Morningstar - Q2 2020 - 84

Investors

phase can last anywhere from five to 10 years.
Over that lengthy time frame, you develop
interpersonal relations between the engineers on
both sides of the equation.
That's why, nine times out of 10, the incumbent
supplier gets the award for the next vehicle
generation. And once you have a signed contract,
the cost to switch suppliers starts to rapidly
increase. To switch to another supplier in the
development phase, you'd have to pretty much rip
up everything that you've already done and
start all over again. In the production phase,
switching costs peak because you've got tooling
involved to make the components and some of
that might be owned by the supplier.
Whiston: Adient is the number-one seating
supplier in the world-roughly a third of
the market. We cover the very top of the food
chain, so to speak, in terms of the largest
Tier 1 suppliers. Whether it's safety or seating
and whatnot, it's generally an oligopoly.
In seating, there's really only two players that
can compete globally, and that's Adient
and Lear LEA.

But Adient got into a lot of trouble under
old leadership; the CEO ultimately had
to be removed. They were spun off from Johnson
Controls JCI in October 2016, and the stock
got annihilated. The balance sheet was starting
to look questionable because they had a
large debt maturity coming due in July 2021. Last
year, they announced a large refinancing,
and they've moved a lot of their maturities out
until at least 2024. It's a big restructuring story
now, much like GM. They brought in as CEO Doug
Del Grosso, who's an operations guy. Adient
needed that operational expertise. A lot of the
old leadership has been removed.
The stock has gotten ridiculously mispriced.
They're selling their 30% ownership stake in the
world's largest automotive interiors firm,
Yanfeng, and that, with some other moves like
selling its fabrics business, is going to raise
just under $575 million this year, so it makes the
balance sheet story a lot safer. Once you
do that, there's potential for some extremely
rapid stock price appreciation.

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Morningstar Q2 2020

This requires patience. I stress that it's not
for everybody, not for someone concerned about
meeting a benchmark every quarter. It's
probably still going to have a lot of volatility.
There's potential for massive upward volatility with
Adient, but our bear-case scenario is bankruptcy
wiping out shareholders.
Lallos: It sounds like BorgWarner is another
good prospect.

Hilgert: In January, BorgWarner and Delphi
Technologies DLPH announced that BorgWarner
would acquire Delphi in an all-stock transaction.
But on March 31, Delphi announced
that it would draw down its entire $500 million
revolving credit line to weather the current
coronavirus-induced industry environment.
BorgWarner sent notice that this is a material
breach of the transaction agreement and
threatened to terminate it; Delphi disputes the
breach assertion. The merger may not
go through, but we still believe the combination
of the companies makes good sense because
they have little overlap in product and differing
customer concentrations.

Both companies are undervalued because
of consensus perception of what would happen
to suppliers with electrification. But the
bear case ignores these companies' economic
moats, especially the intangible asset
moat source and that supplier incumbency that
we talked about.
To the Street, the bear argument is that
BorgWarner is an internal combustion engine
company, and battery electric technologies
are going to be brought in-house at the
manufacturer level or outsourced to industrial
electric motormakers. What they're missing
is that BorgWarner has been an industry adaptor
and innovator for the past 100 years. If BorgWarner
weren't able to adapt over time, they'd
still be making carburetors and three-speed
transmissions today. There's a whole host
of things they're doing on the internal combustion
engine side that make internal combustion
engines more fuel-efficient. But they
also make electric motors, which are patented,
and the gear and drive torque transfer for
electric powertrains.

Now, throw into the mix Delphi Technologies'
product portfolio, which brings in a software and
algorithm element. Combined with what
BorgWarner already has, the company would be
able to offer a complete powertrain package
to its automakers. It would be pretty much
a one-stop shop for battery electrification. I view
both stocks as very attractively valued.
Lallos: Besides electrification, what environmental,
social, and governance issues factor into your analysis?

Whiston: Autonomous vehicles involve both
environmental-because pretty much all
autonomous vehicles are going to be electric-
and social issues, because of the societal benefits
of reduced traffic and fatalities. There are
legislation efforts and regulatory authorities in the
U.S. and around the globe, so we'll see what
ultimately comes from that. But the industry isn't
waiting for legislation, because they need
time to develop these vehicles and these new
powertrains. And places like California are already
adopting electric vehicles at a drastically higher
rate than the nationwide average.

I also think a lot about the governance side of
things. You need to pay attention to other
large shareholders. Are there perhaps unusual
shareholders, such as the UAW's retiree
healthcare fund, called VEBA, which owns a stake
in GM? GM just saw a massive strike last
year that cost $5.4 billion in free cash flow, a little
less than $2 in adjusted EPS for full-year
2019. You can't ignore those things. The UAW
contract is every four years, so it'll come up again.
There's a very nasty issue of healthcare
costs for the Detroit Three. They set up retiree
healthcare a little over a decade ago, but
the ongoing cost for current workers is extremely
expensive to the automakers.
Tesla TSLA has a massive amount of key-man
risk, in that everything seems to be tied around the
cult of personality that is Elon Musk, who owns
roughly 21% of the company. Musk's erratic
behavior, particularly through Twitter TWTR, is not
just drama. It affects the stock price when
the CEO is charged with civil securities fraud by
the SEC. Musk was removed as chairman
as part of the SEC settlement, too, so that affects
governance-and I would argue that it is a
Morningstar - Q2 2020

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