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* Sees lower 2017 operating margin
* Says faces pricing pressure from large carmakers
* Says shift to electric cars increases R&D expenses
* Shares drop 12 pct (Adds comment from supplier ZF)
By Edward Taylor
FRANKFURT, June 27 (Reuters) - German auto supplier Schaeffler cut its annual profit guidance on Tuesday, citing higher steel costs and development costs related to electric cars in a warning that hit shares across the sector.
The company said that earnings in the second quarter, which ends on Friday, would fall substantially, sending its share price down 12 percent to 12.61 euros.
Chief Executive Klaus Rosenfeld told analysts that a shift towards electric cars had forced Schaeffler to build many more prototype components, lifting research and development expenses while price pressures increased elsewhere.
"What is new is that we were not able to compensate by lowering our production costs. This comes amid higher steel prices for certain products in the transmission area," Rosenfeld said in a conference call on Tuesday.
Herzogenaurach-based Schaeffler said it expects a 2017 adjusted operating profit (EBIT) margin of 11-12 percent, compared with previous guidance of 12-13 percent.
Fears of sector-wide margin pressure sent shares in rival suppliers Leoni and ElringKlinger down 3.5 percent and 2.4 percent respectively. Shares in Continental fell by 3.3 percent.
"Schaeffler flagging increased pricing pressure will almost definitely raise concerns across the supplier space, especially with supplier valuation premium to OEMs (original equipment manufacturers) at peak levels," Jefferies analysts said in a note.
Analysts at Morgan Stanley noted that Schaeffler is likely to have the highest exposure to combustion engine products such as engine systems and transmissions and therefore has "the most to do to address future industry changes for electric vehicles".
Elringklinger, ZF and Continental all said they are sticking to their earnings targets. ZF said that pricing pressure is so constant that it is not a reason to change its annual forecast. Unlisted supplier Bosch said it will provide a financial update on results later in the year.
Schaeffler expects growth from the autos business in the second quarter but could not say whether a hit to its profit margin was temporary or permanent.
The odds that this is a lasting hit to margins or only temporary are "50-50", Rosenfeld said.
"Pricing pressure comes from the large customers," he added, declining to name any of those customers.
"It is a negotiation across the board. The fact that there is pricing pressure from the large OEMs is a reflection that they are changing their portfolios."
Schaeffler also said it had suffered a temporary supply chain shortage in the automotive spare parts business, without providing details.
The company cut its forecast for 2017 free cash flow to about 500 million euros ($564 million) from about 600 million euros but stuck with a target of 4-5 percent revenue growth excluding currency effects.
Rosenfeld warned in April that it would be difficult to sustain strong margins in automotive operations given rising steel prices, high R&D costs and growing competition.
Schaeffler said it now expects to report a slide in its first-half margin to about 11 percent from 12.8 percent a year earlier. It said it would publish key figures for the first six months of the year by mid-July and stuck to its 2020 profit guidance. ($1 = 0.8862 euros)
Reporting by Edward Taylor, Jan Schwartz and Maria Sheahan; Editing by Mark Potter, Jason Neely and David Goodman