BorgWarner Inc. (BWA) Earnings Call Transcript & Summary

Okay. We'll go ahead and get started here. 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. Borg is aggressively pivoting into electrification, having just reported its first quarter following the spin-off of PHINIA but also still has a strong combustion backbone as well. Joining us this morning, we have Kevin Nowlan, CFO; and Pat Nolan from Investor Relations. The e-mail address for questions in this session is [email protected]. And with that, why don't we jump right into the Q&A.

So Kevin, I want to start with more of an introductory question given that this is an industrial conference, maybe not everyone is up to speed on the updated Charging Forward strategy through 2027 that you laid out. Can you just walk us through some of the key updates and where we stand today in that front, including maybe some of the macro impacts that you're seeing on the EV front more recently?

Okay. Yes. So Charging Forward fundamentally is the company's strategy to accelerate its path toward electrification. And we announced the initial phase, as you alluded to, 2.5 years ago. That was the first phase of Charging Forward. And as we were on track to execute against the targets that we have laid out for ourselves. We thought it's important to lay out the next iteration of charging forward, which we did back in June, we call charging for 2027. And there's 3 ways that we intend to measure success of that initiative over time. It's looking out through 2027, looking to accomplish 3 objectives: one, delivering $10 billion plus of eProduct related revenue. And just so you understand, when we say eProduct, what do we mean? We mean a product that's used in or for a battery electric vehicle or if that same product is used to support an advanced hybrid. That's an eProduct. So $10 billion in 2027. The second objective is to make sure as we grow that revenue base, we do it profitably. Last year, we were $1.5 billion of the eProduct revenue going up to $10 billion. We want to make sure as we scale, we scale profitably, driving toward a 7% operating margin in 2027. That's not the end state, but that's where we expect to be at 27%. And then the third element of Charging Forward is sustaining our strong foundational business margins. If you look at our business margins in the foundational business, net of corporate costs, we are running around 13%, and we want to sustain that over the horizon as we look out because that's an important piece of our profitability equation. And the reason that element is also important is because it's what allows our portfolio to be resilient over time. Just as we're talking about right now, and I'll address the other part of your question here in a moment with some of the volatility we're seeing in the near and medium term on eProducts and electrification more generally in the markets, the foundational portfolio provides a natural hedge. So over the long term, just like we showed at Investor Day, if e accelerates, it probably means there's a little bit more pressure on our foundational business we probably have higher revenue but a little bit lower margin percentage. If e slows down over that time frame, it probably means our foundational portfolio is holding up more strongly probably a little bit lower revenue profile, but higher margin percentage. At the end of the day, whether it's either one of those scenarios are right down the middle of our planning assumptions, operating income is relatively similar across those. That's why we like to talk about the portfolio being positioned as resilient. So then I'll get to the last part of your question, what are we seeing here in the near term. We are seeing some choppiness in electrification. I think you've seen some of the headlines coming out from a lot of the OEs, particularly in North America and Europe. We've also seen ramp-up and launch delays from a number of our customers in China as well. And so we actually took down our eProduct revenue guide for 2023 by $300 million on our earnings call last week. Now the good news in all that is the foundational portfolio has actually performed very well, and we took up the midpoint of our margin guide, the midpoint of our EPS guide. But we did see a step back in the eProducts revenue, which we think has near and medium-term implications.

Okay. Well, that's a great launching off point. Well, I want to start with eProducts and maybe we can come back to what's going on in the business right now. But maybe bigger picture, if we could talk about the bookings environment and on a forward-looking basis, what you're seeing from customers, understanding, yes, we're seeing some choppiness around EV adoption right now. But what does your bookings? And what does the bookings pipeline tell you about where OEMs are strategically right now, especially next-generation EV platforms? Are you seeing those things out for bid right now as you engage with customers?

Yes. I mean the bookings and the award activity remains really strong right now. And you saw it even last week, we announced 4 new eAwards including an OBC award with a North American customer, our first eProduct award with that customer, a customer who's notoriously talked about vertically integrating, and sourcing, okay, well, we're going to do some power electronics with that company. We announced a High Voltage Coolant Heater award with a European OE, we also do a lot of e-business with here in North America, and we announced another one a combined inverter DC/DC converter program as well. So we continue to see strong award and quoting activity, which is why we continue to believe that over the long term, the momentum continues to be there for electrification both because of that type of activity that we're continuing to see as well as the regulatory environment, particularly in Europe and China, are not changing to slow things down and the investments that need to support the OEs to hit the objectives they have to achieve there.

I want to double-click on one of the most important areas in our view, which is inverters. So you're positioned to be -- I think you've said the biggest non-captive producer of inverters mid decades. How should we just think about benefits of scale inherent in that to more orders, we get more orders from a cost standpoint in that business? And maybe we can talk about the technology road map and in that line of thinking as well?

Yes. So I mean, obviously, numbers are moving around a little bit for 2025. We still think we're going to be one of the largest suppliers of inverters when you look out to that period of time. And I think you're absolutely right. It's one of the areas where we've seen a bit more consolidation versus the areas of the BEV broader environment. I mean it's basically a 4-player market at this point. And that volume and technology leadership is key. I mean we expect to be selling around 6 million inverters by 2027. That gives you significantly more volume than most OEMs. So that really benefits you. It also benefits you in terms of what your question was about awards is you need to get to a point in scale now that or if you're getting a subsequent award from an OEM, can you -- do you have the scale to be able to have 2 succinct supply chains down the value? And if you were smaller, you wouldn't be able to do that. So that's definitely a big advantage in terms of product business.

And what about pulling through other products, be it e-motor, gearing, other things like high voltage, coolant? Is it more typical for products to be booked together or as add-ons? Or is it really independent in terms of individual product types that you've seen?

It really depends on the product categories you're talking about because when you look down at the -- really the ePropulsion side of things, sometimes you'll see motors, inverters and the gearing awarded together as an integrated drive module, sometimes you'll see those sourced independently where you might even see like we talked about the inverter DC/DC converter, we just won where that's more of an integrated offering. But when you think of those propulsion type products versus maybe the thermal products versus the power electronics for auxiliaries, those tend to be sourced separately.

I want to come back to the current environment in China, of course, focus area more broadly in auto and within EV. Specifically, just would love to get some perspective on what you're seeing from Chinese OEMs incrementally here in 2023. Would you say there's any differences on the ground that you're seeing versus maybe what the prevailing wisdom might be as we look at China, especially in terms of customer attitudes and anything that's changed on that front this year?

I'm not sure if things have changed on the attitude front. I mean as you think of the Chinese market. One thing that makes China a little bit different than the other markets we see is there are a lot of OEs out there. And it puts a -- an emphasis on speed to market for those OEs as they're trying to compete successfully in the market. Which means for a company like us, we tend to sell a lot more off-the-shelf system type solutions than we might with an OE who's really designing a product from scratch a program from scratch and trying to build it from the ground up. We see a lot more system offerings in the Chinese market. And to that point too, because there's a lot of OEs, you have to be picking your winners and losers, right? I mean, because there are a lot of OEs out there. Now the good news is we have a pretty diverse portfolio out there. When you look at even the customers we've been able to announce today the BYDs, the LiAutos, Geely, Changan, Chery, we have a lot of breadth in the customers with whom we do business with. And that's important because at the end of the day, in China, not everybody is going to be a winner.

What about in the very near term in China, as you mentioned in your remarks, there have been some launch and ramp delays in the fourth quarter in China, do you think that those are temporary? Are we seeing impacts from the Chinese consumer? Just what's driving that based on your understanding, Kevin?

We're seeing -- I mean we have a number of customers that were in the active ramp-up and launch phase right now. And the fact that we're seeing some of those delays across multiple customers tells us that there's something broader going on that we think it's just the ramp-ups are going more slowly than anticipated. I mean, keep in mind, China is still today 30% NEV. I mean it's already there. And so the market has grown pretty rapidly and we're continuing to see growth there, but we're just seeing some of the launch cadence and wrap up more slowly than we anticipated here heading into the fourth quarter.

And then if we zoom out a little bit to the medium term. So we talked about some of the changes that you had made to the guidance for eProducts and 2023, you also had adjusted your midterm guidance for eProducts, maybe if you can walk us through those changes in especially if we could expand on the process that you took to bridge to those e numbers, how can investors get comfortable that you've calibrated the downside risk based on what we've seen in the market this year?

Fair question. We -- so we obviously took our revenue down for eProducts this year, $300 million. We had a lot of launches and ramp-ups happening in the fourth quarter, particularly in China, a little bit in the third quarter, too, but the fourth quarter. We also had a North American OE program that had slower adoption than what I think that OE has been targeting, and so that's impacted the revenue as well. But with that size of a step down, remember, we're still in the early stages of eProducts in the ramp-up being a $2 billion to $2.1 billion. We're not at the scale level that we expect over time, which just means we're a lot more exposed to launch timings in the shorter term, while we're still in ramp-up mode. And so what we did, though, because we saw pretty sizable impacts across the portfolio, not just 1 or 2 customers, but multiple customers. we went back into the line-by-line review through the medium term of what we thought the potential knock-on impacts could be to the extent that we see '23 getting pushed into '24 and maybe certain things in '24 could get pushed to '25 and so on. And because our heavy launch cadence, it wasn't just the fourth quarter, it's next year and the year after, in particular as well, there's risk to all of that timing moving forward. So based on the things we were seeing in EDIs, what we're hearing from our customers and other market intelligence that comes from our strategy office, we triangulated that on a line-by-line review of our programs to estimate what we think that did to revenue out in '25 versus the $5.6 billion we talked about before. We think that probably puts us somewhere around $5 billion. But there's still uncertainty in that. I mean, none of us have the crystal ball about how all of these things are going to pan out over the coming years. So what we did on top of that is we said, well, let's layer on an additional risk adjustment that says, what if all of our ePropulsion programs on top of what we just did or delayed by 6 months across that portfolio. That takes on another $0.5 billion of risk, which is why we put a range on it of $4.5 billion to $5 billion. So I mean, that's based on our best look today going line by line through our programs. I think the thing that we have going for us that gives us some level of confidence is that, remember, we have a lot of diversity of the customer base, just like we talked about in China. It's true in Europe and North America. We have a lot of diversity in geography and diversity in the product portfolio. So we're going to tend to move a lot more with the way the market moves as opposed to any individual customer or program. So we're going to move a little bit more with the market. And if the market is under pressure in '25, that will probably have implications on us. If it starts to recover, it would have implications to the upside on the eProduct. And maybe the last thing I'll say is, back to the resilient portfolio, I mean that's there's a counterbalance to this. If this is ultimately, we're experiencing some of the headwinds in the market, it means the foundational portfolio is probably holding up a little bit better, which gives us probably a little bit more margin upside pressure just like we saw in the fourth quarter in our guide here. So just something to keep in mind. That's how the portfolio is constructed to be resilient.

Well, let's talk about some of the factors that back that dynamic and maybe it would make sense to start with just the approach you're taking to scaling eProduct products into your manufacturing base? You've outlined this concept of Zebra plants. Maybe if you could expand on that a little bit?

Yes. So we shared that in June that basically by the end of the charging forward period by 2027 about 1/4 of our plants basically 1 at 4 are going to be what we call the Zebra or hybrid plants. And what that means is these are existing foundational facilities where they'll be adding eProduct production over that period of time. Now there's obviously financial benefits to that in terms of the reuse of both that financial and human capital to produce these new e-product components. But for the e-product side, there is operational benefits. These are plants that know how to make components, right? They have the expertise of launching components. They have the ability to manage these complex supply chains that a lot of these products are going to need. So what does that look like from a practical standpoint? So let's use the 1 plant that we've actually disclosed that this is starting with. It's our Seneca facility, which currently is our largest facility in North America. And today, it makes transfer cases. They're adding battery pack production between now over the next 2 years. So effectively, what's going to happen is if eProduct in the world of e comes faster, well, they will ramp up more of that battery production at that facility, and they'll be able to have this facility that know without a launch components launch these very important products. Conversely, if eProducts has become a bit slower or moderate or there's changing in the timing, well, they'll go on producing more of those foundational products longer. So there's benefits from a financial standpoint, there's benefits from an operational standpoint. And those benefits, as Kevin talked about from the resilience standpoint to be able to manage this environment that's not going to be in a straight line, but we know where the trend is going.

Can we talk about -- so we've talked about sort of from an operating standpoint, the counter weights in the organization. Can we talk about more explicitly the protections that you have in your contracts with customers in terms of clawing back any investments that you have, the volumes are outside of expected bands? And given what we're seeing right now, should we even start to think that maybe you could have some of those recoveries in the P&L into 2024. Can you just talk about the mechanics there?

Yes. So traditionally, over time, we've operated as a company whereby in most of our contracts, we would put some sort of volume-type clause and that said, "Hey, if volumes fell outside of a certain band or below a certain percentage of the quoted level of volumes, that it provides the company with the ability to go back and have a negotiation with the customer. And each one was a little bit -- structured a little bit differently, whether it was an ability to claw back capital recovery, eliminate price downs, we'll get increased pricing, whatever it might be. And we've actually been executing on that in the foundational world for years. In fact, we've been recovering this year and last year, in particular, from volume shortfalls on some of those programs in '21 and '22. As we started to really ramp up in the world of electrification, we've made that a requirement for the contracts that we book that we need to have volume clauses. And those volume clauses operate much the same way. In fact, Craig, who's in the audience here with me, our Controller. I mean we were looking at 2 this week like going through the language that we're using on a couple of these programs to make sure that we have the right clawback language that gives us the comfort of either, again, getting capital recovery, limiting price downs or getting outright price increases to mitigate the impact of e-volume misses because unlike the foundational business, you know within a certain band where these volumes are going to pan out on a e program where a company is launching from scratch and hoping to hit something in the hundreds of thousands of units. You don't really know where it's going to end up, which is why we require that we have these volume clauses. What that means is, is we've taken our revenue guide down in 2023. Because, those programs are coming up short, not just from our guide, but probably even from what the -- what we quoted to the customers, which was probably something higher than the guide, it's going to naturally lead to those discussions in 2024. So you should expect us to pursue those types of mechanisms like we always have at the company, but even more so now that it impacts the e-business and not ramping up is quickly.

Yes. The other key thing in the ramp-up has been R&D spend around eProducts. So can you just talk about what's happened this year? I know if you look sequentially -- we're already seeing that start to flatten just as we look out over the next couple of years, what should investors expect in terms of the needs in the P&L for eProduct R&D?

Yes. And that's been part of our planning for the last couple of years. You might remember back in '22, we leaned forward pretty significantly and increased our eProduct related R&D spend, I think it was about $150-ish million year-over-year. And then this year, it's up another $60 million, $70 million. So if you think about that and take a step back, $200 million plus over the last couple of years, 70% to 80% increase over that 2-year time frame. That was a conscious decision we made as a company because we were seeing electrification accelerate, to accelerate our investments to make sure we could capitalize on winning new business and launching new business successfully. But part of that plan was always to start to moderate the growth in that R&D as we got past this year. And we are, just as you pointed out, we're already starting to see that this year. If you look at the sequential R&D increases, Q1 to Q2, Q2 to Q3, about 2% to 4% each of those quarters. In Q3 to Q4, based on our guide, it's either going to be slightly down or slightly up relative to Q3. So that's been part of the plan. Now that's not to say eR&D flat lines. We still are going from $2 billion of revenue today, the $10 billion out 4 years from now. And we'll continue to assess that and watch it closely. But we -- as we guided to in June, we expect our eR&D to be about 7% of that $10 billion out in 2027, which is called $700 million, just a simple math. So a couple of hundred million dollar increase or call it a 40% increase over 4 years as opposed to the 70-plus percent we've had over the last couple of years. Now all of that said, that was our original planning. We'll assess what we're seeing here in the near and the medium term as it relates to the eProducts ramp as we go into our planning process right now for 2024 to see if there's anything we need to do differently. And we don't want to compromise the long term and our ability to successfully launch the programs that are coming out over '25, '26, '27, but we recognize that, hey, we're seeing some near-term headwinds and maybe that needs to impact some of the investments that we're looking to make. So we'll look at that as we go through our planning process, provide more of an update on February.

Okay. A question that we received from an investor. The question is our prices and margin on EV products structurally higher? And will they trend towards conventional combustion levels over time?

Yes, I mean the way -- you want to take that?

No. You start. I'll run over that.

We price our business the same way, whether it's a foundational program or any product program. We start by looking at a 15% return on invested capital. That's any program that comes up to me, any program that comes up to Fred, any program that comes to our BU Presidents, that's what we're looking for. And over time, we believe the capital intensity of the businesses, whether they're foundational or eProduct tend to be substantially similar when you get the steady state, which means what, if you're targeting the same return on capital and the capital investment is roughly the same, it means the margin profile at steady state is roughly the same. But what makes eProducts different is because we're in ramp-up mode right now, the R&D intensity upfront to launch a program that's coming in several years is a lot higher. And so -- so in order to hit that steady state, I've got to get through this initial ramp-up phase. And we've talked about it before. We have an inverter program that we are launching in North America, one program that has 300 people years of engineering of R&D, 300 people years before we get $1 of revenue. And so that's why you see the pressure right now on eProducts margins and profitability. It's not because we're booking loss leaders. It's because we have to get through the R&D phase to get to the revenue phase, and we're in that ramp-up mode. But as you get out over the horizon, we would expect those at a steady state to be substantially similar. The problem is it takes a long time to get the going from $1.5 billion revenue, $2 billion this year, $5 billion and $25 billion, $10 billion, you're still in ramp-up mode. And growing toward that steady state. Even with that, we still expect to be at 7% operating margin by 2027 on the path to 10% by the end of the decade.

I think the -- only thing I'd add is I think it's worth noting that even though we're pricing the components in that method where we're pricing the same way in terms of that return on capital, the addressable market that is offered to us and BEV is still significantly larger. And that's not based on low-volume programs. That's based on these high volume, hundreds of thousands of unit programs that we expect by the middle of this decade. And the addressable market that we see on a light vehicle BEV is roughly 5x that than it isn't foundational. So that's why that dynamic that Kevin referred to earlier, whereas BEV comes faster or a little bit higher in revenue, it's not because we're premium pricing in these components is that the addressable market is larger for us.

Can we talk about the -- I want to talk about the foundational business and especially some of the counterbalance elements there from a top line standpoint and -- maybe if we could look through the lens of what a customer sees from the company in terms of your commitment to foundational products and how we should think about benefits to owning current assets, both financial and strategically having the foundational and product together. To what extent do customer relationships dovetail on that front? And we've talked a lot about eProduct bookings, but what about turbochargers and some other key combustion products.

Yes. I think in addition, we talked on the financial benefits because we talked about leveraging some of the facilities and people. But I think there's also -- there's a certain level of product synergies, too. So for example, our heating products that we have for BEVs. Those largely grew out of our thermal capabilities on the foundational side of the business. Our transmission systems for BEVs those largely grew out of the torque management and transfer capabilities that we have. And even on the electronic side, a lot of the scale that we're afforded in our inverter business is by leveraging the existing scale that we have in our ECU business. So I think we think about it not only purely from a pure financial standpoint, we think about it from a product line standpoint. And that actually factored into which products ultimately remained in our foundational portfolio when we were predicating the spin of PHINIA. I don't know if anything you add.

And what about, I think, another element that's key to understand here is just the capital and investing requirements that are needed for the foundational portfolio going forward. If we look across the industry, we're seeing just a consolidation in the number of engine platforms under development to OEMs as they're seeking to reduce complexity. Does that reduce complexity and fewer platforms translate to, let's say, greater volumes per dollar of investment spend?

I think that's fair. It's really linked to the number of new platforms that are being quoted. And so actually, if you just look at our P&L today and our capital investment, the R&D side of the equation, well, remember, 85% of our business today is foundational, 15% is eProduct, but if you look at our R&D, 2/3 of our R&D dollars are going to eProducts, only 1/3 of it goes to the foundational side. So you can do the math on it pretty quickly and find out an our R&D on foundational is in that 2% zip code. I mean it's a pretty low number. Capital is very similar. If you look at the $800 million guide we have out there, 2/3 of that $800 million is going into our eProducts businesses, which tells you what the other 1/3 is going to foundational must be a much lower percentage. The investment intensity in the foundational business is much lower than it's been. And that's not just capital and R&D. It can be other elements of the P&L, which gives us the ability to really drive to sustain that margin profile for a long period of time in foundational and convert that margin dollar for dollar in the cash flow, which is why that's one of the key objectives of Charging Forward '27.

One of the other things to consider here is you do have a restructuring program as well looking at our foundational business. And can we just talk about costs that you're taking out, specifically thinking relative to the ability to serve foundational demand should it have a longer tail than maybe we were thinking 6 months ago?

Yes, I don't think the restructuring programs compromise that in any way. We look at certain plant footprint that we think we need to address under different scenarios, and we look at some of the SG&A costs, the R&D costs, and that's part of what we announced as well. So we did, back in June, announced a new $150 million cost program to drive $80 million to $90 million of annualized savings by 2027. And you might say, well, how do you size that? Or why did you do that? If you just take a step back, remember, one of the key objectives of Charging Forward is sustain that margin profile and foundational. And if our projections play out the way we think, as we look at the '27 from a markets perspective, it means our foundational revenue is probably a little bit lower, call it, $750 million lower, maybe a little bit more than that in 2027 from where we are today. And when you're losing revenue like that, it tends to come out at a healthier decremental, maybe it's in the low 20s. Okay. So if you just start with that math and say, well, how did you get this $80 million to $90 million? Well, $80 million to $90 million on $750 or so million of revenue ends up getting you a little bit more than 10 points of margin. It ends up meaning you're downward conversion is somewhere in that 13% zip code. That's our margin today. And that's the point. So we're taking proactive steps looking out 4 years from now where the markets could go to make sure we're proactively mitigating the risk that a downward trend in the foundational revenue impacts our margin. And that's why it's sized that way. Just like in 2020, we did this, we're going to continue to be proactive and get out in front of the opportunities to reduce our cost to make sure we maintain that strong top quartile margin.

And the time that we've got left, maybe if you could just touch briefly on capital allocation, especially you still have targets for acquired eProduct revenue in the walk to 2027, any change in thinking in that firm?

Nothing's changed. I mean, we anticipate being disciplined and balanced from a capital allocation perspective. As we got past the PHINIA spin, one of the first priorities became we needed to get our leverage back in line because when we spun off PHINIA, we also spun off $0.5 billion of EBITDA, but our debt was the same at $4.2 billion. So that's why as part of the transaction, we took back, call it, $450-ish million and we turned around and we deployed that to reduce our debt to get down to 2x gross debt to EBITDA. So that was an important milestone, but that's now behind us. So as we look ahead, the capital deployment strategy is really focused on being opportunistic and investing in growth opportunities which would be M&A, if those types of opportunities come up or organic and also looking to return excess capital to shareholders. We -- our dividend came out again today. You can see it's right in line with what we talked about in June. And obviously, buybacks are part of that toolbox. We executed over the last 3 years, $450 million of buybacks. And you can imagine that's probably part of the toolkit. Anytime we have excess capital without a looming investment opportunity that we think makes more sense.

Okay. Well, we're out of time here but management will be available for a breakout up on the 13th floor in the Chestnut room. Please join me in thanking Kevin and Pat for the presentation today. .

Thank you.