Fructivore Investments

My faithful readers will recall that I thought Garrett Motion, maker of turbochargers and related auto parts, was an attractive investment, and indeed it was until the tariff monster was awakened. And while I was looking at it, I compared it to BorgWarner, another company in the auto parts sector, which had comparable R & D expenditure rates and a strategy of technological development. More to the point, it presents an even more attractive valuation based on its free cash flow yield.

As of this writing, BorgWarner has a market cap of $5.9 billion (down from $6.4 billion last Wednesday). However, it has $2.1 billion in cash sitting on its balance sheet despite share repurchases totaling $1.1 billion over the last six years, and despite its significant research & development expenses in order to maintain its earnings power. This creates an effective market cap of $3.8 billion to use as our denominator for free cash flow yield calculations.

BorgWarner operates in several fields in the automotive parts sector: turbos & thermal technologies are about 40% of sales, drivetrain devices a slightly lower proportion, powerdrive, including all-electric car technologies, about 15% of sales, and battery & charging systems, the last 5%. Total net R & D in 2024 came to about 700 million or 5-6% of sales which is comparable to Garrett Motion; however, more than half of that R & D was allocated to powerdrive and batteries despite their lower presence in the sales mix.

BorgWarner’s strategy starting in 2021 was to go all-in on electric vehicles, and the company even spun off its fuel systems division in 2023. However, in 2024 the company determined that adoption of electric vehicles was “volatile” compared to their expectations, and indeed the operating income from both the powertrain and battery segments were negative in 2023 and 2024, so the company refocused its efforts towards growth along its entire portfolio of offerings. This also resulted in a significant goodwill writeoff in the last quarter of 2024 that should be reversed for free cash flow purposes.

Turning to the figures, in the latest fiscal year, Borg Warner reported earnings of $338 million, but this was net of the $646 million goodwill writeoff, the fruit of some aggressive mergers in the electric vehicles, batteries, and charging sectors. Its operating income without the writeoff was $1192 billion, and it has $3.7 billion in debt outstanding with an average interest rate of 2.8%, producing interest expense of $105 million. However, I should note that the company’s latest borrowing in August of 2024 was at 4.95%, and the average interest rate for a BBB+ rated company like BorgWarner is 5.3% as of this writing, so although the company has locked in low interest rates that are essentially free money until the loans are refinanced, for the purposes of assessing the company’s earnings power we should charge the company a 5.3% interest rate, which comes to just about $200 million per year, leaving just about $1 billion. As the company has a global footprint, estimating its tax rate is difficult but the company’s provision is about 23% on average, leaving just about $770 million in after tax free cash flow, which is an impressive free cash flow yield of just over 20% of its effective market cap.

Of course, for a cyclical company like an auto parts manufacturer, one year’s figure is not a reliable measure of earnings power; it could be that 2024 was a particularly good year. One should consider Borg Warner’s earnings power over a complete business cycle, and applying a 5.3% interest rate, free cash flow figures for those years were, starting in 2023, were 2023: 550; 2022: 554; 2021: 754, and 2020: 406 (and 902 in 2019). Long term debt has been stable since 2020, but interest rates were substantially lower, so actual free cash flows were higher, but as we are looking at prospective earnings power we should probably stick with the higher present interest rates. But even in the pandemic year of 2020 the company managed a free cash flow yield of over 10% based on the current effective market cap.

I should point out that in pursuit of its aggressive expansion of electric vehicle capacity that in retrospect was an error, BorgWarner purchased many companies that are not counted in the above calculation as a capital expenditure. It was a regrettable wastage of corporate assets, as shown by the goodwill writeoff, but if BorgWarner’s management is going to be more circumspect about purchasing growth in future, it would be somewhat unfair to ding the company’s future prospects for it, especially as the pace of acquisitions slowed considerably in 2022 and 2023 and ceased completely in 2024.

As an aside, the company itself, for its impairment analysis, used 14% as its weighted cost of capital, and if its cost of capital for debt is 5.3%, then its cost of equity is 19.5% based on its market cap counting its excess cash, or 30.27% not counting its excess cash. The former figure is conservative for a cyclical company that can produce a l0% free cash flow yield in a recession year, and the latter is quite insane. (although in fairness, a company with billions in excess cash would have a lower cost of equity than a company with no billions).

Of course, what with the current tariff chaos, much is up in the air. However, as I stated before BorgWarner has a global footprint, with only 25 of its 84 properties in North America, and the United States represents only 16% of its net sales, and indeed North America represents about 16% of global auto sales in the first place. Of course, some of BorgWarner’s non-US customers could later seek to export their cars to the United States and get caught in the tariff net, but the effects of that are unpredictable. But for what it’s worth, BorgWarner’s stock price has tracked the broader indexes pretty closely since April 3, Tariff Day, so at least the market doesn’t seem to believe the company is particularly exposed.

So, I would argue that with the effective free cash flow yield being so high, and with the company no longer disdaining its non-electric vehicle portfolio, the company’s prospective free cash flow yield is excellent, and there may be scope for the company to save some of its research and development expenses as well. Also, with a substantial amount of money to deploy into share repurchases, which is always an excellent use of cash for an undervalued company, I would suggest BorgWarner as a strong candidate for portfolio inclusion.

Filed under:
Uncategorized by grocca