BorgWarner Inc. (BWA) Earnings Call Transcript & Summary

Our pleasure to host BorgWarner this morning. Borg is well positioned for a variety of powertrain outcomes as the company has both a strong position in electrification, includes both full BEV and hybrid PHEV especially as well as a strong foundational or combustion backbone. Joining us seated directly to my left is Craig Aaron, CFO of the company, and we've got Pat Nolan from IR as well. E-mail address, for questions, you can send those to [email protected]. And with that, why don't we start with a little background newly as of July, you now have 4 segments. They're a little bit different than what was prior.

Just can you talk about what's in each segment, what are the products and how that all fits into the charging forward strategy for the company?

Sure. Yes. So effective July 1, we have 4 segments across the company. And the way to think about it is we have 2 primarily focused foundational BUs. And when we say foundational, that means combustion. So it's turbo and thermal technologies and drivetrain and Morse systems are our foundational businesses. They're primarily combustion-focused. They comprise about 80% of our revenue today, and they have #1 or #2 positions in the markets they serve. And the great news is we still see growth opportunities for these business units and particularly around hybrids, but also the world is looking for more efficient combustion engines, and that's the products that these business units produce. On the other side of the portfolio of our e-products, business units, it's called Power Drive Systems, formerly ePropulsion and the other one is battery and charging systems. The focus for those business units are really around hybrid vehicles and battery electric vehicles. Those businesses are quickly gaining scale. We should have about $2.4 billion in e-product revenue. A lot of that resides in these business units. And the goal is for those businesses to continue to grow and to convert in the mid-teens on an all-in basis. That was a pivot that we made this year. Previously, we were converting, but we had to really focus on investing in R&D. This year, it's really a focus of converting on an all-in basis, incrementing and generating more income across the organization. That's our focus.

Okay. Well, why don't we get just the macro out of the way. I'm sure lots of folks wondering your perspective. We'll try to keep it to kind of the exit rate velocity exiting '24 and what you've already guided to. But clearly, there's been downward pressure on production as we move through the year, just in the near-term lens, what are you seeing in terms of 4Q production schedules and does that inform your view on 2025 just in terms of visibility or the rate of change in production as we exit this year?

Yes. So for 2024, we're expecting the market to be down 3%, 3.5% is the range there out with. Within that, you have the North American market down modestly. China up modestly and Europe down about mid-single digits, right? Different factors affecting each of those markets. You're right, though, that we are exiting the year at a weaker rate than that 3% to 3.5% rate, right? The back half of our guide at the midpoint implies the industry is down about 6% in the back half, kind of similar in the fourth quarter as it was in the third quarter. And I think we're going to ultimately see what 2025 brings. We'll give you that update when we get to 2025. But I think the important point, though, is that we're managing our cost in that environment. So despite the fact that we've had to reduce our revenue guide for the year. We've actually increased our margin forecast and our EPS forecast twice this year.

I think it comes down to focusing on what we can control. And no matter what the production environment is like, need to outgrow industry production. That's what we saw in the third quarter. That's what we've seen through the first half of the year. We need to make sure when we see that outgrowth, we turn that into income, and we generate cash. And if we're successful on those 3 fronts, then BorgWarner will be successful.

Yes. So speaking of things that are within your control, obviously, election, bringing in new administration, that could bring some changes in terms of the business environment. Sitting here today, I realize it's still pretty early stage, but can you talk about maybe focus areas or what your #1 agenda item might be post-election? Are tariffs in focus? Or is there some other element that you'd be looking at internally?

Obviously, I think we'll be monitoring, I think, top of mind for us will be how it impacts the growth in the industry, how it impacts the different mix dynamics in the industry. I think that's tough to tell as we stand here today. We'll have to see what the policies ultimately bring. But I think the good news is the portfolio is designed to be able to grow. Whether or not e is growing faster or slower in North America. We intend to outgrow either the foundational side of our business or the eProducts side of our business. And the dynamics will vary by region just like they do today.

Yes. What about just Mexico specifically? You're in a unique position where you do still have manufacturing capacity in the U.S. Can you just maybe talk at a high level the flexibility from an operational standpoint, if there were tariffs coming out of Mexico? Just how you could manage through that given your U.S. asset base.

Well, I think it will -- it's going to come down to what our customers decide to because for those of you who are not familiar, in general, we produce in the same region that our customers produce. So that we're shipping to Europe, generally producing in the region, same thing in North America. But even within the countries in North America, there are plants in Mexico that ship to our customers' plants in the U.S. But in general, if we're in Mexico, we're usually Mexico for Mexico. So I think, again, we're going to have to wait and see ultimately what our customers decide to do, and then we'll react accordingly and manage our costs accordingly.

Okay. Well, let's talk about the [ Ultra ] side and things that you can control, as you mentioned, eProducts as a category going to be about $2.4 billion in revenue this year. I want to talk about the power drive side of that. As we look through '24, that's been steadily ramping from a new product standpoint. Can you just help us understand what's giving life to that as a ramp of already launched programs? Is it new program launches and kind of what carries over into next year? Is one more important than the other, would you say?

Yes. The quick answer it's both. So when you think about the Power Drive Systems business unit, we've seen some challenges this year in particular, around One North American program and One program in China. That portfolio is still building out. So when you have these little hiccups into individual programs, you can see it in the top line. But we're launching a lot of programs in Q4 of '24 and into '25, we fully expect this to be the growth engine of the company as we move forward, and we fully expect them to deliver income, again, targeting that mid-teens conversion on an all-in basis.

Yes. Just actually, there's a good amount of award activity, especially in Europe next year. Can you just remind us of kind of the scope there? I think it's some inverter awards, in particular, and what you had said at least at the time those awards were announced in terms of the materiality and what it could mean incrementally, obviously, uncertain environment with Europe CO2 rigs and whatnot impacting that?

When you say award activity, you mean the stuff that we won that we're going to be launching [indiscernible].

The, yes, launch activity from prior awards.

Yes. So you'll see -- you have a number of launches into this year as we move into 2025. And I think when you rank order where those regions are, we have launches in China, launches in Europe, and we have some in North America. But I'd say China and Europe are the 2 biggest drivers of that. I think we've done our part in terms of securing the business. Now it's ultimately going to come down to how successful some of those programs are. Can our customers ultimately sell the vehicles. And I think we're also waiting to see whether or not the European emissions regulations will be enforced next year. The good news is we're ready to go. Our customers have the programs. Now we'll see if they sell.

Can you -- the other side of this has been battery packs and AKASOL that's been a real strong part of the story this year. Can you just talk about the revenue outlook there, especially in terms of what you facilitated with the new capacity coming online, both in Seneca and in Europe and what that might mean kind of exiting this year in terms of the velocity of the business. We've seen the benefit of those capacity additions. And then I think if you take a longer-term lens, that's a lot of incremental opportunity for that business over the next several years.

Sure. Yes. So the goal this year was to continue to grow that business, and that's what we've seen. So when you look at our revenue last year, it was about $460 million, this year, right around $700 million, which was at the lower end of our range. Like you mentioned, the good news is we've built out our expansion in North America and Europe. So it's no longer an issue for us and our ability to supply. It really all comes down to customer demand. And that's what we're focused on next year, is ultimately what will the customer demand from us, but it's not going to be limited by our ability to supply. Our build-out in North America and Europe is complete.

Maybe if we could double -- just double-click on the macro and the second layer environment and how that's impacting awards. You made some comments on the 3Q call that, yes, there have been some headwinds in that respect. And just what are offsets to that, how can Borg lean into those offsets? And I guess I'm thinking especially foundational is just a capital and cost-efficient growth driver. Should we think of awards slowing as a headwind? Or are there some things that you can lean into incrementally that maybe offset that?

Yes. So we're seeing lower award activity -- RFQ activity, I should say, not award activity, RFQ activity in North America and Europe. We're still seeing a lot of activity in China. But if there's lower activity, RFQ activity in North America and Europe, that's okay. We have a great foundational business, and we're going to continue to win business on that side of the portfolio. . A great example of that is a transfer case award that we announced in the third quarter. We can't tell the customer, but it's for a large OE that we've been serving for 40 years, and they make big trucks. That's what we can tell you. And ultimately, we're going to continue to see, I think, those types of awards, but there's also going to be programs that we get that are just extensions. You're not going to hear us announce it. It's just the program was supposed to end as an example, in '27, and it got extended to '28, '29, 2030. And so it's going to be a combination of items that we announced, but also just extensions that happen just through normal course.

I want to switch gears to the earnings and margin backdrop. Pat, as you mentioned, in what has been a challenging year. The guidance has gone up a couple of times. You've been pushing the EBIT margin guidance up against a lower sales base. And I just want to sort of unpack the -- just the internal cost posture of the company exiting this year. Obviously, there's been enabling factors in terms of the new restructuring actions in Power Drive Systems, but really just an overall focus on driving those target incremental margins, like you said, Craig, can you maybe just unpack a few more specific things that if we walked into, say, a BorgWarner plant that we'd be seeing put into place that's giving life to the next improvement that you've seen?

Yes, Luke, like you mentioned, I'm really focused on incremental margins, and again, increasing margins, increasing operating income across the company. And when you think about that, there's really, I would say, 3 pillars. The first is at the plant level, we need to continue to drive productivity. We need to continue to drive supply chain savings. Get back to the basics, now that we're through all of the inflationary pressures that kind of occurred in the last couple of years. Let's just get back to the basics of running the business. Also, we need to continue to focus on restructuring. You mentioned Power Drive Systems restructuring. We executed or announced a foundational restructuring a year ago. We need to continue to drive those restructuring actions across the business. And it's not 1 or 2 programs. We have dozens of programs happening across the company, we need to continue to stay cost competitive to continue to win new business and drive margins appropriately. And the third is we're seeing a lot of volatility on the e-product side of the business, and we put capital in place. If volumes don't materialize like we expected them to and what our customers communicated to us, then we need to recover that capital. And we did see that in the third quarter, we had about $24 million in recovery of capital. That is not a windfall for the company. It's simply a recovery of costs that we've already incurred. But it's an important lever that we have to pull just to make sure we get -- we're made whole on those capital investments.

Yes. Can we maybe just double-click on your TTS and DMS segments, those would be the foundational segments and 3Q revenue down about $200 million combined, if my math is right, but margins were flat in 1 segment and only down about 20 basis points in the other. That suggests some additional actions above and beyond restructuring benefit and whatnot. Just what are some of those things even incrementally that you've been doing in the back half of the year? And how should investors, I guess, think about your ability to protect margins and what should we extrapolate into next year in those segments versus maybe what was I don't want to say onetime, but what maybe would you be more cautious about extrapolating.

Yes. So let me unpack Q3. So like you said, the top line was challenged. We were down about 6% year-over-year in each of those segments. But the market was down 6%. So we were basically in line with market production for both of those segments. But as you mentioned, we did a really nice job on margin. We were able to hold income flat in DMS, and we were able to decrement at about 13% in TTT, Turbo and Thermal Technologies. And it all comes back to operating the business, making sure we're focused on productivity, restructuring, all the things I mentioned earlier, supply chain savings. It's those basics. Living and breathing that day in and day out that allows us to decrement at really healthy levels, lower levels or hold margin flat. That's what those businesses need to do. . As we move forward, again, we expect to continue to see growth opportunities in those businesses. If we see those growth opportunities, we need to continue to convert on those in the mid-teens. If those businesses start to decline a little bit, our goal there is, again, decrement in the mid-teens. So part of our portfolio is incrementing, Part of it is decrementing, we're going to make sure, overall, we're growing as a company. And as we're growing across the portfolio, we're expanding income and we're expanding margins.

Yes. Another thing you mentioned was just the capital recoveries in eProducts. That was a big part of the story in 3Q, some catch-up if you will. I think it was $24 million. Just how should we think about your ability to continue to drive those on a go-forward basis. And maybe more importantly, given the lessons of this moderating environment, are there any changes you're making on the front end in terms of contract structure or whatnot to increase your flexibility or increase the likelihood of getting those recoveries if you do need them in the future, Craig?

Yes. When we quote business, we have volume clauses. So we need to make sure that we continue to have those volume clauses, but that's something that we have in the majority of our contracts. When volumes don't materialize, then that's when you have these discussions with the customer. And they're never easy discussions or challenging discussions. But we've shown over time that we can be successful recovering this capital. Again, it's not a windfall for the company. It's simply a recovery of cost. But it's something we have to keep our eye on. We put a lot of capital to work, and we simply can't let that just fall to the cracks. We need to make sure that we're made whole if that situation transpires.

What about incremental margins as you ramp AKASOL in the commercial battery pack and charging business? It's really been a key part of the overall margin trajectory this year. I know that you've spoken to an expectation for that to be at least in line with the overall company. But can you help us understand sort of what has driven a better-than-expected outcome this year and what may be an area of opportunity to push that above that mid-teens level could be as we go forward.

Yes. And we've seen really nice growth this year going from $460 million in revenue, $700 million. And the team's really capitalized on that growth. And like you mentioned in the third quarter, we incremented really well, $0.30 on the dollar. I don't think that's what we should expect quarter in and quarter out. Our goal across our business, including the battery and charging business is increment in the mid-teens. As you see the growth on the top line, we need to make sure that we're incrementing in that mid-teens. And that's their goal.

Can we talk about the R&D side of the house engineering and just the trade-off right now real time in the business between protecting earnings in the near term, investing future -- for future growth and the interplay? Of course, there's been some evolution already that you spoke to this year of the incremental margin being inclusive of that eProducts R&D, it's something about that intensity on a go-forward basis? And then on the foundational side, how should we be thinking about the needs of the business or maybe the ability to even push on that a little bit further as we see program elongation and the sorts of things that you spoke to?

Yes. Obviously, the R&D intensity on the foundational or combustion business is different than the R&D intensity on the eProducts business. They're just in different states. With that said, when I think about growth, we need to continue to invest in R&D, both in foundational and any products. We need to continue to be able to support our customers with great technology that they need. At the same time, we need to continue to deliver mid-teens incremental conversions all in, and we can do both. We can continue to invest in our business to make great -- continue to enhance our capabilities. At the same time, we can deliver incremental income and grow margins. I really think we can do both things.

I want to click out to just a couple of bigger picture things. I guess the first question would be how should investors think about the company's incremental exposure or the opportunity around hybrids. It's already a significant focus of your eProducts business. Just curious what you're hearing incrementally from OEMs, especially in North America overall and in Europe relative to the CO2 rigs.

Yes. I mean, I think you pointed it out. It's already a big part of our eProducts business today. If you look at our light vehicle eProducts business, about 40% of that is in advanced hybrids. Why is that? Well, that's actually -- when you look at the market mix in China, the breakdown of the NAV market, it's in that same range, 35%, 40% advanced hybrid. So that's where we should be. So just because hybrids may be new to North America, they're not new to the overall rental market. So I think that's important. When you think about the opportunity there, the addressable content opportunity on advanced hybrid, it's very similar about a little over $2,500 per vehicle as it is on a BEV. The breakdown of it is a little bit different because the pure eProducts side is closer to $2,100 versus that $2,500 on BEV. But then we're still selling a lot of our fuel efficiency enhancing foundational products. You're still going to have a turbo, you're still going to have an EGR. You're still going to have a lot of those advanced foundational products applied to those hybrid vehicles because otherwise, why would you hybridize them. So we see it as a good opportunity for us. It's already a big part of our eProducts business. To the extent they come in North America, we would expect to be a player there. We're still waiting to see that materialize in terms of RFQs yet. Nothing to announce yet there at least in North America.

We'll stay tuned in North America. What about the impacts to the foundational business, especially for a product like Turbocharger. Craig, you mentioned that there still are growth opportunities on the financial side of the house. Just turbo penetration rates, can you talk about how those have evolved and maybe what a realistic view over the next couple of years might be for Turbo. Can penetration continue to tick higher?

Yes. So obviously, already a relatively high penetration level in Europe. We still see some content opportunities there, particularly with some of the regulations that are coming. In China, you're in the 60% range of foundational vehicles. So maybe some movement higher over time. North America is where we see the biggest opportunity. North America, we're still in the 40s. We think over the next several years, that's going to go into the mid-50s. And to the extent that we see lower BEV penetration in North America, could that go higher over time? We think probably because we think you'll see hybrids and foundational vehicles in North America use those turbo chargers as you look forward.

Could we just talk about China? I mean certainly an area where you have a lot of business, you have very high mix on the eProducts side with local OEMs. I think you've said it's around 95%, which is similarly the market's probably about 90% locals in terms of the NAVs. Just maybe more a question of reflection. It's been a very dynamic market in the last couple of years. What are some of the lessons that you've learned in terms of launch schedules, launch timing, the -- sort of the turnaround, where going from an award to launch could be quite quick. What are some of the ways that you've made Borg more competitive in the China market in response to what's happened from a customer mix standpoint?

Yes. I think it's important to first take a step back and we've been in China for a really long time, decades and decades. And about 15% of our total sales are in China and about 70% of those sales are with locals. So we've been very successful in China for a long time. I think the lessons learned and what we've learned over time is, we have to work very quickly. We have to be able to adapt quickly. We need to have a great intimate customer relationships, understand where they're going next. They tend to buy more systems. So we need to be able to provide system technology and that's what we're seeing. And a lot of the awards that we're winning both on the foundational side and the e-product side is because we're able to work quickly with those customers and support them, and we're going to continue to do that.

Can we talk about just the competitive landscape for your products in China? And just is the market evolving? Are you seeing any new entrants or I think one of the questions is just pressure on local OEMs to use local suppliers? Obviously, you've been very successful booking business historically. Does that opportunity really change in a material way going forward given the competitive backdrop?

I don't think so. I think if you go to the market with great technology and you can service your customers quickly and move at their speed, you'll be successful. And we have a local China team that knows how to navigate that environment, and they've been really successful. So I don't see big changes. We know how to be successful in the market no matter what the technology is, and I think we'll continue to do that.

Okay. Maybe just switching back to the -- some cost-related things. I guess, first on the environment, could you talk about just what that looks like right now and what it might mean as we go into those negotiations early next year? Are we back to a pretty normalized posture, would you say from a customer standpoint, Craig?

Yes, pretty normalized environment. The inflation environment that kind of happened the last couple of years. I don't see those issues anymore. It's back to normal business from where I see.

Okay. What about your supply chain and extracting just concessions in the supply chain or driving that normal activity that would help to pay for those price downs?

I see us doing a really incredible job when you think about margin expansion this year, that was an important lever with supply chain savings. Ultimately, when you look at our margin profile this year, we ended last year at 9.6%. We're going to end the year somewhere between 9.8% and 10.0%. And what we're not factoring in that 9.6% from last year is the Eldor acquisition, which is a 30 basis point headwind. So when you really compare on an apples-to-apples basis, we're going to expand margins 70 basis points year-over-year. How did we do that on relatively flat revenue? Supply chain savings, productivity, restructuring savings, getting back to basics of running the business. And so it's an important lever that we had to focus on.

Yes. Maybe since we've got a little time here, circling back to the election implications. Obviously, the IRA is one thing that could see some influences. I guess the first question would be if there was a change in the tax credits, your relative exposure to that. I think you mentioned China, Europe, those are #1 and #2 in terms of the eProducts side of the business. There is a program that's already been weaker for you. In North America, would you say that we shouldn't be maybe as fearful of North America-related impact to eProducts? Or just how would you frame that incremental risk?

Yes, maybe I'll start and Pat can add on. So when you look at our eProducts portfolio, that $2.4 billion, putting the commercial vehicle business aside, only about 10% of our revenue is North America. So a lot of those OEs we're planning to in-source. And so that's why you see a small portion of our revenue today in eProducts be North America. If the market for North America pivots and it's more focused on highly efficient combustion engines, that's great for BorgWarner. We'll continue to provide turbochargers and transfer cases and all the great -- all the great products that we've been delivering for decades and decades. So from my seat, I think it's the beauty of the portfolio we built. Each region is going to be different. There's going to be ebbs and flows because of changes in regulations or changes in administrations. We can service both sides of the portfolio, whatever the customers need, we can provide them great technology. So from my seat, it's just a shift from selling them eProducts to a combustion product.

The one part of IRA that we do take advantage of is the tax credits related to our battery pack. I think it's important to note that, that is -- don't think about that as a -- that's a great 100% windfall for BorgWarner. Our customers are very much aware of those tax credits. So it's just part of the cost structure of those packs. To the extent that those were adjusted, eliminated whatever could happen. I think that will be part of that cost discussion with our customers. But there -- it's very transparent to them.

What about just capital allocation? Clearly, pressure on industry growth. Stock has been stable in a tougher environment? Just how does that change or evolve your capital allocation priorities as we go into next year and you've already signal from an acquisition standpoint that that's less important in the near term? Anything else that you'd point to going into next year?

Yes. I'd point to, we have a really strong balance sheet. When you look at the end of the third quarter, our liquidity is well over 20% of sales, which is our target. Part of that is because we raised capital to pay out for 2025 notes. But even when you put that aside, our liquidity is really strong. Our leverage is right around gross at 2x. So we have a really strong balance sheet. We don't need to continue to protect the balance sheet in the sense that it's already in good shape. So what we did this year with no M&A in sight, like you mentioned and Fred talked about on our call in the second quarter, we effectively have deployed all of our free cash flow to shareholders. So we expect at the midpoint to deliver about $525 million in free cash flow, $400 million of buybacks has already been executed. We paid $75 million in dividends through the third quarter, and we'll pay another $25 million in dividends in the fourth and effectively all of our cash will be deployed. M&A is still an important part of charging forward. And if there's an opportunity, we're certainly going to look at it. If there's no M&A insight, I think what you can expect is us continue to provide that cash to shareholders. But we'll talk about '25 when we get there.

Okay. Last question here. Just very big picture, the push and pull of how much help your customers need ultimately. And it's been no secret that folks are struggling with getting to profitability in EV. Is that changing the conversation at all in terms of the scope of Borg's opportunity in eProducts?

I think the way I would answer it is our job as the supplier is to provide the technology at a reasonable cost to our customers and create value for them that way. Ultimately, we're pricing our products appropriately, and I think we'll see ultimately that works out for the customers.

Yes, we'll go ahead and leave it there. Management will be available for breakout session that's going to be in the Promenade. That's on the lobby level. So you can have to go down to the lobby, and please join me in thanking Craig and Pat for the presentation.

Excellent. Thank you.

Thank you.