Sum of the Parts

Posted On December 16, 2015 12:01 pm

The biggest beneficiary of the booming automobile sales could be the part suppliers.

The auto industry is on pace to sell over 18 million vehicles in the U.S in 2015, its best year since 2006. Among the drivers for the strong demand are low interest rates and loosening lending standards, the need for replacement as the average age of cars on the road climbed to 11.2 years, and new products that have both style and integrated technology such as internet access and assisted driving capabilities. And of course the backdrop of expectations for gasoline prices to remain low for an extended period.

But even with everything firing on all cylinders investors in the major automakers have not been rewarded. Shares of General Motors (GM), Ford (F) and Toyota (TM) are down 3%, 4.5%, and 5.1% respectively for the year to date. Probably the biggest drag has been concerns over global demand, especially in China, which is quickly becoming the world’s largest market and represents the most of the future growth opportunities. Another drag has been the strong dollar, which has impacted the bottom line.

Borg Warner Ready to Drive Higher

These same issues have plagued companies higher up the supply chain, such as auto part makers and suppliers. Borg Warner (BWA) is a prime example. They manufacture and engineer systems for powertrains in cars, light trucks and commercial vehicles and develop solutions to improve fuel economy, reduce emissions and enhance performance.

The company sells to over 50 automakers in 18 countries.

Borg has seen its shares tumble some 32% since it reported disappointing earnings. But behind the declining top line sales numbers and muted guidance there were some encouraging signs that better times are ahead.

Even though revenue and operating income showed low single digit declines when foreign exchange rates are accounted for, revenues are actually increased by 5.1% over the year ago period. Furthermore, operations continue to improve and margins have been slow but steadily increasing for years.

Borg Warner Income Statements

Industry Consolidation

One of the consequences of past few years of the low cost of capital created through zero interest rates has been an expansion to the point of overcapacity. This is most evident in the oil industry, but can also been seen in other commodity and manufacturing sectors. This in turn is leading to mergers and consolidation as companies look to cut costs by eliminating overlap and hope to regain some pricing power through scale. A few recent examples of these “defensive” mergers include Dow Chemicals (DOW) and DuPont (DD) and the combination of Inbev (BUD) with SABMiller.

While Borg Warner is the world’s largest maker of powertrains the auto supply industry remains very fragmented, with smaller companies specializing in specific parts. It is ripe for consolidation for the larger companies to achieve efficiencies and scale and by integrating the supply chain both vertically and horizontally.

Borg Warner is doing just that. Management has raised close to $1 billion in cheap debt that will be used for acquisitions and stock repurchases. It has made three recent acquisitions, including one of Remy International, a leading manufacturer of rotating electrical components such as alternators, and starter motors for the automotive and commercial vehicle industry. It has also signed new deals with Hyundai and Kia, the fastest growing brands, to supply its advanced cam torque actuated and variable cam timing technology to many of its models.

Technically Sound

The chart shows the beating shares took through late summer and fall. But they appear to found solid support at the $40 level. Given its shares now also trade an attractive valuation of just 14x forward earnings, this looks like a good risk/reward entry point.

BWA 161215

To further limit our risk while boosting the profit potential I want to use call options to establish a bullish position.

-Buy to Open July $40 Calls for $4.20 a contract

These calls give us over six months for the stock to recover. I have an initial price target of $50 per share which would give the calls a minimum value of $10 or over a 110% gain.

About author

Steve Smith

Steve Smith have been involved in all facets of the investment industry in a variety of roles ranging from speculator, educator, manager and advisor. This has taken him from the trading floors of Chicago to hedge funds on Wall Street to the world online. From 1987 to 1996, he served as a market maker at the Chicago Board of Options Exchange (CBOE) and Chicago Board of Trade (CBOT). From 1997 to 2007, he was a Senior Columnist and Managing Editor for TheStreet.com, handling their Option Alert and Short Report newsletters. The Option Alert was awarded the MIN “best business newsletter” in 2006. From 2009 to 2013, Smith was a Senior Columnist and Managing Editor for Minyanville’s OptionSmith newsletter, as well as a Risk Manager Consultant for New Vernon Capital LLC. Smith acted as an advisor to build models and option strategies to reduce portfolio exposure and enhance returns for the four main funds. Since 2015, he has worked for Adam Mesh Trading Group. There, he has managed Options360 and Earning 360, been co-leader of Option Academy, and contributed to The Option Specialist website.