BorgWarner Inc. (BWA) Earnings Call Transcript & Summary

Yes. When you think about securities supply, I think you need to think about 2 things. Can you talk about, first, what are you doing in terms of actually securing component supply. And I think you also need to think about the resilience and the flexibility of your design. So when you think about what we've done in security of supply first. Obviously, last year, you saw us announce the capacity forward agreement with Wolfspeed and Wolfspeed is going to be one of our largest silicon carbide suppliers. That being said, that's not an exclusive agreement. So what we've done since then is reach capacity agreements with multiple other silicon carbide suppliers. So we feel like we positioned ourselves in a pretty strong position to make sure the supply and component level is there. But what you need to also do is make sure that you have flexibility in your production systems. And what I mean by that, when you think about whether silicon carbide chips reside, they reside in the power module within the inverter. Our base power module design, if you're to look at the component, the design of the power module doesn't change when you move from silicon to silicon carbide. And even more importantly, the design of that product doesn't change if you move from one silicon carbide supplier to another. So as long as that inverter has been validated for both chip suppliers, you have inherent flexibility there without a meeting of redesign of the product as you shift between those different sources -- so I think you need to do both. I think can you just care the supply that I think you also need to have some design resilience to manage through it as well.

I mean that's really helpful, Pat. I think to be clear, like, to get the voltages that are required in some of these higher-performance vehicles, is going to take that actual material content, right, silicon carbide. But what you've really done here is create the sort of sourcing versatility so that you don't have to reconfigure the solution depending on supply Okay. That's very helpful. And then you called out the repurposing of the Seneca plant to expand battery production, part of that CapEx you're talking about, Kevin. Just given the domestic content incentives, is it fair to expect that Board will continue to ramp production capacity in the U.S.? Do you have any of you or anything you can share with us in terms of target capacities over time?

I think you'll see more details to move towards our Capital Markets Day later this year there. But I think you should expect that our U.S. capacity has to grow over the next several years. That's part of the Seneca expansion. When you think about -- I think underlying your question as well, would you export from the U.S. to other markets, I think that cost is a consideration, but you tend to see us produce in the same region with our customers. Part of that is risk mitigation, but part of it is also just a function of the decentralized structure that we have that Kevin talked about earlier. And also, when you kind of take a step back and think about what a CD battery pack is, it's a pretty big, pretty heavy item. The logistics costs you need to overcome when you're talking about shipping those from region to region, it's pretty significant. -- what I think is actually pretty telling though out of the Seneca capacity increase is it shows you a model of what we're going to do in terms of moving e-products into some of our existing foundational facilities right? There's a few benefits of doing that. Obviously, at a facility level, that gives them another growth opportunity. But also from a BorgWarner standpoint, I think how much longer a Greenfield plant would take versus using an existing management, infrastructure, supply base, logistics suppliers. And we're not -- and Seneca is not a one-off, either -- there's a plant in Europe, North America and China that we've added our heaters to -- in Wuhan, China, we've added our e-motors and IDMs through an existing foundational facility. And we've also added e-motors and IBMs to existing foundational facilities in both North America and Korea. So it's not a one-off. I think you're going to see us do more and more of that.

Pat, let’s assume electrification is the end game for the majority of the business. How do we get a sense of magnitude on future stranded costs from the combustion side of the business, if you have this ability to pivot the existing asset base, the way that you're describing.

Yes. I mean I think that's an important part of the equation. If you just take a step back and think of the assets in different buckets, first, maybe you start with machinery and equipment. And generally, on a foundational program, we depreciate those assets over the life of the program. So we've already paid for them. They get funded by the program and fully paid for by the time you're at the end of the program effectively. When you look at some of our other main assets then think of the buildings and the people, just like we're talking about here. And as Pat just mentioned, we've already started putting those key products in many of our facilities around the world. And we're able to do that because, remember, we're predominantly in the assembly business from a manufacturing perspective. We don't have these plants that are completely vertically integrated in single-purpose plants. These plants have the ability within the 4 walls to be flexible in terms of the types of products that we manufacture and frankly, assembled there. So this allows us to really reutilize those building assets. And again, just as Pat hit on, whether it's Portugal or Seneca or China or Korea, Poland, all these other places, the story is fairly similar. And that's both from a building perspective as well as the people who work in those buildings because in the assembly world, you can repurpose a lot of the individuals there. And then maybe one other thing I would hit on as it relates to some of our people, our talent. When you look at outside of the 4 walls of the plant and look at engineers, we did launch a year ago, a program we call Power to Evolve, which is a skills agility program really focused on retraining mechanical engineers to be able to work on products like electronic drive systems, batteries, inverters, motors, other things. And so our initial cohort that went through that program was about 100 engineers, and we placed over 90% of them into new -- into new roles in the East space, and we're continuing that program on a go-forward basis. It doesn't work for everybody, but it helps move people from the mechanical world into the electrified world.

On, that's super interesting. To the extent you can speak to it, what are the kind of the core skills or additional tools that are needed in terms of the training to help folks make that transition? What are these types of programs emphasize?

Yes. I mean they're not programs that are going to get somebody who's maybe a 25-year career expert in mechanical engineering to become suddenly an electronics specialist. But there are different skills that you can leverage across the engineering world from a program management to launch perspective with some more, I won't call it basic because it's beyond me the level of understanding of electronics in an electrified world, by getting people up to speed enough that they can effectively manage or work in program management program launches associated with programs but might not have that deep level of knowledge that somebody who's been in that space for 10, 20 years has.

Can we discuss the operating leverage in the propulsion? Our assumption is that these programs have higher R&D intensity upfront, that's potentially higher gross margins or incremental margins as they ramp. If we look at the expected ramp here from 1Q to 4Q that you provided during the earnings call, seems to imply incrementals in the low to mid-teens. How should that trend over a longer time as you build scale in the business?

Yes. And I think you've been listening to our message because you articulated it pretty well. Yes. We price our product programs just like any other program to have a 15% return on invested capital over the life of the program. Same as what we do for our foundational business. And just as you articulated, those programs tend to have higher R&D upfront, which means to get to that same return profile, we need to have healthier contribution margins on the back end. And that tends to be what we see in the e-product world. Our typical foundational products have incrementals in the mid- to high teens. And so we would expect the products to be a little bit north of that as you get to steady state. As I mentioned earlier, as you go through launches, sometimes, you'll have a little bit of a headwind to that because you have inefficiencies with start-up costs and other things. But as you start to get the scale in those businesses, you tend to see a more normalized conversion. If you look at our guidance, you can kind of see that coming through our guide. I mean on a full year basis, our guidance suggests ex the R&D increases, 16-plus-percent incrementals on revenue growth this year and about 2/3 of that revenue growth is coming from the e-product portfolio. And remember, that's absorbing about $65 million of material cost inflation headwinds as well. So if you x that out as well, I mean, I had to take everything out of it. But if you were to pull that out, you'd see you're getting to even higher contribution margins effectively on that $1.2 billion to $2 billion of incremental revenue this year, again, the bulk of which is being driven by the e-products.

And the follow-up to that, and I don't want to steal any thunder from Capital Markets Day, but if you continue to extrapolate that incremental margin progression and the assumed revenue scale, it seems like e-Propulsion will likely get to corporate average EBIT margin or segment EBIT margin type profile within a couple of years. Is that a fair assumption at this point?

Year sounds aggressive. I think we do expect that because we price these programs the same way we price our foundational programs and the capital intensity tends to be substantially similar that they should ultimately have the same return profiles. But because there's more R&D intensity in these programs, as long as you're still in growth mode, your R&D in any given year is high relative to the in-year revenue than it would be at a steady state. So that always poses a bit of an overhang on getting to your steady-state margin. As you start to see growth slow, which might not be for a decade, but as you start to see it level off and that you kind of grow into the R&D within your P&L, then you start to get to more steady state normalized margins, but it might take a while to get there depending on the pace of growth that we continue to experience. The faster we continue to grow, the more R&D would be a headwind to us achieving that steady-state margin profile.

And it reminds me of the conversations we used to have about free cash flow profile of the business that, to some extent, if we were seeing the company spend more in capital, it meant that you had stronger growth prospects. The same would probably be true here for the R&D, right, because this is largely program-specific application engineering.

It is. So you do see that on the R&D. And you see it on the CapEx as well. I mean we talk more about the R&D side of the equation. But just as I mentioned earlier, on the battery pack side, we're investing $100 million of capital this year to support that business. And when you look at the step up we have in capital spending year-over-year, about $150 million at our midpoint, that's almost entirely being driven by the investments we're making in the e-product portfolio from a capital perspective. So it's hitting us on the R&D side, and it's hitting us on the capital side. Yet even with all of that, we're generating 10% to 10.4% margin and $600 million of free cash flow.

Very helpful. I want to end with talking about the PHINIA spin. Just walk us through the main steps you'll be working on as an organization over the coming months to get ready for the spin, I have a follow-up, but I'll start with that question.

Okay. Well, as you imagine, there's a lot of work going on. We announced it back on December 6. Since that time, we did announce the CEO, Brady Ericson; the CFO, Chris Gropp, a couple of months back. But there's now really beyond just making those announcements. There's a handful of steps we really have to execute on. One is we have to finalize the audited annual and quarterly financial statements for the stand-alone company and get those into a Form 10 document that ultimately gets, I'll say, approved by the SEC and becomes effective. That's one thing. We have to establish an appropriate corporate company or structure to support what is a new public company, even though we run a very decentralized model, and so we don't have to staff up maybe as much as some other organizations might the PHINIA business isn't a public company today. So you need to finance, legal, HR and certain IT resources, in particular, to make sure it can operate as a stand-alone company or directors in place. We have to make sure we complete all the separation work, especially on the IT side to parse break the company into 2 pieces. And we have to get a capital structure put in place. And so I think those are really the key things that we have to do. But a lot of that work, as you can imagine, has been well underway since we made the announcement even a little bit before we made the announcement back in December. And given where we are in that process, we're confident in our ability to execute the spend by the end of Q3.

You mentioned how the businesses operate in a fairly decentralized manner. So that may partly address my next question. But just how do you ensure operating continuity in fuel systems and aftermarket ahead of the spin? I mean it's still maybe an improving but a challenging operating environment. There's a lot of puts and takes here. Just talk to us about execution focus.

Yes. I mean we have the existing management team that's been in place running that business, continues to run that business, and they're tasked to drive the performance of that business. And as long as that business, both fuel systems and aftermarket or part of BorgWarner, we go through our regular cadence of internal reviews and oversight of those businesses. So all of that remains in place. Undoubtedly, some of the leaders who are in that business are being tasked as well with working on the spin and making sure they're ready to be a stand-alone public company as well. So we need to make sure that we're providing the right corporate support to the PHINIA business, so that we can allow them to continue to focus on managing the business and the P&L there. But undoubtedly, they're being tasked to wear 2 hats as well. So that's a little bit of an overhang for the individuals, especially at the top of that leadership chain, but they continue to manage the performance of the business and so much of it is managed in our plant environment anyway. And those individuals running the plants aren't distracted really with the spin-off work that we're doing more at the corporate level or at the top of the house in PHINIA org.

Last question for me. A number of analysts have tried to get after PHINIA capital structure and the R&D and CapEx intensity. And I know most of that is being safe for Capital Markets Day. I guess just what can you share with us conceptually about how investment spending for that business was going to be managed?

Yes. So from a capital structure perspective, I would say that just as we've said before, we expect to capitalize both companies in a manner where they have moderate leverage profiles and healthy levels of liquidity so that they can both execute on their go-forward strategies. So that's not a comment on one company or the other. It's a comment on both companies. So hopefully, you can read into that a little bit. And so by doing that, we think it provides BorgWarner on the one hand, PHINIA, on the other hand, with the financial flexibility they need to operate and execute just on the short term, but on the long term. And the reason we're doing that is because the spin-off is about separating 2 companies that have different focuses, different strategies. On the BorgWarner side, very much focused on the path on electrification on the PHINIA side. They'll detail their strategies on a go-forward basis, but you can see the focus they have on aftermarket, on commercial vehicle, on geographic opportunities on hydrogen combustion. And so we want to separate these companies from a position of strength while both are performing and executing very well. And we don't want to put a capital structure profile in place that's going to compromise on either company's ability to execute on those strategies.

That's very helpful context. And with that, I think we're running into time. So again, Kevin and Pat, I want to thank you both for joining us today. I want to thank everyone for the time. I hope you have a great conference. -- a great rest of your day. If there's anything we can help with on a follow-up, please don't be shy. Again, thanks all.

Thank you.

Thanks, everyone.