BorgWarner Still In A Long-Term Growth Lane

By Stephen D. Simpson, CFA | May 13, 2013 AAA

It has been nearly a year since I last wrote on BorgWarner (NYSE:BWA), but in the intervening months a lot of my predictions seemed to come true. In particular, the stock faltered a couple of times on weakness in light vehicle production numbers and investors had the opportunity to buy shares of this high-quality auto components company in the $60s.

Since the late 2012 swoon, though, these shares have rebounded by a third even though European vehicle production remains weak. While liking these shares in the $60s was easy, buying in in the $80s takes a little more faith in an aggressive long-term growth story that isn't often seen in the auto components sector.

Less Bad Is Good Enough
These are interesting times for the auto components sector. The shares of companies like BorgWarner, Lear (NYSE:LEA), Delphi (NYSE:DLPH), and Tower (NYSE:TOWR) are at, or near, 52-week highs and optimism running pretty high after a positive first quarter earnings cycle. It's not that the earnings reports were all that good on balance – revenue growth is in the single digits or negative for many companies – but the results were better than expected and most investors believe the end of the downturn is in sight.

To that end, BorgWarner kept pace in the first quarter. Revenue fell 3% as reported, or about 1% on an organic basis. Revenue from the engine business declined about 4%, while drivetrain revenue was down 2%. Not unlike rival Honeywell (NYSE:HON) (where sales declined about 4%), turbocharger penetration is helping BorgWarner, as adjusted segment revenue was down 1% in the engine group and down 3% in drivetrain.

BorgWarner is also holding the line on margins. On an adjusted basis, gross margin improved half a point from last year, beating most analysts' estimate. Likewise adjusted operating income fell about 4%, leading to an operating margin about half a point higher than the average estimate.

SEE: Analyzing Operating Margins

Still Almost Certainly A When, Not If, Story
Not unlike commercial engine builder Cummins (NYSE:CMI), BorgWarner is in a good spot within its industry with respect to technology. Light vehicles are not going away, and hybrids are just one option for more fuel- and pollution-efficient light vehicles. The turbochargers that Honeywell and BorgWarner offer give automakers like Volkswagen and Ford (NYSE:F) the opportunity to design more fuel-efficient vehicles without comprising the price and performance characteristics that many buyers/drivers like.

I don't see governments backing off of stricter emissions standards in the future, and I believe there will always be drivers who, for whatever reasons, find the hybrids unappealing. Accordingly, I think there's a very bright future for turbochargers in the global light vehicle world, not to mention a real opportunity for diesel passenger vehicles in the U.S. That all means opportunity for BorgWarner, in particular the opportunity to post a long run of strong and above-average growth.

Of course, the “when” in a “when, not if” thesis still matters. European vehicle production was weak in the first quarter (down about 8% or 9%), and the bigger conglomerate players like Eaton (NYSE:ETN), Honeywell, and Illinois Tool Works (NYSE:ITW) seem, at best, cautious about the prospects for a quick turnaround. On the other hand, it seems to be the industry consensus that Europe has bottomed – now the question is what happens in the U.S. (where conditions have looked a little shaky) and China.

SEE: Market Bottom: Are We There Yet

Capital Management Is A Good Problem To Have
Unlike many auto components companies, BorgWarner really doesn't have balance sheet trouble. What trouble there is involves how the company will use the cash it has been generating and is expected to continue to generate in the coming years. While certain analysts and investors are always champions of dividends and buybacks, it looks like BorgWarner is trying to pursue a Solomon-like path of keeping everybody happy.

Management would like to do a deal or two. In particular, they have specified that they'd like to find small/mid-sized privately-owned European companies with good powertrain technology but lacking in scale and global capabilities. That sounds like a pretty specific shopping list, and it also sounds as though sellers are not willing to accept today's multiples as a fair going rate. As a result, I expect the company to keep some cash held back in the hope/intention of doing a deal, while also looking to return some cash to shareholders.

The Bottom Line
A lot of auto players have seen big rebounds off of the bottom. American Axle (NYSE:AXL), Delphi, Lear, and Meritor (NYSE:MTOR) have all nearly doubled off their bottoms. Companies like BorgWarner and Continental AG haven't rebounded as sharply, but then they didn't see quite the same downturn either (due in part to optimism about the long-term and market share, respectively). To that end, investors should spare some consideration for the idea that this sector has already had a sharp rebound in anticipation of improving fundamentals.

SEE: Turnaround Stocks: U-Turn To High Returns

Long-term, I like BorgWarner. While it is an aggressive call for this sector, I believe the company can grow its revenue and free cash flow (FCF) by roughly 10% a year for the long-term, provided the market for turbocharging and passenger diesel develops as I expect. That works out to a fair value in the low $80s today, more or less in line with the share price. At this point, this stock is a tough call. I do like BorgWarner long-term, and I believe it's a rare growth stock in the space, but more conservative investors probably ought to wait in the hopes of a little more margin of safety before stepping up.

At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.

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