For the third quarter in a row, engine and powertrain company BorgWarner (BWA 3.68%) disappointed the market by reducing its full-year revenue and earnings guidance. Once again, currency effects played a part, but clearly weakness in China and commercial vehicle production in parts of the world is also hurting the company. It was an interesting report in terms of observing trends in auto production. In addition, management took the time to explain BorgWarner's exposure to the Volkswagen (VLKAY 3.29%) emissions debacle. Let's take a closer look.
BorgWarner's third-quarter results: The numbers
Net sales declined 7.3% compared to the same quarter last year, but excluding foreign currency movements they rose 3.2%. Operating income from continuing operations declined 1.6% compared to the third-quarter 2014. As you can see in the table below adverse foreign currency movements hit both segments results.
| Segment | Revenue ($ millions) | Reported Sales Growth | Adjusted Sales Growth | Adjusted EBIT ($ millions) | Adjusted EBIT Growth |
|---|---|---|---|---|---|
| Engine | 1308.9 | (7.3%) | 4.1% | 211.9 | (4.8%) |
| Drivetrain | 583.7 | (6.9%) | 1.5% | 70 | 3.4% |
Data source: BorgWarner presentations. Adjusted figures exclude foreign currency and M&A activity.
However, the company's guidance really disappointed the market:
- Full-year net sales growth expected to be negative 6% to negative 5% year over year compared to the previous estimate of negative 5.5% to negative 2.5% At the start of the year, management had predicted 2% to 6%.
- Full-year diluted EPS guidance of $2.95 to $3 compared to the previous estimate of $2.95 to $3.10. BorgWarner started the year estimating $3.35 to $3.55.
- Net sales growth, excluding foreign currency effects, now expected to be 4.5% compared to a previous estimate of 7% to 8%.
Sales and earnings guidance were reduced, and as the last bullet point demonstrates, it wasn't just about currency effects.
What happened in the quarter
In order to explain the trends in the quarter, here is a sequence of quotes from CEO James Verrier from the company's previous quarterly earnings calls:
- In the first-quarter presentation in April, Verrier said, "Our growth was temporarily affected by an unfavorable mix of light vehicle production in North America and launch delays in Asia."
- Come the second quarter in July, "Our growth was affected by an unfavorable mix of light vehicle production in North America, slower light vehicle production growth in China, and weak commercial vehicle markets around the world."
- And now Verrier cited "the impact of weaker than expected market conditions in China on our business and weak commercial vehicle markets around the world" as the main reason behind the guidance reduction.
In short, the weak conditions seen in the first quarter weren't temporary in nature and actually appear to have worsened as the year has progressed.
On a brighter note, management reported some positive news on sales in the drivetrain segment. In the fourth quarter of 2015, the drivetrain segment's sales were negatively affected by the slow ramp-up in production by a major North American customer. The rationale given at the time was that the customer was "running pretty high on volumes in the first two quarters of 2014 as well," according to CFO Ron Hundzinski. He went on to outline that the comparisons would even out in the second half of 2015.
The good news is that in the third-quarter earnings call, Verrier said, "The major North American program ramp that had slowed Drivetrain sales growth over the previous four quarters did return to material volumes in the third quarter." Furthermore, he argued that the benefit of these sales plus "European restructuring" would drive margin expansion in drivetrain next year.
Volkswagen
The German automobile giant is responsible for about 16% of BorgWarner's revenue, so investors have just cause to be nervous. With this in mind, Verrier took the time to outline that only 4% of BorgWarner's sales relate to the light vehicle diesel engine products, with only 0.5% of BorgWarner's total sales relating to the "affected engines that have been disclosed by Volkswagen."
Moreover, Verrier opined that there will be "no impact on BorgWarner" from the recall efforts at Volkswagen because the American company's products weren't "involved in any of the recall solutions."
Looking forward
All told, BorgWarner's results are part of a continuing trend of weaker automotive conditions in China, and investors will be watching closely to see how end-automotive production and sales develop in the country. Verrier doesn't expect a "meaningful improvement" in the overall commercial vehicle market in the near future, but he anticipates "3% to 5% growth" from China in terms of light vehicles. Much will depend on China in 2016.
