Between internal combustion engines, hybrids, and all-electric vehicles, BorgWarner (NYSE:BWA) has an attractive and comprehensive portfolio of solutions, and I expect BorgWarner to remain one of the key suppliers to the industry through this extended transition period. There are certainly short-term risks from COVID-19 and longer-term risks tied to uncertainties in how much OEMs will in-source (and the margins they will be willing to allow to suppliers), but I remain of the opinion that BorgWarner will maintain strong content growth, allowing the company to outgrow underlying production volumes across the next decade.
When I last wrote about BorgWarner, I had some concerns that the rally might have gone a little too far too fast, and the shares have since pulled back about 15%. I’ve taken advantage of this pullback to add shares in my own account, and I believe the shares are once again priced to offer an attractive double-digit long-term total annualized return. I don’t ignore or dismiss the above-average risks here, but I believe the current price undervalues the quality of the company and its ability to leverage not only hybrid/EV content growth, but also growth from more conventional powertrains that will still be in production for some time.
A Return To Growth In A Difficult Operating Environment
The auto parts sector has, in general, done better than expected this quarter on better underlying production volumes and good cost discipline. As is often the case, though, the Street had already bid shares up in anticipation, and we’re seeing more than a few “sell the news” reactions, exacerbated by renewed worries about what rising COVID-19 case counts in the U.S. and Europe may mean for economic growth in 2021.
BorgWarner reported 2% revenue growth in the quarter, or a little less than 1% on an organic basis. That was good for a 6% beat relative to the Street, as well as about 600bp of outperformance relative to global underlying light vehicle production (or closer to 300bp on a weighted-average basis).
Growth and outperformance were driven by the Drivetrain segment, up 8%, as BorgWarner benefited from better dual-clutch transmission sales in China (contributing to a very strong 2,800bp outperformance there) and better mix in North America. Engine sales declined 4%, with BorgWarner seeing increasing headwinds as the company laps some easier comps and once again faces headwinds related to diesel content/production declines in Europe.
Gross margin declined about 60bp in the quarter, but segment income improved 4% and operating income improved 7%, beating expectations by more than 30%. Outperformance was again led by Drivetrain, up 31% with margin up 210bp, while Engine declined 7%, and margin declined 70bp.
Better Guidance, And Moving Quickly To Capture Post-Merger Opportunities
With overall industrywide vehicle production estimates heading higher (including IHS), BorgWarner revised its guidance modestly higher for the remainder of the year. The key part of this guidance from my perspective is a slight boost in its production outgrowth expectation – from +500bp-600bp to +550bp-600bp. Not thesis-changing, I’ll grant, but still welcome, and particularly when matched with the improved margin and cash flow guidance.
BorgWarner closed its acquisition of Delphi right at the start of the fourth quarter, and management is not wasting time looking to leverage this transaction. One of the major arguments for the deal was expanding and filling out BorgWarner’s lineup of components for vehicle electrification (power electronics in particular), and management has already scheduled meetings with OEMs representing about 70% of global production to discuss their electrification and sourcing plans.
While a significant boost to BorgWarner’s BEV capabilities was certainly a key part of the deal, the complementary products in combustion (fuel injection, engine/transmission controls) shouldn’t be ignored, nor should the enhanced scale. Combustion engines aren’t going to vanish (and remember, hybrids have ICEs too), and the enhanced scale post-Delphi should help drive better long-term margins and more efficient product development.
A Few More Wins, But Still A Lot Of Uncertainty
With third quarter earnings, BorgWarner highlighted a few recent platform wins. The company secured a second eTurbo award, this one with a European OEM that will launch in 2023, as well as an 800V inverter award that will launch in 2024 (also in the EU).
In response to a question on the call, and perhaps addressing a wider concern among some of the more neutral-to-bearish analysts, management acknowledged that there’s still really no clarity on how OEMs will handle the question of insourcing/outsourcing their hybrid and EV needs. In fact, management noted that they’re even seeing companies pursuing different strategies across different models. In either case, though, management evaluates business on the basis of its return potential and BorgWarner can still work as investment whether they fully integrated systems or components.
My assumption has always been that there would be some mix of insourcing and outsourcing, particularly in this early phase of transition to hybrids. Auto OEMs want to keep as much profit in-house as they can, and I expect many will at least try to develop their own motors and software; power electronics (like inverters) will be much harder for many OEMs, though. Over time, this will shake out in the market – companies with inferior in-house products will face tough choices between balancing market share and margins, and likewise, there will be a sorting out of the suppliers. I expect that companies like BorgWarner and Valeo (OTCPK:VLEEY) will eventually emerge as top suppliers, with higher market shares driving better margins for key components.
My estimates were already a little higher for BorgWarner, and I don’t see the margin beat in this quarter as meaning all that much for my estimates in 2021 and beyond. Consequently, I’m really not changing my model all that much – including Delphi, I’m looking for long-term revenue growth around 8%, with slightly higher FCF growth. It’s a little difficult to talk about “organic” growth, given that I believe revenue/product synergies between BorgWarner and Delphi are real and meaningful, but I do expect mid-single-digit long-term growth from the starting point of 2021 (the first full year of the combined company), as I expect BorgWarner to outgrow underlying volumes by over 300bp on a long-term basis.
While some analysts are worried that margins for hybrid/EV components will be significantly lower, I don’t see credible evidence of that, and I believe components like power electronics will generate quite good margins.
The Bottom Line
I use a two different modeling/valuation approaches for auto suppliers – discounted free cash flow and margin-driven EV/revenue. As the margin-based approach only looks forward about 12 months, it doesn’t factor in longer-term benefits (including cost synergies) from the Delphi deal and thus generates a lower fair value. In both cases, though, the result is above $40, and I believe BorgWarner is priced for double-digit annualized returns from here. While there are certainly near-term risks from COVID-19 and longer-term risks from competition, insourcing/outsourcing, and margins, I believe BorgWarner is worth consideration today as a long-term leader in vehicle powertrains and drivetrains.
Disclosure: I am/we are long BWA, FR.PA. 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.