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Executives

Ken Lamb – Director of Investor Relations

Timothy M. Manganello - Chairman and Chief Executive Officer

Robin J. Adams – Executive Vice President, Chief Financial Officer and Chief Administrative Officer

Analysts

John Lovallo - Bank of America/Merrill Lynch

H Peter Nesvold – Jefferies & Co.

Chris Ceraso – Credit Suisse

Rich Kwas – Wells Fargo Securities, Llc

Timothy Denoyer – Wolfe Trahan & Co.

Brian Johnson – Barclays Capital

Ravi Shanker – Morgan Stanley

Patrick Nolan – Deutsche Bank Securities

BorgWarner Inc. (BWA) Q3 2011 Earnings Call October 28, 2011 10:00 AM ET

Operator

Good morning. My name is Angela, and I will be your conference facilitator. At this time, I would like to welcome everyone to the BorgWarner 2011 Third Quarter Results Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. (Operator Instructions)

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

Ken Lamb

Thanks, Angela. Good morning, and thank you all for joining us. We issued our earnings release this morning at approximately 8:00 a.m. Eastern Time. It's posted on our website borgwarner.com on our homepage. A replay of today’s conference call will be available through November 4. The dial-in number for that replay is 800-642-1687. You'll need the conference ID, which is 11581019. The replay will also be available on our website.

With regard to our Investor Relations calendar, we’ll be attending several conferences over the next few months. November 1, we will be at the Gabelli Automotive Symposium in Las Vegas; November 8, we will be at the Baird Industrial Conference in Chicago; November 14, we will be at the Barclays Global Automotive Conference in New York; November 17, we will be at the Morgan Stanley Auto Meeting in Los Angeles; December 8, we will be at the Goldman Sachs Global Auto Conference in London; and we will be at the Deutsche Bank Global Auto Industry Conference in Detroit in early January. Also we will be releasing our 2012 to 2014 backlog of net new business on November 8 and providing color on the backlog at the Baird Conference.

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 third 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 M. Manganello

Thank you, Ken, and thank you everyone for joining our call. Today, I’m very pleased to review our third quarter results, our accomplishments and our revised guidance.

But first, I’d like to comment on current production volume concerns within the investment community. In recent weeks, uncertainty about the world economy particularly in Europe has created nervousness and has caused speculation about vehicle production in certain parts of the world.

In July, before this issue surfaced, we raised our 2011 sales and earnings guidance, and today we refined our guidance to the high end of that range at $4.35 to $4.45 per share. All the markets have been assessing vehicle production risks; the outlook for BorgWarner and our business remain strong.

BorgWarner’s performance is linked to the industry’s focus on fuel economy and improved emissions. There may be uncertainty about European vehicle production, but there is no doubt that fuel economy and improved emissions are a focal point for the industry now and for many years to come.

Therefore, we remain bullish about BorgWarner’s near term and our long-term future. However, because there is uncertainty about Europe, I would like to address our BorgWarner will get through another downturn should the need arise.

In the aftermath of the last downturn, BorgWarner emerged stronger than ever, and today we are a leader company and sales and earnings performance continues to set records. Also, we employ more temporary workers now than we did previously. And that means our total cost structure is easier to flux if necessary. We also have agreements, pre-range agreements with our various works counsels in Europe.

In our view, there are no clear signs of a downturn; however, we are prepared to execute cost control plans quickly if needed, and we feel very good about our ability to perform well under any market conditions.

So now, let’s talk about our record third quarter. Sales were $1.8 billion, up 27% from the same period last year. Our operating margin and income margin was 11.1%, another record. U.S. GAAP earnings were $1.15 per share, and three key factors that drove our results were increased global demand for our products, higher volumes in base business, and well executed cost control.

In the Engine Group, third quarter sales were above $1.3 billion, up 23% from a year ago. The Engine Group continues to perform very well, and we saw a growth in all of our engine products around the world. In the Drivetrain Group, sales were above $539 million, up 36% from the third quarter, 2010.

Drivetrain results were driven by increased VCT module sales in Europe, increased four-wheel drive and traditional automated transmission component sales in Korea, and the Traction acquisition. Also the Drivetrain Group’s operating margins continue to improve just like we said earlier in the year.

In the quarter, margins were 8.1%, up from last year and the previous quarter. The Drivetrain Group continues to show improvements in capacity and productivity issues throughout Europe. We also continue to invest for the long-term.

Capital spending continues to grow, and year-to-date, we’ve spent about 5% of sales. We are committed to supporting our future growth and our productivity improvements through continued spending. Our spending for R&D and other new program launches was above 3.3% of sales in the quarter, and this is slightly below our current level of 4%, but an increase from 3.2% a year ago.

Switching gears, we also made some new business announcements in the quarter, which I’d like to highlight. We supplied transmission components for Hyundai’s new 8-speed transmission and it will drive the Hyundai Equus, the Genesis and Kia models. We are also supplying Hyundai with a new silent chain for its GDI engine balance shaft drives. This technology offers OEMs a lower cost alternative, with better durability, and less noise.

And I’m proud to say, once again, three BorgWarner technologies have been named finalists in the prestigious Automotive News PACE competition. We are proud of our winning record and pleased to have our technologies in the final competition.

So now lets take a look at our updated production outlook for light vehicles. North America remains unchanged at 13 million units, up 9% from 2010. Our view on Europe also remains unchanged in spite of the hassles over in Europe, at 19.9 million units, up 5% from 2010. In Europe the vehicle mix of large cars and diesels, which we talked about in previous calls, will probably stabilize at the current levels.

And we now believe China will be a little weaker than expected at 15.5 million, up 6% from last year. Higher interest rates and gas prices along with reduced incentive programs continue to temper vehicle sales and production in China.

Moving over to Japan, our view on Japan has improved. Japan exceeded our expectations in the third quarter and we expect this momentum to continue into the fourth quarter, although, we do not know what the Taiwan effect will have us here. Globally, our forecast is essentially flat with our previous forecasts, and higher volumes in Japan should offset lower volumes in China. In the commercial truck market, our strong outlook for Europe and North America is essentially unchanged from July.

In China, our outlook for the commercial truck market remains so hot, just like we talked about in the last quarter, two of the same factors affecting the light vehicle market. But despite this, our commercial truck business in China is growing for turbochargers through our increased penetration range on turbochargers.

And finally, as mentioned earlier, we have refined our sales in earnings guidance. Our earnings guidance is now $4.35 to $4.45 per share, once again at the high end of the previous range.

Our operating margins are still expected to be better than 10.5%, and we’re very proud of our 11.1% this quarter. And sales growth in 2011, is now expected to be 26% to 27%, which is within the previous guidance range.

The refined guidance is primarily due to a stable outlook for our business, good cost controls at our operations, which we’ve been focusing for on the last number of years, combined with high demand for our leading technologies, which we talk about every quarter.

So in conclusion, the industry's adoption of leading edge powertrain technology, particularly from BorgWarner will continue for years and short-term fluctuations will not affect us. Because of this, BorgWarner will continue to thrive.

No company in the auto sector is better positioned for short-term and long-term profitable growth than BorgWarner. And what I’d like to say is this; we will be in the automotive sweet spot for years to come.

Thank you. And now I’d like turn over to Robin for the financials.

Robin J. Adams

Thanks, Tim, and good day to everyone. Before I begin my review of the financials, I would like to again review the macro auto industry environment for the third quarter to help put our record sales performance in perspective. If you look at third quarter global production, it was about 18.2 million units, which is up about 5% from the third quarter last year.

Our reported sales were up 27%, now that did have some foreign currency benefit, dollar versus the euro, I think the dollar to euro was about $1.32 last year, year-to-date and we are looking about $1.41 this year, so there is a benefit there. As well as the Haldex Traction Systems, a business, which we acquired in the first quarter this year. So excluding those, and to put the year on a comparable year-over-year basis, our sales were up 16% and that’s 11 percentage points better than the 5% increase in global production year-over-year in the quarter. And just another quarter in a row, where our sales growth significantly outperformed the market.

Looking at the income statement, if you work down from the sales line, gross profit as a percent of sales was 19.6% in the quarter, slightly higher than 19.4% a year ago, flat with second quarter 2011. The year-over-year improvement in the quarter was realized despite approximately $11 million of negative impact from higher raw material prices.

SG&A expenses were $151 million or 8.5% of sales in the quarter versus a $150 million or 10.7% of sales in the second quarter last year. Now, let’s spend a little bit of time on the SG&A, because there was an unfavorable event from a shareholder perspective, but a positive event from an SG&A expense perspective, that’s flipping between quarter-on-quarter.

So if you look at SG&A in the quarter, we were actually helped by almost $10 million as a result of the 25% decline in our stock price in the quarter, and then 25% decline in the stock price, we went from $80 a share at the end of June to $60 a share at the end of September, and obviously we recovered quite a bit of it already, but during the quarter the 25% decline in the stock price had a positive impact on employee related incentive compensation. Basically, the value of our compensation is tied to BorgWarner’s stock decline dramatically in the third quarter, which from a comps perspective was a benefit. And that benefit again showed up on the SG&A line item, and that’s why we are $151 million. If the stock had stayed flat in the quarter, $80 at the beginning of the quarter, $80 end of the quarter, our SG&A expenses would have been $10 million higher or about $161 million, and as a percent of sales would be 9% of sales.

So as I look at the quarter, I kind of factor out the benefit we’re getting from a stock price, there will also be a penalty for us in the fourth quarter, I’ll talk a little bit more about that. But if you adjust for the equity incentive compensation benefit we got in the quarter, SG&A would have been $11 million more than last year, of which all of it was tied to recent R&D; in fact R&D spending year-over-year in the quarter was up $13 million.

So although SG&A reported looks relatively flat, the stock price issue was a benefit of $10 million, it’s a short benefit, it’s going to flip in the fourth quarter, and we’ll make the same comment when we get down to operating income. Again as I said, we recovered most of that third quarter stock price decline already in the month of October. Stocks currently at about $75 a share, $75.73, my screen says.

So we’re getting back up to the $80 price, and again there will be a penalty in the fourth quarter. And I hope everyone is pretty clear on that. So I want to take this into the fourth quarter. So if you assumed fourth quarter SG&A for instance was $159 million for us, right now, you better add $10 million to that and look at it as a $170 million, because the stock price has come back and we will get that $10 million back as expense in the fourth quarter.

Operating income in the quarter was $199 million, 11.1% of sales, a record for us compared with $123 million or 8.7% of sales a year ago. Again, to look at this on a comparable basis, you really need to adjust for that equity related compensation expense, and if you do that, operating income would have been $189 million or 10.6% of sales, still tremendous performance relative to last year, 10.6% versus 8.7%.

On an incremental basis, if you exclude the impact of foreign currency, and again the Haldex Traction Systems acquisition, our year-over-year incremental margin in the quarter was 27%. If you adjust for the $10 million equity related compensation expense it’s 23%, 27%, 23%, whatever, it’s great performance.

When we started the year, we talked about, our expectation was 20% incremental margins year-over-year, and we’re above that level, frankly through the first nine-months of the year, we were up 21% incremental margins in the first quarter, and in the second quarter, and now on the third quarter, where we take your pick, 27%, 23%, I’m going to pick the 23%, because I don’t want you to penalize me in fourth quarter for that $10 million that comes back.

So no matter how you look at the third quarter, as reported, our quarterly record operating income margin is 11.1% or if you look at a 10.6% stock price performance adjusted, which is how I’m looking at it. That incremental margin year-over-year, it was 27% or 23% take your pick whatever you look at, it was another quarter of great performance for this company in what continues to be a challenging quarter, the third quarter of the year.

If you look further down income statement, equity in affiliates' earnings was $11.5 million, up about $1 million from $10.5 million last year. And again, as we’ve said, the equity in affiliates' earnings primarily reflects performance of our Drivetrain Systems, 50-50 joint venture in Japan, NSK-Warner. NSK-Warner services are Japanese customers for transmission products in Japan and in China, and obviously, as we said it, earlier in the year, we expect that performance to continue throughout the year as the pace of recovery of our Japanese customers continues to improve.

Interest expense and finance charges, looking down another line in the income statement were $18.5 million in the quarter, relatively flat with the same period a year ago. Income taxes in the quarter, $48 million, which is an effective tax rate of 24%, which is where we were in the second quarter and the first quarter as well, and in line with our full year guidance.

If you look at the third quarter last year, it did have a favorable tax adjustment of approximately $21 million, so they’re really not comparable numbers. Again, we point that amount in our press release as we walk to what we believe is a comparable earnings per share number versus U.S. GAAP, although, both are important numbers.

So if you look at net earnings, total non-controlling interest, formally known as minority interest was about $5.1 million in the quarter, up slightly from $4.8 million a year ago. And again, this reflects our minority partner share in the earnings performance of our Korean and Chinese consolidated joint ventures, and the year-over-year increase reflects the growth in both of those businesses.

And that brings us down the net earning again, which were $142 million in the quarter, a record quarter for us, third quarter, compared with $107 million a year ago. And on a diluted earnings per share basis, we’ve earned $1.15 a share in all time record. And as I said, we did get a $10 million benefit from that equity related incentive compensation to the decline in our stock price that was worth about $0.06 a share. So if you want to look at the quarter relative to what you were expecting, what we were expecting, it’s more like a $1.09 a share. And again, that $0.06 share will penalize us in the fourth quarter.

So on a GAAP basis, $1.15 compared with $0.87 on a GAAP basis in the third quarter last year, again as I said, in the third quarter last year, we did have that non-recurring tax item, which we’ve identified in the table in our press release. And we always want to provide you that table to help you reconcile U.S. GAAP earning measures, which are very important with the financial performance of the continuing operations of our company, and make sure you can compare the results with results of prior periods. And again, we encourage you to review this information in the press release.

On a comparable basis, third quarter 2011 earnings were up 62% from the $0.71 a share a year ago. And as I said that, 25% decline in our stock price in the quarter going from $80 to $60 a share, painful as it was for all of us, it actually provided a $0.06 a share benefit in the quarter. And if you exclude that, that would put earnings up year-over-year at 54%. And as we said earlier that, the dollar that was a little weaker in the quarter, this year versus last year, about $1.41 versus $1.32, that gave us $0.07 a share from currency perspective. So if you take out the benefit from the decline in the stock price, if you take out currency, we are still up 44% earnings per share versus last year, and again very strong performance, no matter how you want to look at it.

Let’s take a look at our operating segments. The Engine segment sales were $1.258 billion in the quarter, up 23% versus the third quarter last year. Again on a comparable basis, we’re excluding the benefit of currency, engine segment sales were up about 16% compared with third quarter last year.

As Tim said, we’re seeing strong global growth across the engine segment portfolio, most notably turbochargers, but also variable cam timing products, engine timing systems and fan drives. Adjusted EBIT for the engine group was $188 million in the quarter or 15% of sales, significantly higher than the 13.4% adjusted EBIT margin reported a year ago.

And if you look at year-over-year incremental margins for the engine group, excluding currency, they were up 26%. Very continued, very strong performance for the engine group, very key – it’s in the cover off the ball there, like the car nosed it last night by the way.

In the Drivetrain segment, sales were $539 million in the quarter or up 36% versus last year. On a comparable basis, again excluding currency and also excluding the Haldex Traction Systems acquisition, if you just look year-over-year comparable, segment sales in the Drivetrain business were up 17% versus last year. Good strong performance driven by strong four-wheel drive system and traditional transmission component sales in Korea, higher dual-clutch transmissions module sales in Europe as well, part of the key growth drivers for this business.

Now, we spent a lot of time talking about EBIT margins in this business. On a reported basis, adjusted EBIT was $44 million or 8.1% of sales, which again is a continued improvement in margins for the Drivetrain Group, we’ve talked before, sequentially they continue to hit margins, and again I’ll remind you, they were 6.6% in the first quarter, 7.4% in the second, now 8.1% in the third. So as we’ve talked before, we expect to see progression here and we’ve seen it, so a great performance by them, $44 million or 8.1% of sales.

As we’ve mentioned before, the purchase accounting expense amortization related to the Haldex Traction Systems’ acquisition is also negatively impacting Drivetrain margins, we’re amortizing north of $3 million a quarter, of excess purchase price expense there, which and again it’s an important part of the accounting system, but from my perspective it moneys the waters, if you take that out of the equation.

So if you look at Drivetrain segment margins excluding the Haldex transaction systems purchase price amortization, our Drivetrain segment margins actually were 8.7% in the quarter, and that is a comparable number to the 7.8% last year. So we’re up one full percentage points in the Drivetrain business on a truly comparable basis year-over-year.

So again, a significant improvement in the performance of that business, that’s just shy of 9%, which is we expect them to get to 9% shortly, 9% plus. So they’re heading in the right direction, if you remember after the first quarter call, Tim said that he expected margins to improve gradually, and by the third quarter to kind of get back to where they expect to be, and they are just about there.

So my compliments to our guys in the Drivetrain business, good work. So again, we’re just shy at 9% level, we saw at the beginning of 2010 and that business continues to progress towards expected performance levels for us.

Let’s take a quick look at the balance sheet and the cash flow statement. We generated $473 million from operating activities, cash flow wise in the first nine months of 2011. It’s up $160 million from the same period last year. And if you look at the third quarter, we had a very strong third quarter from a cash flow perspective; we generated $224 million of cash in the quarter from operating activities versus $104 million in third quarter last year. And right now, we’re on track to generate about $700 million for the full year, and this is a little bit higher than the $650 million guidance we’ve previously given you. So we’re seeing a strong year from the cash flow perspective.

Capital spending as Tim said was, $274 million in the quarter for the first nine months of the year, up $188 million versus the first nine months of last year. And again, the spending is indicative of the growth required to meet the increased level of program launches that we have around the world, especially in markets like Asia, Eastern Europe, and Mexico. We are still targeting about $350 million to $375 million of capital spending for the full year, but frankly, as this business continues to see growth, we might pull forward a little bit, and it could be a little bit north of $375 million.

If you look at balance sheet items itself, balance sheet debt increased by $212 million from year end, while cash decreased about $73 million. So combining, that’s about $285 million increase in net debt. And I know it’s due primarily to the acquisition of Haldex Traction Systems business, again which was north of $200 million. And the buyout of our Emissions joint venture partner in India, which we competed in the third quarter, and if you look at our statement of cash flow, that shows up on the line item as purchase of non-controlling interests billed at north of $30 million. If you look at the business, we generate more than enough cash internally to fund the internal growth of our capital spending and also in the form of stock repurchase program that we carried out throughout the year.

As you look at the result and capital structure, our net debt to capital ratio was about 29% at the end of third quarter, compared to 24% at the end of 2010. Net debt to EBITDA on a trailing 12 month basis was just below one times at the end of the third quarter.

However, as we’ve said many times before, we view our balance sheet in our capital structure on a net converted basis, in other words, if that convertible debt matures and gets converted. And we encourage all to do the same thing. That security will mature in April of next year, so we’re within six months of the maturity and really that’s a fair way to look at the balance sheet.

And if you look at it from that perspective, net debt to capital was about 90% at the end of quarter, and net debt to trailing 12 months EBITDA was approximately 0.6 times. So don’t give any better than that. Tim talked a little bit about 2011 guidance, and I'm going to kind of reconfirm. As Tim mentioned earlier, we’ve refined our sales growth and earnings guidance stream, we now expect sales to grow 26% to 27%. We’ve just tightened around the midpoint of the previous guidance range of 25% to 28%.

And earnings now are expected to be at the high end of the range. We’ve taken $0.10 a share off the bottom, the $4.25 to $4.35 is gone, and we are now looking at the $4.35 to $4.45 a diluted share. And as Tim mentioned, good cost controls at our operations, good performance at NSK-Warner, our joint venture enable us to push that earnings guidance to the high end of the range.

And again, I want to remind you, don’t forget fourth quarter will be negatively impacted on the SG&A line item and the operating income line, by about $10 million as our stock price climbs back to $80 a share level. It will also impact our earnings per share at about $0.06.

And clearly, we are well positioned to achieve the better than 10.5% operating income margin, a guidance that we gave you at the beginning of the year, having posted a 10.8% operating income margin, excluding the gain from Honeywell settlement earlier in the year. Excluding that, we were at about 10.8% operating income margin after three quarters.

And this is again despite the impact of the Haldex Traction Systems acquisition, which was not in our original guidance and was a drag on margins as a result of the purchase accounting adjustments. If you exclude Haldex and look at BorgWarner year-over-year on a comparable basis, our margins year-to-date were 11.2% and compare very favorably to our original guidance for the year, and make us feel pretty comfortable. Again this is not peak margin level for BorgWarner. We are going to see some upside from here.

We believe the impact of high raw material costs will still be in the $35 million to $40 million for the year. And as we’ve said on our last earnings call, we have said it many time, it’s our job – it’s our leadership for this company to absorb and manage the inflationary costs including raw material and really not permit them to have any negative impact on our earnings expectations for the year, and they don’t and they won’t.

So let me summarize again which was another great quarter for BorgWarner, and a string of great quarters. We achieved record third quarter earnings by converting industry leading sales growth to income, the Drivetrain segment continue to improve, and is almost back to kind of pre-struggle levels. The Engine segment margins remain at near record levels consistently here. And as I said, if you look at this quarter from any perspective, you take out the $10 million benefit we get from the stock price decline. This was another great quarter for BorgWarner.

And as we look beyond 2011, we still see opportunities for long-term growth. As Tim mentioned, increasingly stringent regulatory environment, rising fuel costs and the evolution of powertrain technology in the developing markets of the world to meet those challenges. Just to name a few: Tim mentioned that a number of our new innovations were reorganized PACE organization is having significant market impact that act as “game changers” in the industry. And these [anklets] further support the assertion that BorgWarner continues to lead this industry in developing power train technology focused on improving fuel economy lowering emissions and improving vehicle performance. And we will see that changing any time soon, long after I retire believe me.

Our focus on technology leadership of strong global presence, financial discipline in attracting and maintaining our talented our workforce has been the key to this company’s success, and we will continue to drive our success in the future. All I can say is, just another great quarter, and I can’t be more pleased with the performance of our operating guys.

And with that I’ll turn the call back over to Ken.

Ken Lamb

We will now turn to the Q&A portion of the call. I would like to ask the call coordinator to please announce the Q&A procedure.

Operator

(Operator Instructions) Your first question comes from John Murphy with Bank of America Merrill Lynch.

John Lovallo - Bank of America/Merrill Lynch

Hi, guys this is actually John Lovallo on for John Murphy. How are you?

Timothy M. Manganello

Hi, John.

Robin J. Adams

Hi, John.

John Lovallo - Bank of America/Merrill Lynch

First question is, can you just speak a bit about the DCT penetration rate globally today and kind of where you think that, that can go?

Timothy M. Manganello

DCT penetration rate will continue to grow, I don’t have the exact numbers in front, but we have all sorts of charts, I just don’t them in front of me, usually I have two. You’re going to see DCT penetration rates probably grow at 20%, 25% of the total market globally. And all you can see is a continued swing towards probably wet-clutch DCT because dry-clutch DCT, people have dry-clutch DCTs right now are starting to see difficulty in the operational performance of the product line in the marketplace. Well, I don’t mention any customers.

Robin J. Adams

I’ve got that data, John. If you look at the two major markets in the world where DCT really is going to take hold, European markets five years from now, 50% of the automatic transmission will be dual-clutch, five years from now approximately, 40% of the automatic transmission from China will be dual-clutch.

Timothy M. Manganello

And those are big markets, but globally it will be less because of United States penetration rates.

John Lovallo - Bank of America/Merrill Lynch

Great, that’s helpful. Next question, you guys are certainly growing nicely in China, how big of the part of your business do you think China can be, and more importantly, I mean is there sufficient skilled labor there to kind of meet your needs?

Timothy M. Manganello

Skilled labor is a challenge, but we always find the right people, and when we’ve got the right people, and we continue to grow our business. We are growing significant; it will be a significant percentage of our business. Because we are growing so strongly now in Eastern Europe and in Korea, and we are back to growing in the United States.

China will as a percentage, will grow or outpace, on a percentage wise will outpace the company, the rest of the regions, but because the rest of the regions are growing, also the percentage is difference of percentages of growth won’t be that significant. Let me just say this though, our sales from in the last three years have probably tripled in China. And as I look forward in the next five years, our sales will probably more than double in China over the next five years.

And that doubling was often due to a much higher base than the base that we had three years ago when we tripled between three years ago and now. So we don’t breakout – we don’t break it out, that’s by country, that’s specifically, but China will be, let’s just say this. The sales in China will probably be equal to or stronger than our domestic sales to the territory in North America.

John Lovallo - Bank of America/Merrill Lynch

Okay, great. And then the final question, from a capacity standpoint how are you guys doing in China and maybe in the South America as well?

Timothy M. Manganello

Well, reporting in capacity in China as we speak for dual-clutch transmission are often alluded to that now, we are putting in capacity for most chain on a chain products, we are putting in capacity on turbochargers, also in Ningbo. We are putting in capacity, because like I said we are doubling sales in the next four to five years, and that’s on a conservative, what I think is a fairly conservative long-range plan for China.

I think that China is just a phenomenal growth opportunity for BorgWarner for sure because of the focus on fuel economy and emissions, well, it’s an equally good growth opportunity for the rest of the industry, probably just not as good as it for BorgWarner.

Mexico. Brazil, we are growing in Brazil very strongly right now on the commercial side. We’re moving as the Germans are staring to localize as the Koreans on Jim, Brazil just changed the localization loss, and that’s going to force the people who are shipping product into Brazil, there will be – the product that was made in other countries, and they were shipping into Brazil.

They will have to localize in Brazil now, and that we are ready for them, we are just putting in a new campus, say I was just down there a couple of months ago, we’re under construction for a new building, new buildings, new tech center, and what we see in Brazil is what we were doing in China five years ago, we are on the launch pad for more growth in Brazil.

And Mexico, Mexico is growing because we are making all the turbochargers for the Ford Ecoboost down in Mexico right now, and we have tremendous volumes for Ford on the Ecoboost, not just on the six cylinder rear-wheel drive pickup trucks like that are growing, that are very half right now for turbochargers, but we’ve picked up global we have picked up our four-cylinder turbocharger business for Ecoboost, so we have at Ford. So we have a tremendous opportunity for growth in Mexico, those products will be made in Mexico where we shipped to the plants in Mexico and North America.

John Lovallo - Bank of America/Merrill Lynch

Okay, great. Thank you very much, guys.

Timothy M. Manganello

Sure.

Operator

Your next question from Peter Nesvold with Jefferies & Co.

H Peter Nesvold – Jefferies & Co.

Hi, good morning. Just a real quick question on the incentive comp for 3Q, thank you for the detailed explanation on the trends in 3Q to 4Q, just so I can to kind of get a clean EBIT margin number for third quarter, is there a way of breaking down the impact of 3Q between the two different divisions.

Timothy M. Manganello

No. That all sits at corporate. If you look on our second disclosure on the second page of the press release we show Engine, we show Drivetrain and then corporate and all other kind of stuff. It’s in there, it’s very clear if you look at, I think we’re $20 million, $21 million in the third quarter of this year, like 34 last year.

H Peter Nesvold – Jefferies & Co.

Okay, right.

Timothy M. Manganello

That’s where you see the difference.

H Peter Nesvold – Jefferies & Co.

Okay, excellent. All right that’s it.

Timothy M. Manganello

Just to let you know, we all suffered the same pain in the third quarter unfortunately.

H Peter Nesvold – Jefferies & Co.

A lot of us did. All right thank you for the time.

Operator

Your next question comes from Chris Ceraso with Credit Suisse.

Chris Ceraso – Credit Suisse

All right. Thanks, good morning.

Timothy M. Manganello

Hi, Chris.

Robin J. Adams

Hi, Chris.

Chris Ceraso – Credit Suisse

I’m thinking one of these dry dual-clutch programs at one of your biggest customers that doesn’t seem to doing that well in the marketplace, is there an opportunity for you to go in there and win some business with your wet dual-clutch.

Timothy M. Manganello

Well, I think there is always an opportunity for customers to upgrade their technology and we give them that option. We don’t make the whole transmission, we just make the wet clutch module and dry clutch module. I think if the people that are in the dry clutch business, I’m not going to mention any specific names, but people in the dry clutch business or the people that are working on dry clutch, that are working on dry clutch programs, are probably reassessing the path they’re going to take in the future on wet versus dry-clutch and we’re seeing a lot more activity on dry-clutch technology and dry-clutch development. I’m sorry, a lot more activity on what clutch activity and what clutch development programs.

Chris Ceraso – Credit Suisse

Okay. You said, you didn’t really have a feel yet for what sort of an impact the Thailand issue you might have. But maybe you can help us with a little bit of background, do you know roughly what percent of your sales is represented by manufacturing vehicles that you supply there. And what components are you sourcing from that region?

Timothy M. Manganello

Almost nothing. We do almost nothing there, we have a little operation of what they do right now. The issue is, our customers mainly the Japanese customers do a lot of work and source parts from Thailand. So we don’t know, we saw it yesterday in the paper that Toyota is kind of looking at some of their overtime schedules, and they maybe be tweaking overtime temporarily. So for us there is no production effect to speak of, because those percentages are so small, rounding here inside BorgWarner. But it’s what it does to our Japanese customers mainly.

Chris Ceraso – Credit Suisse

Okay. And then just last one, Robin, you gave some expectations about cash flow for the year. If I look at that relative to what you’re talking about in terms of earnings, it looks like their cash flow is about, I don’t know, 50% to 60% roughly of your net income. I understand there is an awful lot of growth here, is that the kind of level that we should expect for the foreseeable future in terms of your cash conversion on your net income?

Robin J. Adams

It's probably a fair number, this year the real driver there is income tax, we are paying for the first nine months, we are paying about $70 million more in cash taxes this year than last year. So one thing, it’s little bit hard to gauge, but I would expect that the level we are running at now is a pretty fair level.

Chris Ceraso – Credit Suisse

Okay. Thank you.

Operator

Your next question comes from Rich Kwas with Wells Fargo Securities.

Rich Kwas – Wells Fargo Securities, Llc

Hi, good morning.

Timothy M. Manganello

Hi, Rich.

Robin J. Adams

Hi, Rich.

Rich Kwas – Wells Fargo Securities, Llc

Robin, your comment around drivetrain on the 9% number, is that going to be an all-in number or is that excluding Haldex in terms of getting to that 9% level?

Robin J. Adams

Well, I think excluding Haldex, that’s not a problem, all-in may be little bit more work to do, but they are driving towards their level.

Rich Kwas – Wells Fargo Securities, Llc

Right. I mean based on kind of the issues you had earlier in the year, late last year and those getting better, is that something that early 2012, we should expect to see that level?

Robin J. Adams

As a Tim said before, we expected a sequential improvement in second quarter and third quarter, and we’re expecting improvement in the fourth quarter as well. So that core year-over-year comparison that business should be north of 9% in the fourth quarter.

Rich Kwas – Wells Fargo Securities, Llc

Okay.

Robin J. Adams

And they are working hard at it.

Rich Kwas – Wells Fargo Securities, Llc

All right. Okay. And then just I know you’re going to give guidance for next year at the Auto Show, but if you think about how Europe, there is a lot of uncertainty there and there could be volatility in schedules, and it could be a decline in overall production next year, you’ve talked about incremental margins being above norm for some period of time, how did that affect the potential for above average incremental margins with increased volatility in Europe, did that dampen that outlook at all, just how should we think about that?

Robin J. Adams

Well, we’ve said this before, as sales decline the incremental margins are higher, or the decremental margins versus sales increasing. And just a function of that, when sales are increasing it’s typically in regions of the world where you are putting growth in place. And Europe as we’ve said before, we don’t have the type of flexibility if we have in other parts of the world, having said that though Tim went through earlier and talked about our plans in case volumes trended down in Europe, we do have a number of temporary workers at least to get us through the first phase, but yeah, volatility is an issue for us, as anyone in the industry we’d loved to see our facilities run 1,000 units a day for 242 days a year instead of 600 and 1,200 and 300, and 1,500. It’s a challenge from an operating perspective.

Timothy M. Manganello

This is Tim. We will do everything we can to protect our margins if there is some kind of significant downturn in Europe let’s say hypothetically. We, as I said, we’ve got pre-agreements with Works Council, we’ve got everything set to go, so if we ever had to flip the switch, we’ve taken all the lag time out of the reaction time. So, we pretty much are going to do everything we can to protect our margins in Europe, and I think our margins will continue to do well and hold strong and North America, Japan, China, Brazil and all the rest of the world. So, in my mind Europe is probably just the only question mark on what happens and how strong we can hold the margins.

Robin J. Adams

Again Tim laid out earlier that all the work that’s been done and getting prepared that we’ve looked at and the actions that our plant would result in managing to about $0.20 on the dollar decremental margins, so, which is kind of where we performed in the last downturn.

Timothy M. Manganello

The other thing is since the last downturn part of the reason why our margins today are doing so well and are stronger and higher than and is because we actually never put a lot of people back in after the last recession, when things started to pick up and we started to get the growth rates back for 2010 and 2011. We didn’t hire a lot of salaried back, we hired enough to support all our growth continue all the development programs and invest for the future on technology, but we still held the line and to this day, I’m still approving every salary hired worldwide. And I think you’re going to see that’s going to turn out to be a tremendous benefit for us. Now, that kept us lean, so because of that, we’re hopefully we are still in, but we don’t have as much to go after if there is another downturn when it comes to salary workforce.

Robin J. Adams

And it shows up in our SG&A, again if you look at year-over-year, I think again excluding the benefit of the stock decline in the quarter, SG&A was only up about $10 million to $11 million year-over-year and $13 million increase in R&D, which means that the rest of the spending in the SG&A line item is being held fairly flat and tight at this point.

Rich Kwas – Wells Fargo Securities, Llc

Right. And then last one for me just on NSK, so the production came back here nicely in the third quarter, I mean do you see more benefit here from the Japanese, I know the Thailand issue, kind of throws some noise into it, but just all else equal where you are going to see more benefit here on the production ramp into the fourth quarter and the first quarter of ’12.

Timothy M. Manganello

On the macro level, if you take the Thailand noise out like you just said, Toyota and the rest of them have not come back up to full pace yet in terms of filling their pipeline on inventory, meeting all our orders, so there is still more upside on sales and more upside on production because of replenishing their inventory worldwide. So, there is more upside on the production side, so now at ’11, we won’t jump in on the rest of it.

Robin J. Adams

If you look at affiliate earnings, which is kind of what’s driving your question to, it appears to us there was quite a bit of catch-up in the third quarter. So, we are not expecting affiliate earnings in the fourth quarter to the level of third quarter that we saw. It'll be close, but we think repeat for the year for NSK one or affiliate earnings, third quarter, as Tim said though, the business continues to grow; we expect that to grow for us in 2012. For the rest of this year, I think third quarter is a peak for us.

Rich Kwas – Wells Fargo Securities, Llc

Okay. Great. Thanks everyone.

Operator

Your next question comes from Tim Denoyer with Wolfe Trahan Research.

Timothy Denoyer – Wolfe Trahan & Co.

Hi, thanks for talking my question.

Timothy M. Manganello

Hi, Tim.

Timothy Denoyer – Wolfe Trahan & Co.

If I look at content per vehicle, I mean, obviously, it was great quarter, I will admit that, but content per vehicle year-to-year growth look like in the engines segment slowed a little bit from 2Q to 3Q, if you look at just vehicles world-wide, were there any destocking in the channel, we’ve certainly heard some of that from more commercial customers, I realize that the commercial and aftermarket isn’t a huge part of what you do, but can you comment on that?

Timothy M. Manganello

Well, we don’t track content per vehicle, number one. So, I couldn’t even give you clue as to what it means to us. As far as the aftermarket, our sales have stayed pretty even, as a percent of sales, the aftermarket is about 6% of our sales and that’s typically where it still has been. On the commercial side, you mentioned commercial, the commercial side for this year and for the last number of quarters is about 15% to 16% of our sales and it stayed constant, I think year-to-date it’s 15% of sales. So, we are seeing a strong growth on the commercial side in Europe and North America and China is the only place where the markets kind of falling down and we are still doing well in China because like I said in my call, or my part of the call. We are selling more turbochargers to increase penetration rates on turbochargers in China, I don’t know if any destocking going on and I don’t know the answer to that, I can’t comment on content per vehicle is that’s not the way we look to run the business.

Timothy Denoyer – Wolfe Trahan & Co.

Yeah, but that’s my estimate.

Robin J. Adams

Yeah, as we look at the growth in the business, the engine business was up year-over-year at 17% in the second quarter and 16% in the third quarter. So, fairly consistent from our perspective.

Timothy Denoyer – Wolfe Trahan & Co.

Yeah, it was up sequentially on my number, just a little flow year-on-year and it’s a tough comp, but on the commercial side again, how (inaudible) to Europe and do you have any thoughts on some of the cuts that we’ve seen there, how does the commercial breakdown between China, Europe and the U.S.?

Timothy M. Manganello

Right now Europe and North America are about even and commercial, they are spread out between turbochargers, and fan and fan drives mainly and I don’t care now with a split between which one is large and which one is between turbo and thermal. I can’t remember, but it’s probably not that important. We’re seeing strength and still seeing strength and like I said commercial turbochargers in Europe is strong, North America is strong, thermal and Europe is strong, North America is strong. And it’s about 50:50 for us between Europe and North America.

Timothy Denoyer – Wolfe Trahan & Co.

Okay, thanks very much.

Robin J. Adams

Thanks.

Operator

Your next question comes from Brian Johnson with Barclays Capital.

Brian Johnson – Barclays Capital

Good morning gentlemen.

Robin J. Adams

Good morning, Brian.

Timothy M. Manganello

Good morning.

Brian Johnson – Barclays Capital

Would like to talk a little bit about the segments in engine other than turbochargers. A couple of questions, I’d start by leveling the detail product profitability and growth, but maybe I wish you won’t care, but at higher level, what percent of turbo is roughly of that what’s the next two or three biggest products that I’m looking at your description on your Investor deck. And which are growing, what’s the relative growth rate as we go across the product lines?

Timothy M. Manganello

We don’t get any numbers, Morse chain is a big growth product for BorgWarner globally. Within Morse Gemini we have two sides of the business, we have the chain side of the business, some of which is timing drive systems of the chains and the rest of the timing drive systems sprockets and guides and snubbers. Good growth globally, China, Brazil, opportunities in Brazil in the future, growth in Korea right now saw a tremendous growth on that side. The other part of the Morse chain side, which is kind of like maybe the sleeping giant for the future is variable cam timing.

We have those variables cam timing, which I’ve said over the last number of years and quarters, it’s the kind of like the generation two or generation three technology. And it basically is so sophisticated that it will allow when combined with turbocharging, it will allow these OEMs from around the world and we are working on development programs with someone right now to recalibrate and redesign their engines, which will give them a long way of meeting this 54.5 mile per gallon CAFÉ in North America, and the more stringent standards for CO2 emissions in Europe. But variable camp timing could be the sleeping giant in the future of this company. But obviously, turbocharges still dwarf everything else on the engine side.

EGR coolers when we did the acquisition on EGR coolers combined with our diesel EGR technology is really EGR valves. We are seeing great growth, the ENSA acquisition combined with our emissions business before hand. It was basically, the ENSA acquisition was hitting it’s targets, we’ve bought it earlier in the year, I think right at the beginning of the year or at the end of last year, I think it was.

And they’re actually starting to exceed our expectations and they are doing better than their original plan. There is tremendous growth opportunity for them because they offer systems approach to EGR and EGR cooling combined with turbocharging. So, we have all these complimentary technologies that all work together whether it’s variable cam timing, EGR cooling, EGR values, and turbocharging that all come together to this optimized engineering management through efficient combustion, which we’ve talked about as a strategy for BorgWarner for the last eight years. Fan and fan drives on the commercial side, tremendous opportunities. So, I mean I could take a whole lot of products, we have probably 15 products I could talk about, but those are some of the big hitters on the engine side, which is where your question was.

Robin J. Adams

Brian, let me help you, every product in the Engine Group had double-digit sales growth in the third quarter. So, it isn’t just turbo driving growth and everyone else relatively flat. Every product area to Tim’s point is growing strongly across the world and we had double-digit sales growth in every product area.

Brian Johnson – Barclays Capital

Okay. I get the VCT adoption curve, what’s driving timing change, what the buying proposition for the …?

Robin J. Adams

There are couple things, there are still a few engines that are growing from belts to chains, but more important, we have better noise performance, better durability performance and we have better efficiency on a chain that allows you to get slight increases in fuel economy. And the last thing a company wants when they are buying a timing chain systems is they don’t want noise, they don’t want chain stretch and they want durability. And we actually are the leaders in probably all three of those benefits within the chain business. We have probably better durability, better noise and low chain stretch or chain wire.

Brian Johnson – Barclays Capital

Great bring one with you when you come to New York and we can show people.

Timothy M. Manganello

Sure, we will show you timing changes. It’s a fairly mundane product, but it’s a hell of a winner.

Brian Johnson – Barclays Capital

Thanks.

Robin J. Adams

Thanks, Brian.

Operator

Your next question comes from Ravi Shanker with Morgan Stanley.

Ravi Shanker – Morgan Stanley

Thanks, good morning everyone. Just a few follow-ups here, Robin I know you addressed the Drivetrain margins quite a bit, but just to clarify, are you guys completely passed all your execution issues there now and so the only real headwind to true margin power there is the Haldex acquisition cost?

Robin J. Adams

No, they still got some work to do in Europe.

Ravi Shanker – Morgan Stanley

Can you quantify that at all?

Robin J. Adams

Not exactly as I said we expect – if you exclude Haldex, again we’re about 8.8% in the third quarter, we expect that to be about 9% in the fourth quarter and growing, and so they’ve got more work to do.

Timothy M. Manganello

I’m not going to say (inaudible) unless I see him with at least a number that’s in the (inaudible) present margin range over there on the Drivetrain, so we got a, it may take us a while, a long while to get there, but we’re on an improvement curve that someday can get, hopefully get us there.

Ravi Shanker – Morgan Stanley

Got it and also just given the size of the beat and the good result of this quarter, it looks like you’ve moved to the higher end of your guidance range, but it probably could have been little bit stronger is the recent 4Q looks a little bit conservative, the SG&A incentive cost, or is there something else going on?

Robin J. Adams

Yes, Jeffrey as I said if you look at our guidance, what you need to do is, if you look at year-to-date performance it implies a fourth quarter of $1.09 to $1.19 a share. And what you need to do is take $0.06 out of the third quarter, add $0.06 to the fourth quarter, so fourth quarter versus what you were thinking before, excluding this timing on the equity. Our employee guidance is really $1.18 to $1.25 for the fourth quarter, which is going to be a record quarter for us for the year, significant improvement over fourth quarter last year. I expect by the end of fourth quarter to be pretty happy talking to you all, and you should be pretty happy as well given the type, if we hit the guidance level we’re indicating here, it will be a damn good quarter.

Ravi Shanker – Morgan Stanley

That makes sense. Thank you.

Operator

We have time for one final question, and that question comes from Rod Lache with Deutsche Bank.

Patrick Nolan – Deutsche Bank Securities

Good morning, everyone. It’s actually Pat Nolan on for Rod.

Timothy M. Manganello

Hi, Pat.

Robin J. Adams

Hi, Pat.

Patrick Nolan – Deutsche Bank Securities

Just two quick ones, most of my questions have been answered. On the net SG&A, it looks like you are going to end the year right around 9% of sales, how much of leverage do you see in that as we go forward, I mean you’re going to be continuing probably in mid-double digit growth, probably through mid decade, where do you ultimately think that can go as a percent of sales for the SG&A line?

Robin J. Adams

One of the things we have said before is, we’re struggling to catch up on the R&D side, and we are still, when you look at R&D spending, that maybe 3.5% for the year as a percent of sales, and we’ve traditionally been 4%. So you’ve got a little bit to go on the R&D side. So we would expect as Tim said, he still approves every hire for salaried employees, and I’ve got five that he hasn’t approved for like nine months now, I want to remind him for everyone.

Timothy M. Manganello

(Inaudible)

Robin J. Adams

Yeah, that’s fine. Thank you, Tim. They are good hires, but nonetheless, but we do have good cost control focus still on the salary side, but the R&D spending will increase with this business. So we’ll see SG&A margins, they will creep up from that 9% level, but they are not going to be 10%, I will tell you that, they will still be closer to 9%.

Timothy M. Manganello

And that’s certainly historical range. Between 9% and 10% is our historical range for a number of years. So every once in a while we top above that, but mostly we’re 9% to 10%.

Patrick Nolan – Deutsche Bank Securities

Okay. Thanks very much. And just lastly on raw materials, I think you said 35% to 45% this year?

Robin J. Adams

35% to 40%, yeah.

Patrick Nolan – Deutsche Bank Securities

What’s it looking like for next year if we held the current prices?

Robin J. Adams

I don’t have that up on top of my head. There is a little bit of material inflation next year. We are still going through our look at 2012, and I know there is some material inflation there, I can’t quantify that. Historically, we’ve been about – no matter what’s going on the world, we’ve been about $25 million to $30 million of increase in raw material prices and without knowing any details, in my expectation, it’s going to be no worse than that next year.

Patrick Nolan – Deutsche Bank Securities

Thanks very much guys. Good quarter.

Timothy M. Manganello

Thank you.

Ken Lamb

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

Operator

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

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