BorgWarner Inc. (BWA) Earnings Call Transcript & Summary

Thanks for joining us. Our next session is with BorgWarner. We're very happy to have Frederic Lissalde, Chief Executive Officer; and Kevin Nowlan, Chief Financial Officer, with us. BorgWarner is a global powertrain technology leader. They are making the transition, we believe faster than the industry is from ICE to EVs. They don't get a lot of credit for it in their stock. We think they should get a whole lot more over time. In 2021, they outlined their CHARGING FORWARD plan, which was a great plan, I think, to outline the strategy. And are actually executing faster than expected on EV wins. And really making some great acquisitions. One part of it that's a little bit behind schedule, but is being solved later this year. With the spin of some of the ICE assets were intended for sale, but the $3.3 billion in sales there are going to be spun later this year. So the pro forma company will be on track and probably even well ahead of track of the other 2 pillars of the plan. So we're happy to have Fred and Kevin here, to talk about all of that. And with that, I'm going to turn it over to Fred for a few opening comments, and go through a couple of slides here.

Thank you. Thank you, John, and good afternoon, everyone. So John was alluding to CHARGING FORWARD. And so back in the March 2021, we announced $4.5 billion of pure BEV revenue in 2025. And we track at $4.3 billion, $3 billion organically with the product portfolio that we had back in March '21 and $1.3 billion are linked to the acquisition made since then. $4.3 billion of pure BEV, if you take this revenue in 2025 and compute whatever CAGR you want to compute having us grow at market from '25 to '30, you are going to get to a pretty big number. We also said we would dispose $3 billion to $4 billion of combustion assets, and this is the spinoff that we announced back late last year that will be spun later this year. And the company is called PHINIA. I'm going to talk about that a little later. These revenues do not take into account high-voltage plug-in hybrids. And in 2025, we will make $1.3 billion of additional revenue on what we call the east side of high-voltage plug-in hybrid, meaning the inverters, the motors and everything that is on the east side of hybrids. This is PHINIA. We've created twovery strong and focused company, well capitalized, able to execute their own strategies. PHINIA is going to be focusing on aftermarket on commercial vehicle, on fuel injection and on hydrogen, whilst BorgWarner is clearly going to focus on electrification. And we believe that this separation will unlock shareholder value and have those two very strong, well capitalized, generating good margin and free cash flow, able to execute on their own strategies going forward. This is the portfolio that we have created over the past years. You see that we have products pretty much wherever the electrons go from grid to wheel. I just want to pick a few, to give you the idea also of the scale that we've created in 2025, if you look at the inverter, we're going to be the #1 in the world, non-captive supplier with more than 3.1 million invertor produced in 2025, more than 2 million drive motors, more than $1 billion of battery pack revenue in 2025 and more than 4 million high-voltage coolant heater also in 2025. Just wanted to give you also a snapshot of some recent awards. I'm not going to go in detail, but you see the variety of the product portfolio. It's a nice mix of system with the integrated drive module on the bottom left, components, battery packs, thermal management systems, which is a good snapshot of the breadth and the width of our portfolio in BEV. That was just opening remarks I want to give you back to you.

Great. Well, thanks so much for that. Maybe we could just start a little bit with some of the near-term more mundane stuff. I mean, obviously, volume has not been really that great for the last couple of years, but schedules have been even more erratic, which has been even a bigger issue. Can you give us sort of an update of maybe where things finished in 2022. Now, we're not going to talk specifically around 2023. But as you look through '23, are you seeing things get a little bit, as far as realization?

It's still a little volatile, but less than before. A good example is our guide on the pure BEV revenue this year. We've announced $1.5 billion to $1.8 billion, which puts us well on track to the $4.3 billion or $4.5 billion in 2025. If we get -- if it's not a demand band, it's a supply band. If we get enough of those chips, we'll be around $1.8 billion, if we don't, we'll be around $1.5 billion. And so, we still see noise in the system as far as supply chain availability.

But it's again -- I mean, it's actually we're getting to a point where it's getting significantly better. Okay. The other issue is the inflation and cost around this volatility have been relatively high. They may actually be getting better from a volatilities productive and raws have come down a little bit. And as you look at sort of the relationship with the automakers, it seems like they've become a little bit more collaborative during the course of the last 2 years, but particularly last year, as far as working with you and understanding cost models and where the pinch points are for you. Do you think this is something that is more structural? Or is this something that is a result of the stress in the system for the last couple of years and their ability to create -- to pass through pricing to their consumers and actually make record margins.

You've got some commodities that are going down, some are not going down. You've got labor going up energy still at a high level. Our goal is to carry on -- working on our productivity to overcome some of the headwinds that we have, but also passing those costs to some of the cost to our customers. Last year, we passed along about 80% to 85% of the headwind that we saw from an inflationary standpoint. And wherever the inflation goes, our goal is to pass on and negotiate with our customers for them to take their fair share.

And that's been more around raws or input costs outside of labor. Labor is becoming a bigger issue for the industry. And I think, once again, the automakers are understanding this as well. Is that kind of pass-through starting to occur on labor costs as well? Is that something that you've had discussions with.

We're starting -- I mean, the labor cost that's coming from two areas, right? One, is through our supply base; and two, through our own operations. So we're doing everything we can to implement product to productivity action to overcome some of the inflation that we have in our 4 walls, but we can't eat it all. And so like last year, customers are going to come to the negotiation table.

Yes. When you look at the cost that we incurred last year that we've talked about publicly, that you mentioned raws mean the underlying commodity costs weren't the biggest driver of the overall increase that we saw from a material cost perspective. They were a meaningful piece, but it was the other things underlying the supplier cost as well, other input costs that they had at labor freight, logistics, energy, lots of different things we're contributing to that. So we had a $674 million headwind last year. We disclosed that in our 10-K, and we recovered $585 million of it, but it wasn't just about raws. It was the overall cost in the material supply chain.

But there's -- I mean there's a more collaborative discussion that seems like it's going on with your business partners than maybe in the past or is it still brass tacks and tough. You seem to be smiling.

We are in the auto space. So it is always a little tough. But times are exceptional. I'm actually pleased to see they realize that they can't just ignore those exceptional times. And the numbers that Kevin just mentioned is, I think, a realization that they are realizing that, and we've done our job to take a fair share, but we can't eat it all. And we won't.

CHARGING FORWARD as 2025, it's an important date to hit those 3 comps. So obviously, you're well ahead of that or as appears you're going to be well ahead of that. That's my opinion. You don't necessarily need to bless that. But -- as we think about the penetration rate on EVs in '25 and maybe in 2030, how do you think about that? I mean what are -- I mean, I don't know if you have point estimates you want to share. I know you've talked about it in the past. How relevant are they to how you run the business, whether EVs like in the U.S. might be 15% or 30% by 2025. I mean, is your product portfolio set up to succeed in whichever direction that penetration ultimately goes?

The answer is yes. We and that -- with the numbers I showed you, those numbers are coming from actual contracts with customers. So they're not -- they're not linked to market itself. They are, but indirectly. We back at the Capital Market Day when we announced CHARGING FORWARD our estimate was 30% of BEV in 2030. We were a little bullish back then. Now, we feel that it might be higher, and we're going to give you more color in Investor Day that we will do at the right time when we spin off PHINIA. What we said also is that the remaining 70% would be split pretty much evenly between combustion and hybrid powertrains. So hybrid powertrains are growing. For us, it is a very good market because on the east side of hybrid, we are also very relevant in terms of inverters, motors, and that gets the scale in those product lines. And those product lines are very similar whether they are applied in high-voltage plug-in hybrids or BEV. On the hybrid side, most of our combustion products are also in very, very high demand. And so we -- electrification overall accelerates our growth. So to give you a point of data, if you compute the data that we've given you over the past few quarters, our average sale price for an inverter is about $750. And the content opportunity in a combustion car should we sell and could we sell all the combustion products that we have in the BorgWarner portfolio is about $930. So that gives you an idea about the acceleration that we are seeing in our portfolio, acceleration of revenue that we're seeing, thanks to our new portfolio.

So one of the challenges that the industry is going through is we're seeing new technology launch, particularly around the powertrain. Is that it is new technology, and launches are always difficult no matter what kind of product it is. And we've seen some cost overruns and even sort of some incremental CapEx to step up to make sure that things are right for certain customers. As you're launching all of this new product on the EV side, what is your comfort level that you're not going to have, if they're going to be able to execute very well and you're not going to have these kind of overruns. Is there something in the portfolio or things that are going on right now that kind of give you this knowledge base to kind of run through this, and not run into these hiccups.

I would say, first of all, we use all the tools that we have at our disposal being an auto supplier with -- from a program management, advanced quality launch reviews. We're actually leaning forward a lot from an R&D standpoint. And we are increasing R&D year-over-year. But at the same time, we're also being very frugal on where we still need to do application engineering on the combustion side. So we feel pretty comfortable that when you combine the very strong growth of e and the associated R&D, combined with the lower R&D needed on the combustion side will stay between 5% and 5.5% of R&D as a percentage of our sales.

And we're looking at those R&D expenses inching up to some degree. I would imagine, a lot of that is advanced engineering or advanced engineers or engineers on that side? Or are there other costs that are coming in. But I mean, on the engineer side, there's labor shortages everywhere and particularly for skilled folks like engineers, the market is incredibly tight. Are you having a hard time finding folks? Or are you just having to pay up for them? I mean, it's an exciting time in the auto industry. So I think, the people are oversetting the lack of interest in auto. It's actually really -- I think there is a lot more interest than people would think. But I mean, as far as finding these engineers and sourcing human capital that you need to execute on this, I mean, how are you finding that?

We're doing pretty good. I think, the vision of clean and energy-efficient world, the story and the opportunity that we give to those engineers in transforming this business, successfully is actually appealing to people. We're recruiting a lot of electronics and software engineers. We also -- we've also launched a program internally called Power to Evolve that takes engineers that are working in the combustion side and through different modules and hands-on activities where training those people and involving those people to become engineers in the world of BEV, that is working very well. That program is in a very, very high demand. So, I would say so far, so good. We're also leveraging low-cost country -- for low-cost countries for software and electronic engineers. So I would say, so far, so good.

And the only other thing I comment on. Do you want to finish?

No, I just wanted to just make sure that the additional R&D year-over-year is essentially linked to application program that we've booked and program that we pursue with a very high percentage of bookings. Those are not research and development as such. They really are applied engineering.

That's what I was going to...

Okay. Then if we think about CHARGING FORWARD, the $3.3 billion that is going to be spun later this year in Phinia, which we'll get into in a few minutes, is a good profitable business, generates a fair amount of cash flow. Obviously, there's a lot of folks that might not have appreciate what that value is, right? So you're going through the spin process, which is fine. But I mean one of the things that we kind of look at in the industry is, cost of capital has gone up, right, rates have gone up. The equity capital markets are a little bit more constrained. There's a lot of concern in the world. So cost of capital has gone up. That cash flow that you're spinning off could theoretically be used to help funds some of the R&D, and sort of the development of your future products, but you're kind of deeming that as not necessary. So if we think about not selling those assets, you're not getting cash in the door. And then you're also spinning off that cash flow from those assets. So it means that you have greater faith in sort of the core of what you're keeping and the cash flow that you're generating there to fund the future. Do you -- I mean, why would you spin that if the cash flow is so strong, and it must mean that you have incredible faith in the core remaining company that it's going to be self-funding. So I mean, I don't know if you can kind of -- it's kind of a question but kind of a statement. I mean how do you think about that?

Maybe I'll start. So I think, we're spinning off this business not related to cash generation or cash proceeds. We don't need those cash proceeds to execute CHARGING FORWARD. We're spinning off this business because we want to create 2 very strong companies, able to execute on their own strategies. And as you remember, during my little remarks here at the beginning of the interview, those are different strategies, and we can't do it all. So when those business leaders come to Kevin and I with an acquisition on hydrogen injection or an acquisition on aftermarket, this is not BorgWarner strategy. And we've done a great job over the past 2, 3 years fixing those businesses. They are very profitable. They are generating a lot of cash. And we believe strongly that we're going to unlock shareholder value by having those 2 companies run their own business.

And I'd say, there will still be some level of proceeds that ultimately comes back to the parent because when we put a moderate level of leverage on the company being spun, that means they're going to be issuing debt and receiving cash for that and some of that cash will come back to the parent company. But as Fred said, this was never about generating proceeds. That's why we always talked about it as dispositions, not divestitures, disposition is the act of separating the businesses because we thought they would end up ending in their own directions, which is where they're going right now. And the businesses are positioned to be able to do that on their own.

I thought, you had a question?

Kevin, I have a follow-up on that.

I know you were going to ask [indiscernible]

I had [indiscernible] the new entity, have you thought about what the capital structure will look for that business? And is there any way for us to scale, what type of your cash would come back to the RemainCo, so we can, kind of think about what the balance sheet would look like post spin.

I mean, I'm not going to give perfect clarity on it. We'll do that when we get closer to the spin date and have Investor Days for both companies. But, what I will say is, we expect to capitalize both businesses such that they're moderately leveraged. And so this isn't an opportunity to take one business and lever it up and dump a bunch of bad liabilities on it, like we've seen in other deals, this is truly about spinning 2 companies capitalized to be able to execute on their own respective strategies.

Keeping them healthy, have you thought about if they be investment grade? Have you gotten that far?

I wouldn't prejudge, what a rating agency might do on this. But again, I think we're more focused on what level of leverage we think makes sense to support the business to be able to execute on the strategies. And I think, you should expect they'll both be moderately leveraged.

Perfect. That's great. We've got news on the IRA last week, some clarity on some of the subsidies is going to consumers, but there's also other subsidies in the background for production, particularly on the battery side. Maybe twofold. I mean, what do you think it might mean for acceleration in EVs, given what's going on in the consumer side. And then on the production and subsidies on the battery side, maybe -- I mean, not even just for what you're doing with stuff like AKASOL but also for charging stations, which are becoming part of the product portfolio over time.

As it relates to the IR, we do think we have the potential to capitalize on some of the benefits afforded to us related to battery module impact production in the U.S., where there are tax credits associated with the kilowatt hours that you produce in the U.S. And so, what came out last week didn't really provide any updated guidance on that aspect of the legislation. So there could be further clarification that comes as the year goes on. But at the moment, we believe, we qualify for those credits. On the charging station side, I guess, taking a step back, when you look at the legislation, you have to keep in mind that a lot of the provisions the way the IRA works is you tend to be able to take advantage of one and not necessarily multiple aspects of the legislation. So you have to look at, what the best fit is for the -- for where you have the opportunity to garner the most tax benefit perspective.

Okay. EV profitability, right now, it's not quite breakeven, but it sounds like late this year, heading into early '24. It will -- you get to better [indiscernible] get the breakeven and presumably breaking through breakeven and making money. Where do you think you'll get to really significant profitability in the EV business? Is that a question of time? Is that a question of revenue? What really kind of defines that? And when do you think it gets to corporate average when -- I mean roughly, I mean, you guys haven't said that yet. And is there the potential maybe in the long run for the margins to be higher on the EV business than they were on the ICE business traditionally?

Yes. I mean, if you look at where we're jumping off today, the EV portfolio loses money. And why is that? It's because we're investing a lot of R&D dollars today, related to the bookings that we're booking that are launching in 3, 4, 5 years from now. So take a look at last year's P&L, $420 million of eProducts related to R&D only $870 million of battery electric vehicle revenue, okay? Well, that math just doesn't make sense. But that's again, because the R&D $420 million isn't linked to that year's revenue. It's linked to the revenue, 5 years from now. So what's happening as we move forward, you look at this year's guide, our eProducts related R&D is going up $60 million to $70 million. So the pace of that growth is slowing versus what it was growing at last year. But the revenue is growing much quicker in battery electric vehicle revenue was going from $870 million to $1.5 billion to $1.8 billion. I mean, it's almost doubling at the midpoint of our guide. The pace at which that volume is growing, the revenue and the contribution margin on that revenue is growing faster than the pace at which R&D is growing, which is why, the margin is getting to that inflection point and hitting breakeven as we exit the year. So that's the math of it. So where does it go from there? Well, as long as the revenue keeps growing, that's the key, which is marching toward the $4.3 billion, $4.5 billion in 2025 and beyond, and that pace of growth is continuing to outpace eProducts R&D growth that margin profile is going to continue to get better and better. Do -- but when do you get to that steady state, it takes a long time because as long as we're growing, that R&D is always going to be a little bit oversized, relative to the in-year revenue that you have. So you never quite hit steady state until you get to a much more leveled out growth trajectory. But we feel good about the overall profitability of the business. We price it the same way we price our combustion-based business. We look for a 15% after-tax ROIC on any program that comes to Fred and me, and that's the way we quote our business and book it.

A big chunk of the portfolio is still going to be ICE post spin later this year. Can you remind us what products you're keeping in there? And is there profit -- is there a potential for those profits, as maybe R&D phase away in some of those products to potentially even improve over time. And I'm sure, we're volumes that are still sub -- not subscale, but we're at trough level of volumes. So I would imagine, that there should be some cyclical benefits over time as volumes recover, but potentially even sort of secular as you might need to invest less in those ICE products that could help generate even more cash than people are expecting.

ICE Products that are kept with RemainCo are #1 or #2 in the world, in everything we do. We keep them for 3 reasons, 3 reasons. The first one is stay connected with all customers around the world with who we make, we do business and help them also transition from C to H&E. Second reason is that you have a lot of foundational know-how from a product and process standpoint in the ICE business that we retain, that are enablers of our BEV growth. I'll give a few examples. Low-voltage electronics to high-voltage electronics. Those are key enablers. In a power in the inverter, you've got a computer, same technology that you're using for engine control units or transmission control units. 4-wheel drive systems, couplings, vehicle stability devices are also very important in the world of BEV, in the world of BEV system supply that we do with our iDMs, thermal management, thermal management in the world of BEV is essential. And we announced last quarter's call, a win with a German customer on a battery cooling plate. This is a very, very interesting example, where we leverage the product foundational know-how and the process of brazing know-how in the world of BEV. And third, last but not least, those product portfolio are going to generate the cash that we will need to carry on the evolution of the company towards CHARGING FORWARD towards past CHARGING FORWARD.

If we think about the integrated drive modules that you guys are supplying to the market, I think you have one contract with an automaker with Cree. I mean with Hyundai. Is that correct?

Yes. And we have several contracts, but we have disclosed that one.

Okay. There -- within that system, I would imagine there's a decent software component as far as the integration. As you think about software as part of the product portfolio over time, I mean everything in the e-Powertrain is going to be controlled. And it is, to some degree, on the ICE side at this point by software. How big a component connect become of sales over time, how much of an opportunity is to price that maybe separately from the iDM. And sort of the. Management of torque and -- or sort of generation of torque management over time. And that -- could that be the kind of thing where there is the potential over time because we're hearing from automakers and other folks that updating software can make the product that much better and over time, you can get efficiencies whether it be range or torque, as that software is developed or other things are changing in the vehicle that you might provide post-sale value that you could -- that you could realize.

There is a lot of software and all the products that I showed you on the page. And there is a tendency to centralized software through domain controllers or zonal controllers the powertrain controller or the inverter is some kind of a domain controller. We need to remember with an inverter is that we're not moving data. It's the nervous system that moves the muscle of the motor. So it is specific to powertrain. Can we do more on software, Yes, not only from a driveline perspective, but also from a battery pack perspective. where we think we can create value, and I'm not on purpose going into more detail, but we think we can monetize some of the smart software ideas that we have in the field of challenging in batteries.

Okay. So I mean -- but I mean, as far as a stand-alone product, it's not something that you're going after. But as part of your existing product or your forward product portfolio, it's going to be a [indiscernible]

We've seen software as an [indiscernible] way enabler.

Got it. I've got a few more questions, but if we can open up for questions in the audience, if we've got any out there. We got one in -- way in the back.

Just wanted to follow up on the differential between the component price and the component volume. So for example, for the inverters, to your point, you're at a 1,600 CPV, that's definitely above the combustion engine portfolio at $940. You're contracted to sell 3 million plus inverters by 2025. I'm curious, if you could talk about what that looks like for the ICE products? What are the really high-volume ICE products? Are they on 8 million vehicles? And how does the evolution of product penetration on those ICE CPV components, even though they're lower price how that volume evolves over time?

We see growth for our ICE product across the portfolio for a few reasons. One, the equipment rate or the take rate in some continents are much lower than others. Take turbo as a proxy. Here in this country, about 35% of the ICE engines [ average ] turbo versus on average 85% or higher in other parts of the world. And turbo makes the engine smaller and leaner. We're gaining market share in some of our products. GDi is a great example. BorgWarner is a late entrant in GDi, there is a low level of in competitive intensity in this field, we're gaining share. So gain share, more take rate. And also remember that those combustion products, turbos GDi, EGR, VCTs, are key elements of hybrid powertrain architectures. So those would be the 3 elements that I would share with you that still drives our ICE business above market. And if you see the outgrowth that we guided for, for this year, you can compute the fact that ICE is still contributing to the outgrowth of BorgWarner.

That's helpful. We got a question over here.

I think the other day, I think it was Mike from IHS, described the plug-in hybrid. Everybody expected this is going to be the bridge, particularly in Europe. But I think, you described it as like nagging share now his expectations as we see the penetration of BEV go up and up and up. So I guess, what's your view on that penetration. And how are you guys set up if he's right, and it only remains a small share of that bridge.

What do you mean by nagging, I don't understand that.

Meaning like they never -- like it never becomes more than a few percent.

Our view is that hybrids are going to be relevant, and I was giving you some numbers right in 2030, 70% of non-BEV and about half of it are hybrid. Mild hybrid doesn't get the customers to being close to meeting regulatory pressure. But plug-in hybrid, especially the high-voltage plug-in hybrid makes a difference. So, I don't want to read in a crystal ball, but there is a lot, and we're totally committed on BEV. We will not do what we do, if we will not. And there is a lot of PR on BEV. But I can tell you, there is still a lot of POs on hybrids and especially high-voltage plug-in hybrids because it makes a difference and it advances our customers to their meeting the regulatory pressures or regulatory environment.

You can see that even in the market data. I mean, look at last year, 10% of the global market is battery like vehicle production, right? But 17% is hybrid, and the bulk of that isn't mild hybrid. And if you look, it's growing this year. I mean, look at Europe, Europe, hybrids are 3x what the battery electric vehicle mix is in the market. Look at China. China is more BEV than hybrid, but hybrid is growing faster right now. So, we'll see how it plays out. We're positioned to capitalize wherever it goes.

But I mean you're making that call based on what you're seeing from your customers, and what they're putting out for quote, right? I mean, I mean, as part of this you're using IHS -- it's probably a little speculation, but then there's part of it, what you're actually see out in the market.

Absolutely. And we have all the accounts. There is no customers that we don't supply around the world. So we know their road map. We know what they want to do. And we are at a level of intimacy with those customers being able to supply combustion, mild hybrid, high-voltage plug-in, BEV in many different products that they come to BorgWarner to discuss their road map and how -- what we see, what they see and being early in those discussions also positions us for success. So -- and we don't -- we have -- we are in a position, where we don't have to sell this and push the customer to buy that because we have nothing else. Wherever they want to go, wherever they want to go, they can go with us. And once they've decided where to go, they can go with us in the system or as a component supplier, and all that is all good for us.

So I'm going to sneak in one last one before we wrap up here. There's a lot of folks that purport to be getting into or chasing the electric powertrain, power electronics, inverters, and electric motors, right? So there's a lot of folks talking about it. Could you give us sort of your lay of the land on the competitive environments? And are some of these folks really just chasing this and never going to really break through or is there going to be a lot of competition and it's not going to be a market that you can dominate or maybe control like you did with not control, but you had one big partner or competitor on turbos. Is this kind of thing we're going to see 24 competitors? Or is it kind of a market that ultimately windows down to 3 to 5 real competitors over time. There's just a lot of folks chasing it right now. But clearly, you could lead.

On inverters, we see the competitive environment pretty much identical to most of the combustion products that we do. If you would have asked me the question 4 years ago, I would have posed and hesitated a little bit. Now we're not -- when we lose business, we're not losing business to a new entrant. There is literally a portfolio of players that are the high-volume electronics usual suspects that you all know in the auto space. For motors, it's more fragmented. There are motors and motors, though, right? Talking about electric drive motors, 800 volts that are driving the wheel, that are commodity products. The power density is very, very high. The management of thermal expansion, the management of the efficiency, the management of -- the combination of the motor and the inverter is very, very important. So even if the market is more fragmented, I would like you to understand that those products are pretty technologically advanced. And so, I mean two examples to answer your questions.

Yes. That's incredibly helpful. With that, we're counting down on time. So we'd really like to thank you guys for joining us today. We really appreciate it. I appreciate you doing all the meetings today. We look forward to catching up to you guys soon off stage.

Thank you very much.

Thank you. Thank you so much. Thank you Fred.