BorgWarner: It Doesn’t Get Cheaper Than This – BorgWarner Inc. (NYSE:BWA)

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BorgWarner (BWA) – a key supplier of powertrain and fuel efficiency technology to the automotive industry – has seen its valuations come down in the recent years as the industry continues to make a transition towards electric vehicles (EVs). I believe there is tremendous scope for improvement from current P/E multiple of 11 as the management continues to deliver on its well-crafted cost-savings plan and new contract wins for critical and high-value hybrid and EV components.

Some green shoots stemming from this strategy were already visible in the third-quarter results announced on October 31, 2019, as the company managed to post better revenues and margins in a struggling market. Following the earnings announcement, BorgWarner’s stock gained traction. However, it shed these gains in the subsequent days and came back to pre-earnings levels. This situation is symptomatic of the general apathy among investors regarding anything which is automotive and isn’t electric!

Needless to say, BorgWarner is significantly undervalued at the current levels. In the last 12 months, the stock’s P/E multiple has remained in the range of high single-digits to low double-digits. As one can see from the chart below, this is the lowest the stock has been valued in the last five years. My thesis is that the combination of better sales and strong margins makes the stock a re-rating candidate. The market is currently putting a very high discount factor on legacy component suppliers, effectively making this space fit for cherry-picking.

Source: YCharts

Another supplier without an edge?

It is not just the P/E multiple which makes the stock a good or bad investment. Several companies trading at low valuations have turned out to be value traps! However, BorgWarner presents genuine reasons to be excited about the future and its own place in the changing automotive industry landscape.

BorgWarner has an extensive portfolio of engine and drivetrain components that helps in increasing fuel-efficiency and reducing emissions. Prominent among these products are engine timing systems, turbochargers, exhaust gas management and automatic transmission components. While these products are mostly found in internal combustion engine (ICE) powertrains, BorgWarner has kept itself relevant through products like power electronics, battery chargers, and various architectures for hybrid electric vehicles.

It is worth highlighting that these are not commodity products and involve a high level of engineering to develop. While this sophistication naturally creates a high barrier to entry, it also helps in maintaining high margins. As one can see in the table below, BorgWarner has a vastly superior margin profile when compared to its prominent and well-funded competitors including Delphi Technologies (DLPH), Lear Corporation (LEA) and Aptiv (APTV).

BorgWarner

Source: Seeking Alpha

Given these profitability figures, it comes as a surprise that BorgWarner and Lear trade at similar P/E ratios. Similarly, Aptiv is closest to BorgWarner in terms of margins but trades at rich valuations of 22 times earnings.

The game is not played in electric but hybrid stadium

Most investors are well aware of the changes in automotive propulsion technology which is causing the gradual demise of traditional combustion engine technology.

However, declining popularity of combustion technology doesn’t translate into an equal boost for pure EVs as a more prominent trend is expected to play out in favor of hybrid vehicles. To some degree, it is already manifested in industry-wide sales mix but it will get even more prominent from here. Leading auto industry forecasting firm IHS Automotive expects that as many as five hybrid and plug-in hybrid vehicles will be sold for every EV retailed in another 10 years.

IHS EV Forecast

Source: IHS Markit

Another industry expert BCG expects this ratio to be around 2.4:1. While this is quite different from IHS projections, both agree that hybrids will outsell pure EVs by a wide margin.

BCG EV ForecastSource: BCG

And BorgWarner is ready to hit

This is where BorgWarner shines through new program wins. During the quarter, the company won its first eTurbo contract from a European OEM for hybrid vehicles and the commercial launch is expected in 2022.

Similarly, it secured new wins for Torque-Vectoring Dual-Clutch and Integrated Drive Module (iDM) – products used in pure EVs. The latter – to be supplied to a Chinese EV brand in 2021 – is particularly noteworthy as it is an integrated module consisting of eGearDrive transmission, electric drive motor and power electronics. This is a high value module, priced in the range of USD1,500–1,800. It is important to note that such system-integration capabilities are in short supply and thus, margins are much better in these products. These wins further augment the strong pipeline the management has built in earlier quarters.

BorgWarner Hybrid Technology Awards

Source: BorgWarner Investor Presentation

While combustion is still growing

A calamity of tectonic shifts in automotive industry will be ICE vehicles, naturally impacting legacy suppliers like BorgWarner which may see reduced demand for some of its products. Nevertheless, most of its other products like turbochargers, engine timing systems and exhaust gas management will continue to be in demand, as penetration rates of these components and technologies increase. This is particularly true in the geographies where cutting-edge EV and hybrid technology may be too costly and BorgWarner’s legacy products can fill the gap at lower price points. A case in point is the recent win of new contracts to supply turbochargers and EGR (exhaust gas re-circulation) technology during the quarter.

Penetration of BorgWarner Products

Source: BorgWarner Investor Presentation

Considering these factors, BorgWarner management expects annual reduction of 3% in industry-wide ICE vehicle sales through 2023. During this time frame, the company expects product innovation and higher penetration rates will help it in posting 1% growth in revenues from efficient ICE products. Given the performance in the latest quarter, this appears to be a reasonable and achievable target.

Annual revenue growth from hybrid and electric vehicle segment is likely to be much stronger at 73%. Despite these steep growth rates, combustion will continue to be the biggest revenue driver for the company with nearly 68% contribution by 2023. Products and technologies for hybrid and electric vehicles are expected to contribute 27% and 5%, respectively.

Margins may play spoilsport

Despite BorgWarner’s industry-leading profit margins, it is clear that the company is faced with strong headwinds. With its biggest business segment not firing, fixed costs have taken a toll on margins. A look at the company’s EBITDA margins in the last five years reveals that profitability has come down in line with the rest of the industry.

The good news is that this decline hasn’t been radical and looking forward, margins are likely to stabilize, if not improve, as the company starts delivering on its hybrid technology backlog. This means that any sluggishness in winning new orders or execution will directly hamper profitability of the company. Unfortunately, this factor is not entirely in BorgWarner’s control as the industry is still in a state of flux with automakers and regulators constantly going back to negotiation table.

BorgWarner

Source: Seeking Alpha

As a result, it wouldn’t be imprudent to expect continued pressure on margins. At the same time, stable margins for another couple of quarters would be a great indication of the company delivering on its strategy and cost management will play a crucial role.

Cost savings and capital allocation discipline

The management has offered more color on its cost-saving efforts. In the second quarter, CEO Fred Lissalde stated that he wasn’t very happy with the margin performance of the company and that initiatives were underway specifically targeting SG&A and corporate costs. Partial success of these efforts is already evident in the latest earnings release as the company hiked its full-year adjusted operating margin outlook to be in the range of 11.7% to 12.0%. While it still falls short of the benchmark 12.3% margin in 2018, I’m willing to buy the management’s guidance that there is lot more to come on the cost-savings front.

BorgWarner’s management has so far taken a prudent and disciplined approach towards capital allocation. It qualifies new projects and capital investments on the basis of an internal hurdle rate of 15% Return on Investment (ROI). In the recent years, the company has followed this guiding principle and has done a good job of splitting the free cash flow equally between strategic growth opportunities through bolt-on acquisitions and returning capital to shareholders. There is little to suggest that the company will deviate from this line.

Conclusion

Overall, BorgWarner comes across as a mispriced opportunity with a lot of skepticism but a granular view gives confidence that it is indeed nicely placed to benefit from shift to vehicle electrification. It is unlikely to become an overnight winner but considering the positives, the market will certainly offer better valuations if the company keeps itself on the track. At this point, I wouldn’t like to put a number on it and would rather start buying it in small quantities regularly. With so many variables in the valuations equation, it is quite possible for the stock to remain in the current price range for another quarter or two. Over longer time frame, however, a powerful tailwind in the form of stronger vehicle sales isn’t ruled out as demand starts recovering in key markets.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in BWA over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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