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BorgWarner Inc. (NYSE:BWA)

Q4 2012 Earnings Call

February 14, 2013 09:30 AM ET

Executives

Ken Lamb - Director, IR

James Verrier - President, COO and CEO

Ron Hundzinski - VP and CFO

Analysts

Rich Kwas - Wells Fargo Securities

Chris Ceraso - Credit Suisse

Joe Spak - RBC Capital Markets

Brett Hoselton - KeyBanc Securities

Pat Nolan - Deutsche Bank

David Leiker - Robert W. Baird & Company

Itay Michaeli - Citigroup

Rahul Chadha - UBS

Ravi Shanker - Morgan Stanley

Matt Stover - Guggenheim Securities

Brian Sponheimer - Gabelli & Company

Operator

Good morning. My name is Brandy and I will be your conference facilitator. At this time, I would like to welcome everyone to the BorgWarner 2012 Fourth Quarter Results Earnings Release Conference Call. All lines have been placed on-mute to prevent any background noise. After the speakers’ remarks, there will be a question-and-answer period. (Operator Instructions).

I would now like to turn the call over to Ken Lamb, Director of Investor Relations. Mr. Lamb, you may begin your conference.

Ken Lamb

Thanks Brandy. Good morning and thank you all for joining us. We issued our earnings release this morning at approximately 8:00 a.m. Eastern Time. It's posted on our website, borgwarner.com, on our homepage. A replay of today's conference call will be available through February 21st. The dial-in number for that replay is 800-585-8367. You’ll need the conference ID, which is 93239384. The replay will also be available on our website.

With regard to our IR calendar, we will be attending a number of conferences over the next couple of months. February 20th we will be at the Barclays’ Industrial Select Conference in Miami. March 12th we will be at the UBS Auto Supplier Mini Conference in Boston. March 19th we’ll be at the Sidoti’s Emerging Growth Conference in New York and on March 27th we’ll be at the BofA Merrill Lynch Auto Summit in New York.

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 10K. Our actual results may differ significantly from the matters discussed here today. Now, moving on to our results James Verrier, President & CEO will comment on fourth quarter and full year results and current industry trends and then, Ron Hundzinski our CFO, will discuss the details of our operating results and also our outlook for 2013. With that, I’ll turn it over to James.

James Verrier

Thank you, Ken, and good day to everybody. Today, I’m very pleased to review our fourth quarter and full year results, as well as our fourth quarter accomplishments. First off, I’d like to congratulate all the BorgWarner employees on a truly outstanding 2012. You dedication to our customers and shareholders is reflected in the Company’s strong performance for this year.

Now on to our results and I will start with the fourth quarter. Reported sales were $1.7 billion, flat from a year ago excluding the impact of foreign currencies and dispositions made in the last 12 months. U.S. GAAP earnings were $1.03 per share, but excluding the non-comparable items, earnings were $1.16per share. Our reported operating income margin was 9.9%, but again, as we exclude non-comparable items, our operating income margin was 10.9% in the quarter, and Ron will discuss the non-comparable items later.

Two key factors drove our results. First, our sales were impacted by a weak production environment, most notably live vehicles in Europe and commercial vehicles globally. And secondly strong operational efficiency and cost controls enabled us to post a solid operating margin despite challenging conditions.

By looking to the segments, first the Engine Group, fourth quarter sales were about $1.2 billion. That’s down 2% from a year ago after excluding the impact of foreign currencies and dispositions made during the last 12 months. Our results were led by turbocharger growth in China, increased sales of BCT in Japan, but these positive results were offset significantly by the lower production volumes in Europe.

At the Drivetrain Group, sales were about $560 million, and that’s up 5% from the fourth quarter of 2011, excluding foreign currencies. Drivetrain’s results were driven by increased all-wheel drive system sales in North America and India and we saw growth in traditional IT component sales in Korea, and this more than offset the lower production volumes in Europe.

Now let me move to the full year. Reported sales were just off $7.1 billion and after excluding the impact of foreign currencies and M&A activities, sales were up 6% from 2011 and this represents strong sales growth, considering the light vehicle production in Europe, a market which comprises nearly half of our sales was down 6%. U.S. GAAP earnings were $4.17 per share, but after we exclude the non-comparable items, net earnings were $4.97 per share, which is up 12% from 2011.

Our full year reported operating income margin was 10.5% or 11.7% as we exclude the non-comparable items. So in all three key metrics; sales, earnings and operating income margin; which hit all-time records in 2012, this is a tremendous accomplishment when we consider the weak market conditions in which it was achieved.

Now looking to the future, BorgWarner continues to invest for the long term. Our capital spending continues to grow. For the full year we spent about 5% of sales and we remain committed to supporting our future growth and productivity improvements. Our spending for R&D was about 3.9% of sales in the quarter and about 3.7% for the full year and we continue to trend towards our targeted level of 4% for R&D spending.

I’m also proud to review some exciting announcements we made during the quarter. In November we reported an expected backlog of $2.3 billion of net new business for the years 2013 through ‘15, as demand for our advanced powertrain technologies remains very strong in the foreseeable future. BorgWarner supplies its three-stage turbocharger technology to BMW, for its M Performance diesel engine. The new engine is the most powerful six cylinder diesel engine in the world.

We also opened another production facility at our campus in Ningbo, China. This hi-tech facility will support engine timing and VCT components to support the launch of over 50 programs with 20 Chinese customers. The opening ceremony also celebrated the inauguration of BorgWarner’s world class Ningbo Engineering Center which provides research and development, application engineering and management support.

Now I would like to review our current outlook for 2013 light vehicle production. We first announced our 2013 outlook at the Deutsche Bank’s Automotive Conference in Detroit last month and our view is unchanged from that forecast. We expect total global production volumes to be up approximately 1% from 2012. In North America we expect production volumes to be up 2% from 2012. We expect Europe to be down 3%, China up 10%, and Japan down 10%.

In the commercial vehicle market, generally we expect stability in 2013, but not much growth. For most of the markets in which we participate, Europe, North America and China, we expect production to be flat compared with 2012. In Brazil however, we do see the potential for low double digit growth.

Finally, our sales and earnings guidance for 2013 also remains unchanged from our announcement last month. Our sales growth in 2013 is expected to be 2% to 6% or 3% to 7% when we exclude 2012 dispositions. Our 2013 earnings guidance is $5.15 to $5.45 per share and our operating margin is expected to be 11.5% or better for the year. I’m confident 2013 will be another strong year for BorgWarner.

So as I mentioned before, 2012 was a tough year from a macro perspective. However, Borg Warner’s financial results underscored our operational proficiency and our ability to manage cost during challenging times. And as we look ahead we see the outlook for our business remain strong. In2013 we expect to grow sales and profits for the fourth year in a row, with more growth to come in 2014 and beyond. No company in the auto sector is better positioned for long term profitable growth than Borg Warner. The industry’s adoption of leading edge Powertrain technology will continue for years and because of this I feel very, very good about the Company’s future.

So with that now I’d like to turn the call over to Ron. Thank you.

Ron Hundzinski

Thanks James and good day everyone. Before I begin reviewing the financials, I would like to put BorgWarner’s performance into perspective within the broader auto industry. Global light vehicle production was up 1% in the fourth quarter,, compared with the same quarter last year. BorgWarner’s reported sales were down 3% from a year ago, but as James explained earlier, if we exclude the impact of foreign currencies and M&A activity in 2011-2012, our sales in the quarter were flat with last year. To get a clear picture of our performance relative to the market, we need to review the light vehicle and commercial vehicle market separately.

First let's take a closer look at the light vehicle market from a regional perspective. In Asia, which I'm defining as China, Korea and Japan, light vehicle production was up 6%. Our light vehicle sales in Asia excluding currency was up 13%. In Europe, light vehicle production was down around 11% in the quarter, our light vehicle sales excluding currency and 2011 and 2012 disposals were down 4%. In North America, light vehicle production was up 8%., our light vehicle sales growth in North America growth was about 10%, slightly better than the market.

Now, let’s review the commercial vehicle market. The fourth quarter saw continued weakness in the commercial vehicle markets around the world. Commercial vehicle production in Brazil and China were sharply lower, while North America and Europe were basically flat. As a result our commercial vehicle sales were down 10% in the quarter.

So to summarize, our typical outperformance of the light vehicle markets was intact in Asia and Europe in the fourth quarter. Despite outperforming the market in Europe, the 11% volume decline in that market had a meaningful impact on our total company growth in the quarter. Weak commercial vehicle markets around the world resulted in a 10% sales decline for us in a segment representing nearly 20% of our business.

Moving down, working down the income statement, gross profit as a percentage of sales was 20% for the quarter. That’s down slightly from 20.3% a year ago, but includes about $2 million to $3 million of higher raw material prices. SG&A expenses were 9.1% of sales in the quarter, versus 8.3% of sales in the fourth quarter of last year. The increase was primarily due to an increase in R&D spending, which as a percentage of sales was 3.9% in the fourth quarter 2012, up 50 basis points from a year ago.

Reported operating income in the quarter was a $171 million. However this includes $17 million of related retirement obligations. There were two parts to this charge. The first part is a $6 million loss related to partial settlement of a pension obligation associated with our now-closed Drivetrain facility in Muncie Indiana. The second part is $11 million charge related to the Company’s decision to wave the forfeiture provisions of an existing stock grants made to certain retiring name executive officers.

Excluding the $17 million charge, operating income was $188 million or 10.9% of sales compared with $213 million or 12% of sales on a comparable basis a year ago. About the half of the 110 basis point decline in margin is related to higher R&D spending as I mentioned before. The rest of the margin decline is primarily related to typical cost pressures including the inflation and price downs to customers which we usually offset with growth related income but were unable to do so in a challenging environment for growth in the fourth quarter. After excluding the impact of foreign currency and non-comparable items in both these quarters and the fourth quarter of 2011, our incremental margin was not measurable as we have lower operating income and flat sales.

As you look further down to income statement, equity and affiliate earnings was $10 million in the quarter, flat with last year. This represents the performance of NSK-Warner, our 50-50 joint venture in Japan, which sells transmission components to our Japanese customers in Japan and China, as well as TEL, our turbocharger joint venture in India.

Interest expense and finance charges were $7 million in the quarter, down from $17 million a year ago. This was primarily due to the maturity of our convertible debt settlement with treasury shares in mid-April. Note that this reduction in convertible related interest expense did not impact earnings per share. We have been calculating EPS on an if-converted basis from the first quarter of 2010 until the securities matured in April 2012.

Provision for income taxes was $48 million in the quarter, which is a 28% effective tax rate. However the provision included two items. The first is a $6 million tax benefit associated with the retirement related obligations I mentioned earlier and $3 million of net-unfavorable tax adjustments which included the closure of certain tax audits and other tax assets no longer viable. Excluding these items, our tax expense was $51 million in the quarter or a run rate effective tax rate of just under 26%. For the full year, our run rate effective tax rate was 26.8% in line with our guidance of 27%.

Net earnings attributable to non-controlling interest was $5.4 million in the quarter, up slightly from $5.2 million a year ago. This line item reflects our minority partners share in the earnings performance of our Korean and Chinese consolidated joint ventures.

Let’s go back to earnings per share, which was $120 million in the quarter, net earnings or a $1.03 per share, on a reported basis. On a comparable basis, net earnings were $136 million in the quarter, or $1.16 per share, slightly down from $1.19 per share a year ago.

That's a 3% decline in earnings per share on flat sales, good performance for the company concerning the challenging market conditions and in line with our guidance provided last October. Also note that foreign currency reduced earnings per share by about $0.02 in the quarter.

As James mentioned 2012 was a record year for sales, earnings and operating income on a comparable basis. Additionally, our four year incremental margin was 17% excluding the impact of foreign currency in 2011 and 2012 dispositions. This is excellent performance concerning the weak market conditions in which it was achieved.

Now let's take a closer look at the operating groups. Engine group sales were just under $1.2 billion in the quarter. Excluding currency in 2011 and 2012 dispositions, Engine Group sales were down 2% compared with the fourth quarter of 2011. Adjusted EBIT for the Engine group was $182 million in the quarter or 15.6% of sales. That's down from 16.3% adjusted EBIT margin reported a year ago.

The year-over-year detrimental margin excluding currency in 2011 and 2012 dispositions was about 80% but this is below our typical results but distorted by a couple of very unique items. The higher R&D spend as I mentioned before was almost entirely in the Engine group.

The investment for the long term was required despite the weak market conditions that impacted our sales in the quarter. We also had a customer-specific issue in our North American commercial vehicle business as well. For the full year, the Engine group’s adjusted EBIT margin was 16% and that’s an all-time record for the Engine group. In the Drivetrain group sales were about $516 million in the quarter. Excluding currency Drivetrain group sales were up 5% compared with the fourth quarter 2011.

On a reported basis, adjusted EBIT was $49 million or 8.8% of sales, in line with the fourth quarter 2011. The year-over-year incremental margin for the Drivetrain group excluding currency was about 6%. The year-over-year variances in the Drivetrain group’s financials were very small, a $2 million improvement in operating income over $26 million improvement in sales.

When the variances are that small, minor changes in the business can have a meaningful impact on the incremental margin calculation. For the full year, the Drivetrain Group’s adjusted EBIT margin was 9.1%, which was on target with our guidance of 9% or better.

Moving to the balance sheet and cash flow, if you look at the balance sheet and cash flow, we generated about $879 million of net cash from operating activities in 2012. That’s up a 171 million from 2011 and was driven by a strong focus on working capital management, that generated that extra cash flow.

Capital spending was $407 million in 2012, up $13 million from the same period a year ago. Our capital spending is required to support our program launches around the world and in particularly Asia, South America, Eastern Europe and Mexico. Free cash flow during the period which we define as net cash from operating activities less capital spending including tooling was $472 million.

Looking at the balance sheet itself, balance sheet debt decreased by $262 million, compared with the end of 2011. Cash increased by $356 million during the same period. This $618 million decrease in net debt was primarily due to net cash provided by operating activities and the maturity of our convertible debt, partially offset by share repurchases. We spent just under $300 million to repurchase 4.2 million shares in 2012 including 1.5 million shares in the fourth quarter.

At the end of the year, our net debt to capital ratio was 10%, compared with 28.3% at the end of 2011. Net debt-to-EBITDA at the end of 2012 on a trailing 12 month basis was 0.3 times. Our capital structure remains in excellent shape.

Now moving on to 2013 guidance, now I like to discuss more of the details in the 2013 guidance which is basically unchanged from what we provided last month. James reviewed our guidance at a high level but I'll go in more finer points here. Our sales growth expectations of 2% to 6% or 3% to 7% excluding 2012 dispositions assumes no currency impact. We recognize that the euro is trending stronger than the original guidance of $1.28 to €1 but conversely the Japanese yen is trending weaker than we expected. If currencies remain unchanged from today's spot rates, we will see some benefit primarily due to the strength of the euro. We expect raw material inflation of $15 million to $20 million in 2013, down from just under $30 million in 2012.

As James mentioned earlier, our operating income margin is expected to be 11.5% or better in 2013, similar to our 2012 margins. In other words, despite sales growth below typical 8% to 10% we need to maintain margins we expect to come very close to the maintaining margins this year. Slower sales growth would mean less incremental income to offset the inflationary cost pressures, but we expect to supplement our incremental income with increased productivity gains and spending controls.

Our expected tax rate of approximately 27% for 2013 is in part based unassumed level of cash repatriation from foreign operations. If our cash repatriation strategy is modified, our tax rate could trend slightly higher. We will provide quarterly updates on this as we progress through the year.

Our diluted share count at the end of 2012 was approximately a 117 million shares. This is the proximate share count and which our guidance is based. Any dilution from equity based compensation in 2013 is assumed to be offset by the share repurchases and any additional share repurchase that we may execute over the course of the year are not factored in our guidance.

So in conclusion we continue to be confident in our ability to execute in any market. This company has demonstrated a heightened focus on efficiency and cost controls since the 2009 recession. This focus resulted in highly efficient growth in record margins in each of the last three years. Weak market conditions, particularly in Europe will likely result in sales growth, below our long term trend in 2013.

Despite this 2013 should be another year of record sales and record profits for BorgWarner. Over the long term we tend to execute our growth strategy and over the short term remain focused on efficiency regardless of the directions in market.

With that, I would like to turn the call over back to Ken.

Ken Lamb

Thanks Ron. Now let’s move to the Q&A portion of the call. I’ll ask the call coordinator to please announce the Q&A procedure.

Question-and-Answer Session

Operator

(Operator Instructions). Our first question comes from the line of Rich Kwas with Wells Fargo Securities.

Rich Kwas - Wells Fargo Securities

Ron, in terms of the guide, I know unchanged for the year but Europe is going to be down pretty significantly in terms of production in the first quarter. I know you don’t give quarterly guidance but just generally speaking, how should we think about the cadence or the earning performance as the year goes on?

Ron Hundzinski

I would say that it’s incrementally improving throughout the year Rich. So, every quarter-on-quarter, it’s improving.

Rich Kwas - Wells Fargo Securities

Okay. Is that a kind of a sequential comment on an EPS line sequentially improving?

Ron Hundzinski

Yes.

Rich Kwas - Wells Fargo Securities

Okay all right. And then anything from a mix standpoint that we should be aware of as it relates to your brother parts of your world. I know your European mix got worse as 2012 progressed. What’s the assumption there for ’13 as it relates to that?

James Verrier

As we look out into the year, we are seeing not a significant change in mix as we are looking out. As we come towards the end of last the high end higher contented vehicles kind of caught up a little bit as the year progressed. Now, we have got that assumption into our guidance and we feel pretty comfortable that that mix level is not going to shift too significantly. So that’s what we are seeing it right now.

Rich Kwas - Wells Fargo Securities

And then just on the consumer reports article from a week or a so ago, as you are probably aware they came out with some negative comments about the benefits of turbochargers and the OEMs have kind of backed the performance, in terms of what they have seen but what are your thoughts on that I mean. I can imagine, I know your stance is but just what’s your thoughts on the report and are you aware of any key differences in terms of the testing or any color you could share on your thoughts, would be helpful?

James Verrier

Yes, we are fully aware of it obviously, Rich and I would say with any of those types of reports, we take them seriosuly. We simply don’t want to dismiss them or anything like that. So we do take a hard look at anything like that, particularly when it relates obviosuly to one of our core products. But I think there is a couple of keypoints here in that specific report. It's very difficult to get a sense of what the testing and driving conditions that are associated with the results, that are coming out of that report and as you know Rich and I think everybody else kind of gets it that you can get variations in the results that you get depending on what test cycle you use, what type of driving behaviour, actually indepndent of any technology. At a simple level though our view is almost every indicator we look at towards turbocharger penetration continues to be very strong and we see that in our clothing activity, we see it in our net new book of business.

We’re not seeing any slowdown in adoption rates, we’re not seeing any slowdown in activity and interest levesls from customers and I think that's just driven by, from our view that the fundamentals of turbochargers remain extremly solid. It’s a key technology to help the engineer's downsize their engines and get the type of fuel economy that we need and we have seen that success all around the world for many, many years and we just see that trend continuing on.

So in a nutshell, we pay attention to the report, but we pay attention to all of those reports and there’s a aweful lot of them that are very postive about turbocharger performance and adoption rates. So hopefully that helps you a little bit Rich.

Operator

Our next question comes from the line of Chris Ceraso with Credit Suisse.

Chris Ceraso- Credit Suisse

Maybe just a follow up on that James. I think the big picture is the difference between what the EPA says fuel economy is versus what real world driving is and as you point out it’s not just turbo it’s a host of different technology's but I wonder if the EPA sort of figures this out and says, we need more realistic testing procedures and when those stickers numbers end up coming down a little bit. Does that threaten at all, what you think car companies would be willing to pay for certain technologies? Had there been a link in the past, where I said okay if I had a turbo I am going to get a 15% bump in my window sticker number. Maybe now it’s only 10%, so I’m not going to pay as much for turbo. So do you think that's a risk?

James Verrier

In a nutshell Chris, I don’t see that as a risk. I think there is always a discussion around the real world driving conditions and the stated conditions, as I've said independent of technology. So I don’t see that as a risk to us and we remain very comfortable as we work with the OEMs and they go through all the testing and validation that they go through and the date of the debt scene is still consistently driving towards the type of technologies that BorgWarner has in the profile. So we're not seeing this as a significant risk to BorgWarner at all Chris.

Chris Ceraso - Credit Suisse

Okay, so even OEM data supports the improvement, so they're willing to go for the technology?

James Verrier

Yes absolutely. That's why we continue to see the adoption rates and penetration rates of the BorgWarner type products that we offer.

Chris Ceraso - Credit Suisse

Okay. And then a follow up again for Ron about the progression of earnings through the year. Not to get too cute, but typically your cadence is roughly 50% first half, 50% back half. Do you expect this year it'll be more like 40-60 or can you give us some bands around first half versus back half?

Ron Hundzinski

So we're talking sequentially, right Chris? First of all, I'd have to go back and take a look at some numbers here. I would say it's more rated to the back half of the year. I wouldn’t say its 50-50, okay. I'd say it’s more backend weighted than it is front weighted.

Chris Ceraso - Credit Suisse

Right, of course. The question is normally you're 50-50. Is this year going to be more like 40% first half, 60% back half? How tilted is it, is the question.

Ron Hundzinski

It's not material. I guess I'll say it that way. There's going to be slight difference but it's not material.

Chris Ceraso - Credit Suisse

Okay, and then just lastly on the incremental margins, Drivetrain you commented was pretty low sub 10%. What's your expectation there for 2013?

Ron Hundzinski

You know our guidance on total company is 11.5% plus or better, right, very similar to what we saw in 2012. I would suggest that operating margins within those segments would be relatively similar as well in 2013 as they were in 2012.

Operator

Our next question comes from the line of Joe Spak with RBC Capital Markets.

Joe Spak - RBC Capital Markets

Is there any update on - I know in the past you've talked about being able to flex down in Europe on some of the temporary workers. Can you give us just the latest metrics there and what you see on card?

James Verrier

Yes sure. Let me talk through that. Just a quick recap is - where we were last year was, we were in the mid 20's type number and to clarify that, temporary employees as a percentage of total direct temporary employees. So we were in the mid 20's in the second quarter and as we explained, I think in the past that we would come down to a high single digits, that type of range. That's fairly much where we at. So we may be in the 10%, 12%, 13% type range of temps as we are going into the year and we think that's a pretty good number for us if there is any further erosion.

Just to add another comment onto that though, as we look around the world we are still seeing growth in all parts of the world from a BorgWarner perspective. And the production volumes may be down but from a BorgWarner perspective we are still seeing growth in every region of the world. So we feel good that we got that 10% to 15% type number of temporary employees in place.

And then any updated thoughts on the cash, the free cash flow guidance is again strong for 13. The cash bounce builds quite quickly. So now I know you talked about repatriating cash. That would lead me to believe its maybe not as M&A focused as in the past. Can you just provide any more color there?

I would not say it’s not M&A focused. I think that is our number one focus as M&A. I am very much aware where my balance sheet is and where the cash and like I demonstrated in the fourth quarter, I am being very proactive in addressing that with the share repurchases. So that flexibility still continues for me but we are very much M&A focused on where the cash needs to be.

Operator

Our next question comes from the line of Brett Hoselton with KeyBanc Securities.

Brett Hoselton - KeyBanc Securities

Two questions for you. First of all, with regards to production, there is probably some concern that European production is going to be done in the first quarter. My question is as you talk to your customers about Europe in particular with regards to first quarter production schedules, with regards to full year production schedules, do you sense a particular bias towards the upside or the downside? I think everybody is surprised that fourth quarter came in better than expected. I am wondering what's the first quarter shaping up like.

Ron Hundzinski

Let me take a shot at that Brett and talk about the yearend first of all and the 3% down for light vehicle production in Europe that we talked about a few weeks ago and we still feel good about that number. We feel pretty comfortable and I would say as we have rolled through the first couple of weeks here in the year, where it’s off to a decent start, there is nothing we have seen in our January run rates and as we go into February run rates that would make us feel uncomfortable at all. We feel good about where we were at from a run rate prospective, from where were say five or six weeks ago.

I think if you take it in a slightly broader prospective, it seems to me that the range of guidance on European light vehicle production seems to have narrowed a little bit. I think people were talking some fairly large spreads of what it could be a couple of months ago and that seems to be narrowing a little bit. So the bottom line that we feel pretty good where we were at from a guide of the 3% down.

Brett Hoselton - KeyBanc Securities

And Ron can you maybe provide a little bit more color on your expectations for share repurchases. I mean over the past 10 to 15 years as I’ve covered you, you have never really been an aggressive re-purchaser of shares and this past quarter you’ve have gone out and brought 1.5 million shares and you always have a very good balance sheet. I know your priority is to grow the business and make acquisitions and so forth but I’m wondering, what are your expectations for share repurchase over the next year or two years or something along those lines?

Ron Hundzinski

We have never announced a formal program as you know and the way I would say this is that the M&A activities are not always at a schedule that you would like to have the transactions down right, every year so much. So, as our cash starts to build on the balance sheet, I am very much aware of the leveraging issue we have on our balance sheet, which then says I need to be much more proactive in those periods where the M&A activity is slower and then I have to return capital issues using the flexibility of share repurchases.

So what I would say is that I use share repurchases in the periods of time where the M&A activity is not being able to close a transaction. It gives me the flexibility to still maintain or return of capital strategy for our investors while the M&A activities that we do internally continue. Does that help you?

Brett Hoselton - KeyBanc Securities

Is there any particular metric or threshold that you kind of use as a guide to say look if I got X amount of cash or X leverage ratio and I start to dip beyond a certain point, I’m going to use that access money to repurchase shares?

Ron Hundzinski

There are several things that go on Brett that I look at internally. We do some valuation modeling ourselves internally for the company. So I get a basis from where I think the value should be. We take a look at the stock prices as well. We know where we’re at on our M&A activity. So, it’s not just a one item. I look at several items that’s going on at a given time and we make decisions based on that. We have a targeted net debt to equity ratio and all that. We've been higher in the mid-20s in the past but I wouldn’t say it’s one metric that I use to determine what I’m going to do when I do it. It’s several factors.

Operator

Our next question comes from the line of Rod Lache with Deutsche Bank.

Pat Nolan - Deutsche Bank

It’s actually Pat Nolan for Rob. Just a couple of questions. First on the cost side and I apologize because I missed the first part of this, where are you expecting R&D to sales to be for the full year in 2013? And as we’re looking further out is to a potential production recovery in 2014, you are doing a really good job this year of controlling costs, actually keeping flat margins without the historic high single digit growth you’ve said you needed to have to maintain margins. Does that imply the incremental in the eventual production recovery won't be as high as historic because the costs will come back a little bit faster.

James Verrier

Let me answer the first question first on the R&D spend. We have always stated that our targeted percent to sales of R&D spend is 4% and we are at the 3.9% in the fourth quarter and I would say that our target still is the 4%. Now can you go through that second part, it’s kind of long question, exactly what you are trying to get at the second part of your question?

Pat Nolan - Deutsche Bank

I apologize. So this year you are doing a very good job of controlling costs, and as a result your able to maintain margins with lower growth than you’ve historically needed to achieve flat margins. So in the eventual production recovery that we could see in ‘14, ‘15, does that mean your incremental margins would be lower than your historic level because the costs would come back a little bit faster?

James Verrier

No, okay I see what question is. As we start to get growth again on the top line, my incremental margin will be in that 20ish range plus or minus. That's where you could expect our margin, that's where we drive our businesses at that 20% range.

Pat Nolan - Deutsche Bank

Okay that cost cutting measures that you’re taking in 2013, we shouldn’t view those as kind of temporary measures that eventually that cost us to come back?

James Verrier

I wouldn’t classify as cost reductions. I would classify them more as cost controls. I guess there is a difference. What we would do is we would defer certain investments at times. It’s not that I am taking costs necessary out. Now with that said we are being more productive. I’m not going to discount the productivity side of it but that's just normal work. So we're not taking our people and cost right now, we're just being very prudent on many line items in our expense reports as far as where we want to put investments in the short term and what we can defer as far as investments. So it's more cost controls than cost reductions.

Pat Nolan - Deutsche Bank

And if I could just sneak one more in, can you give us a rule of thumb for your yen sensitivity to the top line and how it flows through the margin?

James Verrier

We have a facility in Japan and it's not a significant portion of our exposure quite frankly, but it can impact us and we just pointed out because it is a sizeable operation we have up there, it’s 20% (ph) of sales.

Ron Hundzinski

3.5%

James Verrier

Yes 3.5% of sales.

Operator

Our next question comes from the line of David Leiker with Robert W. Baird & Company.

David Leiker - Robert W. Baird & Company

I want to take a cut at this quarterly numbers on a different fashion. And as we are hearing a lot of comments that some of those production cuts you saw in December, particularly with Audi carried over into the first quarter of January. As we look at Q4 to Q1 what things do you think are different? Weather is about the same, seasonality is about the same. What things do you think are different that make Q1 different than what we saw in Q4?

Ron Hundzinski

You're referring to the market?

David Leiker - Robert W. Baird & Company

Your earnings.

Ron Hundzinski

Oh, earnings. What I would say is that obviously the top line sequentially has to be looked at very closely, right? Going through the cost structure side of it, I think we managed our gross profit margin fairly well. We're down 30 basis points year-over-year. I would suspect that we can maintain decent gross profit margins as well going sequentially. If you go further down the SG&A line items and corporate charges, there were some, what I would call some investments in the fourth quarter that may be increased to spend in the corporate line items and SG&A, especially the R&D spend. Maybe that would back to more normalized spend level. David, did I help you?

David Leiker - Robert W. Baird & Company

Great that's useful. And then just to circle back on the turbocharger thing, I think some of what is going around in the market here, are people, I think consumer reports is comparing a 1.6 liter normally aspirated engine with 1.6 liter turbocharged engine and I think James in that scenario, the fuel economy differences may not be that great. What the real opportunity for, the turbos are doing 1.2 turbocharged engine versus a 1.6 liter. Is that some of the misunderstanding that's going on here?

James Verrier

That could well be David. Your example there is a good one. Not to keep repeating myself but I think the key here is the fundamentals of what we're doing with turbochargers is generally to enable the downsizing of the engine and maintain similar levels of performance and get good fuel economy, and that fundamental still remains intact and we've got this test data out there with this consumer report and it's very easy to mix and match and not draw the appropriate conclusion.

David Leiker - Robert W. Baird & Company

What is the fuel efficiency gain, on a 1.6 liter versus a 1.6 liter turbo? It's single digit percentages isn't it?

James Verrier

Well first of all I don’t want to comment for Ford, David on that particular thing. They would be better because it can depend on the whole issue, the calibration of the engine and what other technologies they are utilizing on that engine. So I don't want to comment specifically for Ford on that 1.6 application.

David Leiker - Robert W. Baird & Company

Okay, I was just talking generically. And then onto Europe on the truck side, there is a Euro 6 emission change here at the start of 2014. I guess two questions, one, does Euro 6 present a content opportunity for you, as you look to 2014 and secondly what are your thoughts of whether there's a pre-buy there or not that may push off launches of 2014 Euro 6 engines?

James Verrier

The first part David I think, as we migrate to Euro 6, in general that will help us as they adopt more technology to that level of engine. So that at a general level will help BorgWarner. In terms of a kind of pre-buy for it, as we get through ‘13 ahead of ’14, I don't think that's going to be significant for us. We're actually showing Europe year-over-year about flat for commercial vehicle. So not significant or material for us in terms of pre-buy but Euro 6 does help us a little bit from a technology perspective.

Operator

Our next question comes from the line of Itay Michaeli - Citigroup.

Itay Michaeli - Citigroup

Just want to back to cash deployment. Ron you mentioned M&A is still a top priority but typically when the environment isn't as active, you go out and buy back more stocks. So is it fair to characterize the current environment as not particularly active in terms of what you're seeing out there in M&A and if so why, maybe you could just talk about the M&A landscape a little bit and what you're seeing out there, what's available out there and so on.

Ron Hundzinski

I would not say that M&A activity is not active, it's extremely active. What I was referring to is that the bill that closed transaction currently in the environment, we're a little bit behind paced that would like quite frankly, but I would not say that the activity level is any lower than it ever has been. In fact it's I would say increased in some way. So, if I said that the activity was decreasing I didn't mean to say it that way.

Itay Michaeli - Citigroup

Okay that's helpful, that's good to hear, and then just in terms of a couple of housekeeping items. Just help us in terms of how to think about interest expense in ‘13, is Q4 a good run rate and then also depreciation, amortization?

Ron Hundzinski

Interest rate I say, I would say it that what you saw on the end of the fourth quarter is a good run rate going forward, and depreciation and amortization is on a full year basis, has been around that 4% of sales. I think it was slightly higher in the fourth quarter but I think you're going to have to look at it, on a total year basis, it's at 4%.

Itay Michaeli - Citigroup

That's helpful and then just lastly as we strupping (ph) up our euro sensitivities, can you remind us what, how the European operating margin fee looks relative to the corporate average?

Ron Hundzinski

They're the same so we're trying to understand what the margin impact would be on a change on the Euro, I would use the corporate average.

Operator

Our next question comes from the line of Colin Lengen with UBS.

Rahul Chadha - UBS

This is Rahul Chadha on behalf of Colin. Could you provide us a little more color on what's driving the strong growth in all wheel drive and is this becoming the story for the Drivetrain business going forward?

James Verrier

It's a couple of things that are going on. Well first of all, it's a critical part of our growth plan and we're very confident about the growth opportunities for the all-wheel drive segment. It's a couple of things that we're benefiting from, (inaudible) content in the North American market is strong as we've seen growth and recovery in the north America market, and our acquired business, the Haldex business from a coupling perspective has also seen significant growth in different parts of the world. So both if you like both parts of the all-wheel drive segment for us, both couplings and transfer cases have seen growth in the region and some incremental gains.

Rahul Chadha - UBS

Sorry, what sort of credential does it have to outperform the industry productions sort of over the next couple of years.

James Verrier

I would say there's probably a little more opportunity on the coupling side of the business for us versus the transfer case side of the business, but as we look at it, our long term projection, we some level of outperformance on the transfer case business and the coupling business offers us very good opportunities as we look forward?

Rahul Chadha - UBS

And then one housekeeping outcome, the corporate expense of $33 million seemed like it was up quite notably year-over-year. Could you help us understand what drove that?

Ron Hundzinski

It was up about $8 million year-over-year. I actually look at the sequential but I'll address the year-over-year. It's a whole host of items everything from a little bit of a, we put our advanced engineering expenses in corporate. R&D expenditures related to our segments, stay in the segment. So we had increased R&D spend, we had some foreign corporate offices, primarily in Germany and in Shanghai, China that we've been adding talent to as well, but it's basically a whole host of miscellaneous items there.

Rahul Chadha - UBS

And is this a good rate to model going forward.

Ron Hundzinski

What, from the fourth quarter or from which period?

Rahul Chadha - UBS

From the fourth quarter.

Ron Hundzinski

I would say the fourth quarter's pretty much in line where you could expect it going forward, change a few million here and there but it's not way off.

Operator

Our next question comes from the line of Ravi Shanker with Morgan Stanley

Ravi Shanker - Morgan Stanley

I only have a couple of housekeeping items left and one bigger picture question. You said you had a customer-specific issue in the quarter. Has that been resolved or is that going to continue for another quarter as well?

James Verrier

Ravi this is driven by a commercial vehicle customer that had some technology changes that they were going through that affected us without really naming the customer.

Ravi Shanker - Morgan Stanley

I have no idea who you're talking about, but anyway.

James Verrier

I don't want to name the customer Ravi but,…

Ravi Shanker - Morgan Stanley

I understood,

James Verrier

That's just the volume it's a volume related issue, I'll say it that way, not a cost side.

Ravi Shanker - Morgan Stanley

Got it.

James Verrier

Volume related in other words, they're changing technologies.

Ravi Shanker - Morgan Stanley

But is that expected to persist into next year as well?

James Verrier

It's related to a year over year comparable issue. I think the run rate on this customer will stay where it's at but on a comparable basis it becomes an issue for us.

Ravi Shanker - Morgan Stanley

Okay understood. And speaking of CV you said that was 20% of your revenues, that's a bit higher than normal I think. It’s usually in the 16% level. So is there something going on. Is it because the European light vehicle business is still week or have your CV business run rate kind of step up little bit.

James Verrier

Let me clarify that Ravi. Commercial vehicle is about 16%, 15%. Aftermarket makes up that difference up to 20%. I kind of used 20% because I combined the two of them together because a good portion of our aftermarket really is Commercial Vehicle.

Ravi Shanker - Morgan Stanley

And what exactly was your share count at the end of the quarter.

Ron Hundzinski

117.4.

Ravi Shanker - Morgan Stanley

Okay so similar to the fourth quarter average. And finally a bigger picture question. When you look at R3S turbo versus R2S, what are the advantages of using R3S and do you see that as being more of a niche product with these high performance diesels or do you think it becomes more widespread?

James Verrier

Ravi, my sense right now, it'll start out as more of a niche product. I mean if you look at the application that we're utilizing it on, with BMW, it'll start out as more of a niche application but we will have the potential to grow and I guess the reason I feel pretty comfortable about that is that was the same story with R2S. If you go back many years ago, that was applied to a niche application and it became a little bit more mainstream.

Now will it become a large part of the turbo segment, probably not but what it does do is obviously enables us to support customers our customers with specific cut niche applications such as this BMW M6 that we're talking about with R3. The other follow on comment I would make is as the technology leader which we absolutely view ourselves as in turbochargers, it's another good example for us to utilize some of our new and breakthrough technology which the R3S is a good example of that.

Ron Hundzinski

Hey Ravi, it’s Ron. I just wanted to correct something. I told you it was 117.4. It was actually 117.8. So this 400,000 share difference there, just want to correct my number.

Operator

Our next question comes from the line of Matt Stover with Guggenheim Securities.

Matt Stover - Guggenheim Securities

One the assets that were sold, were they a favorable contributor to income or neutral or did they distract last year?

Ron Hundzinski

Neutral.

Operator

We have time for one final question, and that question comes from the line of Brian Sponheimer with Gabelli & Company.

Brian Sponheimer - Gabelli & Company

Just a question on the luxury automakers as they get more evolved in some of the entry level luxury markets or luxury platforms with the COA class and the One series. How do you guys view this penetration in North America? Is it a good thing for you or is it something that could potentially dilute some of your higher content on some of your larger vehicles if consumers trade down in size?

James Verrier

I would say in general it's good for us. And as we look at the luxury guys bringing those types of vehicles in, our sense is that the adoption rates of the touch technologies that we have, whether it be turbochargers or other products will be strong. So we see that as favorable.

Ken Lamb

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

Operator

That does conclude the BorgWarner 2012 fourth quarter results earnings conference call. You may now disconnect.

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