BorgWarner's Moat Propels Growth

In our opinion, the market has misunderstood

The bear case conflates traditional ICE powertrain demand and BorgWarner’s core competency while ignoring the company’s economic moat. Even though BorgWarner technologies are used in both gasoline and diesel ICEs, the company’s expertise goes beyond traditional powertrain systems.

The trend toward more efficient automotive propulsion systems is driven by globally ubiquitous clean-air regulations and automaker customers’ need to increase propulsion efficiency. While most countries set their standards for passenger vehicles based on carbon dioxide emissions, the United States uses corporate average fuel economy in miles per gallon to achieve clean-air targets similar to other countries’ CO2 targets. Original-equipment manufacturers rely on BorgWarner to support their efforts to achieve clean-air requirements for current and future vehicle programs.

We think BorgWarner should be viewed in a broader sense than just traditional powertrains--if a vehicle has wheels, it has a propulsion system and lies within the company’s addressable market. Intangible assets and switching costs are the main pillars supporting BorgWarner’s moat. We believe BorgWarner’s economic moat enables revenue growth, even in the face of a dramatic shift in propulsion technology due to customers’ regulatory-required need to reduce emissions and increase fuel efficiency.

Intangible Asset Advantage Comes From Product Pipeline, Relationships BorgWarner's intangible asset moat source is supported by a diversified customer base that enables optimal pricing for new technologies, as well as a diversified geographic footprint that provides a buffer to any single geographic region's revenue cyclicality and enables participation in customers' global vehicle architectures. Long-term contracts that include both development and production as well as high customer switching cost promote sticky market share in propulsion systems. For the life of a vehicle program, BorgWarner collaborates extensively with customer engineers during the development and the production phase.

Most vendors are contractually obligated to reduce the price of their products annually by about 3% on average, and they must use lean manufacturing practices just to partially offset margin erosion. Consistent product and process technological advancement enables more favorable pricing relative to many automotive industry suppliers that lack the capability or the desire to innovate. BorgWarner management says its annual contractual price declines average 1.5%-2%, below the industry average.

A single innovation in a highly competitive industry represents a temporary advantage at best, as rivals can quickly adapt to reverse-engineer a competing technology. On the other hand, continuous technical innovation creates a stream of competitive advantages, resulting in moderate pricing power. The recent increase in BorgWarner’s patent count is indicative of customers’ shift to higher propulsion system efficiency and their reliance on the company to provide solutions.

OEMs will pay a premium to vendors for technology that differentiates automakers’ vehicles, reduces vehicle weight, improves fuel efficiency, reduces emissions, improves safety, or lowers costs. Consistent investment in research and development of products and processes--pumping a continuous flow of patents--along with the ability to commercialize innovations creates a high-pressure pipeline that flows into an intangible asset economic moat and fuels pricing power.

Intangible assets that provide the company with a competitive advantage include the ability to regularly develop intellectual property and consistently commercialize new technologies as well as the company’s long-term, highly integrated customer relationships. As propulsion systems migrate from traditional to electrified, BorgWarner’s economic moat creates incumbency for successor model generations and the opportunity to win contracts for completely new vehicle programs.

Automakers require suppliers’ technical expertise very early in the development process, especially when engineers are working on critical areas of the vehicle like propulsion systems. The total development time for any given passenger vehicle program can be 18 months to 3 years. For propulsion systems, BorgWarner’s area of expertise, development time is usually 36-48 months. During the development phase of a contract, suppliers’ personnel work on teams alongside the automaker customer and, in many instances, are co-located with customers’ development engineers.

Programs generally have total production life spans of 5-10 years, while propulsion systems are in the upper end of that range and are used in several different model applications. During the production phase of a contract, suppliers’ engineering personnel work with OEM personnel at their assembly plants and vice versa. Because of the long-term, highly integrated nature of OEM-supplier relationships, Tier I automotive suppliers to a predecessor vehicle program are generally considered incumbent for the successive model generation. BorgWarner’s incumbency, generated by the intangible asset moat source (intellectual property and integral engineering ties) between model generations, supports sticky market share for the company.

Locked-In Customers Results in High Switching Costs Once the OEM and BorgWarner initiate vehicle program development, switching costs to the OEM quickly begin to accrue. Switching costs become the strongest portion of an automotive supplier's economic moat during the production phase of a vehicle program. It is rare that an OEM decides to drop a supplier of a critical component or system; if this occurs, investors should view it as indicative of a much larger problem with the supplier than might readily be apparent to an outsider. In 25 years, we have never seen, nor do we ever expect to see, an instance in which a customer drops BorgWarner from a vehicle program midcontract.

The customers of certain suppliers would incur prohibitively high switching costs should they decide to withdraw business in the middle of a vehicle program, especially when a complex, highly engineered, critical vehicular system is being supplied. Costs for switching to another supplier include the substantial lead time and investment to develop and validate a new system; the potential for production disruptions during transition; and the cost of moving large, expensive heavy equipment and tooling in instances where the customer is the owner. In cases where the supplier owns the tooling and equipment, the new supplier would need to develop new tooling and buy the equipment for its own manufacturing process. The whole course of changing a critical supplier might cost an OEM as little as a few million dollars to as much as $1 billion, because of engineering investment, a potentially immense amount of capital for tooling as well as facilities, and long lead time including preproduction validation.

There is also a switching cost element to BorgWarner’s deep, integral engineering relationships with its OEM customers. Automakers that have relied on BorgWarner for powertrain technology solutions are likely to continue that reliance as global clean-air regulation requires a shift to more efficient propulsion systems. OEMs recognize that switching to another supplier for powertrain efficiency in new vehicle programs could delay development and launch. Having long-standing engineering relationships supports faster, more responsive development as supplier and customer engineering teams already have a degree of cohesiveness from working on projects together. Whenever a vehicle launch is delayed, the automaker risks underutilizing highly capital-intensive capacity, resulting in higher costs and lower returns. Launch delays of more efficient, lower-emission models could also result in fines from governing bodies around the world.

Other Moat Sources Support Sustainable Competitive Advantage Automotive OEMs want vendors that can supply their requirements globally. To reduce cost, the underlying structure of a vehicle sold in the U.S. may be the same as another vehicle that might be sold in Europe, South America, or Asia. In addition, some countries have local-content laws that require a certain percentage of components to be sourced from within that country for a vehicle to be deemed domestically manufactured.

Automobile manufacturers are expanding their use of global architectures to extract greater cost synergies from the larger scale of common parts. In some cases, vendors like BorgWarner have used low-cost countries to expand their global reach, creating a cost advantage moat source. In limited situations, only a handful of industry participants can supply automotive manufacturers’ global platforms on a worldwide basis, creating an efficient scale moat source. While we believe the company’s turbocharger business mildly benefits from an efficient scale source, BorgWarner’s primary moat sources are intangible assets and switching costs.

The economic moat that BorgWarner enjoys enables competitive protection, producing sustainable returns for investors, regardless of automakers’ choice of powertrain. We believe that one of the signs of an economic moat is the consistent generation of return on invested capital in excess of a company’s weighted average cost of capital, also known as economic profit. In our opinion, BorgWarner is more likely than not to generate economic profit for at least 10 years on its intangible asset and switching cost moat sources, in conjunction with industry supply contracts that last 7-13 years, resulting in our narrow economic moat rating. Even so, due to the global growth of vehicle manufacturing overcapacity and the possibility that no-moat mass-market vehicle manufacturers’ pricing could become irrational, passing along the margin pressure into their respective supply chains, we cannot say it is more likely than not that BorgWarner will generate economic profits for at least 20 years, a necessary condition for Morningstar to assign a wide moat rating.

Expertise Extends to All Propulsion Systems BorgWarner has been developing new powertrain technologies since the early 1900s. If the company had not been a powertrain technology innovator, it would still be manufacturing carburetors and automatic transmissions today. We think automaker customers will continue to rely on BorgWarner for efficiency improvements in propulsion technology.

Industrial electric motor manufacturers have a more favorable operating environment compared with the global automotive industry. In many instances, these companies provide off-the-shelf electric motors for generalized applications but also uniquely designed products for specialized applications. In either case, industrial electric motor makers’ volume is relatively low by automotive standards, and manufacturers are accustomed to annual price increases.

Contrast this environment with that of automotive suppliers, where annual volume for one vehicle program can be 1 million units, lean manufacturing practices are rigorously institutionalized, long-term contractual agreements per vehicle program can last 6-13 years, and annual contractual price declines averaging 3% per year are the norm. We think the global mass-market automotive industry has no appeal whatsoever for industrial electric motor makers.

Conversely, automakers would be highly reluctant to do business with a supplier that has no experience working in the harsh environment of the mass-market auto industry. Auto manufacturers are exposed to substantial risk in warranty and consumer litigation if their products are found to be defective once on the road, especially in the U.S., where regulators have forced recalls for products that at the time of production met all required standards.

With the high volume demanded of the industry’s suppliers, risk exposure to recall can be massive. Consider the Takata airbag recall. While this company had long been a trusted industry supplier (it produced the only seat belts that passed the 1973 U.S. crash standard set forth by the National Highway Traffic Safety Administration), the enormity of the recall, warranty expense, government fines, and litigation sent shockwaves through the global auto industry. Approximately 100 million passenger vehicles and 14 automakers have been affected. As a result, Takata filed for bankruptcy protection in June. If this can occur with a trusted industry participant, the potential risk from a company that has no experience with the mass-market auto industry is too onerous.

BorgWarner Benefits Most From Higher Propulsion System Efficiency

We think BorgWarner represents the best alternative for investors looking to play auto supplier stocks with propulsion technologies that enable vehicle makers to reach clean-air regulation targets. Other powertrain suppliers in our coverage universe that benefit from increasing propulsion efficiency include

Continental, Denso, and Magna have specific powertrain groups that are making or developing products that increase propulsion efficiency. While Delphi is in the process of spinning off its powertrain group (DPS) to shareholders, Delphi and Lear benefit from powertrain electrification via their electrical architecture operations (wire harness, junctions, connectors, and other components). We expect the electrical system groups of Delphi and Lear to benefit because vehicles equipped with electrified powertrains require more robust electrical architectures. However, electrical system revenue growth for these companies will be influenced more so by increasing electronic device penetration in the nearer term.

Delphi forecasts that by 2020, its electrical systems business will have a $2.2 billion total addressable market resulting from propulsion electrification. In 2014, Delphi also identified $400 million in incremental revenue from powertrain electrification, but at the time, this included not only electrical architecture but also the soon to be spun-off powertrain group. Lear identified advanced efficiency systems (hybrids and BEV) as representing an addressable market size of $1.0 billion in 2016. Each electrical group already has engine compartment electrical architecture business on current vehicle programs with traditional propulsion systems. Consequently, we estimate concentration of business derived from powertrain at 20% of each electrical groups’ total revenue.

Although both BorgWarner and DPS are solely focused on propulsion systems, investors should be aware of important distinctions between the two, other than the fact that BorgWarner’s 2016 revenue, at $9.1 billion, was a little more than twice that of DPS at $4.5 billion. As clean-air legislation becomes more stringent, automakers will shift production to smaller engine displacements, and the number of cylinders for both traditional ICE and hybrid propulsion systems will decline. This represents incremental turbocharger penetration for suppliers like BorgWarner, but a loss of revenue for fuel injector and valve train suppliers like DPS.

Most of BorgWarner’s traditional ICE propulsion products will be needed to support light-vehicle OEM customers’ efforts to meet clean-air regulations at roughly the same price levels, independent of the displacement or number of cylinders. While we expect the absolute level of ICEs will slowly decline, we think BorgWarner will benefit from increasing penetration rates of certain products like turbochargers, engine timing chain and systems, exhaust gas recirculation valves, dual-clutch modules, transmission electronic control modules, stop-start modules, fans/fan drive systems, and all-wheel drive systems (especially in light of the growing global demand for sport utilities and crossovers).

In contrast, DPS’ main products are fuel injection and valve-train systems along with the sensors and software controls for each. DPS makes fuel injection systems for both diesel- and gasoline-powered ICEs. Diesel engines use direct injection where the fuel is injected directly into the combustion chamber, or cylinder. Gasoline engines can be direct or indirect, where air and fuel are mixed before introduction to the engine cylinder. Even if the absolute number of ICEs remained unchanged and only average displacement and number of cylinders declined, because fuel injectors and valve trains are dependent on displacement and cylinders, a supplier’s revenue from these products would still decline. We believe that global average displacement and average number of cylinders will decline much faster than the decline in ICEs that arises from BEV penetration, creating a potential double negative impact to DPS’ revenue. We think the electrification of passenger vehicle powertrain will have a greater favorable impact on the long-term revenue growth potential of BorgWarner.

BorgWarner Is Attractively Valued Using BorgWarner's assumptions for ICE, hybrid, and BEV global volume, we calculate combined incremental revenue of roughly $4.4 billion through 2023, suggesting a 7% average annual growth rate. Incremental revenue and average annual revenue growth are approximately the same using our BEV demand forecast for 6.7 million units in 2023. Before tapering off into our midcycle terminal forecast year, this roughly matches the revenue growth we forecast as the base-case scenario in the Stage I portion of our discounted cash flow valuation model that generates our $55 fair value estimate.

Including the effects of acquisition integration, we also expect margin expansion from already-impressive levels. For 2016, EBITDA margin was a very healthy 16.9%, even though European auto demand (which accounted for 38% of 2016 revenue) was roughly 7% below its 2007 peak light-vehicle volume and the Remy acquisition diluted margins from the 2015 peak of 17.2%.

We believe the investment community has not adequately factored in BorgWarner’s growth potential and has unduly discounted the company’s economic moat. Bears believe that the company’s revenue is in long-term decline, resulting from faster-than-anticipated BEV consumer adoption rates, auto manufacturers’ making battery electric powertrain a core competency, or industrial electric motor makers taking substantial share in BEV powertrains. In our view, the bear case underappreciates BorgWarner’s intangible asset and switching cost moat sources resulting in innovation and commercialization of new technologies that OEM customers rely on in the development of more-efficient powertrains. We think investors looking to play the clean-air regulation and increasing propulsion efficiency theme in the automotive industry would do well to consider BorgWarner.