Global electric-car parts suppliers BorgWarner and Delphi Technologies stand to benefit from tighter clean air laws and are trading at compelling discounts, says Morningstar.

Five-star, narrow-moat rated Delphi Technologies trades at a 76 per cent discount to the US$55 fair value estimate set by Morningstar automotive analyst Richard Hilgert.

Four-star, narrow-moat BorgWarner currently trades at a 36 per cent discount to Hilgert’s fair value estimate of US$57.

In a research report on electric vehicles published last week, Hilgert argues that tougher emissions laws will force carmakers to shift production to smaller engine displacement, meaning that the average number of cylinders for engines produced in both traditional internal combustion engine (ICE) and hybrid propulsion systems will decline.

By next year, CO2 must be cut to 95 grams per kilometre for 95 per cent of cars from the current 120.5g average. All new cars in the EU must be compliant in 2021.

From the beginning of 2019 to 2022 the carmakers under Morningstar coverage will have launched 141 electrified 'nameplates' – or variants of models

Morningstar has six carmakers under its coverage: BMW, Daimler, Fiat Chrysler, PSA Peugeot Citroen, the Renault-Nissan-Mitsubishi alliance, and Volkswagen.

Hilgert estimates that from the beginning of 2019 to 2022 the carmakers under its coverage will have launched 141 electrified “nameplates” – or variants of models, growing at an annual rate of 24 per cent.

And in turn, parts suppliers such as BorgWarner and Delphi Technologies will also benefit because they have the greatest exposure to electrification.

“We think powertrain-parts suppliers, like favourites BorgWarner and Delphi Technologies, have been overly discounted by the market for their exposure to internal combustion engine powertrains, especially diesel,” says Hilgert.

“In our opinion, current market valuations treat these stocks as though margins were in a permanent state of erosion. We think BorgWarner and Delphi Technologies will benefit from growth in powertrain electrification, offsetting exposure to a declining internal combustion engine market, as well as intangible asset and switching cost moat sources that will result in economic profit generation.”

BorgWarner is a tier one car-parts supplier that has two operating segments. The engine group makes turbochargers, emissions system components, timing chains, and other items that enhance fuel efficiency and reduce emissions. The engine group products have averaged about 70 per cent of sales. The drivetrain group produces transmission and four-wheel-drive/all-wheel-drive system components that facilitate the distribution of engine torque to the wheels.

Delphi Technologies’ main products are fuel injection and valvetrain systems along with the sensors and software controls for each, representing about 60 per cent of 2018 total revenue. Regionally, about 44 per cent of Delphi Technologies’ 2018 revenue from Europe, Middle East, and Africa, 28 per cent from North America, 25 per cent from Asia-Pacific, and 3 per cent from South America.

Here are some of the key takeaways from Hilgert’s report:

BorgWarner investment thesis

Narrow-moat, 4-star-rated BorgWarner is trading at a 36 per cent discount to Higert's fair value estimate. Its economic moat sources derive from powertrain intellectual property and switching costs are not adequately reflected in the market's valuation.

“The market, in our view, has valued shares as though revenue will decline long-term on shrinking internal combustion engine demand, especially diesel, despite BorgWarner's increasing dollar content penetration in ICEs, exposure to globally popular sport utilities, and electrified powertrain growth potential," Hilgert says.

He forecasts annualised revenue growth that exceeds global vehicle demand growth by 2-4 percentage points. The company reports $2 billion-$2.4 billion booked net new business backlog through 2021, which implies a 5-6 per cent average annual revenue growth rate.

Delphi Technologies investment thesis

Narrow-moat, 5-star-rated Delphi Technologies is trading at a 76 per cent discount to Hilgert's fair value estimate.

Hilgert calculates that Delphi Technologies had a 10-percentage-point economic profit in 2018 on an 18 per cent return on investing capital (including goodwill) and an 8 per cent weighted average cost of capital.

The company's narrow economic moat flows from a continuously filling pipeline of innovation (intangible asset) and high customer switching cost moat sources.

“We think Delphi Technologies benefits from globally ubiquitous clean air legislation that requires passenger vehicle and commercial truck manufacturers to enhance efficiency of internal combustion engines and electrify powertrains," Hilgert says.

“We assume a 15.5 per cent normalised sustainable midcycle EBITDA margin."