Dauch Corporation (DCH) Earnings Call Transcript & Summary

All right. Good afternoon, everybody. Thank you so much for joining us for this session with American Axle as part of Deutsche Bank's Global Automotive Conference. My name is Emmanuel Rosner, and I'm the lead U.S. autos and auto technology analyst here at Deutsche Bank. Extremely pleased to be joined by Chris May, who is the CFO of American Axle. As many of you know, American Axe is a leading supplier of driveline, metal forming, powertrain casting technologies, a different range of end markets, including automotive, commercial and industrial. It's also been ramping up its electric powertrain business with several initial production contracts and a few interesting partnerships. So to discuss all this, we're very happy to have you. Thanks Chris.

Thank you, Emmanuel. Good afternoon.

And so maybe just to set the stage before we dive into specifically the American Axle update. Can you talk to us a little bit about the environment. But even before that, I wanted if you could address the news reports from a few weeks ago, which suggested you had hired advisers to explore a sale of the company. Now American Axle promptly denied it. You also reiterated we'll do what creates the most value for shareholders. So what is your view on the sale of the company and what creates the most value for the shareholders?

Well, Emmanuel. Well, first of all, before we begin, good afternoon, everybody. Thank you for hosting us here Emmanuel and Deutsche Bank. It's a great venue to come and have discussions here today. I would also address your attention to our forward-looking disclaimers and comments on our website at www.aam.com. But I think you answered the question already inside of that. We -- those rumors did come out. We do not like to speculate on rumors promptly in the next business day. We issued an 8-K. We are not engaged in the process to sell the company. We're focused on our stand-alone plan to create value for our shareholders and stakeholders. And I think the 8-K is self-explanatory to that question.

Okay. But you reiterated at the same time in the same 8-K that you'll do what creates the most value for shareholders.

So, absolutely. I mean that's our plan. Our stand-alone plan, we believe, does that. And of course, the Board has a fiduciary obligation to consider all options. But right now, there is no process to sell the company, and we're focused on moving ahead on our stand-alone plan.

Great. Very clear. So then let's talk about American Axle on the plan. So first, on the environment. Can you provide an update on what you see as the light vehicle production environment in North America, which is your main market. I think you were a little bit more cautious than IHS last time you updated the market at 14.3% to 14.7%, I think the latest IHS at 14.7%. Based on what you saw so far in this quarter, how things shaping up?

Yes. So we released guidance in early May, our guidance for North America production, which just as a reminder to everybody, is about 75% to 80% of our business. So that's our most important market. When we provide this information, we're trying to shed light on what we see as the macro environment that we face for the balance of the year. It still is a highly volatile and uncertain market. So hence, we had a range at that time from 14.3% to 14.7%. We have not provided any update on that range since our guidance. If any update, we would have in our next earnings call. But as we stepped into the second quarter, we still believe that range is still adequate as we sit here today. What we have experienced on that other 20% of our business, which about half of that relates to our European operations. The other half is predominantly in Asia, mostly centered in China. I would say the impact in China from COVID-related shutdowns is probably a little longer, deeper into the second quarter than we anticipated when we released that guidance. And as you know, the European operations, holistically, that marketplace has been sort of stressed here this quarter. But North America seems to be doing okay and in line with generally with our expectations that we saw earlier in the quarter.

That's good to hear. And then how has the semiconductor shortage progress since the start of the year as far as impact on industry production. Are you seeing things improve sequentially?

When you say sequentially, I'm assuming you mean second quarter to first quarter.

Either second -- first to second or even towards the end of the second, like in the last few weeks.

Okay. Yes. If you take a step back, obviously, the onset of semiconductors were very impactful for us in the middle of last year. The third quarter was the tough in terms of impact, a lot of full-size truck trough downtime. We did see sequential improvement into the fourth quarter. We saw some sequential improvement into the first quarter of this year. As it relates to the second quarter of this year, what I would tell you, it seems and feels from a production cadence, very similar to what we experienced in the first quarter. When we started in the first quarter, there was a lot of downtime in the January period of time with Stellantis with Ford throughout the quarter. As we got into the second quarter, we saw some downtime with General Motors on their full-size truck platform. But really, since the beginning of April, the downtime hasn't been extended weeks of downtime at our customers. We've been experiencing generally more changes in schedules, modifications of schedules versus extended downtimes. It nets over the quarter to the same spot, but the dynamic of how it's impacting us is slightly different. But from a sequential basis, Q2 to Q1, it's roughly similar from a sales perspective. Our expectation, as we step through the course of the year is we'll continue to see some level of sequential improvement and then obviously, hopefully, much better into 2023.

And I guess not too specific take on a customer, but your largest customer is looking for considerable volume growth in 2022. So as it relates to you then, like is there embedded inside your outlook, are you expecting a much better second half than the first half?

Yes. And if you think about some of the things when they make those statements, their truck production has been very robust. It was robust last year. They continue to prioritize that. Obviously, that's a very large element of our business. We expect truck production to continue to be strong. They're adding the light-duty platform at their Asheville facility, which comes online here the back half of the year, which we are the sole supplier of so we should see some beneficiary associated with that. Last year, through semiconductors and otherwise, a lot of the crossover vehicle platforms they produce. We're subject to a lot of downtime. We see some robustness there in terms of trying to rebuild inventories, meet consumer demand from their standpoint. So that was positive in the first quarter continues to be positive.

Great. And maybe finally, in terms of just this year's dynamics, what are some of the big launches that we should expect from you this year and how you're tracking with those?

Yes, I would say that probably the most exciting launch that we had this year, we made an announcement this week of our electrified axles launching on the Mercedes-AMG product that's launched now and is well underway, and we're stepping into expansion on that launch. So that's a big one. It's on track. It's an outstanding product. If you have a chance to go take a look at it. Also, we talked about the Asheville facility for General Motors supporting up production associated with that. And that's on track. I would say the rest of our launches are sort of scattered around a variety of different products inside of our business, and they're pretty much on track. We're not seeing really any delays. It's common to have some puts and takes by a couple of weeks or maybe a month or so, but by and large, everything is on track to support our backlog.

And just a quick personal request as part of next addition, we would love to have the AMG as a test drive in front of...

I love the driver...

Yes, absolutely. We -- I think, 0 to 60, 2.8 seconds. Will be faster as you get to the West Side highway. Let's speak about some of your outlook and margin drivers. I think your updated outlook, which you've updated in Q1, had continued to call $150 million to $200 million in additional index-related metal market customer pass-through and FX. How confident are you in sort of achieving this for the full year?

Yes. So that outlook is specifically tied to -- we have contracts with our OEM customers, where we mechanically every month or every 90 days, update the changes we received from the supply base related to metal indices that move. So scrap was a key component in steel, for example. We buy a lot of aluminum-based products. We buy a lot of product from our supply base that has hot roll as an index of this. And as those prices change, we change those prices with our supply base and then we pass that change to our customer either in the form of a price increase or price decrease depending on that change in that movement. Last year, year-over-year, we stepped that up almost $300 million this year, as you just articulated, another $150 million to $200 million. So we're on pace here on a 2-year basis to pass on over $0.5 billion of its cost mechanically into our customers from -- up from the supply base. And right now, when we set that guidance since it resets every 30 days, these are items that trade daily on various markets. We try to provide an outlook based on sort of the current environment that we see when we provide. Through the course here of 2022, we've seen these indexes increase. Aluminum continues to be a high point, scrap continues to be at high points, and they're still sort of running it at similar levels that we saw at the beginning of the quarter, I mean beginning of May.

Okay. So that part is mostly contractual mostly...

It is contractual. But I mean, in fairness, it changes every 30 days. If they start to turn down, which is always good for everybody, that will go down. If they trend even higher and continue to break through records, that will reset itself as well.

Can you dimension the impact from the other related inflation, whether it's the freight labor utilities that we expect this year, I think in Q1, you called for an incremental increase at $20 million compared to previous expectations of about $60 million total. Has the inflation environment been in support of this forecast? Or is it playing outwards?

So when we stepped into the year, you mentioned $40 million we thought it was the net impact. So that is our gross inflation we were expecting plus an estimate for customer recoveries. As we worked our way through the first quarter, we continue to see an onset of elevated inflation in the areas of utilities, for example. Labor markets inside of the U.S. continue to be challenging. And when we reset our guidance back at the beginning of May, that's where you sort of saw the elements or the increase for that $40 million to $60 million of the net inflation that would impact our company. Again, that's net of customer recoveries. So that environment continues to remain very similar to what we had here from the May time frame. We're still very active in negotiation with our customers to recover some of these costs. Some we get completed in the first quarter, some of which we continue to be very active in dialogue with here in the second quarter, and I would expect some of that to continue yet into the third quarter before the final [indiscernible] So right now, at least at the guidance that we provided at that point in time was our best estimate of the gross to net that we would experience, but we've got work to do yet...

And then sequentially, as you move through the year, will the net impact be shrinking sequentially?

Well, once you sort of...

Net of recoveries.

I wouldn't expect that to change. If we deliver the recovery side and then nothing changes from an inflationary standpoint. For example, utilities in Europe, I mean, spiked dramatically, very quickly. So if you're faced with some of that dynamic in the back half of the year, something we would take a look at it there.

As we look forward to volume recoveries for both in the back half of this year, even into 2023, what is the contribution margin we can expect for American Axle?

So when I think about contribution margin, when we think about contribution side of our company, on the pure movement of volume. Our contribution margin were variable profit, we receive anywhere between 25% to 35%, depending on the mix of product. Generally, it's a little towards the higher end, if it's associated with full-size trucks, if the passenger cars, it's at the lower end and if it's a blend, it's somewhere in the middle. On a pure volume change in a very near term, we're going to continue to experience that contribution margin ship, up or down, it goes both directions, as you know. But when you think about stepping into other periods of time like this year to next year, you need to take a look at some of the other factors that are maybe not volume-related associated with me. What's the position on that inflation? What's our position on R&D spend, things of that nature that would work outside of normal buy. But in terms of pure volume changes, we'll experience significant...

Got it. And I guess, so now as we look bigger picture as the inflationary environment in Q2 for the rest of the year, how comfortable are you at this point, I guess, midway through the year on your view for the full year.

That's a loaded question, Emmanuel. I'm just joking.

It is a loaded question...

We've not provided any guidance update since May Look, that was our best estimate at the time. We're continuing to track through our customer recoveries. That's probably one of the largest open items we have yet to complete through the course of that guidance and obviously subject to a lot of volume and mix in the back half of the year. And if there's any changes in our view on that, we would update accordingly at our next...

Right. And then what are the puts and takes as we look into 2023 that we should consider?

Yes. So I mean, 2023, quite frankly, could be saying up to a very strong year for the company. It could be potentially for the industry. Volume is a key contributor to the success of 2023 not only consumer demand and we can debate consumer demand at a macro level. But consumer demand for the products that we support continues to be very robust, the truck side, on the crossover vehicle side. In addition, we believe there continues to be a strong pent-up demand from an inventory replenishment deal. So not only are customers seeking to supply their products and their end customers, but they're trying to replenish as much inventory into the field as they can to sort of a double pressure, if you will, positively on volume. So that's what we think is very positive, stepping as [indiscernible] a potential. In addition, our new business backlog next year is higher than this year, so it's over $300 million. So that will be a nice tailwind for us heading into 2023 as well. So from a volume perspective, I think 2023 is an opportunity to set itself up quite well given macro situations and taking that into consideration as well. So that should be positive and could serve step into the profits associated with that. If we get any moderation on inflation, that could be a nice tailwind as well.

If we don't, then is that a...

Well, you're already starting to see that being built into our cost structure here this year, and then you're just [ citing ] to the volume, but...

Right. Okay. And then just on the backlog piece, was that a gross number or a net number?

So that's a gross number. So we provide an update to our backlog typically once a year sort of in the January or February time frame. That's a gross number. Our attrition number is anywhere between $100 million to $200 million. It's been running sort of at the lower end of that range recently. So I would expect that similar for '23.

Okay. So maybe shifting our gears once more and then now focusing on some of your electrification efforts. First of all, can you please update us on this Tech 4 acquisition? Where are you in the process? Where does this fit overall in Axle's electrification portfolio?

Yes. It fits quite nicely into American Axle from a wide variety of perspectives. We did make the announcement that we signed into the -- entered into the agreement to acquire Tech 4 at our last earnings call. It's primarily a European metal forming operation, does have some operations in the U.S., Mexico and Brazil, but it's focused in Europe. It's about $300 million worth of revenue that will bring on to the company, and we did close that here now inside of the second quarter. So from a revenue perspective, a growth perspective obviously adds to that. It brings us great diversification from some customers, some new customers coming into the mix, enhances our European footprint for metal forming, and it leverages the strengths of the company from a synergy perspective payment value acquisition. We estimate we procured this for about 3x our 2023 synergized earnings associated with this transaction. So we're excited from that perspective, and it's a nice piece for our capital allocation. We've been talking about bolt-on acquisitions. This is textbook perfect for what we're talking about. But part of your question also relates to electrification and how does this help. So if you think about our metal form operations, obviously, supplies to many different components and many vehicles across North America and Europe predominantly. This will enhance that. But also by 2025, the book of business coming on from Tech 4, 40% of this will either support new product into electrified vehicles or be powertrain agnostic. So as we're pivoting our metal form operation to support the component side of the business for electrification, this fits in perfect for it. They're making shafts that we don't make today inside our metal form operation that go into electrified vehicles, and we'll continue to grow our product set, our product capability and electrification for [indiscernible] operations.

I guess more broadly on the electrification efforts. When would you expect them to be -- or I guess, can you talk about the profitability of the EV revenues as he comes into...

Holistically, for the company. Yes, it will operate in a pattern very similar to how we see our internal combustion engine applications. And what do I mean by that? We will have upfront R&D costs. And we're incurring that today. We've been incurring that the last several years as we build out products that support new business launches in electrification, R&D to support our platform growth and strategy. You heard us talk about our Gen 5 units, which have now been awarded to REE. So that's all going into the upfront R&D dollars to design and develop that scalable drive unit platform. So if you think about that cycle, you'll have upfront R&D, you'll convert that, of course, into new business wins. You'll begin the product launch of that you'll incur some project expense, launch expense, some capital expenditures to bring that online and then the volume will ramp up. And when that volume hits at run rate, that's really when you carve those margins. That product cycle I just described to you is very similar to its comparable driveline applications on our internal combustion engines. You'll go upfront R&D, you start with project launch and make your capital investments and you harvest on the volume. We saw that play out on our EcoTrac systems that we launched in 2013 and '14 with its first product. It turned itself into a $1 billion book of business for us, went through that same cycle where we're putting R&D dollars in upfront in 2012 and 2013, manifest itself into growth that went through project expense, capital expenditures, launch, and you can see now that franchising side of business. We expect a similar trajectory at least on an individual basis how that will play out from an electrification standpoint.

And then so overall as a group for your EV revenues, any specific year in time where you think that the contribution starts being positive towards for the organization?

Well, look, I mean, we've been in production. I mean, our products we supply today are profitable. We started on drive units back in 2017 and '18 with Jaguar. We're launching now a whole host of components into the electrified business space now. We're on the home which you saw outside of your building today. We're counting on that. We're with Neo and others, and those are starting to enter in production. And all of these business cases that we go out and procure I mean, they're designed to be profitable. So once they start to come on, add volume, they'll produce profits for the company. We're subject to the volumes of the customer. And most of these volumes are projected to increase over the course of the decade at upfront.

Okay. Understood. Can you just remind us in terms of your revenue, EV-related revenue and targets?

We don't have a target per se. But in our book of business today is less than 5%, but it tracks with the market...

Okay. Let me ask you the in-sourcing question since I ask every supplier this conference so far, so we'd love your perspective on this. So I think lot of investors worry that some of the suppliers could face increased in-sourcing by automakers of electric powertrains to an extent that wasn't seen in combustion engine, the powertrain. And so to what extent is this a threat for you? And specifically, in the case of GM, looking to do some of their own sort of E-axles, -- right now, obviously, the EV volume is incremental to commercial engine volume. But do you see the risk that over time, it's sort of like cannibalizes and creates basically a threat for you?

Yes, it's a great question. So it's right. Of course, it's a threat on our existing book every driveline book of business that we're the primary supplier into a customer. That customer also produces that in-house or with a partnership with somebody else. So this environment of are taking with customers that we're a supplier in addition to their in-house operation is not new to us at all. We fully expect that, that will continue as we move into the electrification space. So how do we face off to the market here? How do we benefit through this process? Well, it's twofold. Number one, we have a very strong component franchise in internal combustion engine, and we're building and launching a very strong component franchise for electrification, primarily through our metal form group. We talked about some of that. So for the OEMs that look to in-source some of the full EDU driving is, we're supplying components. And you're starting to see us launch this business. We're announcing a fair amount of wins associated with this. We'll grow that segment to support their in-house operations. It's going to be -- our expectation is there will be an appropriate amount of volume for those that do in-house that will reach the supply base. And there's also going to be some OEMs who just want this done out the outside, not in-house, and we'll also then be partaking in that served market as well. But we see growth in both sides of these operations, and it's something we play in today, the same sort of environment. We expect the environment to be similar in the electrified world. And we believe we have the product know-how, the global installed infrastructure and the capability and technology to win our fair share of business as the industry transforms over the next 10 years.

And then when I look at some of your initial wins on the electric vehicle side, some of them seem to be really high end in terms of brand and performance. But at the same time, it's sort of like at the low-end volume in lower end of the spectrum in terms of volume, maybe more niche application. Is it a function of where this industry started electrifying, so a function of what opportunities available? Is it a function of what your product is at in terms of either performance or cost like -- and then do you have room to then move to that high-volume application as those develop?

Yes. First of all, it is our belief Yes. I mean that's sort of where you saw electrification start its growth. And of course, that's where you'll see our product grow in time. That's exactly what's happening. The AMG product this week is a perfect example of that. The Jaguar product is a perfect example. But I would also remind you, we also play at the other end of the scale currently. For example, in China, we have almost a half a dozen different portfolios . We support we're on the Baojun E300 plus and a variety of other smaller-scale vehicles that aren't the AMG for high-performance. So we actually supply across the whole spectrum. And part of our next generation of drive units, you hear us refer to it as our Gen 5 or next-gen drive units we've been designing and developing. The thought process here is we'll make them scalable to serve different markets and different requirements. You're seeing these drive units now come out on our award with REIT automotive. Those are the drive units that will be featured on those skateboard applications. Also applicable that technology will be scalable inside of high-volume applications in the passenger car across or the vehicle or light truck segments as well. So yes, we will have. We do have products that meet the [ payer ] segment...

Right. Let me just turn to your balance sheet and capital allocation. Can you please speak to the time line of reaching 2x net debt-to-EBITDA target Obviously, very encouraging to see you start making acquisitions. So it's sort of like somewhat going in the other direction. But how are you thinking about the balance sheet actions going forward?

Yes. Well, first of all, the Tech 4 acquisition, we believe, is done within our leverage profile. So that shouldn't actually be the number won't impact us from a leverage perspective. But that said, look, our goal is to be the near to midterm because at 2x. We've been articulating that for a period of time here. We continue to generate a lot of cash flow. We've been focused on our capital allocation of paying that debt down. We paid over $1 billion to debt down over the last couple of years. So we continue to drive debt down. We'll continue to allocate a portion of our capital to paying that debt down as a priority for us. We've done it in the first quarter. We continue to do that here this year. So we think we're on a good trajectory from a balance sheet strength perspective from a leverage profile.

Okay. And then, I guess, finally, in terms of additional M&A, are you still -- is that still a priority in terms of capital allocation at the same time as lowering the leverage?

Yes. And over the past couple of years, we've been significantly overweighted in terms of almost our entire capital allocation has been to pay down gross debt. We picked up a couple of very small bolt-on acquisitions, $2 million here and there or $10 million. But we're really predominantly deploying all that capital here. As we continue to enhance our cash flow generation capability, very focused on converting EBITDA to cash flow, we've had record cash flows in the company the past couple of years, more debt down. We continue to be very focused on our product portfolio currents as well as long term, and we believe small tuck-in bolt-on in acquisitions like Tech 4 are perfect for us setting up our product portfolio, leveraging our strengths and also can be done inside of our capital allocation, while still deploying capital to reduce our debt, but also grow that longer-term book of business for the company. So yes, we believe we can accomplish the objectives.

Understood. Let me open it up to you all if you have any questions in the room? You've been extremely efficient at answering them. So maybe one last one for you. What is it that we did not address that you want investors to know about American Axle.

Look, I think if you think about what is the underappreciated elements of our company, right? I think a few years back, there was certainly a lot of discussion made and attention on us from a leverage perspective, as our balance sheet to risk. So look, we were designing this business to be highly profitable, highly cash flow generative. We will take care of this balance sheet. I think our actions have spoken to a lot over the last couple of years. Think of what we've gone through from a strike at our largest customer in '19, COVID in '20, a huge semiconductor impacts last year, and we've generated record cash flow and continue to strengthen that balance sheet through that prior cycle. So I think that's starting to come off the table. So what is now probably the #1 thing on people's mind is you'll hear the word they'll call it terminal value. Where does American Axle play, can American Axle play in an electrified world opportunity. And I think we believe very strongly inside the company, the answer is absolutely yes. We have a business model set up to support electrification from component side, which I think is unique to us because it leverages our driveline skills. It's very well aligned even with our core business, meaning traditionalized and we are advancing our technology and new business wins on electrified drive units and we'll continue to grow that book of business. We continue to invest in it. Our customers are very interested in this. And we'll just continue to post new business win after new business win, and we'll ultimately convert those people that have doubt on our terminal value. At some point, you're going to say, "Hey, these guys got." And I think you'll see a little different answer to it takes some time for us to prove that out -- we're on track.

That's great. Chris, thank you so much again.

Thank you. Thank you, Emmanuel. Appreciated.

Appreciated.