Our Thesis in Summary
Garrett Motion Inc ( GTX ) ( Garrett ) is a small, underfollowed and misunderstood recent spin-off from Honeywell International Inc ( HON ) ( Honeywell ). Garrett commenced trading independently on the NYSE on September 17, 2018.
The dynamics of spin-offs have been comprehensively discussed in Joel Greenblatt's excellent book, You can be a stock market genius (1997). Garrett is no exception: its financial statements are superficially messy, and the stock predictably began falling almost as soon as Honeywell stockholders found it appearing in their brokerage accounts. In fact, the typical dynamics of spin-offs were magnified in this case, for various reasons, including:
- Honeywell offloaded 90% of its asbestos-related liability into Garrett as part of the spin-off;
- Honeywell loaded up Garrett with debt (the proceeds of which went to Honeywell); and
- weakness in the market prices of auto sector companies generally, in line with media noise around a feared peak in the auto sales cycle (and a peak in the business cycle and economic activity generally).
However, an in-depth look at the underlying performance and fundamentals of this business reveal a stable cashflow machine, which is aligned to grow organically faster than the auto industry as a whole, and which is presently trading at a bargain-basement price.
A Brief Overview of the Industry and Recent Trends
There are generally five levels of supply in the auto industry: dealerships, original equipment manufacturers (OEMs), and Tier 1, 2 and 3 suppliers. Garrett is a Tier 1 supplier; like all such suppliers, it supplies automotive components to OEMs.
For some years now, there have been media articles about auto sales having hit a cyclical peak in the US, with a decline expected to be just around the corner. It is hard to know whether this is true, given that US auto sales only recently surpassed their previous peak in 2005, and since then, the US population has grown by around 10% and the age of the vehicle fleet has expanded from 9.8 years in 2005 to 11.7 years in 2017 . It is also hard to know whether, even if sales have peaked, this will result in a future decline in profitability for the industry. What we do know is that sales were higher in 2018 than they were in 2017.
The automotive industry is also undergoing a number of more significant structural changes at the moment, ranging from electrification to automation to shared mobility offerings from the likes of Uber and Lyft. It is widely predicted that these trends will start to converge, so that, for example, people who might previously have purchased vehicles for private use will instead get around in fully autonomous electric Uber vehicles. The expectations surrounding these changes are high, and explain, in part, the sky-high valuation of loss-making Tesla Inc ( TSLA ), while the stock prices of 'traditional' auto companies languish despite their profitability.
One of our many failings as humans is our tendency to project recent experience into the future in a linear way, giving less weight to events that occurred longer ago. This is due to what has been termed by Daniel Kahneman as the 'availability heuristic' (otherwise known as 'recency bias'). In the case of the auto sector, current growth in, and hype about, these structural trends is being projected to continue at the same (or an accelerating) pace into the future. However, investors would do well to realize that none of these trends will disrupt the industry overnight, and many may never do so in a meaningful way:
- electric-powered vehicles still suffer from battery issues including range, weight and climate limitations, higher costs, slow charging times, a lack of industry consensus on standardization and regulatory inertia in many markets;
- the artificial intelligence capability and connectivity speeds necessary for fully autonomous vehicles do not yet exist. According to PwC , 'Level 5' autonomous vehicles are not predicted to be on the road for at least another 7 or 8 years:
- shared mobility services such as Uber tend to work well in densely populated areas, such as the centre of big cities, but less so (or not at all) in the suburbs and rural and regional areas. In addition, they tend not to be appropriate for families.
Moreover, the reliability of forecasts about electrification, automation and shared mobility is questionable. As a saying often attributed to Niels Bohr (and sometimes Yogi Berra) goes, 'It is difficult to make predictions, especially about the future.' Real possibilities that must be acknowledged are that:
- electric vehicles may take longer than expected to replace the existing car fleet, and may contain different technology to that which is presently used;
- Level 5 autonomous vehicles may never arrive, may arrive decades later than currently hoped for, many be confined to certain situations in full self-driving mode (e.g. highways), or may only ever end up addressing a niche;
- shared mobility services will continue to take the place of taxis, but cannot (and therefore will not) completely replace private car ownership.
Even if some or all of these new trends accelerate, new vehicle sales will probably continue to increase for some time:
Apart from their own inherent limitations, each of these trends is vying for dominance against ingrained and long-standing cultural norms, which revolve around the freedom and excitement which individuals can experience by owning and driving their own car. These norms continue to be supported by industry advertising and other media. New vehicles will probably continue to look more like the existing fleet than the futuristic alternatives being dreamed up, for longer than expected:
Despite the very real doubts over the sustainability and inevitability of these new trends, market sentiment indicates that the majority of investors are true believers. As a result, 'traditional' car manufacturers and suppliers are being priced as if they are going to go out of business - despite the fact that, at present, their businesses are as healthy as ever and are throwing off massive amounts of cash.
Therein lies the opportunity.
Garrett is a Tier 1 supplier to 40 OEMs including Ford Motor Company ( F ) and Volkswagen AG (VOW) (its two largest customers). The company principally produces turbochargers for both diesel and gasoline vehicles, as well as 'e-boosters' for hybrid cars. Together with its main competitor BorgWarner Inc ( BWA ) ( BorgWarner ), Garrett dominates the market in turbochargers.
In many ways, this company is at the intersection of the structural trends described above, although it is probably most exposed to the electrification trend.
Superficially, assuming the electrification trend is likely to accelerate and lead to the eventual death of the internal combustion engine, this may be thought to be bad news for Garrett. After all, no turbocharging technology presently exists for purely electric battery-powered vehicles. However, there are several reasons why that superficial view is likely to be wrong.
Demand for Turbos
Turbos have traditionally been thought of as performance enhancers. However, they also increase fuel efficiency. As a result, OEMs are increasingly turning to turbos in order to reduce engine sizes and thereby reduce vehicle emissions. Nearly 30% of all new cars sold today have small turbos installed in order to improve efficiency. This trend feeds in to analyst forecasts of over 9% annual growth in the turbocharger market during the period 2018-2025. Industry players appear to agree, with BorgWarner Inc forecasting a (more conservative) CAGR in the turbo market of 5.8% between 2018 and 2023. That organic growth opportunity for players in the turbocharger market far outstrips forecasted auto market growth as a whole.
This trend of increasing demand for turbos is also likely to benefit from growth in the hybrid car market ahead of full electrification, as significant emissions reductions can be achieved using hybrid technology. Hybrid cars can (and do) also employ turbo technology, further reducing their emissions footprint.
The future of electrification is unclear
The electrification trend is still not standardized, with (at a high level) lithium batteries competing with hydrogen fuel-cell technology. Lithium appears to be winning that race at the moment, but hydrogen fuel cells have better range capability, do not suffer from weight limitations, have faster refueling/charging times, are experiencing declining costs, can take advantage of already-embedded infrastructure (in the form of existing gas stations), are strongly supported by Toyota and Hyundai, and are already popular in some markets, such as Japan. Turbos can be used in hydrogen fuel cell cars, but at present they have no use in fully electric battery vehicles.
Time will tell which technology ultimately wins out, and it is likely to be some considerable time before this becomes clear. At the moment, lithium has a clear head start, but 100% penetration of this technology is not likely to occur for many years to come, if it ever does occur. This is important, because given Garrett's current valuation (discussed below), the market is implying that its business will be dead within just a few short years.
Current Business Results and Future Guidance
The forecast market growth in turbocharger technology is playing out at Garrett, with the company most recently reporting 6% organic growth (9% headline growth) in full year 2018 sales (compared with stagnant general auto industry growth over the same period). This is also occurring at the same time as the company is (successfully) pivoting from being a diesel-focused supplier to one supplying both gasoline and diesel engines, whilst increasing their market share.
For the full year 2018, Garrett reported :
- Net sales of $3.375b
- Adjusted EBITDA margin of 18.3%
- A reduction in net debt to 2.96x EBITDA (from 3.07x on 30 September)
- Adjusted FCF (ignoring asbestos indemnification and tax sharing payments - discussed below) of $164m in Q4, which the company indicated was favourably impacted by seasonality
- FCF (subtracting asbestos indemnification and tax sharing payments) of $104m in Q4
- Adjusted EPS of $3.48 (excluding the benefit of tax restructuring benefits and other items)
For 2019, the company is guiding 2-4% organic sales growth (taking into account an expected slow-down in the first half), adjusted EBITDA of $630-650m (based on a margin of 18-20%), and an adjusted FCF conversion rate of 55-60% (excluding asbestos indemnification and tax sharing payments). This implies FCF of $346-390m.
The company also confirmed that it intends to deploy all FCF to reduce gross debt, and expects to reduce net debt to its target leverage of 2.0x EBITDA by the end of 2020.
As mentioned above, as is typical for many spin-offs, the former parent loaded up Garrett with debt and liabilities: in this case, $1.432b (originally $1.6b) in debt and 90% of Honeywell's historical asbestos liabilities. These liabilities dwarf the current equity market cap of $1.17b (as at 21 February 2019) and are likely to be enough to chase many investors away.
Looking more granularly at the detail, Garrett is currently producing around $370m in annual FCF (excluding the Honeywell asbestos liability and the shared Honeywell tax liability). As noted above, management has said that it is focused on paying down gross debt to a point where it is 2 x EBITDA; it has already made substantial progress towards this goal, and expects it to be achieved by the end of 2020.
As for the asbestos liabilities, Garrett's non-deductible indemnification liability to Honeywell, whilst large in headline terms ($1.24b), is capped at $175m per annum, regardless of the headline 90%/10% split that otherwise applies. Further, recent payments ($41m in Q4 2018, which annualizes to $164m) suggest that the annual cap may not be reached. Given the solid profitability of the business, in reality there is not much to be concerned with here.
Further, the mandatory transition tax to be paid to Honeywell pursuant to the tax sharing agreement entered into as part of the spin-off was revised down to $240m from the expected $350m shortly after the spin-off took place. This amount will amortize and be payable over an 8 year period; $19m was paid in Q4 2018.
As stated in the introduction, since the spinoff, Garrett has exhibited all of the usual spin-off dynamics. As Greenblatt said in his book:
'Generally, the new spinoff stock isn't sold, it's given to shareholders who, for the most part, were investing in the parent company's business. Therefore, once the spinoff's shares are distributed to the parent company's shareholders, they are typically sold immediately without regard to price or fundamental value. The initial excess supply has a predictable effect on the spinoff stock's price: it is usually depressed… [I]nstitutional investors also join in the selling.'
I would add that these dynamics are often compounded by initially messy financial statements and, in this case, the offloading of liabilities to the spinco by its former parent, the small size of the spinco relative to its former parent (~$1b vs ~$110b) and negative sentiment in relation to the industry trends discussed above.
It is no surprise that the Garrett share price has followed the usual path of an initial drop (although it has recovered quite aggressively in the last month or so):
Garrett's management team, whilst obviously new, is experienced. The CEO, Olivier Rabiller, joined Honeywell in 2002 and served in various roles prior to the spin-off, including most recently as the leader of the 'Transportation Systems' division. The CFO, Alessandro Gili, was the CFO of Ferrari NV ( RACE ) and, prior to that company's spin-off from Fiat Chrysler Automobiles NV ( FCAU ) ( Fiat Chrysler ), worked for Fiat Chrysler as its Vice President and Chief Accounting Officer. As such, he has been part of the team led by the late legendary Sergio Marchionne.
Garrett's senior management is incentivised with annual cash bonus payments, as well as long-term equity awards. These vest 3-4 years following the spin-off, which will assist in aligning management's focus to long-term shareholder value creation.
Based on the company's 2019 guidance given during the Q4 2018 earnings call and presentation, we derive the following numbers:
2019 (based on company guidance)
$3.44 - 3.51b
Asbestos indemnity payments (assume maximum)
Tax sharing payments (a guesstimate)
Revenue (adopting 7% organic growth as a midpoint)
$3.68 - 3.75b
EBITDA (18-20% margin)
Adjusted FCF (55-60% conversion ratio)
Asbestos indemnity payments
Tax sharing payments
$3.93 - 4.01b
Asbestos indemnity payments
Tax sharing payments
$4.18 - 4.29b
Asbestos indemnity payments
Tax sharing payments
Market cap (as at 21 February 2019)
2022 Market cap/ Adjusted FCF
2.2 - 2.8x
2022 Market cap/ FCF
3.7 - 5.6x
These calculations assume there will be no improvement in margins or FCF conversion, operating efficiency or market share growth. They assume that asbestos indemnification payments will reach the annual cap each year, despite the fact that (as noted above) the most recently reported results imply something lower. They do not take into account the likely improvement in FCF as a result of deleveraging (due to reduced interest expense). They also assume shares outstanding remain constant.
What we are trying to achieve here are calculations that are roughly right, rather than precisely wrong, and we prefer to use conservative inputs. Something more favourable in relation to any of these levers may improve the projections set out above. Given the favourable economics of the business and the alignment of long-term incentives for management, we expect at least some of them will.
As a sanity check:
- adopting the adjusted 2018 full year adjusted EPS number reported by the company during the Q4 earnings call , Garrett is presently trading at a PE of 4.5 (based on the 21 February 2019 closing price);
- current enterprise value is ~$2.6b ($1.17b equity, $1.432b net debt), so current EV/EBITDA is around 4.2 (again, based on the 21 February 2019 closing price);
- because Garrett is a fairly unique pure-play turbocharger business, it is difficult to directly compare it with peers. However, BorgWarner (which admittedly has a broader business than turbochargers) is (according to data from YCharts ) presently trading at a PE of 9.1, EV/EBITDA of 5.9 and a share price/ TTM FCF ratio of 14.6- after recent market weakness saw its stock decline substantially.
On any metric, Garrett looks cheap, and if the share price doesn't increase substantially, it will keep getting cheaper. Of course it is impossible to predict with precision what the upside is, but it is clearly substantial.
It is also notable that 'guru' Mario Gabelli/ GAMCO bought a sizable position in Garrett during Q4 2018; several other 'gurus' are also investors.
Risks & Catalysts
We believe the investment case set out above is sufficiently conservative so as to take account of all real risks of any significance.
Whilst the main risk to the thesis is a sustained economic downturn (and associated fall in new auto sales), we think this is mitigated for Garrett by the fact that the turbo market is expected to grow far in excess of the auto market as a whole, and the fact that Garrett's cost structure is highly variable. According to the company, 80% of its cost structure is variable, and 75% of its cost footprint is in low-cost countries, making it flexible enough to weather a market downturn.
In addition, one possible outcome of a recession is increased consumer preference for smaller, cheaper vehicles, which are more likely to require turbos as a result of their smaller and less powerful engine sizes.
Other risks (which we think are less likely to eventuate) are:
- the risk of major customers taking their business elsewhere. However, there is no suggestion that this is likely and we think that Garrett's quality technical line-up makes this improbable. In addition, present trends indicate that Garrett is improving its market share;
- the risk of full-battery electrification accelerating at a faster pace than anticipated and the hybrid opportunity being short-lived. However, this seems unlikely for the reasons discussed above. In addition, it is entirely possible that hydrogen fuel cell technology will win out at the end of the day. It is also possible that Garrett could start a business supplying components for full-battery electric power trains;
- execution risk, including an inability to meaningfully reduce leverage. However, this seems unlikely in view of the quality of the management team, their incentives and the fact that substantial progress is already being made on this front.
Conversely, there are a number of catalysts which we believe could lead to a significant positive re-rating of the stock in the next year or two, including a better market understanding of the limited extent of the asbestos liabilities (and, in particular, the annual cap), success in the company's deleveraging plan, the end of the technical overhang from the spin-off, the more transparent accounting that will result once accounting relating to the spin-off falls out of the TTM, and potential buybacks/ initiation of a dividend.
There are many ways to win with this stock and we think that good things will come to those who hold it.
Disclaimer: nothing in this post is intended to constitute financial, legal or other advice or a solicitation or offer to enter into any investment. Before making any investment you should obtain your own advice and rely upon it and your own enquiries. Past performance is not necessarily indicative of future results, and returns are not guaranteed. The statements herein which contain terms such as "may," "will," "should," "expect," "anticipate," "estimate," "intend," "continue" or "believe" or the negatives thereof or other variations thereon or comparable terminology are forward-looking statements and not historical facts. Due to various assumptions, which are inherently uncertain and subject to numerous business, industry, market, regulatory, competitive and financial risks that are outside of Knackwell Capital Management's control, actual events, results or the actual performance of the Fund or any particular investment discussed herein may differ materially from those reflected in or contemplated by such forward-looking statements. The inclusion of any forward-looking statements herein should not be regarded as an indication that Knackwell Capital Management considers the forward- looking statement to be a reliable prediction of future events and should not be relied upon as such.
See also Manulife Financial: An Investment Solution For You on seekingalpha.com