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BorgWarner Inc. (NYSE:BWA)

Q3 2009 Earnings Call Transcript

October 28, 2009 9:00 am ET

Executives

Ken Lamb – Director, IR

Tim Manganello – Chairman and CEO

Robin Adams – EVP, CFO and Chief Administrative Officer

Analysts

Rich Kwas – Wells Fargo Securities

Himanshu Patel – J.P. Morgan

Chris Ceraso – Credit Suisse

Pat Nolan – Deutsche Bank

Brian Johnson – Barclays Capital

Brett Hoselton – Keybanc Capital

Colin Langan – UBS

Operator

Good morning. My name is Dorlene, and I'll be your conference facilitator. At this time, I would like to welcome everyone to the BorgWarner third quarter results conference call. All lines have been placed on a 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, Investor Relations. Mr. Lam, you may begin your conference.

Ken Lamb

Thank you, Dorlene. Good morning and thank you all for joining us. We issued our release this morning at approximately 8:00 AM Eastern Time. It's posted on our website at borgwarner.com on the Investor Relations homepage. There will be a replay of today's conference call available through November 4. The dial in number for the replay is 800-642-1687. You will need the conference ID which is 33375379. The replay will also be available on our website.

With regard to our IR calendar, we will be attending the following conferences over the next three months, the Gabelli Conference in Las Vegas on November 3, the Baird Industrial Conference in Chicago on November 10, and the 2010 Detroit Auto Show Analyst Conference January 12 and 13. Also we will be announcing our net new business for the years 2010 through 2002 on November 9 at 10 AM. We will be sending out a separate notice tomorrow to give you the details.

Before we begin, I need to inform you that during this call, we may make forward-looking statements which involve risks and uncertainties as detailed in our 10-K. Our actual results may differ significantly from the matters discussed today.

Now moving on to our results, Tim Manganello, Chairman and CEO, will be providing highlights on the quarter and sharing his perspective on recent industry trends. And then, Robin Adams, our CFO will discuss our operating results and his thoughts on the rest of the year. With that, I'll turn it over to Tim.

Tim Manganello

Thank you Ken and good day everyone. I am pleased to review our third quarter performance and comment on the state of the industry today.

I'll begin by briefly highlighting our third quarter results. We reported third-quarter sales of just over $1 billion, and while this was lower than the same period last year, it is important to note that BorgWarner achieved an improvement for the second consecutive quarter in both sales and operating profits.

Our earnings were $0.15 per share. Our earnings performance in the third quarter has lifted us close to breakeven year-to-date despite incurring losses in each of the first two quarters of 2009. This is a direct result of resizing our business for profitability at today's sales levels. As a result of actions taken over the last 12 months, BorgWarner is now a much leaner company with a renewed commitment to operational efficiency. This is combined with our continued focus on profitable growth.

At the group level, our engine group sales were $731 million including the unfavorable impact of currency, while drivetrain sales were $297 million, also including currency. Sales and EBIT in both groups were higher versus the second quarter which we regard as a positive sign as we enter the final quarter for 2009. Drivetrain's improvement in EBITA for the same period a year ago provided the real lift for the company. This group posted a quarterly profit for the first time since the second quarter of 2008, and we're encouraged by the turnaround and the future potential for these businesses.

Cash management remained a high priority in the third quarter. We were efficient in both our CapEx and working capital spending. As a result, we once again generated positive free cash flow at about $14 million. However, and most importantly, we continue to invest for the long-term as evidenced by our commitment to maintaining our spending for R&D and new program launches. In addition to our improved financial performance, we also announced several exciting developments during the quarter. These include important new business wins in the fast-growing Chinese market, the advanced automatic transmission area, and with electric vehicle products.

These programs are representative of how BorgWarner is leading the way in important drivetrain development around the world. Specifically, BorgWarner will be supplying First Automotive, China's largest domestic OEM with turbochargers on their 1.3 liter and 2 liter gasoline engines and EGR valves on their new three liter diesel engine. Also BorgWarner has been selected to supply friction plates for the new ZF 8 speed automatic transmission debuting on the 2010 BMW 760i.

We are also supplying clutch packs and one way clutches for Hyundai/Kia's new next-generation six speed automatic transmissions. The new transmission family will ultimately drive 16 Hyundai and Kia vehicles, including Hyundai's new Tuscon, the Sonata, and the Santa Fe, as well as Kia's new Sorento. And the all electric Coda vehicle scheduled to launch in California next year will be equipped with our new eGear single speed transmission.

Now shifting gears, I would like to make a few comments on the broader auto industry as we saw some interesting developments during the last quarter. In Europe, industry production volumes in the third quarter were down slightly compared with the second quarter with most of the decline occurring coming in the A and B segments. We believe the decline in small cars was due to scrappage programs fatigue while flat volumes in midsize and large cars indicates stable conditions with some limited growth in the European market.

Now in the US, the cash for clunkers program boosted volumes in August and industry watchers estimate that program was directly responsible for about 700,000 sold vehicles. There were also claims that the program generated sales simply because it increased showroom traffic. But volumes in September were down suggesting that cash for clunkers did not necessarily generate demand but rather pulled it ahead. However, recent announcements from GM and Ford regarding production increases indicate that demand is on the rise, and our orders from the Detroit Three support this.

Now the commercial vehicle market remains near trough levels in the third quarter, but began to show early signs of recovery. We saw incremental scheduled improvements in North America that maybe the beginning of a trend or at the very least a shift to higher production rates than we saw in the first half of 2009. In Europe, however, volumes were flat, and our view is that there'll be not be much change in the commercial vehicle market in the near term for Europe.

Now that brings me to the outlook for the remainder of the year. In some respects, the fourth quarter will be a continuation of positive trends that occurred in the third quarter. In Europe we expect that vehicle mix will continue to more towards midsize and large sized vehicles but are nervous that volumes may soften a little bit in December from the peak third-quarter levels. In the US, we expect that volumes will improve quarter on quarter, and possibly into 2010, I would say probably into 2010.

Now increasing fourth quarter 2009 schedules in the North American light vehicle and commercial truck markets, combined with reasonable European volumes indicate that BorgWarner will be profitable in the fourth quarter of this year. And most importantly, this allows BorgWarner to reaffirm our previously stated expectations of positive cash flow and positive earnings for the full year 2009.

Longer-term, we expect to leverage our industry-leading technology, our global presence, and our focus on operational rightsizing to continue to drive our growth. We are continually adjusting our cost structure to reflect the current economic landscape and at the same time we continue to focus on new product launches and global growth. Lastly, customer interest in our fuel-efficient engines and transmissions has only grown stronger and this will be our major growth driver for years to come due to more stringent government regulations.

With that, I will turn the meeting over to Robin.

Robin Adams

Thank you Tim and good morning everyone. Before I give you the financials in detail, let us go over the industry environment in the third quarter which was weak from a historical perspective but did show encouraging signs of recovery from the dismal first half we experienced earlier this year.

In the third quarter, global production was down 9%, a weak quarter considering third quarter 2008 was an easy comparison, but on a volume perspective, a market improvement from the past few quarters of the year. If you look at the data, it appears the worst seems to be over, and let me give you some of the data points. Global vehicle production fourth-quarter 2008 was 14 million units, first quarter was 11.6, second quarter was 13.6, third quarter was 14.2. So you could see we have climbed back to that fourth quarter of 2008 level and the trend certainly looks to be in the right direction.

I will give you the same data for North America. In the fourth quarter last year, they produced 2.7 million vehicles in North America, first quarter was 1.7 million, a quarter I would like to forget, the second quarter was 1.8 million, not much better, and the third quarter was 2.4 million. In Europe, fourth quarter was 4 million units, last year, first quarter was 3.4, second quarter, an improvement at 4.3, and as Tim mentioned the third quarter is about 4.1 basically flat or down slightly from the second quarter.

So that gives you a perspective of where the market has been and where it is in the quarter. And if you look at our sales in the quarter, we were down 22% versus last quarter, 18% excluding currency but relative to second quarter levels, we were actually up 8 percentage points excluding currency compared to a global vehicle market that was up about 4% quarter over quarter. So if you look at the sequential growth in this business, the strength is starting to show, and the signs are pretty encouraging with respect to where we were in the first half of the year and where we are today.

For the quarter, as Tim mentioned, earnings were about $0.15 a share compared with a GAAP loss of $1.12 in the third quarter of last year, and if you look at the third quarter of last year, there were a number of nonrecurring items, and we detailed those in a table in the press release. And if you look at that table, hopefully it helps you reconcile the financial performance to both the prior and current periods, and also gives you some sense of how to look at future projections, and we think this is an important part of the release. And I'm going to leave a lot of those details to the release and just talk about the summary number.

So for the third quarter, excluding all those items in 2008, earnings were about $0.44 a share. While sales and earnings in the quarter declined from year ago levels, they are a marked improvement from the previous few quarters in 2009. By the way we also intend to file our 10-Q by the end of the day which should also provide a lot more details on the quarter for you.

Looking at the first nine months, US GAAP earnings were a loss of $0.22 a share compared with a gain of $0.39 per share in the first nine months of 2008, again our press release the details of a number of nonrecurring items in both the first nine months of 2009 and 2008 for your review. If you exclude these items from both periods, our net loss here to date was 3.1 million as Tim said, virtually breakeven or about $0.03 a share loss compared with income of 232 million or $1.97 a share for the first nine months of last year.

And as I said, the year-over-year comparisons don't look pretty obviously driven by a significant decline in sales but the encouraging signs are the sequential quarterly performance that we just talked about. If you look at the income statement, gross profit in the quarter as a percent of sales was 14.8%, not too bad compared to 15.4 in the third quarter over a year ago, but actually up from 12.7% in the second quarter. And this improvement relative to the second quarter in the relative tightness versus the third quarter last year reflects the effectiveness of the restructuring activities and other cost containment actions that we have taken as a company over the past 12 months.

Third-quarter sales SG&A costs were 126 million or 12.3% of sales which is down 5 million compared to the third quarter of last year excluding special items. And then as a percent of sales, it was about 10%. Included in SG &A as you know are R&D costs which were 4% in the third quarter this year versus 3.8% during the same period a year ago. On an absolute dollar basis, that equates to about $41 million, down about $9 million from about 50 million in the third quarter last year. And about a third of that change year-over-year relates to the salary wage reductions that we implemented in early 2009 and our total work force took as a way to try and improve the performance of this company and share the sacrifice.

We are also looking at when you look at third quarter 2009 versus 2008 SG&A, we are experiencing about $8 million increase in pension and OPEB expense versus last year resulting from primarily the closure of the Muncie facility earlier in the year. And relative to the second quarter of this year, now looking at third quarter 2009 versus second quarter 2009, SG&A is up sequentially $9 million with 5 million of that related to increased R&D spending. As Tim said, we continue to try and ratchet up the spending there, and 4 million really related to the impact of currency reported in the third quarter of this year versus the second quarter of this year, and that is primarily driven by the dollar euro.

In the second quarter, we talked about SG&A being negatively impacted by stock related compensation of about $5 million and obviously in the third quarter, fortunately we didn't have that $5 million burden which we would have had it, so there was a benefit rolled into the third quarter in SG&A, but that was offset in the quarter by the start of incurring some incentive comp in the company. Operating income on a reported basis was 27.5 million versus a loss of 103.9 million the same period a year ago, again excluding the nonrecurring certain items. Operating income in the third quarter really came in at about $175 million – I am sorry, $72 million. The adjustment was 175 million; excluding the adjustments of items, third quarter 2008 was 72 million. So 27 million, third quarter this year, 72 million third quarter last year.

If you compare the decline in operating income that 72 to 27.5 relative to the decline in sales year-over-year, it provides a decremental margin of 15%, and you know we have talked, and we have talked last year and early this year about our focus trying to maintain that decline in operating income in the 20 to 25% level and coming in at 15% is obviously our best performance of this year, as something we feel very good about. If you remember, our decremental margins in the first quarter were 21% and 20% in the second quarter, so we have been consistently performing to the top end of our expectations; in the third quarter we actually outperformed our expectations. And if you look at on a year-to-date basis, we're slightly below $0.20 on the dollar from a decremental perspective.

Now the last time as we talked about, the incremental margin on a sequential quarter basis was talked about the third quarter of 2009 versus the second quarter, and if we compare that change, the changes in operating incomes was about 27 million relative to an increase of sales of about 112 million. This translates to an incremental margin of 40 million. However when you look at the increase in sales third quarter versus the second quarter, about 40 million of it was actually just related to currency, and nothing to do with our operations. And when you strip the currency out of the increase third quarter to second quarter, the incremental margin in the third quarter versus second quarter was a pretty impressive 38%.

If you remember in the second quarter, the incremental margin from Q2 to Q1 was about 27%. So if you average the first, the second and third quarter relative to the first quarter, which we consider the industry bottom level for the year, we averaged about $0.32 on the dollar incremental income on incremental sales this year. And again, we are very encouraged by the progress of our operating performance in the second and the third quarter and expect that to continue to improve.

Again, let me give you some relative performance metrics to understand the quarter and again the fact that things are going on the upswing. If you look in the fourth quarter of 2008, basically we broke even from an operating income perspective, the operating margin was 0.4%. And the first quarter was negative 2.1%, and the second quarter again basically breakeven at 0.1%. And then the third quarter 2.7%. So you can see again the trend is coming back and we expect the trend of increasing margins to continue and we expect that incremental margins and sales growth to continue to be about the $0.30 on the dollar plus level.

Looking further down the income statement, interest expense and funding charges, we are about 13 million versus 11.2 in the third quarter last year. And as we said before, the cost of liquidity related to the convertible notes we issued in April to provide liquidity in an environment where there was no liquidity available is putting a little bit of pressure on the interest expense line item in the income statement. Looking to the tax rate in the quarter, the effective tax rate for the quarter is about 7%, which is really the result of a 54% year-to-date tax rate. And the 7% just flops outs after you deduct the full year from the six month reported.

And I know that number looks a little strange but it is a function of losses and gains in different geographies around the world. It is, I will use an operating down, I get a lot from our operating guys, it is a mix issue. But trust me, it really is a mix issue with respect to taxes. We have got some jurisdictions where there are on a year-to-date basis that is a loss and others where there is a slight gain that we get this kind of strange effect of tax rate.

However, as earnings continue to grow, we expect the tax rate to move closer to the about the 25% level that we had prior to the significant decline in industry volumes. In fact as we look at incremental earnings on a incremental quarter basis, those incremental earnings next should be somewhere in the $0.20 to $0.30 on the dollar tax effect. Taking that all into consideration, it gets you back again to the bottom line which is a $0.15 a share earnings for the quarter, and that is down from the third quarter's adjusted $0.44 a share. But as I said earlier, it is up from where we have been in the last few quarters.

And again let me kind of reiterate where we were. In the fourth quarter of 2008, earnings per share were breakeven. In the first quarter of this year, earnings per share were negative $0.12 a share, again this excludes the nonrecurring items. In the second quarter, earnings per share were a negative $0.05 a share, and now we are the third quarter, at $0.15 a share, again the same type of trends whether you look at industry production, whether you look at our sales, whether you look at our operating income, whether you look at our net income, obviously the trends are very favorable and this is best quarter we've had in over a year, and again I think the trends are back in the right direction for BorgWarner and that direction is growth.

Let's look quickly at the operating performance in the quarter by segment. Engine segment sales were 735 million, that is down about 20% year-over-year excluding currency. Earnings before interest and taxes for the engine segment was 57 million, down 38 million from the same period a year ago or about 33 million excluding currency. So on a decremental margin basis, excluding currency, translates to about $0.16 on a dollar, good strong performance, and cost containment on the engine side of the business.

However, as Tim mentioned, it was the dry train side of the business the really provided a much overdue lift for the company, and if I was a drinker, after this call, I would go out and celebrate and have a cocktail on this one, because being a great quarter. Third-quarter sales were 297 million, down 15% from the same period a year ago or 10% excluding currency. Earnings before interest and taxes was 8 million which is up 10 million despite lower sales and that is really excellent relative performance by the drivetrain group. We have been waiting for this.

As you remember, during our first quarter earnings call, Tim stated that he was intensifying the focus on the drivetrain group and that we expected improvements throughout the year, including the benefit of the closure of our Muncie facility. And I think as you look at that third quarter performance, this is solid evidence that that business has turned around, those efforts have yielded results, and we're very excited about the performance of drivetrain in the quarter and the future performance from that segment of the business.

Let's get to the balance sheet and cash flow. Net cash provided by operating activities was close to 225 million in the first nine months of 2009. Capital spending including (inaudible) was 127 million. And while down significantly from 266 million a year ago, it is in line with our expectation of spending 200 million for the full-year. So that leaves about 73 million for the fourth quarter which is a pretty healthy level of spending but I believe our operations still continue to plan to spend the money.

After deducting capital from net cash provided by operating activities, operating cash flow was approximately $100 million during the first nine months of 2009 of which about $14 million was in the third quarter. And as most of you know the third quarter is a challenging quarter from a cash flow perspective due to working capital build ups and we saw that in the quarter; despite that we are still generating cash from our business.

Working capital relative to last year has improved dramatically. Inventory levels are down by about $145 million since the end of last year. Receivables are up on the balance sheet at the end of September versus year end December but that is a good thing and that is a very good thing because it is a result of increased business activity. As you look at September sales versus December our sales were up almost $200 in September versus the level they were in December and while it's an increase in working capital, it is a very exciting increase in working capital for the company.

Overall the focus that we have had managing capital has paid off, but we feel we still have a little bit more to do on the inventory side before year-end. The balance sheet debt in the first nine months of the year increased by 67 million which really is a net effect of the issuance of 374 million convertible notes in April that I mentioned before offset by the retirement of 137 million of senior notes in the first quarter and payments related to other short-term debt obligations.

During the same period, the same first nine months, cash increased by 156 million and again that's a result of parking some of the proceeds from that convertible senior notes to provide liquidity for the company in this environment. And if you net the increase in debt versus the increase in cash, there is a decrease in net debt of close to $90 million.

We further strengthened our investment grade balance sheet during the quarter with net debt to capital ratio of 21% which is versus 24% at the end of the second quarter and 25% versus year end 2008. So despite the first six months of the year being a pretty drastic reductions in industry activity, our balance sheet is actually stronger than it was when we started the year, anywhere we ended of the second quarter. If you look at net debt to EBITDA on a trailing 12 month basis, a little over two times right now, however if you look at just the third quarter EBITDA which was about a little bit north of $100 million and you analyze that at an run rate basis, that would put net debt to EBITDA at about 1.5 times, a very, very respectable leverage ration for BorgWarner.

Now let us talk a little bit about the rest of 2009. Tim talked about 2009 and as he mentioned we do remain cautiously optimistic about the remainder of the year. Our internal view in North America is pretty much directionally aligned with those of you experts that report market forecasts. And if you look at the experts now, the fourth quarter projection is somewhere around 2.7 million units and as I said earlier, third quarter was 2.4, so that translates to about 12% growth over third-quarter levels. Again this is based on the experts and as we have said before we are relying on the experts with a lot of this data.

However, there continues to be a surprising degree of uncertainty in Europe considering where we are in the year. The average expectation is that European volumes will be flat or improved slightly compared with the third quarter. We're watching that closely as Tim mentioned. And again, you know back in January of this year, we provided guidance of positive cash flow and positive earnings for the full-year, that guidance remains intact. And I think if you look at the performance to date, there is very little question about our ability to meet that guidance.

This implies that our cost-cutting efforts in combination with sustained recovered and production volumes will generate another quarter of positive earnings for us in the fourth quarter. In fact, we expect the fourth quarter to be the first quarter in a long time where we will be able to report year-over-year growth in sales and I'm looking forward to a quarter where I don't have to talk about declines. So I will be excited in January when we talk again about performance here.

The data suggests that we are slowly coming out of the industry bottom that we experienced in the first of the year, and again I went over the production levels from fourth quarter 2008 all the way through third quarter 2009 and I think the trend regardless of where you look suggests we are slowly coming out of the bottom. However, we do maintain a level of caution regarding the pace of the industry's recovery, and regardless of that, we remain focused on the key driver of these companies long-term success. And that is our powertrain technology leadership.

As Tim mentioned in his comments, we are a leaner company now but with a workforce that has rededicated itself to ensuring BorgWarner maintains its reputation and its position as the leader in powertrain technology throughout the world. We are well positioned both financially and technologically to remain at the forefront of the growth curve in this growing industry.

And with that I would like to turn the call back over to Ken.

Ken Lamb

Thanks Robin. We will now go to the Q&A portion of the call. I would like to ask the call coordinator to please review the Q&A procedure.

Question-and-Answer Session

Operator

(Operator instructions). The first question comes from Rich Kwas with Wells Fargo Securities.

Rich Kwas – Wells Fargo Securities

I had a few questions regarding just turbochargers and how you think about mix here for 2010. I know that it is a little early at least what you have disclosed so far but you know I guess, Robin or Tim, can we – how do we think about the volume volatility that could occur in Europe, and then how that plays out with the improving mix that you are starting to see on your end?

Tim Manganello

Good morning Rich. We are starting to see a change in mix back towards both premium vehicles and larger sized vehicles and a decline like I said in my report in the smaller vehicles. We are starting to see a rebound back towards diesel, there is a projection that we think that diesel's probably dropped from about 50 to 53% of the penetration rate last historical – recent historical past, down to about 44% plus or minus, we think that that is going to come back about another 4% increase to about 48% plus or minus, so we are seeing a shift back a little bit back towards diesels.

Obviously, we are seeing a tremendous growth in downsized turbocharged gas engines and so turbochargers we're seeing a strong growth platform; over the next 15 months we will be launching 20 new turbocharger programs that are either new programs or conquest programs from our competitors. And we will get into I think it is November 9 to our book of new business, but of these 20 new programs we're working on, it is about a third America, third Europe, a third in the rest of the world.

Rich Kwas – Wells Fargo Securities

Okay. And then you know your primary competitor in that business talked about gaining share last week as 2010 unfolds, seems like they have been picking up some business on larger displacement engines, can you just give us some more color on how that is all playing out with the primary competitors of the turbocharger side?

Tim Manganello

Bob, I'm not going to speak much about Honeywell, but they may have lost share, so they are trying to gain some back. But what I foresee, the focus we had for our long-range plan is we will be maintaining share in a very fast-growing market. So if they're gaining share, must be with somebody else.

Rich Kwas – Wells Fargo Securities

Okay. And then last question, Robin, how do you feel about the cost structure in Europe at this point, it looks like you have made some progress here sequentially, how far, how more, how much more do you have to go to get it to where you want it to be?

Robin Adams

You know, that is a great point, Rich. One of the improvements in the third quarter versus the first and second on the decremental margin was in our non US operations particularly Europe. And as we said before, those costs tend to be sticky, and you know in the first half of the year we struggled with adjusting the cost structure using short work weeks. I think now that we're seeing a little sales growth on a sequential basis, we are doing a good job of managing the cost structure in Europe and trying to contain it before bringing back the full complement of costs back with those sales. So I expect continued good performance outside the US in the fourth quarter as well from a cost containment perspective. And as I said earlier, actually we will be pretty excited to talk about increasing sales and increasing earnings in the fourth quarter versus the prior year.

Rich Kwas – Wells Fargo Securities

Okay. And then just lastly, the salary reductions as we think about it has benefited you this year, as we think about next year, I mean how much, when are you expecting to change that, and that will probably be a little bit of a headwind next year right?

Tim Manganello

Rich, you sound like one of my employees, I get that question every day now.

Robin Adams

Mostly from me, Rich.

Tim Manganello

Well I only talk about the people that deserve it. But anyhow it is our goal and it is our intention to do it as quickly as possible. Like I have said to our employees in a letter to all of our employees just recently, we are trying to do it as quickly as we can, possibly as early as the beginning of next year.

Rich Kwas – Wells Fargo Securities

Okay, great. Thanks.

Operator

Your next question comes from the line of Himanshu Patel with J.P. Morgan.

Himanshu Patel – J.P. Morgan

Hi. Sorry about that. I missed the early part of the call but Robin can you just talk about as we kind of start seeing Europe production ramp up even further in the fourth quarter and then I think in Q1 2010 CSM schedule is actually calling for a bit of a moderation, where do you kind of think about sequential contribution margins over the next 2 to 3 quarters?

Robin Adams

You know I think as we have said before first let me address the European volume. There is still a little bit of uncertainty in the marketplace with respect to the Europe both for first quarter and first quarter and I think if you look at the data some people would suggest that Europe was flat at best in the fourth quarter versus the third quarter. But volumes aside, as we look at incremental margins in the business the next couple of quarters, we are still looking at about that $0.30 on the dollar plus incremental margin sequentially from a quarter perspective. And as I said I think for the second and third quarter we have averaged about $0.32 of incremental margin and the third quarter was quite a bit stronger at 38. But in the next few quarters, we are still looking for some pretty solid incremental margin performance.

Tim Manganello

Himanshu I would just like to add that leaning into the first quarter, we are actually, if you look at the schedules, the schedules were actually, for the schedules we have so far, they are actually holding up pretty well. But we're a little bit cautious on that because you know the first quarter still a little bit ways away and anything can happen. So if we just went by our schedules, the schedules look good, at least for the first couple of months, but we are a little bit guarded.

Himanshu Patel – J.P. Morgan

Okay. And then lastly, when do you guys start worrying about commodity cost inflation?

Robin Adams

We're worried about it now.

Himanshu Patel – J.P. Morgan

I guess in terms of what quarter do we should we start thinking about that surfacing on the P&L?

Robin Adams

Well you know I think we are going to start to see that pretty early in 2010. And what is keeping raw materials costs in line for us right now obviously is nickel and we are starting to see nickel creep up a little bit. And relative to 2009, at current spot rates, nickel will actually be increasing raw material cost for us in 2010 versus 2009. As we have said before, our production guys continue to be concerned about steel and we have seen increases in steel weighted components; in fact in the third quarter we saw close to a $4 million increase year-over-year steel related from a commodity perspective. Now that was more than offset by the improvement in nickel commodity cost in the quarter but we are seeing steel creep, continue to creep, and as I said, as we look at nickel in 2010, it'll be a negative relative to the 2009 kind of levels.

Himanshu Patel – J.P. Morgan

Okay. And then last question Robin I think in Q2 there was like a 5 million non-cash charge related to options or RSUs or something because of changes in stock, what happened to that particular line item in the third quarter?

Robin Adams

It increased, so when you look at second quarter versus third quarter, we actually got a benefit. I may have gone through that quickly. The SG&A third quarter versus second quarter but I did try to cover that. If you look at third quarter of 2008, 2009 versus second quarter of 2009, the sequential performance, you're talking about, SG&A on a reported basis was up $9 million, third quarter versus second quarter. And as you pointed out, the second quarter, we had the good fortune to have increase in compensation related to our stock and equity to the tune of about $5 million.

And as we said in the second quarter, that increase in $5 million would not be an increase in the third quarter, basically be a benefit as we look at third quarter versus second quarter spending. So while spending was up 5 million, we got the benefit of that stock related non-cash increase. So it was really a 14 million excluding that item. And as I said earlier, 5 million of that was related to increased R&D, 4 million is related to the impact of currency versus the third quarter versus the second quarter, and the rest of that is related to incentive compensation in some of our operations around the globe.

Himanshu Patel – J.P. Morgan

Okay, understood. Thank you.

Operator

Your next question comes from Chris Ceraso with Credit Suisse.

Chris Ceraso – Credit Suisse

Thanks, good morning.

Tim Manganello

Hi, Chris.

Chris Ceraso – Credit Suisse

A few things. On the topic of SG&A, it has been running about 12% recently but as recently as the fourth quarter of last year was closer to 10, so as we get volumes back up to 4Q08 levels, can we get it back down to 10 or is it structurally a bit higher going forward?

Tim Manganello

Chris, I think you're going to see it going back down to historical levels. We have chosen not to touch engineers and some of the people that are tied to our future growth in R&D at the R&D side and actually areas on some of the manufacturing and manufacturing engineering side. So as the volume comes back, you're going to see the percentages should be drifting downward towards historical levels.

Chris Ceraso – Credit Suisse

Okay. And then on the drivetrain business, you had some nice improvement as Muncie came out, if I look back historically, that business used to run at around 7% or 8% EBIT margin, can you exceed that now that Muncie is out of the picture or no because you are also doing less transportation is this? What is the long-term expectation for profits in that business?

Robin Adams

You know I think it is always going to be a differential between the engine and the drivetrain side of the business because despite closing Muncie we still have all the legacy cost related with that facility. So they're going to continue to be burdened by a good portion of the legacy cost which is what drives the difference between engine and drivetrain predominantly. But we certainly expect to at least get back to the levels we were previously and I think you know to your point as we grow more and more DCT as part of the drivetrain business and less four wheel drive transfer case, we should see some margin improvement over where you were historically.

Tim Manganello

The other thing I would remind everybody is we look at the world in terms of return on invested capital. And although the margins, the EBIT margins are down a little bit, when you talk about the four wheel drive business, not down but they are historically lower compared to some of our other businesses, the capacity is already in place, we have already got the CapEx, and we actually when it comes to return on invested capital, they do pretty well, and they will actually start to do better as volume starts to come back.

Chris Ceraso – Credit Suisse

You mentioned a couple of times that you expect something in the 30% range in incremental margins as you go forward, are there workers in Europe still that are on three or four day shifts that you have to bring back up to full-time and does that depress your contribution effect it that region?

Tim Manganello

Well, Europe has always been a sticky region for us in terms of labor costs. I think my team has done a very good job in managing it as well or better than most suppliers in our industry, both in terms of what they have done in being proactive and doing it very early. But we have I think probably around 70% of our plants plus or minus are back to five days but that is after they have already, that is five days now versus five days before, but the differences is before, we had anywhere from 10 to 20% temps or contract workers in these plants.

So the temps and the corporate workers are pretty much they are all gone and our permanent workers about probably about 70% of them are back to like you said a five day schedule.. But the other – there is about 30% that are still on a four day schedule. I don't think anybody except maybe one plant is on a three-day schedule right now. But if volumes pickup up, we have the ability to have more volume with pretty much the same amount of workforce or labor that we have today. And if volumes go down, we can go back to four days fairly quickly.

Chris Ceraso – Credit Suisse

But at some point you would want to bring them back to full-time, right? Does the subsidy from the government that is allowing you to do that expire at some point?

Tim Manganello

It's got about a 24 months horizon on it and we've probably only used less than 12 months, I would say probably on average about nine months of the 24 months horizon. The other thing that has been done and I did mention the first answer is a lot for our plants, right of the bat, they went from 35 hour workweeks to 30 hour workweeks, and so some get paid by the hour, that was an automatic five hours per week pay cut. So we actually have some – we can go back to four workweeks at the same time.

Chris Ceraso – Credit Suisse

Okay, thank you very much.

Tim Manganello

Sure.

Robin Adams

Thanks Chris.

Operator

Your next question comes from Rod Lache with Deutsche Bank

Pat Nolan – Deutsche Bank

It is Pat Nolan in actually for Rod Lache.

Tim Manganello

Hi, Pat. Good morning.

Pat Nolan – Deutsche Bank

Good morning. Just two questions, first on the working capital line, you know we're used to seeing working capital be negative for suppliers as production increases, and it doesn't seem to be playing out this way this time, both you and some of your competitors are seeing not the typical drain you would see in this level of pickup in production. I mean what is going on there and do you think that is going to continue or is there going to be some payback moving into Q4?

Tim Manganello

I think it is all tied to the inventory reduction plan that we have at BorgWarner, I can't speak for the rest of the supply base, but I imagine a lot of them as well. What you're looking at is a nine month period of 2009 compared to a year end 2008 where I think a lot of us got caught with because of the significant decline and quick decline in schedules, a lot of us got caught with excess inventory. So if you look at our working capital, we're not going to take $145 million inventory out of our business year in and year out. So a good portion of the working capital improvement for the year has been excess inventory that frankly we wish we didn't have here in 2008 but we did have.

And to your point, as we see growth going forward, we will see increases in working capital requirements. As I said earlier, we think we've still got a little bit more fine-tuning to do within BorgWarner from an inventory perspective in the fourth quarter. But generally, as we see stronger sales, we see increases in working capital. And again to my point about receivables, if you look at receivables, they are up for the first nine months of the year, about $175 million, and it is a function of business activity. Our sales in September are $200 million higher than they were in December. So you're right, you will see that working capital build once everyone finishes their work on the inventory reduction programs.

Pat Nolan – Deutsche Bank

That is helpful. Just ahead of November 9, could you just remind us what your 2.1 billion backlog was based on as far as your industry production and currency assumptions? And just briefly comment on the content of vehicle opportunities you see, the electric vehicles, I know you just commented on the Coda earlier in your presentation?

Tim Manganello

If I remember right, let's just say 12 months ago seems like an eternity based on what we have gone through lately. But if I remember right, $2.1 billion of backlog that we announced last year was based on just the first indication of scheduled cuts that we are starting to see in the end of the third quarter, beginning of the fourth quarter. I guess we saw some scheduled forecast for the fourth quarter last year and we had some scheduled cuts in the third quarter. So we took some of that into consideration on the 2.1 billion.

So the 2.1 billion was already modified for a little bit on the recession, at the time we didn't know it was a recession. But obviously we will now – when we come out in November we will have the full impact of what we think will be the volume reductions as we look forward over the next few years. The currency if I remember it was about $1.25 to $1.30, dollars to the euro. I think it was 1.25. And so that gives you a little bit of framework or context so when we come out on November 9 and we tell you how great our backlog is of net new business, we will have to reset the framework in terms of currency and what we think the recession levels will be.

Pat Nolan – Deutsche Bank

Got it.

Robin Adams

We don't know what our backlog is as of yet. Tim is –

Tim Manganello

I am just hoping.

Robin Adams

Yes, he is anticipating.

Pat Nolan – Deutsche Bank

And just lastly just on that content for vehicles, for electric levels, I mean how should we be thinking about that? I know that you have pretty significant content on the Coda for your transmission, but if you're talking about more of volume type vehicle or an electric medical, the negative content of the vehicle for you, could you actually make that up, obviously the transmission going forward won't be as highly priced at these low levels volumes?

Tim Manganello

Well, let's just say we are going to be happy if farther down the path to know exactly what the content match is between our traditional gas and diesel technology and our new electric vehicle technology. And the reason is, we're developing products right now for like cabin heaters for electric vehicles that don't generate much heat through the engine, because it is mostly in electric, an electric engine, electric motor, so they need technology to provide a cabin heat, and that is part of our (inaudible) core competency.

So we're developing technology for that. We're developing technology for more robust stop technology. That is a lot of these hybrids that they talk about in the future, most of them are going to be very mild hybrids with just basic start stop hybrids, which is kind of a to me it's not much of a hybrid, but that is what they're classified as. And so we have got new chain technology we are developing for that. So it is hard for me to say what the match up is going to be on content but I will tell you the transmissions that we develop and starting to sell, we – Teslo [ph] when we launched the Teslo transmission, it brought a whole lot of players to our – potential customers and people that are working in the hybrid or totally electric vehicle space, it brought them to our doorstep and we're working with probably about I think it is like 14 active development programs on either pure electric vehicles or what I will call really high content hybrid electric vehicles, and high content I mean mainly electric.

So it's been a – that program has been a big plus for us and you know the other thing I would add is on that 13 or 14 programs that I'm talking about, you know three of them were with traditional OEMs and ten of them with nontraditional OEMs, people that I would be honest with you, a years ago I didn't even know that these companies existed, because they are just in their last year too, they are startups. Did I answer your question, sorry for the long answer.

Pat Nolan – Deutsche Bank

Know it does, very helpful. Thank you very much.

Operator

Your next question comes from the line of Brian Johnson with Barclays Capital.

Brian Johnson – Barclays Capital

Yes, good morning. A couple of questions around the torque transfer business, first, in a way you reported that was about 7% of driveline, how did that look in this past quarter? And then if you look sequentially versus how much of the up tick in drive line was due to the big three coming back online in the rear wheel drive business?

Robin Adams

The four wheel drive business is a little bit lower as a percentage of our total business today that the last public disclosure. And you will get the relative growth in the quarter in the drivetrain business, it was more on the DCT side of the business than the four-wheel-drive side of the business. We are not seeing a big reversal in trend where like truck and SUV production is increasing.

Tim Manganello

We are starting to see some pickup in volume on that because…

Robin Adams

Relative to earlier.

Tim Manganello

Right, relative to…

Brian Johnson – Barclays Capital

As we go sequentially, is that up?

Tim Manganello

Yes, right. But relative to the trough, we are starting to see some increases.

Brian Johnson – Barclays Capital

But it is not going to be what it was in the past obviously?

Robin Adams

I don't (inaudible).

Tim Manganello

(inaudible).

Brian Johnson – Barclays Capital

On the cost side you mentioned legacy cost in the driveline, last year, you had ex the curtailment gains about 12 million of pension expense and about 10 million of OPEB expense, so that's 22 million, how much of that is in the drivetrain business, and how much of that is kind of down to the Muncie plant?

Robin Adams

It is all in the drivetrain business. And the majority of that is related to the four-wheel-drive business.

Brian Johnson – Barclays Capital

And so that is going to be offset…

Robin Adams

Some of that is related to discontinued businesses as well.

Robin Adams

So will that continue to be charged against the drivetrain business every quarter?

Robin Adams

Yes.

Brian Johnson – Barclays Capital

Okay, thanks.

Robin Adams

Although they continue to tell us that it ought to come to corporate. I don't know if they asked you to ask question for them.

Brian Johnson – Barclays Capital

So even though it is a disgruntled op, you can't move that expense out of the income statement?

Tim Manganello

Well, we are still in the four-wheel-drive business. We are still in that, we are still making that product, well just to different parts of the world now.

Robin Adams

I need to find out what did the guys in the four wheel drive business (inaudible) you for this question.

Brian Johnson – Barclays Capital

I have just been inside corporations so long I can guess. And any chance (inaudible) to defuse the OPEB liability, is that worthwhile?

Robin Adams

Not at this point in time, no.

Brian Johnson – Barclays Capital

Okay, thanks.

Robin Adams

Thank you.

Operator

Your next question comes from Patrick Archambault with Goldman Sachs.

Tim Manganello

Patrick, are you there?

Operator

Patrick, your line is open. Your next question comes from the line of Brett Hoselton with Keybanc Capital.

Brett Hoselton – Keybanc Capital

Tim, Robin, Ken, good morning.

Tim Manganello

Good morning.

Brett Hoselton – Keybanc Capital

Interest expense, 12.5 million, is that a pretty good run rate?

Robin Adams

Yes, 13 so, 13 or so, 13.5.

Brett Hoselton – Keybanc Capital

And then I apologize, I kind of stepped out for a minute, drivetrain sales, you know obviously much better, what were the key drivers that cost the drivetrain sales to kind of pick up and do significantly better than expected?

Robin Adams

It is very transmission component, dual clutch component side of the business.

Brett Hoselton – Keybanc Capital

Okay. And is that kind of one time in nature or is more just it is really starting to pick up some steam and it is really starting to have an impact on the sales, so we should expect that going forward?

Tim Manganello

It is not one time in nature. It is – we are continuing to – you know in the years past, we have told you that there was going to be a ramp up over time towards couple million units of production for drivetrains – for DCT. We are still continuing to see that the ramp up, we are still continuing to see that penetration, and we're picking up some new business. And that just on the – while we are ramping up on the wet clutch side of the business, we also will be picking up some business on the dry clutch side of the business for dry DCT where we supply the control module for certain customers.

Brett Hoselton – Keybanc Capital

And then as far as just bidding activity on products in general versus six months ago, is bidding activity basically the same it was six months ago? Some people suggests that it had slowed down six months ago due to all the disruption and possibly has priced up a bit, and in other words your thoughts on those lines?

Tim Manganello

Okay. You obviously say is, quoting activity picking up now?

Brett Hoselton – Keybanc Capital

Yes, exactly.

Tim Manganello

I would say that quoting activity is picking up a lot on the emission side of the business. There is a lot of new programs that people are working on and we are – it is obviously on the turbocharger side, we are very active on some new programs now, and we are starting to see some continued and stronger interest with our DC technology China with a couple of programs that haven't been announced because we are in the what I call the beginning of a production development phase.

We're also working with a new Japanese OEM DCT with the what I would call the production, beginning of the production development program. We're seeing increases in strong interest in our CAM timing technology, not just with our historical customers, currently we are supplying for GM and Jaguar, but we are seeing starting to see interest with the Japanese OEMs. And it is all because of strong regulations and strong interest and improved fuel economy and emissions.

Brett Hoselton – Keybanc Capital

I think Robin just as you look from the third quarter earnings to the fourth quarter earnings, what would be some of the major positives, or plusses or minuses as you move forward question here? I mean obviously production you have already mentioned, is there any significant change for example in new business, restructuring, commodities, SG&A, interest taxes, anything along those lines, what would be the major pluses or minuses?

Robin Adams

Well I know I think as we look at the fourth quarter, at this point in time, it looks to be more the same from the third quarter.

Brett Hoselton – Keybanc Capital

Okay, good. Thank you very much gentlemen. I appreciate it.

Tim Manganello

Thank you Brett.

Operator

We have time for one final question, and that question comes from Colin Langan with UBS.

Colin Langan – UBS

Thank you for taking my question. You've actually mentioned the impact of steel in the quarter, what was the overall impact in the quarter from commodity cost? I thought you said last quarter would be a benefit this quarter.

Robin Adams

It was a benefit I think of about $8 million.

Colin Langan – UBS

Okay. And your leverage ratio seems pretty low. I mean what is your intent going forward for cash, I mean any thoughts on acquisitions or assets out there that still interest you?

Robin Adams

First I'm going to bring you with me when I go to see Moody's in November to see if we can get an upgrade. But we are still; despite the strength of the balance sheet, we are still a little cautious on where we're at. But we believe there will be some opportunities that might open up here in the near-term. And while we are a little cautious, we certainly feel that we're getting to the point where we might be able to take advantage of some opportunities that present themselves in the marketplace.

Colin Langan – UBS

And any change in the way you view acquisition going forward?

Tim Manganello

Well, I will jump in on that, and the way we view acquisitions is the same as we have always viewed them. We're looking for acquisitions that are complementary to our technology. We are looking for technology leadership in an acquisition. We're looking for something that stays within the powertrain area, and we're not looking for distressed assets. We also look for a strong management team. And I don't know if that's the intent of your question but that is the way I interpreted it.

Colin Langan – UBS

And how about in terms of trying to move toward more electrical vehicles but you would stay in the powertrain portion of those vehicles?

Tim Manganello

Yes, we would look at something in the electric vehicles. Although I would move more towards hybrid electrics or range extended type of electrics than pure electrics, I don't – although we're developing technology for the electric vehicle market, the pure 100% electric market, we still have a question mark as to what is the relative size of that market for the long-term.

Colin Langan – UBS

Okay. And then just on last one, I think you just mentioned that you doing more business with Japanese, are doing more bidding within Japanese OEMs, what percent of your current business portfolio is with those OEMs and is that a big opportunity if you start winning more business from them?

Tim Manganello

Well, if you go to our products chart, actually on our website, we do a lot of business with the Japanese. We consider what we sell directly and what we sell though our joint venture. We have Toyota at about 5%, this includes our joint venture. Hyundai/Kia at about 3%, Renault/Nissan – well the Nissan/Renault combination, this would be the Nissan portion of it at 2%. And then we have the Chinese that are actually 1% to 2% now but obviously growing more rapidly than actually anybody else in Asia. So most of our Chinese business will be in the next – start to show up in the years let's just say one, two, three or four from now.

Colin Langan – UBS

So the bidding that you are seeing is sort of consistent with your current business mix or…

Tim Manganello

You know what, our current – what you will see historically in our book of new business, on average, and it has been pretty much held through is, we typically – our book of business shows up as 50% Europe, and about 30% Asia, and about 20% North America. But yet today our current business is roughly 50% Europe, 30%, maybe a little less than 30, but 30, just on the slight, the low side of 30% in North America, and plus side of 20% in Asia. So you are seeing a shift from Asia going from roughly 20% up towards 30% in the future.

Colin Langan – UBS

Okay. All right, thanks for taking my question.

Ken Lamb

I would like to thank you all again for joining us. As Robin said, we expect to file the Q by the end of the day, which should provide many of the details that you're looking for in our results. However, if you have any follow-up questions, please direct them to me. Dorlene, please close out the call.

Operator

That does conclude the BorgWarner third quarter results conference call. Thank you for joining. You may now disconnect.

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Source: BorgWarner Inc. Q3 2009 Earnings Call Transcript
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