Dauch Corporation (DCH) Earnings Call Transcript & Summary

Hi. Good afternoon. I'm Ryan Brinkman, the U.S. automotive equity research analyst here at JPMorgan. And thanks for joining us on day 2 of the 2021 J.P. Morgan Automotive Conference. We're going to get going with our next presentation, which is American Axle & Manufacturing. We have here both David Dauch, Chairman and Chief Executive Officer; and Christopher May, Chief Financial Officer. So David and Chris, thanks for joining. Thanks for your time.

Our pleasure to be with you. Thank you.

Excellent. So I thought I'd just launch into some questions here. And the first question is, I'm sure one you're getting a lot, which is what you think of the impact on electrification, its impact on your growth relative to the market going forward, right? I mean there's obviously a number of factors that feed up into that, right, from what type of electrified propulsion that automakers embrace, be it more an axle-type units or at the wheels, et cetera. And then what is the content per vehicle difference versus ICE vehicles? How much is in-sourced versus outsourced? And what is your share going to be of what is outsourced? So it seems like a number of different considerations that investors have to take a view on. Can you maybe help us unpack these various drivers and then say for us, at the end of the day, how you think it all adds up to impact your growth versus the market?

Certainly, Ryan. This is David. And first of all, the electrification market is rapidly unfolding. We all see that. It's only intensifying based on country policies, such as China, government policies as it relates to CO2 emissions across Europe and then even with the Biden administration set here recently, in concert with the domestic OEMs about pushing that 50% of the vehicles sold, the EV vehicles, by the 2030 calendar year period of time. So clearly, that's going to drive all of our customers to modify and change and accelerate their long-range product plans. As you know, we've been in the electrification business since the 2010 period of time when we formed a partnership with Saab, bought Saab off that partnership in 2012. We brought the JLR I-PACE electrification business to market. So we're very pleased on where we end up -- we're already in the business. At the same time, we're not sitting still. We continue to invest and shift a lot of resources, both human capital and financial capital, towards the electrification or mobility market. We're working on advanced technology that we've been able to demonstrate to our customers in vehicle applications, which have received very positive reviews. So as customers intensify their RFI and RFQ activities, we fully expect it to be a player in the market going forward and winning our fair share of the business. We think we have a competitive offering in regards to the technology that we have there. We're looking to bring the future faster. And that technology offering, we think, will offer a value proposition to the OEMs that allows a better packaging space and the performance features and the efficiency features that they're looking for in their vehicles. And the challenge that I put out to my team is really let's be agnostic to the market. We already have a full portfolio of ICE and hybrid electrifications today. We need to develop the full electrification range or EV range going forward between EDUs and beam axles to support the market demand. As we've explained to you all in the past, that we're really approaching the market 4 ways: from a metal forming standpoint, in the component subassembly standpoint and then the driveline standpoint, more from a gearbox and a fully integrated system, whether it be an EDU or [ EV max ]. So overall, we feel very good about how we're positioned in the marketplace. We've developed some very strong partnerships with both Inovance and REE. Inovance, a leading Chinese OEM of inverters and motors; as well as REE, an Israeli start-up company that we've been able to develop a really good relationship with and demonstrate our capabilities to them that's been very complementary to their unique technology that they brought out called the REEcorner. So we think there's content-per-vehicle upside potential for us. I mean the average content per vehicle on a full-sized truck is around $1,600 a content. We've got applications today that are $2,500-plus, so we think there's other opportunities like that in the future for us as well. But we'll scale the product line based on the different approaches that I mentioned to you about how we're going to market, and we're winning business in all 4 of those segments at this point in time. Chris, anything else you might want to add?

Yes. In one of your questions, I think, Ryan, also tailored around continued growth of our market. And our electrification business is really doing 2 things for us. Number one, our flexible platforms are allowing us to move into markets that we typically have not have large exposure to, whether it be small pass car or some of the platforms that David mentioned associated with REE. So we can grow from that perspective. And as David mentioned, on a CPV basis, we absolutely see upside to the CPV versus our traditional base components when you add a comparable EDU versus a traditional [ ICE ] product. So we see some real opportunity here as that growth over market opportunity as the business continues to [ increase ] in the next coming quarters.

Great. Next, I wanted to ask a similar question about electrification, only this time what the impact is likely to be on margin as opposed to revenue, right? So looking at the EBIT margin for electrified versus ICE products is probably not going to be very helpful at this stage for any supplier because the electrification business is still subscale. There's a lot of our R&D and SG&A, right, being allocated toward these efforts and anticipation of much greater scale in the future. But what can you tell us maybe about the gross margin profile for some of these programs that you're working on? I'm curious if the gross margin might be even higher, given these are often more sophisticated sort of higher technology-type products, sometimes even with a software element. And then when electrification revenue does scale, what impact do you think it will ultimately have on operating margins, say, some years out?

Yes. When we think about new business opportunities and in this case, electrification, we had, I would say, a pretty rigid structure or framework we think about when we pursue that business, the appropriate pricing, the appropriate returns on that business. Several hurdle rates, strong focus on ROIC. For example, margins are certainly in all end of that business, payback, et cetera. So first and foremost, this business needs to meet our internal expectations from financial -- from a financial return perspective. But as that evolves, if you think about the electrification and the evolution of that through our P&L over time, right, there will be upfront costs associated with R&D. They'll transfer them into launching those programs, and then it will step up from lower volume, which is typically a [ lower margin than ] gets to the higher volume applications once they step up into the end consumers and those grow in the marketplace. And our objective has been, continues to be and will be once volumes are achieved and we, from a margin perspective, whether it be gross margin or EBITDA margin, continue to maintain or improve on our margin profile. And I think we have proven now over the last several years, we're quite good at sort of attacking our cost structure from a conversion standpoint, meaning the items that are built to consume within inside our walls and developing good margin profile associated with that. I do not expect that to be any different when we launched into the electrification space.

Yes. I wanted to get your thoughts on the battery electric pickup truck market. Given it's a segment that's garnered a lot of attention after the F-150 Lightning unveil, Ford's recent announcement, they've gotten 120,000 reservations. Their earlier GMC Hummer EV pickup reveal. And of course, Tesla's announcements with regard to the Cybertruck. Now how quickly do you think this segment electrifies? And what impact do you see to American Axle?

So Ryan, this is David again. I mean, listen, the truck market's already starting to electrify, okay? But I do think it takes an extended period of time for the full segment, if the full segment fully electrifies or not, that's TBD. But when you got OEMs that are making statements that they're going to be Delphi free emission in the 2035 to 2040 period of time, the [ initial ] indication is it's in the direction that they're headed. But I think it's going to take at least a decade-plus in order for their vehicles to be completely electrified. But as I mentioned, they're already starting to do that with the F-150. GM's come out with their announcement, both for the Silverado and the Sierra. They've already got the Hummer announced as far as that product coming out in the not-too-distant future here. So we're seeing that is the other -- the real question is, does that become an incremental part of the market? Or does that cannibalize the existing market today? But I see a balance of both ICE engines as well as electrification, obviously, growing in demand going forward. And then ultimately, we'll overtake ICE engines for over a period of time. But I think that period of time is an extended period of time. The great news for us is that we're already on all those ICE vehicles today. And we've got a lot of that business locked up for next generation-type products. So that's great for us and our cash generation and our ability to not only service the debt, which we'll have completed during the short term -- or a short period of time, but also will give us a lot of flexibility from a capital allocation standpoint going forward, including funding -- more funding into our electrification R&D activity and hopefully, turning a lot of these electrification opportunities in the new business will work for us in growing our backlog. So we're a player today in the ICE space. We expect to be a player in the electrification space as that market pivots and transitions. But it's not going to take a long period of time. I mean, like I said, it's already started. It's just going to take a decade or so before I think you'll see -- fully see it completely transfer overall.

Okay. And I think you have disclosed that you do have content on 1 battery electric full-sized pickup. Is that right? And you can't name which it is, but what are you able to say? Would you at launches or anything like that? Or what product you're supplying?

Yes. We're on truck programs, both from a commercial vehicle standpoint as well as from a light vehicle standpoint. I can't name any of the customers. It's not a complete beam axle at this point in time. It's more of a component side of things or subassembly, I should say. But we've demonstrated our EDUs as well as our beam axle application. As you've already seen, GM, Ford and others have identified, they're going to be in the business with their different product offerings. We fully expected that, that they need to be in that to fully understand the vehicle system, understand the vertical integration capability and the make-buy. But at the same time, they're also open to value propositions from the supply base, of which we expect to provide those no different than what we're doing today.

Okay. Great. And next, I wanted to ask on the trend in EBITDA margin, which has tracked really very strong since the pandemic start. Just looking over some of my previous notes on the company, I see you beat Bloomberg consensus EBITDA margin in 3Q '20 by 510 basis points and 4Q '20 by 190 bps and 1Q '21 by 270 and in 2Q '21 by 190 bps. So margin has been breaking a lot stronger for you. Many things have probably gone into that, including initially, I think, austerity cost savings, some of which have since been made permanent. But also, there have also been headwinds in there, right, relative to the volatility in production, higher raw material costs, et cetera, investment in R&D to support electrification. So from the outside, it seems obvious that normalized margin has improved relative to our expectations prior to the pandemic. Although there is also a lot of noise in the industry backdrop that's affecting the numbers, maybe making it harder to say what the new normal is for margin. And I was hoping to get your thoughts on what you think the new normal for margin is, maybe once we get back to a more normal industry backdrop, say, in 2022 or maybe beyond.

Yes, Ryan, this is Chris. Great question. Certainly, reflecting on some of the data points you were reporting there back. We have to recall that, obviously, we're very heavily into some of those austerity measures. That's sort of a different profile of business as we think about coming into [ this, for sure ]. But certainly, we've been pleased with our performance so far. And we've been very active and continue to be very active in making sure we're optimizing the cost structure, especially the elements that we -- for the full side of our business to have a good performance. As we think out maybe beyond 2021, and we're certainly not here to provide any guidance associated with that, but our view is the production environment continues to be robust and set up very well for the products that we support, in particular, full-sized trucks, as we see a long time to recover inventory levels and strong production. And as you know, those are good margin products for the company. But we're also continuing to be intensely focused on optimizing our core operations, whether it be [indiscernible] capacity alignment with requirements of the market to just the cost inputs into that to maintain a nice healthy margin. And if you think about pre-semiconductor coming into 2021, our initial guidance was in that sort of 16% to 17% EBITDA margin range. Since then, obviously, we were impacted by semiconductors, and metal markets have really escalated quite rapidly. And those protect the company from our pass-through mechanisms that have some nuances and just [ the margin ] that, I'll call it, in terms of that performance. But we see setting up continued to be very strong performance post-2021. I think also a little bit implied in your question here, if we think about 2021, very strong first half. We released our guidance for the full year a couple of weeks ago from the sales. We still had a guidance range on a sales of $5.3 billion to $5.5 billion. We had EBITDA at $875 million to $925 million, and a strong cash flow, we took up a little bit from $350 million to $425 million. Strong first half performance. We see a strong second half performance in terms of the elements we can control, though some of the extensive downtime, especially on the truck plants, obviously, are a little more weighted towards the second half -- first half. And as I just mentioned, they had some margin impact associated with that. If you get a benefit in the second quarter for inventory absorption, that will come out in the second half of this year. That's not a run rate issue. That's simply just timing. And then we do anticipate stepping up our R&D to support our electrification efforts as we continue to get inbound RFIs for quotation information. And as you heard on our call, 80% now, 80% of the $1.5 billion of new business opportunities were associated with electrification. So that's really exciting for us in terms of that technology. And then we'll continue to deal with the middle market environment as it comes through, as I mentioned. But from a cash flow perspective, very confident from that. So that's a little bit on '21, but I think back to the macro of how it sits for us going forward past 2021, we're quite confident in the strength of our top line revenue and the products we support and our ability to perform on all of the items that we [indiscernible].

Great. Maybe just to follow up a little bit on your -- I'm sorry, were you saying something? Just to follow up a little bit on your free cash flow comments there. I mean the high end of your guide, $425 million for this year, it's like 40% of your current equity cap. And I understand there's financial leverage, even so as a percent of your EV, it's pretty substantial. What allowed you to increase the outlook on the cash flow side, despite more maintaining, I would say, on the EBITDA side of the guide? And then just beyond this year, is there a certain targeted conversion rate of EBITDA into free cash flow? Or how else might investors go about trying to ascertain what kind of normalized free cash flow is at a given level of EBITDA or just overall?

Yes. Look, we're really excited this year about our cash flow generation power. I think you can see it in our guidance. But how are we able to pick up the high end of the range? Really a couple of key factors. We still see strong EBIT performance, and you saw the range that we provided there. But our CapEx, you may have noticed as well, is we actually -- when we started the year, we've been trimming that down towards the lower end of our CapEx ranges. We've been very tightly controlling our CapEx spend, really trying to optimize our current capacity to support new programs, so we can minimize the investments we have to make in the business to support from a CapEx perspective and really increasing the return on the capital we already have inside of the business. So we've reduced our CapEx associated with that. In addition, we've been, I would say, reasonably aggressive in paying down our debt almost over anywhere from $100 million to $100 million-plus per quarter. So we're starting to see the tangible benefits of reduced cash interest associated with that. So put all those together, we see a strong profile of cash delivery this year, and we were able to increase the high end of our reach. So certainly, very excited about our cash flow element for this year. As we think kind of post-2021 on that conversion, I think of the main ingredients for that cash flow conversion. We expect to continue to have very strong EBITDA. We expect to have CapEx at 5% or less of our sales. Again, we're trying to be very aggressive on how we tightly manage that and appropriately manage that to ensure there's maintenance on our capital but also the right spend and optimizing that spend for our future growth. I would expect interest to continue to decline as we pay more and more of our gross debt down. [ Acquisition ], always a key piece of this. I would expect, over time, whether it be in the U.S. or globally, you can see a lot of those elements we use would probably increase. Whether it be '22, '23, '24, again, that will be depending on various legislation around the globe, and everybody will experience that. And we'll continue to tightly manage our working capital. So those are the main ingredients. We don't have a target per se. But I think if you put those ingredients together, you'll see that's a really strong positive free cash flow generation story.