博格華納 (BWA) 2006 Q2 法說會逐字稿

Good morning. My name is Courtney and I will be your conference facilitator today. At this time I would like to welcome everyone to the BorgWarner 2006 second quarter 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 period. [OPERATOR INSTRUCTIONS]

I would like the turn the call over to Mary Brevard, Vice President Investor Relations and Communications. Ms. Brevard, you may begin your conference.

Thank you, Courtney. Welcome and good day to everyone. Thank you tor joining us. The release and copies of the earnings went out today before the market opened, so you should have access to that. We've also posted financial talking points that should help you follow the financial discussion. They're located at our BorgWarner.com website, invest or information, webcast, second quarter conference call talking points. These notes will be helpful to you as Robin reviews the financials and the operations. Also remind you that the conference call replay is at 800-642-1687. The ID number is 1764560 and the replays are also available on our website.

During the next coming months we have an active schedule of conferences. We'll be at the J.P. Morgan Harbor Auto Conference August 7th, the Credit Suisse First Boston conference on September 7th, and make a presentation at the Paris Auto Show at the end of September. 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-Q, Our actual results may differ significantly from the matters discussed today.

Moving on to our results, Tim Manganello, Chairman and CEO, will be providing comments on the quarter and industry trends and then Robin Adams, our CFO will discuss operating results and the rest of the year. Tim?

Thank you, Mary, and good day, everyone. BorgWarner again outpaced industry growth and delivered a solid second quarter against continued softness in North America and shifting market shares amongst our customers. The second quarter highlights include record sales of $1.2 billion, earnings per share was at $1.21 which included a negative $0.04 related to the expensing of options. On a comparable non-U.S. GAAP basis, earnings were up 11% in the quarter versus 2005. Our operating income margin was 9.2% and sales outside the United States were up 12% over the second quarter of last year.

In the Engine Group strong global demand for our products boosted sales 8%. Our Drivetrain Group sales were down 1%. Our sales were up 5% in the quarter while North American vehicle production was flat, and worldwide vehicle production was up approximately 2.5%. We again worked hard in the quarter to overcome the impacts of continued declines in the SUV light truck sales and increased commodity pricing. We are focused on maintaining our margins while leveraging our customer diversity and geographic presence to boost our sales.

In addition to reporting a solid quarter, we have revised our guidance range to $4.35 to $4.60 per share. While we have moved our guidance to the higher end of our previous range, we remain cautious on the second half of the year. Market share shifts and continued weakness in the sport utility and light truck sales persist in creating uncertainty in North America. However, we will benefit from strong demand for our products in the rest of the world.

Right now Robin and I are in Germany for a Board of Directors meeting, and we are reviewing promising engine and drivetrain technologies for our future. During the quarter we saw growing evidence of engine down sizing and other trends around fuel economy and emissions that will continue to create opportunities for BorgWarner. The development of new small engines opens the door for new uses of our technology in both engine and drivetrain. U.S. sales of vehicles equipped with 4 cylinder engines grew from 30% of the market in January of this year to 35% in May. In India all the local passenger car manufacturers are aggressively pursuing a strategy to introduce small cars for the domestic markets as well as for export. Hyundai, Toyota, Suzuki all have plants -- all have plans for small cars. India is on the road to becoming a hub for small car manufacturing, and we are well positioned in that country. Suzuki and Dihatsu will each beef up their sub-compact segments to boost worldwide size. Suzuki and Opal have also agreed to jointly develop a small car for the European market.

Now, on the diesel front, the EPA began requiring refiners and fuel importers to cut the sulfur content of diesel fuel. The June deadline of this year marked the introduction of ultra low sulfur diesel fuel for the U.S., aiding the growth of diesels especially for the imports. In Europe, the increasing quality of synthetic fuels, especially diesel is lowering emissions of diesel powered vehicles. If oil prices stay high, synthetic fuels will become more attractive and price competitive.

Now, in other news of note, the transplants are expanding engine and transmission production in the United States which will again help us expand our business with them. Interest in 6-speed transmissions will continue to grow, and the latest in a series of announcements includes Korean auto makers developing and introducing 6-speeds. In total, automatic transmission production in Korea was up 15% year-to-date in May compared to the same period last year.

Now, while these trends are encouraging, we remember every day that we operate in a tough industry environment. We are committed to continue to go deliver solid results and BorgWarner's leadership in powertrain technology that improves fuel economy, reduces emissions and improves performance sets us apart from other suppliers. Our presence in growing markets such as India, Korea and China as well as our relationships with the merging OEMs will enable us to continue to outpace the industry growth.

With that, I would like the turn the meeting over to Robin for financials.

Thank you, Tim, and good morning to everyone. As Tim says, this quarter was a tough one for the industry but another testament to the resilience of BorgWarner. Our sales, as Tim mentioned, were up 5% in the quarter compared with flat North American and European production and worldwide production actually was up about 2.5%, but if you look at that 2.5% growth, it really represents about 300,000 units, 200,000 of which were in China and 100,000 in Japan and Korea. So, it was a relatively limited growth on a global basis.

Our foreign operations continue to grow and represented 59% of our sales in the quarter versus 55% in the second quarter last year. The impact of currency in this quarter was not meaningful either from a sales or an earnings perspective. If you look at our sales in the U.S., they were actually down 2% and continue to be negatively impacted by our 4-wheel drive transfer case and other products related to sport utility vehicles and light trucks. However, our sales outside of the U.S. were up 12.5% versus last year, so despite the challenges in our environment, our growth continues to outpace the industry on a global basis. On a six-month basis, our sales were up 6%. We did feel some impact of currency in the first quarter. Without the impact of currency on a six-month basis our sales were up 8% on a year-to-date basis. Good strong performance relative to industry conditions.

On a U.S. GAAP basis our net income in the quarter was $1.21 per share compared with $0.63 per share in the second quarter. Now, that translates to about 90% growth or something, but, I -- you all should remember that second quarter last year included a $0.50 a share charge related to the Crystal Springs settlement. The 63 is more like $1.13. Second quarter 2006 this year included $0.04 a share related to the implementation of FAS 123-R or the expensing of options. If you exclude the impact of the expensing of options, and the $0.50 a share Crystal Springs charge from last year, you get, on a comparable basis, although it is non-U.S. GAAP, it is more comparable earnings were up 11% in the quarter. And again, as we look at the earnings, foreign currency impact was negligible on our quarterly earnings for the last year.

For the first six months of 2006 net income, again, on a reported U.S. GAAP basis was $2.27 a share. On a year-to-date basis the implementation of FAS 123-R or expensing of options reduced our earnings $0.07 a share. The first six months of 2005 not only included the Crystal Springs related charge, which I mentioned to you before, but a number of other related special items which totaled about $0.11 a share when it all netted out, some of them tax related if you remember, and we've detailed those one-time items in our press release. So you can walk down from non-GAAP numbers to GAAP numbers and see what those charges are. When you, again, exclude those charges, put 2006 on a comparable basis by eliminating the expensing of options, which we didn't do last year, you get to non-U.S. GAAP numbers which are more comparable which actually translate to 11% growth for the six months this year as well. So, 11% in the quarter, 11% up for the first six months of this year, again, pretty much in line with our expectations from a long-term perspective.

The impact of foreign currency in the first quarter, however, reduced earnings per share for the first six months of this year by $0.07 a share. So, we carry that impact from the first quarter into the six months and that impact on earnings 2006 versus 2005 was $0.07 a share. If you exclude the currency impact as well in the equation, you really get earnings up about 15% for the first six months of this year versus the first six months of last year. And again, we go through these comparisons in trying to eliminate these one-time items because we believe that our earnings excluding these items are a more appropriate comparison to prior period and future period earnings, or in other words better represent how the business runs on an ongoing basis.

Looking at gross margin for the second quarter was about 19.8 compared with 20.9 in the second quarter last year. The impact of higher raw material and energy costs, as well as the incremental margin related to the lower North American SUV and light truck related product sales, those continue to pressure gross margins. Raw material prices, I should mention, we saw increase about $6 million in the quarter. That's on top of 6 million in the first quarter, so it is about 12 million year-to-date pretty much in line with our expectations of 25 million for the year plus or minus.

In the U.S. the rising cost of providing healthcare for active employees along with benefits for pension and post retirement and other post retirement benefits for healthcare continue to impact our industry and also our gross margins. In response we are looking at ways to manage these rising costs down to more reasonable levels and have recently implemented some actions to try to address this.

SG&A as a percentage of sales was 10.6% in the quarter versus 11.8% last year an improvement largely related to continued focus on cost cutting efforts not only in the U.S. but also in our European operations. Operating income was 9.2% in the second quarter 2006 versus, again on a reported basis operating income last year was 5.3%, but you really have to strip out that $45.5 million charge related to the Crystal Springs settlement last year to get something comparable. Last year excluding that charge was about 9.4%. So 9.2 this year versus a comparable 9.4 last year. However, this year also had, again, the expense related to options that we didn't have last year. And if you exclude the expense related to options, operating income margin in the second quarter was about 9.5% versus that 9.4% last year. Again, we continue to perform in the first and second quarter this year in line with our expectations to be able to drive the top line sales growth and to maintain margins in, and again, what continues to be a difficult environment.

Research and development spending was 47.8 million in the quarter, a little over 4% versus 40 million last year a little bit below 4%. The spending is notched up a little bit.

Continuing down the income statement affiliate earnings for the second quarter were up versus the second quarter last year due to the continued strength of our Asian joint ventures where we don't own a majority share and can consolidate. These are unconsolidated joint ventures, and they continue to do well there in Asia. Interest expense year-over-year was flat. The effective tax rate in the quarter was 28%. Again, that tends to be in line with our current estimate for the full year 2006. Second quarter tax rate reported was 22.5% and again excluding the Crystal Springs related charge on a normalized basis it was about 29%. The effective tax rates a little bit lower in the quarter, and you remember, for the full year last year we ended up at about 28%, and we adjusted that later in the last two quarters.

Before we review our segment performance, I would like to point out again as we did in the first quarter that, effective January 1st we assigned an operating facility that was previously reported in the Engine segment to the Drivetrain segment, its product shift mix -- mix shifted, and so when we compared a prior period segment amounts, they're actually been reclassified to conform to the current year's lineup versus reporting last years, just so, if you're carrying over old numbers, you know the conference.

Now, let's focus on Drivetrain segments, operating performance, consolidated sales were down 1% in the quarter. The group continued to benefit from growth outside of North America including the continued ramp up of dual clutch transmission products, as well as torque transfer product sales in Europe. In the U.S., however, the group was negatively impacted by the lower production of light truck and sport utility vehicles equipped with our torque transfer products and also some lower sales of a tradition transmission products. Growth in the Asian market for this business shows up in the income statement as affiliate earnings, and therefore it doesn't get reflected in the calculation of sales growth here. If we included the sales of our joint venture which are unconsolidated, if we included those in the math there, actually the drivetrain sales were up about 2% in the quarter versus last year.

Looking at the EBIT margin in the quarter, and this is on a consolidated basis, EBIT margin was 7.4% versus 7.8% last year. Not a bad job on maintaining margins and actually the 7.4% is above trend when compared with the past several quarters for this business unit. On the engine side of the business, our sales increased 8% in the second quarter versus last year, and I should point out we saw sales increases in every one of our product areas around the globe except for again the torque transfer products. The rest of our products all exhibited good growth in the quarter.

On the engine side, the group continued to benefit from Asian auto maker demand for turbo charged and timing systems first. Second, European auto maker demand for turbochargers, timing systems, exhaust gas recirculation valves, or EGR valves, and also diesel engine ignition systems. Third, also benefited from the continued roll out of it's variable cam timing systems with General Motors, high value V-6 engines and stronger EGR valve sales in North America, and then finally benefited from higher turbocharger and thermal product sales in the global commercial market where we're seeing stronger vehicle production in that segment. The engine group EBIT margin was 12% in the quarter, down slightly from the 12.3% reported in the second quarter 2005. If you look at the incremental income on the incremental sales for the engine group in the quarter, it was about $0.09 on the dollar.

Let's look at the balance sheet now and the cash flow. We'll talk about the -- both of these. And if you look, our investment grade capital structure continues to be strong. Our debt to capital was 27% at the end of the second quarter, down slightly from the 31% at year end 2005. From a cash flow perspective net cash provided by operating activities for the six months of 2006 was $233 million up from 186 million last year, good strong performance there of close to $50 million. Primarily due to improved operating performance.

Regarding working capital levels from a balance sheet perspective, if you look at our net operating position at the end of the quarter and again we define working capital net operating position as receivables and inventories less payables and accruals. If you're looking at that metric it increased $42 million in the first six months of this year or since year end 2005. Half of that's still related to currency. The weakening of the dollar relative to the Euro primarily resulted in reporting our European assets in a higher dollar value in June 30th versus December 31st. The other half was related to business activity levels. As we remind you quite often, if you look at the sales activity in our business at the quarter end of March or the quarter end of June relative to the activity in December, it's quite a bit higher which results in an investment working capital primarily related to receivables.

Capital spending for the first six months of the year was 113 million, and together with net tooling out plays of 32 million totaled about $145 million. That compares to 113 million last year. So, as we continue to grow our business, we continue to invest. Not only invest to grow the business, but also invest to help continue to focus on cost reduction and productivity improvements in our manufacturing operations. From a return on capital perspective, our after tax return at the end of the second quarter on a rolling four quarter basis remained basically unchanged from year end at approximately 13%.

Now let's talk about the outlook for 2006. As Tim mentioned, we've tightened our 2006 full year earnings guidance to the high-end of the previous range. Our guidance has changed from 4.22 to 4.57 a share previously to now $4.35 to $4.60 a share. So we moved the bottom up from 4.22 to 4.35 and basically the top is pretty much the same. The change in our guidance includes a change in our expectations primarily of foreign currency impact on our business in 2006 versus 2005. It also includes a cautious outlook for the remainder of the year. As expected, the industry environment was very challenging in the second quarter with frankly a little evidence that it will improve in the near term. In spite of this BorgWarner was able to execute its growth strategy and continues -- expects to continue to do so for the remainder of 2006.

And with that I will turn the call back over to Mary. Thank you.

Thank you very much, Robin. I will now ask Courtney to give you the Q&A procedure. Courtney?

[OPERATOR INSTRUCTIONS] Your first question is from Brett Hoselton with Keybanc capital market.

Good morning or good afternoon.

Hi, Brad.

Hi, Brad, how are you doing.

Doing good. How are you guys? So it sounds like what you've done for the guidance is you've just basically said that you're expecting a little bit stronger foreign exchanges and you're kind of raising it because of that but that maybe you're getting a little more cautious because you're seeing a little bit of head wind on the sport utility and light truck sales side of things. Is that a fair assessment of your adjustment?

Actually, Brett, the adjustment is more currency. We are putting out a word of caution with respect to the North American sport utility vehicle market for the back half of the year. But if you look at the gist of the adjustment, fundamentally we expect our business to perform for the year pretty much as we expected before. The biggest change is primarily currency.

So you're just simply looking at the light truck as possibly a risk in the back half of the year if we see major adjustments in terms of production and so forth?

That's exactly right. We have factored in what we know today, and we continue to feel that there is a possibility some risk related, this is an industry that's difficult for all of us to predict. We think we have a pretty good handle on it, but there is some risk out there we need to point that out.

Okay. SG&A was a little bit lower than I expected in the quarter, and I am wondering, is there anything unusual in the SG&A line this quarter? And then, as we look forward, your expectations, I was thinking we would see a run rates of kind of around somewhere in the 11% range or so. What are your thoughts there?

You know, it is a little bit lower than actually we would have expected when we started the year. It goes to the ingenuity of our operating guys. They continue to work the whole side of the income statement, which was they try to offset the raw material price increases that they're seeing, and some of the increases they're seeing on the healthcare side. So, as I said earlier, some of this reduction versus last year is at the corporate level, and I think some of you know we transitioned in 2004 and 2005 from Chicago into Detroit, so we should experience lower levels of spending at the corporate level, but also there has been some increased focus in our European operations at the SG&A line. And, as I said, our operating guys manage to operating income, and they're working all ends of the spectrum to try and control costs.

Well, yes, the thing I'd add, Brett, to that is if you'll -- as you'll notice, we increased our actually had a slight increase in our R&D spending. So, none of this is coming at the expense of R&D spending. We're up at around 4, 4.1% range. We typically struggle to get to 4% because of growth. I think this whole thing on SG&A is a good testament to how well we managed our, what I call our disciplined cost reduction approach, in the way the operating guys are really controlling their costs just like Robin said.

And finally, has there been any changes in two different things in the last quarter. One is the ownership of Beru and secondly DCT, is there any meaningful changes in either of those things, new contracts or anything along those lines?

No change in the ownership of Beru. We're currently satisfied with our current position. As far as DCT, we're continuing to go see positive market acceptance on all continents now. You're going to continue to see growth in DCT in Europe, and we're right on schedule, and basically our customer base is trying to increase their production volume as we speak, which is the Volkswagen Audi family. You're going to see dual clutch transmissions moving towards North America, and you're going to see them in multiple countries in Asia. So, things are growing just like we expect. I mean like every CEO, I would like to see it all tomorrow. I don't mind staggered growth. We're in this for the long haul.

Thank you very much, gentlemen.

Thanks, Brett.

Your next question is from the line of Jon Rogers with Citigroup.

Good morning.

Hi, John, how are you doing.

Pretty well. I am wondering, Tim, if you could kind of give us more of a big picture strategic outlook. Does the 4-cylinder engine mix is obviously positive, but are you really seeing more of an interest in North America in turbochargers and when do you think that might hit your revenue line?

I think that you're going to see growth in 4-cylinder engines and turbochargers in North America. One, a couple things. You're going to see boosted gasoline engines, I think, over time. At these price levels for gasoline you're going to see boosted engines that are going to be down sized. There is no doubt in my mind. And as far as diesels are concerned, you're starting to go see a lot of positive press and a lot of what I think will be market acceptance as some of these European diesel vehicles, some of them at the premium end but some of them at basically the mid-sized and compact car segment, and you're going to see good acceptance, so all of that will -- both of those items will allow for increased turbocharger sales in North America. It is just a matter of time for each one.

On a global basis, I can give you one statistic. The typically the V-8's were typically about 35% of the market and 4-cylinders were maybe 30% -- 25 or 30% of the market. The V-8's have dropped 5% and the 4-cylinder market penetration has increased 5%, and V-6's have stayed roughly the same. I can't remember all the math, but basically I can tell you right now globally 4-cylinders are growing, and V-8's are shrinking, and that has a lot of impact on the North American market or a lot of influence by the North American market.

Maybe one from Robin. As I look at the balance sheet, it's just -- balance sheet debt has decreased again. Can you just kind of rank where you think the uses of cash are and I guess as a follow-up to that, is there any advantage to owning Beru 100% versus just a majority position like you have now?

Great question, Jon. Let me rank the importance of available cash flow. First of all, we're always looking for a transaction from acquisition perspective that can add significant value to the Company, from a technology perspective and also from an economic value perspective, so that is our number one priority. However, we are pretty disciplined, and we don't expect to find an acquisition every other day to make. So that's something that we are committed to continue to focus on, but those are far and few between. So it's not something that we can count on tomorrow.

The next thing is we do have a healthy dividend program in place. We're certainly going to maintain that. Our history has been to reflect the strength of the business each year with an increase to that dividend, and we will be reviewing that in the latter part of this year again. Four years in a row, Tim hit me over the head with, he has increased the dividend. Obviously, as you point out from a cash flow perspective and a debt perspective, I think our debt levels are getting a little bit more in line with where we'd like them to be. We do have a stock repurchase authorization program, about a million shares right now that always is an option for us to become active.

Having said all of that, your question specific to Beru, the way we run BorgWarner we have individual business units that are pretty autonomous and run as semi independent entities and organizations. That's why the Beru acquisition for us fits in very well with the culture and the methods that we use to run our businesses. So owning 100% versus the approximately 70% we own today is more or less driven by financial considerations than the ability to run the business because as I said it's not very different from how all of our other businesses are structured. They also have a business unit president, a vp finance, an advanced engineering group, their own sales organizations and on and on and on, very similar to how a stand alone company would be. So, really it comes down to more a financial decision than a critical operating decision.

Having said that, it's always nice to own more of something you think highly of, and we certainly had an interest to own 100% of Beru. In fact, when we did acquire the two-thirds of Beru that we did, we tendered for the rest of the stock, and unfortunately because of the activity in European market, primarily there's some active, I will call them hedge funds, that bought the remaining part of the share there and did not want to tender, so we were unsuccessful in buying 100%, but we did try to do that, and so that's where we stand today. As Tim said, we're very happy with our current ownership position, and there's nothing forcing us or no pressure to buy the other 30%. As we mentioned before, we've had 50% ownership in a company in Japan for --

43 years.

43 years, and it is how we approach the market as I said earlier in Asia. We can't consolidate the sales, but I think everyone sees the importance of that business to us financially, and the importance of that business to us from an overall market perspective. So we're very used to owning and running businesses where we don't own 100%. Our BorgWarner automotive Korea operation is the same thing. We own about 60% of that entity, so I think that's enough said about Beru.

Okay. Thank you.

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

Good morning, everybody.

Hi, Rod.

I've got a couple questions. First, can you give us what your new FX assumption is?

Our expectation for currency from earnings per share impact perspective, we were looking $0.25 to $0.12. Right now we're probably looking at about 12 to 7. That's a mix of predominantly driven by the currency impact, we've seen it. Remember, we've already seen $0.07 a share for the fir six months of this year. The, primarily the rest of that is yen related. Obviously the Euro, dollar relative to the Euro has cooled down a bit. The rest of the year the concern is more on the yen.

You're still looking for a drag?

Possibly, yes. Again, driven by the yen.

And your Euro assumption and yen assumption?

Relatively flat. We're looking at the Euro relatively flat for the rest of the year, and a little bit of strengthening of the dollar versus the yen.

Flat at current levels like 1.27?

Closer to 1.25.

Did you take down your local currency earnings assumptions or is this basically all of the adjustment?

From a guidance perspective?

Yes.

All currency related.

Okay. Just clarification on this SG&A, it's remarkably low, as Tim mentioned on the -- considering what R&D is doing, and I think you guys are putting the option expensing in there, too. Is this kind of a new benchmark, I mean, should we be thinking that like -- as a percentage of revenue or an absolute basis that this is sustainable?

Certainly a lower level is somewhat sustainable, but again our SG&A will fluctuate by quarter depending on sales activity, in that [inaudible] expense and all our activity, our admin expense and operations expense which can fluctuate quarter to quarter. But we have seen some reduction in overall spending in that line item that we expect to continue for the year, but there will be fluctuations quarter to quarter based on circumstances.

Okay. But as a percentage of sales, do you think this level is realistic?

It -- as I said, it might fluctuate quarter to quarter. It is not going to go back up to 13%.

Okay. Can you talk about your expectations for the Drivetrain business in the back half? You were talking about the Pacifica business and there's the MDX falling off. What are your expectations for that business?

Rod, we're contending to grow in Europe. We're continue to go grow in Korea, and we've got the Q-7 and we're continuing to grow with the Hyundai Kia family, and yes, the Pacifica's going to kick in. So as far as the SUV and light truck, well, everything we know of to date, I think Robin said this earlier, everything we know of, in terms of schedule cuts in the SUV light truck area, has pretty much been baked into what we -- into our current guidance. But it is only what we know today, and we -- I think we've done a pretty good job in the past of predicting what's going to happen and we're fairly cautious about that market.

You think from a revenue stand point you could be fairly consistent with what you've been showing in the first half? Just thinking about the Ford production cuts in particular being pretty aggressive looking into the back half?

One thing you've got to remember, because we have a balanced portfolio, some customers go down, but some customers go up as part of that portfolio balance. So, some of the North American OEMs may see some schedule cuts in some of these markets that have a large impact on drivetrain, but yet we pick it up somewhere else. We may pick it up in our joint venture. We may pick it up with one of our foreign customers.

Okay. One last thing, can you just address some of the head winds that you're seeing in terms of the conversion in the engine group? Looks like you are getting conversion here on the additional revenue, but it's lower than what we have been seeing in the past.

It is primarily in two areas, raw material costs as well as healthcare costs.

Can you specify what what raw material costs headwinds were for you?

For the Company in the quarter it was $6 million. I don't have it broken out.

What we projected all along on this 25 million for the year, and we're still holding roughly with that, and that was one of the things Robin point out earlier.

Great. Thank you.

Your next question comes from the line of Chris Ceraso with Credit Suisse.

Thanks. Good morning, everyone.

Good morning, Chris.

A few items, a couple of quick ones. First, any impact from the labor issues at Hyundai in Korea that you'll feel in the third quarter or that you may have felt in the second quarter?

Not that we know of. No, so far -- whatever impact there may be, which I don't think is much, is already accounted for in our forecast, and our guys are pretty well connected with Hyundai, so I think we're okay.

Good. In Europe can you give us an idea just roughly how much revenues were up? And then as a follow-up on that, it looks like some of the French -- some of the key French vehicles were kind of weak in the quarter, some of the important VW vehicles were weak. Can you tell us to the extent you did grow revenue in Europe? Did it come from taking share from other customers or some of your particular product that were growing in terms of penetration, maybe just a feel for how things panned out in Europe in the quarter?

I can give you a little bit just before we dive into some numbers. One thing you've got to remember is in Europe we're pretty strong on diesels, and diesels are staying pretty strong in Europe. So where you may see customers, and some of the customers you mentioned, may have seen overall volume shifts downward, or maybe volume mix changes, the diesels are still staying strong, so overall for the Company, European sales were up about 9 -- 9.5%.

Okay. And then just lastly, if Robin just if you can clarify on the cash flow, it sounded like working capital was not a big source, but it looked like the cash flow was pretty strong in the quarter. Was there some other one off or source of cash that helped the cash flow in the quarter?

Well, obviously you get deferred taxes moving around a little bit. But we did receive a dividend from one of our subsidiaries.

How much was that?

I don't remember the number, but it was north of 10 million.

Okay. Perfect. Thank you.

The next question is from the line of Scott Merlis with Thomas Weisel Partners.

Good morning, everybody. How are you? How do we think about your torque on demand capacity utilization? More specifically, full truck based SUVs, if we assume are permanently lower levels, is that requiring capacity rationalization, how are you going to fill those? Are you assuming the same? And when do you -- what's the timing on refilling the plants? And then I have another question on cost reductions in general.

Why don't we jump on this first one. Yes, you're seeing a first of all, our four-wheel drive business we're starting to develop a pretty global customer base. I can't mention all the customer names. Suffice it to say that we're becoming fairly global. As volumes ramp up with some of the foreign auto makers, both now and in the future, they will help offset some of the demand or some of the -- I am sorry, the volume that we will have lost with some of what our traditional domestics. Yes, we will have to restructure capacity in North America, and yes we are restructuring capacity in North America, and the restructuring will be over time an elimination of capacity in North America although, you will see -- you will probably see somewhat of a potentially see over the long run, maybe a different change in mix in our customer base even amongst some of the North American OEMs. So, we will probably be doing both. Downsizing our capacity or restructuring capacity in North America at the same time we'll be trying to sell some of that capacity with and spread it around various OEMs.

So.

Both North American and non-North American, but you're seeing us. We have a plant in Korea right now that we've opened up and we're growing and we're localizing some of our four-wheel drive, all-wheel drive manufacturing in Korea. We're increasing our volumes daily as the Audi Q-7 ramps up, so you're starting to see -- actually you're starting to see global usage of transfer cases, and you're going to see a redistribution of capacity.

So when you combine those -- that rationalization with your other cost reductions, which are many, how do you think about or how should we think about modeling gross margins over the next year or two? Do we look at gross margin -- do we look at all the new rationalizations and the cost reductions as something that should expand margins from these levels or do we look at it as protecting the downside of your margins because there is so many pressures in the industry?

Initially we're going to do everything to minimize the down sizing of margins, I guess to use your phrase, but in terms of -- we're going to try to maintain our margins as much as we can by using every cost reduction tool and option available. In the long haul, I would hope that it will be eventually be an improving margins as redistribute capacity and rebalance the customer base.

So moving capacity to lower cost countries could have a meaningful effect on margins over time?

You've got to understand, we don't go to low cost countries or outsourcing or anything like that. We go to support the local OEMs in those regions. And what you're seeing is local OEMs in Korea and Europe and other parts of the world are starting to use rear-wheel drive based vehicles, and converting them to all-wheel drive because of their need to stay competitive in the marketplace. We aren't going to other countries for outsourcing reasons. We're going to support growth in the four-wheel drive, traditional rear-wheel drive four-wheel drive business in those other countries, like I said, India, Korea, Europe, and we may support other countries around the world from some of those other plants rather than maybe a higher cost North American plant.

Okay. And just a follow-up on a previous question, you were -- we were discussing 9.5% sales growth in Europe in the quarter. Is that right?

Yes.

Isn't a majority of that your net new business? And then, basically didn't that help you overcome some down production? I know diesel held out better than the market, but certainly there is some diesel products that are having down production.

Well, it's a combination, really, of -- it is probably mostly net new business. A lot of that is on the drivetrain side, and it's due to dual clutch transmissions and some of the four-wheel drive business that we have over there with Audi.

So I'm just thinking if the head wind of down of a weak production environment in western Europe stabilizes, does that give you any more throughput and operating leverage?

Could you repeat the first part that far question, Scott?

There seems to be weak production numbers coming out of Europe. Do you benefit at all and when this stabilizes are you going to pick up more throughput or are your plants still running flat out?

Our plants -- for the most part our plants are doing very well, because we're on the growth portion of the European market. Now, if, in addition to the growth portion that we're already on there is growth in other parts of the European market, we're going to benefit even more. I think the answer to your question is, if the flat parts of the European market start to pick up again, yes, we're going to pick up some of that because your timing drive business -- timing chain business or automatic transmission components and so forth.

Right. Thanks. That answers my questions. Have a good day.

Thanks.

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

Good morning, everyone.

Hi, John.

Just a question on the Acura RDX specifically and then maybe branching that out to you, sort of the forward strategy here. You guys have you a great relationship with Honda and particularly you had launched with the ITM on the MDX. I was wondering what happened there with that program on ITM or torque management system? And then also that's one of the early vehicles here as a 4-cylinder and a turbo in the U.S., and it doesn't sound like you got that either. I was wondering what happened with that? And if we step forward in the CUV market, it sounds like there may actually be more opportunity with the domestics here as they launch more of these CUV's, particularly GM and Ford at the end of this year. I was just wondering where you were on bidding on those contracts with the big three? And that might be more of a growth area than the Japanese given what happened with the RDX.

We're bidding on all the options whether they're North American opportunities or European or Asians. Now, regarding Honda, let's put it this way. Honda's volumes are continuing to go grow, both the pilot, the ridge line and the RDX and basically Honda has always made some of it's production inside their own shop. So, our volume is continue to go grow with Honda, but they also have historically done some internal manufacturing of these type of products, and I think they've decided to keep some of that know-how and technology within some of their own manufacturing base, if for no other reason then they have to employ some of their own workers. But we will continue to grow with Honda. We have a great -- like you pointed out, we have a great relation with Honda, both on the engine side and the drivetrain side.

On the turbocharger side of the business, we're going to Asia. We weren't exactly early into Japan. Japan turbocharger markets supplied by a number of Keiretsu companies. But I will say our competitors was in Japan long before we were, or actually long before we were in the turbocharger business. But we're making penetrations and -- increased penetration in China and Korea and India for turbochargers, and we have lots of discussions going on with the Japanese OEMs. It just takes time.

And then specifically on the turbo market both domestically in the U.S. and internationally, do you think that that market is going to grow more on the diesels, particularly in the U.S. or is it going to be a function of the down sizing of the engine going to GDI's where you have real leading technology in your turbos? If we go towards GDI's, you guys have you a pretty good competitive advantage versus anybody else out there. Is that correct?

Yes, we do, and I think what you're going to see is, I agree with what you said about the GDI's. We will continue to see growth in the GDI's first, John, and we will eventually going to start to see increased penetration of diesels in North America. But at first the diesels in North America will be coming from foreign manufacturers, I think. You're going to see these premium vehicles coming out of Europe. As an example, right now I've got an order, a Audi Q7 with a 3-liter diesel on it. You can't get that in North America right now, but it's on order in Germany, and it's just a matter of time before those type of vehicles come over to North America. There will be some other that you're starting to see diesels coming now and same with the Japanese, they're coming with diesels. It is just a matter of time on diesels. I think your gas engines with turbochargers will probably be first.

Okay.

You may be seeing the down sizing phenomena.

Thank you very much.

Your next question comes from the line of Robert Barry with Goldman Sachs.

Hi, guys, good morning.

Good morning, Robert.

Just a follow-up actually on that question. If you expected to see diesel or turbo or both in North America in the next few years, would that necessarily be in the backlog or backlog already?

Probably some of it is in the backlog because of some of core manufacturers that we're already working with or already in production with. And they have plans to export into United States with some of their diesel applications. But I think it takes engine programs are long in the development stage, and they're three to four years in development at minimum. So as you're working some of these programs you're going to see them most of them are going to be outside the scale of our -- or the time frame of our three-year backlog which is which was '06 to '08.

Right. Okay. And I was wondering if there were any of your products in particular that you thought would see a significant lift from the new emissions regulations that are coming in Europe in '07.

Well, all of them will see a lift. There is no doubt about that. I think the one that's probably the hidden gem in the areas is variable cam timing. I continue to say we have leading technology and slowly but -- it is a technology that's very hard to understand, and you have to be an extremely good engine expert and understand engine calibration to understand the true benefits that this technology can bring to the party, both in terms of emissions reductions and fuel economy benefits. And slowly but surely our customer base is catching on and we're in there are a number of development programs on variable cam timing.

And what are the margins like on that versus the other products?

I don't comment on margins, but typically new business tends to be better than business that's long in the tooth.

Right. Gotcha.

Not materially, though.

Okay.

Not materially.

And then a question on your Nissan exposure. I know that right now Nissan is a relatively weak point in the product cadence, but that's set to change later this year. Can you comment on what your exposure is on, kind of, current Nissan and how it might change with rolling into the new products they're launching?

Well, we do business with Nissan through a number of directions both on the engine side and some on the drivetrain side and some through our joint venture in Japan. We have good relationships with Nissan. We are growing with Nissan. I don't have the exact Nissan numbers in front of me, but I am pretty sure Nissan will be one of our growing customers.

Just a quick follow-up -- Actually, when you talk about Nissan you also have to talk about Renault.

Give you an idea, Renault and Nissan is roughly about 6% of our business, which is a fairly sizable amount, and I don't have the break down between Nissan and Renault, but we're actually, I think, growing with both of them.

Okay. And then just a follow-up on the question earlier about use of cash and the balance sheet. I was current what your current discussions are with rating agencies, and if you had any rating targets in mind in terms of balance sheet reform, et cetera?

A minus rated by S&P, and B-AA2 by Moody's, that's a two-notch difference. We enjoy talking to both of the rating agencies on a routine basis, and however we are a little befuddled by the two-notch different. But we continue to talk and we're very comfortable with where we're at from a rating perspective. We do like to be solid investment grade, and we think our balance sheet reflects that.

Thanks a lot, guys.

Thank you.

We have time for one final question. That question comes from Jonathan Steinmetz with Morgan Stanley.

Thanks, everyone. I had a few questions on the cost side. You talked about the R&D being up to about 48 million versus 40. Can you talk a little about what drove that increase, was there anything that maybe was a one-time in nature and comes back out or is that sort of the right level?

Jonathan, we've said before we target to spend 4% of sales. It was about a little over 4%, maybe around up to 4.1. We continue to try and spend at that 4% level. Last year we lagged a little bit. There's nothing that's out of the ordinary there that is where we'd like to spend. Tim talked about DCT. We've got a lot of activity going on there, so that is part of the uptick in spending on the R&D side, but generally it is throughout all of our business units. And we are striving to try and do more on the R&D side to ensure the future growth programs that we want to participate in to help drive this company at 8 to 10% top line growth rate going forward that we can take advantage of those. There is nothing unique there. It's been our target for a number of years to spend at 4%, and again we're right about there, a little bit higher. I would say maybe last year was a little lower.

Last year was lower mainly because of sales, it is tough to -- let's put it this way. We do zero-base budgeting on R&D expense. We don't target -- we would like to spend 4% because we think that's a nice sustainable number that drives good growth in the Company. But we still build it up as a zero-base budget.

Okay. On the D&A side, if I am doing my math right, it look like the D&A was actually down a little bit year-on-year, which I wouldn't necessarily expect with the CapEx where it's been. First of all, is that accurate? Second what's driving lower D&A?

That is accurate. Actually that's on a GAAP basis. If you remember in the first quarter of 2005, we reflected the initial write-off of excess purchase price related to in-process R&D with when we acquired Beru. That's really the difference.

Okay.

Depreciation and amortization on a normal basis is actually up this year.

Okay. All right. Lastly, you talked about the SG&A reduction being a function of sort of solid efficiency in each of the business units and everybody taking a hard look at things and that kind of thing. Can you give a couple of examples of places where you're able to save? It's pretty stark savings here.

First of all, let me say this, if we look at this level of SG&A, it's actually higher than the fourth quarter of last year. We've been at the levels before. And, in fact, fourth quarter of last year our SG&A as a percent of sales was 10.4 we're looking at about 10.6 this quarter. As I said, our SG&A fluctuates by quarter based on business conditions, activity in the operations side, and also fluctuates a little as a result of some of our increased after-market activity with Beru.

But, having said all of that I can tell you again, regionally where the activity took place, obviously the corporate headquarters, and as I said, last year we were in transition from moving our headquarters from Chicago to Detroit. We had double costs involved in that as we transitioned staff, and we no longer have those costs going forward. That's one specific. And then, our operations in Europe, a number of our operations in Europe spent some time looking at their spending relative to the discretionary items in the SG&A line item and took some efforts there. We continue to look at our organization and our cost structure. The focus was -- in the U.S. at the corporate headquarters and that's a function of transition, and last year you could argue it was a little too high because of the transition, and then the increase focus in our European operations, and --

The other thing I would add is having come from somewhat of a very decentralized company, we are working on initiatives to basically go to a shared services concept on some of the back room areas where the world doesn't care, nor does -- we need duplicate areas in HR or accounts payable or maybe even in purchasing where we're working on some things where we're combining, so we're going to a shared services concept that's also bringing down some -- creating some benefits for us on SG&A.

That's a great example. Let me give you something specific. We used to negotiate licenses for our software around the world individually, each location. We've consolidated that purchase of software and licensing and saved a significant amount of dollars, again primarily in Europe, and I am not going to mention the provider, by negotiating on a BorgWarner basis versus an individual entity basis. That's just an example of the kind of things Tim is talking.

Excellent, thank you, guys.

Thank you, Tim and Robin, and thank you all for joining us today. We've run out of time, but if you have any follow-up questions you can direct them to Ken Lamb or me and with that we will end the call. Thank you.

This does conclude the BorgWarner 2006 second quarter earnings conference call. Thank you for joining. You may now disconnect.