Description

Introduction

BorgWarner (BWA) is a leading producer of advanced powertrain technologies that are used to improve fuel economy and reduce emissions in automobiles.  While the company technically falls into the lowly auto supplier category, its products are playing a critical role in addressing the world’s energy problems which makes BWA a derivative play on structurally higher oil prices.  In addition, global expansion among automotive OEM’s has resulted in a less concentrated customer base for auto suppliers.  I thus believe that the company is entering its halcyon days as a number of trends auger for ongoing revenue growth and strong profitability.  The investment thesis is ultimately a very simple one: economic and regulatory forces are leading to higher fuel economy requirements, and BWA will be one of the primary beneficiaries since it supplies the enabling technologies. 

Background

Two inexorable trends are encouraging auto suppliers to introduce vehicles with progressively better fuel economy and lower emissions.  The most obvious of these is higher oil prices which increases consumers’ demand for fuel efficient vehicles.  The second is government mandated emissions requirements which continue to march upwards around the world, though specific regulations vary by region.  Europe has the most stringent emissions requirements, and China has adopted European standards.  (Chinese OEM’s global aspirations have also translated into a demand for leading edge powertrain technologies among those customers.)  The United States has historically been a fuel economy laggard, but 2009 marked an inflection point in this market as the specter of state-specific requirements in California motivated domestic OEM’s to accept higher national standards.  In 2011, the US federal government introduced new standards that will require OEM’s to achieve a corporate average fuel economy of 54.5 mpg by 2025. 

While the need for better fuel economy and lower emissions has been obvious for several years, it’s important to understand that new powertrains take 3-5 years to develop and then another 3 years to ramp.  Furthermore, government requirements gradually step up over time, and consumers’ willingness to pay for fuel economy tends to fluctuate with gasoline prices.  These dynamics have translated into gradual but steadily increasing demand for BWA’s products.

Segments

BWA has two business segments: “Engine” which focuses on optimizing combustion within the engine, and “Drivetrain” which produces transmission, All Wheel Drive (AWD), and Four Wheel Drive (FWD) components.  Drivetrain’s products also enable better fuel economy.

Engine Segment

The Engine segment represents 68% and 79% of BWA’s revenues and profits, respectively, and this division is expected to grow significantly faster than Drivetrain in the coming years.  Turbochargers are Engine’s largest product category, representing 38% of Engine’s sales (26% of consolidated sales).  Turbochargers also represent half of BWA’s anticipated total revenue growth over the next three years. 

A turbocharger is an energy recovery device in which one turbine (the “turbine wheel”) harvests the energy in an engine’s exhaust stream in order to rotate a second turbine (the “compressor wheel”) that boosts the air being injected into the cylinders.  The efficiency gains enabled by turbochargers varies based on the type of turbocharger used, the degree to which the engine has been redesigned to leverage the turbocharger, and what other fuel economy devices are being employed.  For example, BWA’s turbochargers and Variable Cam Timing products are complimentary.  In general, however, turbochargers are gaining acceptance as means by which OEM’s can downsize engines without reducing vehicle performance.  They are essentially a silver bullet: high performance and high fuel economy. 

Turbochargers have existed for decades, but their adoption was historically constrained by a number of factors.  One of these was a phenomenon called “turbo lag” which is the time delay between when a driver gooses the accelerator and when the turbocharger has harvested enough energy to boost engine output.  Turbo lag historically lasted a couple of seconds and made turbocharged engines less responsive than naturally aspirated ones.  Various technological developments, however, have greatly reduced turbo lag and improved the RPM range over which turbochargers can quickly harvest exhaust energy.  For example, a Variable Turbine Geometry (VTG) turbocharger uses vanes to maintain a constant exhaust pressure against the turbine wheel regardless of the RPM speed.  At low RPM speeds when not as much exhaust is available, the vanes constrict like nozzles in order to increase the speed of the exhaust hitting the Turbine wheel.  As RPM’s increase and exhaust becomes abundant, the vanes open up and reduce the nozzle effect.  Another technological development has been BWA’s Regulated Two Stage Turbocharger (R2S) which couples a high pressure turbocharger with a low pressure turbocharger.  At low RPM’s, exhaust flows primarily to the high pressure turbocharger.  As RPM’s increase, the exhaust load is progressively shifted to the low pressure turbocharger.  (R2S is not the same as “Twin Turbo,” which refers to using two identical turbochargers that each use half of the exhaust energy to perform half of the turbocharging.)  BWA recently introduced an R3S turbo which adds a third turbocharger and is able to increase engine output by nearly 25% and increase fuel economy by 8% compared to its R2S predecessor.  I interpret this as a promising sign of the additional technological advances available in this product category, especially since R2S turbo's are still considered to be advanced products. 

In addition to drawing on complex mechanics, turbochargers also draw on electronic and metallurgical disciplines.  For example, sophisticated embedded software is required to control the vanes of a VTG turbo or the load distribution within a R2S turbo.  Furthermore, the turbocharger’s activities sometimes need to be coordinated with other devices such as Exhaust Gas Recirculation (EGR) Values and Coolers, both of which are other BWA products.  From a metallurgical standpoint, the high temperatures and particulate impact endured by the turbine wheel requires advanced alloys.  For years, the higher exhaust temperatures of gasoline engines limited turbo adoption in that market segment, but aerospace grade alloys have been used to overcome this hurdle.  Turbochargers are also evidently difficult to measure in the lab since they spin at up to 280,000 RPM.  A few years ago, I was at an awards dinner that was hosted by a Test and Measurement company, and a team of BWA engineers won an excellence award for their development of an advanced turbocharger test system. 

Given these high and interdisciplinary technology demands, the turbocharger market is served by a relatively concentrated group of suppliers.  BWA has positioned itself as the technology leader and has roughly 33% marketshare, which they expect to maintain or grow over the next several years.  Honeywell’s Garrett division is the largest supplier, and other vendors include Cummins Turbo, Mitsubishi Heavy Industries, and IHI of Japan.  Bosch is currently attempting to enter the market.

I have discussed turbochargers in detail because they are BWA’s largest product category, and they help illustrate the technological nature of these products.  The Engine segment, however, also produces other components that can all improve emissions when used in isolation, but which work best when they are harnessed together in an engine that has been downsized and completely re-engineered to make full use of them.  Other key product lines within the Engine segment include: Cooling Systems (Fans and Fan Drives), Cam Torque Actuated Variable Cam Timing components, Diesel Cold-Start Technology, Exhaust Gas Recirculation Valves and Coolers, and Engine Timing Systems.

Drivetrain Segment

The Drivetrain Segment represents 32% and 21% of BWA’s revenues and profits, respectively, and while this division’s components also contribute to better fuel economy, its growth is expected to be considerably slower than the Engine segment’s over the next few years.  The most promising product line within the Drivetrain segment are clutch modules and control modules for Dual Clutch Transmissions (DCT).  These modules essentially convert a manual transmission into an automatic transmission so that drivers can enjoy the ease of use of an automatic while maintaining the fuel economy of a manual.  Europe and Asia have historically been manual transmission markets, and their transmission plants are tooled accordingly, but consumer preferences in those regions are transitioning to automatics.  DCT’s thus offer transmission manufacturers a cost effective means by which to supply automatic transmission functionality with their existing manual transmission production lines.

Drivetrain also makes components for automatic transmissions.  This product line is benefitting as automakers add speeds to their transmissions in order to improve fuel economy because each additional speed requires additional BWA componentry.  Drivetrain is also benefitting as BWA’s solenoids gain share within the automatic transmission market.  BWA’s solenoids are faster and crisper than their competitors’, which translates into lower parasitic loss and improved fuel economy.  Lastly, Drivetrain produces transfer cases for AWD and FWD vehicles.  While these obviously do not improve fuel economy directly, BWA continues to improve these products so that they are more fuel efficient than their predecessors and competitors.  As with BWA’s Engine segment, a number of Drivetrain’s products are mechatronic and use embedded software to improve performance.

Improving Profitability

I began following BWA in early 2005, and for the first five years, management maintained that operating margin would be capped in the 8.5-9.5% range because once it began drifting above that level, customers would push for greater price reductions.  Profit growth thus was tightly coupled to revenue growth during that period.  During the downturn, however, BWA undertook significant restructurings that included the closure of two sub-profitable Drivetrain plants, and OM exceeded 11% during 2011 and 2012.  Moreover, management is now saying that BWA’s Incremental Operating Margins should be near 20%. 

While BWA’s structural improvements have contributed to higher margins, this newfound operating leverage also reflects OEMs’ needs to secure cutting edge technology in order to meet rising fuel economy standards.  I also suspect that pricing pressures have relaxed somewhat as the OEM / supplier landscape has become more balanced.  In North America, for example, there are now at least seven OEM’s with a significant market presence which is a huge departure from the Detroit Three’s historic dominance. 

Valuation

Because Europe has lead the world in emissions and fuel economy standards, BWA derives 50% of its revenue from this region.  In addition, roughly 20% of BWA’s revenues come from the commercial vehicle market.  Both of these areas are expected to be weak in 2013 which will offset growth in the rest of BWA’s business.  Revenues and earnings are thus expected to grow modestly in 2013. 

Each fall, BWA reports a three year backlog figure which they refer to as “Net New Business” (NNB).  NNB is management’s estimate of how much incremental revenue new programs and ramps of existing programs will add to BWA’s base business over the next three years.  NNB is updated annually for new contracts, changes in ramp schedules and foreign exchange rates, and the most recent NNB figure suggests that BWA will return to significant growth in 2014 and beyond. 

At $75.52, BWA is trading at 14.2x and 12.6x 2013 and 2014 EPS, respectively.  As shown below, this 2014 multiple is towards the low end of BWA’s range over the last seven years.  

BWA’s EV is currently 7.6x and 6.9x 2013 and 2014 EBITDA, respectively.  As shown by the table below, this 2014 multiple is near the bottom of BWA’s range over the last four years.

Looking out to 2017, I am projecting annual revenue growth of 8-9% which is below management’s long-term guidance for roughly 10-13% revenue growth.  I am also projecting Incremental Operating Margins of 14.4% to 15.9%, which is significantly below management’s projection of near 20%.  My 2015 EPS estimates range from $6.61 to $6.96, and using multiples of 15-16x implies a 2015 stock price of $99.12 to $111.36 (14.6% to 21.4% annualized returns).  My 2017 EPS estimates are $7.86 to $8.54, and using multiples of 15-16x implies stock prices of $117.97 to $136.68 (11.8% to 16.0% annualized returns).

As indicated above, these estimates are likely to be conservative.  The global economy will eventually accelerate which would support higher oil prices and buttress growing demand for BWA’s products.  In addition, OEM’s will have to make full employ of BWA’s technologies to cope with rising fuel economy standards, and recent management commentary suggests the company has abundant opportunity for additional technological advances. 

Risks

BWA recently transitioned to a new CEO and CFO, and while I expect that the new guys will do fine, they are not as inspiring as their predecessors who were more charismatic and enthusiastic.  I suspect that this is merely a matter of having different personalities or becoming accustomed to these new roles.  The company will also transition to a new Chairman next month.  The new Chairman has a background in Private Equity, though he has been on BWA’s board since their IPO in 1993. 

Another risk is the potential for intellectual property theft in China.  In order to serve Chinese OEM’s, BWA has located some of its factories and development centers there.  I am trusting that they have done this in a manner that will protect their core intellectual property.  My concerns in this area are also somewhat allayed by the multi-disciplinary nature of these products, their ongoing technological evolution, and the trust that OEM's place in their powertrain suppliers (i.e. knowledge of product roadmaps).  These dynamics should also help protect BWA's technological advantage. 

Lastly, I do not consider hybrids or electric vehicles to be a threat to BWA.  Hybrids use two engines, one of which is a gasoline engine and thus a candidate for BWA content.  Electric vehicles are crippled by limited range, terrible economics, and dubious environmental benefits, all of which are severely limiting their adoption. 

Historic Results

Catalyst