Description

Phinia could be a growth company disguised as a melting ice cube. At the very least, they will generate a lot of cash in the medium term. 

Borg Warner ($11B market cap EV parts manufacturer) spinned off Phinia, a $1.3B internal combustion engine (ICE) parts manufacturer. Borg Warner has shed the ICE business to “charge forward to an electric future” as a pure-play electric vehicle supplier. The ESG investors and growth investors can get excited about the 100% electric Borg Warner, but I’m happy to pick up the discarded Phinia, which is generating a lot of cash supplying ICE engine components. While ICE light vehicles may be a declining market segment as EV’s take share, Phinia management is quietly explaining that their market is growing less competitive, supporting margins, and that they intend to grow revenues through share gains and attractive opportunities in new markets. Also, FCF yield is 15% already, with most of it likely to be returned through dividends and buybacks. This “melting ice cube” could turn out to be a cash juggernaut.

Phinia’s businesses may be better than they seems:

44% of sales are parts for light vehicles sold to OEMs (especially gasoline direct injection systems), and this is the business that faces the strongest secular headwinds given the growth in electric vehicles.

24% of sales are parts for commercial vehicles sold to OEMs (this business could also face some headwinds, but there are also significant opportunities discussed below).

32% of sales is aftermarket parts (both sold to OEM service centers and independent distributors). This is a very profitable business with significant opportunities. 

Phinia’s largest customer is GM, which accounts for 12% of sales. Phinia is a top three player in all its markets, and is usually #2 or #3 with 10 - 15% market share and generally behind market leader Bosch and often on par with or slightly behind the #2 Denso. I have heard scuttlebut that Phinia is generally on-the-rise in reputation for quality and innovation in ICE fuel injection technology. Denso, a $52B company with other areas of focus, may not have their eye on the ball in this segment. So Phinia may soon become #2. However, time will tell.

Fuel injection components require precise manufacturing, software integration (sometimes) and other technology that is complex and sensitive. Quality is critical for customers. Meanwhile, the hype around the transition to electric vehicles (EVs) is creating favorable industry dynamics with smaller players exiting the market or under-investing, resulting in share gains for the top three players, which increasingly have the strongest lead for quality products. OEM customers need supplier partners committed to investing for next-generation ICE technology, and increasingly there are just three options. Consider CEO Ericson in June 2023 investor presentation: “OEMs are looking for reliable suppliers committed to continuing to invest in the internal combustion engine through 2040 and beyond.” With smaller players exiting the market, Phinia is gaining share, and doing so at attractive margins. 

Within the light vehicle segment (the most challenged segment), Phinia sees revenue growth from now into 2026/2027 due to market share gains, and then flattening of revenues beyond 2027 as market share gains offset volume declines. This is based on informal Q&A at the Deutsche Bank Global Auto Industry Conference and not hard guidance, but I think it’s possible given that fragmented players currently represent 30-40% of sales in many categories, and will likely dwindle over the next ten years, with all the share going to the few players committing R&D to the next generation of ICE technology. Industry experts predict that ICE market share may decline by ~20% through 2027 and ~40% by 2030, which could be fully offset by Phinia's market share gains. Furthermore, ICE parts will be needed for hybrid and plug-in hybrid cars, which may turn out to be more commercially viable than pure EVs. 

We don’t have breakdown of light vs. commercial vehicles, but we know that fuel systems sales to OEMs increased by 3% during 2022, which very likely included growth in light-vehicle segment (which is 2x as large as commercial). The EV cliff may be near, but it is certainly not here yet. 

As discussed above, Phinia is soft-guiding near-term growth and long-term stability for the LV OEM business. For commercial vehicles and the aftermarket business, Phinia is more bullish on long-term growth, driven by:

• Ongoing need for liquid fuels (gasoline, hydrogen, ethanol, or other alternative fuels) for heavy-duty commercial vehicles that are long-range, close to 100% utilized, and/or travel in rural areas and so are not suited for electric charging

• Innovation in hydrogen and alternative fuel systems. Phinia retains critical IP post-spin that allows for integration of electronic control units and powertrain domain control units (i.e. software) with hydrogen fuel injection systems. Phinia’s first hydrogen product will launch during 2024. Ongoing R&D continues to be 3% of sales, supporting technology upgrades and market opportunities with alternative fuels

• There are further opportunities in nascent markets for Phinia, including aerospace, marine, and stationary power equipment

• Growth in aftermarket sales driven by getting all products into all regions, expanding the product offering, and delivering on selective acquisitions. The aftermarket is an especially strong business for Phinia, with the strong Delphi brand and programs to train technicians. Labor is a big cost of aftermarket repairs, which makes using a high quality part important. 

The favorable competitive environment and market share gains are born out by management’s 2025 guidance, which includes 3.4% revenue CAGR from 2022 and return on tangible equity of ~20% (excludes goodwill, but includes other intangibles). 

If we believe what management is saying about 2030 (albeit quietly), the stock is nearly a double:

Management has guided to CVs and aftermarket growing from a combined 56% of sales to 70% of sales. Combining this long-term target with Phinia’s comments that LV sales should be stable due to share gains, we can infer total 2030 revenue of $4.9B (stable LV revenue from 2022 through 2030, and backing into CV and aftermarket revenue of 70%). This sales level requires an acceleration of growth from 2025 to 2030 to 5.8%, which is significant, but not crazy given the avenues for growth post spin. Actually this projection is slightly more conservative than what management has said because we take 2022 as the base year from which LV sales are stable, whereas management said LV sales would growth through 2026 and then be stable. 

Much of the growth outlook is based on management comments and premised on management execution. There are reasons to believe management, including the favorable spin dynamics:

• As with many spinoffs, senior managers have strong incentives to deliver shareholder returns. CEO Brady Ericson has already accumulated 272,643 shares worth $7.5M, which compares favorably to his base salary as CEO of $0.9M and his likely cash bonus in the range of $1.0M. Furthermore, I expect his equity holdings to increase by multiples in coming months and years as performance shares vest. Other top managers also have solid equity holdings. The CEO and other top managers have years of experience in this industry with Borg Warner prior to the spin

• At the time of a spin, management often sandbags targets so that equity awards come at a favorable valuation

• Phinia has a sprawling global operation, complex R&D, and opportunities in new markets. Management is empowered and incentivized post the spin to take control and drive results, as well as a clear vision based on improving aftermarket distribution and executing against opportunities in the CV segment

• Borg Warner is an $11B company, and has spun out this $1.3B company. It’s not hard to imagine that Phinia’s ICE technology was under-resourced under Borg Warner, which prides itself on “charging forward to an electric future” (i.e. focus on EVs)

If we take management seriously – the financials are extremely attractive:

Disclaimer: the 2030 numbers are not hard guidance, but rather inferred from managent's comments that the LV business can be stable while the CV and aftermarket businesses will become 70% of sales. The 2025 numbers, however, are based on explicit management guidance.

Plugging these numbers into a DCF with 12% CoE gets me to ~80% upside to fair value on the current share price of $27. For me, this isn’t a base case, but it shows the powerful upside potential in the stock.

What’s clear from the above table is that Phinia will generate a lot of cash. It’s wonderful to hear management talk about capital allocation, and they clearly articulate favorable priorities in this order of preference / likelihood:

1. Dividend (worth ~4% of the market cap

2. Opportunistic share repurchases

3. Bolt-on acquisitions (but they have to meet ~15% ROI threshold)

In summary, management claims that Phinia will have a 15% FCF yield from the first year that should grow and will turn into dividends and buybacks.

The stock is already priced for the company to melt a significant amount:

Before getting into a conservative scenario and a worst-case scenario, I note two factors relating to Phinia’s margin of safety:

1. The company has net debt of ~$500M, for net debt / EBITDA of ~1.0x (relatively low leverage)

2. Phinia spends 3% of sales, or ~$110M on R&D and 4% of sales or ~$140M on capex. I believe this spend is prudent and will continue, but it signals a company that is cash generative and investing in the future, rather than teetering on implosion

If Phinia does turn out to be a melting ice cube, they will still generate a lot of FCF over the next five years and beyond. We have to assume a lot of melted ice to justify today’s valuation. I consider a scenario in which the next two years of guided free cash are relatively certain (given that Phinia likely has insight into their customers’ investment cycles into automobile platforms), but then FCF shrinks to an amount that would be commensurate with today’s valuation:

This scenario is very conservative, with ROE dropping from ~20% to 11%, un-levered FCF dropping by -28% from the 2025 high, and the stock trading for 7x trailing FCF (P/Tangible Book ~0.8x). Despite these conservative assumptions, shareholders who hold from today until the terminal value in this modeled case will earn the 12% compound annual returns (the cost of equity). That’s actually pretty good for a very conservative case. I expect actual results to exceed this case. 

For a downside case, I assume that the next two years of guided free cash are relatively solid given that Phinia likely has insight into their customers’ investment cycles into automobile platforms. Thus, the company will generate $200M - $220M in annual free cash flow to equity through 2025. Subsequently I model un-levered cash flow to fall by ~24%, -23%, and -16% for each of 2026, 2027, and 2028, ultimately landing at 50% of the 2025 high, thus causing FCF to equity to fall by a total of 71%. I assign a terminal value of 0.3x P/B or 5x P/FCF, discount everything by 12%, and come out with a fair value of $18 today, or -34% downside. In this case, the company will still have plenty of cash to pay for annual interest ($156M in after-tax free cash flow to the firm vs. ~$65M in interest expense). I consider this an absolute worst-case scenario and less than 15% likely.

So, summarizing valuation across my three cases:

1. Management’s softly-guided case: ~80% upside to fair value

2. Fair value case that includes nearly 30% erosion in unlevered FCF: -2% downside to fair value

3. Bear case with less than 15% likelihood: -34% downside to fair value

In all three of these modeled cases, in addition to the upside/downside, equity holders earn 12% annual cost of equity for the period held. I think the most likely outcome is somewhere between cases #1 and #2 above. Considering these cases and the likelihood of landing between #1 and #2, Phinia is a core holding for me.

Catalyst

Free cash flow materializes and returns to shareholders in dividends and buybacks.