BorgWarner Inc. (BWA) Earnings Call Transcript & Summary

We'll go ahead and kick it off. Thanks for joining us. My name is Luke Junk. I cover vehicle, tech and mobility for Baird. We're very pleased to have BorgWarner here with us this morning. $9 billion market cap. Borg is aggressively pivoting into electrification, which is expected to comprise more than 25% of sales by mid-decade. Joining us today, we have Fred Lissalde, CEO; and Kevin Nowlan, CFO. We have 30 minutes for this session. I'll do my best to work in any questions that you've got. You can send those to [email protected]. With that, let's jump right into things. Fred, given that this is an industrial conference, now all the audience likely familiar with your Charging Forward Strategy. Can you just walk us through the key elements of the strategy and where you stand today?

Absolutely. And good morning, everyone. Back in March 2021, we announced our challenging Forward strategy, which calls for $4.5 billion of pure BEV revenue in 2025. We're already at about 5.5% of our revenue, which is pretty much where the market is right now in 2022, going to 45% in 2030. And we also announced that we were going to do that with 3 key execution pillars: The first one is growing our EV portfolio in pass car and commercial vehicle organically. The second pillar is to focus on EV M&A. And the third pillar is to optimize our combustion portfolio. How are we doing that? We're doing that with a great product portfolio that we have within BorgWarner. Some of those portfolios are systems, some of those portfolios are stand-alone products, some of them have been developed organically and some of them have come from acquisition. Overall, our strategy is to have product leadership and scale from grid to wheel. And those -- this is a representation of the products that we have currently in our portfolio. You may recognize some of them. We have great product leadership and great scale with some of them. We've actually announced that for inverters, for example, we'll be the #1 in the world in 2025, a non-captive market. Some other products were great products, still lacking a little bit of scale, and we're going to grow those products as we go. Now with those product portfolio, where are we? Scorecarding charging forward. You remember the $4.5 billion of pure BEV revenue in 2025. We said we wanted to do $2.5 billion of organic growth, and we're ready with business booked up to this call, on this conference, we are above the target. We are at $3.1 billion of product that have been booked globally. From an M&A perspective, we are about half of the way. We acquired 4 companies after the Delphi acquisition that we announced prior to Charging Forward. And so overall, we are at $4 billion of pure BEV revenue in 2025. That's pretty much where we are, and that's the story of our Charging Forward execution in about 3.5 minutes.

Okay. Well, let's pick up the discussion there. I want to start with project Charging Forward. From an organic standpoint, you've been very transparent about your bookings progress relative to that 2025 target. But what I'm wondering about is what's happening after you book the business. So just in the third quarter here, you had an award for increased production. Is that something we should be expecting more of based on your dialogue with customers?

Yes. Actually, we announced that we were significantly increasing production with a leading European customer on inverters. And yes, I think you're right. That is a tendency that we see more and more, and there are a few reasons for that. The first reason is that, overall, I think EV is accelerating. And when customers have good partners that they can work with, it is much easier for them to add the next tranches to the current partner as long as the partner is credible from a product launch perspective, and as long as the partner has scale, because we are at Tier 1 or as Tier 1s will then ensure resilient supply chains for our customers. For example, building in several plants our products, for example, offering resilient supply chains that are not intertwining at Tier 4 or Tier 5 level. And when we are able to do that, then why would the customer go elsewhere? Also, they're saving all the engineering development and validation money, which is pretty expensive, and they also have -- may have some engineering resources bandwidth issues like everybody currently does in the field of electronics and software.

Okay. Well, that leads right into the next area I wanted to touch on, which is your ability to book business. Certainly, there are engineering resources that are required on your end as well. To what extent are you R&D constrained if at all? Can you just elaborate on the approach there?

Yes. We are actually -- we're leading forward towards electrification. And we're spending $150 million more of R&D in 2022 versus 2021. And we are following up very accurately the recruitment that we do from an engineering standpoint. We're partnering with a lot of universities around the globe, we've also launched a program called Power to Evolve that trains hundreds of engineers from the world of combustion to the world of electrified powertrain. And we do that internally and also globally with cooperation with universities. So we're laser focus in attracting people. I think we're doing a very good job at it. But you're right, we're not quoting everything. We are focused into quoting the right product for the right customer, with the right technology, where we can differentiate. And we have a process to do that, and we take great care of doing that.

So another key part of the strategy M&A, you've already executed several transactions. You mentioned that as you look across the portfolio, there are products that you have great scale in today. There are products where you would certainly welcome additional scale. Maybe a question for you, Kevin. Just in terms of the characteristics of a prototypical M&A target. Were there any specific sweet spots that you'd call out that you're really focused on?

Well, I think as you look at that vehicle, you can see the breadth of what we're looking at, where we can move electrons from grid to wheel. There are certain places where we have really strong capability and scale already when you look particularly downstream the battery. And I think as you look upstream the battery, there's probably some opportunity for us to build some gaps there. So we have a pretty healthy active M&A pipeline, and you should expect us to continue to execute against that.

Okay. So the other thing I want to ask about, and I'll wrap up the specific discussion of project Charging Forward with this one. Fred, what do you see as the biggest risk? What keeps you up at night in terms of the strategy?

I would say it's essentially around launch, because we're launching a lot of products. And we are launching a lot of new products. So we are making absolutely sure that we have the right people in the right place to launch those products that are less known than the ones that we've had in the past. So this is a very high focus of the leadership team at BorgWarner. And I would say that so far, we're doing a damn good job.

Okay. Let's talk about the macro. Of course, with the dynamic environment that we're in, it's top of mind. This conference is near year-end, so people are starting to think about 2023. I'm going to pull back the reins and let's just focus on the end of this year. Europe energy risk, certainly something that's top of mind for investors in the world of auto. You had to give guidance for the fourth quarter contemplating those risks. What are you hearing from customers right now? Is that looking better? Is it getting worse? Where does the Europe outlook stand?

We're not seeing a lot of changes from the customers' forecasts and schedules. As far as we are concerned, A lot of our German facilities already have contracts for renewable energy. We are mostly in an assembly business. So we don't use a lot of gas and stuff like that. So it's difficult to -- you'll figure out what's going to happen. But I would say so far, we don't see those news coming at us.

Okay. Supply chain also in focus, certainly under siege in general, post-COVID. Now we've got geopolitical tension in Europe, you've got U.S. and China relationship having some frostiness. It's a polling question we've been asking all of our companies at the conference. Are you considering any related supply chain changes stemming from the experience over the last few years?

At BorgWarner, and we've done that since a long, long time, we buy, produce in the region where we sell. And you may remember, during the trade issues a few years ago, we were in a pretty good shape and less impacted than some of our peers because we have implemented that strategy since a long time.

Kevin, a question for you related to supply chain and inflation. Certainly, there have been impacts to every auto supplier's P&L this year from that standpoint. Can you just give us an update on where you stand as of the third quarter if we take a snapshot? And as we roll into next year, what your focus areas are and what incrementally the opportunity is on price/cost and supply chain for BorgWarner?

I mean, this year, obviously, there's been a significant impact from inflationary cost pressures. I mean, the good news is we saw a little bit of an improvement versus our prior expectations coming out of Q3 based on some of the successful customer recovery mechanisms we were able to negotiate. But still, when you put the full year in context, it's going to be about $110 million to $120 million impact negatively. That's the net material cost increases, net of the customer recoveries that's hitting our P&L this year, and that's embedded in our guidance. So we feel good that we're managing through that with the customer recoveries, as well as delivering cost performance elsewhere. We've been continuing to execute on our Delphi synergies, continuing to execute on the restructuring initiatives that we announced over 2 years ago, 2.5 years ago. And the result is we've been able to mitigate a lot of that cost and deliver margins that are still double digits this year. So as we go into next year, we'll see where things go. I mean, we're seeing mixed signals, right? I guess the inflation ended this morning is what I understand from the end markets here. But we'll continue to monitor that as we go into '23 and see how we need to manage that with our customers and with our supply base. But our expectation is, as we head into next year, we'll continue to look to how we mitigate that, so it's not an incremental headwind going into next year.

And then the final piece to the puzzle here would be FX. Clearly, there's been a big movement in the currency markets. Can you just size up what, as of right now, your view into next year is on?

Yes. I mean, the good news is because we produce, as Fred said, generally produce and source in the geography in which we sell. We tend to not have a significant transaction exposure as it relates to FX. But obviously, as a U.S. reporting company, with the bulk of our business outside the U.S., we have significant translation-related exposure. So this year alone, it's over a $1 billion headwind to our P&L. So when you look at our guide, 15.4% to 15.7%, that's $1 billion lower than it otherwise would have been had currencies held flat on a year-over-year basis, but we're really losing translation on that. So next year, I think clearly, if you marked hold rates where they currently are, that will provide an incremental headwind on a year-over-year comparable basis into next year, again, predominantly from a translation perspective.

Okay. Let's pivot back to electrification and eProducts, and we've got a question that I'll squeeze in here. And the question is if you book additional EV business next year in 2023, can that show up in 2025? Or would that likely be later?

Yes, it can. And the reason is that we have a very modular design of most of our products that you saw in the picture of that car. And you've seen some of the announcement that we've done over the past earnings calls on motors, on inverters and a few other products. Our go-to-market timeline can be less than a year. So yes, we can still have some impact for revenue hitting 2025.

Okay. Let's talk about specific products. You've been very accessible. In inverters, as you mentioned, you're anticipating in 2025, they will be #1 in the world for noncaptive inverter share. Can you just talk about the moat around your IP, the moat around your scale, you mentioned the supply chain, maybe makes sense to expand on that as well?

So what is an inverter? An inverter is a dimmer that controls the motor. If you don't have that dimmer, then when you push the pedal, you would most probably take off. So it's a very complex dimming machine. So the first thing that you have to -- have to be able to dim that motor is you have to have a computer. The computer analyzes a lot of sensors. And in that computer, we have our own ASICs, thanks to the scale that we have, and then ASIC is a microchip that has the same power as a PCB. And when you get up to a certain level of volume, it is interesting to develop and produce your own ASICs. And that's what we do on the computer piece of the inverter. That's one element where I think we are differentiating versus competition. Once you know what that dimmer has to do, you need a lot of energy and you need to store that energy in components that we call capacitors. They're pretty bulky elements, and we've announced recently that we would manufacture our own capacitors with IP that we have acquired, that would reduce the size and the weight of the capacitor by factor 2. That's also a key differentiating element. And then when you are releasing that energy from the capacitor, we need to transmit that energy to the motor. And that is done through a power module, which manage the power. And here, we're also very vertically integrated. We manufacture our own power modules right out of silicon and silicon carbide die. And here, the game is to cool those power module and to have an efficient thermal management of the power module, because if you cool that power module, you can release the maximum amount of energy. And so the cooling of the power module is another differentiation that we have at BorgWarner. Those are 3 examples that tells you why we're going to make more than 3 million inverters in 2025, and then we're going to be the #1 in the world.

So speaking of the competitive side of things, are you seeing new competitors in this world? And what is it that your customers are valuing in eProducts to differentiate why they're picking Borg versus someone else's products?

Yes. We -- if you had asked me the question 3 years ago, I would have paused and ask myself, maybe we'll see some new competitors. Three years after, my answer is no. We're not seeing new competitors that were not the ones that you use to seeing in the propulsion of powertrain domains and high-scale electronics, so power electronic domains. And there are a few reasons for that: product differentiation, scale, but also being able to launch very high-volume products in the auto space globally at the same time in 3 continents. And also, if you put yourself in the shoes of an executive at an OEM, with a supplier like BorgWarner that has great product leadership and competitiveness in the world of E, why would you think about breaking that relationship? There is all interest in the world in that OE side to bridge the relationship from C to H to E. And that's what we are experiencing right now, and that applies when you have the right product at the right price, obviously.

What about indirect competition from your customers themselves? How is that evolving? Are they looking at powertrain as a differentiator when you're basically trying to sell the car to you or me? Has that changed?

So what we see is that, first, there is not one size fits all. We see less outsourcing for start-ups in China, for example. We need more system support. We see customers outsourcing some program, in-sourcing some programs or outsourcing in some regions, in-sourcing some other regions. Overall, what we've said, and it has not changed over the past 2 years, pretty much at the very high level, power electronics is outsourced more than 80% or 83%. And motors are outsourced at the level of about 60%. And customers are more in-sourcing the assembly of the transmission should they want to do that. And that is something that is currently happening. Pretty stable. But I would say that I care less and less about this. What I care about is growing profitably and booking business. And I'm pretty sure that this question in about 1.5 years from now, you're not going to ask it because I think it's a little academic. As long as we're booking and creating profitable growth, this is something that is going to fade away a little bit.

And what about another key question, EV profitability. It's a very common question across all of my companies. Kevin, maybe if you could talk about guardrails, both at the time of booking and as the business launches. And do you think there's something that the Street is a misunderstanding about EV profitability at the company?

Yes. I mean, I think there's something important for the market to understand about it. When we price our EV business, we price it the same way we price any piece of business within BorgWarner. We look at a return on invested capital over the life of a program. And we have certain targets. We normally target a 15% ROIC on those programs. Again, whether it's E or combustion, what makes an E program different than a combustion-based program is that it tends to have a lot more R&D intensity, and that R&D comes up front. What that means is for us to deliver the same types of returns, it must mean we have healthy contribution margin on the back end as well for that math to work out. So why is that important to understand? Because where we are today, we're in growth mode in EV. I mean, we're $850 million of revenue today, growing to $4 billion of booked or acquired revenue in 2025 and continuing to grow from there. But it means we're in the early stages of growth, which means we're seeing a lot of R&D intensity in the P&L today. So if you ask me today, hey, are you profitable on EVs in the current year? The answer is no. But it's not because we're booking bad business. The business over the life of the program is going to hit our return targets. But we're investing in the R&D dollars today, over $400 million in eProducts-related R&D to support the revenue in '26 and '27. But the P&L is only $850 million today. So you can do the math and figure out that just doesn't make sense. That's why we lose money today if you just took a snapshot. But it's a good underlying business. We're just in the early stages. So revenue is high relative -- I'm sorry, R&D is high relative to the in-year revenue that we have. But what's important to also note is as we go forward from here, from 2022 onward, we expect that the pace at which revenue in the EV space and contribution margin is growing, outpaces the growth in our eProducts-related R&D dollars, which means the profitability picture in any given year gets better as we march from here to the point that by the time we think we get to the end of '23, beginning of '24, in-year where we're operating at breakeven on the EV space at any point in time.

Okay. What about another area that you've been investing in, stationary charging. There have been a few investments this year. Can you just expand on what makes this a natural adjacency for BorgWarner and how big of an opportunity do you envision in stationary charging?

So first of all, we focused on high-end DC fast chargers, and essentially bidirectional DC fast chargers. We think that we can apply our product leadership and profitable growth strategy in those machines. When we see those machines, we see about 50% of the bill of material that is composed of components where we have engineering expertise and great scale. We also think that we can leverage the global size of the company from a sales go-to-market and government affairs perspective. And lastly, those chargers are talking to our battery packs. Those are adjacent to our battery packs. And we see more and more. On the battery packs, we're only focusing on commercial vehicles, essentially buses and also midsized trucks. What we see is the end customer willing to buy a fully functional [ fleet ] of, let's take bus, for example, e-buses, and the infrastructure, not that we're going to do and contract an architect and make an infrastructure. Not at all. But having the stationary charging together with the pack, we think we can create customer and shareholder value too in this field.

Okay. I want to ask a couple of combustion-related questions. First one, I think investors naturally look at combustion through the lens of your company, but what about combustion through the lens of OEMs that even as we get to big battery electric penetration in their portfolios, half the cars they make in 2030 for any given company, it's still going to be combustion. Where do those 2 trends intersect in terms of your continued opportunity in combustion over the next, say, 10 or 15 years?

So when you think combustion -- actually, when we think combustion, you also need to think about hybrids. And the world will need quite some high-voltage plug-in hybrids. And we've already disclosed that in 2025, in addition to the [ $4 billion ] of pure EV that we've already booked, we have booked [ $1.3 billion ] of eProducts going into hybrids. Those are the same motors, the same motor controllers, so-called inverters, the same transmission, the same P2 hybrids that would be pretty much the same product that you use in EV. And for us, this is accelerating our scale into products that are necessary into EVs. So high-voltage plug-in hybrids still need a lot of great products that make those combustion engines lean especially around small gasoline engines. So we still see some growth in our combustion products into hybrids, and we see a very high level of growth of our eProducts into hybrids.

And then other part of combustion, Kevin, part of Project Charging Forward is the dispositions that you assumed, clearly, the capital markets are impacting the progress there right now. But can you just talk about your positioning and what you're doing internally to be ready for when those markets open back up? And as we think about the types of deals we're likely to see is the prototypical deal going to be bigger or smaller, would you say, in terms of the dispositions?

Yes. I mean, we had started down the path. Aside from the $200 million execution we had at the end of last year, we had already started down the path of executing more dispositions earlier this year. But as you alluded to, when we started to see a lot of market uncertainty in May-June timeframe, we put those on hold. And there are really 2 elements of the market uncertainty. One is the financing markets, especially the debt markets, which would make it challenging for buyers to be able to buy at an attractive amount of -- attractive pricing and the amount of liquidity that they would need to fund that transaction. Second is that the inflationary environment was creating a lot of uncertainty because while we were getting hit with the costs across all of our businesses, there is a leap of faith potentially for a buyer that, hey, are we really going to recover all those the inflationary headwinds like we've been doing? Are we going to be able to recover those? So with those 2 uncertainties out there in the May-June time frame, we really put the processes on hold at that point in time until we get a little bit more clarity around both things. And obviously, we're still continuing to see some market uncertainty out there. But that's okay, because the businesses that we're talking about disposing of are inherently good businesses. They generate cash flow, and we're perfectly [ content ] to continue to generate that cash flow and support our operations until we can find the right opportunity to enter the market and execute a disposition that generates the right value for our shareholders, and that's our focus. So we'll execute in due course, but we're not in a rush or we're not panicked to sell, but we fully intend to execute a disposition to maximize shareholder value.

A little over a minute left here. I want to leave people with a bit of a parting thoughts. You've gotten a good line of sight to 2025 on eProducts. You have a goal out there for 2030 as well. What I'm wondering is, what could the view to 2030 look like extrapolating what you've already booked and just inherent growth in the market?

I will let you do the math. But if you start with 4 or 5 in 2025, apply whatever CAGR you want to apply between '25 and 2030, and think that we're not going to stop the music and we're still going to carry on booking for start of production in '26, '27, '28, what I can tell you is that we think this number is going to be pretty big.

Okay. Well, I think that's a good place to leave the conversation. Management will be available for a 15-minute breakout session in [indiscernible] C here in the 12th floor. And please join me in thanking Fred and Kevin for the presentation.

Thank you.

Thank you.