BorgWarner Inc. (NYSE:BWA) Q4 2022 Earnings Call Transcript

BorgWarner Inc. (NYSE:BWA) Q4 2022 Earnings Call Transcript February 9, 2023

Patrick Nolan: This is Patrick Nolan. I apologize about the technical difficulties we’ve had this morning, but we’re in a kickoff today’s call. So we have issued our press release earlier this morning. It’s posted on our website, borgwarner.com, on our homepage and on our Investor Relations home page. Before we begin, I to inform in joining this call, we may make forward-looking statements which involves 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 period. When you hear us say on a comparable basis, that is excluding the impact of FX, net M&A and other noncomparable items.

And here 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 also refer to our growth compared to on market. when he say market, that means the change in light vehicle and commercial vehicle production weighted for our geographic exposure. Please note that we’ve posted an 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 morning, everyone. I have a bit of an allergic reaction this morning impacting my speech. So Kevin will cover the prepared remarks. I’ll stay with you and answer the questions. Kevin?

Kevin Nowlan: All right. Thanks, Fred, and good morning, everyone. We’re pleased to share our results for 2022 and provide an overall company update, starting on Slide 5. We continue to be very proud of the strength of our sales relative to the overall industry. With about $15.8 billion in sales, we were up approximately 14% compared to our market, which was up a little less than 4%. Importantly, our BEV-related sales contributed meaningfully to this growth. We’re also pleased with our solid margin performance, which we delivered despite the significant production volatility and inflationary headwinds that we faced during 2022. This performance was achieved while continuing to significantly increase our R&D investment to support the continued growth in our e-product portfolio.

We also delivered record free cash flow which allowed us to continue to make inorganic investments that support our future while at the same time returning cash to our shareholders. Beyond our near-term results, we continue to drive our long-term positioning during the quarter. We took several leading steps in our sustainability efforts. I’ll detail those more in just a moment. We made a significant advancement in charging forward with the announcement of the planned separation of the Fuel Systems and Aftermarket segments. And we also secured multiple new electrification program awards since our last earnings report. Next, on Slide 6, I’d like to give you more color with respect to our progress in our SBTi targets. In mid-December, BorgWarner announced its commitment to reduce its absolute Scope 3 emissions by at least 25% by 2031 from a 2021 baseline.

The Scope 3 target along with our previously announced target to achieve 85% absolute Scope 1 and Scope 2 emissions reductions by 2030 was formally submitted for validation to SBTi. These science-based targets align with charging forward or accelerated path through electrification by aiming to achieve a net 0 carbon emission future for all. We’ve made some meaningful progress in 2022 toward achieving our Scope 1 and 2 emissions targets as we had tied employee bonus opportunities across our global operations to reducing energy intensity while also promoting energy management certification and the procurement of renewable energy. To meet the Scope 3 target, BorgWarner intends to focus its efforts on a number of actions including transitioning the product portfolio to electrification, increasing content of recyclable remanufactured material, reducing product weight and driving sustainable raw material selection.

We’ll also be working with our supply base to do the same. Next, on Slide 7, I’d like to summarize the planned separation of our fuel systems and aftermarket segments, which we refer to as NewCo. We announced this planned separation in December as we believe that now is the right time to separate these businesses and unlock shareholder value. For NewCo, we’ve driven significant margin improvement over the last couple of years despite the challenging industry environment. From a product leadership standpoint, we solidified NewCo’s position in the commercial vehicle segment, including with hydrogen injection in the passenger car segment with our cutting-edge GDI technologies and in the aftermarket business. We believe these things position NewCo well for success as a stand-alone public company.

For BorgWarner, we believe the intended separation accelerates our Charging Forward strategy and focuses all of our energy towards electrified propulsion. It enhances all of our management attention, our focus and our flexibility to pursue attractive EV investments and supports our vision of a clean, energy-efficient world. The intended separation will allow each company to pursue its own strategies with an overarching focus on maximizing the value opportunity for our shareholders. The teams are progressing well through the various work streams and we plan to provide updates as appropriate. We continue to expect the intended separation to close in late 2023. Now let’s look at some new electrification awards on Slide 8. First, BorgWarner will supply a major German vehicle manufacturer with innovative battery cooling plates for the OEM’s next-generation electric vehicles in Europe and the United States.

This is our first award for this new organically developed product with an expected launch in 2025. Compared to alternative solutions, the BorgWarner cooling places provide greater cooling capacity within a smaller installation space as well as reduced weight and cost. We believe that as a global market leader in exhaust gas recirculation cooler technology BorgWarner’s expertise and thermal management and the associated manufacturing processes positions the company to be an ideal pioneer of new developments for the battery cooling market. On the right side of the slide, you can see that we’re announcing a sizable expansion of our silicon carbide inverter business with a top global OEM with an 800-volt award. After partnering with this car manufacturing on a 400-volt inverter product, we’re now being sourced to launch two new 800-volt variants in 2025, 250 kilowatts for an all-wheel drive crossover utility vehicle and a 350-kilowatt module for the OEMs performance vehicles.

Photo by Erik Mclean on Unsplash

This expanded business strengthens our position as one of the strategic inverter suppliers for this long-standing customer as that customer transitions to the next phase of its BEV strategy. As you can see, we’ve made further progress toward our charging forward objectives. So let’s look at what this means in our progress report on Slide 9. Starting first with organic electric vehicle sales growth. With the awards secured as of this call, we now have pure BEV programs that we estimate accounts for about $3 billion of booked sales in 2025. Of note, this estimate reflects about a $150 million headwind versus our prior disclosure, stemming from an update to reflect the FX rates underlying our 2023 guidance. This FX headwind was partially offset by the new business wins I discussed on the prior slide.

Turning to M&A. We’ve now completed or announced 5 acquisitions since the start of Charging Forward; Akasol, Santroll, Rhombus, SSE and Drivetek. Based on our due diligence, we believe those businesses will generate about $1.3 billion of EV-related sales in 2025. This is higher than our previous outlook based on our revised projections for Akasol, which is seeing a faster ramp-up in sales than we initially anticipated. But we’re not done here. We continue to expect that we’ll execute additional acquisitions and are actively engaged with a handful of potential targets that we think will enhance various parts of our EV portfolio. And finally, the planned separation of NewCo will address the third pillar of charging forward for which we set an original goal to complete about $3.5 billion in dispositions by 2025.

With all that we’ve accomplished in the last couple of years, we believe we’re already on track to achieve about $4.3 billion of pure electric vehicle sales in 2025 and we believe it puts us within striking distance of our $4.5 billion EV sales target for 2025. Now let’s move into the financials, starting on Slide 10 for a look at our year-over-year revenue walk for Q4. After adjusting for the disposition of our Water Valley facility, last year’s Q4 revenue was just over $3.6 billion. You can see that the strengthening US dollar drove a year-over-year decrease in revenue of over 8% or approximately $307 million. Then you can see the increase in our organic revenue about 21% year-over-year. That compares to a less than 1% increase in weighted average market production, which means we delivered another quarter of strong outperformance.

The sum of all this was just over $4.1 billion of revenue in Q4, a strong finish to the year. Turning to Slide 11. You can see our earnings and cash flow performance for the quarter. Our fourth quarter adjusted operating income was $428 million, equating to a 10.4% margin. That compares to adjusted operating income of $398 million or 10.9% from a year ago. On a comparable basis, excluding the impact of foreign exchange and the impact of M&A, adjusted operating income increased $74 million on $769 million of higher sales. The biggest positive driver of this performance was that we converted at approximately 15% on our additional sales. But this conversion was partially offset by our planned increase in e-products R&D. In Q4, we increased these R&D investments by $38 million relative to last year.

Our adjusted EPS improved by $0.20 in the fourth quarter driven by the improvement in our adjusted operating income and a nearly 400 basis points lower year-over-year tax rate. That lower tax rate was driven by a favorable mix of earnings across taxing jurisdictions, qualifying for more favorable tax rates in certain jurisdictions and the impact of ongoing tax structuring initiatives, all of which we believe should contribute to a lower tax rate going forward than what we’ve experienced over the last few years. And finally, free cash flow. We generated $670 million plus of positive free cash flow during Q4. The year-over-year increase was driven by 3 things: the improvement in operating income, the timing of collection of a meaningful amount of inflationary price recoveries from our customers and the nonrecurrence of a onetime $130 million warranty payment to a customer last year.

Let’s now turn to Slide 12, where you can see our perspective on global industry production for 2023. When you look at this slide, you can see that our market assumptions continue to contemplate the types of macro uncertainty we’ve been experiencing over the last few years. With that background in mind, we expect our global weighted light and commercial vehicle markets to be flat to up 3% this year. Looking at this by region, we’re planning for our weighted North American markets to be up about 2% to 5%. In Europe, we expect our blended market to be up 1% to down 2% year-over-year. And in China, we expect the overall market to be roughly flat to up 3%. Now let’s take a look at our full year outlook on Slide 13. First, it’s important to note that our guidance assumes an expected full year headwind from weaker foreign currencies of $285 million.

Second, as I previously mentioned, we expect our end markets to be flat to up 3% for the year, which contributes to the organic net sales change you see on the slide. But more important than that slight growth in end markets, we expect our revenue to continue to grow well in excess of industry production driven by new business launches and higher electric vehicle revenue. In fact, in 2023, we’re expecting to deliver between $1.5 billion and $1.8 billion in EV revenue which is up significantly from the $870 million we generated in 2022. Finally, the Santroll and Rhombus acquisitions are expected to add approximately $35 million to 2023 revenue. Based on these assumptions, we’re projecting total 2023 revenue in the range of $16.7 billion to $17.5 billion, which equates to organic growth of approximately 7% to 12%.

Switching to margin. We expect our full year adjusted operating margin to be in the range of 10.0% to 10.4% compared to our 2022 margin of 10.1%. We do expect some variation in the margin level across the quarters in 2023. Specifically, we believe that Q1 is likely to be the weakest reported margin during the year. as we work with our customers and suppliers on finalizing the extent to which inflationary pricing actions negotiated in 2022 carry over into 2023. In the end, our current expectations are that the year-over-year impact of inflationary pressures on full year margins is likely to be negligible. However, we could see some negative impact in Q1. As it relates to R&D, our full year 2023 guidance anticipates a $60 million to $70 million increase in e products-related R&D investment.

With our continued success securing new electrified business wins, we’re continuing to lean forward and invest more in R&D to support our eProducts portfolio. But importantly, as you see on the slide, the year-over-year increase in 2023 is expected to be lower than the year-over-year increase in 2022. Excluding the impact of this increase in eProducts related to R&D, our 2023 margin outlook contemplates the business delivering full year incrementals in the mid-teens, which we view as a solid conversion given the amount of product launches and ramp-ups occurring this year. Based on this revenue and margin outlook, we’re expecting full year adjusted EPS of $4.50 to $5 per diluted share. This EPS guidance contemplates two slight headwinds relative to 2022.

First, we expect an effective tax rate of approximately 25%, up a couple of percentage points relative to last year. However, that rate remains far lower than what we’ve experienced in recent years, and we think it’s a rate that’s likely to be sustainable on a go-forward basis. Second, our EPS guidance assumes a $0.13 per share negative impact coming from higher net pension expense as a result of higher discount rates. Turning to free cash flow. We expect it will deliver free cash flow in the range of $550 million to $650 million for the full year. This cash flow outlook includes a onetime cash cost of approximately $150 million related to the intended spin-off of our Fuel Systems and Aftermarket businesses, arising from outside adviser fees, cash tax payments to facilitate the separation and IT costs to create a stand-alone IT environment for NewCo. Excluding these onetime costs, our cash flow guidance would be $700 million to $800 million which is only slightly lower than the record free cash flow of $846 million we generated in 2022.

That’s our 2023 outlook. So let me summarize this morning’s remarks. Overall, we delivered strong performance in 2022 despite a volatile end market environment and significant inflation headwinds. In the face of this environment, we outgrew the market significantly. We maintained our adjusted operating margins above 10% by delivering incremental margins on our higher sales and successfully completing commercial negotiations with our customers. while also investing $150 million more in R&D to support the future growth of our e-business. And finally, we delivered a record year of free cash flow. As we continue to successfully manage the present, we were also continuing to successfully deliver on the future by making significant progress on our charging forward plan.

Now as we look ahead to 2023, we’ll be keenly focused on continuing to manage the present by sustaining strong high single-digit revenue outperformance compared to industry volumes and driving conversion on this revenue growth, successfully executing the intended spin-off of our Fuel Systems and Aftermarket businesses, and continuing to make disciplined investments, both organic and inorganic, that will help secure our growth and financial strength long into the future. With that, I’d like to turn the call back over to Pat.

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

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Q&A Session

Operator: And we’ll take our first question from Colin Langan with Wells Fargo. Your line is open.

Colin Langan: Just a little follow-up on the comments on inflationary costs. I think you said the guidance implies a negligible impact. I mean so far, it seems like other suppliers have kind of guided to pretty large headwinds. And particularly around labor. Any color on the underlying growth impact that you’re expecting that you’ll need to get price concessions to offset? And any color why you’re not seeing as big of a factor are the suppliers is just the business structure or some other benefits?

Kevin Nowlan: Yes. I think our expectation right now is that we’re going to continue to manage inflationary levels at the way we exited 2022. So to the extent that we continue to see elevated levels of inflation from the supply base, we would expect to continue to maintain the pricing in place with our customers on a go-forward basis to mitigate that. So that’s really what’s underlying the guidance.

Colin Langan: And based on your comments, it sounds like you’re really just renegotiating what you’ve gotten last year? Or are you seeing more increases in the these costs this year too or no?

Kevin Nowlan: I think we’re expecting that we’re going to enter the year and the focus of the negotiations last year was really about how we are 2022, and then we essentially align with the customer base that we would look ahead to 2023 as we were entering the new year and see what types of pricing levels were appropriate to continue to mitigate those impacts. And so as you can imagine, we’ll have those discussions here as we enter the new year about the pricing and cost environment.

Colin Langan: Got it. And your outlook based on your market guidance, it looks like it’s about 8% over market. And I believe you used to historically talk about more 4% to 5%. So what’s driving the strong growth over market this year? Is that sustainable? How should we think about it going forward?

Frederic Lissalde: Yes, Colin, the outgrowth next year is — you’re right around midpoint of 8%, and we’re very proud of that. About 2/3 of it is be products and other products for plug-in hybrids. So next year, we’ll be between $1.5 billion to $1.8 billion of fuel BEV revenue which is approaching 10% of our revenue. I’m very proud about this acceleration.

Colin Langan: And is there anything onetime in nature in the growth for this year?

Frederic Lissalde: Not at all. This confirms that we are on track, marching towards our target of $4.5 billion of fuel BEV revenue in 2025. And you see a 2x increase this year versus prior year, and that’s pretty much part of the plan.

Operator: We’ll take our next question from Emmanuel Rosner with Deutsche Bank.

Emmanuel Rosner: I was hoping you could give us a little bit more color around the year-over-year walk and puts and takes in terms of your margin outlook. And as you mentioned yourself, the at midpoint, it’s basically just slightly better than flat sort of like operating margin despite what seems to be incredibly strong organic growth and I guess growth overall. I understand the R&D, so that going up a bit, but anything else going on? And then can you just maybe talk about R&D overall? Like are you offsetting some of that R&D increase by cutting back on R&D? Or is that sort of like how much the full R&D will be going up by?