BorgWarner Inc (BWA) — Q4 2017 Earnings Call Transcript

Thank you, Sharon. Good morning everyone, and thank you all for joining us. We issued our earnings release at 6:30 AM Eastern Time. It's posted on our website, borgwarner.com, on our homepage and on our Investor Relations homepage. A replay of today's call will be available through February 22. The dial-in for that call is 855-859-2056, and the conference ID will be 9599159, or you can simply listen to the replay on our website. With regard to our investor relations calendar, we will be attending several conferences between now and our next earnings release. Please see the Events section of our Investor Relations homepage 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. Also, during today's presentation, we will highlight certain non-GAAP measures to provide a clear picture of how the core business performed and for comparison purposes to prior periods. When you hear us say on a comparable basis, that means excluding the impact of forex, net M&A, and other non-comparable items. When you hear us say adjusted, that means excluding non-comparable items. And finally, when you hear us say on a reported basis, that means U.S. GAAP. But now back to today's call. First, James Verrier, our President and CEO, will provide a high-level overview of our 2017 results and our recent backlog announcement. James will then comment on the industry and some of our recent product wins. He will conclude with the key items in our outlook and provide an update on our non-core emissions restructuring. Then Ron Hundzinski, our CFO, will discuss our results as well as our guidance. We've posted an earnings call presentation to the IR page of our website. You'll find the link in the Investor Presentation section beneath the notice for this call. We encourage you to follow along with these slides during our discussion today. With that, I'm pleased to hand it over to James.

Good morning, everybody. And, Pat, thanks for that introduction. As Pat said, Ron and I are pleased to share our results for 2017. And then, obviously, we're going to talk a lot about the outlook for 2018. What I thought I would do is start by sharing a few thoughts on 2017 as we wrap that year up. And for those of you that are following along, you can see some of that information on slide number 6 in the deck. The headline really is 2017 was a great year for BorgWarner, with $9.8 billion of sales, which is up 10.3% organically. And that's comparing to a light vehicle end market exposure for us of about 0.5% growth. Looking at that by segment, the Engine sales were $6.1 billion, which is a growth of 7.7% organically. And Drivetrain finished up at $3.8 billion, that's up almost 15% organically; a very strong growth on the Drivetrain side. Regionally, how it broke down: we had strong growth in China and North America, and our Europe light vehicle revenue was up mid-single digits. And that's pretty impressive when you consider some of the diesel and gas mix shift that happened. That light vehicle growth was supplemented also by positive revenue trends in commercial vehicles both on and off-road. Our EPS at $3.89 was up 19% year-over-year, which we're also very proud of. It's a very strong result for us. Away from the specific numbers, we had significant launches and wins across combustion, hybrid, and electric vehicles. We made a lot of progress across all three platforms, and we're expecting that to continue strongly in 2018 also. We also, towards the end of last year, completed the acquisition of Sevcon which was a really important move for us strategically because that increased our scale and capabilities in power electronics, which is really crucial for us. Also, last year, we shared our 2020 revenue outlook of $11.5 billion to $11.8 billion with continued margin improvements. As you can imagine, we're laser-focused on delivering that outlook. I also thought it would be good on slide 7 just to refresh everybody's view on the backlog. You remember last month in Detroit, we announced our net new business backlog of $2.0 billion to $2.4 billion for the period 2018 through 2020. And this new business supports our 2020 revenue outlook that I shared earlier. I think the most important aspect of the backlog from my view is we see a very good balance of growth across the product portfolio. We're deriving growth from many products. One of the ways that shows up, which is a really good move for us, is 50% of our backlog is related to vehicles with hybrid or electric propulsion systems. And then 50% of the backlog is related to vehicles with combustion propulsion. So that drive for combustion, hybrid, and electric balance is certainly coming through. We also have very good regional balance and also a very good customer balance, so we have a nice diversity to the growth. So it's a really good story, and we were proud to share that last month in Detroit. I thought it would be good to refresh everyone on that. As Pat said, I'll share some thoughts on the industry outlook turning to slide number 8. The headline really is we expect the overall global industry to be stable to slightly improved in 2018. Let me break that down a little for you. From a light vehicle 2018 calendar year view, we're pretty closely aligned with the view of IHS. So, really, what that looks like is China growth is about 1%, Europe's up somewhere between 1% and 2% growth, and we see slight growth in North American production. This implies global production growth of about a 1% adjusted win for our geographical exposure. From a commercial vehicle viewpoint, we're assuming a flat commercial vehicle outlook in 2018. Orders in North America remained strong on the Class 8 side, but we do expect more modest growth in medium duty offset by a bit weaker demand in China. I always like to give a sense of some of the key areas that we're paying good attention to as we go through the year. One is just the North American mature cycle. We're in an environment where it's pretty much flat to slightly improved production. But we'll always be watching that in terms of inventories and production in North America. The diesel-gas mix in Europe continues to shift, so diesel share declined by approximately 740 basis points in Q4 and it was 480 basis points for the full year of 2017. We're going into the year expecting a 300 basis point to 400 basis point diesel to gas mix shift in 2018, and we'll be watching that. The good news from us as a company is, as we did last year, we're offsetting that diesel-gas mix with other favorable aspects in the business. The last area we keep an eye on is China. We're expecting modest industry growth in 2018. But like all on the call, we continue to watch demand, particularly with the tax incentive changes that may occur throughout the year. All of that said, we expect to continue to outgrow the market strongly in 2018 based on the strong demand for our product mix. Let me just give a couple of comments on technology trends. The main message I would share with you is the activity and focus on hybrid and electric continues to accelerate around the world. In hybrids, clearly, 48-volt mild hybrids continue to be in focus. That creates an excellent content opportunity for BorgWarner, whether it's P2 clutch modules, eBoosting, or iBAS-type systems. So that's a real push for us. Generally, Europe is probably moving the fastest on hybrids. But we continue to gain more work and interest in both China and North America. With electrics, the Chinese OEMs continue to move at a very fast pace. And you see that flowing into our backlog with multiple awards on eGearDrives. We do see work with the Europeans increasing, and we're engaged with North American customers on electric vehicle products as well. The key point for us is that we expect 2018 and 2019 to bring significant industry awards for hybrids and EVs for BorgWarner, and we're very confident that we have the right portfolio to pursue this business. We will continue to focus on that, and you'll see more announcements and bookings through the year on both hybrids and electrics. Let me just highlight a couple of recent announcements that we made that you can see there on slide number 9. I think these are another good indicator of what I was saying earlier about the strength and breadth of our product portfolio. We have the on-axis P2 module development contract with a major Chinese OEM. That's a really good announcement for us. I think that's clear evidence that the Chinese OEMs are moving forward and accelerating their efforts on hybrids. A great example is the P2 module, for us where we're leveraging both our clutching expertise and our motor expertise to present a unique module that very few people, if any, can do in the world. The HVH250 electric motor and eGearDrive transmission for the initial launch of the FUSO eCanter truck. We talked about that a few weeks ago in Detroit. This is the world's first series-produced all-electric light-duty truck, and this is a great example of our EV capabilities. We are basically providing the complete propulsion system for an electric vehicle truck. A great win. Last but certainly not least, the all-wheel-drive coupling for Volvo's new XC40 compact SUV is an excellent win for us. This reflects our integrated vehicle dynamics software and our ECU knowledge helping us bring a great system forward for Volvo. It's a great example. It represents good balance to what we're winning across all aspects of combustion, hybrid, and electric. Let me shift gears and talk a little bit about 2018 on slide 10. For the full-year outlook, our organic growth and margin outlook is unchanged from the guidance we provided last month. We expect organic growth of between 5% and 7% year-over-year in a market that's basically flat to up 1%. Our consolidated operating income margin is expected to expand to 12.6% to 12.7%. We've updated our EPS guidance to a range of $4.25 to $4.35 to incorporate our updated tax and forex guidance. Ron will share quite a bit of detail with you in his comments shortly after myself. I also wanted to say a few words about our Q1 organic guide because when you look at that, it's a lower number than the full-year outlook. Our organic growth for Q1 remains at 3.0% to 5.5%. There are a few aspects of timing that I want to point out for you to help you have a good understanding of it. First, industry production during Q1 of 2017 saw BorgWarner's weighted industry production grow approximately 4% versus less than 0.5% for the full year of 2017. So it's a tough industry comp for Q1. Q1 2018 industry production is expected to be flat to in line with the 1% for 2018. We also have a North American changeover—a significant changeover program that will occur in Q1, which also creates a little bit of noise. Additionally, regarding Q1, diesel is impacting us because we didn't see much of that diesel-gas mix shift in Q1 of 2017. We're seeing that meaningfully in Q1 of 2018. Lastly, we have a little noise around European launch timing. This context is what helps bridge your understanding of our Q1 flows versus the rest of the year. That said, we're very confident in our full-year guide of 5% to 7% and absolutely confident we'll execute on that number. Before I turn it over to Ron, let me provide a couple of comments about our emissions restructuring. We incurred additional restructuring costs in Q4 and expect some level of expense during the first half of 2018. After a strategic assessment and review, we determined that a sale of the non-core business is our preferred path for the products we've identified. In Q4, we launched a program to locate a buyer for these product lines. As a result, we recorded an asset impairment expense to adjust the net book value of this business to fair value less the cost to sell. Should we not find a buyer, we will take the additional steps necessary to restructure the business to get it where we need it to be. To summarize before handing it over to Ron: 2017 was a great year for the company. We exceeded our expectations for top-line growth, and our operating performance was in line with expectations. We expect to continue this success in 2018 with another year of above-industry average growth and significant new business awards. Finally, we're very committed to delivering the 2020 outlook outlined last month. With that, let me turn the call over to Ron.

Thank you, James, and good morning everyone. Before I review the financial details, I'd like to provide some of the highlights I see for the quarter. First, the quarter was strong, and it was a great finish to the year. Second, operating performance was on target. And finally, we are maintaining the organic growth and margin guidance, but we are increasing our EPS guidance based on tax and forex benefits. As Pat mentioned, I'll be referring to the supplemental financials slide deck that is posted on the IR website, and I encourage you to follow along. Let's turn to slide 12. On a reported basis, sales were up 14.5%. But on a comparable basis, our organic sales were up 10.2%. This is impressive performance compared to our weighted average light vehicle industry production for the quarter, which was up 0.3%. We saw a 25% growth in China against a production market that was down 1%. Europe revenue was up 9% compared to the 5.6% industry production growth in the quarter. North America revenue was 10% versus the 4% production decline in the quarter. And commercial vehicle was a benefit again, contributing more than 200 basis points. The diesel-gas mix in Western Europe served as a headwind but was slightly lower than we expected going into the quarter. Now, let's look at the year-over-year comparison for operating income, which can be found on slide 13. Q4 adjusted operating profit was $328 million, or 12.7% of sales, compared to $284 million in Q4 of 2016. Our operating margin of 12.7% was a 10 basis points improvement year-over-year. On a comparable basis, operating income was up $37 million on $227 million of higher sales. This gives us an incremental margin of 16.4% in a quarter, which is in line with our expectations despite incurring higher bonus accruals in the quarter. Our adjusted provision for income taxes was $85 million for an effective tax rate of 26% for the quarter, and the full-year tax rate came in at 28.2%. If you remember, our guide was 29%, so that's slightly better than expectations for the full year. I would also point out that the year-over-year increase in net earnings attributable to the non-controlling interest reflects our minority partner's share in the earnings performance of our Chinese and consolidated joint ventures. We expect that to increase through 2018. Earnings per share on a reported basis was a loss of $0.70 per share. On an adjusted basis, net earnings were $1.07 per diluted share. Let's take a closer look at our operating segments in the quarter beginning on slide 14 of the deck. Reported Engine segment net sales were $1.578 billion in the quarter. Sales growth for the Engine segment on a comparable basis was 8.4% as demand for our light vehicle OEM products was supplemented by growth in our commercial vehicle business. Adjusted EBIT was $266 million for the Engine segment, or 16.9% of sales. On a comparable basis, the Engine segment's adjusted EBIT was up $7 million on $117 million of higher sales for an incremental margin of 7%. This incremental margin is due to two factors. First, this segment delivered extraordinary incremental margin performance of more than 100% in the fourth quarter of 2016. So it was a difficult comparison. Second, we continued to experience year-over-year earnings headwinds in our emissions business. As James mentioned earlier, we're exploring the sale of our thermostat and pipe product lines in the emissions business, which we believe to be non-core. Turning to slide 15, Drivetrain segment net sales were $1.023 billion for the quarter. Sales growth for the Drivetrain segment on a comparable basis was up 13.1% primarily due to higher all-wheel drive and transmission components and strong DCT growth in China. Adjusted EBIT was $124 million for the Drivetrain segment, or 12.1% of sales. On a comparable basis, the Drivetrain segment's adjusted EBIT was up $31 million on $113 million of higher sales for an incremental margin of 27%. This is very strong performance, reflecting the successful ramp of new products. Before moving on to our full-year guidance, I want to summarize the charge incurred during Q4 related to the U.S. Tax Act and summarize our outlook for taxes going forward, which is on slide 16. Our Q4 tax expense was $338 million, which includes many one-time items. First, a total of $274 million is related to the 2017 Tax Act, comprising $105 million for the transitional tax, also known as the toll tax. Next, $64 million was recorded for the reevaluation of deferred items. Additionally, $94 million was recorded to accrue for the anticipated withholding taxes paid to foreign jurisdictions when cash is remitted back out of those countries. Finally, $11 million of other tax expense related to the Tax Act brought the total amount to $274 million. We are incorporating an updated tax rate of approximately 28% going forward. The largest driver of a modestly higher tax rate than many of you expected is the result of withholding taxes in other countries outside the United States. The good news, though, is that over time, we fully expect that rate will likely come down further after we incorporate some structural changes. We expect cash taxes to remain in the low-to-mid 20% range. Now I'd like to discuss our 2018 guidance, which we have increased from what we presented earlier in January. The increases are due to the foreign currency tailwinds and our updated effective tax rate related to the Tax Act. Turning to sales growth guidance for the full year on slide 18, we continue to expect organic growth of 5% to 7%. The Sevcon acquisition is expected to add $45 million of revenue in 2018. Currency is expected to be a $170 million tailwind now. Total revenue is now expected to be in the range of $10.52 billion to $10.69 billion. From a performance perspective, we expect mid- to high-teens incremental margins on net sales growth. Our consolidated operating income margin is expected to expand to 12.6% to 12.7%. To finish up our full-year guidance, please turn to slide 20. EPS guidance range is now $4.25 to $4.35 per diluted share versus the $4.15 to $4.25 previously. The increase is driven by the impacts of the lower tax rate and larger forex benefit. Free cash flow, defined as net cash provided by operating activities less CapEx, is now expected to be $525 million to $575 million, which is up $25 million from our previous guide. The tax rate is expected to be 28%, as previously mentioned. Our assumptions for the dollar to euro exchange rate have been adjusted to $1.18 versus the $1.15. Just as a reminder, for every $0.01 change in the dollar to euro exchange rate equals about $30 million to $35 million of revenue. This benefit comes through at roughly a 10% margin. So a higher forex benefit could dilute our full-year margin outlook. Our first-quarter guidance can be found on slide 22. We continue to expect organic growth of 3% to 5.5%. This is below our full-year guidance due to launch timing and difficult year-over-year industry comparisons. Forex is expected to be a $100 million revenue benefit in the quarter. EPS is expected to be in the range of $0.99 to $1.03, including a $0.02 dilutive impact from Sevcon. This guidance is based on a 28% tax rate and incorporates a $1.18 euro assumption. My conclusion here is that the summary for Q4 and for the full year 2017 was another strong quarter and a great finish to the year. Organic sales growth of more than 10% despite flattish industry volumes and headwinds in the diesel-gas mix. Incremental margins improved sequentially and were just as expected throughout the year for us. As we look forward to 2018 and beyond, we continue to drive intensity around our new product development and securing customer orders to participate in the impending electrification trend. With that, I'd like to turn the call back to Pat.

Sharon, we're ready for questions.

Good morning, everybody. I wanted to ask you, the lower incremental margin in Engine, how much of that was due specifically to the underperformance in the emissions business? And can you tell us what the losses are running at in that thermostat and pipe business that's for sale?

Sure, Rod. This is Ron. I would tell you that we incurred a year-over-year headwind of about $10 million in the quarter. If you do the math a little bit, I think our margins would have been comparable to the prior year. So we saw significant headwinds, and they actually deteriorated throughout the year. If you remember, we were seeing $5 million, $5 million, $10 million, $10 million as the quarters progressed. It was a significant headwind for us in the quarter.

The loss run rate from the business that's for sale?

Yes. The thermostats and pipes business was about a $10 million headwind for us in the quarter.

Okay. So that is the run rate, the quarterly run rate. And can you remind us regionally what the commercial vehicle revenue breakdown is for you today? And lastly, what is the size of the light vehicle diesel business after the decline that we saw in 2017?

Yeah. Rod, this is James. So the commercial vehicle piece first. It's about one-third in the U.S., about a third in Europe. The other third is split between China and South America. It’s about a 50-50 split between on-road and off-road, if that's helpful for you. Regarding the diesel absolute number, just trying to get that for you. Actually, Rod, if you don't mind, can I unpack that and give you that number in a separate call?

We can follow up with that. Back to the commercial vehicle, you said a third of it is China and South America. That's the reason you're expecting kind of a flat market? Is because of declines?

Yeah, that's right.

Hey, Rod, it's Ron. One more thing back on emissions. This is a higher level. That's about a $200 million business product line for us that's incurring about a negative 10% margin. So you can do the math on that. It's a significant headwind for us throughout the year.

Right. But just on that, there are other issues that are obviously happening on the Engine business because you would have had flat margins despite the growth in the quarter.

But take a look at last year's margins. We blew out the year in 2016. I remember in my script last year, I said don’t model that going forward.

It’s just tough. It really, really didn't comp on the margins.

Thanks, Rod.

Thank you so much, guys. Just a follow-up on the diesel assumption. So a 300 to 400 basis point decline, I think that's up from what you were talking about, roughly 200 to 300. As you said, the market, just the rate of decline could be something like 500 basis points. Could you just help us understand some of the precautions you're doing? How you're thinking about what if we continue to see the declines that we're seeing in the UK and Germany roll out to some of the other markets? What are the implementation plans?

Yeah, sure. So, Chris, this is James. First off, just to clarify, so our assumption on the diesel-gas mix is the same as what it was when we gave our update in Detroit. We're projecting a 300 to 400 basis point shift through this year. It could potentially be worse than that. We had to put a line in the sand. For every 100 basis points it moves, think of it as about a $20 million net revenue negative impact to the company. It's not that huge in a meaningful way. The majority of the diesel vehicles that aren't being sold and replaced with gasoline vehicles, a lot of that has similar content for BorgWarner, such as a turbocharged diesel vehicle in Germany or the UK, which would quickly be replaced with a petrol or gasoline turbocharged vehicle. So when you do all the math and net it out; for every 100 basis point move, it's about a $20 million impact for the company. We're not dismissing it because it is present, but as you see, our ability to manage through that transition, we’re very comfortable with.

That's fantastic. So it seems like you have a transition. This is a larger question and I know you guys have addressed this before on the call. But what are you hearing in terms of how the OEMs themselves will bridge the CO2 hole between, call it, late 2018 and 2021? Because we're seeing as they lose the diesel advantage, their CO2 rates for the fleet, whether it's just a lower number of vehicles or lower demand for PATV, or even 48 volts. It seems like it's going to be a problem for them as they try to hit their targets for 2020. I'm sure you're involved in some of those conversations to bring some of the better architectures forward.

Yeah. Well, you gave a great summary, Chris. That was a really terrific summary of exactly the challenges the OEMs are facing. In the short run, their strategy really is to shift from diesel to gas and optimize gasoline technology. This includes advanced turbos and advanced variable cam timing. Strategically, it's causing an acceleration for the adoption of hybrid technology. That's the significant push. The momentum towards 48-volt mild hybrids, which I talked about in my commentary, is also accelerating. Additionally, they're looking to maximize the advanced gasoline technology available to them since optimization can still be done on the gasoline engine to enhance performance.

Great. Thank you, gentlemen.

Thanks for taking the questions. James, just transitioning here as you did, talking about the hybrid and electric pipeline. If this characterization is wrong, please correct me. But it seems like geographically, what's in the backlog so far for hybrid and electric wins may be heavily China-weighted. So at what point, are we looking at 12 months from now or sooner or further down the line, does that start to even out a little more geographically, getting more of Europe in the balance, for example?

James.

Yeah. What I would say is, looking at the three-year window with the backlog, the initial piece of the backlog is a little China-weighted, predominantly due to a lot of the eGearDrive technology that we've been launching in China. However, as the backlog rolls out, you're seeing that regional balance become more balanced, frankly, as we launch hybrid technologies globally but heavily in Europe. As we move on beyond the backlog, that balance becomes even more equitable. In the short run, in the next year or so, it's a little China-oriented. But that balance becomes much more even as you go forward over the next two or three years.

So just to make sure I'm understanding this right. What's already in backlog includes more geographic balance, say, two or three years from now, out of the three-year net backlog?

Yeah.

Okay, great. And then just after tax reform with repatriation opportunities, how much cash do you think you'll bring back? And what's your view on spending on M&A versus buybacks at this point?

The Tax Act will make it very flexible for bringing back cash. As far as bringing it back like next week or next quarter, we don't have a significant need for that cash right now. But just having the flexibility is fantastic. A couple of years ago, we went through a lot of work to restructure to get cash for our buyback program and a dividend program. This makes it easier. We are looking at our dividend policy and stock purchases. Our stock repurchase program for this year is $100 million. All of those decisions will be updated and reevaluated. The thing I'm looking forward to is deploying more capital back to shareholders in efficient and flexible ways going forward, but you'll have to wait for us to really give our strategies.

Ron gave a good summary. The only thing I would add is we remain active in monitoring M&A opportunities, particularly in the electronics and power electronics space. We're very pleased with Sevcon so far—it’s going very well. It's fair to say, we would want to be involved in some level of M&A activity over the next couple of years to utilize that cash, especially in terms of complementary deals such as Sevcon.

Thanks. Good morning, everyone.

Good morning, Joe.

Good morning, Joe.

James, thanks for all the color on the puts and takes to the first-quarter organic guidance. I was wondering if we could talk a little about what you expect on the margins because it looks like the first-quarter guidance assumes total company margins are about flat year-over-year. If I recall correctly, in the first quarter of last year, you had about a $5 million lease termination item which is about 20 basis points. That should reverse out, implying the segments here would actually be down a little year-over-year. I just want to make sure I'm thinking about that right, and if that's true, what the drivers are there?

That's correct, Joe, on the math. I would say the first quarter includes some transitional costs that we're seeing operationally in the emissions business as well. We need to right-size that business. Secondly, the North American changeover for one of our major launches will impact us as well. This is a profitable product line for us. That launch, as it gears up in the second and third quarters, will give us some momentum. So there are two items: an emissions headwind and this launch in North America.

And the launch is across both segments or more in Engine?

It's going to be in the Drivetrain group—it's a four-wheel drive launch program.

Okay, Drivetrain. And then just to follow on, I guess, one of the prior questions about tax reform. You guys have been active in the market; you seem to have a big pipeline. I think one of the things we’ve heard over the years is some hesitance for companies to sell because of tax implications or leakage. I’m wondering if any of that has changed in terms of what you're seeing in discussions or your pipeline? Or if it’s still too early to tell? Just broadly, do you think this makes it easier to consummate deals?

Joe, that's a good question. In the M&A discussions we’re having, that language hasn't come up regarding it being more favorable to release those assets and not have as much of a tax headwind. But I think that's going to play out over time. I'd have to think about that. But I have not had discussions with investment bankers suggesting that specific individuals would look to divest assets now because they're in a better tax position.

Okay. Thank you.

Hey, great. Thanks for taking my questions. Ron, you mentioned on the tax plan that you're looking at a few things longer term to keep grinding that rate down. I think some of us were expecting a little lower today. Where do you think your tax rate could get to over the medium term, and how many years do you think it will take to establish that?

Yeah, David. Let me talk about what the items would be. There are two main areas we're looking at. One is when we bring cash back through different legal entities; if we can restructure those entities to lower that tax rate. I won't go into details, but that's one area, and it’s kind of out of Asia as we bring cash back and that will be significant to us. The other area relates to how intellectual property reimbursements are allocated across borders currently. We can change our strategy related to where the intellectual property is. Those two items could take one to two years to implement. As for the rate, I hate to give you a number, but you could potentially go down to the mid-20s fairly quickly—23% or 24% is probably a good estimate. But please don't hold me to that number, as there's a lot of work we need to do. However, the best part is there’s a pathway to lower that rate.

Understood. Look, that's incredibly helpful. And then James, on power electronics, how big of a business are you looking to buy versus eventually build? What technology or further capabilities are really needed that the OEMs are asking for in your conversations?

Yeah, it’s a good question, David. What we have with the acquisition of Sevcon puts us in a really good place. We've been investing significantly over the last two to three years to build our organic internal electronics capability and know-how, and we've done a nice job. Sevcon added scale and actual products. Our power electronics strategy focuses not necessarily on being a big power electronics supplier of standalone components, but more on complementary power electronics know-how and products that can work alongside our products. That's our main strategy. So we’re not looking to add large scale and capacity to compete as a standalone power electronics supplier. Instead, we want discrete technology that's complementary to our product offering. We believe we're a propulsion system player, and to fulfill that role, we require engine technology, drivetrain technology, and power electronics know-how and hardware for OEMs. Thus, if we can add another Sevcon or a couple more Sevcons in the upcoming years, that would be advantageous as it would enhance our scale, capability, and engineering resources.

No, it does. And are you finding that there's a plethora of those assets out there to look at? Or is it going to be more challenging to find, as other companies are likely to be trying to bolster technical capabilities through the transition to EV architecture?

Yeah, there are quite a few companies out there that do have that capability. The interesting thing is it's rare to find a pure play. Oftentimes, you'll have companies with power electronics capability, but they may also be involved in other end markets, like industrials. So we're focused on finding firms that have strong automotive technology, or a firm like Sevcon that has substantial automotive technology with their industrial applications. Not a lot of pure plays out there, David, but there are indeed players that could offer us more capability and scale, which we're monitoring.

Good morning. I want to talk a little about the backlog. As I look at the distribution of your backlog over time, it picks up in 2020 and is a bit softer in 2018. You've historically had that pattern going back. I know more recently you've tried to risk-adjust your backlog at least for the near term. So, really, two questions: One, what are the puts and takes within your $650 million to $730 million guide around risk adjustment for either macro conditions, customer schedules, or mix? Secondly, I know powertrain is different from other sectors like seating where the awards are much more short-cycle. But as you look to 2020, based on your discussions you're having, would any of those help the 2020 backlog, or are those really reflected in the next backlog update?

Yeah. The way to think of it is I would characterize that the methodology shift, if you will, that we've made a year or two ago—where we applied a bit more rigidity regarding potential macro downshifts and launch cadence—is the same methodology we're using for this backlog, if that helps. We're continuing to practice what we've done these past couple of years. I feel it’s well-apportioned with the backlog that we now have. We haven't just made drastic cuts; it's not that. My belief is it’s certainly set appropriately. One dynamic that’s different about our backlog compared to prior ones is our product breadth and portfolio balance, which is much broader than it was and is better regionally balanced. We're much less dependent on Europe, so that helps solidify our confidence in our ability to deliver the backlog. That's how I'd characterize it. If you look at it by products, there is a good portion of turbo growth in there. We observe strong DCT growth contributing so all in all, we feel good about this and are confident in executing it.

Okay. Second question, which is somewhat housekeeping and somewhat restructuring. Your 28% GAAP tax rate and 20% cash tax rate suggest you have legal tax entities that can't use deferred tax assets to avoid losses flowing through for that. Is that related to your emissions business? How long do you expect the cash tax rate to run below GAAP?

No, it has nothing to do with the impact of losing credits through legal entities. We fully utilize all of our foreign tax credits in that process. That doesn't apply. Typically, our long-term plan is to have our cash tax lower than our GAAP tax rate. The only time you have differences, quite frankly Brian, is when you go through settlements with taxing authorities on audits. Typically that’s when you see unusual items on a cash basis; those are just one-offs. But, normally, you should expect it to be lower on a run-rate basis. The only difference arises from tax settlements on tax years.

Okay. So it’s more structurally in terms of the expenses and the CapEx you get to depreciate, bonus depreciation and so forth, as opposed to anything like the OEMs not being able to write off losses under GAAP in money-losing geographies? Thanks.

Correct.

Thanks, Brian.

Hi. Good morning, everyone.

Hi, Rich.

Hey, Rich.

On North America, over the last couple of quarters – in the last quarter, you had a 20-point spread versus underlying production. This quarter is 14%. How should we think about this year? It seems like you have very good momentum there. I know there are key launches, and obviously truck market shares are high. But just how do we think about the cadence over the course of 2018 in terms of outperformance?

You’re thinking North America specifically, Rich, or?

Yeah, North America specifically. You’ve had really good outperformance there.

We still expect good outperformance in 2018 versus the market. I don’t have a specific number in mind actually, Rich, but we can get you that. We see good growth. The one thing we observe is in the quarter, we have the changeover program on the truck side that Ron alluded to earlier. Q1 will be distorted because of that truck changeover. However, we do expect good outperformance. It probably won't be quite as high as we did last year, but still pretty good. I‘ll have Pat and Ron try to provide you with a more specific estimate, Rich, so we can get a number to you. Think of it as good outgrowth in North America, but probably not quite at the high level of last year.

Okay, I appreciate that. And then two for Ron here. Just to clarify, the emissions losses on the non-core assets; that's part of guidance, correct? That's included in the Engine—well, that’s how we should model it correctly?

Yes. The 2018 guidance includes the operating performance of the pipe and thermostat business. What I was attempting to communicate was that we just have to execute what's in our plan at this point. Our puts and takes could ultimately lead to us either executing better or worse than what’s in the plan. The restructuring costs will be addressed separately, okay? It won't be in the run rate in the margins.

Sure. But that $10 million is the run rate, correct, $10 million loss?

Yes, that is correct.

And you don't expect that to be any worse or any better. That's kind of the run rate we should think about.

That's the run rate you should expect, correct.

Okay. Just real quick on free cash flow. CapEx is going up; that explains some of the miss or I should say the decline in free cash flow. You had a very good year in 2017. Is there something happening in working capital? Looks like there's maybe a $30 million gap relative to the free cash flow guidance and then the CapEx increase. Anything noteworthy there?

No, I don't think there's anything noteworthy right now. It would be working capital related. A couple of things to note: we have to build banks in the emissions business to shift products back into other plants that we want to move. So that's one challenge—the bank builds throughout 2018. However, on a positive note, we're working on some opportunities to improve it. So, now we are dealing with some headwinds from bank builds.

Okay. This makes sense. Thank you.

Thanks, Rich.

I'd like to thank you all for your great questions today. With that, Sharon, you can close the call.