Dauch Corporation (DCH) Earnings Call Transcript & Summary

All right. I guess since we're on, we're on. So delighted to have representing American Axle, Chris May, Vice President and Chief Financial Officer; and David Lim from Investor Relations. Thanks for being here.

Our pleasure.

We will get on the course of time. Okay. Maybe we'll make that Chris, you can join to you, of course you can join too. Figure when you're not running an actual company. For some important disclosures, please see Morgan Stanley's research disclosures at www.morganstanley.com/researchdisclosures. And any questions, don't hesitate to reach out to your Morgan Stanley representative.

Okay. Well, with out of the way, I won't get fired. I never say never. Why don't you give us a business update since 2Q results, and we'll start out there and tease out some other topics for the audience.

Sounds great. Well, first of all, good morning to everyone, and certainly excited to be here. Thank you, Adam, for hosting us. Thank you to Morgan Stanley. This is a great conference to come and have discussions on key topics of the day. So if you go back to our second quarter earnings call, starting off with electrification, we had some really exciting announcements in the business, right, that we announced formerly our win with Mercedes AMG where we're launching some of our most sophisticated electric drive units that we produce today and that volume will only continue to grow in upcoming years and certainly very excited about that platform and that relationship with Mercedes. And of course, that's been recognized. It's a PACE award finally. So really hoping to get some technical recognition, some great customer recognition from that, and that will continue to expand in the marketplace. At the same time, on the growth front, we announced some additional electrification component awards with 2 global OEMs. We didn't name who they are, but they all go across multiple different platforms, but really demonstrates how we're facing off to the market from an electrification standpoint on a component piece, but also from an electric drive piece. And you're really starting to see that play into our backlog and future growth. Really then sort of pivoting off of that from our current topic in terms of, call it, production cadence. We released our guidance, as you know, back in the early August time frame. And since that time, I would tell you, production volatility has continued, probably a little bit more than we anticipated. You saw General Motors started the quarter off with some downtime at their Fort Wayne facility. They announced a few weeks ago some downtime at their Silao facility, which is a key facility that we support out of our Mexico operations. So I would tell you, production volatility continues in our space, and we're seeing it hit a little bit more into the full-size truck segment than where we would have expected maybe 6 or 8 weeks ago. But like we do, we'll work on the things and control the things we can control and kind of navigate near through the current environment to the best certainly that we can. But with that said, we're focused on free cash flow delivery. We're focused on strengthening that balance sheet. We're focused on securing our traditional book of business, and that's almost substantially done for our company. Used some announcements over the last year or so. We have announced in excess of $10 billion of -- our existing business has been -- successor contracts have been awarded, which will really take us to 2030 and beyond. So a great cash flow generating platform for us there. And of course, the growth in electrification just couple of examples I talked about a few moments ago. So I think we're in a good spot. So maybe I'll pause there and turn it over to you. I'm sure you want to dive into some more of those topics in more detail or anyone in the audience. Happy to take questions.

Yes, we think you're against to our top line supplier for a variety of reasons. And I think you're including the run-off ice business, which is just the one we read about IRA and some of the realities of onshoring things. And it's also an advertiser set for how difficult battery electric vehicles are from an environmental standpoint, permitting and infrastructure. I mean you internal combustion vehicles and in California and in the very next day, you say don't plug in your EV. It's just this seems to get worse before it gets better. But I want to go back to that supply volatility are continuing, is it supply-based? Is it something -- and what character is it? Is it more on the chip side, is it logistics, is it freight? And then kind of we'll pivot to demand and make sure see where that's coming in.

Sure. If you think about the volatility we're experiencing today, just maybe compared to a year ago, really a year ago, it was articulated by the OEMs. It was a semiconductor challenge inside the entire space of the industry. I think what you have seen now maybe transition over the last 12 months as you've seen some level of improvement in semiconductors. We don't directly procure a lot. We could procure some but not a whole lot. But we've seen improvement in our ability to secure what we need. So you're seeing that host sleep, but what you're seeing now is other supply chain challenges sort of worked our way through the system. And if our CEO, David Dauch was here today, he would tell you top on his mind, #1 operational issue is labor availability, in particular, inside the United States, challenging that supply chain. So it's providing some stress inside the supply chain, which is creating probably some pockets of bubbles that the OEMs are experiencing. That's why that volatility continues. In terms of maybe feedback from the OEMs on what causes this volatility. Times, they will share with semiconductor related. Sometimes, they'll say it's supply chain issues. Sometimes they're silent on the issue. So it's clearly becoming a mixed bag, if you will, seeing improvements in areas and some other areas starting to keep a little bit of pressure on in terms of volatility inside the space. David, anything you want to add there?

No. I mean Chris, Chris mentioned everything perfectly.

Yes. So on supply, you had mentioned on your second quarter call, you lost 3 million units of production in the first half, lingering semi issues, you were targeting $1 million of lost production in the second half. The war seems to be over, but how would you describe the rate of change in supply? Is that $1 million of lost second half? Is that still ...

It is sort of a mix of holistic sort of it was a market view. We give our guidance is predicated more on North America production per se. And you've seen that slowly ticked down a little bit from some third-party estimates. Our focus in the very near term now is on our product mix that we supply. Seeming like I said, some improvements in semis from the macro supply issues kind of eating a little bit at the kind of ousting where you're seeing some improvements there.

So we often hear suppliers previous supplier, I interviewed one mention here and said we can build our business to hold or grow margins even in a flat production environment. Of course, the question is what's your mix?

Absolutely.

So how do you -- when you're planning and thinking into 2023, what level of expectations are most believe that current levels of mix have been pumped up because of lack of availability in the OEM can kind of cherry fit and wealthier people who can kind of pay $10,000, $20,000 above MSRP can do that, and that will normalize. But when you feed into your business, how are you thinking about mix delta?

Yes. So mix -- it's an interesting concept as it relates to us. So when you talk about mix often in the industry, we're talking about that end vehicle price point sales plan. So you're clearly seeing the OEMs leverage their price points for mix and obviously, maximizing their profit selling additional features on the vehicles. At the end of the day, they still need our products. You have a driveline system, whether it's an all-wheel drive system, it's an axle for a truck, it's components that aren't necessarily subject to that swing in mix per se. Our biggest probably impact on quote-unquote mix would be all-wheel drive, 4-wheel drive penetration rates. And what we have seen is that to be very static through different cycles and different periods of times. The consumers that want to buy a 4-wheel drive vehicle are going to buy a 4-wheel drive vehicle. If you want all-wheel drive, you're going to buy all-wheel drive. You may separate price levels. It's a different churn level, but you still have the auto drive system. You still have the American Axle auto drive, forward drive system in that truck. So we don't get impacted by that mix concept as much as ours, which we think is a great strength inside of our business model. So when you have that volume go up, it accretes to us without really a change in mix. So even if they're selling lower-priced vehicles, more of them, that's more of our product. So we're actually benefit for an acquisition.

Seeing price elasticity on that on drivetrain?

No.

Remember, we didn't range, but no -- I remember I like on the pickup truck, it's a work truck and it's probably 4x4. You're not going to see a rancher go with a 4x2, just to say $5,000.

You're not going to work with the Maverick. You live in the north and you want an all-wheel-drive crossover vehicle, you're going to buy all because it's an important feature more important than other features.

Due to demand situation, volume, okay, getting a bit better mix for you, stable, maybe improving in some ways, but you're giving us a stable mix. How do we think about margins going into 2023?

Yes, we have been designing our business model, if you will, to really be very strong operating leverage, meaning when volumes go up for us, capturing that 25% to 35% contribution margin on the movement net volume. So when you see volumes start to lift up, we should capture that margin profile from a variable profit as you move from period to period. So I think in the extent that volumes uptick into 2023, and we're not providing any guidance here yet today, we should have and drop to the bottom line, that variable contribution margin as that volume goes up. So we've been designing and building our cost structure to support that, and we're seeing that day in and day out.

So moving to the strategy, you and David have emphasized this agnostic approach of internal combustion all the way to full EV and hybrids in between. You've given some interesting stats on the last call. The business is obviously still extremely ICE dominated today, but 35% of your backlog is electric, electrified 70% of the forward quoting is EV. Now that's EV. Just so definitionally, is that mostly BEV or is that kind of electrification broadly in those aviation.

100% electric.

Right. Okay.

Not hybrid. You consider hybrid internal combustion that definition.

Thank you for clarifying. So what's -- I hear you on the incremental margin, and I'm interpreting that, that you'll take that same level of approach or do you take the same level of approach with the BEV businesses? Or are there some temporary adjustments as you kind of win business and have some higher costs and perhaps lower volume upfront. So kind of what's that impact on margins I'll kind of follow up with a couple of the questions. I don't want to overwhelm you, but just help us think about how -- it's a crazy, so like you're going to at least participate with global EV penetration, how do we think about the impact on margin?

Yes. No, I think you got a couple of things in there. Let me try to kind of bifurcate that. Let's start with maybe your initial point on how we're trying to be agnostic to the market, how we think about setting up our business as our traditional leveraging the strength of our traditional IC business and then also then leveraging the growth in the electrification space. And really, our goal is to serve the market and have our products and capabilities and technologies aligned with what our customers want on both traditional and electrified products. So it starts with setting up the capabilities from an engineering standpoint, from a manufacturing standpoint, and from a capacity standpoint. So I think we can pretty much say certainly, we're pretty much locked and loaded to go on our traditional side of the house and building out and winning our electrified side of the house. And the key, I think, to moving into the back half of the decade as electrification continues to take hold, is making sure we have, I'm going to call it, the term smart capacity in place. So when we're supporting components, if you will, for the electrification space, very similar in terms of our skill sets, capabilities and capital requirements as our traditional business. So this equipment is flexible. So if the market moves and pivots our equipment and our installed capacities and our Console capabilities, can support whatever the market demands and remain very profitable under those different scenarios. And then from a capacity for a drive unit perspective, making sure we time the market appropriately lay that capacity and compensated for it properly on the appropriate returns on those investments, which I think kind of spikes out into your second part of your question is how do we think about margins and profitability on our more holistic electrified business. So when we look at business, where we pursue business opportunities in that space, no different than our traditional business, you'll have certain financial hurdles we're looking for. Return on invested capital is a key metric for us. Obviously, margins are a consideration. And but putting in that capacity that's flexible, the know-how and R&D upfront will allow us to maximize our profitability in the electrification space as it rolls out over the next 3, 5 to 10 years.

At some point, does your disclosure or reporting structure have an opportunity to adapt to help convey that what differences there may be in growth and margin between the ICE business and the bed business. I mean you're introducing the language right now. Let's agree it's too soon to kind of to do something like that. But if we were sitting up here at the 15th Annual Laguna Conference, could your reporting structure maybe, is that something your team consider?

Yes. Look, we would obviously -- we have certain frameworks we need to adhere to on our disclosures. But it's a small piece of -- electrification is a small piece of our business. Today, it's less than 5%. Obviously, it's growing. But as it continues to evolve, our disclosures around that will continue to evolve.

And over that period, at what point what have you disclosed in terms of when you would reach breakeven or are you already breakeven? Or when would you reach parity with the internal combustion margins, which get to in a second, but I don't think that those are static either may be improving.

Yes. No, except when I smile by the way. We can't say that. But what I would say, Adam, from that perspective is the life cycle of our electrified product. We've launched several products. We've launched component products in that space. It takes a very similar life cycle that you see in your traditional business. So what do I mean by that? It starts off with upfront R&D expenditures. And we really started to consume those expenditures over the last couple of years have been ramping up as we have been expanding that business we have been increasing our quotation activity as we've been increasing our award activity. And the what will happen is that we'll then convert into kind of launch mode, right? So you will incur some project expense and launching expense, and then you'll start that volume ramp up from there. Really, obviously, we are the auto suppliers and even the OEMs, they're the best margin they'll make is when the volumes start to materialize. That life cycle applies to our traditional book of business, it's the exact same cycle as it does in an electrification cycle. So you'll start to see as those programs start to come online in terms of full volume applications, that's where you'll see your maximum margins. But they're set up, as I mentioned earlier, to hit certain financial returns. And our objective as a company is to maintain those returns, whether it's traditional or electrical.

I've talked to some of the companies in your industry. I've talked to some investors in the industry that say, you just can't retrain labor that spent their whole life working on mechanical things and have them move into electromechanical or things related to BEV. You seem to be challenging that. But where do you -- why are they wrong? Why are you able to kind of repurpose human talent in addition to capital to do that.

No, great question. So I would tell you, at least on the upfront side of the equation from the engineering and design of this product and the different engineering skill sets right? So we've been in this space arguably since our joint venture with Saab, if was 10-plus years ago, designing and developing electrification. We had a whole host of very skilled engineers through that process and have been growing that technical capability inside of our own operations. You're seeing that product. The first one you saw, of course, was with Jaguar 5 years ago, but that's where you're starting to see these Mercedes products, et cetera, come out of that pipeline. The other equation to that is the production side of this. And if you walk through our factories, our factory in Poland, for example, both the Mercedes and the Jaguar electrified axles prior to the same lines that we're building, Mercedes traditional ICE axles. So the skill set to forge, machine, heat treat, assemble, design, integrate, they are compatible in many cases between electrified and traditional driveline products. That's why we think we bring a great strength into that space. Engineering upfront, what the manufacturer of it is certainly something that's on our skill set. Now as we get into motors and inverters, and we started to do that in some of our prototype labs. We're starting to build them, for example, REE. I know we have a production award for them. We're shipping prototypes. We're building those motors ourselves.

How big is that motor operation right now.

I think it's small because rescale is small, but nothing is in production or e-motors.

No Prototypes.

Only Prototypes.

But this is something you really want to scale.

[indiscernible], we will look at this from a capital investment ratio per [indiscernible].

I can see -- yes, like our R&D effort and understanding that.

But it's a make buy scenario. If it made sense to do it. If it doesn't.

So taunting like a [Nideck] or just like I don't know.

Yes. No, there's a great supply base for that, and it's a make-buy decision and we go on a case-by-case basis. We fundamentally believe that we can be successful either path we take, whether you buy or build on that space.

Any questions for the axle team from the audience? I've got a lot left. So I want to keep bombing through. Okay. Don't be shy. IRA, I know it's too soon even your customers when you ask, like avoid the questions, they don't know. Tesla's not even talking about it really. What are your initial implications? And what would be your advice to treasury as they're kind of tweaking some of the fine print.

Yes. Look, obviously, a lot of the rules and clarification of the specific provisions are not out yet. So that's probably some of the challenges you're hearing from others that are responding to this. So clarifying the specific regulations, obviously, is the first step to that. Through our eyes, incentivizing critical manufacturers such as ourselves, I think, is could be a very important benefit of that. They have some provisions in there related to R&D and credits for investment in key products and continuing to emphasize that. I think strengthens the manufacturing capability in United State, which it's trying to do and continue to pursue that sort of philosophy.

I want to get to your capital allocation strategy and deleveraging. But I just want to go back to ICE one more time please try this smile. Okay. Sorry. I just think -- and it's maybe not like stuff of press releases, but we're really phasing off we're investing our last dollars in ICE and you have a state like California, maybe another 11 or 15 states that are going to follow California rules and represent 40% of the U.S. car market by volume and maybe have more than half by value. And you're not going to invest in the dollar and stuff again. So it's a runoff, but it's a really fat the adoption runoff when you contemplate supply chain and grid and national security. So why will not -- I mean, tell me where I'm wrong or harness my tamp down my expectation is why can't these next remaining decade or more of internal combustion be the most profitable you've had maybe ever.

Yes, look, I think when you're creating an environment, you might -- you have a couple of things going on inside of that product. I think, at least sort of through the manufacturer eyes on our standpoint as customers are launching their next generations of products, which I mentioned earlier that we've already secured they would potentially look to minimize their investments in engineering changes and design changes.

Are they?

Well, they still haven't -- those programs don't come out until the decade. So -- and that's comments they would probably have to provide. But that's our initial expectation. So what does that mean for us? The capital intensity into that business becomes lower than it is today for us. And then you're harvesting a decade plus this call it, runoff business, if you will. So it's very cash generative from that standpoint. If areas of the country are truly starting to maybe rule out or eliminate internal combustion engines, you're going to have pull ahead demand, you are going to want to buy this type of product over the next 10 years. It's great product. So you'll have a lot of these things really starting to take hold. And I've also seen operationally inside our company, if you have this extended run, that's where you harvest productivity, you harvest enhancements, you really start to become really a cash-generating machine for a lack of a better word, on the products that you're supporting into the space. So we can clearly see the recipes.

You're not calling my expectations.

No, I'm not framing anything to mention. I'm sorry, the concept absolutely agree.

What's the -- so what's the downside then is lower scale economies and you can start -- you're decremental down on 35%.

Yes. I mean it goes both ways. I mean, that great operating leverage does go both ways. But if you have a line of sight to an endpoint for that, which I don't think we do by the way.

But a pull-forward comment you made, that's an unproven hypothesis at this point.

Correct. That would be an end consumer behavior. I mean I don't know, but then that would happen obviously more at the tail end of this scenario than upfront.

Financial outlook, leverage is at 3.4x at the end of June -- you're generating -- I'm using round numbers here, folks. $100 million of free cash flow per quarter, no maturities until 2026, 2027, significant maturities. In this environment, interest rate environment, the EV opportunity because, obviously, if you're getting that -- if your backlog and your forward quoting activity, is that much you might have -- what you don't spend the money you don't spend on ICE will go somewhere else. But just tell us how you think about -- remind us of your capital allocation, deleveraging priorities. It things seems like you can do more than one thing at the same time? And would you be able to do those things without having to do with equity holders.

Okay. Yes. First of all start when you mentioned our debt maturities, that's true with our bonds. We do have a term loan B that matures in 2024. So just for the record on that piece. So we will obviously work through that refinancing. We've been paying it down several amounts each quarter, but we'll have to refinance it at some point between here and 2024. And then you're correct on the bonds from that standpoint.

I'm not worried. I'm not worried, but can be.

Fair enough. But in terms of capital allocation, I would expect this to continue to pay down debt. I would expect us to continue to look at bolt-on acquisitions. We announced Tech 4 earlier in the year, a distressed asset, bought it for 3x 2023 earnings.

Actually have earnings.

A little bit. a little bit. But next year -- next year is really when that synergy play comes in for us. And that you'll see that the ability of us to integrate these into our operations and leverage these bolt-on acquisitions. So we're really looking forward to that coming online 2023. It will contribute a little bit to this year. And then we'll continue to, at that point, once we kind of continue to reduce and strengthen the balance sheet of the company, and then that's probably a couple of years out from -- over the next few years as this cash flow continues to generate, we get the balance sheet refinanced. And then if we continue to generate cash flow like we are today, I think that gives us a lot of options.

So I mean a question investors ask about a lot of companies in your industry is this a runoff? Is it a growth story? Both?

I think we can see more I see growth in our electrification business, and I can see a great cash overstating machine in our traditional ICE business for an extended period of time.

On the M&A, any other missing pieces, any divestiture opportunities even bolt off opportunities or just kind of if you think about the whole pallet some valuations are coming in. And I can imagine there's a lot of stranded assets out there that you could have them use for and repurpose.

From a divestiture standpoint, a couple of years ago, we got rid of some small aftermarket elements in our powertrain. As you know in 2019, we divested of the U.S. casting operations. And then over the last couple of years, we brought on a couple of bolt-on acquisitions, a little -- some small power and metal capability. We did 2 years ago. This year, we did Tech 4 work and continuing to see some of those opportunities that play well into our product portfolio, I think it's something we'll clearly keep an eye on. From a divestiture standpoint, I don't see really on a meaningful size, anything significant inside our product portfolio. I mean it's something we continue to look at, think about and how it plays into the next 10-plus years. But I think right now, we're pretty satisfied with our product portfolio from a divestiture standpoint. Acquisition-wise, if we can leverage some of these other opportunities, we certainly would do so.

Europe-- your business in Europe is?

It's was about 10%, 11% with Tech 4 it is going to be closer to 15% on the total run rate.

Comments on -- I mean you can control, but how do your contingency plan? How do you think about an energy situation going on.

Yes. We contingency plan from that perspective, at least through that eyes, the contingency planning is continuity of supply, right? So we can continue to build and meet the requirements of our customers, assuming they're running, okay, that scenario. So there's different ways that we've been contingency planning, obviously, trying to secure different sources or variable sources for energy and real energy is the topic we're talking about. Looking at potentially different ways we can redeploy energy in our footprint, which is one of the strengths of our global footprint. And what do I mean by that? If -- just as an example, if you're consuming a significant amount of energy in your European operations to heat treat and also to forge and forging consumes a lot of electricity, you have to basically take steel bars, making bright red that consumes a lot of electricity to do that your heat treat parts. Well, maybe what you can do is we have heat treating capacity elsewhere around the globe. You can heat treat somewhere else and use that energy capacity to forge only. So there's different things where we can -- I'm calling it rationalized energy usage across our footprint where it's more available. So we're looking at a variety of different elements to ensure companies to play.

Up on hydrogen.

From a vehicle perspective?

Yes, and then how your products could -- is there anything that's from part of the vehicle that you touched that has to be uniquely designed for fuel cell vehicle or is it.

So fuel cell vehicle will continue to use the electric drive units that we would produce today for BEV. So either way, it's great. whichever direction uses our products. So that's nice for us.

So it's agnostic.

Agnostic from a -- we're trying to be agnostic across all powertrains specifically for us, that's an easy one to be because they use the same identical product.

Time for a question here Yes. you want a mic?

So as the industry does this transition on the powertrain. There's this host of Tier 2 suppliers that could end up facing market share loss or they could end up on programs that maybe they were doing 70,000 units a year, and now it's half that. And so my question is, do you have any insight as this happens, can the Tier 2 part of the supply chain keep up with the ICE? Like is there -- or do we get to a breaking point where bigger suppliers like yourself have this runoff and it's very profitable. But half of these Tier 2s may be in trouble because they're running at half or 1/3 of the volumes they ramp for 30 years.

Yes. No, very fair question. Clearly, monitoring the supply base is a critical skill set that OEMs or Tier 1s need to have and monitor that situation over an extended period of time. But that's where you'll start to see, I believe, some consolidation in the Tier 2 or Tier 1/Tier 2 space to leverage and sort of sell for some of that issue.

And also, one thing you want to consider there is we're in an area of time of volatility. But if you look forward looking, right, the production schedules, we're hoping would be stable. So we get that visibility a volume standpoint and plan accordingly.

We're risk manager supply base just like we do today.

I mean do you guys think global production, even with the EV penetration assumptions can get to $90 million, $95 million today? Or do you think there's been the -- last 2 years, there's just been a lack of investment in parts of the supply chain where you're going to run into some issues here at 80% or 85%?

Yes. Look, over time, it can absolutely get to that. I think there's demand for that building inside the system, but that's not something that's going to happen tomorrow. But yes, it absolutely can support that.

We got one more.

Thanks. Just curious on -- I mean you think about the availability to scale EV production supply chain, what -- how do you kind of think about supply chain? I guess you got a lot of time to see if you have enough aluminum copper and nickel, but not enough cobalt, then you can't produce cars. So how do you retain that flexibility that regulation is probably going to -- California is probably going to ban all electricity here and not worry about how people turn anything on. Just walk how do you kind of think through that allocate resource, although I guess you'll have several years in advance to think about it, but are you kind of taking the over or under or how do you kind of think about.

Well, look, we plan and think about our business and when we look at the awards that we have won, the volumes our customers have communicated and look at the industry holistically. And then I think your question is, if it's scaling, but it doesn't get to -- it can't get to where it needs to get to, I think is the heart of your question, how do you manage that? And it goes back to some of my comments I made earlier in terms of our objective is to be agnostic and let the market come to us in terms of what we need. Do we need more ICE or more electric. And if we have that flexible equipment, we have the flexible engineering skill set, we should be able to move within some parameters of how the market moves through our -- from our lands.

Are you asking about battery input material I mean.

I mean that's kind of the state or anything. But ultimately, can you.

I mean if you look at ICE a lot of stuff. I mean a lot of our axles today are all aluminum. I mean they consume a lot of these things you're talking about, at least from our lens, we consume today. And some of these other elements that you're talking about that I think will challenge on more on the battery side, infrastructure side, and those challenges need to be worked out. But from our lens, our goal is to be agnostic and flexible from a capacity and capability standpoint.

Yes. The bigger issue is going to be with battery.

We're in the battery space.

So we're going to wrap it there. Right. Chris, Dave, thanks very much for joining us.

Appreciate it.

Thank you for the session with American Axle. Thank you, everyone.

Thank you.