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BorgWarner: Long-Term Potential With Near-Term Headwinds

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Investment Thesis

During the 2021 Investors day, BorgWarner Inc. (NYSE:BWA) outlined its strategy with the aim to strengthen its EV portfolio and bring its revenue mix to about 45% from EVs by 2030. The company expects the total addressable market for eLV (electric light vehicle) products to more than triple in the next 4 years. In line with the strategy, the company recently acquired AKASOL and Santroll’s eMotor to accelerate its electrification process. The company has also been making R&D expenditures related to EV products. As a result of these efforts, BorgWarner has been selected to provide a high-voltage hair pin eMotor for a leading electric vehicle brand in China, whose production is expected to start in 2023. Additionally, the company will also be providing a leading Chinese OEM with a highly efficient dual inverter for high-voltage hybrid vehicle models slated to launch in 2023.

However, the company is in the very initial stages of this transformation, and currently EVs account for a low single-digit percentage of its revenue. So, there is a great deal of uncertainty about the company’s potential transition. Furthermore, the R&D expenditures to support the company’s initiative will also impact the operating margins in the near term. Additionally, as overseas business accounts for the majority of the company’s revenue, the possibility of further strengthening of the US dollar relative to other currencies should negatively impact the revenue. A possible slowdown in vehicle demand due to higher inflation and rising interest rates should discourage vehicle production, resulting in lower demand for vehicle components moving forward. Given all these factors, I prefer to be on the sidelines until these near-term headwinds subside.

Q1 Earnings

BorgWarner Inc. posted the Q1 results with revenue of ~$3.87 billion beating the consensus estimate of ~$3.71 billion and falling ~3.37% Y/Y while Adjusted EPS decreased ~13.2% to $1.05 versus the consensus estimate of $0.87. The gross profit margin decreased 100 basis points to ~19.4% primarily due to increases in commodity costs. Operating income decreased ~16.16% to ~$389 million compared to ~$464 million in Q1 2021. Net income for the first quarter decreased ~13% to ~$251 million from ~$288.5 million in the same quarter last year.

Shifting To Electrification

The company is directing its investments towards electrification. By 2030, the company expects to have a revenue mix of about 45% EVs, up from less than 3% at present. It will deploy up to $5.5 billion of capital to supplement this shift along with strategic M&A action. In 2020, the company acquired Delphi Technologies to scale up its technology leadership in electronics and software in order to accelerate toward EV mobility. Recently, the company acquired AKASOL and Santroll’s eMotor to further strengthen its vehicle electrification capabilities. The company has been making EV-related R&D expenditures to support its electrification strategy or “CHARGING FORWARD” project.

BorgWarner has been selected to provide high-voltage hair pin eMotor for a leading electric vehicle brand in China, whose production is expected to start in 2023. Additionally, the company will also be providing a leading Chinese OEM with a highly efficient dual inverter for high voltage hybrid vehicle models slated to launch in 2023. This reflects the initial success of the company’s efforts to strengthen its EV portfolio and accelerate toward electrification. However, the company has a long way to go before it successfully transforms into an EV-focused parts manufacturer. It may take several years and there is limited visibility. Plus, it will involve a good deal of investments and R&D expenditures should be a drag on operating margins in the near term. The company expects the EV portfolio to be roughly breakeven or better by 2024. Beyond that point, even with continued growth in R&D, it should drive operating margins.

Macro-Economic Headwinds

With inflation at a multi-year-high, the Fed is taking proactive measures to combat inflation by raising interest rates. With rising interest rates and goods prices already at a higher level, it is less likely for consumers to direct their spending on discretionary products. As vehicles are considered a highly discretionary purchase, interest rate hikes and higher goods prices should result in less demand for vehicles moving forward.

US Total Vehicles Sales

US Total Vehicles Sales (FRED Economic Data)

As shown in the above graph, after 17.4 million vehicle sales in May 2021, total vehicle sales in the U.S. have come down to 13.12 million in May 2022, a drop of ~26% Y/Y. Looking forward, I believe, it will take some time before inflationary pressure eases off and vehicle sales start recovering again. The company has also revised the global weighted light and commercial vehicle production market growth to 2.5% to 5% this year, down from the previous assumption of a 6% to 9% increase.

Given the subdued demand for vehicles, domestic auto production should take a hit, thereby, impacting the demand for vehicle components. As a result, revenue should suffer in the near term.

Additionally, overseas business accounts for the majority of the company’s revenue. While the U.S. dollar strengthened year-over-year, FX impacted revenue by about 3% in Q1 2022 versus Q1 2021. The rising interest rates in the U.S. may further strengthen the U.S. dollar relative to other currencies, which may impact revenues in the near term.

Valuation And conclusion

The stock is trading at ~9.69 times fiscal 2022 consensus estimates, which is not expensive. The long-term strategy also looks interesting, with the company shifting its focus toward electrification. Recently, it acquired AKASOL and Santroll’s eMotor to strengthen its EV portfolio. It is also making R&D expenditures in line with its electrification strategy. However, these expenditures should be a drag on the company’s operating margins and there is limited visibility on how successful the company’s EV strategy will be. Moreover, subdued demand for vehicles due to rising interest rates should lead to fewer vehicle productions and lower demand for vehicle-related components. Additionally, the possibility of further strengthening of the U.S. dollar will put downward pressure on revenue. Although the company stock price is cheap, I believe investors should wait until the near-term headwinds subside and the company EV initiatives gain more traction. Hence, I have a neutral rating on the stock.

BorgWarner technical center. BorgWarner designs and builds transmissions as well as components for electric vehicles.

jetcityimage/iStock Editorial via Getty Images

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