BorgWarner Inc (BWA) — Q2 2018 Earnings Call Transcript

Thank you, Tasha. Good morning, everyone. We issued our earnings release at 6:30 AM Eastern Time. It's posted on our website borgwarner.com both on our Home page and on our Investor Relations home page. A replay of today's call will be available through August 9. The dial-in number for that call is 855-859-2056 and the conference ID is 3496229 or you can simply listen to the reply 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 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 for the matters discussed in this call. During today's presentation, we will highlight certain non-GAAP measures in order to provide a clearer picture of how our 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 non-comparable items. When you hear us say 'adjusted', that means excluding non-comparable items. When you hear us say 'on a reported basis', that means U.S. GAAP. Now, back to today's call. First, James Verrier, our President and CEO, will comment on the industry followed by a high-level overview of our Q2 results and full-year outlook. Then, Fréd Lissalde, our COO, will outline our second-half priorities as well as review some of our recent announcements. Finally, Ron Hundzinski, our CFO, will discuss the details of our results as well as our guidance. Please note that we posted our earnings call presentation to the IR page of the website. You'll find a link in the Events & Presentations section beneath the notice for this call. We encourage you to follow along during our discussion. With that, I'll turn it over to James.

Thank you, Pat, and good morning everybody. Thank you for joining us this morning. Fréd, Ron, and I are very pleased to share our results from Q2 of 2018 and we're also going to update you a little bit on our progress toward delivering our 2018 targets. I thought a good place to start is for me to share a few thoughts on the macro environment and the industry in general. For those of you that are following along on the webcast, we're on slide number 6. The way I would characterize the headline summary to start off with is, for us our growth over the market was in line with our expectations and that was in an environment with global light vehicle production a little bit weaker than we had expected going into the quarter. Let me give a bit of color around Q2 industry results. From a global light vehicle production perspective, it came in up slightly less than 4% year-over-year. When you adjust that for a weighted geographic exposure, the market was up a little under 2% year-over-year. From our perspective, that was about 150 basis points weaker than our expectation when we provided our Q2 guide. Breaking that down regionally for a moment, European light vehicle production was up 4% year-over-year. The highlight on diesel-gas mix in Europe continues to shift; we saw diesel share declining by approximately 870 basis points year-over-year in Q2. Moving to China, light vehicle production there was up close to 9% year-over-year, which was in line with our expectations going into the quarter. From a North American perspective, light vehicle industry production declined about 2.5% year-over-year, which is weaker than expected, partly driven by some lost production at one of our key customers due to the supplier fire incident. From a commercial vehicle perspective, growth was modestly ahead of our expectations. The full-year industry volume outlook remains roughly unchanged for us. Our expectations for the full-year global light vehicle industry is consistent with our prior forecast, implying global production growth of less than 1% adjusted for our geographic exposure. The key for us is we expect to continue to outgrow the market in 2018 based on the strong demand for our products. Now let me talk a little bit about Q2 results and 2018 outlook; I'm on slide number 7. A brief summary of the Q2 results is, I was very pleased – really pleased, our organic growth was in line with our expectations and this was despite slightly weaker industry volume and customer downtime for one of our key platforms. We recorded $2.7 billion of sales, that's up 7.3% organically when we exclude currencies and Sevcon, comparing to our end market exposure of less than 2%. Regionally, we saw strong growth in China; our European revenue growth exceeded industry volume growth; our North American revenue was flat due to lost volume of one of our key customers, somewhat offset by positive revenue trends in commercial vehicle off-road. EPS came in at $1.18 excluding non-comparables, a 23% year-over-year improvement, which is fantastic. Operating margins were at 12.7%, up 20 basis points year-over-year, again, very strong performance. We've increased the low end of our organic growth forecast for the full year to 6% to 7%, in a market growing less than 1%. Our consolidated operating income margin is expected to expand 10 to 20 basis points year-over-year. We're also increasing our EPS guidance range to $4.45 to $4.50 based on our updated growth outlook and more beneficial tax rate. Before I turn it over to Fréd, I want to mention that this will be my last earnings call as I come to the end of a 29-year career with BorgWarner, which has been a wonderful journey for me. I'd like to thank the board for their continuous support for me and the company. Most importantly, I want to thank all of the employees, all 32,000 of you out there listening; it's your commitment and dedication that has made BorgWarner the great company it is. I leave knowing I'm handing over the leadership to the right guy, Fréd, who will continue to be a superb leader. I also leave knowing that the company is strongly positioned, balanced, with a great strategy and great results ahead. I want to thank the analyst community and investors for your support, advice, and challenges, which have helped us become a better company. Finally, I'll turn it over to Fréd.

Thank you, James. On behalf of BorgWarner, I’d like to thank you for your leadership over the past six years as CEO and 29 years at BorgWarner. You are leaving us strongly positioned for future growth. As we look at our priorities for the next six months, there are three we will focus on: First, we are laser-focused on delivering our updated guidance for both organic growth and bottom-line earnings. Second, we will secure significant new business awards. I’m very happy with the programs we’ve secured year-to-date, and there are significant second-half opportunities across our three segments: combustion, hybrid, and electric. Lastly, we will monitor and be prepared to manage through the industry risks, including the potential for additional tariffs. We are strongly positioned on a relative basis, but we need to manage any impact on our business going forward. On slide 10, you will see some highlights of our key announcements during the quarter. The most significant is the establishment of our Indiana Tech Center, which complements our global investments related to electric propulsion. It's an impressive facility with outstanding virtual global collaboration tools; it will be a great research development and testing hub for our electric propulsion activities. We also wanted to highlight our upcoming Investor Day on September 18, which will take place at our Propulsion Technical Center here in Michigan and will feature presentations by several members of our senior management team, along with the opportunity to experience our products that will drive our future growth.

Thank you, Fréd, and good morning, everyone. Before I review the financial details, I would like to provide you with some highlights for the quarter. First, our organic revenue growth was within our guidance range despite close to a 200 basis points headwind from weaker production and a customer plant shutdown. Second, incremental margin performance was stronger than our expectations driven by strong incremental growth within our Engine segment and corporate cost savings. Finally, we are increasing the low end of our organic growth guidance and lowering our expected tax rate for the year from 28% to 26%. As Pat mentioned, I will be referring to a supplemental financial slide deck that is posted on our website, and I encourage you to follow along. Looking at slide 13, reported sales were up 12.7%. On a comparable basis, our organic sales growth was up 7.3%. This performance is solid compared to our weighted average light vehicle industry production for the quarter, which is up under 2% year-over-year. We saw a 26% growth in China against a production market that was up 9%. European revenue was up 7% compared to 4% industry production growth. North American revenue was flat versus a 2.5% production decline. Growth was mitigated by the F-Series production shutdown impacting us about 400 basis points. Commercial vehicles contributed approximately 50 basis points to growth. Now, let's look at the year-over-year comparison for operating income on slide 14. Q2 adjusted operating profit was $341 million compared to $298 million in Q2 of 2017. Our operating margin of 12.7% was a 20-basis-point improvement year-over-year, with an incremental margin of 19%. Our adjusted tax provision was $82 million for an effective tax rate of 24% for the quarter, and EPS on a reported basis was $1.30 per basic share. Looking at our operating segments that begin on slide 15, reported Engine segment net sales were $1.674 billion in the quarter. Sales growth for the Engine segment on a comparable basis was 7.2% as demand for our light vehicle OEM products was supported by growth in commercial vehicles. Adjusted EBIT for the Engine segment was $279 million or 16.7% of sales. On a comparable basis, the adjusted EBIT was up $24 million on $107 million of higher sales for an incremental margin of 23%. The Drivetrain segment's net sales were up to $1.034 billion in the quarter with comparable sales growth of 7.4%. This was primarily due to strong growth in China and all-wheel drive. However, it was partially mitigated by the F-Series shutdown in North America. Adjusted EBIT for the Drivetrain segment was $116 million or 11.2% of sales. EPS guidance range is now $4.45 to $4.50 per diluted share, increased due to the organic growth guidance and lower expected tax rate. We continue to expect free cash flow in the $525 million to $575 million range.

Tasha, we're ready to open it up for questions.

Great. Thanks for taking the question. And James, congratulations on your retirement, and Fréd, likewise, congratulations. I guess, Fréd, I wanted to start with you. You mentioned some of the priorities for the second half which sound reasonable. I also wanted to understand your view broadly of the powertrain industry, how you view it. There's a lot of assets out there, how you think about consolidation, whether that's needed, and what BorgWarner's role in all that could be?

Yes. Thanks, Joe. In the propulsion area, our strategy to be balanced across combustion, hybrid, and electric is the right thing, and this strategy is being executed and will carry on to be executed. We have no missing pieces in our product portfolio to execute this strategy and be growing at mid- to high-single digits year-over-year. We are very happy with our position from both a portfolio and product perspective. If we come across any potential acquisitions on power electronics, we would certainly consider it, but there's absolutely no need to fill any product gaps that do not exist.

Okay. Thank you. And then just maybe on some of the puts and takes and sort of cadence for the rest of the year. I thought I heard you say a 400 basis point impact from the F-Series in the second quarter, and I assume a good portion of that comes back in the third quarter. But then is the offset maybe some WLTP issues in Europe? And then it also sounded like you said maybe some third quarter business was pulled forward in the second quarter. So, I was just wondering if you could dimension some of those puts and takes, Ron?

Yes. Just to clarify something, Joe. When I said 400 basis points, that was a regional impact in North America. Just want to make sure that's clear. Overall, it’s a 50 basis points impact. Your question was more around Q3?

Right; your question is more about Q3.

Yes, the Q3. Because it would seem like some of that F-Series business would come back and help it, but then you talked about some of the offsets from the pull forward, and I was wondering your thoughts on WLTP issues in the back half.

In Q3, our organic growth is 4.5% to 6.5%. We've seen a lot of pull forward into the first half due to a strong backlog. In Q3, we're seeing two market factors. One is a slower growth in China, and secondly, from a European customer mix, including WLTP certification, we project slower numbers.

Hi. Good morning, everyone. James, congratulations on retirement; best wishes. Fréd, I look forward to working with you in the future and best wishes as well. On diesel, it's down significantly more than expected, at least going back to the beginning of the year. How is it playing out in terms of the balance of the year for Europe? It seems like you're compensating with the switch to gas with a new backlog, but as you exit 2018, how do you feel about getting to a neutral standpoint?

Looking at a year-over-year basis, the market drops about 600 to 700 basis points. We see that the headwind declines in 2019 due to growth in gasoline turbo, EGR, and VCT. We're managing through those diesel headwinds effectively, as we have in the past, and will continue to do so.

Regarding the non-core emissions business, we are doing management presentations with potential buyers, and we expect to complete the transaction by the end of Q3 or early Q4. We are moving products out of one of the facilities in Europe and are on track with that process.

Just any thoughts around how much Section 301 is in the back half from China? Any initial thoughts on a Section 232 impact?

Regarding tariffs, we've already been experiencing commodity inflation, particularly with Section 232 around steel and aluminum. For Section 301, we've incorporated costs of about $10 million to $20 million headwinds in the back half, which we are addressing with alternative strategies.

Two questions. One on Drivetrain and the second on the environment in Europe. Incremental margin on Drivetrain despite attractive mid-teen levels, we see Engine moving into the 20% range. Can you provide some color on when we might see improvements in Drivetrain?

Drivetrain margins have actually been outstanding for the last six quarters, with Q2 of 2018 being an anomaly driven by the F-Series drag. We expect transitions and launches coming up that will bring Drivetrain margins back to mid to high teens.

On WLTP certification, the impact is baked into our market assumption and we don’t foresee significant company-specific impacts.

When I think about the propulsion-agnostic portfolio, one of your peers reports a bookings figure for power electronics. When should we start to see some of these power electronics products from Remy and Sevcon start to flow through the backlog?

Power electronics are integral to bigger systems we sell, and you'll see a growth in these products embedded in our offerings. However, we’re not going to break down the power electronics portion distinctly.