Dauch Corporation (DCH) Earnings Call Transcript & Summary

Okay. And I think we are live. Okay. Welcome, everyone. Thank you so much for joining. I'm Dan Levy, I lead autos research coverage at Credit Suisse, and glad to have you as we continue Credit Suisse's 9th Annual Industrials Conference, the autos track of the conference. Very pleased to have with us the team at American Axle, a leader in driveline product, a Tier 1 auto supplier. And we have with us Chris May, American Axle's VP and CFO; David Lim, who leads American Axle's IR as well as Jordan Baxter from the IR team. So we're going to go through a series of questions, fireside chat style, and feel free to send me any questions you have. I'll ask it anonymously. But first, Chris, I think you have a couple of opening comments you'd like to give. You're on mute.

Good afternoon, everyone, for participation here today, and I always appreciate your support of this conference as well as with Credit Suisse. Before we begin, I would direct your attention to our forward-looking disclaimers on our website and also in our Investor Relations materials that will cover the topics we talk about here today. I would suspect a hot topic of semiconductors or the high topic of commodity inflation and certainly on many of your minds. I would suspect we'll address a lot of that here in the Q&A frame. So I'm not going to talk about those in my opening remarks. But really, what I want to do is sort of share with you, take a moment -- take a step back out of those hot topics and look at the momentum American Axle has had within the calendar year of 2021. Our strategy in electrification continues to take hold. You've heard us through the course of the year now announce new awards, new customers and continuing to advance some of our next generation of technology. So awards and partnerships and technology with REE Automotive, on the GMC Hummer electrified vehicle, differentials with NIO. So these are some of the things that I'm referring to in those statements. And at the same time, while advancing those electrification initiatives, we continue to secure the core business of the company for an extended period of time. Early in the year, we announced our extension on the Ram heavy-duty platform through 2030. We announced an award with the Ford Bronco Sport at our PTU applications, and of course, announced that we're the sole access supplier for General Motors' new full-size truck facility in Oshawa, Canada. So that's continuing to solidify that core of our business for an extended period of time. And financially, we continue to strengthen our balance sheet. We paid down in the third quarter another $100 million of gross debt, refinanced a significant portion of our notes. And if you look over the last 12 months, we have made now over $0.5 billion of net payments off of our gross debt balance. So we continue to navigate and manage the things under our control. We continue to invest in our electrification future, and we believe, over time, these things are going to drive long-term shareholder value. So those would be my opening remarks. I think now would be a good time to pause, Dan, and maybe turn it back over to you for some Q&A.

Great. Thanks, Chris. Okay. Let's kick it off just by asking the question, this is a question we've been asking everyone. Maybe you can give us a feel for how the fourth quarter is trending versus what you discussed on the third quarter earnings call, which was now about a month ago? Are you seeing any better visibility production schedules? Any sense of higher volumes? I don't know if you have any -- I mean, I know it's very early. I don't know if Omicron has had any impact on the production schedule. So just broadly speaking, what are you seeing right now on the production schedule side, which has, up until now, been very choppy and very start-stop?

Yes, certainly. If you rewind the clock 30 days or so to our earnings call, or even 90 days prior to that for our second quarter call, we thought maybe second quarter was the trough, thought some stability would be coming. And third quarter, of course, having been in a completely opposite direction and it was quite frankly, not only for us but the entire industry, a very challenging quarter. Our expectation was that potentially was the bottom and we would start to see some level of improvement thereafter. So what I would tell you is October, the first part of the fourth quarter continued to have a fair amount of challenges similar to what we saw in the third quarter, but kind of in line with some of our customer announcements to bring plants back online, try to stabilize some level of production in the November, December time frame. We are certainly seeing some of that. Many of our customers have restarted production in many cases in November, and facility that had been down for extended periods of time. But the reality is there's still a level of uncertainty here. We still see changes in schedules, short notices, et cetera, but a little bit better from a disruption standpoint than it was, call it, 90 days ago. So we're cautious but optimistic. And of course, our view is this issue will be with us for an extended period of time. Hopefully, it continues to get sequentially better, but we continue to see this issue dragging deep into 2022, possibly early 2023. But again, the thought process is sequentially quarter-over-quarter-over-quarter, continues to show a level of improvement. So big picture to your question. Fourth quarter, we are seeing some level of stability more in the back half of the quarter than when we started the quarter, started the quarter more similar to what we saw in the third quarter, but we are seeing some of that. As it relates to the influences on Omicron or others at this point, I think it would be too early to draw that conclusion that that's having any impact on any of the activity we see in production schedules.

Great. Why don't we just take a look at what you did in the third quarter on margin. Actually, when we back out the commodity impact, your third quarter margin, interestingly, even with all this start-stop, was in line with your trailing 12-month margin. You had some really good quarters on a trailing 12-month basis. So maybe you could just give us a flavor. As we start to think about how the setup is into 2022. And this is leading into my broader question on 2022, which is sort of walk us through maybe some of the puts and takes. As we look at that third quarter results, you strip out the commodities, what does this tell us about the setup into '22? What are the things that can be extrapolated versus what was unique in the third quarter?

Yes. Look, I mean, the reality is we did have a challenging third quarter. It was choppy, but our teams did a really good job of managing, again, those elements that are inside of their control, meaning our operational footprint within our 4 walls. And if you rewind the clock even back maybe 12 months prior to that at the onset of COVID, we've really doubled down on many of our initiatives to restructure the company from a cost perspective. Heavily focused cash conversion from EBITDA to cash flow, heavy focus on optimization of our factory production. And you're starting to see a lot of that activity really bear out, and you saw really almost every quarter this year, you saw it again here in the third quarter with that American Axle operating system on full display in terms of navigating the dynamics of the industry up and down. It's not been easy. It's not perfect. We do have obviously some costs continuing to drive through our third quarter because of that inefficiency, but the team's reactive in a very quick and positive way. Another element to think about that also a little bit as we go forward, as you know, our customers have continued to, to the extent they can, try to protect their production of full-size trucks and full-size SUVs, which, as you know, is a large element of our business and typically has a little bit of a richer mix to it from a profitability standpoint. So you probably have a little bit also overweighting of some mix associated with that versus on a normal kind of period where you have full production across all customer platforms. But aside from volume, and so when volume recovers, I would expect to continue to drive great performance from that standpoint. But I think the other part of your question is, hey, set us up into 2022, what should we be thinking about how from a performance wise, some puts and takes. So I would say it like this, certainly, our view is production should get better, of course, through the course of 2022, and we should convert on the true, just pure volume-related volume and mix associated with that. Outside of just that, we've articulated, we continue to have a high degree of interest in our electrification product. And as we're pushing more of our new next-gen product out there, the interest continues to elevate. So in preparation for those inbounds and preparation for business award wins and pursuits in many years to come, we continue to invest in R&D. I would expect our R&D spend to increase through the course of 2022, similar to the ranges we've talked about before. We said we're running at $35 million to $40 million range, we've been running currently closer to $30 million on a -- net on a per quarter basis. We got running closer to $30 million and has opportunities to continue to present themselves to support current production or future opportunities, we'll continue to make those investments. We think that's a great investment for the future. And of course, going into next year, in addition to the production schedule changes, our General Motors Oshawa facility comes online to expanding their truck production and supporting that will be a positive. Offsetting some of that will probably be some net inflation. We're -- we do pass through a lot of our commodity costs to our customers today. But the reality is you have pressures on a commodity basis, but also in your base inflation that we're negotiating with our supply base and our customers right now. I would expect to have some net residual inflation that we'll have to deal with movements in 2022 as well. So it's just somewhat a high-level puts and takes, Dan. Hopefully, that addresses your question.

Yes. I mean just to drill down on a couple of those, and I think you hit on a lot of that. One is, on the commodity side, let's just start there. I don't know if there's a finer -- I know you still have a ways to go, but is there a finer point on the magnitude, if we're looking at sort of the pace of net EBITDA commodity impact that we saw in 3Q that you're on pace for 4Q? Is something like continuing that into the first half of next year, and then year-over-year in the second half sort of flattish, is that ballpark what we're looking at? Or is it just still too early to tell?

Well, certainly, it's too early to tell. But I can share with you some of our views on that. And I think it's important for people to understand in terms of commodities or purchase components as it relates to our business, you have to really think of this in 1 of 2 buckets. Number 1 is sort of that pure pass-through element that we have on contract with our supply base and our customers. So as prices in the commodity markets such as scrap, aluminum, nickel, moly, things or these things that we procure into our products, as they always go up and down, as you know, they're spot traded, we reset pricing every 30, 60, 90 days with the supply base, generally back-to-back arrangements with our customers and pass those through. That's what you're referring to. We've talked a lot about that this year. We're going to have over $300 million of that pass-through going through here in 2021. And keep in mind, as that really started to escalate in the first quarter and then, of course, into the second quarter. So as that levels out in the back half of the year, which we've seen happen now, you will get a little bit of pickup of that in 2022 as it annualizes the back half of this year into 2022, assuming that those markets remain flat. But again, those are subject to change every 30 days practically. The second element would be the base element that we go out and negotiate with the supply base, that's American Axle's responsibility to go out procure that supply, negotiate with the supply base. Our supply base as well as everyone else's supply base is facing some of these inflationary pressures that you talked about. So we're in process now of negotiations for next year, looking for ways to mitigate those costs either through productivity, through negotiation and also in dialogue with our customers on that. But I would expect we'll have some net level of inflation associated with that as we work through the course of 2022.

Okay. And then just another one for you is mix. And I think we can define mix in 2 ways. One is you'll have some EV programs launching. I would assume that's margin dilutive. And maybe you have this very favorable mix. How much could mix be a drag on margins? Or is that just directionally the right way to think of it, and we'll figure out magnitude over time?

Yes. I think of mix, you mentioned 2 ways. I would look at it very similar but not exact. Mix in relation to 2022, right, as I mentioned previously, 2021 has been somewhat overweighted, if you will, on full-size trucks because our customers are not protecting those builds to the extent they can. As we move into 2022 and production comes back across the full vehicle set, I mean, crossover vehicles, passenger cars, et cetera, that will spin out our mix benefit a little bit. It will sort of move more towards the average for the company into 2022. But as it relates to electrification, the awards that we won there really impact us 2 ways. You have upfront R&D, which we spoke about. But that much of move into launch mode, meaning you have some project expense, you have some launch costs, those programs are very similar from that framework of a cost of a traditional ICE platform. So I wouldn't expect anything unusual from a launch perspective. Where we're seeing an impact a little bit on margin, if you will, is that upfront R&D spend associated with that. But once they -- once we're awarded and go into production, very similar to our existing product set today.

Great. One more for you just on '22 and before we go into the questions on EV. Backlog, any early sense on how the composition of the backlog may change, whether it's by product or region, net backlog impact, anything you could give us a sense on backlog?

Yes. I would expect we're going to update on our backlog. That's something we typically do once a year. I would expect we're going to update that at our next earnings call in early February time frame. But that said, holistically, if you think about our backlog that we disclosed earlier this year, about $600 million, a little bit -- at least compared to the company average, a little bit more overweight in Europe and Asia, right? We expect to continue to press in the diversification. And electrification was 15% of our backlog and. And as you know, we've been winning awards in that space. We're seeing opportunities grow in that space. Driving more on the electrification front is where I would start to think about potential mix in terms of that backlog changing as we go forward. But we'll give an official update, if you will, at our next earnings call.

Great. Let's move to the EV side of things. And let's actually start -- let's break it out by ICE versus EV. Maybe you could just give us a sense, your ICE programs where there is a long tail and a very large customer of yours was publicly saying they still expect their trucks to be largely intact through the end of the decade, which is good for you. As we see these program shifts over time on EV sourcing, should we expect just the ICE content to remain fairly consistent, the contribution margin to remain fairly consistent, especially on your large programs, T1XX and Ram?

Yes, absolutely. From a transition standpoint -- and by the way, some of these long tails on some of these programs, as I mentioned earlier, right, our Ram program, we were extended through 2030. This is going to be really good for us on our core book of business for the next decade, right? That is a cash flow machine for us in terms of our traditional business or of the company. But from a margin perspective, yes, I wouldn't expect significant differences over time. Look, there's mix in even inside those post joint size truck applications. So plus or minus, we're going to be pretty close. I wouldn't expect a lot of differences associated with that.

Great. Let's just start with -- let's go to the EV side of things. And let's maybe frame out the opportunities because you're attacking this in a variety of different ways between will you drive units presumably like what you have with I-PACE, more components, subassemblies, stuff like what we just saw with Hummer gearboxes. Just help us frame the opportunity size for each of these areas? How you're focusing your efforts or resources? I mean, is there an early read right now on where you might have moats or advantages on the product front?

Yes. We articulated, Dan, earlier in the year, we believe our served market was somewhere between $18 billion to $20 billion, and that is the entire product set we provide, whether they be components, subassembly such as differential, gearboxes or full drive units. And of course, that included a view of supporting customers that want to do that inside of their operations or some customers that want to have the supply base to do the EDU. So we believe that's a pretty sizable market. And again, that was struck earlier in the year, and the penetration levels, as you know, by third-party estimates have only increased since then. So we see a very attractive marketplace for all our components of the supply and playing into the electrification field. And then R&D that we're spending now is supporting those efforts to support that certain market. But just what are some of the moats, I think was the term you used in terms of how we could benefit from those moats inside of this market. And we really see a couple of moats for us associated with the electrification market. First, certainly, the expertise as a driveline supplier, being able to integrate EDDs, integrate precision components into EDUs, vehicle overall systems, vehicle integration, noise, vibration, harshness, heat management. These are things that are done at the expertise level of a driveline supplier. So at some level, that is a moat around our driveline capabilities. Obviously, there's a few others that can do that, but it's only a limited population. And then, of course, being able to support a broad set of participation in this market through the component level, through our metal farm operations, through subassembly levels, through gearbox levels, through EDU levels and a variety of different EDU applications in terms of platforms, EVs, RDM. So that product set alone, we believe, gives us a nice competitive value proposition moat to go when we talk to our customers. That's kind of how we think about framing up the market, how we're kind of attacking the market and some of the moats around our skill sets, capabilities and product set in that space.

Okay. Let me unpack that maybe a little differently. I think that's a helpful intro. When we think about American Axle today, I think for you, there's a very obvious signature program, which is the T1XX truck. And I think it's something like 20% of your revenue today. You include Ram, and it's probably even a higher percentage of your profit when you add up those 2 programs. So those are your signature programs in a powertrain 1.0 world. When we transition to EV, do you think you'll have a signature product or a signature program? Or is it just going to be more diverse?

Yes. I think, look, the opportunity -- and part of, as you know, probably for a long time, part of our drive at the revenue level was diversification, right, and that informs products, geography, customer. And what we're seeing in the early days of our electrification initiatives is a lot of that diversity, and so that's some of the names we mentioned already here today from a customer, from a product set. So I think it's going to absolutely bring the benefits of diversification. But at the same time, the nature of the driveline business have high content per vehicle applications. We have that today in our traditional side. We see that and more on the electrification side. So you could find yourself, and very positively, by the way, to have a few key signature platforms you support in the context of your overall revenue company because of the high content value we bring into those platforms. Look, we're starting to see this emerge on our content, on our platforms with REE. You're starting to see the early days of some of the broader sets across vehicles coming out into the marketplace. So that absolutely for driveline suppliers, such as ourselves, you can actually have some of those key platforms. I think honestly, I don't -- probably we can benefit from both through this course.

Maybe we can maybe take this a different angle, this is -- unpacking this from a regional perspective. A, give us a sense of what your approach is in Europe, which really feels like ground 0 of EV inflection. And I know you have a large program or a P3 or advanced hybrid program that's launching in this quarter, so an update on that would be helpful. And then how do we compare and contrast that versus what you're doing in China where you're working with me, I think that's on the differential side, but you also have the 3-in-1 eDrive units with Inovance. So compare and contrast your approach in Europe versus China?

Yes. And the market, as you know...

I don't know a lot there. Sorry.

That's okay. Those markets are somewhat different, as you know. So if you think about where we started our electrification journey as a company really was centered around Europe. It started back in 2010 when we had our joint venture with Saab to begin design and development of electrification products to support them. As you know, we acquired that whole JV as they went out of business. But we launched the Jaguar I-PACE and our facility in Poland to support JLR. So that's in the market today, again, based out of Europe. We are launching, as you mentioned, a high-performance P3 application in Europe here in 2022. And we're also starting to see the component side of the business to take off in Europe to European customers. But again, all the vehicles are very different than what we're pursuing in the China market. So those are more luxury, high-performance passenger car-type applications. We transform our operations over in Asia, China in particular, but we've partnered with some great partners such as Inovance. We also have some small joint ventures over there with the Baojun E300 for example, on many car applications. So bringing that scalable EDU technology that can play in front wheel drive, small passenger car markets still be very profitable and continue to gain share in there. That's been our approach with a partnership approach in China. We believe it's been successful. Different market. But again, we see a lot of growth opportunity over there. And of course, lastly, our home market of North America, we see kind of starting to catch up now. You're starting to see us talk about component wins over here in North America. You're starting to see EDU opportunities expand over here in North America. That will be next online. And of course, we'll have something work its way into the truck market.

What are we seeing from -- what from an opportunity perspective have we not seen yet for you that -- where you could have a future opportunity, be it in commercial vehicles? Or is there a vertical integration play that you could pursue that expands the opportunity set, what could be ahead that you're not playing in today?

Yes. I mean, from a vertical integration perspective, we'll maybe start with that from a few items. I think you had in there -- look, that would drive -- I think we partner with mowers or partner with inverters where appropriate. Our next generation of product is integrating these all together inside of one drive unit. As you know, core to us, it's been our legacy in terms of strength of vertical integration. We can absolutely see opportunity in that set. But the areas we continue to see growth, if you think about what's not hitting into the marketplace yet, what is sort of still on the verge in the back half of this decade or a little beyond trucks that have come out recently, we obviously supply light trucks on all size and scales from 2-wheel drive all the way up to the large 4-wheel drive, heavy-duty applications that will require different suspension systems, different gearing, different e-drive motors and units. Those aren't in the marketplace yet. So I think driving towards that segment plays very well to our skill sets. It also hits the low end of the commercial vehicle applications. It plays very well into our skill sets and are very transferable between all of these different segments. With our skillful approach, just looking to the right design and develop costs effective way is a great value proposition to our customers in that space. I can clearly see that line excitement in those areas.

One of the programs that you've won, you just talked -- you talked about you've gotten the differential content on the Hummer EV with GM on the Ultium platform. What can we extrapolate from that to a future opportunity to partake on more content with Ultium platform?

Yes. I think, look, I think that supports -- we've talked about how we face off to the market, how customers on, I would put, key platforms from their eyes that they're trying to push in the marketplace or trying to go to the best, most capable suppliers to supply into that value stream. We, of course, were selected for that program. It's very important. And that will just continue to drive, we believe, more and more opportunities to support, especially on the component side, but also ultimately be into the EDU side. But being in the marketplace, being selected for these applications, I mean for us, it speaks volumes of our capabilities. And people take notice when those announcements come out, customers come to us looking for that type of components. NIO, for example, reached out to us for our expertise in that space, which I think drove a lot of word to us in terms of that particular component. So it will just be continued momentum going forward in that space.

I'll ask you a couple more on EV, and then we'll wrap on capital allocation. Margin, and I think you talked about margins. I think you've sort of answered this already. There's the upfront spend on a program to support that. What's the early read on margin profiles across your content? How easily can you scale? Is it that the incremental or contribution margin versus ICE could be fairly comparable, and it's just all that upfront spend that's really impacting the margin profile?

Yes. I mean specifically to e-Drive applications for example, do it with upfront R&D spend. And you do, by the way, have that out in your traditional book of business. It's just not as high because it's not a revenue generic product in some cases. But you like to have upfront R&D spend and then you will earn -- increase your earning power as you go off the launch curve or ramp curve of production, very similar to the traditional side. So I would expect, once programs are up to volume, they are at or very similar to our existing book of business.

Great. And then maybe just a final here on in-sourcing. Some people, I think, will argue that if you win a program today, the risk is that we can't extrapolate that to the next-gen version of that program because you may have automakers that over time, they want to optimize margins or they're looking for more scale. So what's the rebuttal to that argument? What is it that keeps -- if you win a program today, give you confidence that on the next-gen version of that program, and I realize it's a ways out, but on the next-gen version, that you can maintain that content?

Yes. That's a great question, but I would tell you, this risk that you're articulating for a response to has existed on all our programs through the history of time, right, whether it be traditional ICE or electrification. It's our job, it's incumbent on us to give the OEM a value proposition on leading technology, leading quality, leading cost and price. And I think that's true under electrification. It's certainly true under the traditional world of internal combustion engine products. And that's why we believe it plays to our strength, technology leadership, operational excellence to drive in quality, of course, to drive the award for the next-gen award after our first generation work. So those core elements are still true and beneficial to the OEMs.

Great. Let's just wrap on capital allocation because I know we're running up on time here. So is the target still 2x leverage? And once that occurs, I mean, just give us a sense of how the capital -- I mean you referenced in the past that once you hit 2x, it sort of opens up the capital allocation play. Can you maybe expand on that a little bit?

Yes. Look, our articulated target was to achieve a 2x leverage ratio for a variety of reasons. I mean, it's encompassed with continuing to strengthening the balance sheet but also not be an outlier as it relates to a leverage profile, right? We would expect to continue to reduce our gross debt from a capital allocation. Of course, that was after the investments in capital to support the business programs and after the support of our R&D expenditures. But we'll do that and then we'll have other capital allocation considerations in balance with funding towards our 2x goal. We've done some small -- very small tactical M&A inside of our core traditional space. I can still see the opportunity for small M&A where it would make sense either from a product portfolio perspective or the technology side, but again, while driving towards that lower leverage goal. But the fact of the matter is once you get to that, it does continue to open the playbook and it brings not only continuing thoughts and growth of the company, but also on shareholder type of activity, if it made sense at that time. First of all, we got to get to that leverage point. As you know, we're going through a little bit of blunt here with shortfall for semiconductors that will work and safe play through the system. But look, we're continuing to favorably step down, continuing to strengthen the balance sheet that ultimately gets to the point where that playbook is wide open for us with that leverage point.

M&A, maybe you can give us a flavor for the type of options that you have? I mean what type of bolt-ons? Are you really just technologies or -- I mean you've been sort of creative actually with some of your M&A. It's small stuff that's flown under the radar, but it actually seems somewhat compelling an opportunity here or there. Just give us a sense of like what things you're looking on in M&A? And then is that really from this noncore in the portfolio?

Okay. Well, it's in reverse. From 9 points in portfolio, we've divested a few things over the last couple of years. Right now, I think from a portfolio perspective inside the company, we're in pretty good shape, nothing of significance in terms of noncore. But in terms of M&A, we think of it from really 2 perspectives, something that may bolster with really good business case returns of traditional product where we could see a nice way to consolidate portions of our existing business. We've done that in a very small way a couple of times over the past couple of years. So something small in that space or smaller oriented. And then, of course, we think about technology and our future participations in electrification and things that could potentially bolster our capabilities and skill sets in terms of our EDUs and electrification profile. That's certainly something we need look at if it made good sense for the long term product portfolio. We see growth in that segment.

And one final here because I know we're out of time. To the extent that from a cash generation standpoint you're doing better than anticipated, I mean what's the cadence of debt paydown? Are you going to try to attack this aggressively? Or is there some conservatism given some of the choppiness in the environment you may hold on to...

Yes. Look, as we generate cash, we have seasonality elements to our cash flow. Typically, the first quarter is an outflow, although this year will be inflow. So we navigate through and around those. But just being prudent in how we would pay down debt in comparison with the current environment. We've been paying almost $100 million down -- a quarter down over the last year or so. And then if any of these smaller M&A opportunities appear or came out, we would do those in balance. But continuing to chip away that gross debt is important to us. I can see us doing continued cadence in there. We have a lot of flexibility and term loans that are prepayable part. We have unsecured notes within our structure that are callable. So we have a lot of flexibility in terms of how we would handle any debt pay down. So we just -- again, we would be prudent and just do it [indiscernible].

Perfect. Okay. We're actually over time. Thank you, Chris, David, Jordan for the time, very insightful, very helpful, and look forward to continuing the dialogue. Thank you.

Thank you, Dan, and thank you, everyone, for participating today.