BorgWarner Inc. (BWA) Earnings Call Transcript & Summary

With powertrain dominant supplier, BorgWarner. Today, we have the pleasure of basically 3 members of management: Joe Fadool, CEO of BorgWarner, Craig Aaron, CFO; and obviously, a long time industry friend, Patrick Nolan within Investor Relations. So maybe we kick it off, Joe, just a 60-second intro. People know who BorgWarner is, but just a little bit of background and obviously, your step into the new role.

Yes. First, thanks, Chris. Great to be at this conference. Yes, I've been with the company about 15 years, been through most of the business units and just recently taken over as the CEO. Maybe for some background, what has BorgWarner been up to since the beginning of the year. First of all, we couldn't be more pleased with our performance in the first quarter. We outgrew our end market, strong margin performance and really good free cash flow. So for us, despite all the headwinds and turmoil that's going on, our teams continue to navigate through some of these near-term uncertainties, and I'm confident they'll continue to be able to manage through it, including the tariff environment. So I know tariffs will come up quite a bit. It's in the news every week. For BorgWarner, as of last week, we continue to look at all the news coming out of Washington. We're actually tracking a little bit better than our prior estimate, which was a gross impact on sales of about 1.6%. So real pleased with where that direction is headed. For us, the big takeaway is tariffs are a manageable issue. It really is more what is the uncertainty around customer demand and what does that mean for the production environment, especially in the second half. So in good BorgWarner nature. We're focused on the things we do control, and that's driving financial performance and continue to outgrow the market, increment in the mid-teens and then drive strong free cash flow, which is good for our shareholders.

Yes, absolutely. I mean one of the things we commented on Q1 and both Joe and Craig, I really do appreciate the detail you gave is I thought you gave one of the highest levels of disclosure into -- look, it's an uncertain world, but we're going to try to prepare somewhat for the worst. I think even your North American production guidance is down 7% to 12%. Hopefully, we're going to do a little bit better. And then you also gave the tariff number that you mentioned, Joe, so that's really helpful. Maybe one of the ways that we can start off with the tariff discussion. So last year, I spent a lot of time with you, and I love the idea of this BorgWarner back to basics. Right? You're talking about essentially a well-positioned regional e-powertrain mix regardless of what ICE or EV speed we've seen. And so I think really tariffs is more about North America. Can you talk a little bit about some of the trends outside North America where it's probably a little bit less impacted, right? If we think about China, you saw growth in Q1. We think about Europe, where we're starting to get an EV year. Maybe we could talk a little bit about regional trends before we have to get into sort of the uncertainty of North America?

Sure. No, happy to. And you're absolutely right, BorgWarner being a global propulsion player. Sometimes we get more defined by what's going on in North America. But when you think about electrification, it is playing out more regional. And I think it really speaks to our resilient portfolio we've built, especially over the last 5 or 6 years. Whether our customers want a pure combustion product or a hybrid or BEV, we've got the right portfolio to serve them. So if you think about specifically China, where electrification is playing out at a fairly rapid rate. NEVs are reaching 50% of that market, which is both hybrid and electric. We're performing quite well. I mean, just for some context, 20% of BorgWarner's revenue comes from China. And when you break that down further, 75% of that revenue is with the domestic OEMs, which is slightly overweight. We've been in China for over 30 years. We have great customer intimacy there. And when we look at that market, it's really leveraging our entire portfolio. In Europe, electrification is playing out a little bit more slowly, but it is still growing there. And if you look at some of our wins across our portfolio, you can see we're winning across the entire portfolio and a lot of our launches are in Europe and in China. Here in this market, it's playing out more slowly, right? And we expect that slow growth to continue. The good news is we've got a great combustion portfolio. And we're #1 or #2 in nearly every one of those products. So whether customers or the market is demanding C, H or E, we think we're in a great position. And I think some of the announcements of new business that we shared in the first quarter are a great example of that.

And just to remind people who are less familiar, even though you have balanced growth in a -- look at Europe, for example, in a strong NEV year, it could be up 25% or maybe even 30% this year to hit regulations. You do see a top line pickup, meaning you have a commitment to do margin -- incremental margins regardless of where it comes from ICE or EV. But you do see a top line pickup on the growth over market in a good EV year like in Europe, right? So is that a great example of this will be probably a strong contributor from Europe?

No, you're right. So first quarter, our light vehicle eProducts sales were up 47%, which I think is proof that we're participating across the globe and especially in China, you mentioned Shanghai or what's playing out in the regions. I was recently in Shanghai, and I'm really pleased with how our teams are performing there and how we're participating in that growth.

Yes. And then my follow-up on China is the exact one. If you read my China ponderings, we talked a lot about -- I know you can't talk about specific OEMs, but I wanted to sort of a backdoor kind of a calculation that you do have one of the best exposures to a mega giant like BYD. And that's obviously evident in your 75% exposure. Can you talk about some of the products that are driving China both from on the ICE business. I mean you have a good kind of powertrain business to BYD through sort of the PHEV and some of the products that you're driving on pure BEV as well?

Yes. We don't comment generally on any specific customer, but let's just say BYD is a very good customer of BorgWarner. And we serve them on both the foundational side and the E side. That market, just as a reminder, is the largest automotive market in the world, 30 million vehicles. And as we mentioned, it's 20% of our total sales. So our customer diversification is actually one of our strengths. We're not too weighted or underweighted on any particular customer. So as those customers succeed or maybe slow down in the market, it doesn't really affect us like maybe some of our competitors. So we think it's a great strength for the company.

And particularly, when I think of China, less so because it's not really a thing yet in North America, but extended range EVs, plug-ins kind of place the BorgWarner's strength because you can kind of give the broad portfolio of the BorgWarner product exposure.

That's right. So we call those advanced hybrids. So when you think about plug-in hybrids, or even range extenders. We announced in the past year, our wins on the range extenders, which is a new and, I would say, even emerging style of hybrids, but it leverages the same great products we have. All of these advanced hybrids, they need an inverter, they need a boost function, they need a motor and a drivetrain. So for us, those are great market products that we continue to win with.

Excellent. Just because we have to -- we do the Tariffs 101 sort of the review because I think it's so confusing for everyone. What we learned from most suppliers is we're getting coverage on where we're not compliant. But my quick review and tell me if I'm wrong, Craig, is basically, 1.6% in revenue is basically your recoveries that you're going to pass through from companies -- from your customers, you think you're going to get most of that. It's dilutive, right, to the tune of 20 bps simply because it's a pass-through. But sort of the math, what percentage of your content is USMCA compliant? And are there any tariffs that you're not getting recoveries for or that may be difficult, meaning it's a negotiation or it's to be determined. I know there's a lot there, but it's the one that everyone always asks about.

Sure. I just want to reemphasize a couple of the points that Joe brought up, which is, you're right, 1.6% of sales was our original estimate that we shared with analysts in our April call. We do see that number coming down for a couple of reasons. One is our teams are doing a fantastic job coming up with great solutions to mitigate tariffs. So a great job by our team.

Win-win for everyone in the chain.

Everybody. And also executive orders have changed. So we're incorporating that into our estimates. And we'll provide a much more robust view as we get into our next earnings call. As you think about pass-through, our goal is to pass through any impact that we can mitigate to our customers, and we're having active dialogues with all of our customers. So we're working through that process. Some working -- some of those dialogues are moving faster than others, but that's okay. We know how to navigate this. We've done it before with inflation and other headwinds. So I think we're doing a fantastic job from a management perspective. When you think about USMCA compliance, just a couple of numbers. When we import material from Canada, we're 100%. From Mexico, about 70% compliant. I think for the audience here, the key takeaway and Joe already emphasized that this is a manageable issue for us. We're going to navigate it quite well. It's really industry production in the second half of the year that we're most worried about and that's the 7% to 12% in North America, Chris, that you mentioned earlier. So we're watching that really closely. The good news is our production schedules held up quite nicely in the second quarter. So we haven't seen that headwind yet. But again, we got to watch Q3 and Q4 pretty closely.

No, that's perfect. It actually leads into my next production question. We're going to have our forecasting partner here, Global Data. We've all seen that the schedules haven't changed too much over the last couple of months. We saw that initial sort of weakness where everyone's being a little bit more cautious, simply because of the uncertainty. But one of the things that we've heard anecdotally is that the visibility, particularly from OEMs, is shortened, meaning no one wants to go out 8 weeks. It's more 4 to 6 weeks because of the obvious uncertainty. Can you talk about call-off volatility or anything that could be a detriment? Because we do see the numbers, which aren't that bad, but I'm more worried behind the scenes. Is it more volatile or more uncertain than we can see?

Do you want to take that?

Well, I would just say when you look at second quarter, we're performing exactly as we thought. The call-offs are there, the sales are there. The back half is what you're talking about is less certain, and we need a few more months to see what that looks like. And you're right, OEMs have gotten a little more careful because they're trying to manage June...

And they're waiting to see what the end result and end rules are going to be like in the summer.

But I'm confident regardless of what the environment is, our teams are very experienced at navigating through those ups and downs, whether it's headwinds like tariffs, some other crisis that pops up or it's lower production volume.

We like to talk about the resilience of our business and our teams are pretty resilient. We've navigated a lot of difficult situations over the last handful of years. And as Joe mentioned, we know how to navigate different environments. So whether it's up a little bit or down a little bit, we'll execute quite well. I think we're both confident of that.

And just that same sort of question, the one -- the reason I feel like that is not getting the same potential is like Europe is -- the sales are a little bit better, production is holding up. I think it's the surprise. I think we always are fearful that Europe is always going to have another down year. Anything -- is that the same comment that it's sort of as planned or...

Yes, Europe is performing well. We don't see any dip there in the second quarter that's unmanageable. I think, again, this is a global business. So the uncertainty that exists in the second half isn't just related to North America. It also applies to Europe. But we're really pleased with how the second quarter is playing out. It really comes down to the second half of the year.

Okay. Perfect. I wanted to take a step back now almost to that back to BorgWarner Basics kind of thesis. You used to talk about and you still do your business as sort of 2 parts, foundational and everything electrified. When I look at the numbers, high level, and they can kind of move around, the ICE volumes globally will come down, I don't know, low to mid-single digits depending upon the year. And your goal is to sort of offset that by a couple of points, which ultimately means that foundation could kind of be a flattish business, give or take. And then you grow your top line with the electrified business and hope to, I think, always outgrow each of those foundational and electrified. Can you -- is that a fair way to think about the business? Because I try to sometimes summarize it to generous where it seems like there's multiple moving parts. But ultimately, you could have a flat foundation business and then pretty strong growth as the world at whatever pace by region grows with a plug-in an electrified future.

That is the right way to view it. For us, what's important is that we outgrow our end markets. So for the combustion businesses or what we call foundational businesses where we're #1 or #2, we want to see them outgrow the C+ H side of that, okay? When it comes to the eProducts, same thing. We take the H+ E end market, and we want to see outgrowth there. And fortunately, we continue to see outgrowth across both sides of the portfolio. And this was a change we made nearly a year ago in our strategy that we want to leverage growth across the entire portfolio. So we still see great opportunities. I think the announcements we made in the first quarter across the portfolio and some of the wins kind of speaks to that.

Yes, because I think sometimes like the mind share for investors, we're going to go back to remembering the growth in the ICE business, the turbocharger and basic fuel efficiency if we have a longer kind of road map in North America, for example.

That's right. In fact, some of our penetration rates, which is something we look at for some of our technologies is actually quite below Europe and China. So if you take turbochargers, which runs a little bit under 50% penetration, we expect to continue to see outgrowth of turbochargers. When it comes to variable cam timing, same thing. So there's still a need for fuel efficiency. Customers also -- pocket books are tight, and that's one of the things they look at when they buy a vehicle is, okay, what kind of fuel economy do I get? So we still think there's good futures for some of those combustion products.

And maybe since we're on the topic of electrification, we could talk about portfolio review, some of the actions you took in Q1. So you made the decision to exit EV charging, which wasn't really getting up to scale. As you discussed, you also consolidated some of the North American battery systems where business has been maybe a little bit weak where we have obviously the change in regulations in the U.S. But I think when people think of BorgWarner, they think of execution. So you already talked about, I think it's a $30 million a tailwind to EBIT on a full run rate basis by next year. Can you just talk about the logic of continual review how you thought about taking some of the actions? And how quickly you move when maybe a business is underperforming like charging?

When we think about that charging business, I think it's a good example of the discipline we're bringing to the portfolio. So the market assumptions, especially in Europe and North America changed around charging. We weren't getting to scale that we expected. And the bottom line is we want to see these businesses become profitable in the midterm. We're not willing to wait long, long periods of time. So we took the difficult decision to exit that business. I think it is a great example of the discipline we bring and what you can expect when we look at future investments to strengthen the portfolio.

So maybe outside of it self-help coming from charging. And I know you said the 1.6% in recoveries is now lower due to some of your own solutions. Can you -- what are some of those solutions? What has actually been the levers you've been able to pull to maybe have more success than your peers on getting recoveries on your own?

Yes. So first of all, some of it has to do with the executive orders that softened the requirements a little bit. But when it comes to mitigation, the first thing is getting to USMCA compliance that's the biggest lever any supplier is using. As you get compliant, those tariffs get reduced dramatically. There's other mitigation efforts where we are sourcing components to mitigate some of the tariffs. I would say the third one is working through the tariff requirements themselves. The devil is in the detail and you have to really get down to a part level and work through to make sure you're using the extent of the law to every way you can to make sure you're only paying what is due on the tariffs. So our teams are really focused on going through those details, finding those ways to mitigate and in the event that we can't mitigate those in the short term, that's where we're having discussions with our customers, which are moving quite well. All of our customers are participating in those discussions. Some of the customers we've closed deals with. We're very happy with that and others are taking a little bit longer due to their process.

Maybe just a couple of items to add. When you think about what are we focused on at BorgWarner, it's what we can control and driving operational excellence through our business units. And you see that in our numbers. When we exited the first quarter, our margin was at 10%, including tariffs, 10.2% excluding tariffs. And when you look at our performance over the last year, we've been at 10% or above for every quarter. And there's a few levers that we are really focused on. We've continued to restructure our business, take cost out, become more competitive when customers look for our solutions, really important. Supply chain savings, productivity, all of those items are critically important. We have to continue to focus on taking costs out of our business to stay competitive, but also to drive incremental conversion in the mid-teens, which is our ultimate goal.

Yes. And Craig, if I could follow through because I think in that BorgWarner basics framework, which is so compelling is growth from either side, gets you into the mid-single digits and then compounding that incrementals in the mid-teens. When we look at the segmentation for the divisions though, it seems like the foundational business, if you can keep it flattish, is to keep those margins where they are. I think years ago, everyone looked at the great margins. We were worried if they were to come down. That does not seem to be the case. That would be sort of question number one. And is it fair that the -- because you're coming from a lower base and you have more restructuring that some of the more e-businesses will actually maybe see incrementals in certain years when revenue is better above mid-teens. And obviously, that averages out to incrementals in the mid-teens across all 4 divisions.

Yes. I mean we think about each of our divisions in the same way. We have 2 primarily focused foundational business units, 2 primarily focused eProducts business units. And the goal is increment in the mid-teens, increment in the mid-teens. And they're going to use those various cost drivers to get there. So I think that's the right way to think about it. We've seen really great performance on the foundational side of the business, taking costs out, productivity, restructuring and we're seeing the benefits of that through our margin profile of those businesses. When you look at the first quarter, a lot of our growth came from PowerDrive Systems, eProducts business. 47% growth is what Joe mentioned, and they incremented in the mid-teens, which is exactly what we want to see. We did announce a restructuring of that business last year. That was a great evidence point for us that we got that cost structure right. And as we continue to grow in that business, which we 100% expect, we have the right cost structure to make sure we increment in the mid-teens. So that's how we're thinking about it.

I mean, if I read that answer literally is the foundational business because we get this question all the time. So it's my sneaky way of sort of jumping into a second question is that those elevated margins aren't going to come down because it's an older portfolio product, the pricing we always get, oh, shouldn't pricing then get worse 2% to 3% per year. If growth is flat, margins are going to stay high in the foundational divisions. Is that a fair assumption?

Volumes are critically important, of course, for any business. So if volumes stay reasonably flat, we expect to maintain our margin profile.

And I think it's important to maybe step back and look at how we're running the company. It's to outgrow those end markets. It's to expand margins and it's to drive strong free cash flow. So businesses are going to ebb and flow. But when you think about how Craig and I are leading the business overall, we want to drive outgrowth and we want to expand margins at the same time. So that's what we're focused on and different businesses have different levers at any particular time to do that.

Perfect. I have my China question penciled in here, and we discussed a bit on your mix to start. I mean Joe, given the -- what could be now an increasingly China domestic starting to move into export margins. So BYD, for example, discussed going from 700,000 units to 4 million units of non-China. From a high-level strategy, do you think your portfolio is in the right place for that, meaning that the relationships of BorgWarner to the Chinese domestics will maybe be even better in some of these export markets? Or is there anything that you have to do about your business? If China becomes a bigger player outside of China that you may have to sort of move your feet on more?

So we love this question. As I said, we've been in China for over 30 years, and the domestics are a big part of our business there. We are focused on winning in China because as we win in China, we're in a great position to support them whether they're exporting products, which we got a tailwind last year on our 4-wheel drive business due to the export business from some of those OEMs or as they begin to localize. And we've got the footprint. We've got the knowledge of the local markets and the regulations and the workforce to help them localize.

And they tend to up content as well when they localize outside of China.

Yes, if you think about OEMs when they localize, they start to do it with kits first, some sort of knockdown kit and then eventually, they start to localize the systems and then the component. So it's going to take some time for that localization to play out. But fortunately, since we're so strong inside of China, we're participating in a meaningful way on their export business. So we think it's less of a threat, it's more of an opportunity for us to continue to support them as they grow.

And then maybe we can end for me on capital allocation, where you've also been disciplined, but it does seem like there's more of a commitment to a repurchase. So one, how would you characterize if there was a summary statement to basically how you're thinking about capital allocation over the next couple of years? And then maybe I could do a quick follow-up.

Yes. Maybe you want to start and elaborate.

Sure. Yes. So Joe mentioned it right from the beginning, balanced out capital allocation approach. That's one of our major goals. And when you think about where is BorgWarner from a balance sheet perspective, we're in a great position. We look at our liquidity, specifically our cash balance. We had $2 billion of cash at the end of the year, $1.7 billion at the end of the first quarter, and we're projecting at the midpoint of our guide to generate another $700 million of free cash flow. The goal with our liquidity and our free cash flow is create shareholder value, and we're going to do that through a balanced capital allocation approach. We're in a great position to continue to have a strong dividend that we sustain. We don't turn it on. We don't turn it off. So that's a fixed obligation. That's how we think about it. We're going to continue to look at opportunistic share repurchases. You mentioned it last year. We repurchased $400 million, and we're not afraid to use that as an option to generate shareholder value. And then we'll look at M&A, and I'll turn it over to Joe to talk about what are our M&A priorities? How do we think about M&A as we look at each individual targets?

So M&A continues to be an important tool in our toolbox. When we think about M&A on a go-forward basis, there's really 3 criteria we're using to evaluate each of these targets. First is it has to make industrial logic sense. It has to leverage our core competence. We're always asking the question, how can we strengthen our existing portfolio? The second is we want to see near-term accretion. So we had to do some heavy lifting in the last 5 or 6 years, but our portfolio is in a lot better position now. So near-term profitability and accretion is really important. And then finally, how do we value that business? So it's important that we run a lot of different scenarios, but at the end of the day, we don't want to overpay on asset. So if you want to think about it, we've really opened up the aperture of what's possible, especially with all the turmoil, we're in a unique position to execute upon something very attractive. But when it comes to the decision itself, we've raised the bar and we're really looking to value those assets properly. And in fact, since we've been doing this the last few months, Craig and I together and our team, there's a number of assets we looked at, and they didn't meet the criteria, and we moved on from them. So I'm really pleased with our process to date.

Joe and Craig, that's a great overview because I think Pat and I have discussed. I felt in the market there's been some confusion about the type of deals you do. And when I think about an accretive deal immediately, that sort of gets a very specific type of deal. It doesn't have to necessarily be bolt-on. It could theoretically be a larger deal. But that's a very -- that's a tight limiter on a deal. And I think the view is from investors is that M&A has been somewhat problematic for the industry over the last decade because of some of the growth stumbles, whereas the M&A that was the decade before, bolt-on accretive tended to be great. It tends to work out. So I think that I'm glad you're able to add the accretion as the #2 because I think that sort of gets a very concise type of deal. And so you're saying there's no size limiter, but that's a very important sort of classification.

I think when you think about BorgWarner and what our goal is, is drive operating income higher. So whether it's an inorganic investment or organic investment, we're always looking at return on invested capital and making sure that our operating income is growing over time because ultimately, the value of our company is only as good as the operating income that we generate and the free cash flow that we generate. And so those are the main metrics that we have to keep our eye on to make sure that we're fundamentally growing those metrics that we believe will drive long-term shareholder value as we move forward.

The only thing I'd add is just when you think about the cash flow, you talked about capital allocation. Fundamentally, what are we trying to achieve with our cash flow generation? We want to create additional shareholder value. So whether or not it is forms of return on capital going back to our shareholders or inorganic investments would bring accretion, i.e., more earnings power to the company. You're trying to additional to growing the earnings power of the company organically, use that cash flow to -- through means that are going to create additional value for shareholders. That's the goal.

Perfect I have a follow-up on free cash flow. I want to open it up to the audience for questions to start.

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So we saw the announcement and a few OEMs have started to question where can they bring the most value. And usually the answer comes back to the areas where the customer cares and pays for it at the end. So yes, it is an opportunity for us. We do a lot of great components like turbos and friction material, but we've also stepped into systems. We do complete drivelines, complete integrated drive modules, especially for hybrids and EVs. So this question about in-sourcing, if you go back a few years, there's always been a question on the E side. We've always felt strongly that we're going to be able to build scale more than any one particular OEM. And so for us, we're starting to see that some of the OEMs are also wanting to leverage that. So we think that is a long-term opportunity.

Anywhere else?

Maybe on consolidation, which typically comes as a question on the E side. Are you seeing any of the smaller players fall out, struggle? And do you think in medium term 5 years from now that we need to see some consolidation given that obviously foundational, your share, I think, is in the 30s in a lot of the products whereas it's maybe half of that, just given the fragmented nature of the e-business right now?

I mean in most industries, what tends to happen, especially as you reach peak on a segment and then it starts to decline, the strong players survive. We're #1 or #2 in all those foundational products. So we expect you're going to see some weakening of some of the smaller players. Those are great opportunities for us, not just from an M&A standpoint, from an organic standpoint. When our teams smell blood in the water, they're on it, and we've won a number of conquest businesses, which will eventually come to production. So the market will require some consolidation also on the E side, very few people are making money on the eProducts side. So it's inevitable that over time, there will be some consolidation.

And just high level, do you have a sense for typically on the E side, where you mostly see in bids like the 2 or 3 players that you -- the largest players that you typically go up against for eProducts?

Yes. I mean it's different by product. So being a large company, we play in a lot of different segments. So for any particular product, there's always a couple of usual suspects that show up around the globe and that's independent of F or E. So our teams know how to compete. We know how to reduce cost, bring competitive technology. And at the end, what we're focused on is really outgrowing those end markets and our teams are well aware of that.

Well, if not, any more questions. Thank you, gentlemen, so much. Thank you, BorgWarner for participating. We'll be back in a couple of minutes with our friend, Matt Aks, from our policy team to talk about that little thing called tariffs.

All right. Thank you.

Thanks so much.