Martinrea International Inc
TSX:MRE
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Martinrea International Inc
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Good evening, ladies and gentlemen, and welcome to the Martinrea International Second Quarter Results Conference call. Instructions for submitting questions will be provided to you later in the call. I would now like to turn the call over to Mr. Rob Wildeboer. Please go ahead, sir.
Good evening, everyone. Thank you for joining us today. We always look forward to talking with our shareholders, and we hope to inform you well and answer questions. We also note that we have many other stakeholders, including many employees on the call, and our remarks are addressed to them as well as we disseminate our results commentary through our network. With me are Pat D'Eramo, Martinrea's CEO and President; and our CFO, Fred Di Tosto. Today, we will be discussing Martinrea's results for the quarter ended June 30, 2022. I refer you to our usual disclaimer in our press release and filed documents I will speak briefly. Pat will speak, then Fred and we'll do some Q&A.
I am going to be very brief today and focus on one takeaway point for you and one only. Better times are ahead for us and for automotive suppliers. Write that down, embrace that concept and brand it on your foreheads. Despite all you read about war in Ukraine, interest rates, inflation, recession, house prices, supply chains, labor shortages, erratic production schedules, cyber, pandemic, climate change, tariffs, Joe Biden, Donald Trump, whatever, so much doom and gloom. Despite all that, better times are coming for us. As this quarter shows, we had a good quarter, making decent money even today and will continue to improve. I want to enter this outlook in detail in my speech at our Annual General Meeting in June. You can see it or read it by accessing our website. I won't repeat it here. It's fairly lengthy with a lot of data.
The fact is that automotive parts suppliers, note I'm saying suppliers, not OEMs or dealers, have been in a recession for over 2 years. We are hit when production volumes are down. We were hit badly in 2020 when the industry stopped for 3 months. The second half of 2020, we came back strong. But since that time, we have been hit by supply shortages, inflation and so on, but things are looking up. For us, production is going to increase from here, and that will help us. Even if there is a general recession next year, production volumes are up. That's what drives our revenue and profit to a great extent. There's a lot of demand for what we make. Inventories are low and people got to buy vehicles. Sales are down these days because production is down. Sales will go up as production does and production will go up. Pat and Fred will talk about our company, operations and financials, and you can see the strength of our company and what we are doing in so many ways from them. But once again, my point is this. Things are decent now, and they're going to get better. I believe the company and our outlook have never been stronger.
And now here's Pat.
Thanks, Rob. Hello, everyone. As noted in our press release, we generated an adjusted earnings per share of $0.32 and an adjusted operating income of $46 million in Q2, up 17% year-over-year. Production sales came in at $1.1 billion, up 25% year-over-year. Adjusted operating income margin came in at 4.1%, much improved over Q3 and Q4 of 2021 and better than Q1 of 2022 on lower production sales. While the production environment has improved compared to the back half of last year, we continue to deal with supply-related disruptions with our customers. At the same time, we've made good progress on recovering inflationary costs through commercial negotiations. I'm proud of the team. This is a cumbersome activity, and they have worked diligently throughout the year with our customers.
We have concluded a number of agreements on favorable terms and will achieve more inflationary adjustments before wrapping up these discussions. The negotiations are ongoing, and we expect them to be substantially complete by the end of the year. Keep in mind, commercial discussions tend to be a normal part of the business, though at a much lower level. We are making good progress on margin recovery. Having said that, margins are still below our potential and our outlook for next year as we continue to be held back by cost inflation, program launches, primarily where customers have not achieved ramp volumes due to chip and other supply shortages as well as continued production disruptions.
On the cost side, energy remained a significant headwind in Europe. Natural gas prices continue to move higher, which impacts our overall operations in the region. As discussed earlier, we are looking for our customers to share this inflationary burden. Other commodities such as steel and aluminum are beginning to normalize from very high levels. Of course, a large portion of our input costs, but not all, are protected from price fluctuations in these commodities through OEM resale agreements in the case of steel, and other pricing pass-through mechanisms in the case of aluminum.
Overall, while the environment remains challenging, our Q2 performance is where we expected it to be, and our results are expected to improve in Q3 and beyond as these challenges subside in customer productions moves. This should set the stage for a multiyear period of strong production volumes, margins and free cash flow with the majority of our plans essentially running at full capacity as vehicle inventories remain historically low and demand still high. As such, we expect 2023 to be a strong year for us.
Turning to North American operations. Our Q2 operating income performance was generally consistent with Q1 on lower production sales. As mentioned, we are still seeing disruptions from the customers, though better than we saw last year, particularly in the back half of last year. And as I mentioned earlier, we are making good progress on recovering inflationary costs. We continue to launch on the largest book of business in the company's history worth $800 million in annualized sales once these programs reach mature volumes. As I've said over the past year, this record program activity has resulted in higher-than-normal log costs, which has been compounded by the volatile production environment we're experiencing. The good news is we are now hitting an inflection point where you should start to see these costs decline more meaningfully, resulting in better margin performance.
This, of course, assumes that customers are meeting ramp-up volumes, which so far is hit and miss. Post-pandemic, with continually improving supply issues, we are picking up progress on our Lean or Martinrea operating system activity. Resource constraints inhibit speed, but as the workforce stabilizes, we continue to see great potential. This, along with continued commercial settlements will improve our margin profile as well.
Turning to Europe. Operating incomes were positive this quarter, given the recovery of inflationary costs and continued operational progress. Energy cost remains a significant headwind in this segment. And as such, we are devoting a lot of time and effort to recovering our fair share of these extra costs. We are still a long way from where we need to be in Europe, but I'm happy with the progress being made in the face of some pretty significant challenges.
In our Rest of World segment, we continue to perform close to breakeven, given weaker volume and mix year-to-date as well as the strict COVID lockdown measures in China, which made it difficult for people to come to work in both our facilities as well as our customers' plants. I'm pleased to announce that we have been awarded $85 million in new business since our last call, $70 million in our lightweight structures group, which includes additional volume on the Ford Mach E and additional content on the GM BEV3 electric vehicle program. In our propulsion systems group, we have a $15 million addition in volume. As you will note, we continue to win meaningful work on EV platforms with key customers.
Now I'd like to look forward and take a moment to talk about the great progress we are making on our Project BreakThrough strategy. Launched in 2019, Project BreakThrough is both a product strategy as well as a commercial strategy. It involves the company marketing itself to customers through 3 major product groups: lightweight structures, which includes body in white, suspension and other structural applications, primarily steel and aluminum; propulsion systems, which relates to products that propel or stop the vehicle, products like engine blocks, transmission housings, battery enclosures, electric motor housings as well as fluid system products, including thermal management solutions; and last, our flexible manufacturing group or FMG which includes automotive module assembly and components for various industrial applications.
In essence, Project BreakThrough is intended to grow our revenue and margins by providing more value-added products to our customers. That represents an evolution in our business model from being a supplier of components that are more commoditized in nature to one that provides highly engineered systems and assemblies that often contain multiple unlike materials. This involves combining different types of steel and/or aluminum using complex joining methods, a capability in which we are quite advanced. Project BreakThrough also is intended to forge deeper long-term partnerships with our customers by providing them with a reliable product engineering source, an area that we have grown and have strong capability.
We've introduced a number of breakthrough products to our customers since launching the strategy in 2019, which are unique in the marketplace. We spoke about a number of these products at our AGM back in June, and we have published an investor newsletter called Project BreakThrough Progress to Date, outlining these products. I'll touch on a few of these, but I would encourage you to check up a newsletter and the video from our Annual General Meeting, both of which are available on our website.
First, the Stellantis Jeep Grand Cherokee front rail assembly. This is the front rail assembly on the new Grand Cherokee. It contains multiple materials as well as advanced technologies and joining processes, and therefore, has a high degree of value add to our customer. The assembly has the hydro-formed upper tail, and a die cast stock tower that involves joining Gen 3 advanced strength steel with aluminum, using a combination of structural adhesives and advanced fastening and welding techniques. We provide these assemblies for both the ICE and plug-in hybrid variants of the Jeep Grand Cherokee.
Next, we have the front and rear sub-frame for the Ford Mach E. On this, we are fully responsible for design and development as well as validation of these products on a very tight timeline. They consist of multi-material front sub-frame that has a lower pressure die cast hollow aluminum rear attached to a welded steel front structure and a one-piece low pressure die cast hollow aluminum rear sub-frame.
Moving along, we have the Lucid Air front sub-frame which is made of hollow low-pressure die cast and extruded aluminum components. What makes this product unique is that it is joined by using only structural adhesive and rivets. There's no welding involved, which is a first in my experience. The rear subframe is a one-piece hollow aluminum die cast structure. Last for today, but certainly not least, we have our graphene-enhanced brake line that we introduced in late 2020, which has recently been named a 2022 Automotive News PACE Award finalist. GrapheneGuard is a patented technology that coats brake lines with graphene in order to provide industry-leading abrasion protection, a rate reduction of up to 25% compared to a standard brake line due to the elimination of components and improved chemical resistance and high-temperature performance.
The brake line is currently in production on 3 programs with Ford, the Ford Super Duty Truck, the Ford Explorer and Lincoln Aviator and the Ford Edge and Lincoln Nautilus as well as the Sierra and Silverado heavy-duty trucks with General Motors.
We have made some great progress in both product and process innovation since launching Project BreakThrough in 2019. We've introduced some truly unique products to the market that are complex and value-added in that they solve problems or deliver superior attributes to our customers. Some of these are an industry-firsts. I'm excited about the work our team has done to bring these innovative products to market. Innovation is ingrained in the Martinrea culture and Project BreakThrough is a cornerstone of our innovation efforts. It is a key aspect of our organic growth story and is expected to help drive sales growth and margin expansion well into the future. Lastly, I'd like to thank the Martinrea team, I'm very impressed with the work we have been accomplishing especially over the last few months, and I applaud your efforts.
With that, I'll pass it to Fred.
Thanks, Pat, and good evening, everyone. As Pat noted, our second quarter financial results were generally consistent quarter-over-quarter as the impact of lower production sales was offset by better operating margins. We continue to face the challenging environment on several fronts, including supply-related disruptions from our customers as well as inflationary cost pressures, including more recently increasing natural gas and electricity prices in Europe. Having said that, we have been successful in recovering some of these costs through commercial negotiations with our customers. I would personally like to applaud our team for their efforts on this front. They have worked tirelessly on these agreements with the aim of protecting our margins. We expect more positive results to come from this commercial activity in the coming weeks and months.
Overall, our second quarter results are right where we expected them to be. I also believe they demonstrate that the worst is behind us operationally and that the progress we have made during the first half of this year is, in fact, sustainable. And there is more to come. We expect our Q3 financial results to be better than our Q2 results as the supply chain bottlenecks improve, our launch activity normalizes, and we drive further cost recoveries through commercial negotiations. We believe our results over the next couple of quarters will set the stage for a multiyear period of strong volumes, sales, margins and free cash flow, starting with 2023.
Taking a closer look at our performance quarter-over-quarter. Production sales were about 5% lower and slightly weaker mix. We continue to work through supply-related production disruptions from our customers, so the environment is much better than what we experienced in the back half of last year. Adjusted operating income margin came in at 4.1%, better than the 3.8% we generated last quarter despite lower production sales and inflationary cost headwinds in energy and materials. The positive performance is a result of favorable commercial settlements with our customers and operational improvements, as Pat noted earlier.
As such, adjusted operating income and adjusted EBITDA were both flat in Q2 compared to Q1. Free cash flow was a positive $23.5 million compared to negative $52.1 million in Q1. The increase primarily reflects the timing of working capital flows. We continue to expect free cash flow to be approximately breakeven to slightly positive for the full year 2022.
Looking at our performance on a year-over-year basis. Second quarter adjusted operating income was up about 17% and adjusted EBITDA was up about 15% on 25% higher production sales. Recall that Q1 2021 was the first quarter we began to feel the impact of chip and other supply shortages and operations. While higher year-over-year operating results are always nice to see, operating margins are still well below what we know we can achieve. It takes time, but ultimately, we do expect to get there.
Turning to our 2023 outlook. We continue to expect total sales, including tooling sales of $4.6 billion to $4.8 billion and adjusted operating income margin exceeding 8% and more than $200 million in free cash flow. We're off to a good start in 2022 as our first half performance demonstrates. We expect further improvement as we progress through the year, starting with Q3, which we expected better than Q2, as supply conditions and launch activity normalize, and we gain some more commercial relief on the cost side. As Pat mentioned, demand for vehicles remains robust and vehicle inventories continue to trend near an all-time low, which should support strong industry production volumes for years to come.
As part of our outlook and consistent with what we have said in the past, capital spending is expected to decline to a range approximately depreciation as a percent of sales in 2023. The 2 main drivers continue to be second-generation programs on our flexible weld lines, which require less capital in their first iteration and getting past their heavy investment cycle in aluminum. This continues to be one of the key drivers underpinning our strong free cash flow outlook for 2023. Overall, we are right on track with where we expected to be at this point, and we continue to view 2022 as a transition year towards a much better margin and free cash flow performance in 2023 and beyond.
Moving on to our balance sheet. Net debt was about flat quarter-over-quarter at $931 million in Q2. As we announced earlier this year, we have an amended covenant structure with our lenders. Our adjusted EBITDA in Q3 and Q4 of last year is ignored, and the remaining quarters in the trailing 12-month period are prorated when calculating net debt to EBITDA for covenant purposes. Our leverage ratio is also subject to higher limits to the third quarter of this year.
On this basis, our calculated net debt to EBITDA under the revised terms was 2.38x in Q2, down from 2.43x in Q1, a comfortable level and well below the covenant maximum of 4.5x for the quarter. Overall, we are comfortable with our balance sheet position and expect to remain well within the covenants stipulated in our amended credit agreement. This ultimately is a byproduct going into the pandemic with a strong balance sheet as a starting point. A strong balance sheet gives you the flexibility you need to manage your way through the tough times like the last 2 years, for example. Our leverage ratio should naturally improve in the coming quarters as we generate an increasing amount of EBITDA and free cash flow, a portion of which we will use to pay down some debt. Our first half results are a step in the right direction, and we expect more to follow. We have strong relationships with our lenders, so we thank them for their continued support.
And with that, I'll now turn it back over to Rob.
Thanks, Fred, and Pat. Now it's time for questions. We see we have shareholders, analysts and competitors on the phone, also some employees, so we may have to be a little careful with our answers, but we'll answer what we can. Thank you all for calling.
[Operator Instructions] The first question is from David Ocampo from Cormark Securities.
Fred, maybe this is something that you can answer. In the previous quarters, you provided the annualized impact from the inflationary pressures. I think it was quoted at $100 million last quarter. Has that changed significantly? And probably most importantly here, how much has that been mitigated from your price initiatives with the discussions that you have with the OEM partners?
At this point, I wouldn't say it's changed significantly. I think maybe on the energy side, it's probably gone up since the last call. We are starting to see some relief on material just in the marketplace. So I think broadly speaking, it's probably in line maybe slightly higher than what we talked about the last quarter. And as relates to the commercial segments, we're not going to get into specifics on how much we're recovering there. Needless to say, we're definitely making progress. We're spending a lot of time and effort on this. And the commercial activity is not just related to customers, it's also related to suppliers. So there's 2 facets to it. And these agreements are multifaceted, very complex and pulling from various different issues and buckets of monies. So I'm not going to specifically say but we continue negotiations with the customer suppliers, meaning to say we're starting to chip away at that headwind.
That's very helpful. And then I don't know if you want to take this, but is there a leverage ratio that you guys are comfortable with before we start to see shareholder returns, whether or not through a buyback program? Just curious just given how much free cash flow you guys are guiding to for 2023?
I'll answer that. It's -- I mean, I think the focus right now is to go towards our 2023 targets. I think right now, as you get extra cash, you pay down the debt you got the revolving lines. And we'll see where we are, but it's premature to say where we are. I do think that the key focus is let's get to the free cash flow and strengthen the balance sheet. There's 2 ways to do that, of course. One is to lower the debt. The other way is to increase the EBITDA, and we're seeing good improvement on that. So the numbers are getting better. And I think what we said traditionally, 2019 before the world changed on us that we were comfortable with debt-to-EBITDA range around 1.5 or a little less than that.
The next question is from Michael Glen from Raymond James.
So just again on -- I just want to circle back to the free cash target. In the past, when you talked about free cash, you've characterized it as it could always be something that is offset if you win new business because you have to invest with that business. So which you are right -- with where you are right now looking at $200 million, knowing what the pipeline of new business potentially looks like, like how confident are you in that $200 million? Is there any large new business wins that could provide -- that could need investment upfront that might delay that $200 million?
The way I would answer that question is as follows. So we've got the organization to rally around this free cash flow target and guidance we've put out there. And we've aligned our capital programs over the next couple of years to align with that objective. So we're working within certain limits and constraints to the organization to allow us to generate that free cash flow that we're talking about. So I think at this point in time, we have a good line of sight. We have next year lined up quite nicely, and we'll work towards executing on that thinking in that capital program that we've laid out for the organization.
I think the other thing in addition to that is if you look back 6, 7 years ago when we were spending quite a bit of capital, we had a lot of space in a lot of our plants. And for the most part, the majority of our plants are full. So we can be a little more choosy about what type of business we go after versus a number of years ago, we needed to go after a lot of business.
And just you highlighted the Lucid business win. And I imagine there's others in the portfolio with some of the emerging new entrants into the market. How do you price that business versus others? Is it priced to recognize there might be some inherent risk in what volumes may ultimately look like for a company such as that?
Yes. Without getting too specific, based on -- especially in the EV market because of the -- no one's really sure how fast it's going to take off. There's a lot of media hype, but when you really boil down to it, it's going to take time. So the way you approach pricing or investment I'll say is, in many cases, adjusted. And depending on the model of the company and if it's a new company versus an old company, those adjustments may vary some. So we wouldn't go into something high risk without us believing that we had a big benefit at the end of the day.
And that doesn't just apply to EV start-ups or any start-ups for that matter. We apply risk-adjusted, thanking to all our quotes.
Where it is, what it is, regions and so forth. Yes.
And then the EPS for Q3, you're giving some directionality in terms of how to think about it. Are you at a point where you could provide EPS guidance as you used to for the coming quarter?
At this point in time, as we talked about on the last call, we're not there yet. The environment continues to be quite volatile, although much better than where we've come from. So at this point in time, for next quarter, we're confident in saying that it's going to be better than the second quarter, but explicit guidance, we're going to reassess that as we kind of get through the next couple of quarters.
You're right, though, we are being directional both for the rest of the year and next year, and I think that's going in the right direction from our perspective.
The next question is from Peter Sklar from BMO Capital Markets.
Fred, I just have a question on how you account for these commercial recoveries or exactly what you do negotiate. Are there -- like is it recoveries from previous quarters and an agreement on price increases going forward? Like what -- what exactly are you recovering? And how do you account for it?
So the accounting around essentially recognize it when it's virtually certain. And in most of those cases, there's POs in hand related to that. As it relates to the different elements to those negotiations, I mean, there's various pieces to it. Again, what we're finding is customers are pulling money from different pools internally. I would characterize it as a shell game in terms of where they can get money to help the suppliers through some of these -- dealing with these cost headwinds. So again, I'm not going to get too specific because, again, a lot of these discussions are ongoing, and they're not closed. But needless to say, we're making some good progress there, and we're finding ways to offset some of these cost headwinds.
And the reality is the whole environment is volatile, as you can appreciate, Peter. I mean we've got things going on in Europe. We've got inflationary pressures. We are in a bit of an era that we haven't seen -- you probably haven't seen over many years. It's -- so everyone on every side that includes our supply base, our customer base ourselves and probably our competitors as well are having discussions about how to deal with the environment. But you get pretty good at it when you're doing it every day.
Looking forward, as some of these things end up in the piece price, I mean that's the ideal state. Some of them don't end up in the piece price, end up having these quarterly monthly reconciliations that you work with the customers to recover. So again, everyone, every deal is a little different, and they end up being quite complex because there are so many different facets to it.
And some of it is going forward and some of it is in the past, but overall, as Fred said, the target is try to get it into base price.
Okay. Okay. Got it. Sounds quite complex. And then my other question is, like your Rest of World profitability was down. It sounds like it was really out of your control because it's due to the COVID lockdowns in and around Shanghai. And so I'm just wondering if that was the larger fact, or you also talked about some mix and like have things improve, like I would think things are improving in Q3 because my understanding is, essentially, Shanghai is out of lockdown and manufacturing is back to normal levels. Can you comment on that?
Yes. I don't know that it's back to normal levels. We're still seeing some fluctuation in China, though it's improving. But essentially, people travel some distance in the way they, I guess, lack of a better term box areas. You think about it as a grid. And if you're living in one grid and you go to another grid that happens to have some COVID event, you can't go home. You have to stay there. So a lot of people are -- it's a deterrent to go to work. This happens in both our customer plants, which is what added to the mix issue and then our own, but it is improving for sure.
Because Pat, when you read the newspaper, you hear kind of these horrible stories, what you just alluded to, is that the plants are up and running because they don't allow the workers to leave. They're literally sleeping on the floor. So I wasn't too sure -- does that mean the plants are running? Or it's like you say, it's a deterrent, so people just don't show up because they know they're going to be locked in?
It's both. And certainly, we wouldn't -- it's a government call as far as locking down in certain areas, and it does. It does both. Some people don't come to work and other people are stuck at work, but the numbers don't add up where you can run normal production with what you have, especially when it comes to our customers because they have a lot more people and the fluctuation is much greater.
Shout out to our employees in China. They are willing to stay at work. But of course, you've still got to have places to ship your product or to supply the parts.
Yes. And it's interesting. We've had plants in particular that comes to mind that basically they knew the lockdown was coming and their general manager said, hey -- they basically said, we'd like to have people stay if they want to, and we'll take care of them while they're here and then the rest can go home. And some people actually wanted to basically hang out for a week or 2. So they set them, and bedded them and ran production. But of course, at that point, our customers stopped polling but such is life.
Yes. Okay. And then, Pat, just 1 question. I mean, you're at the elevated ramp now in North America and which is suppressing your earnings. So can you call out -- are there any particular programs that are disproportionately weighing on you in terms of ramp costs that you can identify?
I could, but I would prefer not to throw any particular product or customer under the bus, but there are some that are still significant fluctuation on a weekly basis. So you'll run part of a week, and then there are some that just haven't hit their numbers yet. And some of them are pretty decent-sized programs. On the other hand, we've had some that are running full, but it definitely does inhibit things. And our assumption, in our numbers for next year are that this has now gone by the wayside and everybody's running normal production. So it's better, but it's still a problem.
The next question is from Krista Friesen from CIBC.
Congrats on a good quarter. I just wanted to ask on your 2023 target. So you've maintained your target but I'm assuming that Europe is probably tracking a bit below what you were initially thinking when you put that guidance out there and assuming it just track a bit lower in 2023. Is that what you're assuming? And are you assuming there is some offset there? And is that coming from North America? Or are you assuming that Europe is back to some sort of status quo in that energy prices are at some sort of normal levels there?
I guess the way I'd answer that, simplistically, we're expecting progress in each of the 3 segments. In North America, obviously, our largest segment, that's the one that's going to drive us for next year for the most part. It was nice to see Europe increase this quarter sequentially. So that's momentum there, and we're expecting to build off that. And the anticipation is by the time next year, as Pat alluded to, we expect some normal production, some stability. We expect a lot of these commercial negotiations of both customer suppliers to be done by the end of the year, and then we're entering the year with the right pricing in our formulas. So a lot has to happen now to that point, but it is trending in the right direction, and we're expecting each of our segments to contribute to our ultimate goals for next year.
Okay. Great. And then I guess just more on the near term as we look at Q3 and you mentioned that we should see improvement from Q2. But are you able to talk about anything specific that you're seeing in Europe? I know there was a supplier last week who said they're already starting to see some of their OEM partners dial back their schedules. Are you starting to see that yet or not yet?
No, not at this point. But the environment, again, in the last couple of quarters, good quarters considering the environment, but we're not out of the woods. We're still dealing with disruption in various different places.
The majority of conversations we're having in Europe at our plants is -- from our customers is how do we increase volumes, in a lot of cases, beyond contractual levels. Now this is in the future for them, but they're very focused on them producing more, and there may be short-term disruptions, but we haven't seen a lot so far.
Okay. Great. And then I guess just 1 last one. What are you seeing on the labor front? Are you having any issues getting labor? Or does that issue seem to have resolved a bit?
No, we're definitely still fighting through that. I would tell you it's improving some. The U.S. is by far the most complicated and difficult, but we're seeing a little bit better day by day, but it's still a struggle. Germany, a little bit, frankly, which was surprising, has tightened up a bit. And I'd say the rest of the world, we're pretty decent, other than what I talked about earlier in China as far as being able to get the people to work. So again, that's improving some.
The next question is from Ben Jekic from PI Financial.
Good quarter. Congratulations. I do have a question, but I think probably 85% has been answered. But if I just maybe approach it from a different angle. So I know you won't -- you don't want to disclose too much in terms of negotiations, but for the price recovery, but it is -- it does seem that Europe has slightly different concerns than U.S. Are you finding that maybe because of the energy costs, they're a bit more receptive or -- and the reason why I'm asking this is, I'm just trying to see that -- it seems like there is a linearity in your expectation that things will get better in the third quarter, better in the fourth quarter just as we look into 2023?
I think from the cost perspective, I mean, the discussions with customers and suppliers, I would say, compared to Europe to North America, very similar. I mean, obviously...
I think there's one difference in the supply base is that they're more aggressive in North America. In Europe, frankly, a lot of them just go bankrupt. That's probably the bigger challenge in Europe like our suppliers. Yes.
But overall, I mean, I don't think the experience in getting through these commercial discussions are any different. I mean the OEMs don't want to pay for it, and we're just finally getting them to pay for.
I would tell you this. I was in OEM for 24 years, and I've been in the supply base for 13, and this is a really difficult activity. It's diligent. It's transparent. You got to have the relationships and do your best to maintain them. And at the end of the day, when I look at our organization's progress, as I said in my note, I'm really proud of our team because you really got to do this cross-functionally. It's not something that sales guys go and do or commercial guys are going do. It's something that the operators, sales, commercial, finance and personally, I'm very involved on a weekly basis, making this thing move and we're moving it. I'm pretty happy with the progress.
And then in terms of -- okay, this is the last question. Like when we look at 2023, you have $200 million free cash. That if you encounter difficulties -- theoretically speaking, if you encounter difficulties in renegotiating these arrangements, when would that -- it doesn't strike me that the $200 million will make or break with these negotiations, right?
Well, I guess there's a couple of elements. I mean we're not going through this. I mean we're not going to recover everything, right, quite frankly. And there's also an element of expectation that the market, the cost will stabilize and normalize to some extent. They may not go back to where they were before, but some of these levels are just unsustainable, right? So there's an expectation that the market will also contribute to that.
The next question is from Mark Neville from Scotiabank.
Good results. Maybe just on energy drops in Europe. I mean how big of a headwind is that? Or how like -- what percentage of the cost structure is that? I'm just trying to get a sense for the risk.
I guess, what I would say there, again, our customers have cost breakdown of all our quotes and so forth. So I'm not going to earmark a percentage of sales. But I would say it's a fairly significant portion of the $100 million that we talked about earlier. And we do have some hedges in place in different places to kind of walk in some quoting some pricing there, but it's not fully hedged. So there's also some protection there. But it has, over the last few months, become an increasing piece of that $100 million headwind that we're dealing with. So it is fairly significant, in particular, in our aluminum die casting business, which is very energy intensive.
Right, right. And in terms of the recoveries and the conversations with customers, is there sort of any part of this that would just happen organically? Meaning, I don't know, is there a period of time where something might get reset? Or it's like the conversation is less difficult because for whatever reason?
Outside of material that's on resale or index already, then you got to wait until the next model if you don't do something about it. It's not going to happen automatically and no one's going to -- you wouldn't go into a store and pay more money for something because the price of the thread went up. You have to work for it. It takes a lot of work. So not really, I would say very little adjust on its own, unless it was in a previous contract.
All right. All right. And I guess, again, just in terms of energy costs in some of these headwinds, I mean, I assume your suppliers are having similar conversations with you guys. So just sort of curious sort of how that would go on your end?
Yes, absolutely. I mean that's what really drives it initially. Our suppliers come to us first, and then it's passed through. If none of our suppliers, other than energy, of course, but none of our suppliers ever asked for anything, it'd be a lot easier because we're basically driving our supply cost through to our customer. It's not -- we're not going after anything over and above that.
And that also includes freight costs, which has gone over quite a bit.
Yes. And so significant to our...
So that's a big element of it.
Okay. Maybe in terms of the launch costs, can you just kind of remind us the curve or the cadence of when they sort of peak and sort of how they roll out?
Well, the complication, and Peter kind of touched on it a little earlier, is when we launch normally, pre-pandemic, there's a timeline in there from A to B that says, we're going to ramp up from 2 a day to 1,000 a day, which is the final number, let's say. And that may happen over a period of 3 to 6 months. That's normal and you build your cost model around that. But these launches, because of the chip shortage and other supply chain issues, have stretched well beyond that. And until you can get into steady state, your workforces and fluctuation plus, as we talked about earlier, you're getting turnover, which is much higher than normal, especially in the U.S.
So that has to stabilize at some flat level, even if it's not at full ramp. They say, okay, this is as far as we're going to go, and we're not going to go any higher until this thing cleans up meeting the supply chain. And that's happened in a few cases, but most are key -- because it's a new model they want to get everyone out that they can. So they'll run 3 days, stop 2 days, run a Saturday, which cost additional money and whatever it takes to get vehicles out when it's new, it's very important to the OEM.
And so this is -- I've never seen anything like this in 37 years. And it definitely complicates our ability to get to a normal run rate. And there are still a number of launches out there that though improved, as I said earlier, are still fighting through it because they can't run the ramp curve, they being the customer.
Right. Okay. But the expectation is, does get better. And for 2023, again, hit the $200 million, I assume, there's still some launch costs in there, but it's, I guess, materially better than where you're at now.
It's built in. It would be, I'd say, normal. We make an assumption in that budget that the supply issues have improved and these current launches have stabilized, and then, of course, we account for the launches that we have scheduled during 2023. So that's all buried in there.
Which we envision to be a much more normal year.
Yes. We envision it as a normal launch curve. And we don't have as many launches in '23 as we had the last few years. I'd say it's substantially less. We have some complex ones, but not a bunch of them.
Yes. Okay. And I guess, just broad stroke, since we're talking about 2023, would you guys be assuming like a big increase in production volume [indiscernible] what the number is, but would there be significant growth in your production volume numbers next year?
Yes. I mean, we rely on IHS to kind of help most projection forecast. I mean they have dropped recently. So I think we're still in the range and so forth that we outlined in terms of sales, but we're keeping a close eye on that, and that's kind of the benchmark that we use.
I think that's consistent with everybody else. Everybody is in the game, particularly in North America, I mean, the typical -- you have U.S. sales north of $16 million, you have Canadian sales of 1.5 to 2, you have Mexican sales. And underlying that, of course, the production. What we're seeing right now is sales rates are less than -- they've been normalized for the last 25 years, and that's because you can't produce enough to sell. Everything that's getting produced is getting sold pretty quickly. And so we'll see -- so the demand is there and the production should go up. And that's what we're hearing from everybody.
Yes. I think what you're going to see is going to be very interesting, if you go back in time to 2009 and '10 during that recovery, the production numbers went through the roof. All the OEMs went to max volume, which really hurt the suppliers in a different way because you're trying to build max for everybody. So it will be very interesting because this time around, you have the same situation, only there's no inventory where prior to, if we go back to 2009 and '10, there was an inventory. So it had a much higher base yet, production went through the roof. This is going to compound. And if we just had typical sales like we have today, let's say it doesn't get a lot better in sales. Just to fill the inventory back up, it could be 18 months, maybe more on some products. So there is going to be pretty decent production numbers when the supply chain corrects itself regardless to some extent of sales, at least initially.
I guess while we're having this conversation, I guess what would your view be on how the OEs sort of manage inventory? I mean would the expectation be sort of back at 60, 70-day level? Or something else in between maybe more?
I think it -- I think they've all come to the conclusion that they can go with less. I don't know what that number is for sure. I'd say I'd target 45 would be my guess, 45 to 50 some place, again, depending on the model, maybe a little greater, but just based on the current sales rate, it's very difficult for them to maintain anything. So it could be higher. Back in the day, the inventory is 80, 90, that's dropped over time. But I think there's going to be a hole that needs to be filled even if sales don't increase significantly for a period of time.
[Operator Instructions] The next question is from Brian Morrison from TD Securities.
I guess the question I have is for Pat. Now that you've got your operating margins up to 4%, you go through your 4 drivers there, the launch and the commercial settlements, plant efficiencies and volume. And with the progress that you've made, I don't really see a substantial variance in the contribution in any of them really to get from 4% to 8%. So I'm wondering if that's the case. And if not, maybe you can just provide color on a ranking of the -- which is the highest or lowest in terms of contribution to get to that 8% margin from the 4% run rate you're at right now?
I'm sitting here thinking about that a little bit. I mean, certainly, Fred had shared the numbers a while ago on what that would look like as far as how far behind we are. I would say in the commercial side, it's pretty significant. I think that will make a pretty significant impact, assuming we achieve what we expect to achieve. And as I said earlier, I think we've made some good progress.
The launch and the sales curve of those new launches, it's really hard for me to predict, but some of those could be pretty significant because some of those we have pretty big investments, and they're pretty good products for us once they start running normally. And then on the productivity side, stabilizing the workforce is important. For you to make good improvements in the operation, you have to have a stable workforce. So in some countries, Canada, Mexico, most of Europe, I'd say that even Brazil, we're feeling pretty confident that we have a pretty stable workforce. We're going to have to fight through that a little bit for the rest of the year in the U.S. But to really break it down would be kind of difficult.
Maybe I'll provide some comments. So when we laid that out, we started off with our Q4 margin which was essentially 0, right? So we're kind of halfway there now.
Yes, that's a good way to say it.
And I think if I think of the broad buckets we laid out, the 1 piece where we haven't necessarily seen any benefit would be the launch activity. So as we noted in the past, the launch activity is going to start normalizing in the back half of this year. So we're going to start seeing that benefit. As it relates to the other buckets, I mean, we talked about the instability and volumes are still dealing with that, so there's still some more upside to generate from that. Offsetting the cost headwinds, we're not done in that area as well. So that should be a benefit as we kind of close those over the coming months. So we still got work to do there. We still got -- the road map is very similar. I would say we're halfway there with 50% of the work in front of us still.
Yes. It's a good way to say it.
I appreciate that color. I just want to clarify that, Fred, is are you saying that launch would be the largest contributor to get from where you are now to that 8% margin?
It's 1 piece. There's volume that still has to come. There's the cost offset still has to come and there's the operational improvements, driven in large part by the stability of volumes.
So I guess we aren't ranking it for you.
There's 2 things you have to achieve in a launch. One is resolving your own production issues and the other is steady state. We are -- we've reached the point where we've stabilized the majority of our production issues, which are a normal part of the launch, but we have not achieved steady state because the customer is not pulling steadily. And it's creating a lot of fluctuation. So is that 1%, 2% of the margin? I can't tell you that because it's very erratic. But I can tell you, as they improve, get closer to steady state, the operational improvements in the plant follow. And it's crystal clear on the ones that have gotten better. The plant starts to hit their numbers on a more ready basis. So -- but I can't predict what the customer is going to do because, frankly, a lot of them can't predict themselves.
All right. Is it fair to say that over the past quarters since our last release that your confidence in -- with the progress that you've made to hitting that 8% has gone up?
I think about -- I'd say it's the same.
I'd say it's the same. Because as you -- again, we're having an expectation of performance in the back half of the year where things stabilize. And I would tell you, in some cases and some customers and some products is not as stable as I expected it to be by now. So that would be maybe a concern. On the other side of the coin, there are some that have stabilized much better than I thought they would have. That mix doesn't necessarily paint the picture for you, but I can tell you that there's some people that are behind and there are some that are ahead. So I'd say I'm about where I was 6 months ago.
But I'm pleased, especially on the commercial side with the progress. And again, as the customer stabilizes, I don't want to name the customers, but 1 customer in particular came out this year, and they created a very level schedule, all right? They may have lowered their overall number, but they are delivering a level schedule to our plants and the other suppliers, and it's making tremendous difference in efficiency, tremendous difference. So the other customers and other big investments can do the same by the end of this year, I feel really good about next year.
I appreciate that color. Fred, 1 last question, if I can. I think you mentioned your capital intensity for 2023 would be similar to your rate of D&A. I don't have that right in front of me. Are you looking at CapEx next year, $250 million to $275 million in that ballpark. Is that to get your free cash flow numbers?
D&A as a percentage of sales hovering around 6% right now. So you may see that creep up a little bit as some of these assets come online, but that's in the range. So it's probably slightly higher than the range that you outlined, but pretty close.
The next question is from Michael Glen from Raymond James.
One last one from me. Can you just update us on Volta Explore, the JV? There's -- everybody is sort of waiting for some news flow with regard to the financing package that was discussed earlier this year. Are you able to give any update on where things sit with Volta?
Yes. I mean, as you know, we announced on Battery Day that we were going to look at 3 things in connection with moving to a bigger plant. One is location, one is financing, and one is a validated economics. So we're looking at that, but we're also having discussions with financing sources, including governments. And those discussions should be in secret as opposed to public, but we're having a number of those discussions there. And I'll kind of leave it at that because there's 2 public companies involved in having those discussions. And I'll just give you the general view.
We're excited about graphene. We're excited about graphene-enhanced batteries because of the discussions that we have there. And as Pat said, we're very excited with the graphene in our brake lines and a whole bunch of other products that are coming. So we're actually very excited overall about the future of all of this stuff. I think it's a situation where we intend to look at a number of graphene-enhanced products using our technologies, which is very exciting. And as Pat mentioned, we're a finalist for the PACE award, which is the top innovation award, generally recognized in the auto industry for that product and hope we win it. But just being nominated, it's a fantastic thing, a testament to everyone working on it.
There are no further questions registered at this time. I will now turn the call back to Mr. Wildeboer.
Well, thanks very much, everyone, for spending some time with us this afternoon and into your dinner hour. Feel free to call us or connect with us after. We like talking to you, and have a great evening.
The conference has now ended. Please disconnect your lines at this time, and we thank you for your participation.