BorgWarner Inc. (BWA) March 12, 2015 Consumer Discretionary Auto Parts & Equipment Manufacturing Stock Rating Hold

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1 The Henry Fund Henry B. Tippie School of Management Liana Tamakloe BorgWarner Inc. (BWA) March 12, 2015 Consumer Discretionary Auto Parts & Equipment Manufacturing Stock Rating Hold BorgWarner has been a market leader in the powertrain component supply business and has strategic locations in 19 countries with 57 manufacturing facilities. Additionally, implementation of emission regulations in China, Europe and the US which is set to start in 2015 and continue through 2018 will lead to higher demand for fuel efficient vehicles and for this reason we propose a HOLD rating for BorgWarner. Drivers of Thesis Investment Thesis Target Price $63 $65 Henry Fund DCF $76.63 Henry Fund DDM $55.32 Relative Multiple $36.73 Price Data Current Price $ wk Range $48.40 $67.49 Consensus 1yr Target $65.65 Key Statistics Market Cap (B) $13.45 Shares Outstanding (M) Institutional Ownership 91.2% Implementation of Emissions Standards From September this year, emissions standards implementation will drive growth in demand for fuel efficient vehicles which in turn will drive demand for auto parts, and this we forecast will grow BorgWarner s business by 5% on average in the long run starting 2020 and beyond. Strategic location and business model operations BorgWarner has locations in the high automotive demand locations in the world and has established strategic partnerships with all the major automotive manufacturers, we believe this will continue to keep the company appreciably diversified by geographic location thus growing its revenues on average 7.6% over the 6-year forecast period. Current favorable economic conditions, namely low interest rates and low oil prices coupled with improving employment levels will drive demand for automobiles and by extension auto parts and equipment. Risks to Thesis BorgWarner s exposure to Europe is significant and can reduce growth targets as the region is forecasted to grow by only about 1% in Also foreign currency effect from these areas may reduce sales by about 6%. Drastic emission regulations changes unanticipated changes to emission regulations will impact BWA s business if imposing higher than expected changes to emissions and fuel efficiency standards on motor vehicles. Earnings Estimates Year E 2016E 2017E EPS $2.18 $2.89 $3.18 $3.43 $ growth 1.17% 32.45% 9.83% 7.86% 17.49% 18.11% 25% 15% 5% -5% -15% -25% Important disclosures appear on the last page of this report. Dividend Yield 0.9% Est. 5yr Growth 14.01% Price/Earnings (TTM) Price/Earnings (FY1) Price/Sales (TTM) 1.66 Price/Book (mrq) 3.8 Profitability Operating Margin 12.86% Profit Margin 8.3% Return on Assets (TTM) 9.7% Return on Equity (TTM) 18.6% 12 Month Performance Company Description M A M J J A S O N D J F Source: Yahoo Finance BWA S&P Source: Factset 13.2 BWA 18.3 Industry P/E ROE EV/EBITDA BorgWarner is an auto parts and equipment manufacturing company headquartered in Auburn Hills, Michigan. The company engineers and supplies powertrain components such as turbo-chargers, emission systems, thermal systems and transmission systems to Original Equipment Manufacturers (OEMs) of passenger vehicles, SUVs, light trucks and vans. Some of its products are also supplied to manufacturers of commercial vehicles and other off-highway vehicles. 1 BorgWarner operates internationally, and has production facilities in Europe and Asia, in addition to its North and South American locations.

2 EXECUTIVE SUMMARY The US, China and Europe have all enacted additional regulations aimed at controlling vehicle emissions and ensuring fuel efficiency. They will be implemented starting September 2015 for the US and in the coming years for the other regions. These standards will ensure demand for new vehicles when old ones do not meet the standards, and will influence the manufacture of new cars. This will drive up demand for fuel efficient parts and equipment such as is produced by BorgWarner. On an economic level also, current indicators are favorable to expansion in economic activity, creation of jobs and of wealth. These include low oil prices, low interest rates and reducing unemployment rates. These together make resources available for consumers to spend on goods and services, among which will be demand for consumer durables, such as cars. As a global competitor, BWA has a diversified operations, and has very well established relationships with its customer OEMS. These long-term relationships provide BWA with the added advantage of continued revenues from OEMs for years to come. Our analysis estimated revenue growth averaging 7.6% over the 6-year forecast period, slowing down to 5% in 2020 and beyond for the continuing years. With a WACC of 9.13%, our analysis led us to a DCF price of $76.63, DDM price of $55.32 and a value relative to its peers of $36.73 for the 2015 target year. Taking a weight of 60% for the DCF value and 20% each for the DDM and relative valuation, we come to a target price of $64.39, yielding a 7.17% potential upside for the stock. We believe this is a fair representation of the value of the stock as vehicle emission regulations, coupled with BWA s client partnerships will ramp up demand in the coming years, however this will not achieve its full potential because of slow growth in external markets, especially in Europe all together which generate about 76% of BWAs revenues. COMPANY DESCRIPTION BorgWarner manufactures and supplies auto parts and components for powertrain applications in the manufacture of automobiles. The company operates two segments; Drivetrain and Engine, and has production facilities in the United States, Europe and Asia. 2 8% 2014 SALES REVENUE BY REGION 13% 11% 5% 7% 6% Source: BorgWarner K The products of the company are used in the manufacture of new light vehicles, commercial vehicles and to a comparatively lesser extent, manufacture of offhighway vehicles. Among the output of BorgWarner are turbo, thermal, emission and transmission systems that improve vehicle s performance through fuel efficiency, stability and emissions control and provides better air quality. BorgWarner sells its products to every major Original Equipment Manufacturer (OEM) of motor vehicles in the world, some Tier One vehicle systems suppliers and then the aftermarket. Engine Segment 24% 26% Europe - 50% United States Germany Hungary France Other Europe South Korea China Other Foreign BorgWarner s Engine Segment produces turbochargers, timing systems, thermostats, emission systems, diesel cold starts and gasoline ignition technology for use in both light and commercial vehicles. These products, which make up about 67% of sales are mainly employed to improve fuel economy, reduce emissions and enhance performance of those vehicles in which they are used. In management s discussion in the company s K, it was noted that the segment benefited largely from growth in turbocharger demand for both diesel and gasoline engines globally. Turbocharger sales for light vehicles in 2014 were approximately 28% of total net sales for the year, and were supplied to major companies such as BMW, Daimler, Ford, GM, Hyundai, Renault, VW etc. For the commercial vehicle market as well, BorgWarner supplied its turbochargers to manufacturers of commercial and off-highway OEMs such as Caterpillar, Deutz, John Deere, Daimler, MAN and Navistar. 2 Page 2

3 As a unit focused on producing fuel efficient components, the Engine segment benefits from increasing fuel efficiency standards and demand from consumers for more economy vehicles. Under normal conditions, falling oil prices as is being experienced currently will make consumers indifferent about the fuel usage of their vehicles. However, this will not affect BWA s business because when a vehicle manufacturing platform is installed, manufacturers will incur considerable costs to switch to other parts suppliers or less fuel efficient technologies. For this reason the effect of short term fuel price changes is greatly curtailed. In September 2014, BorgWarner announced the opening of its second turbo manufacturing plant in Tiancang, China and in November of the same year, officially opened its new production plant in Lanheses Portugal for the manufacture of Exhaust Gas Recirculation (EGR) technologies and diesel cold-start technologies 3. In light of these moves to boost production of turbochargers, EGR and diesel cold-start technologies, to meet growing global demand, especially in areas such as China, we believe BorgWarner will increase sales generated from this segment by about 8.7% on average between and should normalize to about 5% in 2020 and beyond. Drivetrain Segment The Drivetrain segment which makes up the remaining 33% of BorgWarner s portfolio of products manufactures clutch modules, friction and steel plates, transmission bands, torsional vibration dampeners, and coupling systems for torque management in vehicles. These products are for automatic transmissions and all-wheel drive (AWD) vehicles that enable precise control, better response time and minimal parasitic losses to improve fuel economy and vehicle performance. the last financial year, Dec Drawing from this background and from management guidance, we are of the opinion the drivetrain segment will grow by about 7% in 2015, and then about 10% for the following two years, after which we should expect a long-run growth of 5% in 2020 and beyond. For the years 2015 to 2017, the company forecasts the distribution of output from both its operating segments to be distributed 71% and 29% between the Engine and Drivetrain segments respectively. This is depicted in the chart below with a subdivision of the various kinds of components manufactured in each segment. Source: BWA Presentation, Deustche Bank 2015 Automotive Industry Conference Company Analysis Markets- The output of BorgWarner is sold to OEMs in all the global markets the company operates in. BorgWarner sells to all the major automobile manufacturers in North America, Asia and Europe. Among its clients, Volkswagon and Ford have been the largest in terms of sales making up 17% and 13% of net sales respectively as at year end The remaining OEMs to which the company sells to are indicated in the chart below. This segment is a global leader in dual-clutch transmission (DCT) through its DualTronic technology that transforms a manual gearbox into an automatic transmission system by eliminating the break that occurs when shifting gears in a manual transmission system. As part of the company s restructuring efforts in Western Europe, the company has been moving its manufacturing operations to Poland in Eastern Europe. This program is expected to be completed by the end of this year and was highlighted by management of the company as one of the factors that negatively impacted the segment in Page 3 Source: BWA Presentation, Deustche Bank 2015 Automotive Industry Conference

4 Also, by classification of the kind of vehicle application, in the year 2014, about 83% of the company s output was for light vehicle applications. This represents a strong position in the light vehicle production space. Source: BWA K PRODUCT LINES (2014) Light Vehicles Off-Highway vehicles Commercial Vehicles After-market 83% 8% 5%4% 0% 20% 40% 60% 80% 100% Locations - BorgWarner has 57 manufacturing, assembly and technical locations globally. In Asia, the company has operations in China, Japan, Thailand, India and South Korea. In Europe, BWA s locations are in Germany, France, Hungary, Poland, UK, Portugal, Spain, Sweden, Ireland, Italy and Monaco. In the Americas, it has locations primarily in the US, then Brazil and Mexico. Strategic Advantages - BorgWarner has several strategic benefits as opposed to its competitors. The company s dispersed location base ensures that it is strategically close to the OEMs it serves. Having presence close to markets provides transportation advantages to BWA, and reduces the volume of inventory the company would otherwise have to carry. Additionally, there is extensive collaboration between BWA and their OEM engineers to implement and launch and production programs. Once a program is launched, switching costs become very high and prohibitive for OEMs. Compared to BWA s main competitors who serve a variety of product offerings to different market segments such as Honeywell, BWA has a focus on the light vehicle market with about 83% of sales tailored to that segment. This has helped BWA build proficiency and establish strong relationships in these markets. It also allows the company to focus its research efforts efficiently to generate innovative solutions for the market, and reinforce its position in that space. Key Risks - In spite of its robust strategy, BWA continues to face competition from several industry players. In each of its engine and drivetrain segments, there are other competitors who compete with BWA on the basis of quality, price, delivery, program launch support and technological innovation. In light of the competitive environment, the main risk to BorgWarner is the bigger size and financial strength of these competitors. Demand for auto parts products draw largely from the demand for new motor vehicles. As demand is cyclical and especially during summer months when many OEMs run their facilities at low productivity levels for changeovers and vacations, sales of auto parts is adversely affected. This is usually evident in the 3 rd quarter sales drop. BorgWarner uses aluminum, iron, steel, copper, plastic resins and alloys in the manufacture of its products. For this reason, commodity prices of such items as aluminum, steel and iron go a long way to affect productivity and profitability. The company employs hedging, among other measures such as using long-term contracts, cost-sharing arrangements with OEMs and changes to product design to control these costs however. RECENT DEVELOPMENTS Acquisition of Gustav Wahler GmbH & Co. In the first quarter of 2014, BWA acquired 100% ownership of the German EGR manufacturer Gustav Wahler GmbH & Co. This acquisition was intended to strengthen the company s footprint in the production of EGR valves, EGR tubes, and thermostats. Wahler operates in Brazil, Germany, US, Slovakia and China. This was also a strategic move to acquire the clientele base of Wahler which had among its customers, manufacturers of commercial vehicles to strengthen BWAs presence in this market. On assets acquired, net of cash paid was $110.5m at the time the acquisition was finalized in February Page 4

5 $1 Billion Share Buy-Back In February of this year, the management of the company announced that its board had approved a $1 billion 3 share repurchase program to be completed over the next three years representing approximately 7.35% of shares outstanding at the date of this report. Management did not provide specific dates or periods when repurchases shall be carried out, but indicated that it will be subject to prevailing market conditions. They were of the opinion that this demonstrated management s belief in the growth of the company in the long-term. We are of the opinion that in addition to the company s growth potential, this is a secure means to return earnings to shareholders without unnecessarily causing dividend volatility in the coming years. Based on this backdrop, we forecasted treasury shares acquisition to be $300 million in the first 3 years, and $200 million going forward. At the time of this report also, the company had registered a $1billion offering of Senior Notes with the Securities & Exchange Commission and among the stated use of the proceeds of the offering was to for general business needs and also to support its share repurchase program. Opening New Production Facilities In growing its business across both its drivetrain and engine segments, the company opened two new manufacturing plants in China and Portugal. The Chinese facility located in Taicing China, is set to produce fuel-efficient turbocharging technology for the increasing demand in the Chinese engine market where emissions controls is projected to increase demand to 8.9m by The facility, which is the company s second turbocharger facility in China, is strategically located to developments near Shanghai and is designed be green and efficient, having won the Gold LEED Certification (Leadership in Energy and Environmental Design). In Portugal, the state-of-the-art facility is located in Lanheses, Viana do Castelo. This facility was opened in November of last year and it is to meet demand for growing EGR technologies in the drivetrain segment. This facility happens to be 50% bigger in size compared to company s current site in Valenca, Portugal and so offers opportunities for easy expansion to accommodate growing demand in the future. Reported 2014 Annual Results BorgWarner recorded record net sales of $8.3bn. This was representative of a growth of 11.7% over that of In effect, operating income generated for the year was $963.7m, being a margin of 12.9%, an increase over the 2013 margin of 12.4% (margin percentage is exclusive of non-comparable items). Net earnings per share for 2014 was $2.86, an increase of $0.16 over that for Performance was impacted by headwinds in the foreign currency market, reducing sales by $8m and leading to a $0.02 per share decrease in net earnings. In 2014, the company increased its quarterly cash dividend by 4%, and engaged in share repurchases to a tune of 2.4 million shares at a total cost of $139.9 million. Thus, total returns to shareholders was 18.28% in In January 2015, the company issued guidance for its Full Year 2015 earnings, projecting net sales to increase by about 9.5% - 12%, but incorporating the impact of weaker foreign currency, net sales growth is forecast to be between 2% - 6%. The main foreign currencies expected to negatively impact earnings include the Brazilian Real, Chinese Yuan, Euro, Japanese Yen, Korean Won, Mexican Peso and the Swedish Krona. This is estimated to generate an EPS of between $3.35 and $3.55 with an operating margin of 13%. The increase in operating margin is expected to come from incremental income as a result of higher net sales and the company s focus on managing costs. In comparison to our model, we forecast EPS to be $2.9 for 2015, arising from a net sales growth of 7.6% over the same period. Our analysis further leads to an operating margin of 11.75%. Our estimates are below that of the company s guidance as we considered the impact of weakening foreign currency experienced from the time of management s publication of its guidance until the preparation of this report. INDUSTRY TRENDS Emission Control Regulation In recent times, the auto parts manufacturing industry has been impacted by more stringent regulation among Page 5

6 other factors. The main market areas for automobile production, namely the US, China and Europe all have on-going vehicle emission reduction standards that are reviewed on a regular basis to ensure a cleaner, safer environment in their respective countries. New standards however have been set which will come into effect from May 2017 for the US Tier 3 regulations, September 2015 for the Euro 6 applicable to the EU countries and January 2018 for the China 5 standard 4. The regulations pose varying degrees of motor vehicle exhaust emission limits as well as required fuel consumption limits for both diesel and gasoline passenger and light-duty vehicles. As these dates are in future times, there is current demand on auto parts manufacturers to develop emission and fuel efficiency systems to meet these requirements. The graph below shows the implementation dates for some of the prominent global emission control regulations. shows the projected rate of electric vehicle production. It does not appear to grow dramatically up until the end of this decade but there lies prospects if a company positions itself well to develop the energy storage devices and systems needed to make these cars normal standard. VEHICLE EMISSION REGULATIONS GLOBAL TREND Source: KPMG Global Automotive Executive Survey BorgWarner manufactures the egeardrive electric drive transmission for the emerging electric vehicle market. Clearly, BWA has positioned itself to be proactive in the trend towards electrification of the automotive market. Source: BWA Presentation, Deustche Bank 2015 Automotive Industry Conference Electric Vehicles There is growing interest in the development of electric vehicles. This interest stems from the benefits derived from this class of vehicles; namely fuel economy, reduced carbon dioxide emissions (no emissions in All- Electric vehicles), fuel cost savings and flexibility with refueling. Some electric vehicles are either hybrids between hydrocarbon fueled or electricity charged, or are All-Electric. Increasing interest in production of these cars on a larger scale than is produced now has many different implications for the auto parts suppliers (APS) industry. It will eliminate the exhaust system manufacturers in the industry, and at the same time create opportunities for research and development in the areas of more efficient battery charging and energy storage systems for these vehicles. The graph below With respect to demand for electric vehicles, information available shows a mixed reaction from consumers. General Motors and Toyota both had sales of their hybrid electric passenger vehicles fall by 12% and 11.5% respectively as at mid-year On the other hand though, Nissan Motors and Tesla Motors Inc. both recorded increased sales of 34% and 47% in sales growth as at the same period last year 5. Sales of electric vehicles have increased year on year from 2012 to , but the rate of growth was lower in With the growing interest in generating cleaner energy to sustain the environment, evident in the enactment of emission regulations, we believe increasingly electric vehicle sales will pick up in the coming years and this should have a positive impact on BWA s business as our search revealed that compared to its competitors, BWA Page 6

7 # of Cars (m) is a leading producer of electric vehicle transmission systems for the light vehicle market. 140, , ,000 80,000 60,000 40,000 20, ,607 Source: Seeking Alpha, 2015 No. of Hybrids Sold 97, , This situation may be attributable to the current low oil prices being experienced whose fall started in the middle of last year. A survey of automotive industry executives by KPMG however shows that it is anticipated that by 2025, 10% of new vehicle sales will be electricity powered. innovation, engineering development and program launch support to OEMs. Dominance by one or a few manufacturers in the industry is generally low, making income distribution for industry participants dispersed. As a result, small specialized firms concentrating on a specific niche in the market generate the majority of the revenue, whereas about 27.4% is accounted for by the top four largest companies. In the wake of the credit crunch of 2008, many automobile manufacturers experienced reduced demand while they had built up inventories in anticipation of sales. As people were not making new purchases of vehicles, demand for automotive parts also fell and as some of the companies filed for Chapter 11 bankruptcy, the negative fortunes also affected the businesses of many auto parts suppliers WORLD AUTOMOBILE PRODUCTION Source: Factset Competitive Landscape Source: KPMG Global Automotive Executive Survey MARKETS AND COMPETITION Competitive advantage in the industry is achieved through price, quality, delivery, technological Number of competitors - There are a number competitors within the industry with each player focused on a specific niche in the market. Competition among these players can be fierce as establishing a contract with an OEM leads to long-term relationships and continued business. Smaller companies sometimes sell their products to the larger suppliers who have contract relationships with OEMs. Potential for New Entrants The industry is fairly capital intensive and operates on the basis of technological innovations. Additionally, it is fairly regulated and very competitive among the present participants. Power of Suppliers Suppliers of raw materials such as aluminum, iron, rubber etc., are not very powerful. This is because prices of raw materials are more often than not dictated by global commodity prices. However, when prices are not favorable at a particular time, suppliers Page 7

8 create artificial shortages in the market until market prices rebalance to acceptable levels to suppliers. automobile industry is onto a strong recovery from the slump during the 2008/2009 financial crises. Power of Customers Customers tend to be very powerful as they have a good number of alternative APSs to fall on. One single supplier does not supply all the component parts for all the different classes of a manufacturer s vehicle range. OEMs source different parts from different OEMs. They therefore wield a lot of influence on selecting a particular supplier. Threat of substitution Some OEMs have integrated backward into the APS industry mostly through acquisitions. This threat is high and intensifies competition, even between suppliers and customers. In summary, parts suppliers go to great lengths to satisfy their clients in the area in which they operate. This includes yielding to annual price reductions in supply contract renegotiations, partnering with OEMs to design, develop and launch a program for manufacture of a range of vehicles, and sharing in liability costs that arise from product liability suits to the OEMs. Also, to remain competitive suppliers invest heavily in R&D making it a key component of the cost structure of ASPs. Peer Comparisons Compared to its peers, BorgWarner appears to be an average performer in terms of operational metrics but trades as the highest PE in that range at 17.3x earnings. This is attributable to the fact that despite its mid-size, it is able to efficiently manage its costs which then improves the bottom line. It is reflective of the high earnings potential of the company which it derives from its focus, as a company, on components for application in automobile manufacturing whereas its competitors such as Cummins also manufacture components for other industrial uses such as power generation. The Company Ticker Mkt Cap P/E(ntm) EPS ( 15) Page 8 Additionally, the market may be judging it to be a low risk investment as it only has a debt ratio of 10%, which is among the lowest in its range. The next best competitor to BorgWarner judging from the comparable metrics is Honeywell Inc. with a P/E of 16.8, a higher EPS forecast of $6.1 and a higher net profit margin and ROE of 10.5% and 24% respectively, compared with BWA s 8% and 19% respectively. Even more interesting is the fact that with only just 2.7 of sales spent on capex, Honeywell generated such impressive results. Research and development is an integral component of the business of the auto parts manufacturers. In 2014, among BWA s main competitors, DLPH spent the most on R&D as a percentage of net sales, followed by HON, with each spending 7.8% and 4.5% respectively of net sales on R&D. BWA, CMI and AXL each spent 4%, 3.8% and 2.8% respectively on R&D. In absolute value terms, HON spent the most on R&D being a big player in the industry, and this represents a 5% increase over that of 2013, and which was attributed to new product development in its Automation & Controls division, and Performance Materials & Technologies division. BWA has a policy of spending approximately 4% of net sales on R&D. The percentages vary across firms but each firm has a threshold they work to operate within in order to control costs. Additionally, clients reimburse the parts suppliers for some of the R&D work. We believe considering BWA s market size compared to competitors, 4% is an appropriate level of R&D investment, as the average across all firms stands at 4.54%. Div. Yield (%) Net Profit Margin (%) Debt Ratio (%) ROE (%) Operating Margin (%) BorgWarner Inc. BWA 13.6B American Axle & Manufacturing Holdings, Inc. AXL 1.9B Cummins Inc. CMI 25.5B Delphi Automotive PLC DLPH 22.7B Honeywell International Inc. HON 80.2B Source: Factset and Companies K Capex/ Sales (%)

9 Yield as at 31st. Dec. (%) ECONOMIC OUTLOOK As a company in the Consumer Discretionary Sector, occurrences in the wider economic sphere often have a direct impact on the immediate future of the company. Among the most prominent drivers are: GDP Growth As the US, and by extension the world economy grows, more people will have jobs and earn income, and will have money to spend on consumer durables. Additionally, economic growth will mean that people will demand vehicles to commute to work, and a growing middle class will then shift demand from commercial transport options to owning their own vehicles, especially in economies such as China. In 2015, the Congressional Budget Office of the US anticipates that US GDP growth will be 2.9% 7 whereas the IMF forecasts global GDP to grow at about 3.5% 8. We anticipate GDP growth to be about 3.05% in the long run for the US, and about 3.12% over the next 6 months. With increased growth forecast, we anticipate growth in the economy to fuel increased wealth of individuals who will in turn spend some discretionary income on consumer durables such as automobiles. This will be help drive the growth in the business of BWA. Interest Rates In the wake of the economic crises, central banks all over the world cut interest rates in an attempt to stimulate demand and generate economic growth. The recovery from the recession was however very sluggish although some economies such at the United States and the United Kingdom have experienced steady growth signaling recovery from the crisis. Interest rates have however remained low with some central banks in countries such as Japan, China, India, Australia among others cutting back interest rates in recent times. It is expected that the rate reductions will filter through the economy to the individual consumer to stimulate demand. If we see this low interest environment persist, consumers will continue to take out loans at lower costs for purchases of durables, including automobiles. However, with the recent uncertainty regarding the Federal Reserve timeline for increasing its Fed Funds rate, we are likely to witness interest rates rise soon, likely with minimal increases by the end of this year, and which will impact negatively on vehicle demand Source: US Dept. of the Treasury Strengthening Dollar BorgWarner has almost half of its revenue being generated outside the United States. Even though this provides the company diversification in terms of the sources of its revenue, translation of foreign revenue into US Dollar terms negatively impacts reported performance. With the current outlook of the global economy, the strengthening of the dollar is likely to persist at least for the greater part of The company expects growth in net sales in 2015 to be 6% - 7.5% lower than what would have been achieved ignoring the impact of currency translations. We modeled sales growth therefore to be 7.6% as a result. Fuel Prices 1-YR USTREASURY YIELD Fuel prices have been trading just about the $50 mark in the last month, a moderate price appreciation from its all-time low of $45/barrel in January. This price is about 50% of its peak of about $100 in June of As fuel becomes cheaper, it increases disposable income of consumers, leading to increased demand for goods and services, and thereby demand for vehicles. Sentiments amongst business participants is that oil is yet to reach its bottom price. We anticipate that in the coming half year, oil prices should still be about $50/b. As this era of low oil prices persist, consumers will continue to make more savings, and have money to spend on durable goods. This should positively impact on the performance Page 9

10 of BorgWarner through increased demand from OEMs. It would be expected that as BWA produces more fuel efficient vehicles, low oil prices will be detrimental to its business as consumers will be indifferent to the fuel efficiency of the cars they purchase. However, the effect of regulations and the high switching costs to OEMs from changing production platforms to less fuel efficient components will be detrimental and ensure continued demand for BWA parts. Additionally, BWA manufactures parts for SUV s and light trucks and so should consumers substitute demand for such vehicles, it will not have a negative impact on sales by BWA. The effect of the low oil prices then will essentially just translate into increased disposable income for consumers. Source: Nasdaq, March 2015 Improved Labor Statistics For the month of February the US economy added on an additional 295,000 non-farm jobs and reported an unemployment rate of 5.5%, a reduction of 0.2% only a month earlier. Improved employment conditions mean that more people will have jobs, some will get better jobs and which translates to more income to spend. The prospects of improved expenditure by the population holds positive promise for the automobile and auto parts manufacturing industry. CATALYSTS FOR GROWTH As fuel efficiency and vehicle performance with respect emissions control become more stringently regulated in all the markets that BorgWarner operates in, there will be increased demand for turbochargers and the other performance enhancing components BorgWarner manufactures. The adoption and implementation timelines for the US Tier 3, Europe s Euro 6 and China s China 5 standards are not far off into the future and as such present immense growth opportunities in BWA s current markets. Demand for new vehicles is influenced by a number of factors. As we witness improving economic conditions especially in the US, growth in GDP will translate to more jobs, more income and then more spending, some of which will be on durable goods such as vehicles. Stronger GDP growth, in Europe where currently 50% of sales is generated will grow demand for BWA engine and drivetrain components. Also, higher than expected growth in China, India and Brazil should drive growth for BWA. The average age of vehicles on US roads is about 11.4years and this number is expected to grow to 11.5 in 2017 and 11.9 in This rate of change in average vehicle age is estimated to be slower than in the last 5 years 9, implying that all things equal, people are likely to change their vehicles more often than in the last 5 years. This will mean demand for new cars and will positively impact demand for auto parts. Also as new technologies are being developed and consumers are increasing seeking out ways to make technology a part of their everyday lives, new inventions in new cars will cause consumers to scrap, or change vehicles more regularly, given that economic trends remain positive. INVESTMENT POSITIVES BorgWarner has operations in the major auto manufacturing hubs around the world, and has established solid relationships with OEMs in all these locations. We believe this makes it very well geographically diversified to take advantage of growing opportunities in those markets, and have a good hedge against downturns in others. BorgWarner has invested strategically in businesses that provides it a wide portfolio of powertrain application components, yet has designed a model to concentrate in the two main business segments, engine and drivetrain. This has allowed the company Page 10

11 to develop expertise and innovative capabilities in these segments whereas its competitors operate in other auto parts markets, gaining more diverse revenue sources but not quite the expertise of BWA. INVESTMENT NEGATIVES With about 50% exposure to the European market, and with the less than favorable growth forecast of for this year, BorgWarner may find achieving its growth targets in those markets a stretch. Compounding the risk is the strengthening of the US dollar in recent months, which will lead to lower net sales for BWA as about 75% of net sales is generated outside the US. As a result, we anticipate that net sales growth will be about 6% less than what could be achieved assuming there was no external market effect. VALUATION Terminal Growth Rate A terminal growth rate of 5% was chosen as the rate at which BorgWarner will grow future revenues in the steady state. This was selected because we believe this level of growth is reflective of long-term US GDP growth which is forecasted to be 2.9% 7 in 2015 & 2016, and with enough allowance factoring in BorgWarner s strong growth capacity arising from its strong global presence (18 global locations 2 ), innovative capacity, and the recent surge in production and sales of automobiles. In the forecast years leading to the terminal period, the Engine segment was forecasted to grow at 7% in the 1 st FY, 100bp ahead of the Drivetrain segment as the movement of the Drivetrain segment in Eastern Europe is still underway and will not generate immediate outstanding growth results until the restructuring is completed. Upon completion of the move, growth in Drivetrain is expected to outstrip Engine by about 2% on average before both converge at the terminal rate of 5%. Cost of Sales COGS was forecasted at 76.2% of sales. This was the 6-year historic average from 2009 to This percentage had not changed significantly in the said time frame and was thus used as the constant percentage over the forecast period. SG&A SG&A was forecast at 5% of net sales. Average SG&A was 5.62% over the 6years preceding our forecasts, however a lower 5% was chosen to cater for cost savings the company will realize arising from efficiency of its processes over the forecast period. Operating Margin Operating margin for 2015 is estimated to be 11.75%, increasing by an average 138bp over the forecast period to 18.65% in Research & Development Expenditure on R&D was estimated to be 4% of sales throughout the forecast period. This was used because an analysis of R&D expenditures in the 6year period spanning 2009 to 2014 showed an average expenditure of 4% 3 and management also strongly reinforced its commitment to investing at least that much in research as it was considered a vital function in the success of the company. Capital Expenditures - Capex was forecasted to grow at the rate of growth of sales as we believe that as sales grow, BorgWarner shall invest in equipment to facilitate production at the increased rate of sales. The new production site in Poland is assessed to be 1.5 times that of the facility in Western Europe with management indicating that an expansion of the facility to meet increasing demand will be easier. Beta A beta of 1.47, representing a simple average of the 2-year and 3-year monthly betas from Bloomberg was used. Both betas did not vary widely in value, and were chosen because we felt that represented more accurately the variability of the stock in recent times, and thus a more stable estimate. A beta beyond three years would be higher and exhibit more variability as the world economy at the time was still recovering from the recession. Risk Premium and Risk-Free Rate - An equity risk premium of 4.85% was used, which is an average of the 87-year Geometric average of stock returns in excess of the 30-year Treasury bond yield, and Damodaran s monthly equity premium as at March 1, We believe this is representative of market returns over a wide span evening out effects of such Page 11

12 times as the Great Depression of the 1930s, the Dot com bubble and the more recent recession. In light of taking a long term view of events and estimates, we used the 30-year Treasury bond rate of 2.71% as the risk-free rate also. Our DCF and Economic Profit models yielded a year-end target price of $ According to relative valuation based on industry peer P/E and PEG ratios, BorgWarner stock price is valued at $36.73 and $31.90 respectively for The Dividend Discount model resulted in a price of $ Our price target range however is $63 65, leading us to a HOLD recommendation as this represents a modest 7.17% appreciation of the stock above the current price and our target price. This price range is within ±$1.39 of our target price of $ We came by this price by applying a weighting to our DCF, DDM and Relative Multiples valuation respectively. We assigned a higher weighting to the DCF because it captures all the assumptions that went into our analysis of the company, its industry and the economy. KEYS TO MONITOR Our model is highly sensitive to growth estimates for BorgWarner. We are likely to change our recommendation if the company is unable to achieve the 8% and 7% growth forecasted for the Engine and Drivetrain segments respectively in Additionally, a simultaneous increase in oil prices and interest rates will send a negative signal to consumers and even though GDP growth fundamentals have not changed severely, it may cause consumers to put of purchasing new cars. This will not generate the resulting demand for BWA products from OEMs. Therefore in the near future, it will be important to monitor interest rates and oil prices as these will affect the growth estimates anticipated. As the need for fuel efficient and low emission vehicles is largely steered by regulations and standards, it will be important to keep a close watch on what new standards will be formulated in the near future, alongside keeping track of progress and timelines towards implementation of the Tier 3, China 5 and Euro 6 emissioin regulation standards. REFERENCES 1. Factset 2. BorgWarner 10-K for /a10k htm#s6C670F 6671D751F68F E BorgWarner Corporate Website News Releases 4. Global Transport Policy Data Website t-duty:_emissions 5. The Wall Street Journal Demand Ebbs for Electric, Hybrid Vehicles 6. Seeking Alpha Electric Vehicles: Here to stay 7. Congressional Budget Office The Budget and Economic Outlook 2015 to tachments/49892-outlook2015.pdf 8. International Monetary Fund 15/NEW012015A.htm 9. HIS Automotive Industry Research Report IMPORTANT DISCLAIMER Henry Fund reports are created by student enrolled in the Applied Securities Management (Henry Fund) program at the University of Iowa s Tippie School of Management. These reports are intended to provide potential employers and other interested parties an example of the analytical skills, investment knowledge, and communication abilities of Henry Fund students. Henry Fund analysts are not registered investment advisors, brokers or officially licensed financial professionals. The investment opinion contained in this report does not represent an offer or solicitation to buy Page 12

13 or sell any of the aforementioned securities. Unless otherwise noted, facts and figures included in this report are from publicly available sources. This report is not a complete compilation of data, and its accuracy is not guaranteed. From time to time, the University of Iowa, its faculty, staff, students, or the Henry Fund may hold a financial interest in the companies mentioned in this report. Page 13

14 BorgWarner Inc. Key Assumptions of Valuation Model Ticker Symbol BWA Current Share Price $60.08 Current Model Date 5-Mar-15 Fiscal Year End Dec. 31 Steady State Growth 5.00% 10-Year Treasury Bond Rate 1.47% Marginal Tax 31.18% Average Depreciation 15.45% R&D Expense 4.00% Pre-Tax Cost of Debt 3.70% Risk-Free Rate - 30 Yr Treasury 2.71% Current Dividend Yield 0.85% Inflation Rate 0.80% Beta Equity Risk Premium 4.85% WACC 9.13% Cost of Equity 9.82%

15 BorgWarner Inc. Revenue Decomposition Fiscal Years Ending Dec E 2016E 2017E 2018E 2019E 2020E Net Sales by Product Segment : Engine 4, , , Drive Train 2, , , Intersegment Elimination Total Net Sales 7, , , , , , , , ,874.7 YEAR-ON-YEAR GROWTH Net Sales by Product Segment : Engine -2.7% 2.2% 13.6% 8.0% 10.0% 8.0% 7.0% 6.5% 5.0% Drive Train 10.3% 6.4% 7.6% 7.0% 12.0% 10.0% 8.0% 6.5% 5.0% Intersegment Elimination 39.7% 12.3% 0.6% 20.0% 18.0% 16.0% 14.0% 12.0% 10.0% Total Net Sales 1.0% 3.5% 11.7% 7.6% 10.6% 8.6% 7.3% 6.5% 5.0% Net Sales by Geography : United States 1, , ,008.1 Europe: Germany 1, , ,145.6 Hungary United Kingdom France Other Europe 1, , ,097.3 Total Europe 3, , ,166.2 South Korea China Other Foreign Total Net Sales 7, , ,305.1 YEAR-ON-YEAR GROWTH Net Sales by Geography : United States 10.9% 4.4% 3.5% Europe: Germany -14.9% -5.9% 21.9% Hungary -10.8% 0.6% 14.8% United Kingdom 0.0% 0.0% 0.0% France -7.7% -2.3% 23.7% Other Europe 10.6% 11.6% -3.1% Total Europe -7.9% 0.0% 13.5% South Korea 7.2% 11.5% 10.6% China 19.8% 27.5% 39.1% Other Foreign 14.5% -3.9% -0.4% Total Net Sales 1.0% 3.5% 11.7%

16 BorgWarner Inc. Income Statement Fiscal Years Ending Dec E 2016E 2017E 2018E 2019E 2020E Net sales 7, , , , , , , , ,874.7 Cost of sales (excluding Depr. & Amortiation) 5, , , , , , , , ,810.5 Depreciation & tooling Amortization of intangible assets Gross profit 1, , , , , , , , ,708.0 Selling, general & administrative expenses Net Research & Development Restructuring expense Goodwill impairment charge Total other income (expense) Operating income (loss) , , , , ,549.3 Equity in affiliates' earnings, net of tax (42.8) (43.5) (47.3) (48.0) (57.5) (63.6) (69.1) (74.1) (78.9) Interest income (4.7) (4.8) (5.5) (5.93) (7.10) (7.85) (9.15) (9.74) Interest expense & finance charges Earnings before income taxes and noncontrolling interest , , , , ,592.1 Provision (benefit) for income taxes Net earnings (loss) , ,095.7 Net earnings attributable to the noncontrolling interest, net of tax (21.5) (26.7) (31.7) (28.3) (31.3) (34.0) (36.4) (38.8) (40.7) Net earnings (loss) attributable to BorgWarner Inc ,054.9 Weighted average shares outstanding - basic Net earnings (loss) per share - basic Dividends per common share Dividends Paid Dividend Payout Ratio

17 BorgWarner Inc. Balance Sheet Fiscal Years Ending Dec E 2016E 2017E 2018E 2019E 2020E ASSETS Cash & cash equivalents Marketable securities Receivables, net , Inventories, net Deferred income taxes Prepayments & other current assets Total current assets Property, plant & equipment,gross , , , , , , ,218.8 Accumulated Depreciation (1,567.0) (1,099.3) (1,076.0) (1,399.6) (1,717.3) (2,036.6) (2,362.1) (2,688.5) (3,019.8) Investments & advances Goodwill , , , , , , ,205.7 Deferred Income taxes Net Other Intangible assets Product Liability Insurance Other non-current assets TOTAL ASSETS LIABILITIES & EQUITY Notes payable & other short-term debt Trade Payables & Customer related Payroll & Employee accruals Product warranties Product liabilities Severance & Retirement related Dividends to non-controlling interests Other payables & accrued expenses Income taxes payable Total current liabilities Long-term debt Other non-current liabilities: Retirement-related liabilities Product Liabailities Deferred Income taxes Product Warranties Deferred Revenue Cross-currency swaps & Derivatives Other non-current liabilities Total other non-current liabilities Common stock , , , , , , ,142.4 Unearned compensation on restricted stock Retained earnings (accumulated deficit) , , , , , , ,842.2 Accumulated other comprehensive income (loss) (121.3) (14.0) (383.6) (383.6) (383.6) (383.6) (383.6) (383.6) (383.6) Common stock held in treasury, at cost (569.2) (727.2) (832.2) (1,132.2) (1,432.2) (1,732.2) (1,932.2) (2,132.2) (2,332.2) Total BorgWarner Inc. stockholders' equity , , , , , , ,268.8 Noncontrolling interest Total equity , , , , , , ,343.5 TOTAL LIABILITIES & EQUITY , , , , , ,037.9