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BorgWarner Inc. (NYSE:BWA)

Q4 2009 Earnings Call Transcript

February 11, 2010 9:30 am ET

Executives

Ken Lamb – Director, IR

Tim Manganello – Chairman and CEO

Robin Adams – EVP, CFO and Chief Administrative Officer

Analysts

Itay Michaeli – Citi

Rod Lache – Deutsche Bank

Chris Ceraso – Credit Suisse

Brian Johnson – Barclays Capital

Rich Kwas – Well Fargo Securities

Operator

Good morning. My name is Tracy, and I will be your conference facilitator. At this time, I would like to welcome everyone to the BorgWarner 2009 fourth quarter and full year earnings 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, Investor Relations. Mr. Lamb, you may begin your conference.

Ken Lamb

Thanks, Tracy. Good morning, and thank you all for joining us. We issued our release this morning at approximately 8:00 a.m. Eastern. It's posted on our Web site on the Investor Relations homepage. There will be a replay of today's conference call available through February 18th. The dial-in number for the replay is 800-642-1687. You'll need the conference ID, which is 52013358. The replay will also be available on our Web site.

With regard to our IR calendar, we’ll be attending the following conferences over the next three months, the Barclays Industrial Conference in Miami on February 17th, the Sidoti Institutional Investor Forum in New York on March 23rd, the Bank of America/Merrill Lynch Inaugural Automotive Summit in New York on March 31st, and the City Industrial Conference in New York on May 5th.

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 these matters discussed today.

Now moving on to our results, Tim Manganello, Chairman and CEO, will be providing highlights on the quarter and full year, and he'll also share his perspective on recent industry trends. Then you’ll hear from Robin Adams, our CFO, with a detailed of the discussion of our fourth quarter and full year results and our guidance for 2010. With that, I'll turn it over to Tim.

Tim Manganello

Thank you, Ken, and good day, everyone. I'm pleased to review our excellent fourth quarter results and 2009 accomplishments, followed by comments on the state of the industry and our 2010 guidance.

I'll begin by briefly highlighting our fourth quarter results. We recorded fourth quarter sales of $1.2 billion, up 29% from the same period last year and US GAAP ratings of $0.45 per share. This marks the third consecutive quarter the BorgWarner has posted both higher sales and higher operating profits, compared with the prior quarter. Our earnings performance in the fourth quarter was the result of controlling costs, combined with increased volumes in our base business.

And at the group level, the engine group sales were $853 million for the quarter, up 25% from the same period a year ago. Increased demand for our turbochargers and engine timing systems in Europe and China drove higher segment sales and operating profits. It was another impressive quarter for the Drivetrain Group as sales were up 37% to approximately $350 million versus the fourth quarter of 2008. Sales growth in our transmission and All-Wheel Drive business significantly outpaced industry growth in every major region of the world.

Our balance sheet continued to strengthen as strong cash flow from operations, combined with efficient capital spending, generated nearly $80 million of free cash flow in the quarter. However, and most importantly, we continued to invest for the long term as evidenced by our continued spending for R&D and new program launches.

And in addition to our improved financial strength or performance, we also announced a number of developments during the quarter. These programs are representative of the importance of BorgWarner’s fuel efficient technologies. We were very pleased to announce that Ford has selected BorgWarner as the turbo charger supplier for all of its new four-cylinder EcoBoost GDI engines. This program is in addition to turbo chargers we will supply to Ford for their rear-wheel drive 3.5 litter six-cylinder EcoBoost engines. Ford expects up to 90% of its vehicles sold in North America will be available with EcoBoost engines by 2013, and most of which will be equipped with BorgWarner turbo chargers.

In another exciting development, BorgWarner was selected by Chrysler to supply our patented Torque-On-Demand and part time transfer cases for all of their four-wheel drive RAM trucks. This includes all RAM 1300 – or I'm sorry, 1500, 2500, and 3500 pickup trucks with four-wheel drive. We’re very encouraged by our re-energized relationships with Ford, Chrysler, and General Motors. And we look forward to many years of collaboration and partnership with the Detroit 3.

Also, we announced our participation in an important alternative fuel market called compressed natural gas or CNG. BorgWarner turbo chargers are boosting the performance of the Opel 1.6-liter compressed natural gas engine and the Volkswagen 1.4-liter TSI EcoFuel engine modified for compressed natural gas. Both engines achieved 150 horsepower with better fuel economy and lower emissions than comparable gasoline and diesel engines. There are 8 million compressed natural gas engines on the road worldwide.

Lastly, we’re very pleased to announce our net new business backlog of $1.8 billion for the period 2010 to 2012. This represents a strong top line growth rate in the mid teens. And our backlog encompasses some of the most promising technologies in the auto sector, like dual clutch transmissions and turbo charging. Over the three-year period, the breakdown of our new programs will be 50% in Europe, 30% in Asia, and 20% in the Americas.

And now, I’d like to spend a few minutes reviewing the full year. At the beginning of the year, we provided directional guidance indicating that we would be earnings positive and cash flow positive in 2009. Considering the dire condition of the industry at that time, it was clear that decisive actions were required to achieve these targets. And these actions included salaried employee cuts or wage reductions of 10% to 15%, which have now been restored effective January 1st, 2010.

Capital spending was scrutinized and prioritized for critical projects. We implemented a four-day and in some cases three-day work weeks in Europe. We closed our Drivetrain facility in Muncie, Indiana. We announced plans to close another Drivetrain facility is Margam, Wales. And our global staffing, all those were reduced by approximately 5,000 employees or 28%.

As we executed plan throughout the year, our performance continued to improve. Our results in each quarter of 2009 were better than the previous quarter, and in the end, we reported full year US GAAP ratings of $0.23 per share for 2009 in line with our guidance. In addition, we were cash flow positive not only for the full year, but in each quarter of 2009, which was a remarkable accomplishment considering the difficult environment last year.

Now shifting gears, I would like to make a few comments on the broader auto industry. Despite fears and post scrappage drop off in the fourth quarter, European production lines were relatively strong. Lines where higher year-over-year, and were also higher, compared with third quarter 2009. Now forecasting actual market demand in Europe for 2010 is and will be difficult since scrappage incentive programs concealed actual demand for nearly all of 2009. However, in the fourth quarter and into the first quarter of this year, we were encouraged by a change in model mix, which shifted more volume to the mid and large-sized vehicles, along with the shift towards more diesels in Europe. This is a benefit for BorgWarner.

And on the US light vehicle market, fourth quarter 2009 volumes were flat versus the same period in 2008, or higher compared with third quarter 2009. This is the third consecutive quarter in which volumes improved.

Now in the North American commercial truck market, there was increased production activity in the fourth quarter. Effective January 1st, 2010, the US adopted tougher emissions regulations for commercial trucks, which drove vehicle orders and engine production higher at the end of 2009. And while there was no such catalyst in Europe, lines improved there as well.

Now that brings me to our outlook for 2010. Today, we announced expected sales growth of 15% to 19% in 2010, and provided earnings guidance of $1.40 to $1.70 per share. This outlook considers a number of macroeconomic factors. Europe is the big question mark, and could have a measurable effect on our results for 2010. At the negative end of the spectrum, industry production may be down enough to offset some of the gains from improved vehicle mix in Europe. In this scenario, there will be little change for BorgWarner between 2009 and 2010. At the positive end of the spectrum, industry production may be flat or slightly higher for 2010 as compared to 2009 levels. This, coupled with impaired mix, will drive higher sales for BorgWarner in 2010.

Now in the US, we expect the production rates for the second half of 2009 will extend into the 2010 full year period. This translates into annual production of approximately 10.5 million units. I think personally that there will be upside to this number. And in the commercial truck markets, we expect improved volumes in both North America and Europe, although most of that will likely occur in the second half of the year.

Now looking forward, the restructuring activities taken by BorgWarner in 2008 and 2009 have positioned us for success. In my opinion, the fourth quarter 2009 is a strong indication of what to expect from BorgWarner in 2010. Longer term, we expect to leverage our industry leading technology, our global presence, and our financial strength to drive profitable growth for BorgWarner. Customer interest and fuel efficient power trains has only grown stronger. And this will be our major growth driver for years to come.

I have one more area. On a personal note, I would like to send a message to all BorgWarner employees. 2009 was a very difficult year, and all of our employees worldwide made tremendous sacrifices for the benefit of our company and our shareholders. I’m extremely proud of the results our employees delivered in a horrible economic environment. And as a result of our employees’ hard work and sacrifices, BorgWarner remains financially strong, technology driven, and very primed for profitable growth in all regions of the world. We have had to make very tough decisions last year, and I am sorry for all of the 5,000 employees we have laid off over the last 18 months. In addition, I want to say thank you to all of our present and past employees for their contributions to BorgWarner during 2008 and 2009. With this difficult period behind us, I look forward to a prosperous 2010. With that I’ll turn it over to Robin.

Robin Adams

Thank you, Tim. Good morning, everyone. Before I give you the financial update in detail, let’s review the industry environment again in the fourth quarter, which showed encouraging signs, as Tim mentioned, as we look toward 2010. During the last quarter’s call, we noted the improvement in global vehicle production over the previous two quarters. This is an indication that the market appears to be headed in the right direction for us.

And fourth quarter 2009 was a continuation of that trend as global production was up 9% from – sequentially from the third quarter 2009. Relative to fourth quarter of 2008, or a year ago, our global production was up 16%, in which frankly, it’s the first year-over-year quarterly improvement that we’ve seen since the first half of 2008. And it feels good to be talking about growth. It was the strong quarter for the industry relative to our recent production levels, and a good sign, as Tim said that there are better days ahead.

From a regional perspective, production volumes were up in every major region of the world versus the third quarter. And most areas are up year-over-year fourth quarter 2009 versus fourth quarter 2008, with the exception of Japan, which was actually down 5% and North America surprisingly was flat year-over-year in the quarter.

From a BorgWarner perspective, our sales were up 29% in the quarter versus last year. We did get some benefits from currency in the quarter year-over-year, excluding currency, we were up 20%. Again, looking at that relative global vehicle market, which was up 16%.

Comparing sales growth on a sequential basis, our fourth quarter sales were up 17% from our third quarter sales levels. And yes, there were some currency benefits there. Excluding currency, we showed sequential growth of about 11%. Again, better than what’s going on in the global market.

If you’ll look at the breakdown of our sales in the quarter, a year up [ph] represented 55% versus 53% in the fourth quarter a year ago. North America has declined from 36% to 29% in the current quarter. An age is growing for us, 11% of our business in the fourth quarter 2008, 15% in 2009, and the significant portion of that is growth in China. For the quarter, as Tim mentioned as well, earnings on a GAPP basis reported were $0.45 a share compared with a US GAPP reported loss of $0.70 a share in the fourth quarter last year.

We have provided an analysis in the press release, detailing what we believe are non-recurring and/or unusual items for both the fourth quarter of this year and last year, and the full year this year and last year. To help you better understand how the fundamental business is operating the table has been provided to help reconcile you with GAPP measures to the financial performance of what we believe to be the continuing operations of the company which, again, provide a better comparison period-to-period of our financial results.

And at this time, I’m going to focus most of my comments on those numbers that exclude the non-recurring and/or unusual items. So as we look at fourth quarter, excluding those items, earnings were $0.42 a share, a significant improvement from fourth quarter 2008 during which our earnings were essentially flat. And fourth quarter was up from the $0.27 a share we earned in the third quarter 2009. We think that sequentially how this company has performed, we’ll go back to the third quarter of 2008. We’re at $0.44 a share in the fourth quarter. We were breakeven in the first quarter, we lost $0.12. Second quarter, $0.05, third quarter started to come back with $0.15 a share. And now we’re back at our growth curve with a strong fourth quarter $0.42 a share.

If we look at the full year, sales were just under $4 billion, down 25% from $5.3 billion in 2008. And again, on a GAPP basis, earnings per share were $0.23 versus a GAPP loss of $0.31 a share in 2008, again excluding the non-recurring and/or unusual items from both periods. In 2009, we are on $0.40 a share compared with $2.07 in 2008.

There’re a lot of details in our financials. And as usual, we intend to file our 10-K by the end of the day. So those of you who want to go through all the gory details on the footnotes, you can do that tonight over a cocktail or a hot tea.

If we move down the income statement, gross profit in the fourth quarter percent of sales were 17.8%, a very strong quarter, nearly 10 percentage points higher than the same period a year ago. But it is also a significant improvement over the third quarter, where our gross profit margin was at 14.8%.

If we look at the improvement, it really reflects the effectiveness of the restructuring activities that we took as a company in late 2008 and in 2009, and the additional cost contain in actions that we’ve taken, that Tim talked about in his remarks.

As we move down below, our gross profit SG&A cost in the quarter were $144 million or 11.9% of sales, almost $50 million compared with the fourth quarter last year. And if you look at it, including SG&A as we said before, net R&D which was about 4% in the fourth quarter, consistent with our historical rates. On an absolute dollar basis, however, R&D was up $6 million year-over-year in the quarter.

Also in SG&A, we experienced a $10 million in pension and overhead expense versus the fourth quarter last year. And some of this was related to the closure of the Muncie facility earlier in the year. As we look again year-over-year, $6 million increase was related to changes in foreign currency. And then the rest of the increase is primarily related to incentive compensation for both our hourly and salary employee, which obviously, we booked in the fourth quarter this year given the stronger performance, compared with a fourth quarter last year where we were reducing incentive compensation expense as the year tended to decline from a performance perspective.

If we look at sequentially fourth quarter versus third quarter of this year, there’s about $18 million increase in SG&A, $4 million of that is R&D related, about $5 million is currency-related, and the remaining piece is hedge in PRVs plus some incentive compensation. If you look at sequentially fourth quarter versus third quarter, percent of sales basically was essentially flat.

If you move down to the next line item, operating income, $67.3 million in the quarter, a 5.6% margin. Again, if we compare that to prior year, excluding the non-recurring unusual items, prior year, the fourth quarter was $3.7 million. So there was a $63 million increase in operating income on a comparable basis year-over-year in the quarter with approximately $270 million increase in sales. And if you do the math, that’s an incremental margin of 24%. And by BorgWarner’s historical standards, that’s strong performance.

However, there is some currency impact to those numbers, sales actually increased $62 million year-over-year on the quarter. As I said before, just related to currency. So if you exclude the impact of quality on both sales, and operating income year-over-year, our incremental margin, actually, in the quarter was 31%. A very strong performance in this industry in line with our expectations and relative to what we’ve experienced historically at 15% to 20%, that’s a very strong quarter.

Now let’s look at that same margin comparison with the prior quarter around the sequential basis, which we have spent sometime in the past two earnings calls, talking about and measuring that performance relative to the actions that we took to adjust the cost structure. Again, operating include the fourth quarter $67 million, compared with a little over $27 million in the third quarter. So on a sequential basis, there’s about $40 million more operating income for fourth quarter versus third quarter, and on a sequential basis about $170 million in sales.

Again, if you do the math, that’s about a 24% incremental margin. However as I said before, a good portion of the sales increase between third, fourth quarter was related to currency, about $57 million, and some of the operating income, was also related to currency, was about $3 million. So if you exclude the impact of currency, if you look at our bases business, our incremental margin for the quarter, fourth quarter versus third quarter, or on a sequential basis was, was 33%. Again, a very strong quarter in line with our expectations and our guidance of being between $0.30 to $0.35 on a dollar. And frankly, a good run from where we’ve got a share.

As we’ve said before, the second quarter and the third quarter we saw good sequential margin improvement. In fact it averaged about 32%, and you add the 33% share in the third quarter. And I think it’s evident that the actions we took, the cost reductions we put in place, the restructuring actions, we are seeing the benefits in our income statement.

As we look farther down the income statement below operating income, equity affiliated earnings were up $10.3 million versus $8.2 million to a year ago. And remember, a major portion as driven a Drivetrain system, the joint venture in Japan where we sold our trade mission components to our Japanese customers.

Interest expense and finance charge in the quarter were up $6 million, $16 million versus $10 million in the fourth quarter a year ago. And the difference there is the convertible notes we issued early in 2009 to provide liquidity for us when basically the markets were shutdown. And the cost of that liquidity is basically about $6 million a quarter for us, and it’s driving interest expense higher. But again, if you look at the balance sheet, it provides us some comfort and we've got a significant amount of liquidity.

Effective tax rate in the quarter, excluding a FIB 48 [ph] favorable adjustment, which again, we outlay in the press release, was 14%. And this is, again, below our traditional 20% to 25% range but as we see a continued increases in operating earnings, we expect that rate to trend back to that 20% plus level.

After taking all of these into consideration, sales growth, strong incremental margins, the equity and affiliates, the interest expense, the tax rate, again, we reported on a comparable basis, $0.42 a share in the quarter, a very strong quarter versus break even last year.

Let’s look at the operating performance for our segments in the quarter starting with the engine segment. Sales were $853 million and excluding currency that translates to 18% growth versus a year ago. EBIT in the quarter, $83 million, up $47 million versus the year ago. And if you will get incremental margin for the engine group excluding currency, slightly below 40%, very good performance for our engine group, a little bit stronger than we’ve seen in previous quarters.

The Drivetrain segment continues to show a significant improvement year-over-year and reflecting the benefit of the closure of our Muncie, Indiana facility in the first quarter of 2009 and the other restructuring actions we’ve taken in this business. Drivetrain sales were approximately $350 million in the quarter, up $84 million a year ago excluding currency, or about 33%. But you really need to look at EBIT line item to see why we’re so excited about Drivetrain performance for the quarter. They reported a little over $20 million operating income in the quarter compared with the loss of $42 million a year ago, reported loss. That loss did include some warranty-relates expenses that we talked about a year ago. So excluding that warranty-related expense, the year-over-year improvement’s about $38 million.

And you’re looking at incremental margin of 45% and operating income margin that are north to that 5% level where they bend historically. And you really look at that Drivetrain business, it’s almost 6% operating income margin. And that’s where they are part of this recession. So I can’t say enough about the improvement in the Drivetrain business. This goes back, I think, the discussion we had after our first quarter earnings call.

We talked about the disappointment we had in the first quarter for Drivetrain performance. He talked about seeing the Drivetrain restructuring impact in the rest of the year and his intense focus on making sure we have the right people running that business, and that’s the improvements out if that. and I think if you’ll look at the fourth quarter maybe you can see that we achieved exactly what we needed to do in the Drivetrain business and that’s business is running well and homing right now. And it’s a clear indication that Tim’s focus certainly helped him more improve there.

With that, let’s go to the balance sheet, let’s look at the balance sheet and cash flow. Net cash provided by operating activity toward the year was $351 million. Capital spending, including tubing] was $172 million. And the capital was down from a year ago as we said it would be. But it was also below our original expectations of $200 million for the year. Now we will be spending that $200 million versus $172 million shortfall in 2010 and you’ll see that as we talk about 2010 spending.

After you deduct capital spending from net cash provided by operating activities, pre-cash flow’s approaching $180 million during 2009, about $80 million was in the fourth quarter. And fairly consistent performance, a stronger performance than what we had in 2008 despite the industry environment.

And if you’ll look at the difficulties that Tim talked about in the industry in 2009 particularly in the first half of the year, and we still were able to generate quick cash flow needs a quarter last year. I remember the earnings call we did late January or early February in 2009 talking about the end of the year. And when we started the year, most of the conversation in the industry was around how much cash burn each copy would experience.

And that was one of the comments from the board. What do we think the cash burn was? And frankly, I couldn’t relate to the statement because we expected to generate cash flow in 2009. This business generates strong cash flow consistently. There hasn’t been a year since we went public where we haven’t generated cash flow. I just couldn’t get my arms around it. And that’s why we said that as we said earlier.

For 2009, we’ll be cash flow positive. And in fact we were. We were not – now we’re cash flow positive for the year, we were cash flow positive for every darn quarter in 2009. And I think that’s something about the fundamental financial strength of this company. And the worst industry environment we’ve seen in our careers BorgWarner is still consistently generating good strong cash flow. And as a result of that, our balance sheet net debt decreased by about $200 million over the year. And balance sheet debt increased by $62 million, again primarily due to the effect of the issuance of those convertible notes in April, $374 million converts.

But during the same period, cash increased by $254 million. And again, if you look at that from a net perspective, net debt decreased $200 million in probably one of the worst environments we’ve seen in many, many years. And none of that was the result of any equity issuance in the market like some of our peers that improved their balance sheet. So if you look at where we are, the result of the activity from a cash flow perspective in 2009 is that we actually strengthened our investment grade balance sheet even more during the tough year. Net debt to capital ended the year at 18% versus 25% at the end of 2008. And if you take the last six months of the year, EBITDA and annualize it, we're running at about net debt to EBITDA one time. That’s a very strong financial (inaudible).

Let’s go on to 2010 now, as Tim mentioned, we provided sales growth rate with a 15% to 19% from 2009 levels, along with the earnings guidance range of 140 to – $1.40, I’m sorry, which was 140 – $1.40 – $1.70 a share. And there are a number of variables that really need to be taken in consideration with respect to 2010. I’m going to monitor those throughout the year. But what really defines where we're going to end up, primarily is sales revenue. It is a big driver for us that could drive earnings anywhere from $0 to $0.30 a share for it. And as Tim mentioned, the real question mark for us is Europe.

If we look at operating income, we expect operating income margin to be about 6% in 2010 up from about a 2% level in 2009, good strong performance and if we look throughout the year, as we said earlier, early in the year we still expect to generate about $0.30 of incremental income and incremental sales for the first couple quarters and as we get towards the end of the year, it’ll be trending down more towards our 15% to 20% rate, but certainly, improving margins for 2010 versus 2009.

Having said where we’re at, the other factors that are driving the variation in our expectations for 2010 are the inability to pinpoint the tax rate. The tax rate, we think we’re going to be in the range of anywhere 15% to 20%. And that could drive a difference in earnings to $0.10 to $0.12 a share. And the other major variable here is currency, dollar to the euro, we put a range of $1.35 to $1.45 around the year.

And again, that variation is another $0.15 a share for us. So there’s a number of moving parts. It’s early February. We think we’re going to be a lot smarter, at least on the 2010 industry by the time we report first quarter earnings. And I would expect that at that time, we’ll be fine-tuning guidance for the rest of the year. And as Tim said, I think that as we fine-tune, the only way we think we’re going is in the upward direction.

As we look at the other metrics for the year, capital spending will be approximately $250 million in 2010 net’s going to increase from 2009 levels as we start to bring capacity back on stream for the significant growth we’re seeing, and as Tim pointed out, the significant backlog we have sitting behind us. As we look at cash flow generation in the year, we expect 2010 to be another strong year like 2009, good strong cash flow generation in an around $200 million level. Frankly, if we look out at 2010, again, it’s only February, but we are really looking forward to a great 2010 for BorgWarner. And as I said, we seem more upside than downside for the year as we look out from this vantage point.

With the last half of 2008 and the first half of 2009 behind us, thank goodness, we see BorgWarner back on a historical growth curve. And we’re excited, in fact, to see BorgWarner back growing, generating incremental income, top line growth sales, double digit in earnings growth. The math is kind of ridiculous, $1.40 to $1.70 a share on the $0.20-some adjusted we earned in 2000. And I don't know what that translates to as a multiple, but it’s a big number.

As we look at the company – though we are continuing to be longer term focused, as Tim mentioned. And we remain focused on the key drivers of our long term success. And that's our powertrain technology and leadership. We are a leader company now. And it’s evidenced by the financial performance you've continued to see from us in the third quarter to fourth quarter, and what we expect to provide in the fourth quarter. And also, as Tim mentioned, we have a workforce that’s rededicated itself to ensuring BorgWarner maintains its reputation, its position as leader in powertrain technologies throughout the world, and one of the strongest financial performers in the auto industry. We’re well positioned, both financially and technologically, to remain at the forefront of this growth curve in this growing industry.

With that, I’d like to turn the call back over to Ken. Ken?

Question-and-Answer Session

Ken Lamb

Thanks, Robin. Now we’ll turn to the Q&A portion of the call. Tracy, can you announce the procedure please.

Operator

(Operator instructions) We’ll pause for just a moment to compile the Q&A roster. Your first question comes from Itay Michaeli with Citi.

Itay Michaeli – Citi

Thanks. Good morning.

Ken Lamb

Good morning, Itay.

Itay Michaeli – Citi

Two quick questions on the 2010 guidance, and I apologize if I missed it, but can you share what you’re assuming for the tax rate as well as your mix assumptions for Europe?

Robin Adams

Well as I said, the tax rate, it’s going to be somewhere between 15% and 20%. We did 14% in the fourth quarter. Going through 2009, and again, if you looked at what we were reported, the tax rate made no sense for the full year. As we come back out of the loss that we had in the first half of 2009 and growing earnings, we expect to gravitate towards that 20% rate. But right now, as we look at the range and guidance we’ve given, we've bracketed the tax rate between 15% to 20%. And as I said, I think that if you look at the impact there, that’s maybe – that range is somewhere between about $0.10 to $0.12 a share difference on the year between the two ranges – two numbers. All right?

Itay Michaeli – Citi

Right. And the mix assumption in Europe?

Tim Manganello

Well, the mix assumption in Europe is – first of all, we see diesels coming back more towards the traditional 53%, 52% market share penetration in the light vehicle side, mainly fast car. We’re seeing the mix shift towards higher content vehicles, mid-sized and larger-sized, or premium and tight vehicles. So the mix is coming back our way, Itay.

Itay Michaeli – Citi

That’s helpful, and just as a follow up, can you maybe talk about how you’re thinking about cash deployment in 2010, you’ve had some strong progress on cash flow, particularly as it pertains to how you’re thinking about the dividend? And to what extent would a Moody's upgrade to investment grade influence any of the decision process?

Tim Manganello

Well, first of all, we look at – for uses of the cash, acquisitions first for – strategic acquisitions. Then we look at paying down debt, although I’m not so sure of that factor given our financial strength right now, and our debt to total cap. Then we look at the dividend policy. But right now we have restrictions on dividends. We have caps. And we’ll have to – when we get those things lifted, we can readdress the dividends like we do every year at the November Board meeting.

Itay Michaeli – Citi

Terrific. Thank you so much.

Operator

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

Rod Lache – Deutsche Bank

Good morning, everybody.

Tim Manganello

Hi, Rod.

Robin Adams

Hi, Rod.

Rod Lache – Deutsche Bank

I was hoping you can elaborate a little bit more on this mix issue in Europe. It definitely looks like the diesel penetration’s been picking up over course of 2009 and into early 2010. And maybe just to characterize it a little bit, if you don’t mind, if you would sort of say, hypothetically, production was flat in Europe and if you were to exclude the backlog that you’ve got coming in, what – how much of a tailwind would you assume the – that the mix could be? Could it be like an extra percent or two or would it be more? How do you put it into perspective?

Tim Manganello

An extra percent or two of what?

Rod Lache – Deutsche Bank

Of top line growth just from the mix in a flat production environment.

Tim Manganello

Well, I think you can see, if things continue to improve in Europe, you may be able to see the kind of change that we saw from the third to the fourth of 2009. You may see that – we're going to see that probably from the fourth quarter to the first quarter of 2010. Now how long that remains is anybody’s guess in Europe right now. But if the mix shift comes up – continues to improve like it has been, you’re going to see a first quarter that’s stronger than the fourth quarter. And I can’t really give you a percentage of because it's like – it’s just too difficult to nail down.

Rod Lache – Deutsche Bank

Okay. So even if European, I believe, the production is down sequentially, global production slightly down in Q1 versus Q4 because of the improving mix, you think that BorgWarner’s revenue at the end of the day could be up sequentially, is that fair?

Tim Manganello

Yes. And I think you – I’ll go back to what I say, the kind of change you saw from the third quarter to the fourth quarter of 2009, you'll probably start to see that from the fourth quarter of 2009 to the first quarter of 2010, and then we’ll just see how it happens quarter by quarter is we go throughout the year. I think Europe’s going to be a little bit wobbly. It’s going to be up. It’s going to be down. It’s going to be up and be down, by country, and between Western Europe and Eastern Europe.

Rod Lache – Deutsche Bank

Okay. And can you remind us of the backlog breakdown by year, 2010, '11, and '12?

Robin Adams

It’s about $570 million for 2010. I don’t remember '11 and '12.

Rod Lache – Deutsche Bank

It was about $600 million in 2011, and $630 million in 2012

Tim Manganello

That's it for me. It closed up all the way up.

Rod Lache – Deutsche Bank

And then what was the end of your pension and OPEV-funded status, you expect that to be a tailwind in 2010 versus ’09. And is this – in terms of dollars, is this a good run rate to use for the SG&A for 2010?

Robin Adams

No, it’s not a good run rate to use. It’s the percent of sales – we're about 12% – north 12% the quarter. We've not run the business at a 12% SG&A level, and we’re not going to. We expect that to decline close to the 11% of sales level. As we look at pension and OPEV, actually, the – our funding position is better at the end of 2009 versus 2008. We actually made some headway there. We’ve made some adjustments to the liability through the closure of Muncie. We also funded a little bit of our pension plan in the fourth quarter. And we did get some returns on our assets. So we’re in better position at the end of 2009, at the end of 2008 from a liability perspective.

Rod Lache – Deutsche Bank

What do you expect to the P&L impact ’09 – ’10 versus ’09?

Robin Adams

We’ll still see a little of incremental expense ’09 versus – I mean ’10 versus ’09.

Rod Lache – Deutsche Bank

Great. Okay, thank you.

Robin Adams

You’re welcome.

Operator

Your next question comes from Chris Ceraso with Credit Suisse.

Chris Ceraso – Credit Suisse

Thanks, good morning.

Robin Adams

Good morning, Chris.

Tim Manganello

Good morning, Chris.

Chris Ceraso – Credit Suisse

A couple of follow up, you mentioned that the contribution margin will start out strong like what you saw in Q3, and then get a little bit back more to normal by the end of the year. Were you talking about a year-over-year contribution, Robin, or sequential?

Robin Adams

Sequential. When I say a little bit back to normal towards the end of the year, I would expect to be at 15% to 20% rate in the fourth quarter, but trending towards that level. You know what I mean? So if it will be north of there, so we should be in that 30% range for the first couple quarters, and we’ll be trending downwards towards the end of the year. But I don't expect to be at 15% contribution margin sequentially in the fourth quarter.

Chris Ceraso – Credit Suisse

Okay. That gets to my second question, I think when we were in Detroit earlier in the year, you mentioned that by the end of the year, you could be back at an 8.5% to 9% operating margin. Is that consistent with what you’ve told us here in terms of full year guidance for earnings? Will you be quite that strong by the end of 2010?

Robin Adams

It all depends on revenue growth, Chris. I think that if you look at the sequential margin improvement that we expect, if we get that type of revenue growth probably towards the high top end of the year – of the range here, then we should be close, towards the end of the year, at a run rate basis of about that 8% range.

Chris Ceraso – Credit Suisse

That puts you above your guidance range or is that at the top of your guidance range?

Robin Adams

Well, as I've said, we expect to be about 6% for the year, somewhere in that range to be a little bit stronger, a little bit weaker. Third quarter is always the weak margin – margin quarter because of the shutdowns and so on, and so. Again, that's built in to some expectations on the top end.

Chris Ceraso – Credit Suisse

Can you give us an update on the Chinese DCT situation? I think on the last quarter you said that there has been some delays. What’s your expectation now on the launch timing for that program?

Tim Manganello

Well it’s still in our backlog. I think it’s on schedule with a slight delay built-in that’s already taken into consideration. We’ll be watching probably in the 2011, 2012 timeframe for DCTs in China. And we’re still working in developing new – a new transmission and a new program was a Chinese OEM, in actuality, in addition to a potential Japanese OEMs. So and that’s focused on this new technology we developed a smaller and more fuel efficient, and more price competitive dual clutch transmissions. So nothing's changed since the last quarter is the short answer, Chris.

Chris Ceraso – Credit Suisse

Okay. Just a quick one on some of the expense items. You mentioned expenses probably up a little bit. Can you give us a feel, up or down or sideways 2010 versus ’09 on things like launch cost, engineering cost and any other wage compensation?

Robin Adams

That’s a great point. I can’t remember if Tim mentioned or not, but last year, as part of our cost-cutting efforts. The salaried employees of BorgWarner around the globe took a 10% reduction in salary. And the executives of the company took a 15% of reduction in salary. Those wages were reinstated January 1st of 2010. So we’re back to 2008 levels from the salary compensation. So we will see an increase in cost above and beyond normal incremental, decremental margins as a result of that. We’ll see if slight increase in pension (inaudible) I think as I said earlier, commodity cost right now will to be – again, prominently still related $20 million to $25 million, up year-over-year nickel relatively flat for us.

Tim Manganello

And as far as our engineering expense and CapEx spending, I will continue to spend in our traditional levels, they were the levels, percentage-wise, that drove us up to $6 billion run-rate in 2008. So we have not –Although we prioritize and although we scrutinized to make sure our R&D spending is being spent on the right programs, and actually some of us being shifted a little bit towards hybrids and electrics, we’re continuing to spend at the same rate we’ve always spent and we’ve never really cut spending on any project that has a growth attached to it.

CapEx we’ve actually scrutinized capital spending. Like we said in 2009, some of the excess capacity we now have, we’ve been able to take some of the newer programs and put them on existing capacity which will allow us to eliminate some of the CapEx spending in 2010. And as I look forward to 2011 and 2012, we’ll probably have a little bit less capital spending in 2011 but we’re still spending on all programs as necessary for growth or cost reductions.

Robin Adams

Chris, let me help you on the margin question you have and on the impact of the reinstatement of wage levels. You know in the fourth quarter we were put up with an income of 5.6%, if you’ll use that as a jumping-off point here. The reinstatement of wages to 2008 levels would convert that to about 5.1%. So we are looking for margin improvement in 2010. As I said, we expect to be about at a 6% rate, may be plus for the year on average which means some improvements is going to be driven by contribution margins and additional revenue. Okay?

Chris Ceraso – Credit Suisse

That makes sense. Appreciate it.

Operator

Your next question comes from Brian Johnson with Barclays Capital.

Brian Johnson – Barclays Capital

Good morning.

Tim Manganello

Good morning.

Brian Johnson – Barclays Capital

I’d like to drive down on the driveline business. Just trying to understand where it stands now. What are the components of revenue? If you could maybe split it between Europe, US, Asia, and then between torque transfer, traditional transmission products, and DCT. What of those segments is accounting for both the revenue, and then what of those segments is (inaudible) corporate and margin expansion, particularly quarter-over-quarter?

Robin Adams

I tell you, we’re seeing, if you look at year-over-year, a significant portion of the revenue was driven by the transmissions of the component part of the business first, as the four-wheel drive, all-wheel drive business. We talked before that four-wheel drive, all-wheel drive for, I don’t know, the last three years quarter-over-quarter was only the drag. It was always the decline is that market (inaudible) in North America here. And fourth quarter ’09 versus ’08 basically revenues stabilized or are relatively flat in that side of the business. So almost all the growth in the sales side in the quarter is coming out of the transmission component side of the business.

On the income side it’s a mixture of both, the restructuring that took place in North America, a major portion that was in the torque transfer four-wheel drive side of the business. That Muncie facility we talked about, that was a four-wheel drive facility, we call that facility consolidated manufacturing in different locations. We’re in the process of closing a facility in Margam, Wales, also part of the business units. So the majority of restructuring actions took place in that business to give it back to the upper tax return level that we feel we need as we run this business to make that business financially viable. And frankly, we’re back there.

Sales, predominantly in the transmission systems business. The income improvement year-over-year basically both sides of the business but probably on a percentage basis. The operating income gain is much stronger in the torque transfer business, just as a function of the restructuring.

Tim Manganello

I will. So in addition to the improvements and profits to the restructuring in 2010, we expect to have a really good year in the form of drive business because of the restructuring and improvements in cost structure. And when we start to pick-up, we started to launch this case of transfer case business which we haven’t mad price for business for Dodge or for RAM trucks now, but Dodge RAM trucks for a long time, that’s going to make that business even much more profitable as we go forward. So that huge amount of business we picked up on the RAM truck will be a major, major benefit for the Drivetrain Group business in the next few years.

Brian Johnson – Barclays Capital

And is that the electronic cash transfer case on their heavy duties?

Tim Manganello

We picked up all transfer cases for Dodge trucks including 1500, 2500, and 3500. All RAM trucks.

Brian Johnson – Barclays Capital

Are you doing transfer cases on any other Super Duties?

Tim Manganello

At Ford. We have pretty much all the transfer cases at Ford except the Super Duty. And we have some miscellaneous transfer cases at General Motors. We have almost all the Cadillac, Four-wheel Drive, General Motors, some of the vehicle stability system transfer cases at General Motors on the larger side SUVs and I don’t know if they have that on the pick-ups. I don’t think they have that on pick-up truck.

Brian Johnson – Barclays Capital

They just find all the sum-up, where does that get you in terms of sustainability of these 5% to 6% margins in the Driveline business through 2010?

Tim Manganello

I think that the sustainability is there. Both margins will be sustainable, if not better as we move through 2010.

Brian Johnson – Barclays Capital

Okay, thanks.

Tim Manganello

Sure.

Robin Adams

Thanks, Brian.

Operator

We have time for one final question, and that question comes from Rich Kwas with Wells Fargo Securities.

Rich Kwas – Well Fargo Securities

Hi, Good morning.

Tim Manganello

Hi, Rich. How are you doing?

Rich Kwas – Well Fargo Securities

Good, doing all right. A couple of quick questions around the guidance. The 6% operating margin, is that the midpoint? So, Robin, if we think about 140 to 170, I think it's a midpoint of about 155, does 6% reflect that?

Robin Adams

Yes, it's kind of the midpoint.

Rich Kwas – Well Fargo Securities

Okay. All right. And then, Tim, or maybe Robin, you talked about production guidance for Europe. It sounds like the low end, about 40% assumes some production decline in Europe. And mix will helpful, but there’s actual unit production decline? Could you quantify how you’re thinking about production for Europe in terms of bracketing the 140 and the 150?

Tim Manganello

Well, here's what we've got, for total Europe, we think that production will be relatively flat. Okay. But there are a lot of people, and they've done a lot of estimates, and talked to a lot of CEOs, they're thinking a minus – a 5% decline, and that's probably at the lower end. They're actually thinking 5% to 10% decline in Europe. And we don't see it. We don't see the production decline. We think it will be flat for the full year. We also see the mix shift moving in our favor.

But so, our guidance has some degree of conservatism that if Europe goes down a little bit, we've got it covered in terms of guidance. But we actually – like Robin said, we think that on our guidance, it's all skewed towards the upside.

Robin Adams

Let me put it in a different way, this whole issue of our guidance, we struggle with it. I look at the guidance and feel – things feel good. But here's the issue we're looking at, you're looking at the fourth quarter. I think a lot of people are using the fourth as a jumping off point from relative performance. If you're looking in the fourth quarter where they produced – and remember, Europe's about 55% of our sales. They produced 4.5 million units in Europe in the fourth quarter. If you annualize that, that's 18 million units a year. There isn't anyone out there publicly that comes close to saying production in 2010 in Europe's going to be 18 million. In fact, the average of the analysts we cover is about 16.4, the range is 15.3 to 17.3. I think Europe's probably is at the higher end of the range, right?

But if you look at the data that's staring us in the face, as we look at 2010, it says that from fourth quarter levels, we'll see some design – some decline in production in Europe. And again, it's 55% of our sales. So when we look at 2010, that's a dilemma for us. It feels a lot better. Believe me, it feels a lot better than 16.4, a lot better. But when you look at the data, and that's what we're doing, we're looking at data rather than how we feel – because Tim and I feel good every day. But if we look at the data – and this is what's driving both Tim and I crazy.

And I think we've had this discussion before in January at the North (inaudible). We had this with a number of you, how frustrated we were looking at what the data suggests relative to how the business feels. And the data suggests, again, that the fourth quarter was 18 million units. And there isn't a person out there that says, "We're going to come close to that in 2010", which means that if you look at fourth quarter for us, it's an indication it's a jumping off point, we should see – excluding net new business and mix, we should see a sizable decline in sales in Europe.

And again, the average of the views out there is about a 9%, 10% decline. And I know there're some of you that are a little bit on the higher side, some of you on the lower side. But that's the issue with respect to this guidance, and that is the unknown. And that is the wildcard here. And as I said earlier, I think at the end of the first quarter when we talked about how we did in the first quarter, we will update guidance. We'll be a lot smarter for 2010 as will everyone else here on the call.

And again, the data is where it is today and the guidance we're giving you is based on that data. My expectation at the end of the first quarter, you will have all increased your estimates for European production. We will be increasing our estimates for sales and earnings for the year. And that's my expectation. But at this point in time, all we have, unfortunately, is the data we're staring at.

Tim Manganello

Let me just–

Rich Kwas – Wells Fargo Security

Is it fair to say that about 40% reflects some kind of production decline in Europe?

Robin Adams

Oh yes, I would say so.

Tim Manganello

Definitely. And Rich, let me just a little bit what I believe at this point at the risk of over-killing this thing. But when I talked to you guys in January and we talked with a number of the analysts, I was – what the word was – and my network was, first quarter was going to be somewhat positive. The mix shift was going to be positive in our favor. But at the end of the first quarter in Europe – we're talking Europe now, the automotive sector may struggle and the economy may struggle. And consequently, it was a big question mark of what was going to happen in Europe.

I spent a week in Davos a couple of weeks ago now, and I talked to a lot of CEOs from a lot of different companies that were automotive and non-automotive related. And I walked away more positive about Europe after I came back from Davos, and here's what I picked up. The feeling was now that the auto sector, not only was it probably going to be – have a decent first quarter, but it was probably going to have a decent second quarter. And then, if things get a little bit shaky in Europe, in general, both the economy and the auto sector, it would probably be towards the second half.

So what happens is that optimism and this better economy in Europe seems to be gathering momentum that – instead of just being possibly a first quarter phenomenon. It could be a second quarter phenomenon. So the bad news of the European economy seems to be getting snow-plowed towards the second half. And at first I think that every quarter that goes by, the bad news is just going to slowly disappear or melt, so it's a smaller level of bad news and will be pushed out farter.

But until we get a better window into Europe, like Robin says, maybe at the end of the first quarter we'll have a better window into Europe. We've given the guides we've given. It may be conservative, but we've got all year to adjust it.

Rich Kwas – Wells Fargo Security

Okay. That's really helpful. Last question is just on the – on EcoBoost, the I-4s, do you have that outside of North America?

Tim Manganello

Yes. The four-cylinder EcoBoost engine we've picked up is a global engine. It's going to start production in Europe. And then eventually, the products will be sold in Europe, and eventually be brought – the engine will be used in products or sold in North America.

Rich Kwas – Wells Fargo Security

Okay.

Tim Manganello

And it's also going to be in China – it's going to be in China, so a Chinese engine also.

Rich Kwas – Wells Fargo Security

Okay. Great. That's great. I appreciate it. Thanks.

Tim Manganello

Yes, sure. Oh, one thing I would add, Ford said that by 2013, they're going to have 1.3 million engines, EcoBoost engines with turbo chargers on it globally. And so far, we picked up the majority of all that global EcoBoost engine. And their number is 1.3 million units globally by 2013.

Rich Kwas – Wells Fargo Security

Great. Thanks.

Ken Lamb

Thanks, Rich. All right. Thank you. I'd like to thank you all for joining us. As Robin said, we expect to file the cable for the end of the–

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Source: BorgWarner Inc. Q4 2009 Earnings Call Transcript
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