BorgWarner

BorgWarner increased second-quarter sales by 0.3% and adjusted operating income by 11% year over year, improving its adjusted operating income margin by 100 basis points to 11.3%. Strong profitability supports an increase in its share repurchase program by $1 billion.

Why it matters: This result shows another period of strong execution by management, using strong cost control to drive double-digit earnings growth despite organic net sales, excluding battery sales, declining 1.2%, reflecting the direction of the market. BorgWarner plans to increase its research and development spending this year to accelerate future growth opportunities in the data center space. Despite this, it maintains its full-year operating margin outlook, seeking further cost efficiencies to offset this higher spend. Guidance for full-year adjusted EPS has been increased ever so slightly with greater-than-expected share repurchases; guidance for all other metrics is unchanged.

The bottom line: We are increasing our fair value estimate for narrow-moat BorgWarner to $62 per share to reflect the increasing industrial segment opportunities. The growth trajectory for BorgWarner's new industrial segment is highly uncertain. The greater than $300 million revenue guided for the sale of turbine generator systems in 2027 is just one product in its ramp-up year, and a share of the total capacity installed for this product. There are opportunities to grow capacity for this product line, as well as revenue streams from battery energy storage and inverters for the data center market. By the end of the forecast period, we see this industrial segment's revenue matching that of some of the company's legacy segments, and at the same high-teen gross margins. This supports earnings growth above 10% each year over the forecast period.

Coming up: Management will decide by the end of this year whether to add additional capacity for the turbine generator system sales given the continued strong customer demand.

We raise our fair value estimate to $62 to reflect BorgWarner’s significant opportunities in the data center power management market, matched with its history of strong execution in new technologies. We use a 10-year explicit period in our discounted cash flow model.

We forecast average group revenue growth of 5% per year, with the foundational business experiencing a marginal declining compounded annual growth rate and about 10% growth for the e-business. Most of the e-business’s revenue growth is market growth-driven. We forecast global industry battery electric vehicle and plug-in hybrid electric vehicle sales to grow at CAGRs of 10% and 12%, respectively, implying that total new energy vehicle (BEV plus PHEV) penetration increases from 24% in 2025 to 60% in 2035. Therefore, BorgWarner delivers slightly above market growth. BorgWarner estimates that its content-per-vehicle opportunity is approximately 3 times greater for BEVs than for ICE vehicles. While our content per vehicle estimates are far more conservative, they support above-market growth for BorgWarner. In contrast, we forecast a CAGR of negative 5% for global industry ICE vehicle sales. The penetration of turbochargers in ICE vehicles is expected to continue as OEMs look to reduce fuel consumption and carbon dioxide emissions from their ICE ranges. This is one example of how BorgWarner will continue to outgrow the ICE market.

All segments reach at least midteen gross margins over the long term. We think the foundational segment can continue to become more efficient even as volumes decline over time. We think the e-business will see margins increase, but slightly below those of the foundational segment, given greater market fragmentation. A key driver of margin enhancement for the e-business is declining R&D intensity. While we forecast the e-business’s R&D expense to continue to grow above inflation throughout the forecast, its R&D intensity declines to 8% by the end of the forecast from 15% in 2025.

The real growth driver is the entry into the data center market in 2027 with revenue of $400 million, which scales quickly to over $4 billion by the end of the forecast period. This assumes the addition of further adjacencies, over and above the three products – turbine generator systems, inverters and battery energy storage - already in testing. We estimate gross margins to initially lag the at least mid-teens of the other well-oiled segments, however quickly improving to 18% as capacity utilization increases.

Capex/revenue remains at historic average levels of around 5%, through to 2035. From the latter part of the decade, we foresee capital expense in the foundational business remaining at levels below depreciation. This is a key driver of reduced capital intensity as investment levels remain elevated in the newer segments throughout the forecast. We do not make any assumptions about M&A over the forecast.

We use a discount rate of 9%. We think a higher cost of equity of 11% is reasonable in this industry—and in line with that used for our automotive OEM coverage—given industry headwinds and uncertainty of their outcomes. Our cost of debt assumption is 4% on relatively low financial leverage and an investment-grade credit rating. We weigh equity as a proportion of capital at just under 70%, in line with the historical average.

We believe BorgWarner has a narrow economic moat supported by switching costs and intangible assets, supported by its historical ability to generate a positive economic profit.

Intangible Assets

We believe BorgWarner’s most significant intangible asset is its strong brand among its automotive OEM customers. The company’s tier one supplier status, built and maintained over decades by supplying customers with innovative, complex, and reliable technology, customizable to their specifications at a reasonable price, attracts customers to the business.

The company supplies parts to virtually every automotive OEM. It holds number-one or -two positions in its foundational segments—turbos and thermal technologies and drivetrain systems—and aims to reach the same in its e-business. Approximately half of all vehicles have a BorgWarner part installed.

BorgWarner is a tried and tested supplier; its brand is built on reliability. Where product defects can result in the loss of life, automotive OEMs have a natural risk aversion to trying unfamiliar brands. According to the US Department of Transportation’s National Highway Traffic Safety Administration’s database for product recalls, BorgWarner has had one product recall since 2000. This compares with peers Continental (nine), Autoliv (seven), Bosch (four), Denso (two), Mitsubishi (two), Magna (one), Valeo (one), and Bosch (zero).

Automotive OEMs can always rely on BorgWarner for a relevant portfolio of technology supporting vehicle efficiency. In the 1990s, it quickly became a market leader in turbo technology. Less than 1% of cars in the US had turbochargers in 1996 versus 33% in 2021 (European penetration is far higher). In the 2010s, BorgWarner became one of the first suppliers of dual-clutch modules in China. In 2020, 80% of cars produced by 12 of the largest Chinese auto OEMs were equipped with dual-clutch gearboxes. The electrification of BorgWarner’s portfolio began in 2015 with its first acquisition, when EV penetration was below 1%.

BorgWarner’s intellectual property lies in identifying the next wave of technology, investing accordingly, then allocating most of its R&D budget to customizing and adapting its chosen programs to its customers’ unique needs. BorgWarner ranks as average in terms of its total capital intensity versus peers. We view this as R&D efficiency—knowing where to focus spending that best serves customers. Its ability to customize and adapt at speed has allowed it to gain favor with domestic Chinese OEMs. Approximately 70% of BorgWarner’s China revenue is derived from local OEMs. This personalization ability versus diverting attention to inventing one-hit wonders supports brand strength.

Geographic portfolio diversification allows BorgWarner to supply its global customers with ease and speed. BorgWarner’s sales largely reflect its production capacity, which is split roughly equally among Europe, North America, and Asia.

We view BorgWarner’s ability to consistently deliver strong technology as a factor that supports the group’s reputation, rather than any of one of its products’ patents being a moat source. While BorgWarner may have intellectual property advantages in certain products, the nature of the automotive industry is that those IP advantages are unlikely to be relevant three or four years down the line, given the constant state of evolution. However, this is where switching costs pick up, supporting the moat. BorgWarner and Garrett hold 5,700 and 1,300 patents, respectively, but have industry-leading gross margins. In contrast, Denso and Valeo hold 39,000 and 33,000 patents, respectively, yet generate industry-average gross margins.

Innovation does not support pricing power in this industry. Rather, constant innovation to improve vehicle efficiency is the basic requirement from OEMs. BorgWarner states that the nominal price of a turbocharger currently is the same as it was two decades ago; adding more value to the customer in terms of vehicle operating efficiencies delivered by the product has allowed the price to stay the same rather than decline. Instead, OEM customers expect annual price reductions. Even in an environment of high input-cost inflation, cost recoveries can be less than 100% or delayed. BorgWarner’s customer contracts typically include annual price reductions of 1.0%-1.5% on average. Historically, BorgWarner has achieved smaller price reductions versus peers.

Switching Costs

A new award is a commitment from the customer for the next seven to 10 years. Most BorgWarner products are in the propulsion segment, which are contracted much further in advance than most. For Western automotive OEMs, contract awards can be three to four years before production. This timeline is shortened to less than two years among Chinese automakers. These programs then run for four to seven years. From the start of production, EV component programs can last four to five years; for engine components, this is about five to six years, and it’s longer for drivetrain components. Component programs for internal combustion engine vehicles are expected to extend for longer as innovation focuses on electric vehicles. The longer-term nature of these contracts gives us some certainty over the medium term, but not beyond 10 years; thus, we do not think a wide moat rating is warranted.

Exiting a contract is prohibitively costly for an automotive OEM from both a time and money perspective. Customer contracts generally include minimum volume offtake provisions that at least cover BorgWarner’s capital cost if the minimum volume is not met, whether it be market demand-related or by customer choice. The lead time between component award and start of production is several years. Switching suppliers during this process would significantly delay the automotive OEM’s production schedule with redesign required around the new part. The opportunity cost of being late to market and thus losing share in an intensely competitive market can be significant.

Among a risk-averse customer base, BorgWarner’s decades of trustworthy product delivery has created a strong brand moat source that we believe will carry over into the supply of EV parts.

BorgWarner’s entry into data center-facing markets provides it with its next large, underpenetrated market, a growth tailwind, and a proof point for future expansion into industrial segments.

A lean operating model is reflected in a decreasing ratio of SG&A expense to revenue over the last two decades, allowing for steady operating margins (pre-2020) in an industry with limited pricing power.

Increasing exposure to Chinese OEMs can impair BorgWarner's switching cost moat source over time, given the OEMs' greater efficiency, faster pace of innovation, and shorter contracts.

Uncertain timing around the transition from ICEs to EVs may create volatility in BorgWarner’s financials and delay a recovery in ROIC to a value-accretive level.

EV product margins may have a lower ceiling than their ICE counterparts with greater market fragmentation.