Dauch Corporation (DCH) Earnings Call Transcript & Summary

Everyone, as we continue the Barclays Global Automotive and mobility tech conference. I'm Dan Levy, U.S. autos research coverage at Barclays and very pleased to have with us American Axle manufacturing leader in driveline products. We have with us today David Dauch, Chairman and CEO; And Chris May, Company's CFO. So we're going to have a conversation fireside chat style. Anyone who has any questions in the room, feel free to raise your hand. If you have a question on the webcast, please e-mail my colleagues, Joshua [indiscernible] or Daniel [indiscernible] first name dot last name at barclays.com. And they're glad to answer your questions. David, Chris, thank you so much.

Great. Glad to be here.

Okay. Let's jump right in, and let's go straight into sort of the near-term environment strikes over. Maybe you can give us a sense on how the environment has looked post strike. To what extent have we seen some normalization and recovered a schedule?

Yes. So let me go first and Chris, you can add in. Clearly, we're all very happy that the strike is over. Obviously, we're dealing with a lot of uncertainty and volatility before the strike. The strike just compounded matters, especially with the rolling strike that took place there. We are seeing the OEMs start to get their assembly plants back up and running. Once you shut down an assembly plan, it's not easy to start and back up. It takes days and sometimes weeks to do that. Most of our customers are getting their assembly plants back to where they need to be. Some of the limiting factor is still the supply base at this point in time.

Great. Is there any opportunity, I think you had guided to $70 million to $100 million of lost revenue from the strike. Any opportunity to make that up in the fourth quarter? Or is that -- that's probably more of a 2024 opportunity.

Yes. I would think about that more as a 2024 opportunity. Our guide for impact for sales loss was $70 million to $100 million, as you mentioned, only $15 million of that was inside of the third quarter. Bounces in the fourth quarter, which the bulk was October and the ramp-up pace that David just articulated. So we don't see recovery off of that here in 2024. -- or 2023, sorry.

I'd agree. I think it's going to be hard pressed for the OEMs to make up some of those units right now.

As far as production stability, I think one of the themes that we saw in the third quarter was T1XX volumes were choppy down in Silao. What are you seeing in terms of production stability more broadly? Obviously, the environment is a lot better today than where it was the last couple of years. But what do you think it takes for us to get back to maybe a pre-COVID type level of stability that we've seen on the production side?

I personally don't think we'll get back to 17 million units for some time. This year production-wise, we were going to be around 15.5 million, which was going to be a good year with the strike, we'll probably finish around 15.2 million, 15.3 million. Next year, we think that number is between 15.5 million and 16 million. I think it kind of levels off of that area for a period of time. Inventories on many of the vehicles are at the desired state that the OEMs want to be at. They're not going to go back to historical levels. There are still some, especially the full-size SUVs that are below the desired level. So they need to still build that. I think interest rates right now are going to curtail some of the demand for a period of time. But at the same time, we are seeing an increase in schedules, but I don't think it will go beyond that 16 million level for several years.

As far as the health of the supply base, is that still a limiting factor, the Tier 2, Tier 3?

Absolutely. And we've experienced some of our own issues as a Tier 1 with labor availability or labor scarcity. That's throughout the supply chain at this point in time. That's limiting some of the recoveries of some of the assembly plants right now is just suppliers' ability to provide product to meet the customer schedules, but it's largely driven by labor. I've been saying for 3 years, I thought labor was going to be one of the biggest issues that the industry faced for the years going forward, and that's only got compounded with the cost of labor going forward now because of the labor negotiations.

Just to pivot off of that. Third quarter metal forming saw a number of issues. But I think one of the core issues here has been labor availability, and this is something that's been elevated all the way to the top of the organization to address sort of better efficiency within that segment. So maybe you could just talk broadly. Help us appreciate what it's going to take to -- I mean, we can talk about metal forming specifically, but then broadly, what it's going to take to get a better level of labor stability for you. What are the things that you are doing?

Okay. Let me just touch just in regards to general when you look at pre-Covid, obviously, there was plenty of workers in the workforce at that point in time. During COVID, a lot of the baby boomers that retired. You had a lot of 2/3 of the child care in this country went away. So you have a lot of parents stay at home to look after kids or elderly parents. At the same time, our government was paying people not to work. Some of those people never went back to the workforce and others have decided to stay out of the workforce altogether. So what was once readily available isn't necessarily readily available from a labor standpoint. We're not immune to it, meaning American Axle. We have several facilities that we do not have a labor issue, but we have select facilities where we have a labor scarcity or labor availability problem. That's led to some of our metal forming issues. Some of our powder metal facilities were impacted based on labor availability. So we've had to unload certain plants and reload them at other AAM plants or find -- have the supply base supplement some of our capacity that at the same time, customer schedules, prior to the strike, they were trying to build inventory. So they're running at maximum capacity levels. Post strike, they're now trying to make up where they can. So they're keeping the demand there. We're running 6 and 7 days a week. At the same time, once you get into 6 and 7 days a week, you're not maintaining your equipment the way you should your people burn out. At the same time, you have quality issues and scrap issues and premium freight issues. And that's exactly what we experienced at a few of these powder metal, metal forming facilities. And we're highly confident to get the issue resolved. We put a chart together that we covered in our earnings call saying that most of these issues will be behind us by the end of the fourth quarter, but some of it would carry over into the first quarter of next year. But we're confident that we can get it contained within that. And we're unloading the facilities where it makes sense and reloading other plants where we do have labor. We're making permanent structural change where we're doing plant loading and we're looking at automation, robotics where it makes sense as we go forward. And that's not just at the troubled plants. That's across the board now because we think this labor issue is going to continue to faster for a period of time.

How much of the solution is just higher wage. I mean, wages are going up regardless, but how much of it is just use have to flow through more to your labor base?

Well, that's obviously part of it as well. And we've done that throughout the year, we've been increasing our wages and our benefits in order to attract it, providing signing bonuses or even recommendation bonuses to our personnel in order to attract talent to the organization. But at the same time, you have to have a desire and ambition to work too.

One more on what we were seeing in the third quarter. And I think back to the late 2018 time frame, there were a number of operational issues as well that you worked a way through. So maybe you could just talk about in the past, the company's ability to tackle when there are operational challenges to put out a road map and then get through just. How are you leveraging that in terms of getting smoother operations? Because the labor availability issue, that seems to be the larger one, but there are a number of other one-off issues that seem to pop up in the third quarter as well.

Yes. I mean we're essentially using a similar playbook that we did in 2018. If you remember, we acquired MPG in 2017. We inherited some launch problems. We were very transparent with the investment community in regards to what those launch problems were. We identified the corrective action plan to address the issues and the timetable to do that. We're doing that exact same thing here with the metal forming plants. And like I said, we're highly confident that we can put these issues to bed and resolve. I mean those that know AAM and have followed AAM now that we're known for our operational excellence and our performance. That's one of our differentiating features as a company. So it's very unusual for us to have to call out the issue we did in the third quarter, but we experienced it. And as always, if we have an issue or a mistake, we highlight it, but we also tell you what we're doing to fix the issue, and we're not trying to hide behind it, right?

So let's pivot to maybe some of the considerations on 2024. And I wanted to start with -- maybe you can give us some comments on what you're hearing on T1 schedules. I think most of the -- even though GM volumes may be up, that could be closer to flat, potentially down. How are you planning for that?

Yes. Today, if you think about looking using some, I'll call it, third-party providers of volume projections, you'll see year-over-year, it's flat. Generally speaking, obviously, we're very bullish on that platform. We believe there's strong demand for that platform, especially all three segments of that platform, the full-size SUV, which you know is running red hot, low days of inventory on hand. The heavy-duty subsegment of that platform continues to be in high demand, not a lot of inventory. And the light duty is sort of transition now to -- appears to us anyway, the inventory levels at once and still good demand for that vehicle. So we felt that way here in 2023, we could see that same level of demand and interest for that platform next year in 2024.

Let's unpack some of the other drivers. FX, you actually held in fairly well on not seeing transactional headwinds this year. You have hedges in place. Explain to us the dynamics of these hedges. At what point they expire can we maybe frame the magnitude of potential headwinds we could be seeing?

Sure. And I think when you refer to FX, the largest impact from a cost element for us on FX is the Mexican peso. As you know, we have large operations in Mexico. We consume somewhere between PHP 5 billion to PHP 6 billion a year. We are on a 3-year rolling hedge program. So if you think about the next 12 months, we typically have anywhere from 70% to 80% of that hedged. But really over the last, I would call it, 9 months, the peso has strengthened in a meaningful fashion, right? It was 20x about a year ago from a conversion rate is closer to 17x today. We did benefit, obviously, from our hedge protection through the course of '23. But inside, if you look -- even inside our third quarter, the drag of the peso versus the prior year, where it was running 20-plus from an FX rate conversion was $5 million to $10 million. So you're starting to see that impact settle in on us here in the back half of if it remains flat from here on out, you'll continue to have some year-over-year pressure in the first half of next year as it relates to the peso FX and then it'll settle into sort of the run rate you see here in the back half of this year.

Great. Is there a way to frame the amount of labor inflation that you're going to have? And just how should -- given the timing and structure of your labor agreements, how should we think about the path to those cost increasing? I assume it's going to be on a rolling basis over the next couple of...

Yes, that's a fair way to think about it. But just for context, if you think about our cost of sales, 60% of our cost of sales is associated with material purchases from our supply base, about 5% to 10% is D&A. The balance of the two is split between other overhead elements, tooling, coolants, things of that nature and then labor and benefits of that other piece. So that's really where, when you talk about inflation from a labor perspective, where that cost -- that inflation would it center in [time]. For our UAW contracts or union contracts inside the U.S. they're in place today. They start to renew and expire in '25 and '26 with the larger one being in '26. But as David mentioned in some of his comments a few moments ago, we've been giving some wage increases around the board to continue to attract and retain labor inflation is real, and we'll continue to work our way through dealing with that to make sure we have labor availability inside of our facilities, and obviously, productivity to help mitigate some of those costs as well. But again, next contracts are really about 2 years out.

And there's no master agreement like we see...

No master agreement.

We eliminated the master agreement in our labor negotiations. And for those, again, that have followed us know that we had an 87-day work stoppage in 2008 with the UAW because we needed a market competitive Tier 1 supplier agreement, not an OEM agreement, which is what we had at the time. And ultimately, we achieved that market competitive agreement. Each of our plants are now on a stand-alone independent agreement. All those plants are staggered in regards to their contract durations. And then we also look to back up supply capabilities across our enterprise.

Great. We could just wrap one on inflation. And -- maybe we could just talk about the broader cost recovery environment, right? And I think the question is, automakers, and we just see [indiscernible] D3 or each absorbing at least a couple of billion dollars of incremental costs off of labor over the next handful of years now. EVs are challenged. Pricing is probably going to be headwind. What is the recovery environment or the tone and tenor of discussions you're having? Is it incrementally tougher? Or is the answer, it's always tough, and it never changes.

Well, it's always tough. But if you compare last year to this year, last year, we had much better success earlier in the process at a lower level in the negotiations, meaning a lower level in the organization to deal with this year with the European and the Asians, we've worked our way through the majority of those issues. Our biggest challenge has really been with the Detroit 3. And clearly, a lot of it stemmed around where they were from a labor negotiation standpoint and just trying to curtail costs. We're making -- we're having meaningful discussions with them. We're making progress there, but we don't have it completed yet. We called that out in our third quarter earnings call, but we expect to address that here in the fourth quarter.

Are there any other discrete costs on the inflationary side that you would call out. Anything that's normalizing that's getting a little better?

Well, we saw through the course of this year, utilities get better, right? That was a very significant cost for us last year, early part of this year and has gotten better through the course of this year. But from an inflation standpoint, labor is sticky. That's going to continue around. We have seen metal market indices. These are our pass-through mechanisms, which are also aligned a little bit with inflation but also some commodity pricing. Those have come down since last year, though they seem to be sort of plateauing and stabilizing. And we probably have a little residual pressure yet from our supply base that we have to work through, but that is starting to come down a little bit as well as some of these other cost pressures are coming down on our suppliers.

And I'd say some of the freight and logistics costs have come down as well along with the energy side.

Can you just remind us of the dynamics on metal markets, just given -- I believe your steel purchases are partially indexed, partially annual buys. How do we net out -- and steel has been erratic and how do we net out like where we stand today, how that could impact you next year?

Yes. So the cost structure for our steel and other elements inside of our purchase buy as well that are generally metal-based really come in the form of two fashions. Number one, there's an index component. So the -- think of the ingredients used to make steel for an example, you have they melt down scrap, you have nickel, [ moly ], we buy aluminum, things of that nature, are traded in exchanges, the prices change every 30, 60, 90 days. The change in those prices, we have arrangements with our supply base to compensate for and generally a back-to-back arrangement with our customers to pass that commodity-like exposure up through the chain or any price decreases as it goes down also up through the chain. We retain about 80% to 90% of that transaction, whether either favorable or unfavorable depending on the price change. As it relates to base costs, where we are in negotiation with our supplier for what the base cost of that component would be to purchase, whether it be a pound of steel or other structural component that we buy. Generally, we're on annual or biannual contracts and those come up for renewal from time to time. A lot of our steel contracts that we come out here in 2024, and we're working through those now. And they face some of the challenges that we have, but obviously, it's a robust negotiation with the supply base.

For those of us who are less in tune with SBQ versus hot-roll coil [indiscernible] any differences to highlight?

No. I mean hot roll seems to bounce around a lot more, and you see that traded and obviously, the rate for hot-roll moves around. We don't have that level of exposure. SBQ. We're also one of the largest buyers in the world, frankly, for that component. So we have some leveraging elements there from a buying power. But it's really the commodities that go into that SBQ that drives a lot of the price up and down that we pass through in the metal market mechanisms.

Great. Let's pivot to the EV slowdown because I think that's been the central theme that's been in discussion. You've laid out a plan to transition your portfolio. A year ago at CES, there was a very attractive play. You're going to be at CES again this year, and we'll make sure you can plug your presence there. How has this shift in environment change the way that you're approaching your portfolio? Or has it not?

Quite honestly it really hasn't. I mean, we never totally believe what some of the prognosticators we're saying in regards to the adoption rates of electrification over the period of time that they're saying 40% in the U.S. by 2030. We obviously have to have a plan in case it does happen, but we also have a plan if it doesn't. Now I think the rubber is hitting the road and reality is starting to settle in that things are being pushed out or delayed especially because the labor negotiations that cost the OEMs a lot of money, they can't fund everything they wanted to do in the past. What we've always said is that we want to be agnostic to the market. We've got a full portfolio for ICE products. We have a full portfolio for hybrid products. We're developing that portfolio right now for electrification. We've been in the electrification business making electric axles since the 2017 period of time, but we got into the electrification business in 2010, but the market just wasn't ready yet. And so like I said, we've been making products since 2017 for the Jaguar I-PACE. We make the front and rear axles there. We're doing work for Mercedes and AMG on multiple variants for their portfolio. We're doing a lot of work in China today. It was really the U.S. market, the North American market that was lagging behind. That's our biggest market. And obviously, we're going to do what we need to do to protect that market. It's heavily weighted towards trucks and beam axle applications. We announced in the first quarter, a big win for us with Stellantis. So that's very encouraging. For us, it's also improved our capability and our relevancy and our technology there. Each quarter thereafter, we've announced other wins, both in the component form or subassembly form, thinking like differentials, gearbox form, but also in the electric drive unit and the e-Beam form. We've picked up work in India. We picked up work in China here in the second and third quarter, and we're quoting on $1.5 billion of new and incremental business. Now our concern is how much of that $1.5 billion that we're quoting today, of which about 75% to 80% is electrification based, how much of that's going to slide out because of the retiming of the programs that are going on. That might impact us a little bit in regards to our win rate and the timing of that win rate, but we're going to historically deliver. We're going to deliver way historically at one before in the past on those. I mean the big thing for us is just -- we're going to continue our R&D to get our portfolio where it needs to be so that when the market does ultimately move faster towards electrification that we have the products ready to support it. But we're a big believer in electrification. We've been making investments, like I said, since 2010. We're going to continue to make investments in that area there. It's just we thought the adoption rate would be low or slower than what was being originally communicated and forecasted by many and accepted by many. And like I said, I think reality is really setting in.

The core of your business your driveline exposure on T1XX trucks, Ram HD, I assume that's perfectly intact. And to the extent that tail is extended. That's great news for you, yes?

Absolutely. I mean, we're -- I mean, EVs make up probably less than 2% of our business today. We're a very strong ICE producer. We generate strong cash flow from our business, strong EBITDA margins, top quartile for the business. The longer ICE stays, the greater cash generation we can realize, the more optionality we have to strengthen our balance sheet fund additional electrification growth and fund additional profitability growth, both on the side and on the EV side.

And over the last year or 2, and you may have noticed, we've made announcements that we have secured the next generation of some of our most critical ICE programs. And I think the value of that will continue to shine for many, many years to come.

Yes. I mean if you go back and look at what our priorities are, and we've been very consistent on this, it's one we want to secure our next-generation business. Majority of that's done. We've got a couple of programs that we're working on, but we expect that to be done in the, let's say, the next couple of quarters. So we're hopeful to get that done. We want to make sure that we're optimizing our business to generate cash from the business. We're doing that. We continue to generate positive free cash flow every year for the last 10-plus years. We're using that cash flow to pay down debt. We paid over $1.4 billion in the last 5 years, paying it down just to strengthen our balance sheet. We've overcome Murphy along the way or a lot of adversity between the GM strike in '19 and then COVID in semiconductors and the other issues that we're all dealing with. And meanwhile, we've been spending $35 million to $40 million a quarter on R&D, with the majority of that being dedicated towards electrification. All those priorities are really set so that we can ultimately position ourselves for profitable growth, both on the ICE side and the EV, but there's really two things that are the boss, our customers and the market. And right now, the consumer is really speaking that they're not fully ready for the EV at the rate that the government would like to politicize it or try to drive it to. And the OEMs now are having to respond because ultimately, it's all said and done, the consumer is the boss.

If we could double-click on the Stellantis [ Ebimaxell ] win. I think most people probably say that's probably the most impressive win, the best proof point you have on the electrification side what you have in said which vehicles, but we can imagine which one they are. And you've said content is like 2,500 plus plus, I think, has been the

Plus, plus, plus.

A lot of plus. So what led you to that win? And maybe as a follow-up, if some of the automakers are maybe pulling back on some of their efforts on volume, and this changes the dynamic around vertical integration and how the math works. Are you seeing any more increased conversations with automakers that would have otherwise in-source and say, okay, maybe it doesn't make as much sense now.

I think it's too early to answer that question just now. I mean what I would say is this, is that clearly, every OEM is going to have to go back and reevaluate their electrification strategies. As far as the timing, the amount of money they're going to spend both from an R&D standpoint and from a CapEx standpoint. At the same time, they're also going to have to go out and reevaluate their make-buy strategies. And when they have reputable companies like ourselves and other qualified suppliers in the marketplace, they're going to find the right balance as good for them, while at the same time, being supportive of their partners. And we've got excellent relationships with all of our customers. Our largest customers are the Detroit 3. Obviously, they've got some big decisions to make. Their cost structure just got a lot more expensive with these negotiations. Clearly, there's a cascading effect, so we'll all feel a little bit of that, but we won't feel the magnitude that they're feeling. But with that, we're going to continue to invest in electrification. Really what differentiated us in regards to our portfolio was our engineering creativity and innovation is outstanding. We always are known for our operational excellence, but we also have tremendous technology leadership and we deliver quality -- excellent quality products on time every time. So we feel really good about where we are. And like you said earlier, the delay in electrification is only going to benefit American Axle for a stronger cash generation, profitability and performance while allowing us more time to develop the portfolio on EV.

Okay. I want to wrap with a couple more questions on, one on EV spend and another just on cash and the balance sheet. EV spend, you're running at $35 million to $40 million a quarter. Just remind us how much of that is sort of hard spend that you have to do on future product development versus application engineering that's going to vary depending on the timing of programs. So to what extent should we -- if things slow down, will we see you pull back on some of the spend?

Yes. Keep in mind, a piece of that spend is still to support our internal combustion engine business, right, because that can still continues to grow for us. And we also have launches coming up. But think about probably 50% to 60% of that is sort of base spend where you are in current programs that you're supporting or getting ready to launch future support. And then you have then the balance of that is really building out our new electrification programs and supporting some new electrification program quotations coming at us. That's how I would think about it from an R&D spend perspective.

And then just final on cash flow and the balance sheet. Maybe you can give a comment on CapEx, which as it's been running at roughly 3% of sales, which is like really low, below what you've done historically. And it seems like spend pushed out, but maybe there's something structural here. Can you just talk about what's happening on the CapEx side? And then maybe an update on the path to get to 2x and how the capital allocation [goals]?

Yes. In the past couple of years, we spent closer to 3%. As you know, previously, we've been spending much higher than that to launch programs. But we put in several years ago, a very conscious effort to reduce our CapEx spend and attack it for many different ways. Reuse the capital, redeployment of capital. We continue those themes. But as you know, CapEx also ebbs and flows with program launches. So as we have program launches that will also increase potentially if they are large programs coming at us. But our goal here, I would tell you, in the near to midterm, we'd keep our CapEx number at 5% of sales or less. You may have a period of time if you get a compressed year or so or 18-month period where you're launching a lot of new programs, you could have a spike over that. But that means you're launching big new programs, so which, of course, in our view, would be a good thing. So -- I mean, that's sort of how we're thinking about CapEx. I think we got a good control over that. It will be subject to programs going forward. That's sort of our line of sight going forward.

Yes. We're going to spend 1%, 1.5% minimum every year just on maintenance capital. At the same time, when we -- historically, we spent 4% to 6% for legacy AAM business. When we took over MPG in 2017, they were in the midst of some major launches as well. So that CapEx as a percentage of the sales, swelled up to 6% to 8%. But to your point and Chris' comment, we've been able to bring that down to that around 3%. But as we launch electrification programs and some of this replacement next-generation ICE business. The capital demand isn't as great on the ice, but there's still some changes because of horsepower and torque and engineering changes that take place that we need to be able to fund and support. But as Chris said, we made a conscious effort to bring that down and keep it at a disciplined level, and we're reusing a lot of capital where we can. But the majority of our ICE capacity is in place. And was only going to come down. OS EV penetration increase. Now as EV penetration goes out a little bit longer, it's just going to drive a little bit more maintenance capital for us, but it's not going to be the big program capital until we really get to the electrification programs. And even then, we're going to try to use as much as we can from ICE to EV, but their select components and even some assembly that we'll have to put in specialized capital to support EV requirements.

Great. We're going to cut it off here. Chris, David. Thank you so much. Very insightful. And CES, you want to give 1 second plug to CES?

We'll be at the CES show here early in January, come stop by our booth. I think you'll see a lot of these great technologies that we've been talking about. You've got some thoughts and questions on our technologies. We'll be happy to answer anything on your mind and, of course, walk you through and so you can touch and feel some of this stuff. It will be a great show.

Great. Thank you.