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This has been a tougher-than-expected year for auto suppliers, as component availability (particularly semiconductors) has continued to impact production schedules, leading to lower-than-expected volumes and margin headwinds from inefficient production schedules, compounded by ongoing inflationary pressures on inputs. Despite those challenges, BorgWarner (NYSE:BWA) has done better than many peers relative to expectations, and management has kept the company on track with respect to building out its capabilities in electrification.
BorgWarner shares have lost about 5% of their value since my last update, a disappointing result, though still better than the S&P 500 and better than many peers/rivals like Faurecia (OTCPK:FURCF), Valeo (OTCPK:VLEEY), Aptiv (APTV), Lear (LEA), and Dana (DAN), though trailing American Axle (AXL) and Vitesco (OTCPK:VTSCY). While I do still believe that BorgWarner is meaningfully undervalued, a weaker consumer spending backdrop for 2023 isn’t helping near-term sentiment, and significant ongoing questions remain about the long-term market share and profitability of BorgWarner’s EV-based businesses.
Making A Sharper Split Between The ICE Present And The EV Future
BorgWarner recently announced that the company had decided to split and spin-off its Fuel Systems and Aftermarket operations in a tax-free transaction.
The business (“NewCo”) will be largely focused on technologies and products tied to internal combustion engine (or ICE) powertrains, including fuel injection (and gasoline direct injection) systems and aftermarket parts for a range of applications including fuel injection, electronics, thermal management, transmissions, engine timing, starters/alternators, and vehicle diagnostics. Based on expected full-year 2022 results, NewCo will represent a little more than 20% of revenue with a 12.5% margin.
The surviving company (“RemainCo”) will include the Air Management and e-Propulsion/Drivetrain segments, including the company’s operations in turbocharging, transmissions, emissions, thermal, and electric powertrains. RemainCo’s operations will account for around 80% of FY’22 expected revenue, with a blended margin of around 10.9%.
I have mixed feelings about this split. While I thought such a separation was likely an inevitable outcome, I am a little surprised by the timing. One of the things I’ve liked about the BorgWarner story is that the legacy ICE businesses could continue to provide solid cash flow through the long sunsetting period of ICE powertrains, helping to fund the R&D and ramp of BorgWarner’s newer EV-based offerings. While RemainCo will still have significant operations tied to ICE-powered vehicles (including turbocharging, timing systems, and EGR), it will be considerably more dependent on the long-term adoption of e-hybrid and full electric powertrains.
It will be some time before all of the financial details of the split are set, but NewCo will be an interesting investment proposition. As I’ve mentioned in conjunction with Cummins (CMI) and a few other names, I do see opportunities for consolidation and “optimization” in ICE-dependent technologies. These powertrains aren’t going away anytime soon, but auto OEMs don’t have the inclination or resources to continue to invest in new technologies, and I see attractive opportunities for companies like BorgWarner’s NewCo to act as consolidators and late-cycle innovators – offering ongoing improvements in ICE technologies (to comply with increasingly stringent emissions rules) with a better margin structure.
BorgWarner’s EV Opportunities Continue To Expand
While I think NewCo may have more to offer than some readers may assume at first glance, I do see a stronger long-term future with RemainCo and its growing portfolio of electric powertrain technologies.
BorgWarner already has around $4B in OEM commitments for EV-related products in 2025, making the company one of the largest EV suppliers at this point (along with Bosch, Faurecia, Valeo, and Vitesco). Moreover, BorgWarner has a broader set of opportunities than some appreciate. While the company has talked up its capabilities in high-value inverters and battery management systems, as well as electric motors, management has also been building up capabilities in areas like charging, with a particular focus on DC fast charging (or DCFC).
Some of the arguments for BorgWarner’s EV business are familiar, and ones I’ve made before. Inverters are high-value components that will be more challenging for OEMs to in-source, and the company continues to build out its capabilities, including a strategic partnership with Wolfspeed (WOLF) meant to secure silicon carbide needs in 2024 and beyond. E-motors are likely to be less highly-valued (and OEMs like General Motors (GM) are, for now, trying to go in-house), but I think there will be a “sorting out” over time as not all e-motor projects/portfolios will be up to scratch and some would-be in-sourcers will have to turn to suppliers like BorgWarner or risk losing customers due to inadequate performance.
Other opportunities are less well-appreciated. BorgWarner’s ambitions in vehicle charging are relatively new, but they do fit with the company’s prior investments in high-voltage components and capabilities. I also think it’s notable that BorgWarner has won some EV commercial vehicle awards; commercial vehicles are only about 15% of the business mix (and most of that in Fuel Systems and Aftermarket), but many of the technologies that BorgWarner has under its EV umbrella are applicable to commercial and off-road vehicles without substantial re-engineering, raising the possibility that BorgWarner’s addressable market could expand with electrification.
The Outlook
Clearly there is still a lot of uncertainty regarding the ICE-EV evolution. GM recently pushed out some of its EV launch targets, and a group of European OEMs (BMW, Renault, and Stellantis (STLA)) recently called on the EU for greater flexibility regarding 2035 electrification targets. On top of that, there are still very valid questions as to what the margins on EV components and systems will look like compared to traditional ICE components. It’s a meaningful risk for companies like Allison (ALSN), BorgWarner, and Dana (DAN) with healthy ICE businesses, but I think OEMs will still have to pay for high-value components like inverters (and may well need external suppliers of e-motors like BorgWarner more than they realize).
This hasn’t been the year I expected for BorgWarner, but the company has still managed to outperform on a relative basis. My 2022-2024 revenue estimates are about 6% to 8% lower than they were previously due to lower expected vehicle production, and my margins are lower as well due to inflationary pressures and the impact of erratic production schedules, but I expect margin reacceleration in FY’23/FY’24, with mid-to-high-teens EBITDA margins in ’24/’25.
Over the long term, I expect around 5% to 6% revenue growth from BorgWarner, with mid-single-digit free cash flow margins supporting high single-digit FCF growth.
Between discounted free cash flow, margin-driven EV/revenue, and EV/EBITDA, BorgWarner shares continue to look undervalued today. Discounted cash flow suggests a long-term double-digit total annualized return potential, though there is significant modeling uncertainty where long-term margins are concerned. Looking at near-term margins, though, a 14% to 15% EBITDA margin in FY’23 can support a 1.1x forward EV/revenue; even discounting that by 10% (to account for macroeconomic uncertainties), I get a fair value of close to $50, while a 5.75x forward EBITDA multiple (in line with its 5-year average and below its longer-term average of 6.4x) supports a fair value in the low $50’s.
The Bottom Line
BorgWarner has been an unrewarding hold, but I’m not in a hurry at this point and I still believe that BorgWarner will emerge as a leading supplier of EV components and systems. Sentiment on auto suppliers is likely to remain pressured a little while longer as the Street digests the impact of a weaker consumer environment in 2023, but I believe BorgWarner’s execution and opportunity will eventually get more recognition. It may yet be premature to buy the shares in anticipation of that rerating, but I’d at least argue for BorgWarner as a candidate for further due diligence today.
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