BorgWarner Inc (BWA) — Q2 2016 Earnings Call Transcript

Thank you, Chrissie. Good morning and thank you all for joining us. We issued our earnings release this morning at around 8:00 A.M. Eastern Time. It's posted on our website, borgwarner.com, on our Investor Relations home page. A replay of today's conference call will be available through August 11. The dial-in number for that replay is 800-585-8367. You'll need the conference ID, which is 26650635 or you can listen to the replay on our website. With regard to our investor relations calendar, we will be attending the following conferences between now and our next earnings release. The JPMorgan Automotive Conference in New York on August 9. The RBC Capital Global Industrial Conference in Las Vegas on September 8. The Morgan Stanley Laguna conference on September 15. Finally, I would like to cordially invite the investment community to our Investor Day in Auburn Hills on September 7. We will be presenting new information regarding our views on the future of the industry and our role in it. We will have product displays to demonstrate some of our newest technologies and vehicles available for you to experience these technologies firsthand. Our senior leadership team will be present and available to answer questions throughout the event. We've set up an RSVP link for you to confirm your attendance. You can find the link in a press release that we sent out on June 13 or send me an email and I’ll get you the information. Please join us for what we expect to be the most meaningful investor event in our history. Now, back to today’s earnings release. 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. Now, moving on to our results, James Verrier, President and CEO, will comment on the industry and provide a high-level overview of our results and expectations for 2016 and Ron Hundzinski, our CFO, will discuss the details of our results and guidance. Please note that we have posted an earnings call presentation to the IR page of the website. You'll find the link at the events and presentation section beneath the notice for this conference call. We encourage you to follow along with these charts during our discussion of our results. With that, I will turn it over to James.

Thank you, Ken, and welcome to everybody. As Ken said, Ron and I are really pleased to share our results from the second quarter with you and also talk about what the rest of the year looks like. What I’d like to do is just start and make a few high-level comments on some of the bigger picture perspective as we look out into the macro industry environment. The theme I would highlight is the notion of uncertainty out there in the world, whether that’s some of the civil unrest issues that we see particularly in Europe, tense political environments recently in Turkey and the Middle East, pending U.S. elections, and of course, the Brexit vote. All of that creates a sense of uncertainty at a macro view. However, when I look at the world of autos, we’ve generally seen a fairly steady environment and things playing out pretty much as we had expected. As we look forward, I think that macro uncertainty will continue, but I do see the auto sector remaining stable. From a light-vehicle perspective, from a BorgWarner viewpoint, we are well aligned with IHS. We see the China market growing in the mid single-digit range, around 5% to 6%. We see Europe in a 2% to 3% growth range, and we see the U.S. in that same 2% to 3% range of growth for light-vehicle production. We acknowledge that the U.S. plateau effect is on the horizon, and we are very mindful of that. From a commercial vehicle point of view, the space remains challenged and there is really not a lot of growth globally, with persistent weakness around off-road segments. Some of this translates into several new programs currently under review. So, I would characterize the North American market as one to watch closely, including how the plateau will play out and how inventory and production levels are managed. VW remains a critical customer, and we must monitor VW market share globally. We are also paying attention to the potential impacts of volumes in Europe given Brexit, along with the commercial vehicle weaknesses. Overall, we believe we are on track for our guidance and remain optimistic. The pull for fuel economy and emissions regulations remains unchanged. We also see that the shift towards electrification continues and we are deeply engaged with customers globally to discuss solutions concerning additional electrification. Our quoting activity remains strong, and I am pleased with our engagement on new technology aligned with electrification. With that in mind, we look forward to showcasing our advancements at our Investor Day on September 7. To summarize Q2, we had a remarkable quarter. Sales reached $2.3 billion, up 3.5% excluding FX and Remy, with strong operating performance. Regionally, we saw stronger growth in North America, particularly in Korea, balanced with expected lower growth in Europe and China. EPS was $0.84 a share, excluding non-comparables, and operating margin was 12.4%, which I would call impressive. On a segment basis, Engine sales were $1.4 billion, up about 2.8% when excluding currency. In Drivetrain, sales totaled $895 million, reflecting 5.4% growth after excluding currency and Remy, primarily driven by all-wheel drive sales in North America and Europe. For 2016, we have narrowed our guidance range to reflect an optimistic outlook, with major launches this year including Pentastar Engine, Ford Scorpion, Ford Super Duty, and GM Duramax. Although some launches may proceed slower than initially assumed, our guidance reflects anticipated performance. Going into the second half of the year, I believe our risks and opportunities are balanced. While we are watching challenges, we also see positive aspects ahead and we remain confident in our full-year guidance. The integration of Remy is progressing well, and we are excited about combining our technologies to create innovative products. Overall, we are optimistic about our growth trajectory and look forward to discussing more in the upcoming Investor Day. Let me turn it over to Ron.

Thank you, James, and good day everyone. Before I review the financial details, I'd like to highlight some key takeaways from the quarter. In summary, we saw solid growth, great operating performance, and a return to normal CapEx spending and free cash flow generation. As Ken mentioned, I will refer to a supplemental financial slide deck posted on our website, so I encourage you to follow along. Firstly, on a reported basis, which includes changes in sales due to market growth, pricing, net new business, foreign exchange, and the Remy acquisition, sales were up 14.6%. On a comparable basis, our sales grew by 3.5%, just above the midpoint of our guidance. The gross profit as a percentage of sales was 21.3% for the quarter, while on a comparable basis, the gross margin was 21.4%, up 30 basis points from the prior year. For SG&A, on a reported basis, it accounted for 8.7% of sales, and on a comparable basis, SG&A was 8.2% of sales, remaining flat compared to the same period last year. Now let’s evaluate operating income. In Q2 2016, the operating income excluding non-comparable items but including Remy was $288 million or 12.4% of sales. If we also exclude Remy’s $13 million contribution, operating income on a comparable basis was $275 million, or 13.2% of sales, a notable improvement. Incremental margin was 23% for the quarter, which is outstanding performance. In the Drivetrain segment, net sales were $895 million, including $240 million from Remy, reflecting 5.4% growth on a comparable basis driven by higher all-wheel drive sales. We generated $362 million in net cash from operating activities in the first half of the year, with capital spending at $235 million, which is down from a year ago, representing a return to normal spending levels. Our guidance for free cash flow generation remains between $400 million and $475 million for 2016. Regarding our 2016 guidance, we have raised the low end of our growth range to between 13.7% and 17.5% for the year, reflecting increased confidence in volume and launch assumptions. We expect the impact of currency to be less negative than previously anticipated. The operating income margin is projected to exceed 13% on a comparable basis and remain above 12% including Remy. Overall, we are pleased with the results and outlook for the year, and I would now like to turn the call back to Ken.

Thanks, Ron. We are now going to move to the Q&A portion of the call. Chrissie, could you please remind everyone of the Q&A procedure?

Hi, good morning everyone.

Good morning, Rich.

Good morning, Rich.

So I just wanted to follow up on the launches here. So Ford indicated some issues on their end with Super Duty. You indicated that it launched on your end. Have you factored any potential incremental risk for the launches into the back half of the year?

Yes, I think, Rich, what I would say is, let me try and take it this way with you. As we started the year, we had a lot of launches and the approach we took was to factor in some judgment into the launch cadence by timing and volume. Based on first half performance and upcoming launches, we feel we’ve done a great job of building in those factors as we forecast.

Okay, and then, just a last quick one for me on the fuel efficiency standards. You indicated that the discussions are still very healthy around Powertrain. Any updated thoughts now that we have something on paper to debate?

Yes, I think you captured it well, Rich. There are modest changes expected. The essential standards remain unchanged. The demand for the types of technologies we offer to meet these standards remains robust. We expect some minor adjustments, but nothing that significantly alters the direction of the OEMs and our collaborative efforts.

Okay. Thanks, I’ll pass it on. I appreciate it.

Thanks.

Hi, this is Adam on the line for David.

Good morning, Adam.

Good morning.

I appreciate we are still several quarters away from you guys giving a bookings number, but as we sit here halfway through the year, can you give a little more color on the pace of new bookings over the past several years compared to 2015?

Yes, I think you are right. We will do our net new business update come January. Reflecting on the current backlog of new business, we have seen mid single-digit growth this year and we have so far delivered against that. We expect to see similar trends going into 2017 and 2018.

Great, and then on the strong incremental margins in the quarter driving your margin gains, how sustainable are these moving forward?

A good example, Adam. The Drivetrain segment has nearly 30% incremental margins due in part to the benefits from restructuring activities, which will moderate over time to normal mid-teen incremental margins. We still expect a bit of that in the remaining half of this year.

Great, and then lastly, from me, you have one of the largest European businesses across the auto supply space. Just wondering what you are hearing from your customers, post-Brexit?

Yes, I think, you are correct. The second quarter was strong across Europe for most OEMs. Year-to-date, it has been stable. However, we expect the UK car production will face some impact ahead, while BorgWarner’s exposure to the UK is minimal. We are monitoring the situation closely.

Great. Thanks, guys.

Thank you.

Thank you.

Hi, guys. Thanks so much. I wanted to go into detail on the Drivetrain margin, which was extremely strong for the quarter. Can you discuss some of the costs you cut and what to expect sequentially for the Drivetrain margin moving forward?

For the second quarter, the Drivetrain segment had a 29% incremental margin, attributable to restructuring activities. While we expect tailwinds from restructuring, increased SG&A spending will moderate margins.

Okay. Perfect. Thanks so much.

Thank you, Chris.

Thank you, Chris.

Yes, good morning.

Good morning, Brian.

On the third quarter, you have a fairly wide range of revenue estimates. Can you talk about the factors around that plus or minus 5% swing?

Good observation, Brian. The wide range is intentional due to variables like customer schedules and potential new conquest business. Customer shutdowns also add an element of uncertainty, so we've kept the range broad.

Okay, and what is the overall sentiment around bookings activity in the 48V and hybrid systems?

We are seeing a strong range of quote activity across various products related to EVs and hybrids. I can’t delve into specifics just yet due to customer approval processes, but you can expect to see robust activity.

And just to confirm, were your forecasts for Ford done with conservative assumptions, considering their inventory situation?

Yes, we’ve modeled for a sequential decrease in the second half. We have done well in the first half, and I think we’ve done a nice job of balancing customer relations and schedules.

Hi, this is Samik on for Ryan. Could you share what kind of revenues the Ford Super Duty launch represents for you?

Looking at North America, it’s around $400 million to $500 million. It’s important but manageable for BorgWarner, allowing us the opportunity to grow from a zero in conquest business.

What is your guidance for growth in the commercial vehicle markets in the second half, and what degree of risk do you see there?

We anticipate a very low growth environment for commercial vehicles. Class-8 builds in North America are low, and there is overall weak performance within this market segment.

I got a question about incremental margins in the Engine segment, they declined slightly in Q2. What’s driving that?

That is primarily driven by sequential increases in SG&A costs. Overall, we expect to see margins move back towards mid-teen averages.

Hi, good morning.

Good morning, Dave.

I'm unpacking the revenue growth of the two segments. Wondering what's driving the Drivetrain segment to grow faster than the Engine segment?

Commercial vehicle weakness significantly impacted the Engine segment, while Drivetrain saw growth driven by higher all-wheel drive sales. Furthermore, low growth in major Chinese markets affected Engine substantially.

Understood. Thank you very much for your details.

Your European production guide sounds stable despite uncertainties post-Brexit. Is that accurate?

Yes, you're correct. We believe the Brexit impact will unveil itself moving into 2017 but so far, there has been no detrimental effect noted.

Good morning, gentlemen.

Good morning, Brett.

Good morning, Brett.

Could you give specific examples of how Remy helps in electrification, and do you see an uptick in revenue growth?

Remy presents two growth avenues: existing tech sales through BorgWarner channels and expanding into electrification with hybrid vehicle solutions. Revenue growth from Remy is expected to align with BorgWarner levels, but specifics on timing and scale will be revealed in future updates.

Thank you very much. Regarding the equity and affiliates, I assume Japanese profitability was up year-to-year in the second quarter. How should we think about profits from other regions?

That line item tends to fluctuate and doesn’t move dramatically. Overall, production is positive, but FX variability can have notable effects, so I would say it's reasonable to expect a slight positive bias.

Good morning, guys. Could you indicate your content on the Super Duty truck and how it compares to the F-150?

The Super Duty represents a conquest business for us. It’s around $400 million to $500 million in potential content, which is less than the F-150, but significant nonetheless.

And also, how are the margins and cost performance relative to your expectations at Remy?

Remy’s profitability has improved, reflecting our expectations for operational synergies post-acquisition.

Have you observed any change in your relationships with OEMs regarding bidding or pricing due to the macro pressures?

Overall, we haven't noticed any significant changes in pricing or bidding, and our quoting activity remains strong. The technology engagement and advanced engineering programs continue as expected.

Could you comment on the M&A pipeline and what you're assuming for buybacks for the rest of the year?

Our primary focus is the successful integration of Remy, but we remain active in M&A, particularly in the power electronics space. On buybacks, we are trending towards the high end of our guidance for the year.

I would like to thank you all again for joining us. We expect to file our 10-Q before the end of the day, which will provide details on our results. If you have any follow-up questions about our earnings release, the matters discussed during this call, or our 10-Q, please direct them to me. Chrissie, please close out the call.