As the transition from traditional internal combustion engine (or ICE) vehicles to electric vehicles (or EVs) has hit a few bumps, investors have taken another look at companies leveraged to more traditional powertrain components, and particularly those that could have a longer run of profitable cash generation even as the EV transition picks up.
That brings me to PHINIA (NYSE:PHIN). This 2023 spin-out from BorgWarner (BWA) has not only seen its share price outperform that of its former parent, it has outperformed its auto supplier peers by a healthy margin since its debut (by around 50% on average) and is, I believe, the only U.S. supplier to outperform the S&P 500 over that time.
I am bullish on the long-term potential of the EV transition (and I own both BorgWarner and Valeo (FR.PA) as a consequence of that bullishness), but the success of EV doesn’t have to come at the complete expense of quality players in the ICE space – ICE-powered vehicles will be with us for a long time to come, and I believe PHINIA has an undervalued opportunity to benefit from not only a long sunset for ICE technologies, but also more company-specific drivers.
A Healthy First Quarter
Looking back at the first quarter reporting cycle, suppliers like PHINIA with more leverage to ICE and/or hybrid powertrains did comparatively better. Of the companies that beat expectations on the top line, names like American Axle (AXL), BorgWarner (which does still have some ICE and hybrid exposure), Magna (MGA), and PHINIA featured prominently, though in the case of PHINIA there is currently so little coverage (two analysts), that beats have to be taken with a grain of salt.
In any case, revenue rose about 3% as reported, or about 1% on an adjusted basis (excluding some contract manufacturing revenue). Fuel Systems revenue was up slightly on an adjusted basis, while Aftermarket revenue rose 3%.
Gross margin improved nicely (up 160bp to 22.2%), while adjusted operating income rose 18% (operating margin up 170bp to 11.5%) and segment income rose 26% (with margin up 240bp to 13.6%, with both segments in double-digits).
A Technology-Based Player With A Long Runway
The core of my PHINIA bullishness is based on the company’s leverage to fuel injection technology, specifically gasoline direct injection (or GDI), diesel injection, and alternative fuel injection. Not only does this positioning leverage what is likely to be a long sunset for ICE-powered vehicles (I don’t expect EVs to be more than 50% of total passenger vehicle sales until 2030-2033), it gives the company leverage to ongoing demand for more fuel-efficient vehicles, commercial vehicles, and alternative fueling systems.
GDI Growth Should Offset EV Penetration
Gasoline direct injection offers several benefits to auto and light truck OEMs. Injecting fuel directly into the combustion chamber leads to higher fuel efficiency, lower emissions, and improved torque, and it also gives OEMs the option to build vehicles with smaller engines without sacrificing performance. All of these appeals to manufacturers facing ever stricter efficiency and emissions standards around the world.
PHINIA has around 12% share of the overall light vehicle fuel injection market (Bosch and Denso are the market leaders with combined share around 67%), but a greater share in GDI. GDI is currently used in just under half of ICE-powered engines, and this ratio continues to increase. Importantly, GDI is more often used on light trucks, SUVs, and CUVs, which tend to be the better-performing categories in light vehicles.
As time goes on, I expect GDI penetration to grow as more OEMs use it as a means to reach higher efficiency/emissions compliance standards, and with an ASP of roughly 3x standard port injection systems, PHINIA should see decent revenue growth and margin support even as overall ICE build rates decline. I’d also note that GDI systems are popular on hybrid vehicles, and hybrids may well have a longer run of success given the challenges in scaling up EV infrastructure.
Diesel Opportunities Are Underrated
PHINIA also has what I believe to be an underrated opportunity in commercial vehicles through its diesel injection systems. Components for commercial vehicles and industrial applications (including diesel fuel injection, starters, and alternators) make up about 25% of the business today and management is looking to grow this to over one-third of the business in 2030.
Relative to passenger vehicles, the transition to electrification is likely to be slower for heavy-duty commercial vehicles; there’s a good argument for transitioning vocational vehicles (like garbage trucks), but the case for electrification is more challenging for long-haul Class 8 vehicles without a significant leap forward in battery technology.
This, then, is a chance for PHINIA to build upon existing technology and build share (it has around 10% share in diesel fuel injection versus 80%+ for Bosch and Denso combined) using technology it already has in-house at a time when many suppliers and OEMs are moving away from diesel system development in favor of prioritizing electric powertrain technologies.
PHINA Could Reapply Core Technologies To New Alternatives
Building on its core gasoline and diesel injection technologies, PHINIA has also been developing injection systems for alternative fuels like CNG, LNG, and hydrogen. None of these are widely used today, but large commercial vehicle suppliers like Cummins (CMI) have invested significant resources into developing powertrains using these alternatives, and hydrogen could yet emerge as an important bridge technology for both commercial and light vehicles if green hydrogen (hydrogen generated with non-polluting energy sources like solar) really takes off.
An Opportunity To Be Opportunistic
Given that I don’t believe EVs will outsell ICE vehicles until the early 2030s and given that ICE vehicles are likely to be more than 50% of the vehicles on the road for at least another decade beyond that, I see a long sunset period for this technology, and that is a runway for cash flow generation at PHINIA.
As I said above, many companies have significantly reduced their focus and spending on ICE technologies (BorgWarner spinning PHINIA off, for instance, though it did retain other technologies like turbocharging), and that is an opportunity for PHINIA to step up into the breach with new technologies and fresh product lineups (including aftermarket parts) to gain share. At the same time, the company likely won’t have to spend as much on R&D and capex to support that growth, leading to better cash flow generation.
I also believe PHINIA will have some opportunities to be selectively active in M&A. I believe other suppliers and OEMs may look to jettison ICE powertrain component businesses, and that could be an opportunity for PHINIA to acquire complementary assets (particularly for the higher-margin aftermarket business) at attractive multiples.
I don’t want to go too far with analogies here, but if you look back through history you see a lot of examples of companies in legacy technology spaces generating solid margins and cash flows for longer than many expected – I’m thinking of legacy technology systems like mainframes and tape storage systems. I think PHINIA has that opportunity and more, as the company still stands to benefit from growing adoption of GDI as well as growth in commercial vehicle/industrial markets and alternative fueling technologies.
The Opportunity
I’m only modeling around 1% to 2% long-term revenue growth from PHINIA and relative to management’s own targets and projections, that could be quite conservative (management is looking for around 5% annualized growth through 2030).
Modeling beyond the mid-2030’s is tough; modeling always involves guesswork, but there are so many unknowns now about what role hybrids may still play then, what role alternate fuels like hydrogen may play, and how successful the company is in buying/building a stronger commercial and off-road vehicle business. At a minimum, I do think the company will see revenue growth through the mid-2030’s.
How much margin and free cash flow leverage PHINIA can squeeze from the combination of greater GDI sales, improved CV sales, and more efficient legacy sales (in aftermarket primarily) is another key unknown. I think EBITDA margins will probably peak in around five years, but I don’t think the dropoff afterwards will be all that severe, and I believe PHINIA could still generate mid-teens margins in a decade. Depending on the mix of sales from legacy and newer products/technologies, cash flow leverage could be significant as the company won’t need to reinvest much into new capex for legacy aftermarket products.
I’m looking for free cash flow margins in the mid-single-digits for several more years, and I see the potential for this to move into the high single-digits over time as the company leverages share gains, mix, and capital efficiency to generate more free cash flow. That, then, works out to high single-digit annualized free cash flow growth on low single-digit revenue growth.
Discounting that back, I think PHINIA can trade above $50, and that’s with both a negative long-term FCF growth rate (after the explicit forecast period) and an elevated discount rate. I get similar results from margin-driven EV/EBITDA and other multiples-based approaches that suggest a “fair” forward multiple of 5.5x EBITDA.
The Bottom Line
In prior articles on BorgWarner I did question whether management was being too hasty in jettisoning PHINIA, as I thought the transition to EV may not be as smooth as hoped, and I still saw opportunities to benefit from quality ICE powertrain components. As an independent entity, then, I do still see worthwhile opportunities for PHINIA, not only in growing technologies like GDI, but also in taking share from legacy rivals and expanding into other markets.
I do have some concerns that the switch from EV-oriented names to ICE-oriented names may run out of steam (a sentiment risk, in other words), but I think PHINIA’s valuation is more than reasonable and there’s enough value here to merit a closer look.
Read the full article here