BorgWarner Inc. (BWA) Earnings Call Transcript & Summary

Good afternoon. Sorry for the short delay. But we're pleased to have with us BorgWarner for our next slot, represented by Kevin Nowlan, CFO; and Harry Husted, CTO.

So I just want to dive right in. We've had a lot of suppliers talk about the kind of choppiness in the environment, but -- so I don't want to drill down as much as I did in other suppliers. But just want to get your sense of what you're seeing around the 4Q production environment and then your sense of how it might get better in terms of volumes in 2023 -- I mean 2022.

Yes, I mean our sense is as we head into Q4 that we're likely to see a little bit a sequential improvement versus what we saw in Q3. But I'd tell you it's still pretty choppy out there. We're seeing a lot of volatility continuing right now. And our expectation is that, that choppiness and volatility is going to continue well onto 2022. I know you're seeing some reports probably from others, whether it's OEs or others, saying maybe it's getting better, maybe it's not getting better. I can tell you what we're seeing and based on our being a large purchaser of semiconductor chips, that we are seeing the volatility continuing and expected well into next year.

Okay. And kind of broader point on broader inflation, you certainly have had pass-throughs around certainly some of the specialty metals. Your competitor kind of flagged the experience in indexing from nickel back in '07. But do you have inflationary cost pressures that are not tied to mechanical pass-throughs? I'm thinking for example, the cost of heating factories in Europe, the cost of shipping freight across oceans or either internally in North America. And can you offset those? Or do you have to go back into negotiations and get things repriced?

Yes, if you start with the commodities whether you're talking steel, nickel, aluminum, copper, those types of things, we have contractual pass-through mechanisms that cover about 50% of the underlying commodity spend that's embedded in our cost of goods sold. So about 50% of that passes through automatically. And that's been happening, so those mechanisms are working. But to the question you have about what about other mechanisms for the types of things you spoke of, there are not natural mechanisms. And normally, what we have to do is we have to just manage our performance to be able to offset those things. So if we see labor inflation in the plants, our job is to figure out how to drive more efficiency into our operations to offset those inflationary pressures. Now I will say, though, when you get into an environment like this, which seems to be a more protracted period of high levels of inflation across lots of different things, whether it's those commodities or other types of things, freight, logistics, et cetera, you can imagine it leads to some broader conversations with our customers. And so I would say generally speaking, the customers recognize that it's a different kind of an environment and understand that those types of conversations are likely coming. And we'll see how those conversations go. TBD. We're not relying on those things, but we do think it's important that we figure out how we operate on a longer-term basis with our customers if this environment were to continue longer term. So nothing contractual that we can pass through, but you should imagine that those types of discussions go on when it's this level of inflationary pressure. In the meantime, we'll do our part to continue to execute operationally and defer those costs where we can. That's part of the reason we do things like the proactive restructuring we talked about 21 months ago when we announced, hey, we're executing these big restructuring programs. Well, why? Well, it's to anticipate the unknown. Our job in managing the business is to prepare for those things that you don't know are coming and mitigate those through the proactive actions that you take well in advance, hopefully.

Sure. So let's move on to the broader strategic, in particular kind of fleshing out the progress around the CHARGING FORWARD initiative. Let's just dive into on the light vehicle side primarily. You've had a number of inverter wins like the IBM with Hyundai, OEM in China. You have an AKASOL award or that might be a -- the commercial side. So maybe if we think about just broadly light vehicles, e-motors, power electronics, iDMs, what's driving your awards? And in particular, are customers coming in and saying, "I want an iDM," or do they have 3 RFQs going out an inverter drive unit, perhaps some gearing, and you wind up -- you show up with your iDM and win all the business?

Yes. Yes, I mean so to the product categories you're talking about and focused exclusively on the light vehicle side as you suggested. When you look at the inverters, the motors, the iDMs, the high-voltage cooling heaters as well and some other ancillary products, we've achieved about $2.3 billion of that $2.5 billion revenue target that we established for ourselves in 2025, which means we're 90% of the way there. So how are we winning? It's really through a combination of our technology leadership, bringing products to market that our customers want and need and the customer intimacy and relationships that we have with our customers along with that breadth of portfolio. So all those things come to bear as we engage in conversations with our customers. So what is it that they're looking for from us? To your question, is it they want an iDM? They want a component? I'd say it's really a mix. Sometimes, they'll come to market and say, "Hey, why don't you quote on these different components and also quote on the system?" And then the OE makes a determination, based on what they're seeing, what way they want to move forward. So it's not always, "Give me the iDM quote," or "give me a component quote." Sometimes, it is. And sometimes, it's broader than that. "Hey, quote both and then let's see where we want to move forward."

And maybe a question for Harry, kind of when you look at those kind of opportunities. What is, I'd say, on the strategic level, what's truly unique about your e-motor capabilities? What's truly unique about your power electronics capabilities? And then when you put together what's unique squared, if you will?

Yes. No, that's a great question. So when we look at our products, for example, on power electronics, we bring some really unique proprietary things to the table there. We've been working in this space in automotive power electronics for 30-plus years, right, going back to the very early days. So we've got a team that's got this longer-term perspective of what needed to be done in power electronics. It was about taking the cost out of the power electronics. So one of the things we've done is develop a proprietary power switch for our inverter products. And what that does is it helps take cost and size and mass out of the inverter. Because it's smaller and because we cool the silicon or the silicon carbide in there better, we need less area, which means lower cost. So that's an example of where innovation over time has brought us to a place where we have a really great product that our customers are recognizing. The other thing we're combining that with is our in-house integrated circuit design capabilities. So we have the ability to do what's called ASICs. It's an application-specific IC. And when we do that, we can go in and look at a section of the schematic, the circuit board and say, we're going to need a lot of these. And we can take that and shrink that down onto a chip and add in some proprietary functionality and come up with -- once again, it takes cost out. It takes size out and it makes us more competitive. So these are the kinds of things we're doing in the power electronics space that our customers are recognizing and going ahead in the end and sourcing us for those products because of those types of unique things we're bringing to the table. In electric motors, similar kind of story there. We've got our high-voltage hairpin technology that we've been using. And we do that at both 400 volts and now at 800 volts. So we've got high-efficiency machines. We've got the experience and the ability to oil cool those, so that we can have a more efficient design. And then we draw on our many, many years of driveline experience for like an iDM to pull in that gear reduction set and that combination of things. Very similar to transfer case technology where we're under many, many forward drive trucks today with transfer cases. So that combination, when our OEMs look at that and they look at our ability to deliver, it really becomes a very attractive package.

And AKASOL is a relatively more recent addition to the portfolio. So if I talk about unique cubed, what is unique about AKASOL? Is it really just for commercial vehicles? Or do you see light vehicle opportunities there? And then how does that add to the iDM or sort of the pitch when it's both power electronics, e-motors and potentially batteries as well?

Well, I'm going to talk to the technology side. Kevin can talk the opportunity side, what he sees. But on the technology side, AKASOL is a great add for us, right? What they bring is the ability to have very high-cycle life packs that are ready to go for customers. And they offer an energy option there where we can bring in high-energy cells. They can bring in very high-power cells depending on what the application needs. And they do it in a very structured way that customers appreciate. Today the big focus is on commercial vehicles, and they're getting a ton of traction there. So they've been a great add to the portfolio. I don't know, Kevin, if you want to say anything.

Yes, and that's really where our focus is with that business. It's on the commercial vehicle and industrial side. We're not looking to compete in the battery space on the light vehicle side. We think that's largely going to be vertically integrated. It's just not part of our value proposition and where we think that we're likely to be successful. So we've intentionally gone into this space in the AKASOL transaction on the basis of commercial vehicle and industrial.

[Operator Instructions] Drilling down into power electronics. This is a question from e-mail. [Operator Instructions] What -- can you provide us an update on your silicon carbide power electronics partnerships, that semiconductor companies you're working with, how deep... [Technical Difficulty]

Brian, we lost your audio.

Brian, your audio went out.

Kevin?

There, we're back. Just came back.

Okay, yes. It's -- sorry. That was actually a power electronics. I try to charge and plug in my Lightning cable at the same time and sometimes, Apple -- because it's a non-Apple thing, it doesn't like that. My question was, and this comes in from e-mail. [Operator Instructions] Can you update us on your silicon carbide partnerships?

Yes. Silicon carbide is an area where we're seeing a lot of high interest, and that's because of the efficiency it brings. So we're working with several companies. We've been very public about our partnership with Wolfspeed. So that's really the best one for me to talk about. It's not the only company we're working with, but Wolfspeed is a company we've done a lot with and we're designing their parts into our upcoming products. If you've been watching the company, you've seen us come out with a string of announcements here recently about sourcing decisions by OEMs. And they're picking silicon carbide because of the efficiency. In a company like Wolfspeed, when we work with them, one of the things that we get in addition to the technology is the understanding of their capacity investments, so that we're positioned to deliver product and high volume because of the capacity that they're putting in place.

And how does that partnership, when you -- and this question we often get, which is what's the unique value you add in your power electronics? And by working with the silicon carbide, do you have a -- do you know their next-gen, next-gen chipset, so you know how exactly you're going to package that and cool that? And then I guess secondly, related to power electronics as well, obviously chips run on firmware and software. How involved are you with the power management software that actually drives the flow through the power electronic sets?

Yes, those are great questions. So when we did this early work on our proprietary power switch package, we also started work very early on silicon carbide. But as we looked back on it, it's almost the ideal package to put silicon carbide in because -- so what we're able to do is our proprietary package where we've got silicon in, we'd pull the die out for the IGBT in the transistor or the diode. And then for silicon carbide, you don't put one chip back in there. Silicon carbide die are much smaller because of the defect density. So now you're putting a matrix of smaller silicon carbide die in to achieve that same current level. And the Viper package that we have is really a great place for that. It turns out we can lay that out, drop that in. We get the same great double-sided cooling. But as everybody knows, when you think about what silicon carbide is bringing, the losses are lower. And so for the power levels we're putting through, the devices actually need less cooling, right? They're not throwing off the type of heat that a silicon IGBT does. So we're really well positioned. On the software side of the question, we've been doing the full software stack for inverters for years now. So we offer from top to bottom, everything that's needed to run the inverter, do the high-speed motor control with a high-frequency PWM that's all inside our software stack. It's out in the field, it's proven. And we continue to innovate there, but we're in a great position regarding that.

And what would you say your fundamental moats are? I mean I think the reason we're drilling down so much on power electronics is everyone understood the moats around turbochargers. And the question we get and why I'm glad you could join here is kind of -- can power electronics be that kind of moated high-engineering value-add business as turbochargers were for ICEs?

Yes. So -- and I think it is, yes. And the reason is I'll just step back and talk about it a little bit. A piece of power electronics like an inverter, it's a really difficult and specialized product to do, okay? You have to have a lot of depth in the traditional low-voltage controller engineering, where you're doing your computing and your control board, your communications and all that, right? You need to be able to bring that to the table because there's one of those in every inverter. Then you bring in the high-voltage, high-power engineering for that power switching section that runs the motor. So now you have to have a team that knows high power, high voltage, all those safety-related things. And yet still, you have to fit all of that in a very small box. And so it becomes what I call, for my mechanical engineering friends, a 3-dimensional puzzle, right? Because I have to get all these control signals in. I have to get hundreds of amps bussed in this box and back out with low electromagnetic emissions. And I have to get liquid cooling in and out to get all the high-power section cooled. And then I have to put about a million lines of code in there as well and be very cost effective. So this is a really high-challenge product. And that's part of the moating around it in addition to the proprietary stuff that we bring to the table that I talked about earlier.

Yes. So as long as we're on this, got another good question in. GM struck a big partnership with Wolf, one of your suppliers for silicon carbide on Ultium. That's an example, in this questioner's mind, of an OE going straight to the supply source. And how would that change your role as a tier 1 in the value chain? And I think the subtext there is with the semiconductors companies reaching out directly to the OEMs, the OEMs becoming more involved, does it impact the role of tier 1s to be more build-to-print?

Well, we're just not seeing that much of that really. Because in the end, we're the electronics experts. We go very deep into this. We have the silicon and the semiconductor experts. So when we talk to and work with these suppliers, we're working at a level where we're designing this into our products. So -- and we buy a lot of this. So when an OEM goes and wants to source things, remember we're buying across multiple OEMs at high volume. So the question is are they really getting a better deal or not, when we're buying so much ourselves across many programs? So it can be a factor but we just don't see that much of it. Sometimes, OEMs talk to the suppliers. But we're purchasing directly the semiconductors that go into our products.

And so even if an OEM has a relationship, say, with a Wolf or a Cree, can you still add value? Or does at that point become an RFP for a build-to-print design the OEM and chip supplier have cooked up?

Like I said, we don't see a lot of that today. These are really difficult products for OEMs to do, requires a lot of breadth of capability in many different areas. And after you design it, you have to have a plan to validate it. You have to have a plan to run it for months and months and months and prove out the mileage in a test facility before you take it out on the road in high volume. And we're already invested and capitalized to do that in our -- inside our company.

And just to close off on power electronics, so I do have a bunch of CHARGING FORWARD questions coming in. You indicated that inverters could be about $8.8 billion. Your current backlog by 2025 your current backlog points to about $1.7 billion. So that seems to be about 20% market share. Is there upside implied by your current win rates? Do you expect your share to grow over time?

Yes, I can take that one, Brian. I mean it's -- to put it apples-to-apples with that $8.8 billion, that $8.8 billion is actually battery electric vehicles only. The $1.7 billion you noted actually includes hybrids in it as well, the 600,000 or so units related to hybrids. So if you back off the same kind of a transaction price equivalent for what's just on the EV side, the true BEV side for the 1.9 million units, it's about $1.3 billion in inverter. So the $1.3 billion is more comparable to the $8.8 billion apples-to-apples. And so it still implies a pretty healthy share of the market. And the question is there are more out there? Absolutely. We're pursuing additional opportunities. So the quoting for 2025 has not yet ended, and we're still looking at the potential for additional opportunities out there. That said, as we see the market today and we look at the non-captive market, we think the booked business we already have puts us out there as the #1 non-captive supplier of inverters in the world in 2021.

Okay. So let's move on to CHARGING FORWARD. I was going to start with acquisitions, but I'm going to actually start with dispositions because that's the question that came in. So the question is kind of where are you on ICE dispositions in general? Is it safe -- what kind of assets are you thinking about? Is it mostly legacy Delphi assets? Or could it also be legacy Borg assets? And the specific question that came in very much in that vein is Schaeffler just sold its timing chain business to a private equity company. Would you -- you have timing chain. You have transmission clutches. Are -- would you consider selling timing -- these timing chain businesses or legacy Borg products, not just legacy Delphi products?

Yes, a few things in that question. So the first, in terms of where we stand, we actually have a couple of potential dispositions that are actively being marketed today. In fact, you can see some evidence of that in our 10-Q where we actually noted that we moved some of our assets and liabilities to held-for-sale accounting, which just means that a particular transaction has gotten to a point that it's well down the path of a prospective disposition. So there's a couple that are active right now toward that $1 billion of revenue that we expect to dispose of within the first 12 to 18 months of announcing CHARGING FORWARD. And we have a couple more that we're looking at in the planning phases right now. So that's kind of question 1, where we stand at the moment. And question 2, does it include Delphi only or other related progress -- products? Our portfolio management process, we go through on an annual basis about this time each year. And we put all of our products through. And it doesn't matter where they came from. Whether it came from legacy BorgWarner or legacy Delphi or somewhere else, it doesn't matter. They all go through the same scrutiny. And we assess, do we have product leadership? Do we have medium-term or longer-term prospects for growth? And do we have the path to a strong margin and cash flow-generating profile? And if we tick all those 3 boxes, that's a keeper for BorgWarner. That's what we like. And if it doesn't tick one of those 3, then it's a candidate for disposition no matter where it came from. In terms of the question about so timing chains or other things, we're not going to talk about specific products today. We'll announce those once the time comes. But I would say everything is on the table in terms of going through the portfolio management process and assessed against those 3 attributes. The good news is as we've assessed our product portfolio and because of the strength of that underlying portfolio we have, we talked about $3 billion to $4 billion of dispositions over the next few years. But that implies there's $10-plus billion of our portfolio where we have product leadership, where we are seeing medium-term growth, and we are seeing strong margin profiles. And the growth piece, the point I want to emphasize there is make sure when you think of that underlying portfolio of legacy combustion-based products, they go on combustion-only vehicles, but they also go on hybrid vehicles, especially as those products that are making vehicles and the engines more efficient, whether you're talking about turbos and VCT and GDi. So we're seeing adoption rates for those types of products actually grow in the hybrid world, which is why we continue to see in a lot of those products continuing growth prospects at least over the medium term. But again, we go through this process every year and take a look at our portfolio and what we think the prospects are relative to those 3 attributes.

The investor deck seemed to imply a 0.5 turn, 0.5 EV to sales for the valuations. Just based on where you are in your negotiations, is that still a number we should be thinking about? Or could it be better or unfortunately worse?

Yes, I mean it's going to -- 2 things. One, the 0.5 turn, keep in mind, is that's on the basis of an expectation relative to net of the cash flows that we would lose in selling that business. So it's the disposition proceeds that we would get, but then recognizing that you'll no longer have the cash flows on a go-forward basis that might have been underlying our overall cash flow plan. So just keep that in mind. But overall, I think you're going to have dispositions that come in below that level, dispositions that come in above that level. It's going to depend on how many of those attributes that the particular product portfolio ticks and which ones they tick. If something is struggling from a growth perspective and a margin perspective, it will probably be much more challenged than something that's stable from a revenue perspective with really strong margins. That might command a different premium. So I think it's going to be a mix, but we still feel pretty good about that net disposition proceeds as we look out over the next few years executing on the $3 billion to $4 billion.

And are the buyers likely to be private equity or strategics? Or does it -- and are you seeing kind of -- because you want an auction where they're tripping -- those 2 sides trip over themselves.

It's going to be a mix of both. It's going to depend on the particular product portfolio. I think some products will actually lend themselves to the potential for a strategic execution. I think a lot of products are going to lend themselves to probably solely a private equity or a financial sponsor type of execution. I think we're going to see a mix of both as we go through this, depending on which products we're looking at, but probably a little bit more weighted to the financial buyers.

And on CHARGING FORWARD on the buy side, at least some estimates, our outside-in math suggests that you could do $2 billion to $3 billion from M&A, now maybe we're underestimating the inorganic growth -- I mean the organic growth. Where are you on that? And are you -- would you be looking for new product lines? Or now that you really have somewhat soup to nuts on electrification, deepening or going into adjacencies with what you have already?

Well, it's still going to be very much focused on technology. I mean that's the -- that's what we're looking at as we look at acquisition candidates. And I think there's really different ways you might see that manifest itself. We look at existing products that we have or places that we play today in the electrified propulsion of the vehicle. And we look where we might have gaps in a particular product area. Or maybe we lack scale or we lack product leadership in a particular product category. That's one place we'll look at as it relates to potential acquisitions. We'll look at the diversity of the technology, the diversity of the -- from a geographic perspective, from a customer perspective. Are there ways to fill out that diversity within a particular product? That's another place. And there might be some opportunities for vertical integration. But again, it's going to all come down to things that improve our technology capability in the world of EV. And I think as you think about the types of companies we'd be looking at, they're probably going to look a lot more like an AKASOL, like a model line or very much a portfolio concentrated in EV products, than a Delphi. And that's not to say the Delphi transaction was bad. I think it's been a fantastic transaction for us in a lot of different ways. But I think as we look to the future and doing additional acquisitions, we're very much focused on those that come with probably less of a combustion legacy and more focused in the EV space in particular.

And speaking of the EV space, AKASOL gets you deeper into the commercial vehicle market. The truck driveline suppliers aren't standing still. In particular your former employer, Dana, stressed their version of iDM is the e-axle, bundling power electronics together with axles together with e-motors obviously. How do you think about competing in commercial vehicle without that e-axle capability? Or is that something that when -- if there's an acquisition out there, organic efforts you would think of moving into?

Yes, a couple of things there. I mean, first, remember AKASOL is obviously a piece of that equation in terms of how we're playing in the truck and industrials space. And so obviously, that's independent really of the e-axle discussion. So we like the prospects for growth in that business. When you come back though to the CV market, what you talked about in e-axles, a few things I would say is one, today as we see it, the bulk of the business that we're seeing in the market right now is central drive driven. It's not e-axle driven. But we do see that trend accelerating. We do think as you look out over the next decade, you're going to see more movement toward the axles. But probably a decade from now, you're still looking at probably half of the market driven by central drive. And within the e-axle, there's still the opportunity to supply components. And in fact, I think one of the trends that we've seen in some of the discussions we've had about e-axles is because of the unsprung mass in the axle and the level of vibration in that product, some providers of the e-axle are actually looking at moving certain technology out of the axle and maybe keeping it separate for the viability of that product when you think of inverters or other things. Nonetheless, whether it's an e-axle or a central drive solution, we still think there's a long-term play in the component space here. And whether that's from an e-motor perspective or an inverter perspective, in addition to the battery modules and packs through AKASOL.

And just to close out, I know you're not giving guidance next for next year, but just kind of directionally. You did 10% growth over market this year. There's been some rebounds like Delphi's ICE business, diesel. But for next year, should we start with your 4- to 5-point outgrowth? And are there specific headwinds and tailwinds plus or minus that we ought to be thinking about?

Yes, I think the -- you start with the premise that we continue to believe that the portfolio we have today is going to continue to grow at that mid-single digit, call it that 3.5 to 5-point type of outgrowth. I think that's the right way to think about us. I think what we still need to assess, is there any amount of the outgrowth that occurred here, particularly in the back half of 2021, that may be a giveback as you head into 2022? Whether that was because of partially built vehicles where we've been supplying the OEs and they haven't produced the end vehicle, and that maybe inflated the outgrowth this year at the expense of next year on a year-over-year basis. Whereas we look at the mix of vehicles that OEs are producing, a lot more trucks being produced right now than maybe a historically normal mix. Does that have the potential for some giveback next year? So we'll look at those types of things as we get through the fourth quarter and into next year to see -- you start with that normalized outgrowth that we would expect. But is there any amount of overhang coming from what's happened here, particularly in the back half of 2021? Because we're not normally at 10% or even like last quarter at 13% outgrowth company. And so there are some unnatural things that I think happened during that quarter and the back half of the year that could have an overhang on that 3.5 to 5 points we would normally expect.

And similarly on margins, what are the headwinds, tailwinds around the incrementals and, hence, the margins we ought to think about for next year?

Yes, I think the biggest headwind, which is a positive for us too, is the fact that we intend to lean forward in a pretty significant way, continuing to invest in R&D up over $100 million next year entirely focused, that growth on e-product investment. And so we're intentionally leaning forward there. That's a headwind. And we think that gets substantially funded by the restructuring savings we've been delivering, by the Delphi-related cost synergies that, that offsets it. But that is a real investment headwind. I think if commodities stay where they currently are, then we've seen the bulk of that impact in the second half of the year. But we didn't really see the impact of that in the first half of the year in 2021. So if commodities stay at the current level, that's likely to be a headwind as we head into Q1 and Q2 of 2022. And then beyond that, you're really looking at normalized conversion as we see, hopefully, some level of revenue step-up, with production up moderately as we look to next year, plus our outgrowth that we would expect.

Okay. Great. I want to thank you, Kevin. Thank you for bringing Harry along as well. And look forward to ongoing progress on the -- in the BorgWarner CHARGING FORWARD. Thank you.

All right. Thanks, Brian.

Thank you. Bye now.