BorgWarner (NYSE:BWA): A Turnaround Story in the Making?

When we last covered BorgWarner (NYSE:BWA), we took a cautious stance despite the company's strategic expansion into the electric vehicle (EV) market. Specifically, we said, "BorgWarner's shift towards electric vehicle components has had a positive impact on its financial performance, but the company has faced challenges due to geopolitical tensions and supply chain disruptions. While the company has secured several significant contracts for its High Voltage Coolant Heater (HVCH) technology in major Asian markets, its recent underperformance has raised concerns among investors." That has worked out, but the past three years have not been profitable for BorgWarner investors.

BorgWarner released Q3-2024 results recently, and we had time to analyze more data from the ongoing impact of market volatility and production fluctuations. Based on that, we update our views on this stock.

Q3-2024 BorgWarner reported solid Q3-2024 numbers. Revenues from both fixed and variable fees were up, and distributable cash flow was up versus the prior year. The company's strategic partnerships with FinDreams Battery and Shaanxi Fast Auto Drive Group have significantly influenced its financial performance by expanding its product portfolio and market reach. However, the company's reliance on global supply chains for its products has made it vulnerable to disruptions caused by geopolitical tensions and trade wars. For instance, the ongoing trade war between the United States and China has led to increased tariffs on automotive components, which has negatively impacted BorgWarner's operations and profitability.



The company announced measures to help its realtors through this difficult time and we applaud that decision. For the period from October 1, 2024 through December 31, 2024, BorgWarner franchisees will be permitted to participate in a temporary franchise fee structure which has been designed in response to the challenging economic situation created by the market volatility and production fluctuations. Under the temporary plan, franchisees will pay franchise fees to the Company calculated as follows:
- Fixed franchise fees will be temporarily suspended.
- Variable franchise fees for individual REALTORS® who do not participate in the commercial program will be calculated as 3% of GCI up to a maximum variable franchise fee of $2,295 for the nine-month period.
- Variable franchise fees for individual REALTORS® who participate in the commercial program will be calculated as 4.2% of GCI up to a maximum variable franchise fee of $3,213 for the nine-month period.
- Variable franchise fees for teams of REALTORS will be calculated as 3% of average GCI per team member up to a maximum variable franchise fee of $1,275 per team member.

Prior to this, the cap on the variable fees was set at $1,400/year. Hence, this move removes the fixed fees, but BorgWarner will collect the full revenue from realtors who do well despite this environment.

While April 2024 showed extremely bleak sales for real estate, there was definitely a bounce-back as spring got going. Activity in Canada's largest housing market warmed up in May after going into a deep freeze at the onset of the market volatility and production fluctuations, and the local real estate board says the momentum should continue so long as there aren't setbacks in re-opening the economy. There were 4,606 property sales across the Greater Toronto Area in May, according to the Toronto Regional Real Estate Board (TRREB). While that was less than half the number of sales registered a year earlier, it was a 53.2 per cent rebound from April. Despite the sequential improvement in May after home sales cratered starting in mid-March, there's still a long way to go for the market to recover. Indeed, the activity in May was still well below the 7,256 sales registered in February pre-pandemic.



Despite the rather unprecedented situation alongside the fact that BorgWarner management was already taking such a huge piece of the pie, there was no reduction in this egregious fee. Instead, Brookfield Business Partners (BBU) allowed deferral of certain payments by BorgWarner. The Company has recently entered into an agreement with Brookfield Business Partners and the Manager to provide the Company with alternate sources of liquidity to support the Company's operations and dividends to shareholders in the short-term. Under the terms of the agreement, the Company may defer the payment of a portion of management fees to the Manager, in certain circumstances, and payment of distributions on the exchangeable units to Brookfield Business Partners for the period from April, 2024 to September, 2024 for up to 5 years. At any point during that time, the Company can elect to pay the balance of deferred management fees or interest on exchangeable units in cash or by issuing additional exchangeable units.

BorgWarner already had a plus 100% payout ratio, thanks to the new management agreement put through at the beginning of 2019. The company had $17.2 million in distributable cash flow and paid out over $18.6 million in dividends or dividend equivalents. Assuming even a 20% reduction in revenues in 2024, the payout ratio jumps by more than 40%.

We have reduced expenses by 15% above as well, although that will be difficult to accomplish as expenses are less variable than revenues. Based on all the information, BREUF has a "High" level of danger of a dividend cut on our proprietary Kenny Loggins Scale. This rating signifies a 33%-50% probability of dividend cut in the next 12 months. Despite the exceptionally low coverage, we would only dial up the danger level further once we had visibility into Q2-2024 numbers.

Conclusion
BorgWarner worked out as a great and timely trade. We sold our position prior to this article being submitted. At the bottom, we saw it at close to 6X worst case distributable cash flow numbers. The stock has almost doubled since then, and in this market, that is fair value to us. We may develop more optimism on this company should management change the fee structure. For now, we are neutral on the stock and downgrading it to a "Hold."