Is Diesel Done?
We think the demise of the diesel engine may be inevitable, but it is definitely not imminent.
Diesel engine powertrains have come under heightened scrutiny with the revelation of Volkswagen's U.S. emission test cheating. Some pundits have opined an early demise to the technology. However, automakers have invested heavily in diesel capacity, especially in Europe. Legislation in the European Union aimed at reducing carbon dioxide emissions, as well as the region's tax schemes, has played a major role in the industry's investment and consumer demand for the engines. 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. In our view, alternative powertrain technologies are too costly and not ready to completely supplant diesel engines.
Because of diesel's higher operating efficiency relative to gasoline, diesel engines represent a means to achieving legislated fuel economy and CO2 emissions targets. On average, diesels are about two thirds less costly than hybrid powertrains for automakers and consumers. In the capital-intense auto industry, pulling forward development of relatively higher-cost hybrid powertrain passenger vehicles represents an immense hurdle. Most vehicle programs remain in production for 5-10 years, while engine programs last 10-15 years. As a result, we believe that a substantial number of model-year 2025 passenger vehicles around the world will contain diesel engine powertrains.
Higher fuel economy is inversely related to engine emissions. The higher the fuel economy, the lower the greenhouse gases emitted. As a result, manufacturers use three primary means to make internal combustion engines greener. Technologies that make engines more efficient translate into less fuel used per distance traveled, meaning less pollution. Manufacturing and materials technologies that reduce vehicle mass enable the use of smaller, less powerful engines, which results in emission reduction. Lastly, emissions generated by an engine can be scrubbed before reaching the end of the tailpipe.
We expect several stocks to benefit from automakers' demand for fuel efficiency and emission reduction, including BorgWarner (BWA), Continental (CON), Delphi Automotive (DLPH), Faurecia (EO), and Tenneco (TEN). However, we would focus investors' attention on BorgWarner owing to its more attractive valuation.
Diesel an Integral Part of Compliance With Global Clean Air Regulations
In Europe, where the powertrains are much more popular among consumers, government scrutiny was already on the rise before the Volkswagen scandal, with new restrictions on commuter use of diesel-powered passenger vehicles in London and Paris.
While it may seem counterintuitive to some, automakers have invested heavily in diesel technology, mainly owing to clean air legislation. Carbon dioxide is regulated separately from other emissions. U.S. regulators seek to legislate CO2 levels by mandating corporate average fuel economy standards. Under U.S. Tier II regulations, automakers can certify vehicles within several categories, or bins. However, their product portfolios have to meet certain fleet averages for a given model year over the useful life of each vehicle (Tier II 120,000 miles). EU standards set the average emission limits for each respective manufacturer's entire vehicle lineup. Once a vehicle is "type approved" by one member state's appointed approval authority, the vehicle is registered as type-certified in all EU states. There is no durability or useful life requirement in European standards. Comparatively speaking, U.S. clean air restrictions are more stringent for nitrogen oxide emissions than European standards. EU legislation has greater restrictions on carbon dioxide emissions. The regulations in both regions (CAFE in the U.S. and CO2 emissions in Europe) favor the use of diesel. However, emissions of nitrogen and particulate matter are problematic for diesel.
According to the U.S. Environmental Protection Agency, the average vehicle CO2 emission for the 2014 model year was 290 grams per mile, or 180 grams per kilometer. The result is roughly 27 grams per mile higher on average than the Tier II target. The difference results from manufacturers' ability to purchase carbon credits under clean air legislation. Owing to the popularity of large sport utility vehicles in the U.S. and the premium prices they can command, in some cases returns are higher if manufacturers pay for carbon credits and produce larger, higher-polluting passenger trucks (crossovers, SUVs, vans) as a portion of their fleet rather than making an entire fleet of vehicles that comply with emission regulations. To achieve the 2025 CO2 target, on average, U.S. manufacturers will need to cut emissions by 44% from 290 grams per mile in 2014.
European CO2 emissions in 2014 were materially lower than the U.S. The EU28 average was roughly 125 grams per kilometer or 201 grams per mile. The reduction in CO2 emissions to reach the 2025 70 g/km target proposed by the European Parliament would need to be approximately 44% versus the EU28 2014 average. Coincidentally, the relative amount of percentage reduction in CO2 emissions needed to achieve EU and U.S. regulators' 2025 targets are nearly identical.
Diesel engines generally produce about 15% more carbon dioxide per unit of fuel consumed than gasoline engines. According to the EPA, the carbon content of a gallon of gasoline is 2,421 grams while a gallon of diesel fuel contains 2,778 grams. However, diesel engines operate more efficiently than gas engines.
The difference arises in the method of combustion and the latent energy released by the respective fuels. A gasoline engine relies on a spark plug to ignite the air/fuel mixture in the cylinder. The combustion of the fuel propagates via the air from the spark outward to the cylinder wall.
A diesel engine operates on the principle that when air is compressed, energy is released in the form of heat. Air is first compressed, then fuel is injected just before the piston reaches its apex, and the heated air causes the fuel to self-ignite as the cylinder reaches maximum compression. As a result, diesel engine combustion is more lean and efficient as the fuel burns through diffusion across the cylinder.
Diesel engines are also more efficient because of the higher energy content of diesel fuel relative to gasoline. According to the Department of Energy, gasoline with 10% ethanol, which is sold at most pumps in the U.S., has energy content of 112,114-124,340 British thermal units per gallon. Low-sulfur diesel fuel sold in the U.S. has an energy density of 128,488-138,490 Btu/gallon. In other words, diesel fuel has on average 13% more energy content than a comparable volume of gasoline.
As a result of leaner combustion and higher energy content, diesel engines enable a vehicle to travel farther on lower fuel usage. Therefore, diesel engines produce fewer grams of CO2 per unit of distance traveled. Diesel-powered passenger vehicles have a substantial fuel economy advantage over gas engines--roughly 15%-30% more. This fuel economy advantage then translates into the lower CO2 emissions.
In the small- and medium-displacement category, diesels are 36% more fuel-efficient than gas-powered passenger vehicles. However, in the large-displacement category, diesel engines are 42% more fuel-efficient than comparably sized gasoline engines. Diesel CO2 emissions were 16%, 17%, and 24% lower than gas in the respective displacement categories.
In the overall category, fuel economy and CO2 emissions are weighted by the respective registrations of each engine displacement. Weightings for all gas engines were based on 49% registered in small displacement, 43% in medium, and 7% in large. In contrast, only 28% of diesel engines were small, 50% medium, and 21% large. Even though the weighting was unfavorable to diesel, the diesel engine weighted average fuel economy was 23% higher, while emissions were 9% lower than gasoline engines.
U.S. Lags Europe in Embracing Diesel, Although We Expect Slight Increase
Diesel engine technology has been little more than an oddity to U.S. consumers. Many car aficionados recognize the hefty torque at low engine revolutions, high fuel economy, and durability of the technology. However, buffs in the U.S. also prefer the power and the deep growl of a V-8 gasoline engine. On the other hand, ordinary automobile consumers have had limited exposure to new diesel technology. Perceptions of black-smoke-spewing, smelly, noisy vehicles that need to be fueled up at a truck stop still linger in the minds of most U.S. buyers.
Until the Volkswagen scandal hit the headlines, U.S. vehicle shoppers were becoming slightly more interested in the powertrain as evidenced by the proliferation of models equipped with diesel engines being offered. Marketed as "clean diesel technology," VW vehicles were also touted as highly fuel-efficient, traveling more than 800 miles on one tank, providing more consumers with exposure to the technology. (As a side note, automakers with diesel models in the U.S., including Volkswagen, have said there has been little impact on diesel sales since the scandal was made public in September, with the exception of the affected models, the sales of which Volkswagen froze.)
We expect slightly more penetration of diesel powertrain technology in U.S. passenger vehicles. U.S. CAFE regulations will require 54.5 miles per gallon in 2025, up approximately 67% from the 32.6 mpg mandated in 2015. Larger, more fuel-thirsty sport utilities and crossovers remain a favorite of the U.S. consumer. Given the technology's proven fuel economy advantage over gasoline, diesel provides a low-cost way, relative to an electrified powertrain, for manufacturers to dramatically improve fuel efficiency under increasingly more stringent CAFE standards, given America's love of passenger trucks.
Research firm IHS Automotive estimates that global demand for diesel-powered light-duty vehicles will remain fairly constant in absolute numbers through 2027. The puts and takes from the IHS forecast include slight declines in Europe with modest increases in developing markets but relatively little interest from U.S. consumers. In contrast, PIRA Energy Group forecasts a substantial increase in diesel engines to 14% of the U.S. light-vehicle market by 2030 from an estimated 5% in 2015. (This forecast was published in October 2014, 11 months before the Volkswagen scandal came to light.)
Owing to the consumer perception problem in the U.S., we think U.S. new-vehicle shoppers will not adopt diesel technology to the extent that PIRA forecasts. However, diesel-powered passenger vehicles represent a proven technology in which manufacturers have already heavily invested, especially European automakers that export to the U.S. As a result, there is less cost to automakers and consumers for the increase in fuel efficiency and reduction in carbon emissions. Consequently, we believe diesel engine penetration of the U.S. passenger-vehicle market will increase slightly from the mid-single-digit range today, perhaps into the high single digits as a percentage of total light-vehicle demand--modestly ahead of IHS Automotive's forecast but less than the penetration estimated by PIRA.
In contrast, European consumers have embraced diesel-powered passenger vehicles. Since the mid-1990s, diesel penetration in the EU15 has more than doubled to 53% of new-car registrations in 2014. The demand for diesel engines among passenger-vehicle shoppers has been driven by not only emission regulations but also tax schemes that affect fuel prices and new-vehicle transaction prices.
Owing to tax incentives to spur commerce among EU countries, the price of diesel fuel at the pump is lower than gas in nearly every country in the region. In comparison, the U.S. pump price of diesel is about 15% higher than gasoline because of strategically restrained refinery capacity. When low-sulfur diesel fuel in the U.S. first became mandated in 1993, refiners kept prices higher by limiting new capacity relative to historical levels, recognizing that businesses were the primary consumers of the fuel.
In addition to fuel taxes, there are taxes due at the registration of a new vehicle and possible annual taxes charged for a registered vehicle in most member states of the EU. The tax varies by state, but the rates are linked to CO2 emissions in nearly every country. In Germany, there is an annual base "circulation" tax of EUR 2.00 per 100 cc displacement for gas and EUR 9.50 per 100 cc for diesel. Germans also pay an annual CO2 linear tax of EUR 2.00 per g/km emitted above 95 g/km. Passenger vehicles that emit less than 95 g/km of CO2 are exempt. Since diesel technology is more capable of achieving the CO2 tax target, the tax scheme encourages small-displacement diesel-engine-powered passenger vehicles.
Contrast this with the United Kingdom, where taxes are more expensive at the high end than those paid in Germany but are gas- or diesel-agnostic. A first-year "rate of registration" applies and the tax varies from zero for engines emitting up to 130 g/km of CO2 to GBP 1,090 for engines that emit more than 255 g/km of CO2. Thereafter, annual rates range from no tax for engines that emit up to 100 g/km of CO2 to GBP 500 for passenger cars with engines that emit CO2 at a rate of more than 255 g/km. With CO2 emissions being the target, as in Germany, smaller-displacement diesel engines are more favored under the U.K. tax scheme.
BorgWarner Improves the Efficiency of Automakers' Engines
BorgWarner supplies automotive systems and components primarily for powertrain applications. The company's engine group produces turbochargers, timing devices and chains, emissions systems, thermal systems, diesel cold start, gasoline ignition technology, and cabin heaters. The drivetrain group's products include components and modules for conventional automatic, dual-clutch transmissions, automated manual transmissions, and continuously variable transmissions. The primary sources of BorgWarner's narrow economic moat include intangible assets supported by consistent, frequent innovation and high customer switching costs, since automakers would pay exorbitant amounts to replace BorgWarner with another supplier in the middle of a vehicle or engine program.
The company has 30% more content on gasoline engines than diesel, but management expects to increase its content on diesel engines. Eventually, BorgWarner believes its content will be roughly equal between diesel and gasoline engines. Because of diesel's 15%-30% higher fuel economy, greater durability, and lower carbon dioxide 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.
BorgWarner's technologies, like turbochargers, enable customers of original-equipment manufacturers to increase the horsepower derived from smaller, more fuel-efficient engines, which typically produce lower environmentally harmful 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.
While turbochargers also improve the fuel efficiency of gasoline engines, because of the way that diesel engines work, turbochargers are generally more often used in diesel-powered passenger-vehicle applications. BorgWarner has a net new business backlog of roughly $1.4 billion slated to launch in 2016-18. We estimate 2015 revenue at nearly $8.0 billion. Slightly more than 21% of BorgWarner's backlog is attributable to diesel turbochargers. Volkswagen, BorgWarner's largest customer, accounted for 17% of 2014 revenue, while total turbocharger (gasoline and diesel) accounted for 28%.
We forecast around 10% average annual revenue growth in the five-year Stage I portion of our discounted cash flow model. BorgWarner's growth is derived from increasing average dollar content per vehicle and acquisitions. We estimate the company's base revenue growth, excluding acquisitions, at 5%-7%.
We also assume modest expansion in EBITDA margin to a peak of 17.0% in 2017 from 16.5% in 2014 owing to continuation of demand recovery in Europe. Roughly half of BorgWarner's revenue comes from Europe. Since the company has been able to maintain 16.5% EBITDA margin when European demand has been in a cycle trough, we believe it's reasonable to assume that a normalized, sustainable midcycle EBITDA margin should exceed the 10-year historical median of 14.0%. As a result of recent profitability despite weak European demand, we forecast a 15.4% EBITDA margin in the final year of our five-year forecast, representing a 140-basis-point increase over the 10-year median.
Richard Hilgert does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.