TRW Automotive Holdings Corporation Q4 2009 Earnings Call Transcript

Executives

Mark Oswald – Director, IR

John Plant – President and CEO

Joe Cantie – EVP and CFO

Analysts

Himanshu Patel – JP Morgan

John Murphy – Banc of America/Merrill Lynch

Chris Ceraso – Credit Suisse

Brett Hoselton – KeyBanc

Patrick Nolan – Deutsche Bank

Kirk Ludtke – CRT Capital Group

TRW Automotive Holdings Corporation (TRW) Q4 2009 Earnings Call Transcript February 25, 2010 8:30 AM ET

Operator

Good morning and welcome to the TRW conference call. All lines have been placed on listen-only mode. And as a reminder, this conference call is being recorded. Presentation material for today’s call was posted to the company’s website this morning at trw.com/results. Please download the material now if you have not already done so. After the speakers’ remarks, there will be a question-and-answer period. Due to today’s limitation on time, the company requests that participants limit follow-up questions to one per caller. (Operator instructions) I would now like to introduce your host for today’s conference call, Mark Oswald, Director of Investor Relations. Sir, you may begin.

Mark Oswald

Thank you and good morning. I would like to welcome everyone to our fourth quarter and full-year 2009 financial results conference call. Joining me this morning are John Plant, our President and Chief Executive Officer, and Joe Cantie, our Chief Financial Officer.

On today’s call, John will provide an overview of the current automotive environment and its impact on TRW. John will also provide a brief summary of the financial results for the quarter and full year, which were released earlier today. After that, John will discuss other related business matters, including our outlook for 2010. After John’s comments, Joe will provide an expanded review of the financial information. At the conclusion of Joe’s comments, we will open the call to your questions.

As usual, there are a few items I would like to cover before getting started. First, today’s conference call will include forward-looking statements. These statements are based on the environment as we see it today and therefore involve risks and uncertainties. I would caution you that our actual results could differ materially from the forward-looking statements made on this call.

Please refer to slide two of the presentation for our complete Safe Harbor statement. The Risk Factors section of our 2008 Form 10-K and our second and third quarter 10-Qs contain additional information about risks and uncertainties that could impact our business. You can access a copy of our 2008 10-K and 2009 quarterly SEC filings by visiting the Investors section on our website at trw.com or through the SEC’s website at sec.gov.

On a related matter, we expect to file our 2009 Form 10-K within the next day or so. Once filed, the 10-K can also be accessed through either website. In addition to the financial results presented on a GAAP basis, we will be discussing non-GAAP information that we believe is useful in evaluating the company’s operating performance.

Reconciliations for these non-GAAP measures to the closest GAAP equivalent can be found in the conference call materials, which are posted on the Investors section of our website at trw.com. And finally, a replay of this call can be accessed via dial-in or through a webcast on our website. Replay instructions were included in our release this morning. We have not given our permission for any other recording of this call and do not approve or sanction any transcribing of the call. These conclude my comments.

I’ll now turn the call over to John.

John Plant

Thank you, Mark. And good morning, everyone. I’m pleased to report that TRW completed 2009 with a strong fourth quarter. Sales increased over Q3 and also were 20% higher compared to the fourth quarter of 2008. Operating profit was $255 million, excluding restructuring charges. Net income was $168 million on the same basis. And year-end net debt was reduced to $1.583 billion, an all time low, with free cash flow up to $154 million for the year. This was a very good conclusion to a year that faced many challenges.

The challenges of extremely low vehicle production in the first half, certain vehicle manufacturer bankruptcies, supplier and peer group bankruptcies, and the poor availability of bank credit throughout the supply chain and the industry at large. The strong fourth quarter production levels reinforce our belief that the industry is trending back towards a sustainable and more normalized level of production albeit reaching the true normalized levels, which will be some years away.

In this time of gradual recovery, the downturn management actions that were taken by TRW are paying and will continue to pay significant dividends. The positive impact of those actions was demonstrated in our strong results as well as our second and third quarter results earlier this year.

Separate from our ongoing efforts to improve the cost structure, we also successfully completed a series of capital markets transactions, which have resulted in a more flexible and strengthened balance sheet. During the quarter, we raised approximately $900 million of capital to new bonds and term loans, which we used to repay existing debt, and we extended the maturity of the company’s undrawn revolving credit facility, more of which will be commented on in Joe’s section.

Our strong results combined with these financial restructuring actions and the success of equity offering completed in the third quarter provide increased flexibility to manage TRW’s capital structure in support of the company’s future growth. We remain focused on taking the necessary steps to position the company for long-term success. As we entered 2010, we believe that TRW is very well positioned.

In order to provide more context to the fourth quarter, I’ll add the following comments. In North America, overall vehicle production was up 2%, with the Detroit 3 production levels down about 6%. Although overall production was about equal compared to year-ago levels, production in the fourth quarter marked the highest level in the quarters in 2009 of just over 2.7 million units.

Production in Europe continued to hold strong and also reached its highest quarter level for the year as a result of the various government scrappage schemes. In Western Europe, production was up 19% for the quarter compared to the same period a year ago and 11% compared to the third quarter. In developing markets, China continued to set the pace with production up 89%, followed by India with increases of 56% and Brazil an increase of over 52%. Russia was the exception, with production falling over 42%.

The increasing levels during the second half of the year combined with our lower cost base highlight the earnings potential of the company. In fact, our fourth quarter results witnessed the highest quarterly profits achieved in the history of the company, a welcome outcome when you consider that the industry – of the industry dynamics in 2009 and the below normal levels of production.

Our efforts to further reduce costs and improve our earnings potential continued in the fourth quarter. In fact, we completed smaller targeted reductions of our direct labor and solid workforce. And since we began our headcount reduction programs last year, approximately 3,000 salaried positions have been eliminated with about 1,600 occurring in 2009.

In addition to the workforce reductions, we continued to utilize short-term working programs in Western Europe albeit at a lower level compared to the prior quarters, and that is due to the increased production levels. Related to personnel costs, we also are very focused on managing our benefit liabilities. For example, in the fourth quarter, the company closed its UK pension plan for future accruals and thereby capping the benefit obligations on a go-forward basis.

With regard to our facilities and plants, the decision was made to close our plant of Mount Vernon in North America, and it was a braking in suspension plant. The final closure is expected to take place in the summer of 2010. In the UK, we recently announced the closure of our Mere Green electronics plant by the end of 2010, and a consolidation of its operations into other electronic facilities.

We expect the magnitude and impact of our 2010 restructuring actions will be closer to a more normalized levels, which typically result in charges in the range $30 million to $40 million per year. Separate from restructuring, our ongoing efforts to ensure efficiencies and cost management, which are part of our day-to-day operations will continue since these values are in engrained in the actions of our employees. This mindset of cost containment is essential in a period of recovery, as various costs potential begin to creep back into the system. The team is focused on mitigating and controlling those costs.

Moving on to fourth quarter business developments. During the quarter we continued to strengthen our diversification and leadership in intelligent safety solutions to a number of product launches at various customers. A few examples include the driver and passenger airbag modules and seatbelt system on the Hyundai Sonata in North America; our innovative and fully electronic park brake system and ECU on the new BMW 5 Series; in Asia-Pacific, the Audi Q5 was recently launched with our side airbag modules, electronic park brake and seatbelt retractors.

These recent launches are a few examples of how the company is driving affordable safety. As we started the new decade, TRW is excited to continue our work with various industry groups, national governments and our customers to make a real difference in road safety. The significance of TRW’s broad portfolio of products is being recognized by vehicle manufacturers around the world.

In fact, both the North American car of the year and the European car of the year are well equipped with some of our newest technologies. The recently named North American car of the year, Ford’s Fusion hybrid, is equipped with TRW’s electric steering system, new airbags and suspension components. And Europe’s car of the year, the VW Polo, features TRW's electrohydraulic steering system, seatbelts, driver and passenger side impact airbags. The VW Polo was also named as the top performer in the European NCAP test for 2009.

Our quality and six sigma programs ensure recently launched and future products are delivered with world-class quality. For example, on the year, our quality averaged six parts per million across all products and customers. This represents a further improvement compared to our 2008 results of 11 PPM, another accomplishment of which we are proud in 2009.

Turning to 2010, increasing confidence, supported by upward revisions to forecasted production volumes in most regions, are resulted in a more optimistic move for the industry, notably in the US and Asia. In North America, we expect first quarter production to be roughly 2.7 million units, an increase of some 62% compared to last year and about equal to the fourth quarter of 2009. For the full year, our planning assumptions are based on a 10.8 million build in North America, which would represent a 27% increase compared to with 2009.

The strong finish in 2009 has resulted in some industry observers predicting vehicle bills in excess of 11 million units in North America. As usual, we will provide revised estimates, if necessary, as more information becomes available throughout the course of the year.

Turning to Europe, vehicle production is more difficult to predict. As a result of the uncertainty surrounding the payback effect of the cessation of the scrappage programs that were in place in 2009; most notably, in Germany. During the first quarter, vehicle production in Western Europe is projected to be about 3 million units, up some 22% from last year, but down $250,000 units compared to the fourth quarter of 2009. Total European production is forecasted at 4.2 million units in the quarter.

For the full year, our forecast for production is 16 million units for Europe. Within this estimate, Western European production is 11.3 million units and a decline of some 4% compared to last year. We believe production is likely to slump moderately in late Q2 and into the third quarter and to begin to turn in the second half of the year.

Our view is that there is a greater propensity for lower European production in 2010 compared with last year, and that's evidenced by Fiat's recent plans to halt production in two weeks starting in late February and that’s due to the softer consumer demand. We plan to monitor the production plans of our customers closely and make any necessary adjustments to our operations accordingly.

Beyond North America and Europe, full year production levels in high growth countries of the world such as China, India, South America are also expected to increase compared to 2009. The increases in vehicle production in North America and the emerging markets, combined with uncertainty in production for Europe are reflected in our 2010 planning assumptions.

Based on the forecasted production levels, we expect sales of approximately $12.3 billion to $12.9 billion for 2010. Sales in the first quarter are expected to be approximately $3.4 billion or some 42% higher than the prior year. Capital spending is expected to be in the range of $300 million to $325 million due to increases in vehicle production and the launch plans of our customers as we go into 2011. This level of spending continues to be well below our historical levels that averaged about $500 million a year.

In summary, we are optimistic and excited as we head into 2010. Our low cost base combined with our strengthened balance sheet and flexible capital structure positions TRW to take full advantage of the industry rebounds. TRW robustly faced the challenges of 2009 and emerged as a stronger global company with the broadest array of safety technologies and leading market positions.

And with that, I’ll now hand the call over to Joe to discuss in more detail our financial results.

Joe Cantie

Thank you, John. And good morning, everyone. As you can see from our financials published this morning along with John’s earlier comments, we finished 2009 very strong. Our results continued to benefit from our aggressive downturn management focus and the improving vehicle production schedules. The European production levels in the later part of the fourth quarter were surprisingly strong and better than we thought at the time of our last conference call with you.

During the quarter, there were quite a few highlights that stand out in our results that support our optimism for 2010. First, our sales were 9% higher compared with the previous quarter and 20% higher compared with Q4 of last year. This was the third sequential quarter of improved sales and marked our highest quarterly sales result in 2009.

We were profitable for the second consecutive quarter on an operating and net income level. In fact, the fourth quarter was a best ever quarterly results since becoming an independent company. We generated $432 million of free cash flow for the quarter, which allowed us to be cash flow positive for the year, generating $254 million. This accomplishment also resulted in TRW achieving its lowest level of net debt in the history of the company.

And finally, in addition to the positive operating results, we were able to complete a number of capital markets transactions and amend our primary credit facility, which significantly strengthened our balance sheet and improved the flexibility of our capital structure. I’ll expand on the capital structure in a few minutes.

First, let me review our fourth quarter results with you in a bit more detail. For the quarter, we reported sales of $3.4 billion, an increase of $571 million or 20.3% when compared to same period a year ago. In addition to the higher production volumes discussed earlier, currency translation also increased sales by $249 million.

The Euro to dollar exchange rate averaged 1.48 in the fourth quarter, which was about 12% higher than the same period a year ago. Partially offsetting the positive impact of higher production and currency translation was the fewer number of days in our fourth quarter as compared to the prior year, given that our third quarter cut off on October 2nd in 2009.

Excluding the effects of currency translation, sales increased about 11% compared to the previous year. Last point on sales, we had a 6% decline in revenue in North America, which is more than offset by the 17% revenue increase in Europe and 40% increase in the rest of the world, excluding the effects of currency.

For the quarter, we had an operating profit of $229 million compared to an operating loss of $892 million in the 2008 period. Of course, included in this quarter’s operating profit were restructuring and fixed asset impairment charges totaling $26 million compared with $81 million last year. The 2008 period also included goodwill and other intangible asset impairment charges of $787 million.

Excluding these charges from both periods, operating income in the fourth quarter of this year was $255 million compared with an operating loss of $24 million last year. The primary reasons for the increase in operating income were the positive impact of higher sales, the significant impact of our restructuring and cost containment programs implemented over the past year, and lower raw material prices.

Similar to our third quarter results, the fourth quarter also benefited from a number of non-repeating, but hard fought customer and benefit plan settlements, totaling approximately $25 million. In total, our 2009 results contained a high level of favorable one-off items, especially in the second half of the year.

Back to the quarter, the low operating income, interest expense totaled $51 million, an increase of $3 million compared to the prior year. The reduced level of debt during the quarter partially offset the higher interest rates between the two periods. I’ll provide some guidance on 2010 interest expense in a few minutes.

Finally, in terms of tax expense, we had $30 million in the quarter, which compares to an expense of nil in 2008. The increase was the result of the higher pretax earnings in the current quarter. The 2009 period included a tax benefit of $7 million relating to restructuring actions compared to a net tax expense of $4 million relating to special items in 2008.

So at the bottom line, first on a GAAP basis, we had net earnings of $1.18 per share compared with a net loss of $9.35 per share in the 2008 period. However, after excluding the restructuring and impairment charges, net of tax benefits from both periods and the loss on retirement of debt in the current quarter, we reported net earnings of $1.40 per share compared with a loss of $0.73 per share in the prior year, quite a turnaround for us.

In terms of EBITDA, we had a healthy $384 million for the quarter, excluding special items, compared with $111 million in the prior year, measured on the same basis, reflecting the improved operating income between the two periods.

Briefly for full-year 2009, we reported sales of $11.6 billion, which is a decline of $3.4 billion or 23% compared to the previous year. This comparison is a reminder of the depressed production levels we experienced in the first half of 2009. In addition to the decline in our customers’ production of vehicles, currency translation accounted for about $870 million of the decrease in sales.

For the full year, the company incurred asset impairments and restructuring charges totaling $130 million compared to $932 million in 2008. Excluding these charges from both years, our operating income for 2009 was $419 million, which compares the $464 million in 2008. Given the significantly reduced production levels, this outcome is a strong accomplishment and demonstrates the effect of this of our downturn management actions.

The low operating income, interest related expense was $190 million, which is $6 million higher compared to last year as a result of interest rates being reset as part of our June bank amendment process. In addition, the net gain on retirements of debt totaling $26 million was recognized in 2009. Tax expense was $67 million compared to $126 million in the prior year, lower as a result of changes in our geographic earnings profile. The current year included a tax benefit of $22 million relating to restructuring charges.

At the bottom line, we reported GAAP net earnings of $0.51 per share, which compares to a GAAP net loss of $7.71 per share in the previous year. Excluding the special items, we had earnings of $1.26 per share, which compares to $1.50 per share in 2008. And finally, in terms of adjusted EBITDA, in a year of great turbulence, we had $911 million in 2009 compared to $1,039 million in the prior year, measured on the same basis.

Moving on to our cash flow and capital structure, we are pretty proud of the accomplishments we achieved in 2009 on this front. First, on operating cash flow for the quarter, we had $512 million, which compares to $769 million in 2008. Cash flow after capital expenditures was $432 million in 2009 compared to $625 million last year.

This result, while lower than last year, is much better than our previous guidance due to our strong fourth quarter, continued CapEx management, and a few favorable timing outcomes. The decline year-over-year is due to a shift in working capital levels, given the increase in sales between the quarters and our October 2nd third quarter of 2009 cut-off. For the year, net cash flow from operating activities after capital expenditures was $254 million, which compares to $291 million in 2008.

A point of interest, in two of the most challenging years in the auto industry, we generated $545 million of absolute free cash flow. For all of 2009, capital expenditures were $201 million, which is significantly lower than the $482 million invested last year. The ability to be cash flow positive in both the quarter and the full year demonstrates the ongoing focus we place on managing every dollar of capital in the company.

Regarding our capital structure, we are equally pleased with what we have accomplished in 2009. During the quarter, we successfully completed several actions that together with the company’s solid operating results have significantly improved the strength and flexibility of our capital structure. In November, we completed a $259 million exchangeable and a $250 million straight bond offering. We then raised $400 million of new bank term loans.

Proceeds from the bonds, the new term loans, as well as cash on hand were used to pay off the previous term loans, which carried higher interest rates and shorter maturities. And prior to year-end, we amended the company’s primary credit facility, which included extending $845 million of its revolver commitments to November of 2014. These actions reduced our debt, extended the maturities of our debt structure, secured significant liquidity through the extension of a portion of our currently undrawn revolving credit facility, and decreased the level of secured senior debt, which provides the company further flexibility if needed.

At December 31st, our total debt and net debt outstanding were $2,371 million and $1,583 million respectively. Our net debt to EBITDA ratio was 1.74 times based on our trailing 12 months EBITDA, again a record low for us. 2009 marked the fourth consecutive year that we successfully reduced our net debt. Both total debt and net debt are historic lows since becoming an independent company.

In terms of liquidity, at the end of 2009, we had in excess of $1.8 billion available to us, consisting primarily of cash on hand and our undrawn revolver. As you can see, including our equity offering in August, we took decisive steps to improve the strength and flexibility of our capital structure, which now stands ready to support the future growth of the company or withstand any storm that may occur.

Switching subjects now to our expectations for 2010, John discussed our outlook for production in North America and Western Europe, up 27% and down 4% respectively, which should translate the full year sales for us in the range of $12.3 billion to $12.9 billion. At the midpoint of that range, our sales will be up about 9% from 2009 or about $1 billion. At this time, we are expecting first quarter sales of about $3.4 billion, which is 42% above last year’s level.

As mentioned, CapEx is expected to range between $300 million to $325 million, as we continue to align our spending with the product plans of our customers. With regards to restructuring, given the majority of restructuring actions that have been implemented over the past 12 to 18 months, we expect our 2010 restructuring to be lower, somewhere in the range between $30 million and $40 million, as John mentioned, a level closer to our historical run rate.

Interest expense is forecasted to range between $200 million and $210 million, given the cost and level of debt for the company. In 2010, a higher level of pension and OPEB expense will need to be incorporated in your models. We expect an increase in pension and OPEB expense of about $50 million for the year, resulting mainly from lower discount rates and other assumptions for our plans as we head into 2010.

In addition to the pension headwind, we are forecasting a higher level of commodity inflation as we move through the year. While we are not experiencing higher cost today, we are seeing prices of raw materials increasing over the past months. With the lag effect, it’s reasonable to assume commodity inflation will impact us in the second half of this year. Similar to previous periods of inflation, we will aggressively work to recover and minimize the negative impact of these rising costs.

Just a quick work with respect to taxes. We anticipate our effective tax rate will range between 39% and 44% for the year. Regarding expectations for our first quarter, clearly any comparisons to 2009 first quarter will be highly favorable, as our sales are expected to be over 40% higher year-on-year. When looking at the sequential comparison to our fourth quarter reported today, just a reminder that there are several seasonal factors between fourth and first quarters that will result in operating margins being a bit lower in Q1 as compared to Q4 on roughly the same level of sales between the two quarters.

In closing, we entered 2010 from a position of strength and remain focused on executing our strategy. Although we are optimistic about the future given our accomplishments in 2009, we are also cautious of the challenges and headwinds facing the industry and TRW primarily in the second half of the year. As always, we will work hard to mitigate those challenges to ensure long-term success for the company.

That completes my comments. Mandy, we will now move to the question-and-answer portion of the call.

Question-and-Answer Session

Operator

Yes, sir. (Operator instructions) We will take our first question from Himanshu Patel with JP Morgan.

Himanshu Patel – JP Morgan

Hi, good morning, guys.

John Plant

Good morning.

Himanshu Patel – JP Morgan

Joe, can you help us quantify the dollar impact of restoration of competitive pay and benefits in 2010?

Joe Cantie

Sure. I mean, if you look at us, our company in total, in 2009 we had a labor spend – total labor spend of somewhere around $2.5 billion. When you think about merit increases going into 2010 across the world, if I had to call it, we averages somewhere around 2.5% to 3.0%. So you are talking somewhere around, just doing the math quickly, $70 million. So that’s the labor side of it. In addition, there is always some expenses that we held down in 2009. You mentioned 401(k). We did restate that in North America. So there is some additional expenses relating to those items.

Himanshu Patel – JP Morgan

Okay. None of those were reversed – none of those temporary pay cuts were actually reversed in the fourth quarter, right?

Joe Cantie

No.

Himanshu Patel – JP Morgan

But does that all got reversed January 1, 2010?

Joe Cantie

Toward the early part of the quarter, yes.

Himanshu Patel – JP Morgan

Okay, okay. And is that one of the main reasons as well is not-repeat of the commercial settlement that you're saying that sequentially margins would be down Q4 to Q1 despite flat sales?

Joe Cantie

There is a number of things, Himanshu. When you look at our historical over the last five, six, seven years, our first quarter margins always tend to be low in the fourth quarter because you have a number of things that occur when the new year changes over. So for example, we may have certain arrangements with our customers where effective January 1st of pricing level kicks in, now we work to offset that with cost reductions, but what you wind up getting is the cost reductions ramp up sort of evenly through the year, but yet you are starting some of your price changes at the beginning of the year. Similarly on the suppliers side as well. So there is a number of factors that drive that outcome of the first quarter margin historically being lower than the fourth quarter.

Himanshu Patel – JP Morgan

Okay. And then, I don’t know if you have this handy, but just to help us understand how much you are hurt by adverse mix in Europe on a full-year ’09 basis, is there any way to tell us what your full year revenue growth rate change in Europe would have been on a constant currency basis and also exclusive of any –excluding any new business you onboarded [ph] in ’09?

John Plant

Himanshu, I will take that one. I’m not sure that we’ve got a good number for you on the, I’ll say, the average transactional value effect between more A and B class vehicles compared to C and D class in the year. So let's say we understand the question, but nothing we could give you today.

Joe Cantie

And on the currency one, excluding currency, as I said in the comments, our sales were up 11%. I don’t know if that helps you. That’s for the quarter, in the fourth quarter. And Mark can give it for the full year on a follow-up. I just don’t have it handy.

Himanshu Patel – JP Morgan

Okay, no worries. And then lastly, sequentially I think European production, at least CSM is calling for a decline in the second half. When you think of sequential decremental margins as we go through that period, should we think about that low $0.20 on the dollar range that you've talked about before?

Joe Cantie

A lot of things come into play. I mean, our contribution margin is typically in that 23% to 25% range. So again, as we go down, you would think we would lose that contribution margin. And then of course, it depends on what’s happening in the broader economies and what’s going up and down around it, but 23% to 25% continues to hold as contribution margin on our sales.

Himanshu Patel – JP Morgan

Okay, great. Thank you.

John Plant

Thank you.

Operator

Our next question is from John Murphy with Banc of America/Merrill Lynch.

John Murphy – Banc of America/Merrill Lynch

Good morning, guys.

Joe Cantie

Good morning.

John Plant

Hi, John.

John Murphy – Banc of America/Merrill Lynch

Looking at your projection and to follow up on the question on mix, on your projection for Europe, you have volume down about 2% in 2010, but you also have commented that you think mix will be a pretty good offset to that. I mean, is that 2% going to be offset by mix or could we go down 5% or 10%? Do you think mix could still be an offset? I'm just trying to gauge where the absolute level of production starts to swamp this potential positive mix.

John Plant

I think the issue, John, is we don’t understand yet the positive mix effect because it hasn’t yet happened. I mean, what we think of is, last year, let’s say, two of the major manufacturers in Europe, the Mercedes Benz and BMW, they didn’t benefit that much of the scrappage programs. And therefore in a recovering economy, I mean, that’s up for debate for Europe. Let’s assume that we guess that maybe those two manufacturers will have higher sales and higher outputs, and some of those cars will be exported, let’s say, to China or to North America. So you think that the mix will be higher. I mean, the question which is out there at the moment is really what will that positive mix effect be as these scrappage programs cease. And of course, we don’t really know. So because we don’t really know that number, it’s difficult to say to you, is it going to be sufficient to offset the lower production. And if you think that Europe has a greater propensity to go down, then – it’s really (inaudible) question basically. So mix, we expect to be positive. We just don’t know how positive.

John Murphy – Banc of America/Merrill Lynch

Okay. But it's fair to say also that it was a pretty big headwind in the second half of the year despite the higher volumes. I mean, it was pretty weak, right, given the clunker or the cash for clunker programs over there?

John Plant

We have to be absolutely clear, the A and B class segments gained, I think, about 6 or 7 percentage points of share during the course of 2009 due to those scrappage programs. We think that it’s going to still be a higher percentage than normal in 2010, but it won’t be as extreme as the 2009. And so the question is, of that 6 percentage point share gain of those smaller vehicles, what the rollback will be in 2010? And again, the question is not just as the scrappage program fees, but the degree to which the buying public will choose to have smaller cars because, for example, in France the bonus mile system, the whole CO2 emissions, taxation effects that are being put in place by the European governments. And so clearly I think there is lot more likely to be in the next five or 10 years a greater portion of smaller cars, so you got that effect also instead of flowing on. And so you’ve got many things which you are getting on here, which means that basically you won’t see the same 6% in 2010, but to tell you at this point whether it’s halfway, is it 3% or is it 4% or – I mean, nobody knows.

John Murphy – Banc of America/Merrill Lynch

Okay.

John Plant

And so struggling to give you that definition apart – sure, you're absolutely right, 2009 definitely the average mix was hurt by the transactional values for the smaller cars.

John Murphy – Banc of America/Merrill Lynch

Okay. Joe, if we look at the incremental margins, sequentially it's up 33% third quarter to fourth quarter, year-over-year it's up 49%. Obviously, as you mentioned, 23% to 25% is the incremental you're looking for. Is the delta there really your cost saves? And is any of this upside in this operating leverage explained by the fact that we were just so low in the cost curve that as you kind of scrape back from these – the despair on these volumes that your operating leverage actually might be a little bit higher for a while?

Joe Cantie

Couple things. First of all, when you look at the incremental margin between last year and this year, 50%. I think you said 49%. Let’s round that for 50%, it sounds better. 23%, 25% is just the contribution margin on the sales. The other half of that just clearly demonstrates the amount of fixed cost and other costs that we are talking out of the company over the past year. When I look at the sequential one from third to fourth quarter, again I did mention in my comments that we did have about $25 million of one-off items. We had a slightly lower level in third quarter. So there is a little bit there.

And then I would say the rest of it over and above the contribution margin pull-through was just some continued, what I’ll call, lagging benefit effect of all the actions that we were taking. They didn’t all just end on September 30th. There were still some more things that were going on in the fourth quarter. So that was the benefit. Your last part of your question, when I look forward, again, as things start to come back, of course things are going to drive closer to that 23%, 25% contribution margin. Just given the example of the question Himanshu came with, we didn’t give merit increases last year. We gave merit increases this year. That will have an effect on the ability for us to continue to put up these above 23% to 25% incremental margin levels.

John Murphy – Banc of America/Merrill Lynch

Okay. And then just lastly, John, or Joe, obviously there's a lot of noise around electronics in the vehicle and some – obviously some high-level issues and late issues that are kind of circulating in the press at this point. As we look at going to more brake by wire and steer by wire and other electronic systems in the vehicle, are you seeing any higher costs that might come in for product testing or anything as you're bidding – as you're putting in bids for new programs that might be somewhat disruptive going forward? Or do you think that the cadence or the developments in the electrification of all parts of the vehicle will continue without a pause here?

John Plant

I don’t think we can say we see anything at this point in time. The specifications that have been established in the industry and then by each specific customer are currently the ones we continue to work to. What I would say is, outside of that, I mean, TRW goes through extensive safety cases, particularly with its, I'll say, active chassis programs in terms of electronics control. So the most notable one would be what I call an always arm system. For example, pure electric steering. For example, the one that we just launched in 2009 on the Ford Fusion programs et cetera, et cetera, and you will see that further expanded in 2010.

Then we spent a lot of time, lot of diligence on our own internal safety cases in addition to what the customers specify. And within the things I’ve given you in terms of parts per million and also I could actually quote warrantee data, at the moment I'll say touchwood because we have to be cautious. So far we’re satisfied with the robustness of our electronic systems. Now, is it possible in the face of, say, recent new developments of certain vehicle manufacturers that additional things come into play? Of course, it’s possible. But at this point, we would think that with the established routines we have in place that that wouldn’t be an additional burn for TRW.

John Murphy – Banc of America/Merrill Lynch

Okay. Thank you very much.

John Plant

Thank you.

Operator

Our next question is from Chris Ceraso with Credit Suisse.

Chris Ceraso – Credit Suisse

Thanks, good morning.

John Plant

Hi, Chris.

Joe Cantie

Good morning.

Chris Ceraso – Credit Suisse

A question on the cadence – and you've given some good detail on this. But if I look historically, TRW generally earns a lot more in the first half of the year than the second half of the year. So I just want to clarify that we shouldn't assume that you're going to see a step-up in profit levels from the second half of ‘09 to the second half – or rather to the first half of ‘10. Is the key underlying difference here that European volume is usually much weaker in the second half and this time you actually had some pretty strong European volume in Q3 and Q4?

John Plant

I mean, the one notable effect of 2009 was that the third quarter was as strong as it was, and that was in both North America and Europe. North America just (inaudible) certain vehicle manufacturers were restoring that production post bankruptcy. And in Europe, we had the effect of the scrappage program. So I think if you should look year-to-year, then clearly – probably those two effects won’t be there in the third quarter of 2010. And indeed the, let’s say, outside forecasting agencies are already calling for clearly a low production in the third quarter of 2010. And that’s all – everything is set up for, I think, probably a weaker second half. And at the moment, we’ve already commented on a fairly strong start for 2010 first quarter and the production levels we have quoted today.

Chris Ceraso – Credit Suisse

Okay. Joe, you mentioned some favorable commodities as part of the walk in the fourth quarter. Can you quantify that and then maybe give us a feel for just how much you think you will experience going the other way in second half of ‘10?

Joe Cantie

Yes, it’s a tough one, Chris. I mean, first of all, we did benefit from lower raw material prices through the fourth quarter. There is always a lag. I don’t have a number ready to quote here as to what the positive effect of that was. As far as going into 2010, we do expect, as I said, inflation in the second half. What that will be? I really don’t know. If I look at the spot rates over the last three, four months of things like rolled bar, flat steel, scrap steel, which – those are the things that impact us the most. They have been trending up. And we would expect that with the lag effect because most of our exposure comes through Tier 2s, Tier 3s that would be in the second half. And I just don’t know where that will go. So it’s tough for us to quote a possible impact.

Chris Ceraso – Credit Suisse

Okay. And then just lastly, you mentioned the effective tax rate, you expect high 30s, low 40s percent. What do you think it is on a cash basis?

Joe Cantie

I would expect – I think for 2009 our cash taxes were somewhere around $60 million to $65 million. You will see that when we file the K later today. I would expect a similar, maybe slightly higher, maybe $5 million or $10 million higher than that number in 2010. So it’s going to be a good answer for us for the two years.

Chris Ceraso – Credit Suisse

Okay, great. Thanks, guys.

John Plant

Thank you.

Operator

Our next question is from Brett Hoselton with KeyBanc.

Brett Hoselton – KeyBanc

Good morning, John, Joe, Mark.

Joe Cantie

Good morning.

Mark Oswald

Good morning.

John Plant

Hi, Brett.

Brett Hoselton – KeyBanc

Let’s see, in looking at your revenue guidance, and this is a follow-on to John's question, the European production number down 4%. You obviously anticipate some mix benefit. But am I to assume that in your guidance at this point you haven't assumed any sort of a mix benefit for 2010?

John Plant

At this point, we don’t know.

Brett Hoselton – KeyBanc

Yes. Okay. Switching gears over to your longer-term margins, obviously you are reporting some very, very good margins versus where you've been historically. And I know that, John, you don't like to talk about margins specifically. My question really is, what would be some of the things that might be different a year, two years from now that might result or depress margins versus where we are today? What's happening potentially unusually, and what's unusually good today that might inhibit you from having structurally higher margins in the future? And what are some of the potential headwinds?

John Plant

Well, I mean, I guess when you read our K, you will see all the risk factors we always put down, which always seem to be as long as your arm. But the things which we’ve talked about historically, which was commodity inflation of course could be a negative. That’s always something, which is we’ve talked already about the fact that we already have and intend to be, I’ll say, fair to all of our stakeholders, including our employees. And we’ve increased pay in 2010. And there is also the question is, to what degree that cost-cutting programs will be able to offset any price reductions that we may or may not grant to our customer [ph]. There is always a lot of stuff, which is going on. I think the – you're absolute right that I’ve never stated a margin target and certainly I have no intention to doing so now.

I do note, as you’ve noted, that our fourth quarter margins were healthy. And clearly we always like to keep them healthy, but at the same time, it would be hard to anticipate that that level would continue on a go-forward basis. And Joe has already covered question I think this morning. I might add this example. The first quarter 2010 probably will be the same margin percentage as the fourth quarter of 2009. So I think you’ve got to take a broader sweep through all the factors of seasonality within the year and the fact that we had a couple of non-recurring things in the fourth quarter due to really establishing a year in force on what our margin will be. But I don’t think you just take the fourth quarter and extrapolate it and multiply it by four or something like that, or just take that margin percentage. That would probably be the wrong way to think of it.

Brett Hoselton – KeyBanc

Okay. Very helpful. Thank you very much, gentlemen. Great quarter.

Joe Cantie

Thank you.

John Plant

Thank you.

Operator

Our next question is Patrick Nolan with Deutsche Bank.

Patrick Nolan – Deutsche Bank

Hey, guys. Congratulations on the quarter.

John Plant

Thanks, Pat.

Patrick Nolan – Deutsche Bank

Just a few quick ones. You talked about the headwind of the salary increase in the states. What about the temporary work week in Europe or any other type of support you got from the governments last year that may not necessarily repeat in 2010?

John Plant

For the majority of the short-time working programs, those have been extended into 2010. And in fact, we are continuing to access those right now. So even though that production is up, we still have pieces [ph] on short-term working. I mean, clearly it’s much lower than the average of 2009 just because with attrition and with volumes in the fourth quarter and the first quarter this year being that much better is that the short-term working programs are being used. They are important to us. And at this point in time, it would be clearly a blow if they were to go away. Having said that, our expectation is at the moment that we do note that the – those programs are formally supposed to, I’ll say, about a [ph] broad average cease in the fourth quarter of 2010 during that quarter.

And the question will be for us is, to what degree will they cease? Will there be renewal? Because I’d have also thought that unless there is fundamental strong economic recovery in Europe, then it will likely that the governments will probably taper it as programs into 2011, because the consequence of mass redundancies, as companies were to address that problem, is something which is probably unthinkable in the European culture. And so my expectation is that there will be therefore the whole 2010 albeit we don’t know that, as you get halfway through the second quarter – I'm sorry, halfway through the fourth quarter. But really our underlying thought is that they will be extending in 2011. But clearly it’s the estimates of production are correct, then as we see ourselves tapering those programs down during the course of the year, as we adjust our workforce and even noted, for example, the closure of one of our major European plant that we announced in our restructuring. Then – we said (inaudible) we’re managing the program and we hope it is not a problem for ’10.

Patrick Nolan – Deutsche Bank

And when you look at raw materials, could you just refresh us, what percent of your contracts basically have either escalators in them or pass-through agreements and what percent of that are the ones that you're actually going to have to go and actually negotiate with the customers?

John Plant

I would rather call it out in three buckets rather than two because it represents the consolidated play. I mean, yes, we do have escalators with certain of our customers, and that would be bucket one. Bucket two would be those customers which we have come to an understanding and customer practice with in terms of recovery even without formal escalators. And then the final bucket will be those customers which, let’s say, have not. And so we’ve clearly increased the first category of those customers with formal escalators. And I’ll take a broad swipe.

It’s not that easy to get a continuous change with mix of production when you’ve got huge swings going on like plus 27% production in the US, minus 3% or 4% [ph] or whatever, we’d call that vehicle build in Europe. You’ve got big swings going on in – within sales in 2010. So that obviously affects the mix of those customers. But if you take category one, that is on formal escalators, I’m going to say – I'm going to put a range between 40% and 60%. And understanding then another 20 percentage points on top of that, maybe 25%. And then there is the bottom. So that gives you a very approximate thing [ph], but I couldn’t call you a point percentage of that.

Patrick Nolan – Deutsche Bank

That's very helpful. And just lastly, on the customer settlement agreement, the $25 million, I recall you had somewhere in the similar magnitude in Q3. Is that incorrect?

Joe Cantie

No. Yes. First of all, it was not one customer settlement item. There was several different items in there. Some of them customer settlements, some of them related to our benefit plans where we had one-time gains from some of the downturn management actions we took on them. So it’s not one thing. And it’s approximately $25 million in the fourth, and in the third quarter, we said it was approximately $20 million. So slightly up between the two quarters.

Patrick Nolan – Deutsche Bank

So should that $45 million – if I'm doing a year-over-year walk, that should be a headwind for you next year?

Joe Cantie

Absolutely.

Patrick Nolan – Deutsche Bank

Got it. Thanks very much, guys.

Mark Oswald

Mandy, I think we have time for one more question.

Operator

Yes, sir. Our final question comes from Kirk Ludtke with CRT Capital Group.