Phinia Inc. (PHIN) Q3 2023 Earnings Call Transcript

Thank you for standing by, and welcome to the PHINIA Q3 Earnings Call 2023. I would now like to welcome Michael Heifler, Vice President of Investor Relations to begin the call. Michael, over to you.

Thank you, Mandeep, and good morning, everyone. We appreciate you joining us. Our conference call materials were issued this morning and are available on PHINIA's Investor Relations website including a slide deck that we will be referencing in our remarks. We are also broadcasting this call via webcast. Joining us today are Brady Ericson, CEO; and Chris Gropp, CFO. Today, we will discuss our Q3 results and updated forecast for full year 2023. Please keep in mind when we make year-over-year or second half 2023 to first half 2023 comparisons, we are comparing our standalone results, including actual or expected corporate costs to pro forma results with corporate allocations when we were part of BorgWarner. During this call, we will make forward-looking statements, which are based on management's current expectations and are subject to risks and uncertainties. Actual results may differ materially from these statements due to a variety of factors, including those described in our SEC filings. And with that, it's my pleasure to turn the call over to Brady.

Thanks, Mike, and thank you for joining us this morning. I'm pleased to share our first earnings report as an independent company and proud to represent our nearly 13,000 employees who remain focused on delivering quality products to our customers and delivering solid financial results in the quarter. I'll get into some of the numbers shortly and then hand it over to Chris for more details but let me first provide some color on our journey so far. Throughout the past several months, I've spent considerable time with customers, employees and investors. The feedback externally and internally has been universally supportive and positive about PHINIA's focus on its core business and strategy for the future. Customers appreciate our commitment to combustion products and that we're going to be a reliable partner to them for decades to come. They are aligned with our efforts to develop robust, practical solutions for today and the carbon-neutral and carbon-free solutions of tomorrow. Our employees are excited that our profits and resources are being reinvested in our product lines and our operations to further strengthen and grow our business. Finally, investors are supportive of our strategy commitment to being financially disciplined and our focus on total shareholder returns. Continuing to deliver solid financial performance and executing on our strategies will be key to building shareholder confidence. With regard to the transition from our former parent, the team has been hard at work exiting transitional services agreements, or TSAs in IT, cloud services, HR, facilities, operations, procurement, sales and IP and have been making strong progress. IT-related services make up the majority of the costs and will take the longest to exit. We expect to close out all these TSAs by the middle of next year. As we are negotiating independent services and hiring key talent, we are prioritizing establishing strong, efficient, long-term solutions against the backdrop of inflationary pricing. As such, we're working to keep as close as we can to the $80 million of annual corporate costs discussed at the time of the spin. Given what we know now, we see the potential for higher costs, but we believe our longer-term overall margin goals are still quite obtainable. Chris will speak to our corporate costs and other metrics shortly. We are also still on pace to exit all contract manufacturing agreements or CMAs by the end of 2024 in a stepped and managed fashion. Providing great products and service for our customers has allowed us to continue to win new business across all product lines and in all regions in support of our strategies. A few examples are: PHINIA is expanding into new markets by being selected to supply fuel injectors to a major aircraft equipment manufacturer; PHINIA is broadening its zero-carbon product solutions with its first major award to supply hydrogen fuel system components for a large OEM's medium-duty truck hydrogen fuel cell electric vehicle; PHINIA is helping customers reduce carbon emissions today while increasing our market share with a significant GDi program award from a prominent domestic Chinese OEM for its new light vehicle plug-in hybrid programs. These business wins are proof points on how we are diversifying and growing by leveraging our product leadership, global footprint and proven capabilities. Our quote activity and new business wins remain robust, and we believe we have the right strategy to achieve stable long-term growth. We think our exposure to commercial vehicle, industrial and aftermarket businesses is going to allow us to continue to grow through this decade and beyond. Our new business wins are supported by our product leadership strategy of bringing new technology to market that provides value for our customers, such as market-leading 500 bar GDi technology, helping customers improve efficiency, reduce emissions and lower costs leveraging our GDi technology and capital to provide a value-focused solution for our off-highway diesel applications and hydrogen ICE that differentiates us from our competition. Additionally, we are providing customers with complete system solutions from the injector to the ECU and calibration services. We can provide a complete turnkey solution for our customers that will help drive additional efficiencies and increase the value we provide. Finally, we're helping our customers move towards carbon-neutral and carbon-free fuels with solutions using ethanol, biofuels and hydrogen, as it's our view that a liquefied or gaseous fuel is going to be a key element of our journey to carbon neutrality. There are just too many applications where a battery-electric solution is suboptimal and where hydrogen or renewable fuel will provide an economical, practical and carbon-neutral solution. As summarized in our earnings deck on Slide 4, there's a lot of activity around hydrogen. In fact, many governments and industry participants around the world are working on commercializing hydrogen solutions. I participated last month in the Hydrogen Americas Summit in Washington, D.C. along with other leaders from private industry and government officials, including Energy Secretary, Jennifer Granholm to discuss future hydrogen initiatives. A significant development occurred shortly after when the Biden administration allocated $7 billion in appropriations for 7 hydrogen hub projects. Combined with over $40 billion in private funding, the DOE expects the projects to produce 3 million metric tons of clean hydrogen by 2030. We are investing prudently in hydrogen, leveraging our core technologies and resources as we see this opportunity not being a substantial part of our revenues until 2030 and beyond. In the near to medium term, our focus is on growing and optimizing our core OEM and aftermarket businesses. We believe our business is resilient with about 1/3 of our business going to the OES and aftermarket providing a nice ballast under all macro conditions. Our commercial and industrial business, making up nearly 1/4 of our sales, provides a stable and growing opportunity. And in the light vehicle business, we see our increasing market share and the higher market penetration rates of GDi, especially in hybrids, supporting our position that our light vehicle business has staying power. We also tend to be weighted more on the larger SUV, van and truck segments, which will be among the last segment to convert to full battery electric vehicles. We're going to grow in a financially disciplined way. Our objectives are to continue to maintain low leverage and make all decisions based on maximizing return on invested capital while always exceeding our internal hurdle rates. Now moving to Q3. Our core operations continue to perform well with total segment adjusted operating margins consistent with our first half average results. As we previously mentioned, our Fuel Systems segment experienced a challenging year-over-year comparison with Q3 last year due to retroactive inflationary customer recoveries. As a result, our Fuel Systems adjusted operating margins decreased by 540 basis points compared to a year ago, standing at 10.3%. However, when compared to the first half of 2023, adjusted operating margins increased by 40 basis points. We have been actively collaborating with our customers to recover costs and ensure fair pricing against overall inflationary pressures, which Chris will elaborate on shortly. Our aftermarket segment margins decreased by 110 basis points from last year and approximately 90 basis points from our first half results, mainly due to higher inflationary costs and negative mix. We anticipate this trend will persist into Q4 but have strategies in place for recovery in 2024. The adjusted segment results for Q3 demonstrate positive underlying momentum in our business. As we indicated in our Q2 call, we expect a headwind in our adjusted operating income line due to rising corporate and dis-synergy costs. Q3 corporate costs were $19 million, aligning with our expectations of around $20 million per quarter. We anticipate these costs will increase somewhat in Q4 as we expand our independent services. Over time, as we grow our revenue, we will be able to leverage these costs and lessen their impact on our margins. Revenues in Q3 were weaker than expected, primarily due to ongoing softness in CV demand in China. While the CV market in China is recovering, customer demand remains significantly below previous year levels and our earlier expectations. We do not expect this to recover until mid-next year. We are also observing signs of slowing demand in our European CV business relative to our earlier expectations. Although strikes in the U.S. had minimal impact on our business in Q3, we anticipate a more significant effect in Q4 from strikes affecting the major light vehicle OEMs and Mack Volvo. The expected impact for Q4 is around $25 million to $30 million, corresponding to about a 3% to 4% reduction in PHINIA revenues. Despite some tentative settlements being reached, the timeline for ramping up to full capacity remains uncertain. Additionally, we are experiencing foreign exchange effects from a stronger U.S. dollar since our last guidance. Therefore, we are adjusting our full year 2023 guidance for adjusted sales, adjusted EBITDA, and adjusted EBITDA margin to ranges of $3.4 billion to $3.45 billion, $465 million to $475 million, and an EBITDA margin of 13.6% to 13.9%, respectively. We are also revising our 2023 tax guidance to 34% from 27%. As we conclude our TSAs and CMAs and align our business operating model with our post-spin legal entity structure, we expect our effective tax rate to decline toward our original expectation of 27%. We are generating strong free cash flow and maintain a solid financial position. In the quarter, we generated free cash flow of $118 million and finished September with $367 million in cash. We continue to work collaboratively with our former parent regarding some of this cash being payable to them, while also anticipating cash receivables from them. Our balance sheet remains under 1x net leverage. Our confidence in the business prompted the Board of Directors at the end of August to authorize a $0.25 per share quarterly dividend and a $150 million share repurchase program. In September, we repurchased $9 million of our shares at an average price just over $27. Overall, $21 million was returned to shareholders in the quarter. As previously stated, our priority is to maintain a strong balance sheet and maximize total shareholder returns. This strategy encompasses dividends, optimizing our debt structure, and, at the appropriate time, making rapidly accretive and high ROIC acquisitions to expand our commercial, industrial, and aftermarket businesses, alongside opportunistic share repurchases. With that, I'd like to hand it over to Chris, who will take us through our Q3 results and our outlook for the rest of the year. Chris?

Thanks, Brady. I'm also pleased to reach this milestone of reporting our first standalone quarter. Please keep in mind there continue to be TSAs and CMAs with our former parent which we are phasing out in step through 2024 and expect to fully exit by the end of 2024. Also, as Brady mentioned, we continue to work with them on balance sheet items related to the spin and expect it will take the next few quarters for payables and receivables to and from, from them to close out. In Q3 2023, we generated $870 million in adjusted total sales, up slightly versus a year ago. Our adjusted earnings per share were $0.53. We earned $82 million in adjusted operating income and $117 million of adjusted EBITDA, resulting in an adjusted operating margin of 9.4% and an adjusted EBITDA margin of 13.4%, a year-over-year decrease of 400 basis points and 420 basis points, respectively. As Brady mentioned, we faced difficult comparisons of Q3 a year ago when we received retroactive inflationary cost recovery from our customers. In addition, as we anticipated, we are flowing through higher standalone corporate costs. As depicted in Slides 7 and 8, our sales performance in the quarter was affected by continued softness in our CV business in China. We saw favorable sales from positive customer pricing of $18 million, which was offset by $32 million of inflationary costs from suppliers. Volume mix was a headwind of $20 million, mostly due to lower CV sales in China. Customer recoveries represent approximately 70% of our realized inflationary costs for the first 9 months and we have reached agreements on recovery mechanisms with most of our top customers for inflationary cost recovery for the year. Please keep in mind that we have recently asked our customers for recovery from broader inflationary costs beyond materials, including utilities and employee costs. From a core business performance standpoint, our segments reported solid overall margin. Q3 segment adjusted operating margins were healthy at 11.6%. This was roughly in line with the average segment adjusted operating margin in the first half despite lower aftermarket margins due to higher inflationary costs not recovered in the quarter and mix headwinds from lower North American sales. As expected, higher standalone corporate costs in Q3 drove an overall lower adjusted operating margin of 9.4%. Looking at performance on a segment level. As we forecasted, Fuel Systems margins contracted on a year-over-year basis due to challenging comparisons with retroactive recoveries in Q3 of last year. However, as Brady mentioned, Fuel Systems adjusted operating margins improved 40 basis points from the first half of this year's average. This was driven primarily from better customer recovery of inflationary costs, Fuel Systems also continues to benefit from GDi growth in the Americas, partially offset by lower than prior year and expected CV revenues in China that is primarily due to underperforming customers. While we have been expecting them to recover in the second half, we now believe we will not see recovery until mid-next year. We are looking to partially offset this revenue loss by utilizing this capacity for aftermarket business and continuing to pursue new business opportunities with other customers. Our aftermarket business sales grew 3% year-over-year driven by positive currency and growth in the European market. Adjusted operating margin came in at 13.7%, down 110 basis points from the same period of a year ago as non-commodity inflationary costs were not covered by prior pricing actions and we experienced weaker mix. Overall, we continue to target longer-term EBITDA margins of 14% to 15%. And as I mentioned last quarter, we are also continuing to assess our cost of footprint with an eye to further efficiency. In addition, we will continue to incur costs related to the spin as we adjust our footprint to reflect the separation. Corporate costs came in at $19 million in Q3, in line with our previous expectations. And we continue to forecast corporate costs in the $60 million to $70 million range for the full year. We expect corporate costs to likely annualize next year at around $80 million but there is still considerable noise from exiting the TSAs as we finalize new contracts, complete our staffing and finalize allocations between segments and corporate. We'll have more to share with you during our Q4 earnings call in February when we plan to give full year guidance for 2024. Q3 cash from operations was $155 million. During the quarter, we generated strong free cash flow of $118 million as we partially unwound the working capital build related to the spin. We see an opportunity to further reduce our working capital going forward in the tens of millions of dollar magnitude. Next, turning to our liquidity. We are committed to a strong financial foundation and having ample liquidity to run our business and execute our strategy. We ended Q3 with $367 million in cash and $425 million of committed revolver availability, giving us total liquidity of more than $790 million and net leverage of less than 1x EBITDA. In closing, I want to reiterate Brady's message regarding our focus on financial discipline and generating strong shareholder returns.

Our first question comes from the line of Jake Scholl with BNP Paribas Exane.

Congratulations on your first quarter. Can you just remind us approximately what percentage of sales the China commercial market represents? And then can you just confirm that, that market runs above corporate average margins? And what's your level of confidence in the headwinds for the remainder of the year?

I think our CV business as a percent of our total revenue or it's about 50% of our China sales.

Correct.

It's approximately $250 million to $300 million in total. Our commercial vehicle business is comparable across all regions, with our operations in China performing slightly better than average. We expect the headwinds to ease in the coming year for the commercial vehicle sector. A key factor for us is the pace at which the major three manufacturers increase their production in North America and the resulting demand. While we are noticing some softness in the commercial vehicle market in Europe, it is not significant at this time and is a concern for us. Our aftermarket business remains steady and continues to generate strong cash flow.

And then free cash flow was definitely a point of strength in the quarter. Can you just talk about how we should think about that in the fourth quarter and then into 2024?

I think it will be positive again. A typical fourth quarter usually shows positive cash flow. There will be a strong emphasis on closing it out and minimizing our working capital. Overall, we anticipate generating around $200 million of free cash flow regularly once we navigate through all the different CMAs and TSAs and work through other matters.

But it will slow down slightly because in Q4, we are still collecting money and paying out money for BorgWarner, that's going to slow. So it is going to have an effect. We're getting more cash in than paying it out for them. So as a part of that, it will affect our total run rate cash flow in Q4 compared to Q3.

As Chris mentioned, I think that will kind of work its way through over the next few quarters for us to kind of finalize all the accounts receivable and accounts payable between the two companies as well as tax matters agreements and a few other things that we've been paying for them and they're paying for us.

Our next question comes from the line of Joseph Spak with UBS.

Chris, for my first question, you mentioned that some of the recovery isn't expected until the middle of next year. How should we approach price and cost for next year? Is it likely to remain neutral, or can we anticipate some benefits in 2024?

We are not observing significant changes in commodities; they remain stable compared to last year. The inflation we are experiencing is primarily related to utilities and employee compensation, which we have already adjusted for this year, similar to others in the industry, and those adjustments will carry over into next year. We anticipate maintaining the same pricing level with our customers. This year, rather than receiving lump sum payments as we did previously, we are incorporating these costs into our piece price. Therefore, we expect the pricing to remain relatively stable. If we encounter any increased challenges, we will address them with our customers, but I believe we will see a consistent run rate into next year as we have this year.

Yes. From a year-over-year perspective, we believe we've reached our peak, and we don't anticipate any challenges from inflationary costs. As Chris mentioned, we won't face the same negotiation battles we experienced in previous years. Instead, we've readjusted the base price for many of our customers, establishing it as the new standard moving forward. This should help reduce the volatility in our earnings that we've observed over the last couple of years. In the third quarter of last year, we had three quarters of retroactivity, which caused a spike. While we saw some impact in the second quarter of this year as well, we expect that by incorporating it all into the piece price, we'll achieve more stable quarter-over-quarter comparisons.

Is the piece price negotiation consistent across all your customers in different end markets, or is it specific to light vehicles or commercial vehicles?

No. It's across all customers. That was more of a direction that we had to get that resolved because the uncertainty or the volatility from all those negotiations was not adding any value for our customers or for us. And so we took the initiative to really push that through into piece price.

To be fair, most of the commercial vehicle customers were already inclined that way. They are much more direct about ensuring the pricing is set on a per-piece basis compared to the light vehicle customers. Regionally, the Americas and Europe approach it in a very similar manner. In China, we've encountered fewer inflationary issues, so it has been more about the ongoing negotiations regarding pricing, which is typical in China anyway. All of this contributes to the piece price.

Great. That's helpful. And then just the second question. Obviously, a lot of news and noise and headlines, particularly in North America about this EV push out. And I know there's a lot of your customers have probably been distracted with some other things this quarter and now they need to sort of ramp up. But I'm curious on some early level of discussions you're having with them about '24, maybe even '25 plans. Are we seeing any indication of upsized orders for GDi or other products if the mix of the vehicles they plan to produce is changing?

Yes. I'm not going to overreact and claim that everything is going to take off for us. However, we are seeing strong demand for our products. GDi has experienced growth in North America over the years, and customers are requesting extensions for programs that were previously expected to end. One example is the GDi program we won in China for plug-in hybrids, which continues to show strong activity and requests from customers. This is why we believe our light vehicle business has significant staying power. Additionally, a large portion of our North American light vehicle business focuses on SUVs, trucks, and vans, which also tend to have longer staying power. We continue to see solid demand for those products and expect this trend to persist throughout the decade.

CV in China has definitely been a tailwind for this year. CV has been down in China, but the GDi in China has definitely been a positive and it has been higher than we expected from budget and compared to prior year.

I think as we shared in the past, too, is our light vehicle quote activity remains really robust. We haven't seen a decline in quote activity or new business wins over the last few years. And so this is consistent with that. I just think the market is finally catching up to maybe some of the things that we've already been seeing.

There are no further questions at this time. I would now like to turn the call over to Brady Ericson for closing remarks.

Great. Thank you very much, and thanks for joining the call, everybody. I think we're excited about the long-term future of this business. The quote activity remains strong. We've got some great technology that our customers continue to pull on. And again, we think a liquefied and a gaseous fuel is going to be key for all of us to achieve carbon neutrality in the time frame that each of us have defined. And so we're really happy with the strength of our balance sheet, the flexibility it's going to give us and our ability to continue to return money to our shareholders to provide them great returns as well. So looking forward to the future of PHINIA. Thank you.

I'd like to thank today's speakers for today's presentation and thank you all for joining us. This now concludes today's call, and you may now disconnect.