BorgWarner - Patience May Not Be Futile

By Stephen D. Simpson, CFA | July 27, 2012 AAA

With European vehicle production softening and any company with substantial European business facing significant currency headwinds, the question going into BorgWarner's (NYSE:BWA) second quarter seemed to be just how bad things would be. While BorgWarner did disappoint (the second miss in a row) and lower guidance, this remains an interesting growth story within a very mature industry, and one that investors may want to follow a little more closely.

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Performance Wasn't Great, nor Was It Terrible
BorgWarner didn't have a disastrous quarter. Reported revenue rose 2%, but underlying (constant currency) growth was more on the order of 10%. Engine revenue was down 2% on a reported basis, but up about 7% in constant currency and drivetrain was much stronger - up 13%/20%. To offer a little "instant context," Honeywell's (NYSE:HON) transportation systems business (which is also skewed towards turbochargers) was down slightly on an organic basis.

Margins held up pretty well. Gross margin improved a point from last year, while "core" operating income rose at a mid-teens rate (with company-reported adjusted EBIT up about 12%).

SEE: Understanding The Income Statement

Guidance Comes Down Again
Although BorgWarner is executing relatively well, there's not a lot that a parts/components supplier can do when the larger industry it serves starts to choke. Moreover, with more than half of its revenue coming from the EU (about 30% of total revenue from Germany), there are clearly some regional factors at play.

Management sliced its 2012 revenue growth outlook substantially - down to a range of 4-6% from 10-12%. Relative to what we've heard from other vehicle suppliers like Honeywell, Eaton (NYSE:ETN), Illinois Tool Works (NYSE:ITW) and Cummins (NYSE:CMI), that is not an especially surprising revision and it still implies meaningful above-market growth for BorgWarner.

BorgWarner didn't dissect its revision part by part, but triangulating with other companies suggests that the company is seeing lower light vehicle production in Europe, lower global commercial vehicle production and push-outs of new product/line launches.

Building up Versus Paying out
I still like the long-term opportunities at BorgWarner. As I've written before, I think it's just a matter of time before the U.S. shows more interest in diesel passenger vehicles and I also believe that more manufacturers will trade down to turbocharged 4-cylinder or 6-cylinder engines to achieve emissions compliance.

However, BorgWarner isn't going to just sit and wait for that to happen. Management seems more interested in using cash flow to acquire other businesses than to pay out a larger dividend. I'm OK with that, but I know some investors and analysts won't like it - paying out dividends (or buying back stock) is a fail-safe that almost no management can screw up, while M&A represents risk.

SEE: Analyzing An Acquisition Announcement

The Bottom Line
BorgWarner is not the easiest stock to recommend for purchase. For starters, it's part of the auto industry and the record of finding long-term winning stocks in this sector is not very good. Second, we now have two straight misses in the bag and I don't think anybody is really feeling better about the global economy today than they were 30 or 90 days ago.

All of that said, I'm still intrigued by this name. I do believe that the market opportunity is there for BorgWarner to deliver double-digit revenue growth on the back of demand for turbochargers and drivetrain products. Perhaps the biggest question is whether the company can lift its free cash flow margin from the uninspiring low-to-mid single-digit range of most auto/truck part suppliers and into the high single digits. If the company can, an $80 fair value is not unreasonable even with this quarter's downward revision in growth expectations.

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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