BorgWarner Inc. (NYSE:BWA) Q3 2023 Earnings Call Transcript

BorgWarner Inc. (NYSE:BWA) Q3 2023 Earnings Call Transcript November 2, 2023

BorgWarner Inc. beats earnings expectations. Reported EPS is $0.98, expectations were $0.91.

Operator: Good morning. My name is Leo, and I’ll be your conference facilitator. At this time, I would like to welcome everyone to the BorgWarner 2023 Third Quarter Results Conference Call. [Operator Instructions]. I would now like to turn the call over to Patrick Nolan, Vice President of Investor Relations. Mr. Nolan, you may begin your conference.

Patrick Nolan: Thank you, Leo. Good morning, everyone, and thank you for joining us today. We issued our earnings release earlier this morning. It’s posted on our website, borgwarner.com, both on our home page and on our Investor Relations home page. With regard to our Investor Relations calendar, we will be attending multiple conferences between now and our next earnings release. Please see the Events section of our Investor Relations home page for a full list. Before we begin, I need to inform you that during this call, we may make forward-looking statements, which involve risks and uncertainties as detailed in our 10-K. Our actual results may differ significantly from the matters discussed today. During today’s presentation, we will highlight certain non-GAAP measures in order to provide a clearer picture of how the core business performed and for comparison purposes with prior periods.

When you hear us say on a comparable basis, that means excluding the impact of FX, net M&A and other noncomparable items. When you hear us say adjusted, that means excluding noncomparable items. When you hear us say organic, that means excluding the impact of FX and net M&A. We will also refer to our growth compared to our market. When you hear us say market, that means the change in light and commercial vehicle production weighted for our geographic exposure. Please note that we have posted today’s earnings call presentation to the IR page of our website. We encourage you to follow along with these slides during our discussion. With that, I’m happy to turn the call over to Fred.

Frederic Lissalde: Thank you, Pat, and good day, everyone. We’re pleased to share our results for the third quarter 2023 and provide an overall company update, starting on Slide 5. With approximately $3.6 billion in sales, we delivered double-digit organic growth in the quarter. Our margin performance was strong. Our free cash flow was modestly positive in the quarter, which we believe sets us up nicely to deliver on our full year cash flow outlook. Our Charging Forward progress continued on multiple fronts. As I will discuss in a moment, our long-term Scope 1, 2 and 3 emission targets were validated by the Science Based Target Initiative, the SBTi. We secured multiple new eProduct awards during the quarter. I’m encouraged to see these awards across several parts of our portfolio both for BEVs and for several types of hybrid architectures.

I continue to be impressed by the sourcing pool for our products and the strength of our EV and hybrid portfolio globally. BorgWarner continues to focus on the long-term growth opportunities in our eProduct encouraged by the high intensity of the new business quoting activities in spite of the fact that we’re seeing some near-term pressures on the industry production ramp-up of electrified vehicles. Gaining scale now on EV and hybrid architectures globally is our strategy, and this remains unchanged. We’re proud to be in production or launching eProducts for 7 out of the 10 leading OEMs in the electrification area as well as several other OEMs outside this top 10. Now let’s turn to Slide 6, which summarizes our commitments to reduce emissions through the end of the decade.

Building on our previous commitments to achieve carbon neutrality by 2035, late last year, we submitted Scope 1, 2 and 3 targets to the SBTi. In August, SBTi validated those targets in which we have committed to reduce Scope 1 and 2 emissions 85% by 2030 and Scope 3 25% also by 2030. BorgWarner’s Charging Forward strategy is expected to play a pivotal role in reducing Scope 3 emissions as the portfolio shifts towards our e-mobility products. We will also focus on how we design and purchase those products and components. From a design perspective, we’re expanding our circularity efforts and placing a greater emphasis on lightweighting. Within the supply chain, BorgWarner is working to enhance our green material sourcing and supplier contribution to our goals.

We’re proud to have our targets validated by the SBTi as it affirms the direction we are headed and the positive impact we’re making in furthering our vision of a clean, energy-efficient world. Now let’s look at some new eProduct awards on Slide 7. First, BorgWarner will supply a bidirectional 800-volt onboard charger to a major North American OEM. This onboard charger will be on premium passenger car BEV platforms with an expected SOP in early 2027. The technology leverages BorgWarner’s silicon carbide power switches for improved efficiency and delivers superior power density and safety compliance. This is a big accomplishment for the BorgWarner team, highlighting our first major eProduct win with this OEM and also our first onboard charger win in North America.

Second, at the IAA in September, we disclosed that BorgWarner will supply silicon carbide inverters for Volvo cars next-generation electric vehicles. Next, BorgWarner entered into an agreement with a major global OEM to supply its 400-volt high-voltage cooling meters for the automakers’ European light vehicle program. We anticipate the start of production in 2026. This business win marks the second recent contract secured with this global OEM over the course of just a few months with wins spanning different regions. Finally, a premium European OEM has awarded BorgWarner a program to supply combined inverter and DC/DC converter for use in the customers’ always drive B and C segment hybrid applications. Production of this program is expected to start in 2025.

By combining the inverter and converter elements, we can manage both the electric drive and the accessory systems of an electrified vehicle, in this case a hybrid, in a lighter, smaller and more cost-effective package. Our knowledge, scale and production experience on inverters, DC/DC converters and onboard chargers or what I would call power conversion technology is a key enabler for BorgWarner to be adding value to our customers by combining these technologies into efficient system packages. Now let’s touch on our eProduct sales outlook on Slide 8. Today, we’re reducing our 2023 eProduct sales outlook by about $300 million. The 2 largest drivers of the adjustments are launch delays and forecasted slower volume ramp-ups from customers. We now expect eProduct sales to increase about 40% year-over-year.

As we have seen these continuing near-term pressures on electrified vehicle production in the marketplace, we have taken the opportunity to reassess what that might mean looking out over the next few years. Looking through that lens, we do believe this has the potential to impact industry-wide new energy vehicle production over the next couple of years. As such, we now expect our eProduct sales to be in the range of $4.5 billion to $5 billion in 2025. As we have looked at the situation program by program, it is our view that the headwinds we are seeing are likely to be short to midterm in nature. As we look further out, we continue to believe that the long-term trends towards electrification remains strong. That is why our view of overall industry penetration of electrified propulsion is unchanged looking out to 2027.

I would make the following 3 additional observations. First, we have seen no meaningful changes in the world of quoting activity from our customers. We continue to secure new business awards that are very much supportive of our long-term revenue objective. The pace of new business development has not slowed. Second, our estimated midterm exposure to eProduct customers and regions is well diversified. As we are in the early stages of eProduct revenue growth in 2023, BorgWarner does tend to be currently more exposed to a handful of important launches and ramp-ups of customer products, particularly in China. As we look further out and announce many additional programs over the next 2 years, we expect to benefit from more diversity in the portfolio.

Our 2027 eProduct revenue expectations are fairly balanced across customers, across regions as well as across vehicle sizes. Third, we believe our long-term profitability objectives are still intact. As we’ve told you previously, the biggest driver of our improving eProduct profitability is our ability to leverage the rapidly increasing scale of the business. Since that ramp-up is not happening as quickly as we previously anticipated, it means the path to our ePropulsion segment achieving break-even margin is slightly delayed. As we look ahead to next year, we will assess what, if any, actions are necessary to appropriately balance near-term margins relative to our long-term objectives. Regardless, break-even margins remain in sight and our 2027 outlook remains unchanged, both from a revenue perspective and a profitability perspective.

The takeaways from today are these: BorgWarner’s third quarter results were strong. We delivered strong organic growth and margin performance. As we wrap up 2023, we expect to finish with another year of strong top line growth, top-quartile margins and solid free cash flow generation. As we look at our Charging Forward strategy, which is focused on aggressively positioning the company to win in the world of electrification, we do see some near-term, industry-wide challenges that we will manage through. We remain convinced in the long-term prospects for electrification and believe we are successfully executing on our strategy in that regard. I have stated on multiple occasions that the industry growth in BEV and hybrid will not be a straight line.

The near-term volatility, while frustrating, is not entirely surprising given the magnitude of the industry shift. As we highlighted in our Investor Day in June and as you can see evidenced in our Q3 results and full year guidance, we believe that we have structured our portfolio to be resilient and to deliver strong earnings under wide range of BEV and hybrid penetration scenarios. That is true today, and we fully expect that this will also be true going forward. With that, I will turn the call over to Kevin.

Kevin Nowlan: Thank you, Fred, and good morning, everyone. Let’s dive right into the third quarter results by turning to Slide 9, where you can see our year-over-year revenue walk. Last year’s Q3 revenue from continuing operations was just over $3.2 billion. You can see that the weakening U.S. dollar drove a year-over-year increase in revenue of approximately 1% or $44 million. Then you can see the increase in our organic revenue close to 11% year-over-year. We’re particularly pleased that as we look at this growth, it’s being driven by eProduct-related growth across all major geographies in which we operate. Finally, the acquisitions of Rhombus and SSE added $8 million to revenue year-over-year. The sum of all this was just over $3.6 billion of revenue in Q3.

Turning to Slide 10, you can see our earnings and cash flow performance for the quarter. Our third quarter adjusted operating income was $349 million, equating to a 9.6% margin. That compares to adjusted operating income for continuing operations of $305 million or 9.5% from a year ago. On a comparable basis, excluding the impact of foreign exchange and the impact of M&A, adjusted operating income increased $46 million on $344 million of higher sales. This performance includes a planned eProduct-related R&D increase of $13 million. Excluding this higher ER&D investment, we converted at approximately 17% on our additional sales. As it relates to customer recoveries of inflationary cost impacts, we were able to finalize full year agreements during the third quarter with nearly all of our major customers.

Those third quarter customer recoveries, net of material cost inflation from our suppliers, did not have a significant year-over-year impact on our adjusted earnings. Our adjusted EPS from continuing operations improved by $0.18 compared to a year ago by the increase in our adjusted operating income and lower effective tax rate. Finally, free cash flow generation from continuing operations was $36 million during the third quarter. Now let’s take a look at our full year outlook on Slide 11. Our guidance now assumes that weaker foreign currencies will reduce revenue by $110 million in 2023. This is a headwind of $75 million in revenue versus our prior guidance with the Chinese yuan and the euro being the largest drivers of the change in our outlook.

Second, we expect organic growth of approximately 12% to 14% year-over-year compared to our prior guidance of 12% to 15%. The narrowing of this outlook incorporates both an increasing industry production outlook as well as our updated outlook for eProduct revenue. As Fred mentioned earlier, we’re now expecting eProduct revenue of between $2.0 billion and $2.1 billion in 2023, which is up from the approximately $1.5 billion we generated in 2022, but that’s down from our prior guidance of $2.3 billion to $2.4 billion. That decline is due to a number of customer programs that include our ePropulsion products experiencing launch delays or ramping up more slowly. Finally, the Santroll, Rhombus and SSE acquisitions are expected to add approximately $63 million to 2023 revenue.

Based on these expectations, we’re projecting total 2023 revenue in the range of $14.1 billion to $14.3 billion, which compares to our prior guidance of $14.2 billion to $14.6 billion. Let’s switch to margin. We expect our full year adjusted operating margin to be in the range of 9.4% to 9.6%, which compares to our prior guidance of 9.2% to 9.6% and our 2022 margin of 9.3%. As it relates to R&D, our full year 2023 guidance continues to anticipate a $60 million to $70 million increase in eProduct-related R&D. Despite the near-term eProduct revenue headwinds, we continue to see significant new award and quote activity. Therefore, we’re investing in eProduct-related R&D to support those growth opportunities consistent with the plan we outlined at the beginning of the year.

Excluding the impact of this planned increase in eProduct-related R&D, our 2023 margin outlook contemplates the business delivering full year incrementals in the high teens. Based on this revenue and margin outlook, we’re expecting full year adjusted EPS from continuing operations in the range of $3.60 to $3.80 per diluted share. Turning to free cash flow. We expect that we’ll deliver free cash flow from continuing operations in the range of $400 million to $450 million for the full year. This compares to our prior guidance of $400 million to $500 million as we expect capital spending to come in at around $800 million, in line with the high end of our prior CapEx guidance range. Our cash flow guidance contemplates a strong Q4, which is normal for us due to seasonality and traditionally strong working capital performance.

But in addition to those typical trends and similar to last year, we expect to collect in Q4 a significant portion of the full year customer inflation recoveries that we’ve negotiated to date but have not yet collected. That’s our 2023 outlook. Turning to Slide 12. I wanted to provide an update on the company’s overall leverage and liquidity profile. As you know, we’ve traditionally operated with a gross debt to adjusted EBITDA ratio below 2.0x, which is where we think the business should operate and it’s where we were operating leading up to the spin-off of PHINIA. However, when we executed the spin-off of PHINIA in early July, we lost their adjusted EBITDA to support our debt going forward. That effectively increased our gross leverage ratio to 2.3x on a pro forma basis excluding PHINIA.

With that in mind, during the third quarter, we used the PHINIA spin-off proceeds to execute a tender offer for $438 million of our 2025 notes. By executing the tender offer, we were able to reduce the company’s gross debt to adjusted EBITDA ratio back down to 2x. With respect to liquidity, during the third quarter, we extended the maturity of our undrawn $2 billion revolving credit facility by 5 years to September 2028. We’re not only pleased with the fact that we were able to renew the facility but that we were able to do so with pricing spreads unchanged versus the prior facility. That speaks to BorgWarner’s financial strength. Both of these transactions were important steps in maintaining the company’s strong balance sheet and liquidity position, which gives us confidence in continuing to make the necessary organic and inorganic investments that support our expected future profitable growth.

So let me summarize my financial remarks. Overall, our third quarter financial results were strong. We achieved organic growth of close to 11% year-over-year. We generated 9.6% adjusted operating margin based on a 17% conversion on incremental revenue excluding higher ER&D. And we delivered strong year-over-year growth in bottom line adjusted EPS. As we look beyond 2023, we continue to expect to deliver strong organic growth despite near-term volatility in the global NEV markets, to drive improved profitability in our eProducts businesses as we leverage our top line growth and prudently manage costs, and to continue to leverage the resiliency in our financial performance and our balance sheet to make the necessary investments to grow long-term earnings under a wide range of BEV market scenarios.

With that, I’d like to turn the call back over to Pat.

Patrick Nolan: Thank you, Kevin. Leo, we’re ready to open up for questions.

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Q&A Session

Operator: [Operator Instructions]. Your first question comes from Colin Langan with Wells Fargo.

Colin Langan: If I look at the full year guidance, it implies a pretty low margin or a step down in margins into Q4 of around 9.2%. Anything unusual going on in Q4 driving that weaker margin? Should we be thinking about that sort of run rate into next year? Or is this something more one-off going on in Q4?

Kevin Nowlan: No. I mean as we look at it overall, we’re pleased with the fact that our margin percentage on a full year basis we took the bottom end of the guide up and held the top end of the guide despite some of the eProduct revenue pressure. As you look at it, what it implies at the high end of the range is Q4 is right in line with where we’ve been on a year-to-date basis at 9.6%. And at the bottom end of the range, we’re seeing effectively a sequential decline in revenue, and we’re just generating negative conversion on that. So I don’t think there’s anything out of the ordinary on that.

Colin Langan: Got it. And there’s obviously a lot of focus the last couple of weeks off of the EV delays. And I do remember from your Investor Day, you highlighted, and I think it was more in the 2030 time frame, that you’re somewhat derisked because if EV penetration was a bit higher, you’d have higher sales but lower margin. And if it was lower, you’d have lower sales but higher margin. And dollar-wise, that might be similar. How should we think about that more near term? I mean, are you — can you — is there a good hedge offset? Or with all the engineering that’s required ahead of these EV launches, that’s going to be a bit of a burden if the EV volumes are pulled back a bit in the near term?

Frederic Lissalde: Colin, I think you’re right. The portfolio is resilient, and that’s exactly why we’ve structured it that way. And that’s what we presented in the Capital Market Day. And it’s resilient under a wide range of scenario. And I think what you see also this year is an example of what happens, E going down and and actually margin is slightly going up. And you see that the top line is somehow resilient too. So this is absolutely the purpose of the portfolio the way it’s laid out. We have a great portfolio to enable growth in E. But if you see a slowdown, the products that we have in combustions are going to generate proceeds, cash and earnings.

Operator: Your next question comes from John Murphy with Bank of America.

John Murphy: Maybe I can follow up on Tom’s question in 3 kind of distinct ways. If we look at Slide 8, just curious why you’ve taken down ’23 and ’25 and maybe not reconsider ’27. And then also, as we look at this, Fred, to your point, I mean, you guys have set yourself up well to deal with the volatility here. So kudos to you for doing that. But is there an opportunity potentially on the ICE side of the business to maybe get better economics because the automakers are meeting you in this direction of investing in EV products? Then also on the EV product side, is there — can you just talk about sort of the structure of those contracts, their buying guarantees? If they’re widely missing or pushing programs out, are you protected in some way, shape or form on those contracts?

Frederic Lissalde: A lot of questions, John, in one question. Let me take it in pieces. So first, ’23, ’25, ’27, right? That’s a bit of your question. So ’23, when you look at the reduction, it’s mostly in our ePropulsion segment. It’s coming from, as you mentioned, timing of launches and volume reduction, volume reduction in ramp-up. And since we’re launching a lot of new products, a delay has a big impact in the quarter and a delay — and a ramp-up change has a big impact in the quarter. We continue to see volume pressures. But if you take a step back, in fact, it was still growing 40% year-over-year. So that allows us to. When you look at beyond 2023, we’ve looked at program by program looking at ’25. And from what I remember, we announced 29 programs in June, and we booked more programs.

seeing a lot of programs. What we see potential delays and downsides enjoy ’22 to ’23. In ’27, we have a strong new business that will be very comfortable with p ’25, the launching ’25, ’26, ’27. And so we see a path to $10 billion. But also we’ve structured the portfolio to be resilient under a wide range of scenario. Again, when you look at the CAGR, ’25 to ’27, if you take out $1.7 billion of acquisition that we’ve also taken into account in the $10 billion, CAGR is about 35%, which is a little lower than ’22 to ’23. That’s why we feel comfortable about the fact that the long-term prospect is unchanged. Yes, I think you had a question…

Kevin Nowlan: I can talk about the others. I think you had a question about — on the foundational and if there’s a longer tail on that, are there opportunities there. I think you were maybe alluding to pricing. I mean, overall, our objective as part of Charging Forward 2027 is to sustain that strong margin profile we’ve had in the business. And that means we look at all aspects of the P&L, whether it’s on the cost side or the pricing side to make sure that we’re driving towards that. And so we’ll continue to work with our suppliers, we’ll work with our customers to make sure that we’re executing successfully on that. And then the last thing I think you asked about was on EV contracts and how they’re structured, particularly in light of some of these volume shortfalls.

As we’ve talked about in the past, one of the things that we’ve made at a particular area of focus when we book new business on E because of a lot of the uncertainty around the ramp-up of E programs is to make sure that we put volume clauses in those agreements. And those volume clauses traditionally work like they’ve worked historically for us in a way where if volumes are outside a certain band, then there is a discussion that happens between us and our customer about how we ensure that we recoup investment or pricing or some other adjustment to make sure that we’re not out for the fact that the revenue came in significantly short. So as we head into 2024, we’re going through our planning process right now. You can imagine that’s something we’re thinking about.

Operator: Your next question comes from Emmanuel Rosner with Deutsche Bank.

Emmanuel Rosner: One follow-up on the ramp-up in eProduct revenue — maybe actually a couple of follow-ups, if I may. First of all, how did you go about the assumptions that are now underpinning your new revenue walk? I assume, obviously, for 2023, you have direct production schedules and commentary from the automakers. But as you move into sort of like mid-decade, is this sort of like a top-down approach or like EV adoption or penetration curve or assumptions that you could share with us? Or how do you compare with previous one?

Frederic Lissalde: Emmanuel, so for 2023, it’s obviously linked to EDIs and schedules and detailed discussions that we have with our customers. It’s the same for ’25. ’25 is a bottom-up line-by-line analysis of programs by programs and launch timing accuracy and discussion with our customers. ’25 revenue is just around the corner. So we know pretty well, and we see pretty well through when the customers are going to actually launch those programs and the impact that this has on 2025.

Emmanuel Rosner: I guess, if I could follow up on this, and I do have another question after that, but just following on this one. I’m struck by the fact that some of the large North American OEM, for example, have obviously pushed out meaningfully some volumes in the near term and certainly next year as well being pushed out. But at the same time, in some cases, sort of like pretty forcefully sort of left unchanged like for a some of the midterm or mid-decade targets. And so I’m sort of like wondering, how could you give investors confidence around the amount of derisking that you have now embedded in your sort of like mid-decade revised outlook?