Four auto stocks that may benefit from tighter emission regulations

These components manufacturers are well positioned to capitalize on automakers' push for fuel efficiency and improved green credentials.

Vikram Barhat 8 April, 2016 | 5:00PM

Ever since the news of German automaker Volkswagen's emission-rigging scandal came to light in September of last year, there has been a heightened scrutiny of vehicle emissions and fuel efficiency. As regulators impose newer and tighter standards, automakers globally are scrambling for ways to improve fuel efficiency of vehicles and reduce their carbon footprint.

"If car companies' use of diesel as a means of reducing CO2 emissions from their entire product portfolio is restricted, technologies other than gasoline engines must be ready to launch today," said Morningstar senior equity analyst Richard Hilgert in a recent article. However, he added, alternative powertrain technologies are neither widely affordable, nor are they ready to meaningfully replace engines powered by conventional fuels. In fact, he believes that a substantial number of passenger vehicles around the world will contain diesel engine powertrains by 2025.

And therein lies an investment theme. Automakers consider companies that supply automotive systems and components that help improve fuel economy as crucial to meeting future clean air regulations. Some of these auto components makers are well positioned to capitalize on automakers' push for fuel efficiency and improved green credentials as nations legislate to regulate emission, according to Morningstar equity research.

BorgWarner Inc.
Ticker BWA
Current yield 1.48%
Forward P/E 9.4
Price US$35.18
Fair value US$52
Data as of Apr. 5, 2016

 BorgWarner (BWA) is a leading auto-parts supplier whose engine group (70% of sales) makes turbochargers, emissions system components, timing chains and other items that enhance fuel efficiency and reduce emissions. The firm's drivetrain group produces transmission and all-wheel-drive system components.

BorgWarner's turbochargers increase the horsepower output of smaller, more fuel-efficient engines, which typically produce lower levels of emissions. "We expect substantial long-term growth opportunities, with revenue growing in excess of global vehicle production growth as the U.S. government mandates increases in corporate average fuel economy and other nations legislate vehicle emissions reduction," Hilgert said in a Morningstar report.

In the drivetrain business segment, the firm's wet dual-clutch technology generates 5% to 15% in fuel savings. This will prove beneficial as the demand for fuel economy and lower emissions increases, said Hilgert, who pegged the stock's fair value at US$52 and forecasted a 10% average annual revenue growth through demand recovery in Europe.

The company has been working to increase its focus on diesel engines that offer 15% to 30% higher fuel economy and lower emissions. "Manufacturers still view diesel engines as crucial to meeting future clean air regulations despite their higher nitrogen and particulate (unconsumed carbon, black soot) emissions," said Hilgert.

BorgWarner, he added, has a net new business backlog of roughly US$1.4 billion slated to launch between 2016 and 2018, of which more than 21% is attributable to diesel turbochargers.

Tenneco Inc.
Ticker TEN
Current yield -
Forward P/E 7.5
Price US$46.09
Fair value US$55
Data as of Apr. 5, 2016

 Tenneco (TEN) designs, manufactures and markets emissions-control products that meet strict air-quality legislation and improve fuel economy. Its ride-control products enhance vehicle safety. The firm supplies to more than 60 automakers.

"Automakers demand technologically advanced emission-control systems to support their efforts to meet ever-increasing clean-air legislation around the world," Hilgert said in a Morningstar report, noting that Tenneco holds one of the top two spots in each of its product markets.

Around 45% of Tenneco's total revenue is in North America, a third in Europe, and the rest in South America and Asia/Pacific. This geographic diversification, combined with new technologies, allows Tenneco access to new, adjacent markets, said Hilgert.

"Substantial new business should enable Tenneco's average annual revenue growth to be approximately 10%," he said. He also projects the firm's earnings before interest, taxes, depreciation and amortization (EBITDA) margin to be close to 11% and its return on invested capital to be above 20%.

Hilgert pointed out that the five-to-10-year life cycle of vehicle programs helps generate long-term contractual streams of revenue for Tennecos. The company "enjoys steep customer-switching costs, has relatively moderate pricing power, and benefits from a globally oligopolistic emissions market," said Hilgert who appraised the stock's worth at US$55.

Delphi Automotive PLC.
Ticker DLPH
Current yield 1.46%
Forward P/E 10.3
Price US$71.01
Fair value US$60
Data as of Apr. 5, 2016

One of the largest auto-parts suppliers in the world,  Delphi (DLPH) produces electrical and electronic, powertrain, safety and thermal technology components for automobile manufacturers. Delphi's largest customer is  General Motors (GM) (about 20% of revenue) while its largest market is Europe (around 45% of total revenue).

"Delphi will benefit from automakers' increasing use of electronic devices, electronic controls, safety equipment, and auto companies' legislated need to improve fuel efficiency and lower engine emissions," Hilgert said in a Morningstar report.

The auto-parts maker's competitive advantage is anchored in consistent technical upgrades, the cost advantages of its global presence and high switching costs. "The ability to continuously innovate new process and product technologies should enable Delphi to generate excess returns over its cost of capital," said Hilgert. "A global manufacturing footprint enables participation in global vehicle platforms and provides penetration in developing markets."

Morningstar projected Delphi's sales to grow faster than global vehicle demand growth. "The company provides products in high demand by consumers that government legislation requires to be installed," the report said. "Delphi's main product areas that have solid growth potential include electrical architecture, electronic devices, powertrain and safety."

The stock currently trades at a hefty premium of almost 20% to its US$60 fair value, so now may not be the best time to buy in. However, its price has been quite volatile over the past year, ranging from a high of US$90.57 to a low of US$55.59, so investors would do well to keep an eye on this stock.

Johnson Controls Inc.
Ticker JCI
Current yield 2.9%
Forward P/E 9.4
Price US$37.89
Fair value US$50
Data as of Apr. 5, 2016

 Johnson Controls (JCI) operates three businesses: controls and services for heating and air conditioning systems, auto seats and interior products, and batteries for passenger vehicles and trucks.

"Johnson is the dominant player in start-stop vehicle technology thanks to its leading position in absorbent glass mat batteries (AGMs)," said Morningstar strategist David Whiston in a report. "[The firm's] power solutions [unit] should benefit from automakers needing more fuel-efficient vehicles to meet environmental regulations."

AGM technology is at the heart of the start-stop system, which prevents vehicle engines from running while idling, generating 5% fuel savings. JCI is well positioned to benefit from the growing popularity of the technology.

"We see tremendous growth and profit potential in AGMs because the batteries sell for twice the price of a normal lead acid battery," said Whiston, who recently raised the stock's fair value from US$49 to US$50 to reflect higher long-term profit growth. "AGMs also have 50% better profit margin."

The company plans to spin-off its automotive unit to focus on the auto battery segment. As part of that plan, it recently tied up with Beijing Hainachuan Automotive Parts Co. Ltd. to expand sales and manufacturing of fuel-saving automotive batteries in the world's largest vehicle market.

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Securities Mentioned in Article

Security NamePriceChange (%)Morningstar Rating
Aptiv PLC89.11 USD1.20
BorgWarner Inc38.33 USD1.59
General Motors Co36.65 USD1.08
Johnson Controls International PLC42.00 USD-0.47
Tenneco Inc Class A13.08 USD9.18

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Vikram Barhat

Vikram Barhat  Vikram Barhat is a freelance writer.