BorgWarner's CEO Discusses Q2 2011 Results - Earnings Call Transcript

 |  About: BorgWarner Inc. (BWA)
by: SA Transcripts


Good morning. My name is Rebecca, and I will be your conference facilitator. At this time, I would like to welcome everyone to the BorgWarner 2011 Second Quarter Results Earnings Conference Call. [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

Thank you, Rebecca. Good morning, and thank you all for joining us. We issued our earnings release this morning at approximately 8 a.m. Eastern Time. It's posted on our website,, on our homepage. A replay of today's conference call will be available through August 4. The dial-in number for the replay is (800) 642-1687. You'll need the conference ID which is 79909349. The replay will also be available on our website.

With regard to our Investor Relations calendar, we will be attending a number of conferences over the next few months. August 11, we'll be at the J.P. Morgan Conference in Detroit; September 7, we'll be at the Crédit Suisse Conference in New York; September 13, we'll be at the Frankfurt Auto Show Investor Conference in Frankfurt; and on November 1, we will be at the Gabelli Automotive Symposium in Las Vegas. Also, as we do reach fall, we will be announcing our 3-year backlog of net new business in early November.

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

Now moving on to our results. Tim Manganello, Chairman and CEO, will comment on the second quarter and current industry trends; and then Robin Adams, our CFO, will discuss the details of our operating results and also our outlook for the rest of the year.

With that, I'll turn it over to Tim.

Timothy Manganello

Thank you, Ken, and good day, everyone. I'm very pleased to review our second quarter results, our accomplishments, some comments on the industry and our revised guidance. But first, I'd like to thank all of BorgWarner employees, worldwide, for another record quarter. In addition, we recently recognized over 70 BorgWarner employees with awards for innovation and product development, customer excellence, operational excellence and collaboration. I'm very proud of our employees and their dedication, teamwork and creativity that drives BorgWarner's success.

So now I'll begin by highlighting our strong second quarter results. Sales were $1.8 billion, up 28% from the same period last year. Our operating income margin, excluding a nonrecurring item was 11%. U.S. GAAP earnings were $1.31 per share and excluding nonrecurring items, earnings were $1.12 per share.

Four key factors drove our results: increased global demand for our products; higher volumes on our base business; well executed cost controls by all BorgWarner locations; and better than expected results from our Japanese operations.

Now let's take a look at second quarter results at the group level.

In the Engine Group, first quarter sales were about $1.3 billion, up 28% from a year ago. Higher sales in the Engine Group were the result of growth in 3 key areas: Engine timing system sales were up in North America and China; fee-in and fan drive sales were sharply higher as the commercial vehicle market continues its strong recovery; and the rapid adoption of turbocharger technology continued around the world.

The turbocharger market continues to be a major driver for BorgWarner. It is a growing market that is attracting new competitors, but despite this, we expect to maintain or increase our global market share of the rapidly growing global turbocharger market during the next 5 years.

In the Drivetrain Group, sales were up $526 million -- or, I'm sorry, were about $526 million, up 29% from the second quarter. There were 3 primary drivers for Drivetrain sales growth: increased DCT module sales in Europe; increased 4-wheel drive and traditional automatic transmission components sales in Korea; and the attraction acquisition from Haldex.

Regarding Drivetrain margins, the Drivetrain Group's operating margins are improving. In the quarter, margins were 7.4%, which is an improvement over Q1 of this year but not quite where we plan to be. The Drivetrain Group continues to manage through capacity constraints and productivity issues in Europe and these issues have been challenging but we are continuing to execute plans that will improve their performance.

Now at the corporate level, capital spending continues to grow. It was about 5% of sales in the quarter, and we are committed to supporting our future growth with new investment and productivity improvements. We also repurchased about 1 million shares of common stock in the second quarter. We have now accumulated all of the shares required to settle our convertible debt obligation, which is due in April of 2012. We continue to invest for the long term also. Our spending for R&D and new program launches was about 3.6% of sales in the quarter and this is slightly below our targeted level of 4% but an increase of -- or increased from 3.2% a year ago.

I'm also excited to tell you about several noteworthy business wins by the BorgWarner team. BorgWarner now supplies Torque-On-Demand transfer cases for the Tata Aria, India's first 4-wheel drive crossover vehicle. Torque-On-Demand technology provides improved traction in automatic 4-wheel drive, when it is needed, and it will help the Aria compete with imports in the Indian market.

In China, BorgWarner produces several advanced technologies for the Great Wall Motor new 2.0-liter diesel Haval H5 and Hover SUV. These technologies include VTG turbochargers, Torque-On-Demand transfer cases, self-regulating glow plugs and EGR valves.

We are also very proud to produce compact plug top ignition coils and timing chain systems for Fiat's new 0.9L TwinAir gasoline engine. This engine was recently named 2011 International Engine of the Year, Best New Engine and Green Engine of the Year.

Also, the Fiat 3.0-litre F1C engine features our regulated 2-stage or R2S turbochargers. They have been available in Europe and Asia since 2009 but the engine is now available in North America for the first time. An additional good news on this engine is, one of the Asian's -- or Asia's leading commercial vehicle manufacturers plans to use this fuel-efficient engine for its next-generation of medium-duty trucks in over 40 countries by the end of 2012.

And in North America, Freightliner's Cascadia trucks offer BorgWarner's Visctronic fan drives, a first for Class A commercial trucks in North America. BorgWarner's electronically controlled Visctronic fan drives provide the right cooling at the right time to improve fuel economy for trucks.

Now changing subjects. We settled the patent infringement lawsuit with Honeywell in May. Honeywell agreed to pay $32.5 million for a paid-up license to use the asserted BorgWarner patents. We're very pleased with this outcome. And it validates our reputation as the leader in turbocharger technology.

Now, I would like to make a few comments about the broader auto industry for the second quarter.

Global production was down 2% in the second quarter compared with a year ago. Robin will go over the details in a moment on that one.

In summary, industry production was flat in Europe and North America, higher in China and India and sharply lower in Japan. Now in Japan, production was better than we expected at our NSK Warner Drivetrain joint venture and at our wholly-owned Japanese chain operations.

During our first quarter earnings call, we said that we believe both businesses would be breakeven, at best, in the second quarter. But both businesses were actually profitable. This is a remarkable result and a testament to the resiliency of our team in Japan and our customers in Japan. Congratulations to both.

Our closer look at Europe reveals that the mix of vehicles continued to shift in our favor. C, D and E segment vehicles represented nearly 66% of vehicles produced in Europe in the second quarter. This was 2 percentage points higher than the second quarter of 2010 and essentially flat with the first quarter of this year. The diesel market share was up a couple of percentage points from a year ago and essentially flat with the first quarter of 2011.

Next, let's take a look at our updated production outlook. North America remains unchanged at 13 million units. Our view on Europe has improved to 19.9 million units, up from 19.2 million. And the vehicle mix will probably stabilize at the current percentages, which is good for BorgWarner.

We now realize that China will be a little weaker than expected at about 15.9 million units, down from 16.5 million. Higher interest rates and gas prices, along with reduced incentive programs, have tempered vehicle sales and production in China. However, this appears -- it appears that sales of higher-end vehicles are now starting to come back and that China pass car market will be improving.

In Japan, we expect production levels to continue to improve to normal levels throughout the year. Although it does not appear that there will be much second half recovery of lost first half volumes.

For the full year, our global forecast is down slightly. We expect higher volumes in North America, Europe and Korea to nearly offset lower volumes in Japan and China.

In the commercial truck market, we continue to expect solid growth in North America, Europe and South America. And in China, the truck market is expected to decline due to the same factors affecting the light vehicle market in China. But despite this, our commercial truck business is growing in China due to our increased penetration rates.

And finally, we have raised our guidance for 2011. Our earnings guidance is now $4.25 to $4.45 per share, which is up from $3.85 to $4.15 per share. And we still expect our operating margins to be better than 10.5% for the full year. Sales growth in 2011 compared with 2010 is now expected to be 25% to 28%, up from our 19% to 23% guidance earlier this year. The change is primarily due to an improved outlook for our business along with updated currency expectations. Also for the longer term, the demand for our technology continues to gain momentum.

As you all know, BorgWarner has become synonymous with improving fuel economy and lowering emissions and both are major long-term trends in the global auto industry and are driving our growth. And as a result, and as I have said many times, probably every time in the quarterly calls, the high demand for our leading edge technologies will continue to drive solid BorgWarner growth for years to come.

And I'd like to emphasize one more time, no company in the auto sector is better positioned for short-term or long-term profitable growth than BorgWarner.

Thank you and now I'll turn the meeting over to Robin.

Robin Adams

Thanks, Tim. That's pretty good, I'll watch out to say, I guess. Good day, everyone. Before I begin review the financials, again, I'd like to quickly review the macroenvironment for the industry in the second quarter to help put our record performance in the quarter in perspective.

As Tim mentioned, second quarter global production was about 17.6 million units, down about 2% from the second quarter last year and actually down 7% from the first quarter. Our sales moved opposite of the market and were up in the quarter both year-over-year and also sequentially. On a year-over-year basis, as Tim mentioned, our reported sales were up 28%. Excluding currency in the Haldex acquisition, which were made in the first quarter of this year, the year-over-year increase was 15% and that's about 17 percentage points stronger than the 2% year-over-year decline in the global vehicle market.

In another quarter where our sales growth significantly outperformed the market. Sequentially, excluding currency in the Haldex acquisition, our sales were up about 3%, which is 10 percentage points better than the 7% sequential decline in the marketplace.

When you look at our sales from a regional perspective, our sales growth from the second quarter outpaced the market in every major region of the world. In the U.S., with our sales up 16% versus last year, the market was up only 3%. In Europe, again, on a comparable basis excluding currency at Haldex, our sales were up 13%. And as Tim said, the market was up 1%. Our sales in Asia, excluding currency, were up 11% while the market was down 6%, again, primarily related to the tragedy in Japan.

Clearly, the growth of our leading-edge technology products continues to penetrate all the markets around the world and continues to differentiate BorgWarner from the rest of the industry from an overall growth perspective. If you look at where our sales took place in the quarter, approximately 57% of our sales occurred in Europe, about 45% were in Euroland, exposure to the euro, approximately 23% in the U.S., about 15% in Asia and the rest in South America and other smaller countries.

As we look at the earnings per share numbers, as Tim mentioned, on a GAAP basis, we reported a record $1.31 per diluted share compared with $0.68 per diluted share in the second quarter of 2010. However, as we indicated in our press release, both periods included nonrecurring items, they really have nothing to do with the ongoing operations of the business. So we've identified those items in a table in our press release and these include the $29.1 million net gain, net of expenses, related to the Honeywell patent infringement in the second quarter 2001 that Tim mentioned. And that's shown in the other income line item in our income statement.

We also had a positive tax account adjustments in the second quarter of approximately $6.2 million that kind of skews the tax rate. I'll talk about that in a little bit. In the second quarter last year, there was approximately $20 million of nonrecurring items, also shown in the other income line item in the income statement. So that's easy for you to see where these large items are.

And again, in the press release, we have this table and we typically provide it to help you reconcile our reported U.S. GAAP earnings measures with the financial performance of the continuing operations of our company and also to help you in comparing these results with the results of other periods. As always, we encourage you to review this information as it is an important part of the press release.

So excluding these nonrecurring items, again, second quarter 2011 earnings were $1.12 a share, a new all-time record for the company and up 44% from $0.78 a share a year ago. And again, another quarter in a string of very strong quarterly performances by BorgWarner.

As we look at the rest of the income statement, gross profit as a percent of sales was 19.6% in the quarter, slightly higher than the 19.4% a year ago and it’s just under 19.8% in the first quarter 2011. And remember we've got a lot of purchase accounting, entries running through gross profit as a result of the acquisition of Haldex in the first quarter.

The year-over-year improvement in the quarter was realized despite about $8 million of higher raw material prices in the second quarter this year than we experienced in the second quarter last year. It brings us to about $20 million year-to-date, actually.

SG&A expenses were $158 million or 8.7% of sales in the quarter versus $138 million or 9.7% of sales in the second quarter last year. Now this is an increase in spending, year-over-year, of about $20 million. But if you look at that $20 million increase in the quarter, nearly all that was related to R&D spending. So we continue to see operating leverage in the business reflected in our SG&A expenses, at particularly, as a percent of sales.

Talking about R&D, as Tim mentioned, as a percent of sales, R&D was 3.6% in the second quarter, an increase from 3.2% a year ago and 3.5% in the first quarter. On a dollar basis, R&D spending was up 40% year-over-year, which is huge. And we continue to trend towards our 4% target. And although on a full year basis, we'll probably fall short of that 4%. We expect to be closer to that 4% run rate by the end of the year. And again we expect R&D spending to be up over 50% on a dollar basis versus last year. So a significant investment in the future of this company running through our SG&A line items.

Reported operating income in the quarter was $228 million. However, this did include that $29 million net gain related to the Honeywell patent infringement settlement. Although I'd like to say that we'd love to see that settlement every quarter, that's really not going to happen, it has nothing to do with our operations. So as we exclude that operating income, it was $199 million or about 11% of sales compared with $137 million or 9.7% of sales a year ago. Again, also excluding nonrecurring items.

The 11% margin is a new quarterly record for BorgWarner. And if you exclude Haldex, really, operating margins were 11.3% in the quarter. So relative to where this business has been, we actually saw margins north of 11% in the quarter. That shows you how strong the performance of our business has been this year. And again, as I said the last quarter, whether you include or exclude Haldex, we are having a fantastic year, setting new operating income margin records quarter-on-quarter.

On a reported basis, if you look at incremental margins, the year-over-year incremental margin on incremental sales was approximately 16%. And again if you exclude the impact of currency in the Haldex acquisition, so if you look on a comparable basis, the year-over-year incremental margin was about 21%. And this solid conversion of higher sales to incremental income reflects the effectiveness of our past restructuring activities, a continuing well-executed cost control program throughout the world at BorgWarner and a benefit of our operating leverage.

If you remember when we started the year, we gave guidance and said that we were expecting about 20% incremental margins year-over-year throughout 2011 versus 2010, and we've achieved 21% incremental margins, on a comparable basis, in both the first and second quarters. And that's pretty darn good performance relative to guidance there.

If we look at the incremental margin on a sequential basis from the first quarter to the second quarter, again excluding currency, our sequential margin was about 19%. If you exclude Haldex, it was actually a little bit higher, probably in the mid-20s.

If you look further down the income statement, equity affiliate earnings was $8.1 million, down from $10 million last year, down about 20%. As Tim mentioned, our equity affiliate earnings primarily reflects performance of our Drivetrain Systems, 50/50 joint venture Japan NSK-Warner that services our Japanese customers for transmission products in Japan and China. And also our turbocharger joint venture in India. Affiliate earnings were stronger than we expected in the quarter. And as we look at it, sales at our NSK-Warner joint venture in Japan declined about 33%, which was in line with our expectations as a result for the disaster in Japan. However, as Tim mentioned again, they did a much better job of managing the cost structure, but the incremental margins of only $0.20 on the dollar, associated with the sales decline versus our 40% expectation.

And as we look ahead, we will continue to see slightly below prior-year levels of affiliate income in the third, fourth quarter but the variance will not be as severe as we originally anticipated.

Interest expense and finance charges were $21 million in the quarter compared with $14 million a year ago and that's primarily due to higher debt levels. We've invested approximately $375 million in acquisitions in the last 15 months in BorgWarner. Provision for income taxes was $50 million in the quarter for a tax rate just below 24%. And this reported number includes both the tax impact of the Honeywell patent infringement settlement payment and other tax account adjustments related to changes to the state tax laws and the closure of certain federal audits around the globe. If we exclude these items, the effective tax rate on our ongoing operations was about 24% in the quarter, in line with the first quarter and pretty much in line with the guidance we've given for the full year 2011.

Net earnings in the quarter were $162 million compared with $82.8 million a year ago. And at the bottom of the income statement page of our press release, as always, you'll find information on how we calculate diluted earnings per share. It’s kind of a convoluted process but you've been through that in the last couple of quarters and I'm not going to explain it to you again. So as we get down to diluted earnings per share on U.S. GAAP basis, we've earned $1.31, as I said earlier, versus $0.68 a share. And again, excluding nonrecurring items, $1.12, an all-time quarterly record for the company. And again, up 44% year-over-year from the second quarter 2010. That's a phenomenal performance.

Now let's look at operating segments. Again, good performance on both sides of the equation. The Engine segment sales were $1.3 billion in the quarter, up 28% versus last year. But again, to be fair on a comparable basis, excluding currency, Engine segment sales were up 17% compared with the second quarter of 2010, significantly outperforming the industry. And as Tim mentioned, we are seeing strong global growth across all the Engine segment product portfolio. Every product area in BorgWarner is showing strong double digit growth versus last year on the Engine side.

Adjusted EBIT for the Engine Group was $197 million in the quarter or 15.3% of sales. Again, new quarterly record for the Engine Group at BorgWarner and significantly higher than the 13.1% adjusted EBIT margin reported a year ago. If you look at year-over-year incremental margins, excluding currency, the Engine really hit the ball out of the park with a 29% incremental margins year-over-year. If you look second quarter versus first quarter of 2011 or on a sequential basis, Engine sales were up about 3% excluding currency in a market that was down about 7%. And again, the incremental margin on a sequential basis was about 28%. And this Engine segment continues to perform at industry leading levels.

In the Drivetrain segment, as Tim said, sales were $526 million in the quarter, up 29% versus the second quarter last year but we did get some benefit from currency in the quarter and also, we now own Haldex, which we didn't own last year. So on a comparable basis, if you strip the impact done on sales, Drivetrain segment sales were up 9%. And again, as compared to the second quarter 2010, if you look at it relative to the market, that's 11 percentage points stronger than the market which, as we said earlier was down about 2%.

On a reported basis, adjusted EBIT was $39 million or 7.4%, which was down from 9.1% in the second quarter 2010. And as we said on our last earnings call, the Haldex acquisition, the sales that we have as a result of the Haldex acquisition, will actually be a drag on margins this year as a result of the purchase accounting adjustments related to that acquisition. So the profits we're generating in that business, which are in line with our Drivetrain margins before purchase accounting adjustments are pretty much being eaten up there. So it is impacting the margin reported a for this business. If you exclude the impact to Haldex in currency, Drivetrain segment margins were about 8.2% in the quarter, still below last year but as Tim mentioned, we are seeing quite an improvement in the Drivetrain business. If you look on a sequential basis or again comparing second quarter to first quarter of this year, Drivetrain sales were up 4% on a comparable basis. Solid growth again in a market that declined about 7% sequentially.

And if we look at incremental margins on a sequential basis, they were only about at 11%, again below our target of 20% but definitely trending in the right direction. In fact, if you look at the Drivetrain margins, they actually filed out in the last half of 2010 and are showing improvement off those levels. If I look back sequentially starting in the first quarter 2010 Drivetrain margins were reported at 9.9%, in the second quarter 9.1%. In the third quarter last year, they were 7.8%, in the fourth quarter, 7.6%.

As we've got into the first quarter this year on a reported basis, they were 6.6%. But without Haldex, actually, not a comparable basis, they were 8%, much higher than third and fourth quarters. So you see the progression.

And now as we look at the second quarter, again, reported 7.4% but excluding Haldex, 8.1%. So you see that, again, they bottomed out in the last half of 2010. We're seeing some improvement in the first quarter of 2011, further improvement in the second quarter 2011 and we expect further sequential improvements in Drivetrain margins in the third and fourth quarter of this year. And in fact, exceeding prior year margin levels. So as we get into the back half of the year, we should see Drivetrain margins actually stronger than Drivetrain margins in 2010, which is a good thing.

As we look at the balance sheet and cash flow statement now, moving away from the income statement. We generated about $249 million cash from operating activities in the first 6 months of 2011, up $40 million from the same of period last year. We had a very strong second quarter from a cash flow perspective generating $290 million of cash from operations activities. And if you look at, again, of where we are year-to-date, we are on track to generate over $650 million of cash from operating activities for the full year. And that's up about $50 million from our previous guidance on cash provided in January.

Capital spending for the 6 months of the year is approximately $160 million, up about $107 million of the same period last year but this increase is indicative of the growth in capital spending that's required to meet the increased level of program launches we have around the world, particularly in markets like Asia, in Eastern Europe and Mexico.

As we look at the full year, as we said before, we expect an increase in capital spending versus last year. We're now talking about $350 million to $375 million capital spending, which is up slightly from our previous guidance. But we're generating more additional cash flow to cover that.

Looking at the balance sheet itself. Debt increased by $289 million from year-end while cash decreased about $78 million in the quarter. And if you look at this $350 million or so increase in net debt, it was primarily due to the acquisition of Haldex Traction Systems which was over $200 million, as well as the purchase of the remaining treasury stock required to settle our convertible that matures next April. So we're in good shape there.

If you look at the capital structure, our net-to-capital ratio was about 31% at the end of the second quarter compared to 24% at the end of 2010. If you look at net debt to EBITDA on a trailing 12-month basis, it was about 1.1x at the end of the second quarter. As we've said before, we really view our balance sheet and capital structure on a net converted basis. That convertible is in the money and will look mature in April of next year. We've bought all the shares to take care of that, it's sitting in our equity, shows us equity right now. So we encourage all of you to do the same thing when you look at the capital structure. When you think , from that perspective, net debt to capital is about 20% at the end of the quarter. Net debt to EBITDA was 0.8x.

We also recently renewed our revolving credit facility in the second quarter. The new facility is $650 million within an accordion feature that allows us to upsize to $1 billion of credit if we need. It’s a 5-year term facility. And given all that, I think our capital structure is in excellent shape and makes us well positioned to take advantage of any strategic acquisition opportunities presented by the market.

I'm going to move onto guidance for 2010 (sic) [ 2011 ]. Tim covered it briefly, I'm going just hammer it home just one more time. We have raised our sales growth and earnings guidance for the year. We now expect sales growth of 25% to 28% compared with 2010 versus industry growth of about 4%. I'm sorry 2011 guidance. But this is up from our previous sales guidance of 19% to 22%. Again, earnings per share excluding nonrecurring items are now expected to be within a range of $4.25 and $4.45 per diluted share and that translates to an earnings per share growth rate of 40% to 47% in the year versus 2010, up from $3.85 to $4.85 diluted share, our previous guidance.

The dollar year exchange rate, we have changed for the year. It is part of the increase of about the sales and earnings but not all of it. We finally said, "Uncle," and decided to increase the exchange rate and expect the dollar to be about 6% weaker than previously expected. So we're at $1.40 to the euro in 2011 versus $1.32. And that $1.40 is just happens to be where we are at 6 months year-to-date performance. Again the dollar to euro exchange rate change -- the change guidance accounts for roughly 3% of the expected year-over-year sales grow rate. So again if you exclude currency, you're looking at 22% to 25% compared to 19% to 23% before, so still significant improvement. It also represents the dollar euro exchange rate, represents approximately $0.12 a share in earnings growth relative to previous guidance. Again, in the remainder of the increase in guidance is phenomenal relative to where we were before due to an improved outlook for our business.

As we've said, the Haldex acquisition will be a drag on margins for this year and my rough estimate is to the tune of 0.03 of percentage point. And that's due to upfront transaction costs and purchase price amortization. Despite the Haldex margin drag, we still expect to achieve better than 10.5% operating income margins for the year, including Haldex.

And if you look at where we are, year-to-date, we are at about 10.7%, including Haldex and about 11% without Haldex. So again, very strong margin performance for this company year-to-date. And continued expected margin performance for the rest of the year.

As we said earlier, the negative impact we expected from our NSK-Warner joint venture in Japan has been minimized and although we still expect affiliate income in third to fourth quarter to be below prior year levels, only slightly. And certainly not as severe as we originally anticipated.

Also the compaging [ph] from the disasters in Japan, at some period, would severely impact the global industry and we saw a lot of selloff in stocks in this sector early in the second quarter. I think it was unfounded because that's not materialized, certainly not at BorgWarner. As we look at higher raw material costs, we continue to believe that, that would be a negative impact of about $35 million to $40 million for us in 2011 versus 2010. As we said in our last earnings call, and we've said over the years, our intentions with respect to raw material prices have always been to absorb and manage these inflationary costs and not permit them to have any negative impact to our earnings expectations for the year.

If you look at the year-over-year projected sales and earnings growth range for 2011, it implies incremental margins, excluding Haldex, of about 20% and again in line with our original target for the year and in line with the first half of 2011 actual performance. And again, we did a pretty good job on getting that number for the year.

So let me summarize the quarter for you. It was another record from a sales perspective, another record from an earnings perspective, another record from an operating income perspective. And believe me, we do not believe that we're done setting records this year. Six months left to go and this train is moving. Engine margins are an all-time record highs, while Drivetrain margins have bottomed out and are improving sequentially.

We continue to gain momentum in this business, and I look -- as I look to this quarter from a critical perspective, for me, it's hard to find anything to be negative about. And with this a performance, we just set the bar even higher for ourselves, but I know everyone within this company is up to the challenge.

And with that, I'd like to turn the call back over to Ken.

Ken Lamb

Thank you, Robin. We will now turn to the Q&A portion of the call. I'd like to ask the call coordinator to please announce the Q&A procedure.

Question-and-Answer Session


[Operator Instructions] And your first question comes from Rich Kwas with Wells Fargo Securities.

Richard Kwas - Wells Fargo Securities, LLC

On Drivetrain, Tim or Robin, can you give us some color on what's happening in Europe? It sounds like you still -- some of these issues that were -- that occurred earlier in the year are sticky. What's the update there? And then, I know you're spending some dollars in China for the DCT program, the DCT launch, where are you with that? And then just to confirm, it sounds like you expect margins to be up year-over-year for Drivetrain for the second half of the year, any color around magnitude would be helpful.

Timothy Manganello

Well, we are continuing to see some issues in Europe both on capacity constraints because they're trying to get more capacity in. We've had some operational issues in a couple of plants that are improving, but then, that's where I want them to be yet. I don't want to give any the details. But in China we are -- well, I'm going to China actually, next month or I guess early September, to do the dedication ceremony in the opening ceremony for that Drivetrain plant in Dalian. We will be in production later at the end of this year, ramping up in the first quarter next year, which is still on schedule. We ask for -- continuing to invest our money on R&D, we have more and more projects that we are involved with from the Chinese OEMs. This has already been public, but we're launching with Shanghai and then we're going to have significant amount of business with First Auto. We're continuing to grow with other -- with those 2 main players and we're getting more and more projects and more and more involved in development programs. Our transmission, the new BorgWarner transmission design that we worked on our low-cost transmission is moved into the next phase of development program, which is one state -- basically one phase before a production contract. So we're in the preproduction contract phase with one major Chinese OEM and one major Japanese OEM, but I can't announce them yet. And so we're spending money on engineering costs and the Drivetrain that's going to be well spent for the future. That's got a little bit of a drag on us right now. We've got some operational issues in Europe that are improving. They would -- the third quarter and the fourth quarter projections are better on margins for Drivetrain than the first of the second quarter, and we're just continuing to run our plan, Rich.

Richard Kwas - Wells Fargo Securities, LLC

Okay. But the magnitude. It sounds like the magnitude is -- we should expect some modest expansion from here given the...

Timothy Manganello

Okay. I forgot to talk about the magnitude. Robin gave you some historical ramp-ups and we're going to get -- we're going to restart moving up in those ranges.

Robin Adams

Let me help you there, Rich. As I said, third quarter, fourth quarter last year was 7.8% to 7.6%. In the second quarter this year, we're at 7.4%, and again, we expect improvements through the remainder of the year so we'll be north of 7.8%, in the back half of the year, if you look at it without Haldex where they belong in the second quarter. So we will see sequential improvement beyond second quarter levels that will put us in a better position from a margin perspective than we want in the back half of last year and continue to improve, as Tim said, working on a gradual improvements in that business in Europe.

Richard Kwas - Wells Fargo Securities, LLC

Okay, that's helpful. And then, just final one for me. Tim, a bigger picture question. Cummins, it looks like is going to be -- is investing in a light-duty diesel for light-truck applications. How do you think that affects the overall competitive landscape going forward? It seems like it's a ways out but I just want to get your thoughts.

Timothy Manganello

No, that's a ways out. I mean, they're a player in the market. And as far as -- we're tracking turbocharger growth in both the commercial markets and in pass car. We are growing in that segment of the market that Cummins' new engine will play in. Our turbocharger volume is growing in that segment in the next 5 to 6 years and they're going to have -- we already know that the Chinese are targeting that market, and that there is tremendous growth for us in China. We also know that the Chinese are preparing to go into global competition and they're going to be using turbochargers like the kind that BorgWarner makes.


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

Dan Galves - Deutsche Bank AG

This is Dan Galves in for Rod. So SG&A looked quite low in the quarter. You know it's down $7.5 million and it sounds, from what you're saying at R&D, R&D expenses were actually up about $5 million. So what caused the decline in SG&A outside of the R&D line?

Timothy Manganello

Well, the macro answer is we're leveraging our resources as we grow our sales. But we are continuing to grow our R&D spending from last year to this year, there is tremendous growth in actual dollars. As far as the rest of SA, we're basically managing our hiring, and we're managing our travel cost, and we're basically managing all the lessons that we learned during the recession. We're trying to continue on as we go forward in this company. But we're still not doing anything that would harm our growth. So we're just investing wisely.

Dan Galves - Deutsche Bank AG

Okay, great. So I just wanted to check if there were any kind of specific expenses related to Japan outside of any -- in your core business in terms of premium freight anything like that? Was there anything material in the quarter?

Timothy Manganello

No, not really. It was just normal. The guys did a great job of cutting costs, keeping their decremental margins as low as possible. Some of the things that we did in Japan to keep our plants running was we were tight at capacity in Korea and some products in the timing chain area. So we started making -- we made similar products between Korea and Japan. So we, basically, cranked up our Japanese plant to ship products to Korea to relieve some of the capacity challenges in our Korean operations. So we kept our chain plant in Japan running as best as we could even though we we're making product that wasn't necessarily being used and shipped and consumed inside Japan.

Dan Galves - Deutsche Bank AG

Okay, great. And just one housekeeping thing. Can you remind us on what the dollar impact on revenue from Haldex was in the quarter and what you expect for the full year?

Robin Adams

As we said before, Haldex is about $200 million in revenue on annual basis. So divided by 4, its about $50 million.


Your next question comes from line of John Murphy with Bank of America Merrill Lynch.

John Murphy - BofA Merrill Lynch

Just a first question on the Engine business and the Commercial exposure in aggregate. And Tim, you've mentioned that the Commercial business was a really good positive in the quarter for the fan and fan drive business in the Engine business. I'm just wondering if you could remind us how big Commercial is in your aggregate portfolio right now. And also, it looks like it's going to be, I mean, the outlook is a lot brighter there than it is on the light vehicle side particularly, as we go through the second half of the year. Just curious, how you was thinking about that business really ramping up and how big a contributor it will be in the second half?

Timothy Manganello

Well, it's about 15% of our sales when you consider medium-duty, heavy-duty, vessels and some of the ags that we'll call off-highway. If you define that for us, that's what we defined as Commercial. That's about 15% of our sales. And our sales are growing so significantly and we're still maintaining that 15% to 16% range. So you've seen really good actual growth in the Commercial side. The turbocharger business is increasing penetrations on the Commercial side, pretty much worldwide but particularly China. The fan and fan drives have seen tremendous growth in China, India and so forth. Although as we look forward, the Turbocharger business is penetrating business in China and holding strong in North America and Europe. But the Fan and Fan Drive is growing and doing very well and holding strong in North America and Europe, where I think we have, in now, roughly 60% of the fan drive market in North America now at least for the last month or 2, which is a very high penetration rate for us. But the fan drive market has seen a little bit of a softness in the Chinese market basically, because the Chinese market, they've lost somewhat heat incentives, the fuel prices are going up and the same things that we are seeing on pass car. They hit that commercial side of the market a lot heavier. The other thing is we're seeing tremendous growth in penetration rates for the fan and fan drive and the turbocharger business in South America in particularly brazil and Argentina.

John Murphy - BofA Merrill Lynch

So it's fair to say that in the second half there might be a little bit faster growth in light vehicle because of the bounce there, but in aggregate, it's growing in line with your portfolio of businesses?

Timothy Manganello

May I'd say -- and I don't have the numbers in front of me, but we just gone through and I can tell you this. Both commercial and light vehicle is growing well in the second half of the year. Light vehicle may pull ahead a little bit more than usual in the second half for no other reason that the fan drives on the commercial side in China may just be a little bit of a headwind. But yet, that's going to be offset by stronger tailwinds in Brazil. So we'll have to wait and the see how it plays out. Did I help with your question or not?

John Murphy - BofA Merrill Lynch

Got you. Kind of yes, it getting me there. Second question just on the adoption curve of turbos in the U.S., I mean, do you get this sense there's a greater sense of urgency among the automakers to really downsize and turbocharge their engines since there is this increasing pressure on CAFE both in the near term, more importantly in the long-term and that we might see a faster adoption curve than we might have thought 6 months ago?

Timothy Manganello

Yes. There is a tremendous amount of interest in turbochargers and a tremendous amount of interest in the U.S. on all of our other technologies. Variable cam timing is going to turn out to be a huge growth platform for BorgWarner because we've got the latest and greatest technology that the people finally discovered how potent and how beneficial this technology is, in terms of improving fuel economy. Chain systems are growing strong. As I said, variable cam timing, turbochargers. We got a really strong portfolio, dual-clutch transmission is still strong around the world and growing rapidly in the country. The parts of the world that have manual transmissions and want to convert automatic but they want fuel efficiency out of their automatics, they're focused on that dual-clutch. We're getting the wet-clutch business real solid and we're getting a good portion of the dry-clutch business now, on the control modules. So -- but to note to, specifically, to your question, the Detroit Three have finally and really discovered fuel economy and it's a major focus for them.

John Murphy - BofA Merrill Lynch

And then just lastly, Robin, you mentioned as you got the new revolver in place, you have this option to toggle it up to $1 billion. You also mentioned that acquisitions might be a reason that you would toggle it up and you seemed a little but more enthusiastic there about making acquisitions. At least, it sounded like you were a little bit more enthusiastic, but anything changed on the landscape where you see anything that might be larger out there than what you've done more recently that would really be a good fit for BorgWarner?

Robin Adams

I don't see a thing out there that's a lot larger than what we've done historically. I'm just overall excited about the company: Operations, acquisitions, cash flow, you name it.


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

Ravi Shanker - Morgan Stanley

Just on the competitive situation on the Turbo side. Can you give us an update in terms of what you're hearing and where, I think, Carndi [ph] and Bosch are high to the store fare, most prominent in margin competitors. Where they are in terms of development and contract and such?

Timothy Manganello

Well, I think at some programs in Europe, they are mainly focused in Europe but they're strong alliance partners over there typically, are the Germans. I don't think they're really into any major, any big launch phases yet. But they're going to launch anything they're -- I mean they're creeping up on the SOP dates. There's a big difference between actually being in production and talking about being in production. We'll sort of see how things work out for them. Like I said in my speech, though, in my presentation, we, or as we see the next 5- to 6-year horizon, we see ourselves either gaining -- or maintaining or gaining market share, globally, on turbochargers. And there may be a little bit of redistribution of what part of the world our turbocharger growth comes from and -- because up to now, it's been fairly European centric. Now our turbocharger footprint is becoming more balanced all over the world between Asia and now soon-to-be North America with all the penetration rates programs that we're gaining in North America. So you're going to see strong growth in turbochargers for everybody. There's huge opportunities for all of us and there's plenty of room for all the competitors in the turbocharger side of the business.

Ravi Shanker - Morgan Stanley

All right, thanks for that. And on the --we're hearing, almost everyday, a new investigation into suppliers for price-fixing in different regions of the world. So, a, can you confirm if any of your units are being investigated globally and, b, would you just care to comment on what's causing this and how you see this ending?

Timothy Manganello

Let's just say this. None of that has anything to do with BorgWarner. And we've heard nothing, we've seen nothing, we do nothing. It has nothing to do with BorgWarner, totally and unequivocally. That's it.

Ravi Shanker - Morgan Stanley

Got it, that's pretty emphatic. Then finally, Robin, I may have missed this in the numbers you gave out, but are you updating your raw mats guidance for the year, given that it's running ahead of the first half?

Robin Adams

No, we're staying the same on raw materials.


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

Himanshu Patel - JP Morgan Chase & Co

Thanks for the anti-trust answer, very clear. I guess my bigger question on that is do you have any -- is there any historical context you can provide us on this issue? For example, have there ever been any prior investigations over the last 10 to 15 years or so that you guys know about in some of the product segments that you're in? Or even that has never happened?

Timothy Manganello

No. Nothing has been -- we've never been involved in anything like that and I would expect that our salespeople and anybody else in our company is smarter than to get involved in anything like that.

Himanshu Patel - JP Morgan Chase & Co

Okay. I had a question about operating margins. You guys said 11%. I know you have kind of an open-ended target on margins being better than a certain level. But I'm just curious how we should think about this new record margin. Is this a figure that could still have some upside potential from here? Is it -- should we think about this more as kind of a ceiling or is this kind of a new norm, if you will?

Robin Adams

It -- as I said earlier, we set a lot of records this quarter and they're not going to stand for very long, including that operating income margin level.

Himanshu Patel - JP Morgan Chase & Co

I guess, Robin, there's been a couple of suppliers, not all, that have reported so far that have had some fairly material, intra-year, increases that they've had to do on their CapEx guidance, engineering cost, et cetera. And it's been various issues whether its emerging market investments or greater launch velocity. I'm just curious is there -- are you guys seeing any of that? And I guess the heart of the questions, are there any of those pressures building in your business such that maybe we could have a situation towards the end of this year or early next year where we see some step change increases in cost pressures for you guys?

Robin Adams

On the capital side, as we said, we are increasing our capital investments. Previously, we were a little bit below $3.50, now we're looking at $3.50 and $3.75. On the same side, as we said, we're going to generally release $50 million more of cash from operating activities than we thought before. So from a cash perspective for the year, we're still looking at the same number, maybe a little bit stronger. We've had challenges from a capacity perspective. Since late last year, we continue to have those challenges. We're working like crazy, consistently, to try and continue to get more capacity in place for ourselves and also to make sure that our suppliers are there. At this point in time, that's one of our challenges in Europe, in the Drivetrain business, but we're slowly working our way out of that. And from my perspective, if you think about the industry today, we feel much better about struggling to provide additional product to our customers and putting in capacity than we were in 2008 and 2009, when we had so much excess capacity and we couldn't get a customer to take product from us. So we'll take this pressure at any day of the week and we're going to manage through it and it's not a concern for us. In fact, we're looking forward to any more pressure from increased volume.

Himanshu Patel - JP Morgan Chase & Co

I guess if you could touch a little bit on China specifically. I think you and I have spoken about this before but are you -- is that investment phase linear? Or is it maybe that you invested a lot several years ago in the business and was just being drowned in fixed growth, and now we're kind of hitting our -- you're hitting your stride maybe on the emerging markets where the incremental investment needs in that region is really just not that much and you're seeing some operating leverage out there for the first time?

Timothy Manganello

I'm not sure I would take that one. Basically, we are seeing operating leverage on some of the initial investments. But the investment going forward will continue to be, I'll use your word, probably, roughly linear because we were just -- we're continuing to gain programs and programs, and we have a compound annual growth rate, as I look forward, and it's going to be somewhere probably around 35% compound annual growth rate and it's not a lumpy growth rate. It's fairly -- it looks like a 45 degree straight line almost. So you're going to see us -- right now, for example, in Ningbo, we've pretty much maxed out on our initial large building and maxed out on our joint venture building across the street. We're putting expansions into the wholly-owned part of that Ningbo campus. We're building a new building for, basically, for Morse chain. We have turbo growth there, Morse chain growth and emissions growth. And we're basically putting in new buildings on the second half of that site as we speak. But it's actually just built into our run rate. The engineering expense is built into that 4% annual expense that we spend in R&D, the CapEx as we typically run 6% plus or minus annually on CapEx, and it's all kind of built into our business model. And so far, those kind of investments, which are somewhat linear investments, can continue to drive our current compound annual growth rate that is significantly greater than the industry.

Himanshu Patel - JP Morgan Chase & Co

Okay. And then last question on contribution or incremental margins. You've -- it sounds like the date when incremental is kind of converged to your operating margin keeps getting pushed back of it. Are you kind of thinking about that now as being more kind of middle of '12 is when we should think about that or could that start happening even at the end of this year?

Robin Adams

As we said before, one of the biggest drivers for that is the top line sales growth numbers. And if we continue to increase our sales growth projections for the year, we're going to continue to push out the leveling off of operating income margins. So we'll see what 2012 looks like, but given where we're running right now and running into the back half of the year, I have a feeling that our growth rate next year is going to be higher than we would have thought maybe a year ago, which means the leveling off of margins will take a little bit longer.


We have time for one final question and that question comes from Chris Ceraso with Crédit Suisse.

Christopher Ceraso - Crédit Suisse AG

A couple of questions for you. First, this kind of gets back to the incremental margin question. I know you keep talking about things ex-Haldex, Robin, but that amortization is going to stay with you. But my question is when we lap the acquisition, will we start to see more normal incrementals in the Driveline business maybe in the high-teens or even 20?

Robin Adams

Oh, yes. There is no doubt about it. I mean, we said before, on an incremental margin basis, there should be no difference between the Engine and Drivetrain in those product areas. We've been pretty clear that in the first -- that this business is struggling in Europe and it has struggled. And you see the margin declined from the first half of last year at the 9% level down to, it's called, 7.7% average for the last half of the year, it's starting to come back for us. But they're still -- they're not where they need to be. We expect that business to generate 20% incremental margins just like the Engine side of the business. There is no expectation of any lower performance in that business. They just -- they need to work a little bit harder to get where they're supposed to be.

Christopher Ceraso - Crédit Suisse AG

Okay. And then, bigger picture question maybe for Tim. Can you give us your view on the proposed 54-mile per gallon new standard for 2025? A few things on this. Do you think it's realistic, first of all? Can the car companies get there largely with internal combustion engines? And what do you think the mix of electric and hybrid vehicles might have to be in that world at 54 miles per gallon? And what's Borg's role in that world?

Timothy Manganello

Well, as far as the 54, I think it’s going to be very challenging. Is there a technology that will work to get the car companies towards that goal? Yes, and we have a significant number of those. If you look at a list of like 10 Drivetrain technologies or Powertrain Technologies that can improve fuel economy, we're on probably 7 out of the 10, which is based off an EPA list. And we're one of the market leaders in probably 7 out of the 10 key technologies. All I can tell you is, it's going to be very challenging. But every day -- we just finished the R&D reviews on new technologies in our advanced engineering area for both Drivetrain and Engine. And each product we're looking at, it's got a 1%, 2%, 5%, 7% improvement in fuel economy. And yes, they're going to be -- there is no doubt about it. To get that higher fuel economy there, people have to pay higher prices. Now, that being said, the higher prices that they pay will probably still be cheaper than and more beneficial than the higher prices you pay for an electric vehicle. Regarding your electric vehicle, I don't see that as being -- unless there is some major change in battery technology, major change in distribution of charging stations and a major change in the pricing of electric vehicles, combined with the range anxiety issues that go with the range -- with the electric vehicles, I don't see a major penetration rate of electric vehicles other than for certain applications like commercial trucks that run a certain route every day and go back to their home base and get charged up at the end of the day. Maybe taxi fleets in New York and some of the other places. But there's a lot of technical challenges on electric vehicles. And it's in terms of -- everything you do for air conditioning in summertime or heating in the wintertime or up a hill or down a hill, these all influence what your range is on electric vehicle. But just to be, kind of to wrap it up is, I think that 54 -- if the car companies and the federal government agree on it, which it sounds like they're working towards an agreement, then it's going to be doable. The question is how much are people willing to pay for the technology? I think companies like BorgWarner have the technology to get them there or get them very close over time. And we will continue to invent technologies that will get them, maybe, all the way there by 2025.

Christopher Ceraso - Crédit Suisse AG

So it sounds like you're still saying that the industry can get there without a big increase in hybrid penetration, is that fair?

Timothy Manganello

No. I said electric vehicles. Hybrids are different story. Hybrids are basically traditional passenger cars that have a supplemental electric powertrain that go with it, okay? So basically, and a lot of hybrids are going to be considered stop-start technology, which is basically a traditional automotive with an IC engine or traditional automatic transmission or dual-clutch transmission, and it will have a stop-start. That's going to be the major proportion of the major volume of what people will, in the future, call hybrids. Yes, there will be more for full hybrids which will have electronic assist for the first 40 miles or something like that on a battery and -- or maybe 25 miles on a battery and then you can go the rest of the time on a gas -- traditional gas engine. But hybrids is a very broad term for a lot of different types of technology. So most of the hybrids will have traditional engine and the traditional transmissions to improve fuel economy.

Christopher Ceraso - Crédit Suisse AG

Right. And in that world, is it the traditional engine in that setup, they're going to want to be as fuel efficient as possible, so you're still in the game?

Timothy Manganello

No, we're in the game, we're helping to create the game. We're going to be driving turbochargers on 2-cylinder and 3-cylinder engines and we're going to be driving low-cost, fuel-efficient dual-clutch transmissions and those kinds of things.

Ken Lamb

I'd like to thank you all again for joining us. As Robin said, we expect to file our 10-Q before the end of the day. We'll provide details of our results. If you have any follow-up questions about our earnings release and matters discussed in the call or the Q, please direct them to me. Rebecca, please close out the call.


That does conclude the BorgWarner's 2011 Second Quarter Results Earnings Conference Call. Thank you for joining. You may now disconnect.

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