All the talk about alternative energy does not seem to have dampened crude oil prices. Similarly, I do not see electric cars becoming the norm in the near future. That's why BorgWarner (BWA +1.72%), a global supplier of drivetrain and engine applications driving fuel and emissions savings, will likely remain in business for the foreseeable future.
What keeps the CEO awake at night?
In my opinion, the top three fears of CEOs and investors alike are product substitution, loss of pricing power, and new competitors. Let's address these one at a time with BorgWarner.
Firstly, the fears of substitution are often overblown. An April 2013 report by the International Energy Agency validates my view that electric vehicles have a long way to go before achieving mainstream status. Based on data for the first nine months of 2012, electric vehicle penetration has not gone beyond 1% of total passenger vehicle sales in most countries, except for Norway. Although I am positive on the future of electric vehicles, it is far too early to call the end of conventional powertrains in auto production. Moreover, BorgWarner has also started developing advanced powertrain products for electric vehicles.
Secondly, BorgWarner's products are not a large part of its customers' budgets. These products typically contribute to either fuel economy or emission reduction – the things that automakers and consumers really care about. As a result, BorgWarner's customers exhibit relatively low price sensitivity, given the high benefit-to-cost ratio.
Thirdly, the long time-to-market and capital-intensive nature of the industry act as natural barriers to entry. This is validated by the fact that there are only a handful of significant players competing with BorgWarner in engine and drivetrain products.
Investing for the future
I tend to be concerned about companies that choose the 'quick & dirty' way of growing aggressively via M&A at the expense of building up their own core capabilities for the long run through R&D spending. BorgWarner puts such fears to rest with its capital allocation policy.
For the past three fiscal years from 2010 to 2012, BorgWarner has invested an average of 3.5% and 5.4% of its revenues in R&D and capital expenditures, respectively. Its commitment to investing for the future is a strong indication that innovation is a top management priority.
In contrast, BorgWarner has been far more prudent when it comes to M&A. In the past five years from 2008 to 2012, BorgWarner spent about $1.6 billion on capital expenditures, but only $377 million on M&A. In addition, it has historically focused on smaller bolt-on acquisitions, not exceeding half a billion dollars, instead of high-risk mega deals. For example, BorgWarner bought Haldex Traction Systems for its complementary technologies in the area of electric all-wheel drive and torque vectoring. Furthermore, it did not break the bank to get what it wanted--the purchase price of $205 million represented less than the acquired division's estimated 2011 sales.
More importantly, all this spending has not come at the expense of balance sheet strength. BorgWarner has limited financial risk with low net debt-to-capital and net debt-to-trailing twelve months EBITDA ratios of 11.3% and 0.4, respectively.
Financial review
BorgWarner delivered record quarterly operating margin and diluted EPS of 12.9% and $1.50, respectively, in the second quarter of fiscal 2013. Although its largest market, Europe, registered light vehicle production growth of a mere 1% during the same period, BorgWarner managed to grow earnings significantly through operational efficiency and cost control.
The good results also prompted BorgWarner to raise the lower end of its 2013 revenue growth and operating margin to 3% and 12%, respectively. It also rewarded shareholders with a quarterly cash dividend of $0.25 per share in August 2013 for the first time since 2009.
Peer comparison
BorgWarner's peers include Autoliv (ALV +0.61%) and Gentex (GNTX +2.78%).
Although Autoliv does not compete directly with BorgWarner, it offers something that is as important as fuel economy to automakers – automotive safety. As the largest global supplier of automotive safety equipment, it also benefits from high customer switching costs. Besides the fact that Autoliv's safety products cost only a fraction of the total manufacturing costs of an automobile, automakers will want to avoid damaged reputations and liability lawsuits at all costs.
Active safety systems, such as traction-control and brake-assist systems, which help "actively" avoid accidents, have been a key area of growth for Autoliv. According to its second quarter of fiscal 2013 earnings report, it increased organic sales for its active safety products by more than 70% and management is confident of meeting its $500 million active safety sales target in 2015. External forces are at play here, with automobile rating programs like the European New Car Assessment Programme (EuroNCAP) increasing the Active Safety weighting from 10% to 20% in its assessments from 2014 onward.
Gentex manufactures automatic-dimming rearview mirrors, which help enhance safety by improving the reaction times and stopping distances of drivers. It grew net sales and gross margin by 2.4% and 270 basis points, respectively, for the second quarter of 2013. Based on IHS Automotive's July 2013 light vehicle production forecast, strong demand from North America, Japan & Korea will help to offset the continued weakness in Europe.
Gentex recently completed the acquisition of HomeLink from Johnson Controls in September. Prior to this, it licensed HomeLink, a vehicle-based control system used for operating garage doors, estate gates, and home lighting, and has integrated this into its rearview mirrors for more than a decade. Having complete control over HomeLink's intellectual property and testing facilities will allow Gentex to extend HomeLink's applications to its new products going forward.
A Foolish conclusion
While BorgWarner is not the only supplier of "must-have" products to automakers, it stands out with its low customer price sensitivity, high barriers to entry, R&D focus and prudent M&A approach.
