BorgWarner Inc (BWA) — Q1 2019 Earnings Call Transcript

Thank you, Sharon. Good morning, everyone, and thank you for joining us. We issued our earnings release at 6:30 a.m. Eastern Time, posted on our website, borgwarner.com, both on the homepage and on our Investor Relations homepage. A replay of today's call will be available through May 9. The dial-in number is 855-859-2056, and the conference ID is 6599394 or you can simply listen to the replay on our website. With regard to our investor relations calendar, we will be attending multiple conferences between now and our next earnings release. Please see the Events section of our IR page for a full list. Before we begin, I need to inform you that during this call, we may make forward-looking statements which involve risks and uncertainties as detailed in our 10-K. Our actual results may differ significantly from the matters discussed today. During today's presentation, we will highlight certain non-GAAP measures in order to provide a clearer picture of how the core business performed and for comparison purposes with prior periods. When you hear us say on a comparable basis, that means excluding the impact of FX, net M&A and other non-comparable items. When you hear us say adjusted, that means excluding non-comparable items. And when you hear us say organic, that means excluding the impact of FX and net M&A. We will also refer to our growth compared to our market. When you hear us say market, that means the change in light vehicle production weighted for our geographic exposure. Our outgrowth is defined as our organic revenue change versus the market. Now back to today's call. First, Fred Lissalde, our President and CEO, will comment on the industry. He will then follow this with a high-level overview of our Q1 results, our 2019 outlook, and the cost restructuring plan that we announced this morning. Fred will conclude with a discussion of our recent product highlights. Then Tom McGill, our Controller, will discuss the details of our results as well as our guidance. Also with us today is Kevin Nowlan, our recently appointed CFO. Please note that we have 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'll turn it over to Fred.

Thanks, Pat, and good morning, everyone. We're very pleased to share our results from Q1 2019 today and provide an overall company update. Before we begin, I'd like to welcome Kevin Nowlan to his first earnings call with BorgWarner as our new CFO. Kevin's impressive background speaks for itself. But suffice it to say, his experience will be invaluable as we continue our long legacy of strong financial discipline. He hit the ground running during his first few weeks, and you will be hearing more from him in the coming months. I also want to thank Tom McGill for his excellent financial leadership, and I'm very pleased that he is now our Controller with responsibilities for all our accounting, tax, and enterprise risk management operations. Now I'll start by sharing a few thoughts on the industry shown on Slide 5, starting with Q1. The global light vehicle production came down about 5.2%, which is more than 100 basis points better than the midpoint of our expectation going into the quarter. In addition, I'm very proud to say that our outgrowth in Q1 was also stronger than expected, driven by a higher volume of new programs, especially in Europe and North America. European light vehicle production was down about 5.5% as customers worked through the final stages of the WLTP certification. China light vehicle production was down mid-teens year-over-year as our customers reacted to lower demand and reduced their inventories. North American light vehicle industry production declined about 2.5% year-over-year. Now looking to the remainder of 2019. We expect that the challenging conditions in China and Europe will continue for the remainder of the year. Even with these challenging conditions, we expect to be able to deliver on our full-year earnings and cash flow guidance. On a full-year basis, we continue to expect a market decline in the minus 2% to minus 5% range. At the midpoint of our guidance, we're factoring in China down high single digits, Europe down more than 3%, and North America down more than 2%. The key is that we expect to continue to outgrow the market in 2019 based on continuous strong demand for our products. Let me now move to Slide 6. First, a brief summary of our Q1 results. Overall, I'm very pleased. Organic growth was above our guidance. And while we fell short of our typical 20% decremental margin, the performance was in line with our Q1 guide. With $2.6 billion in sales, we were down 3.3% organically. This compares to our market being down approximately 5.2%, so our outgrowth was approximately 200 basis points in the quarter, which was ahead of our expectations. Regionally, our China revenue declined high teens as ramp-up schedules of new programs were impacted by inventory reduction at our customers. Our European light vehicle revenue was down about 1%, outperforming the industry decline. Our North American light vehicle revenue was flat year-over-year, and our commercial vehicle off-road and aftermarket business was also flat year-over-year. Adjusted earnings per share came in at $1, which was ahead of our guidance, driven by revenue outperformance. Now for the full year 2019. While we are encouraged by the stronger Q1 performance, we're maintaining our full-year guidance. We continue to expect revenue to be down 2.5% to up 2% organically, and this represents an outgrowth of 250 to 400 basis points over our expected market decline. We continue to expect our adjusted earnings per share to be at $4 to $4.35. I would also like to briefly touch on our planned margin and R&D cadence for 2019. As Tom will explain later, our guidance for Q2 implies a shortfall compared to our typical decremental margin. In addition to the costs related to tariffs and supply bankruptcies, we're also supporting elevated R&D spending in Q2. This is mostly related to the recently awarded programs. The prototype spending for this program is a bit lumpy throughout 2019, with some of the largest impacts in Q2. For example, during this quarter, we will experience a $10 million year-over-year impact from prototype spending related to recent complete module awards for P2 hybrids. However, at the highest level, our R&D spending expectations for 2019 remain unchanged. We continue to deliver strong outgrowth in 2019, and we must continuously look at ways to adjust our cost structure without compromising our long-term aspiration. The cost restructuring plan that we announced in our press release this morning is consistent with this long-term commitment. We've taken a company-wide view of areas to reduce our current cost structure. Based on our analysis, we believe that we can achieve a $40 million to $50 million annual improvement in our current structural cost over the next 2 years. These cost actions will range from capacity realignment, efficiency improvement in SG&A expenses within our businesses and cost reduction opportunities within our corporate overhead. We expect these actions will result in restructuring expenses in the $80 million to $100 million range through the end of 2020. Our plan is to really deploy these savings into spending to support future growth in hybrid and electric propulsion. Specifically, we expect to use savings to increase our R&D spending as a percentage of sales without negatively impacting our overall operating margins. We continue to see a strong pull for our products from our customers. And we expect the return on this higher spending will not only drive stronger growth but generate returns in line with our historic levels. Now I'd like to discuss some of our recent product successes, which are on Slide 7. For the second year in a row, BorgWarner has been recognized as an Automotive News PACE Awards winner. This year, we won for our revolutionary dual volute turbocharger for gasoline engines. General Motors is the first OEM to put this innovative technology in its full-size pickups with its 4-cylinder turbocharged engine. This is a great example of technology that will help support our above-market growth in combustion propulsion. In hybrid, we also announced that a major European commercial vehicle manufacturer has chosen our HVH410 electric motor for a plug-in hybrid electric truck to be announced in 2019. I'm also strongly encouraged by our year-to-date wins across multiple hybrid architectures and electric products. Before I turn it over to Tom, let me summarize my opening remarks. Q1 was a strong start to the year, and we feel very confident in our full-year outlook. Our cost restructuring plan will help support our future profitable growth while sustaining margin performance. And the year-to-date new business wins that we've achieved across combustion, hybrid and electric vehicles will position us strongly for the future. Now let me turn it over to Tom.

Thank you, Fred. Good morning, everyone. Before I review the financial details, I would like to provide you some of the highlights as I see them for the quarter. First, our outgrowth was better than expected at 190 basis points. This, combined with a more modest decline in industry volume, allowed us to deliver a stronger top-line sales performance. Second, decremental margin performance was below our long-term targets, but the shortfall was in line with our expectations going into the quarter. As a result, the stronger sales from the quarter flowed through in line with our long-term incremental margin expectations. And finally, we are maintaining our guidance for the year, but feel increasingly confident in our earnings and free cash flow outlook for the full year. Let's turn to Slide 9. On a comparable basis, our organic sales were down 3.3% year-over-year. This is solid performance compared to the market, which was down approximately 5.2% year-over-year. We saw a high-teens decline in China against a production market that was down mid-teens. Europe revenue was down 1% compared to the 5.5% industry production decline in the quarter. North America revenue was flat versus the 2.5% production decline in the quarter, and our commercial vehicle and aftermarket business was flat year-over-year. So now let's look at the year-over-year comparison for adjusted operating income, which can be found on Slide 10. The Q1 adjusted operating income was $295 million compared to $339 million in Q1 of '18. Our adjusted operating margin of 11.5% was down versus 12.2% last year. On a comparable basis, adjusted operating income was down $29 million or $91 million of lower sales. This gives us the decremental margin of 32% in the quarter, which is worse than our long-term decremental margin target of 20%. This $11 million shortfall compared to a 20% decremental margin can be explained by tariff-related costs, supplier bankruptcy costs in Europe, and timing of costs related to a new business launch later in 2019. Our earnings per share on a reported basis were $0.77 per diluted share. On an adjusted basis, net earnings were $1 per diluted share. Now let's take a closer look at our operating segments in the quarter beginning on Slide 11 of the deck. The reported Engine segment net sales were $1.6 billion in the quarter. On a comparable basis, sales for the Engine segment declined 1.8% as growth in North America was offset by lower Europe and China volumes. Adjusted EBIT was $241 million for the Engine segment or 15.1% of sales. On a comparable basis, the Engine segment's adjusted EBIT was down $28 million on $31 million of lower sales. This week, decremental margin performance was driven by the decline in sales and costs related to supplier bankruptcies. So turning to Slide 12, the Drivetrain segment net sales were $982 million in the quarter. On a comparable basis, sales for the Drivetrain segment declined 5.6% year-over-year, primarily due to lower volumes on European customers with higher-than-average Drivetrain content and low volumes of recently launched new programs in China. Adjusted EBIT was $105 million for the Drivetrain segment or 10.7% of sales. On a comparable basis, the Drivetrain segment's adjusted EBIT was down $12 million on $61 million of lower sales for a decremental margin of 20%. So now I'd like to discuss our 2019 full-year guidance, which is unchanged. So turning to the sales growth guidance for the full year on Slide 14, our guidance is based on market assumptions down 2% to down 5%. We expect an organic revenue change of down negative 2.5% to positive 2.0% or 250 to 400 basis points of outgrowth over the market. Total revenue is expected to be in the range of $9.9 billion to $10.37 billion. Our adjusted operating income walk is on Slide 15. Our consolidated adjusted operating income margin is expected to be flat to down in 2019, and this margin performance is due to the decline in sales year-over-year, combined with costs related to tariffs, supplier bankruptcy costs in Europe, and changes to launch timing throughout 2019. To finish up our full-year guidance, please turn to Slide 16. Our adjusted EPS guidance range is unchanged at $4 to $4.35 per diluted share. We continue to target free cash flow of $550 million to $600 million. And our effective tax rate is expected to be approximately 26%. Our second-quarter guidance is on Slide 18. So first, sales. We expect organic sales to be in the range of down 2.5% to flat year-over-year. This would represent an outgrowth of 350 to 400 basis points versus our market forecast of down 4% to 6%. The sequential improvement in our outgrowth is expected to be driven by recovery in volumes of new programs in China and newly launched programs in North America. Adjusted EPS for Q2 is expected to be in the range of $0.99 to $1.05 per diluted share, and our Q2 guidance is based on a 26% effective tax rate and incorporates $100 million of FX revenue headwind year-over-year. As Fred indicated earlier, our guidance for Q2 implies roughly a $20 million operating income shortfall compared to our typical incremental and decremental margin performance. And as with the case in Q1, the Q2 results will be impacted by tariffs and supplier bankruptcy costs. And in addition, higher R&D spending will impact our year-over-year margin performance in the quarter. But most of this impact was timing-related, and the largest impact is related to recently awarded programs. The prototype spending for these programs is a bit lumpy throughout 2019 with some of the largest impacts in Q2. On a full-year basis, we still feel comfortable that the R&D will be in the low 4% range, but timing of spending will vary from quarter to quarter. Specifically, we expect our Q4 R&D spending to be $10 million to $20 million less than the Q2 levels. So in conclusion, let me summarize Q1 and our outlook. Overall, execution was solid in light of the challenging industry volume. Organic sales decline of 3.3% was better than our expectations. Decremental margin performance in the quarter was in line with our expectations. And as we look into the remainder of 2019, we remain confident in the reacceleration of our outgrowth and our ability to achieve both our earnings and cash flow guidance.

With that, I'd like to thank you all for your good questions today. If you have any follow-ups, feel free to reach out to me afterwards. Thank you.

Just wanted to ask a first question on your sort of the step-up in R&D versus the restructuring actions. I'm just curious, I mean, as you're thinking about this, are the restructuring actions being taken because there's some potential underperformance that you're seeing in things that need to be fixed or is the direct motivation to fund a step-up in R&D going forward, and it really will be almost a 1-for-1 offset? Just trying to understand what's going on there between the two.

I think it's both, John. We have to adjust our cost structure to the latest industry evolutions, and we then are going to focus on our growth and also make sure that our operating margin evolutions are in line with what we've announced and what we committed to. So it's both, John. It's absolutely both. So we're taking a company-wide view to reduce the cost structure. At the end of the day, the pool is there from our customers, and we see growth potential that requires R&D. I think those two things have to be done, and we're doing it. We're executing it, and we'll execute it. And that's going to be good for profitable growth for the company.

So should we think about the $40 million or $50 million of ongoing cost savings would be directly offset by a step-up in R&D that should drive sales, which should keep R&D as a percentage of sales roughly in the low 4% range? Is that a sort of a logic that's correct? Or am I missing something?

No, your logic is correct. The R&D would be up a little more than that, and that would be topping 2020, 2021. Don't consider that the R&D that is currently at 4.1% of sales in 2019 is going to change. And also the margin profile expectations are going to be unchanged.

Okay. And then if I could just sneak in a follow-up. Just on this Slide 10, Fred, and maybe for you, Tom, as well. I mean, as you're going through the tariffs impact, the supplier bankruptcy and the new launches as headwinds to your decremental margins or sort of losses to decremental margins, are those relatively equal? Or how should we think about the three of those as we go through the course of '19 and potentially into 2020?

Are you talking about full year?

Well, I mean, in the quarter, but then, also, it sounds like they're going to persist a little bit in the second quarter. So I just want to understand what are the sort of the buckets of those? Were they equally split in the first quarter? And is that the same allocation we should think about going forward? Or is there something changing going forward?

Yes. So with the tariffs, we've talked about that being up to maybe $10 million a quarter, and that will continue through Q2. And then come Q3, that year-over-year comparison, the tariffs will be in both. So again, a little bit in Q2, but by Q3, the year-over-year will even out. For the supplier bankruptcies, yes, that will continue in Q3 and probably through the year, but we'll see that coming down in Q3 and Q4, especially on a comparable basis.

And for R&D in Q2, John, it's about $10 million, and it's timing.

A couple of things. To make the full year number, it implies that the second-half margins are in the 12.5% range after the mid-11s in the first half. And it sounds like part of this is moderation of R&D, and part of it is the supplier bankruptcies. And I presume that you're also anticipating easier comps in European production, but I was hoping you might be able to just elaborate a little bit more on each of these components and how we should be thinking about that because it's pretty unusual to see BorgWarner have stronger back-half margins versus first half.

So one is related to R&D timing. We have Q4 R&D, which is $10 million to $20 million lower than Q2, and also you have a stronger growth in the second half of the year which is linked to stronger backlog and demand of our products for Europe and North America, but also in the second half of the year, and we see that starting in Q2 in China.

What's the bankruptcy part of this? And what are you assuming for European production in the back half?

Our midpoint for European production is estimated to be slightly under a decline of more than 3%. To give you an idea, we estimate that the costs related to the bankruptcy and everything we have to manage amount to about $5 million each quarter.

Okay, okay. And then secondly, I know that you're...

Which is the supplier bankruptcies started last year. So there's $5 million of growth that we'll start lapping in the second half.

So can you talk more about the factors that led you to conclude that higher investment in hybrid and EV products were necessary? Does this contemplate a faster mix shift towards electrification than you saw previously? If so, why?

Because the customers are in high demand and because we're winning.

Can you expand on that a little bit?

Well, yes. I mean, we have technologies from a hybrid perspective that are being pulled by our customers in different architectures, in different regions of the world, especially in China and in Europe. At this point in time, we're winning advanced hybrids in Europe. And we're just focusing on long-term profitable growth. The returns are going to be good, and we need to deliver.

Just our first question, looking toward your second quarter guidance, what are your regional production assumptions for the industry?

So for Q2 regional production for the industry is pretty much North America, slightly down; Europe, down more than 5%; China, down double-digit. And overall, on the global, both on a weighted average, we're pretty much down around 5%.

Okay. And then just looking at commercial vehicle, it looks like that was just kind of flat in the quarter, where you've been seeing it positive in the past. What sort of expectations do you have for that going forward?

In the commercial vehicle sector, our business accounts for about 12% of our total revenue. One-third of this revenue comes from the U.S., another third from Europe, and the remaining third from China and Brazil, with China making up two-thirds of that last portion. Our operations are divided into 60% on-road and 40% off-road, which includes construction and agriculture. This business is highly diverse and dispersed. Our approach to forecasting is to consider it as flat due to this complexity. Therefore, do not associate our performance with the Class 8 North America market or industry volume; our situation is much more intricate than that.

Okay. Then just one last question, if I could get it in there. As we're looking, and you have more backlog in hybrids and EVs, are you starting to see any sort of material customer mix shift, especially in China? Or is it still kind of the same as you've seen in the past?

We don't see a meaningful customer mix change.

If I could just follow up to, I think, just one of the questions that have been asked before, particularly Rod's question, around Europe. I mean, if we think about the next two years, where you're talking about sort of an increase in R&D specific for new launches in Europe, can you just give a little bit more color on the type of vehicles that you're getting, maybe increased requests for or maybe volume requests are going up, so that European OEMs can meet the O2 standards, which start essentially in 2020? Is there still P2 PHEV 48-volt? But are you also seeing some EV programs pull forward for you specifically in Europe?

Okay. Chris, until 2020, 100% of the business is booked. And the stuff that we're booking right now is past the backlog period. It's 2021, 2022. And yes, it's going to be around advanced hybrid. Most of those programs are going to be advanced hybrid, 48-volts and higher voltages, a variety of products.

Okay. So is it fair to say that we're not actually seeing volume change? I think there's a view out there that essentially, some of the volumes on some of these programs that need to be increased, the OEMs are going to push them to avoid fines because of a greater-than-expected shortfall that they've seen in, for example, diesel.

And here you're asking within the next two years, right? Shorter-term, right?

Yes, exactly.

Well, shorter-term, we can react. If we have the program, we can react. And if they want more volume, we'll react, and we can react pretty fast. The impact of the additional R&D is certainly past 2020. And, yes, that's what I was saying.

And just a couple of quick ones. I think, clearly, the China production weakness was well broadcast, but we've been hearing from others that the market appears to be at least stabilizing. Just can you speak to if there's any change from your vantage point in either customer sentiment around potential volume improvement on the horizon or if there's any change in maybe the potential outgrowth you're seeing for the pipeline in your market?

The market is stabilizing from the current run rate. We anticipate the next generation of our new programs in China. We expect the schedules for these new programs to accelerate starting in Q2. However, from a market perspective, we do not believe the market will recover.

Yes. So for that, it's still at that $20 million. There's very little impact for us with those three. But again, $20 million, $10 million in the quarter in Q1 and 2. And by Q3 and four, that will be in both years.

Thank you all for your attendance and insightful questions today.