BorgWarner Inc. (BWA) Earnings Call Transcript & Summary

Hello, everyone. I'm Joe Spak, lead auto analyst at RBC Capital Markets, and I want to welcome everyone today to the kickoff of our 2021 Global Industrials Conference. Starting off the day with us, we're very pleased to have Kevin Nowlan, CFO from BorgWarner, joined by Pat Nolan and Eddie [ Sanders ] from Investor Relations. Kevin, thanks for joining us this morning.

Yes, thanks for having us. And as we mentioned, too bad we can't be in Vegas with you like we normally would be.

Maybe just to start. Obviously, BorgWarner is a company in the midst of transitioning their portfolio in an industry that's transitioning towards alternative forms of propulsion. You guys have recently announced a whole bunch of awards. Can we just start by reviewing some of the recent electrification awards and highlight how this sort of really fits into the BorgWarner's strategy and the long-term BorgWarner growth initiative that you laid out earlier this year?

Okay. Well, yes, maybe I'll flip that then and just start by talking about what we laid out and then how those awards fit into it. And so as you know, we -- back in March, we announced our Project CHARGING FORWARD, which is basically the company's acceleration toward electrification. We have been operating under a balanced strategy previously. And with the more aggressive moves we're seeing in the market toward electrification ramping up, we've pivoted more aggressively toward electrification as well. And so when we talked about back in March, as our part of our Project CHARGING FORWARD, is that by 2025, we expect 25% of our revenue to come from EVs and by 2030 about 45% to come from EVs. And to put that in perspective, that compares to low single digits today for our revenue base. So what does that mean in 2025 revenue? It means that when we talk about 25% of our revenue coming from EVs, it's about $4.5 billion of our revenue base from EVs, about $2.5 billion coming from organic growth and a bit more than $2 billion coming from M&A. And on the M&A side, just to spend a moment on that, we're already well on our way to that with the completion of the AKASOL acquisition back in June, which accounts for probably upwards of about 25% of that total M&A revenue we expect. But let me come back now to your question on the organic side, that other $2 billion, $2.5 billion of revenue. Just this past quarter, we disclosed our high-voltage coolant heater business, we had another win there, and we're going to deliver about $400 million in revenue by 2025 just in that product category alone. The second thing we've talked about over the course of this year, we've secured a couple of key iDM awards that leverage our 3-in-1 product offering, that combines our motor, gearbox, inverter capability all in one, all BorgWarner content. We had Hyundai we announced earlier in the year. And then we had the leading luxury NEV maker in China, both of which use all those BorgWarner components. And that's even in addition to the iDM award that we supply for the Ford Mustang Mach-E, which is where we do the assembly and integration work, along with supplying our transmission and thermal controls. Then we've had multiple eDM awards in China that we've disclosed previously, which combine our transmission and motor. And then on the inverter side, we previously told you about inverter programs we secured with 3 premium OEMs. And our volumes with those OEMs are expected to be about 1.1 million units in 2025. And so that's just on those 3 programs. And obviously, we've got additional programs outside of those. And then maybe the last thing I just hit on is, that's a lot of discussion about the light vehicle side, but we're also seeing wins on the CV side as well. Earlier this year, we disclosed our 800-volt electric motor win with a global commercial OE, and that launches in 2024. So that's just a series of the wins you've seen us talk about, even just this year, that progresses us down the path of delivering that $2.5 billion of organic revenue in 2025 associated with EVs.

Great. Thanks for that overview. [Operator Instructions] But Kevin, that was a great overview of where BorgWarner is going. I'm sure there's more we can dive into over the course of the conversation. I do want to take a step back and maybe more towards the here and now because you guys put out some guidance with your second quarter earnings report, where I think on the light vehicle side you were looking for about 8% to 10% light vehicle production growth. Since then, we've obviously seen a number of automakers announced production stoppages. This -- earlier this week, we had another shutdown in Malaysia, which was obviously the cause of some chip shortage earlier this year. So can you give us some color on what you're seeing in your business and how you're thinking about how you talked about the balance of the year towards the Street?

Yes. I mean, obviously, there's a lot of volatility in the market right now with the semiconductor situation. And so it continues to remain fluid. And I don't think we've reached the point yet that we can say our visibility even has improved a whole lot from even where we were just a few months ago. And we continue to see volatility on a weekly basis in terms of call-offs from our customers. And you've seen a lot of that in the market. You've seen external industry forecast, they're all still moving around. Now when we gave our guidance range back about a month ago, it did incorporate a wide range of scenarios. That's why we had still a $400 million revenue range, going from the bottom end of our guide to the top end of our guide. And that was based on an assumption we see some level of stabilization of semiconductor supply in the back half of the year, but with really little recovery in production. And so our guide doesn't anticipate any real upticks for the balance of the year. And frankly, it remains to be seen what that's going to mean as we look ahead to 2022. So still seeing a lot of volatility right now. Our guide contemplated a wide variety of outcomes. And as you can imagine, it's a day-to-day issue right now, and we're continuing to work with our customers and suppliers daily to manage through this.

So is it fair to say what you -- some of the announcements you've seen thus far, maybe not on a very specific basis, but that guidance range encapsulated some sort of potential issues as we sort of move through the third quarter and potentially even the fourth?

Yes. I mean I can't comment customer by customer or every announcement, but by and large, when you look at that $400 million revenue range, we were contemplating a wide variety of potential outcomes of how the back half of the year might play out. So we didn't just base that range on what we saw publicly already discussed. We knew there was the potential for volatility either way in that and that's how we guided.

And then just as we think about you as a CFO and you had a plan for the business, and putting even aside how you would sort of guide to The Street, I'm really curious how you think about internal planning here given the shortage and, as you mentioned, sort of a real lack of visibility. Like how do you sort of internally plan about when things can potentially return back to normal? Or is this a new normal? Cars obviously require more chips than prior. So can this be a sort of constraint on production over the coming years?

Yes. I mean as far as a planning perspective goes, we model with our business unit presidents and our business unit teams the variety of potential scenarios that we're seeing out there. But what we do is we drive the businesses, and as our business leaders drive their teams, is we focus on the things we can control. And so we try to manage our incrementals and decrementals appropriately. We manage our labor and burden performance. We drive our revenue outgrowth. And whatever is happening in the market that's outside of our control, we try to manage through that. So from a planning perspective, we say focus on what you can control and build scenarios that contemplate what could happen under a variety of, I'll say, external factors that might impact the market, that might, in the near term, be outside our control. Now if we think those things might be longer term in nature impacting the business, then obviously, we need to plan for that, because you can't wash your hands off those forever if it's a permanent impact on our business and we've got to figure out how you plan ahead. No different than when we talked about 1.5 years ago, we announced a bunch of restructuring initiatives and people asked us, why are you restructuring the business? And we said, because it's to prepare for the things we haven't anticipated that are going to pop up, whether it's semiconductors, whether it's commodities or other things, we've always got to be planning ahead for the unknown, the risk of the unknown, so we have things that can mitigate those things when they pop up. So that's really the way we manage it. Focus on what you can control, manage through volatile environments and make sure you've got coverage longer term if issues continue to sustain themselves in a negative way.

So do you have an internal view as to sort of when you think we can get back to either what I would call more normalized levels or maybe even sort of like a high 80s, 90 million global production vehicle unit? Is that possible next year? Or the visibility is just not quite there yet?

I'm not prepared to comment on that as we head into next year, but I, as you can imagine, along with some of our other leaders in the company, are spending a lot of time really understanding the root issues and how we think those root issues in the semiconductor supply space subside or get addressed to lead to something different. It's not just about monitoring the week-to-week or month-to-month announcements coming from our customers, it's really understanding what is really the root cause and how do we get out of this situation that therefore leads to the type of production environment you would ordinarily expect? So we're really spending time trying to understand that to know how long an issue we expect this to be.

Okay. And then maybe one more on sort of the top line. I mean, last quarter, I think you actually had an upward revision to your growth over market or your outgrowth, if you will, despite that sort of lower production volume. So you've talked about some of the stuff going on, maybe you could sort of dive in a little bit more detail to sort of what really is driving some of that outperformance. And even if you can, by end market as well, because I think commercial vehicles was a contributor there as well.

Yes. I mean we saw definitely outgrowth during the first half of the year, including the second quarter stronger than we anticipated. I mean, if you put the first 2 quarters together, combined for about 670 basis points of outgrowth. But I'd say be cautious jumping on that and taking that and running with it because there's been such a significant change year-over-year in industry production. A year ago, we had COVID-19 impacting results in the second quarter. So jumping off a really low base like that into a year like this, I'd love us to thump our chest and say, wow, 830 basis points of outgrowth. But I think that's -- it's hard to tell. Is that something sustainable? Or is it really just something unique going on in the quarter or as you look at the year-over-year? And then this year, obviously, you've got the varying levels of supply disruption among our customers that can impact the mix or other things. So it really makes it hard to draw conclusions about the outgrowth we've delivered so far this year. But nonetheless, we're pleased with what we have delivered thus far to date. 670 basis points is a strong level. But TBD how that plays out really longer term. I'm not sure that's a real sustainable level of outgrowth as we look ahead. When you look at what our -- is implied in our guidance for the second half, our guidance implies an outgrowth of about 400 to 550 basis points, which I think is a more normalized outgrowth for the business right now as we look ahead. We've always talked about 350, 500 basis points, somewhere in that range. And that's where we think the business is trending as we go to the back half of the year. And so that's ahead of the expectations we had going into this year, and it's really being driven by that performance that we saw at the beginning -- in the first half of this year. And where is that coming from? We've continued to see the strong growth in China, as we've talked about. We've continued to see strong growth -- outgrowth in Europe. We've seen stronger-than-anticipated performance coming from the legacy Delphi Technologies businesses. So we've really seen it from a lot of different places within our business, particularly last quarter in Europe and China.

Okay. Maybe -- and we talked a lot about obviously the semi issue and some of the challenges that's adding to the supply chain. There's been a host of other, I guess, supply chain issues. You talked a little bit about higher commodities on the last call, maybe you can sort of update on your latest thinking there. And then I'm also curious, correct me if I'm wrong, but I don't think this sort of came up last quarter, but we've seen a lot of reports about freight and both ocean and trucks, and sort of how is that sort of filtering into your business here in the back half of the year?

Yes. On the commodity side, nothing new to report from what we talked about a month ago on the earnings call. It's obviously been a headwind on the business this year. And as we look into the back half of the year from a guidance perspective, it impacted our guide. Now the good news is we have recovery mechanisms which offset about 50% of the underlying commodity exposure. But also, if you look at our guide, we've been able to offset some of that incremental headwind by our synergy performance as well, as well as some of the R&D recoveries, engineering recoveries, that we were able to achieve above and beyond our initial planning. From a freight perspective and logistics cost perspective, we have been seeing elevated costs but nowhere near the level of what we've seen on the commodity side.

Okay. Okay. And I guess, as we think about some of these pressures in the back half, and you mentioned the 10.2% to 10.5% margin guidance, you have a longer-term sort of 11% margin target guidance, which I think is sort of a '23, how do we think about what's going on in the back half of the year here as we begin to think about some of the puts and takes for '22? And what are some of the potential offsets to some of these headwinds that can get those margins higher? Or is it really just we kind of need to see volume come back and you'll get your sort of historical incremental margins off that volume?

Yes. I mean, if you think about, you referenced it, walking from this year really to that 11% even in 2023, so as you look out over the next couple of years, we think we're absolutely on track to deliver that 11-plus percent in 2023. In addition to delivering typical type of mid-teens incrementals for revenue growth, which we historically do at BorgWarner, I think you should expect that. Now keep in mind, that's an annualized expectation. So on a quarterly basis, you're going to see some volatility in those numbers given the volatile environment we're operating in. It might be impacted by commodities, it could be freight logistics, could be the timing of R&D spending. So those types of things can impact any quarter. But in general, you should continue to think about us as a mid-teens incremental company as we drive revenue growth. But back to the 11% then. So if you look at our 2021 guidance and then look at the 100 -- the 11% margin there's about $100 million operating income gap between this year and that 11% at the current revenue levels. So how do we close that $100 million gap? Well, first, we're continuing to drive the synergies associated with the Delphi transaction. We think in the P&L this year we'll be already around $115 million, $120 million cumulatively, both last year and this year, which means there's another $55 million to $60 million to go in '22 and '23. So that's a piece of the equation. Second, I referenced it earlier, we talked about those legacy BorgWarner restructuring actions that we announced about 18 months ago. And remember, we said those were going to mitigate some of these risks that we didn't anticipate at the time. While those risks are coming to fruition, they're impacting this year's margin. But we still got tailwind coming from those restructuring initiatives. And as we talked about 18 months ago, we thought 2022 and 2023 would deliver cumulatively about another $40 million of tailwind coming from the restructuring savings relative to what we're delivering in 2021. And then finally, there's even the legacy Delphi restructuring actions, the so-called Project Pioneer. And those are going to contribute a little bit as well as we look ahead between now and 2023. So all those things, even before revenue, get you $100-plus million in operating income. And then as we contribute mid-teens on any revenue growth between now, that $15.4 billion midpoint and something hopefully larger as we look ahead the next couple of years, it's pretty clear that we're on track to delivering that 11% margin.

Yes, that was very helpful, Kevin. Thanks for providing that lens. I guess on the Delphi acquisition, since you brought it up, you updated the synergies for this year, it seems like that's more of a pull-forward than an overall raise of the synergy pie. I would be a little bit curious to sort of what exactly it is that's occurring that allowed you to sort of recognize some of those faster? Is it just sort of timing of integration? And is there still at least the potential -- obviously you're not doing this today and you haven't done it thus far, but is there some potential for the synergies to be even greater? Or is it getting harder and harder to sort of actually pinpoint what the synergies are from that deal?

Yes, to answer the timing question, I mean, the primary driver is simply that we've been able to execute the SG&A-related headcount reductions more quickly than we originally planned. We had it a little bit more spread out as we went through 2021 and maybe even bleeding a touch into 2022. And as it stands right now, we've completed well over 90% of the headcount reductions that were associated with our plan. So basically, we've accelerated the execution of those headcount reductions. So it is truly a pull forward as opposed to an expansion of the pie. Now when we closed on the transaction, we announced the expansion of the pie in terms of the size of the synergy pool, we've been able to accelerate some of that. So what's left is another $55 million to $60 million in synergies beyond 2021. And those are predominantly related to purchasing synergies and IT synergies. And there tends to be some heavier lifting associated with those, which is why they take longer to recognize. Headcount, replacing some of the leadership teams where you have duplicative costs, that's a lot easier to make happen in effect in the near term versus recognizing a purchasing synergy or combining information technology systems and getting out some of the cost. So we believe we're right on track for delivering that $55 million to $60 million, and it positions us to be right on track for the $175 million in total. We're not prepared to talk about, hey, do we think there's opportunity beyond the $175 million? We're pleased that we were able to talk about it going up to $175 million when we closed on the transaction, and now we're pleased that we're able to accelerate some of those synergies. And we'll continue to drive more, we don't stop just because we put a $175 million marker out there. But that's what we're comfortable talking about today and we know we're on track for.

Great. Great. On AKASOL, I know that acquisition closed in June. There was a release last month also, which talked about their Gigafactory for battery systems. Can you just talk a little bit about [ exactly this producer ]. I don't think they're making cells. I think it's just sort of final pack assembly. So -- but maybe you could talk a little bit about what's going on at that factory, what sort of maybe initial capacity, initial opportunity from that factory is and maybe ultimately what you think you can get out of that factory.

Okay. Yes, I mean you're right, AKASOL is not making cells, they use cells to incorporate in battery modules and then battery packs. So what they're involved in is the assembly of the modules in the packs. That's what they do. And so that's the production process that's going to take place at the new facility that they announced that they're opening. And so when you look at that new facility here in Southeast Michigan and look at it along with the other 2 facilities that are already in operation in Europe, combined, we expect that as those facilities ramp up and implement certain capacity expansion initiatives over the balance of this year and into the beginning of next, those 3 facilities will combine for about 4.7 gigawatt hours of battery pack production capability. And so when you think about, well, what does that mean? What's 4.7 gigawatt hours? That's enough capacity to support our revenue expectations for this business through at least the middle of the decade and probably even a little bit beyond. I mean, rough math, if you think $150, $175 per gigawatt hour, that's $700 million to $800 million of revenue opportunity that, that capacity in totality can support.

Okay. And how should we think about how you price that? Well, let's maybe talk a little bit how this sort of works with the [ names ] because you're not making the cells, you're sourcing the cells, so it would seem like maybe the cells are somewhat of a pass-through in there. So how do you think about, when you go to price that business and when you're looking for your -- the right return for BorgWarner, how do you think about the ultimate margin profile of that business?

Yes. I mean, ultimately, and just to take a step back at the moment, to be clear, under German law right now, we don't fully control the company. We own 93%. We're pleased that we're already at 93%. And given that we're above 90%, we're in a position to move forward toward full control and ownership of the company through a squeeze-out process that we initiated a month or so ago. So until we get to that point, we actually manage the company only through our appointment of positions to the Supervisory Board. So I have to be careful talking about what -- how we're managing that business from a return perspective. But what I can tell you is this, the disciplines that we instill at BorgWarner are the same disciplines we would expect to instill when we have full operational control of that business around having that ROIC discipline. And so we're going to look for return on invested capital that supports the objectives that we have as a company and how that ultimately translates to margin. Now as you think about cells, how do cells factor into this? AKASOL has certain strategic supply relationships with cell suppliers, but it also depends on the customer, because some of the customers have directed buys as it relates to cells, and that's not uncommon in this space. So again, once we get in there more and have full operational control, which we would expect by the middle of next year, we'll be able to more BorgWarnerize the approach to conducting business. But you should expect that we'll have that same ROIC discipline that we've instilled in the rest of the businesses.

Okay. Great. [Operator Instructions] There's one that came in, and I'll integrate into this question. So earlier on, when you were talking about the long-term opportunity, top line opportunity for Warner, you mentioned acquisitions in AKASOL, which we just spent some time talking about, is obviously a key portion of that. What else are you sort of interested in from an acquisition standpoint? And then the flip side of that is, you also talked about back at that March day some divestitures. So can you update us at all on how some of those discussions are going or at least a time frame for when you think those can be divested? Because I think there's been some powertrain suppliers that have struggled to divest some of those ICE assets for targeted valuations. So how are those discussions progressing?

Yes. So if I start with the acquisition side of the question, technology is going to continue to drive our approach to M&A. Today, if you look at what our portfolio capability is, we have products that can move electrons from actually the stationary charger all the way to the wheels. But we want to grow and improve our positioning and we can do that in various ways. There are places in our portfolio where we think we have opportunities where we need to gain some scale. There's places where we think we need to pursue specific technologies within a product area or specific geographic or customer exposures that we want to get to. There's also opportunities to drive some level of vertical integration where we think it can differentiate our product offering. So I think when you think of technology as the driver in those particular areas, those are the types of acquisitions you should think about us doing. And I also think you should think about them the way we're looking at it right now. The EV-related acquisition activity that we're going to be pursuing is going to more likely be focused in terms of the scope of the company we're acquiring. What does that mean? It means that the acquisitions we're looking at look a lot more like maybe an AKASOL than they do at Delphi, where it might be more of a single-product focus, having leadership in technology, maybe a good book of business and install capacity but not necessarily with billions and billions of dollars of other legacy types of assets. We're looking at things that are much more focused from a technology perspective in the EV space. Those are the types of things we're looking at. They can be private companies. They can be carve-outs of public companies. It's not often that you're just looking at, oh, go buy that public company or that public company. It's much more nuanced than that. And so we have an active pipeline and portfolio that we're looking at, and we'll update you as we move forward there. And then on the disposition side, we are actively monitoring that process. So when we look at our portfolio, which we do regularly, we do a deep dive every year, and we have a midyear refresh where we just update certain assumptions, we're actually looking at our total portfolio. Whether it came from Delphi, BorgWarner, it doesn't matter. We look at the total portfolio every year, and we ask ourselves 3 questions: Does our product or business have medium-term to long-term sales growth? Does the product have a strong margin and cash flow generating profile? And do we have product leadership or a path to product leadership? If we don't tick all 3 of those boxes, it's probably not a product or business that fits with BorgWarner, and those are the candidates for disposition. Now when you think about that, it doesn't mean these are bad businesses. So you talked about some other companies that have struggled maybe disposing of certain combustion-based assets. I would challenge whether those maybe had the same positioning as some of the things that we might be looking at. When you're jumping off a company that's operated with a top quartile margin profile, and you can imagine some of the businesses we're looking at might have pretty strong margins, but they might not have product leadership or they might not have long-term growth prospects. Those might be businesses that are still good businesses, but they are a better fit with somebody else. So as we talked about back in March, we are actively pursuing $3 billion to $4 billion of dispositions, with about $1 billion occurring at some point next year, call it mid- to late 2022, in line with the timing [Technical Difficulty] in March. And so as we are ready to sign a deal, we'll talk more publicly about those deals and we think we're on track.

Okay. Great. I guess just to close here, as you talked about on the acquisition front, the target margin profile, that all makes sense. And I guess a common question we get from investors, whether this is organic EV business or acquired EV businesses, the margin profile and how that sort of fits into your 11% plus sort of target over time, because some of these businesses may still need to ramp, some of them may still need further R&D development. So when you talk about margin profiles on some of those acquisitions or on the EV business, I can understand that at some level of maturity, they are -- they can hit that margin profile. But how do you think about the ramp to there and how that can sort of impact the overall margins? Or is that already considered, some of that lumpiness in investment and ramping, towards that 11% plus target?

Yes. And I'll start by saying we take a lot of pride at this company in delivering that top quartile margin profile that we've been doing for a long time, and we don't expect that to change. I mean we think it's core to what we do and what we deliver to our investors. And so step one is, hey, we remain committed to that 11% margin in 2023 as we've talked about and we talked about the path there. But in terms of then your question, how are we going to be impacted with the ramp in EVs. Let me just take a step back. The way we price our business is the same whether it's a combustion-based business or an EV-based business, we start with ROIC and we start with the consistent approach to ROIC. We're also predominantly in the assembly business when it comes to manufacturing, which means what? It means the capital intensity of these businesses is substantially similar. So we target comparable ROIC. We have substantially similar capital requirements, which means that the margin profile over the life of any program is substantially similar, EV or combustion. But to your point, the big caveat on this is the upfront R&D intensity of an EV program is a lot greater than it was on combustion-based programs. And that's the reason you see our R&D ramping to more than 5% in the coming years. It's to support the business wins we're delivering in EV. And what that means is that our R&D is ramping rapidly, but the revenues and the corresponding profitability come much later. So as EV is ramping, it generates in-year margin pressures, even though over the life of those programs the margin is good. That's the near-term headwind that we're going to experience with the ramp-up of EVs. But I think you need to recognize, that's already in our P&L, today, right now. We have $725 million of R&D this year, more than $200 million of that is for our eProduct portfolio. And we have less than $350 million of e-revenue today. So obviously, we've got a P&L headwind right now associated with that, but our legacy business is overcoming that and we're still generating a double-digit margin. So the headwind is there, over the life of the programs, these are exactly what we want, but that ramp-up creates a headwind, but that headwind is already in our P&L., we're funding it today.

Great. Well, that was very helpful, Kevin. The entire conversation, I think, was enlightening. So I want to thank you for your time today. I thank the BorgWarner team for your time. Like I said, hopefully, next year in Vegas. And thanks again, really appreciate you joining us this year.

Thanks. Good to see you, Joe.

Thank you.