.

And we get some questions coming in. So I'm bouncing a little bit in direction here, but we have one question coming on the chip shortage, what you're seeing in supply chain disruption. Generally, chip shortage, all -- ship's stuck in the Suez Canal, disruption in certain areas like Mexico. Are you seeing any increased volatility in schedules, which I'm probably sure you are? Or if you can talk about that if there's any product launches that may have been delayed or any decisions that might have shifted over the course of the last year as a result of the pressures in the market, particularly around supply chain? I mean generally, what are your thoughts? I know we're not getting the guidance today. So I'm not trying to figure out 2021. But I mean when do you think this normalizes? What kind of disruptions are you seeing? How should investors think about this generally?

Yes. So first, we don't see program delays, new program delays linked to chip shortages. Chip shortages is a fact, right? We're jumping through hoops and working very close to our suppliers and customers to try and align schedules as much as we can. I think this speaks volume to the fact that scale is important in this business because scale enhances the relationship that you have on the supply chain standpoint with both your sub-suppliers and customers. And so the strength of those relationships are more important than before. I would say that right now the bottom end of our guide accounts for a bit more than 1 billion -- 1 million vehicles lost in the full year. We still think that the second half of the year might be a way for our customers to recoup some of what could be lost in the first half or some of what will be lost in the first half, but that remains to be seen. It's still a very, very volatile environment.

Okay. And then also, I mean, I guess maybe a follow-up on that. There may be a potential where there's a flood of chips and some of these supply chain issues get worked out, either second half of this year or into 2022. I mean, in that case, it does seem like the demand environment is more than there to backfill for whatever might be lost this year, 1 million units, it gets made up in the second half of the year or into 2022. So do you almost see like a whipsawing here where we're constrained here in the short run but then there's a catch-up and then some because demand is so strong in the industry? I mean it's more a market commentary as opposed to board specific, but it seems like there's some potential opportunity.

It's tough to -- we see that the electrification is very profound and more profound than it has ever been. We've seen an acceleration in willingness of customers to really lean forward. We see an acceleration in requests for quotes and bookings. But it's tough to speculate on what the chip shortage will lead to or not in the next year. So I won't go there, but the electrification trend is profound, a different speed in different regions, but profound.

And maybe one -- just a slightly mundane question. I mean raw mat prices are rising. How are you guys thinking about that? How do your exposures work? I mean there's obviously rolling contracts, hedging, indexing, directed buys and a whole lot of mechanisms here for investors to think about it, and I'm sure that you're using. But how do you think about rising raws? And how you deal with them strategically and maybe mechanically as well?

So we have contractual elements that govern pass-throughs with our customers, we generally are covered at about 70% of pass-through through contractual clauses. Usually, when we negotiate with our customers, we tend to do a little bit better than that. But that's how we're thinking about this.

Okay. I think Doug Karson just had a question on the balance sheet side.

Sure. Thanks. Maybe I'll direct the question to Kevin. The balance sheet has always been very secure. Leverage always very manageable, investment-grade always a focus. Just give us a little update. The leverage right now, I think, is targeted to be like 1.9. Longer-term view, what do you feel is a sweet spot for that leverage and as we kind of head out into the cycle here?

Yes. I mean, I think we view the balance sheet as a source of a competitive advantage for us. It's not just our strong income statement and cash flow generation, but it's also having strong liquidity and a strong balance sheet. And so that's an important part of our strategy going forward is to maintain that strong balance sheet. Now as you undoubtedly saw last week in our Investor Day, we also talked about, as we generate capital over the next few years, a piece of that equation actually comes from the potential for us to increase our debt balances. We made comment on increasing our leverage profile is the ability to have more room to grow debt because our underlying EBITDA and earnings are increasing and, therefore, supporting more leverage. So as we talked last week about the potential to issue another $1 billion of debt or so through 2025, it was based on continuing to sustain a debt-to-EBITDA ratio, let's call it, that was mathematically, at least for purposes of the presentation, we showed it less than 1.8x on a gross basis, obviously, quite a bit lower when you look it at net basis. I think maintaining that balance sheet that continues to sustain solid investment-grade credit ratings is where you should expect us to be as we look out over time.

That's great. Thanks for the update. I'll turn it back to John.

Maybe just to follow up on that, Kevin, I know you guys outlined $1 billion, it sounds like it would be more on the credit side. But given your product portfolio, tilting your solutions on the EV side, often, there's a lot of companies that are purely EV that are getting a lot of access to the low-cost equity convert, some stuff more junior in the credit stack, in the cash structure. Is there, over time, the potential opportunity if you were to do a deal to maybe fund it through equity or do a convert? I mean I know you've outlined credit is an opportunity. But I mean, over time, your story should catch fire, your cost of capital on the equity side should go down. Is that something that you would consider given the right opportunity?

I'd say TBD. I'd say it's not part of our baseline planning. We wanted to make sure this is an initiative we could self-fund from our cash generation from our dispositions and maintaining a strong balance sheet. So that's really our focus right now. If we head down that path, it's something we'd have to think very carefully about whether we really wanted to access the markets in that way, but it's not part of our baseline planning right now. The potential to issue new debt absolutely is and given where the debt markets are, especially as you look at the European debt markets, we do believe there's some attractive opportunity for us to access some pretty compelling rates and putting it into the long-term capital structure for the company. So I think you should expect over the coming years to see us tap into those markets at a minimum while maintaining our strong balance sheet.

Okay. And then I've got -- we've got 2 more questions back to sort of on the strategy side. I mean there's a lot of new EV companies that are coming in, whether they be the digital suspects or not, this is talking of the new suspects in the U.S. then a bunch in China. So just curious what kind of opportunity they present to you versus what's going on with the traditional players? And really, how you think about working with them and building backlogs that may be a little bit less stable? Although they might be less stable on the EV side for some of the traditional players as well, but I mean, how are those relationships building? Where are the opportunities there for you? And are they maybe even bigger opportunity than the traditional players?

We're working with those startups in China and in the U.S. and also, in some cases, in Europe. They tend to need sometimes a little bit more support that we're providing. And also we've created, for that particular purpose, in the U.S., to support those start-ups. We created about 2 years ago now, Cascadia Motion who's tailored to support those startups. They can pretty much equip battery electric vehicle from soup to nuts, and they are the sparing partners of those startups. When those startups become real volume, real, real growth, then we will support them from the -- from BorgWarner. They are important prospects for us, and we're working with them.

And maybe sort of a techie question, Fred, from your engineering side and -- I mean, how do you think about hub motor technology? I know -- I'm sorry, this is not a on script. Just something -- can you talk about that some of these startups actually have different configurations on their skateboards and some really interesting stuff that's going on as far as the way that they're structuring the powertrain? I mean, how do you -- I mean -- honestly, I'm sure you guys are planning in all sorts of different content there. But how do you think about that in general as an opportunity for Borg and really just vehicle architectures in general?

Yes. So from a component standpoint, we're supporting some of the strategies of new motors from a power electronics standpoint. But so far, we're not moving into that from a system support standpoint.

Okay. And then maybe lastly, in the 3 product examples you gave last week on e-gear boxes, electric motors and inverters, I think there was about 40% that appear on your pie charts to still be in-house at OEM. So we kind of understand maybe early days as they're working through their EV development that they might keep some more content and products in-house to learn how everything works, right? I mean it is kind of natural. But is there an opportunity over time for more and more of that to be outsourced? I know this is content concern that they're going to post off in-house. But in reality, over time, once they understand things, they seem to have a propensity to want to outsource and leverage your technology and manufacturing expertise. I mean I would actually -- there's a yin and yang and how you look at this, but it seems like ultimately, it's probably more of an opportunity than a risk. I mean how are you thinking about that, generally, as we move forward into the EV world?

So generally, what's happening right now, John, is that there is not a one-size-fits-all. You have customers that are in-sourcing some of their platform, outsourcing some of this. Some customers are in-sourcing in the region, outsourcing in some others. Some customers want to start by in-sourcing, but it's clear that they are going to outsource. At the end of the day, I've learned over the past 30 years in this business, that fighting with your customers is not a great idea. What we are focusing on is focusing our product leadership, making sure that we're adding technology value to our customers and competitiveness through our scale. This is what, at the end of the day, will prevail, competitiveness and product leadership. So I don't think it's -- I think it's when you see a shift like that from ICE to BEV, I think it's normal that customers are asking themselves what they want to do and how they want to do it. But the available market is huge for us. And just to give you an example, a state-of-the-art inverter high-voltage silicon carbide, for example, is pretty much the same content that we have per vehicle in the case that we would sell compared to what we would sell in combustion. Everything we have in combustion, we would sell to that engine. If you compare that power electronics, it's pretty much the same content. So electrification really accelerates the growth for us. We have 3x content in BEV than we have in combustion. And that is really important because when you build that -- on top of that, when you bring product leadership and scale, we're winning in this market.

And then I -- we just have a few minutes left, just to sneak one last one in here. When you're going to market and working through the RFP or RFQ for all of the -- your e-products, inverters, gear boxes, whatever you're going to market with, are you running into largely similar competitors that you're used to? Or are there new competitors that are showing up? And how important is your incumbency position? I mean as long as you're coming to the market with good technology, it seems like you should win but I think that some skeptics are saying, hey, there's going to be new competition coming in, and you're going to lose share. I mean just -- what's the competitive dynamic? And what are you running into in early days here? Maybe there's even an opportunity for you to gain share. I mean, that's probably where things will go, but that's my opinion. But I mean who are you seeing in the competitive landscape right now as you're going up for bidding? Is it the same suspects? Or are there new folks coming in?

In this field, the recipe for success is product, scale for competitiveness and being able to support the customers globally and customer intimacy. We're not in the business of making deals. We're in the business of working with those customers for decades and for the next decades. So from a competitive environment, on the power electronics and electronics standpoint, we honestly see that the credible amount of competitors are pretty similar to what we see in combustion or in transmission, let's say, in more traditional powertrain architectures. On motors, we see a few more. And on systems, people being able to produce systems like an iDM, we actually see a little bit less than what we see from a combustion standpoint. They're not all the same names, right? But this is the color I can give you.

That's very interesting. And I mean I think that highlights maybe more opportunity than a risk, at least, once again, in my opinion. Well, we thank you very much for the time today. We appreciate what you delivered to us last week in the Investor Day. It was incredibly helpful and informative, and we appreciate the time today. So thank you so much for the opportunity to host you, and we look forward to catching up sometime soon in person. Fred, Kevin, thank you so much.

Thank you.

Thanks.

Thank you.