PHIN - NYSE

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's 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 [ bev ]. We're going to grow in a financially disciplined way. Our objectives are to continue to maintain low leverage and making 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 posted segment -- total segment adjusted operating margins in line with our first half average results. As we previously discussed, our Fuel Systems segment faced a difficult year-over-year comparison with Q3 last year as it benefited from retroactive inflationary customer recoveries. Consequently, our Fuel Systems adjusted operating margins were down 540 basis points versus a year ago at 10.3%. However, when viewed versus our first half of 2023, adjusted operating margins were actually up 40 basis points. As Chris will discuss shortly, we've been working proactively with our customers to achieve recovery and fair pricing against overall inflationary cost pressures. Our aftermarket segment margins were down 110 basis points from last year and down approximately 90 basis points from our first half results due to primarily -- primarily to higher inflationary costs and negative mix. We expect this dynamic to continue into Q4 but have actions to recover in 2024. Q3 adjusted segment results demonstrate positive underlying momentum in our business. As we discussed in our Q2 call, we expect a headwind in our adjusted operating income line from increasing corporate and dis-synergy costs. Q3 corporate costs came in at $19 million in line with our expectations of approximately $20 million per quarter. We expect these costs to be somewhat higher in Q4 as we build out our independent services. Over time, as we grow our top line, we'll be able to leverage these costs and reduce their impact on our margins. Revenues have softened below our expectations in Q3, primarily due to the continued weakness in CV demand in China. Although the CV market in China is recovering, our market -- our customer demand is well below prior year and our prior -- our previous expectations. We do not see this recovering until the middle of next year. We're also seeing some signs of slowing demand in our European CV business versus our prior expectation. While strikes in the U.S. had a minimal impact on our business in Q3, a more substantial impact is expected in Q4 from the strikes across the big 3 light vehicle OEMs and Mack Volvo. Current expected impact in Q4 is around $25 million to $30 million or about a 3% to 4% reduction in PHINIA revenues for Q4. Although some tentative settlements have been reached, timing to ramp up to full capacity is still unknown. Finally, we're also seeing FX effects from a stronger U.S. dollar from when we provided our guidance. Consequently, we're revising our full year 2023 adjusted sales, adjusted EBITDA and adjusted EBITDA margin guidance range to $3.4 billion to $3.45 billion, $465 million to $475 million and an EBITDA margin range of 13.6% to 13.9%, respectively. We're also revising our 2023 tax guidance to 34% from 27%. As we exit our TSAs and CMAs and achieve better alignment of our business operating model with our post-spin legal entity structure, we see our effective tax rate coming back down towards our original 27% expectation. We're generating strong free cash flow and have a solid financial position. In the quarter, we generated free cash flow of $118 million, and we ended September with $367 million of cash on hand. We continue to work collaboratively with our former parent that some of this cash will be payable to them, and we will also have some cash receivable from them. Our balance sheet remains under 1x net levered. Our confidence in the business led 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. During the month of September, we bought back $9 million of our shares at an average price of just over $27. In total, $21 million was returned to shareholders in the quarter. As we've previously articulated, our focus will be to maintain our strong balance sheet and maximize total shareholder returns. This will include dividends; optimizing our debt structure; at the right time, making rapidly accretive and high ROIC acquisitions to grow our commercial, industrial and aftermarket businesses; and opportunistically repurchasing shares. 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. With that, we will now move to the Q&A portion of our call.

[Operator Instructions] 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.

So it's about $250 million to $300 million in total. Our CV business, I think, with all regions are all kind of comparable. Some of the CV business that we have in China is probably a little bit better than average for us. And as far as kind of the headwinds, we see it abating going into next year on the CV side. I think the big question for us is how quickly the big 3 ramp up in North America and where that demand kind of comes in. As I mentioned, we see a little bit of softness in CV, but in Europe, but not significant at this point. It's just a concern for us right now and our aftermarket continues to be pretty steady and strong generating -- strong cash flow generation for us.

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 mean, I think -- we think it's going to be positive again. We -- a typical Q4 is a positive cash flow quarter. Obviously, a lot of focus is going to be on closing it out and reducing our working capital. I think in general, we're going to keep with our overall guide that we see ourselves generating plus or minus about $200 million of free cash flow on an ongoing basis once we get through all the different CMAs and TSAs and kind of working through things. So...

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 AR and AP between the 2 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.

I guess, Chris, first question. You briefly mentioned some of the recovery is not expected until middle of next year now. How broadly should we think about price/cost next year? Is that expected to be neutral? Or should you still -- should we still expect some benefit in '24?

Well, we still -- we really aren't seeing much on commodities. They're really flat year-over-year. Where we're seeing our inflationary in terms of utilities and merit for employees and things like that, that obviously, we've already increased the rate for this year like everybody else and that will feed into next year. What we expect is we will keep at the same level with our customers. For the most part, this year, instead of getting lump sums like we did last year, we're building it into piece price. So we expect it to remain basically flat. And then if we experience any higher headwinds, obviously, we'll go after the customers again. But I think we'll just continue seeing the same run rate going into next year as for this year.

Yes. So from a year-over-year, from '23 to '24, we think it's -- we've kind of hit the peak, and so we don't see any headwinds from inflationary costs. As Chris mentioned, I think we're not going to be in the battle that we have in the last few years where there was a complete negotiation and starting from scratch on January 1, where a large portion of our customers, we've actually just readjusted the base piece price, knowing that's going to be the new base kind of going forward. So hopefully, that will then reduce the volatility that we've seen in our earnings over the last couple of years, as Chris mentioned. I think in Q3 of last year in '22, we had 3 quarters of retro, which is why we had the spike. And we saw most of those in Q2 of this year but still had a little bit of a bump in Q2. And so hopefully, with rolling it all into piece price we'll have a more stable quarter-over-quarter comparisons.

And that piece price negotiation, that's consistent across the different -- all your customers across different end markets? Or is it specific to either light vehicle or commercial vehicle?

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 CV customers were already -- they lean that way. They're much more upfront with making sure the pricing is kind of set in a piece price than the LV customers are. And then by region, Americas and Europe are very similar in how it's approached. In China, we've seen less inflationary issues. So it's been more of the ongoing negotiations with all pricing, which is how it typically works in China in any event. And that all goes into 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 mean again, it's -- I'm not going to overreact and say, hey, things are going to take off for us. But I think we continue to see strong demand for our products. I think GDi has been growing in North America over the years. And I think we're continuing to see customers ask for extensions of programs that were previously planning on kind of dying out. I think the one example that we gave as part of the new business win was the GDi program we won in China for plug-in hybrids. Those continue to quote activity and requests from customers continue to remain relatively strong. And that's why we think our light vehicle business has a lot of staying power. And as I mentioned, too, is our -- a lot of our North American light vehicle business tends to be on SUVs and trucks and vans, and those also have kind of longer staying power as well. And so we continue to see solid demand for those products, and we think that's going to continue through 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.