Description

Garrett Motion Inc (“GTX”) is no stranger to VIC as it’s been written up 4 times during its short but eventful history first as an orphaned spin-off and then as a post-bankruptcy reorg. Now that the right side of the balance sheet is fixed, I believe this is an opportune time to take a fresh look at GTX’s common equity. At its recent price of $7.50/share GTX has a $1.8bn market capitalization and a $3.3bn enterprise value. During its October analyst day, GTX’s management presented a credible plan to generate $1.7-2.1bn of free cash flow (FCF) over the next 5 years, which implies an annualized FCF yield to equity of ~20%. Stocks with high FCF yields are often “value traps” due to some combination of a bad business model, highly leveraged balance sheet, and value destructive capital allocation. However, as I’ll explain below, I believe GTX does not have these characteristics and is therefore an undervalued stock which could double over the next 3 years using conservative assumptions.

The prior VIC write-ups have detailed descriptions of GTX’s business, so I won’t go into the weeds, but I will quickly summarize why I think this is a good business (or at least a better business than the current valuation implies). GTX has approximately 1/3 of the market for turbo chargers used in light vehicles (passenger cars and trucks or “LVs”). GTX’s leading competitor in turbo chargers is BWA, who has a similar market share. GTX and BWA are technological leaders in the market, and I believe both are gaining share from smaller competitors in the industry (e.g. MHI, IHI and BMTS). Unlike many other automotive components, turbo chargers are highly engineered and only a handful of companies have a proven ability to design and manufacture turbochargers at scale. The “moat” in the turbo charger business is evidenced by consistently high margins (both GTX and BWA have turbo charger operating margins in the mid-to-high teens) and lack of competitive entrants despite these high margins.

Turbo chargers are a cost-effective way to increase fuel efficiency for internal combustion engines (ICE). As consumers and governments demand higher fuel efficiency, turbo chargers have increased penetration within ICE LVs from an estimated 47% in 2017 to approximately 54% in 2022. Going forward, the biggest threat to LV turbo charger volumes is the substitution of ICE vehicles with EVs. Assuming EVs go from ~10% of LV sales today to 25-30% in 5 years, LV turbo charger units will likely peak in the next 3-4 years. Since GTX has been winning business on future vehicle model launches, I believe they have good visibility into market share gains so GTX’s LV turbo charger revenues are likely to continue growing for a couple years past the industry peak. For those who are worried about the impending recession, it’s worth noting that due to supply chain constraints, global LV production never saw a big volume boom like other types of big-ticket consumer purchases. Thus, 2023 LV production volumes are just recovering to 2019 pre-Covid levels and are ~5% below 2017 levels. I also don’t think it’s a forgone conclusion that 25-30% of vehicles sold in 5 years will be EVs as evidenced by signs that EV penetration is already slowing https://www.wsj.com/business/autos/are-americans-falling-out-of-love-with-evs-2c7e6a1a.

In addition to manufacturing turbochargers for LVs, GTX earns 30% of its revenue from commercial vehicles, aftermarket and industrial end markets. This 30% of revenue is not directly exposed to EV adoption and is higher margin than LV turbo chargers, so I estimate ~40% of GTX’s profits are earned from non-LV end markets. Putting this together, I believe GTX’s overall revenues are likely to grow slightly for another 3-5 years leading to annual revenues in the low $4bn range.

GTX has an ~80% of variable cost structure and low capital intensity (CapEx is <3% of revenue and working capital is negative) leading to relatively consistent free cash flow generation. Over the last 9 years, GTX’s EBITDA margins have averaged 17.2% with a low of 14.5% (in 2020 when Covid reduced industry LV production ~15%). CapEx/revenue has averaged 2.7% and depreciation/revenue has averaged a similar 2.3% during the same period.

A back-of-envelope annual FCF calculation assumes $4bn of revenues, 13.0-14.0% EBITDA-CapEx margins (50-150bps lower than historical average), $100m of interest and $100m of taxes, resulting in $320-360 of annual FCF. Thus, I believe GTX is likely to earn enough FCF in the next 5 years to cover its market capitalization.

GTX hosted an analyst day last month in which they outlined their plans to achieve $1bn in Zero Emission Vehicle (ZEV) revenue by 2030. GTX believes the technological expertise developed from turbo chargers gives them a strong foundation to develop products for ZEVs (see slide below from their presentation). I personally see this $1bn target as speculative as they haven’t yet sold large volumes of ZEV products. However, I do believe that GTX has technological expertise that goes beyond the capabilities of most auto parts manufacturers (as evidenced by the durability of margins and market share in the turbo charger business). Thus, pending future proof points, I am viewing GTX’s pivot into ZEVs as a “free call option” or upside case as the current market capitalization is already covered by the existing turbo charger business.

The prior VIC write-ups from October 2020, October 2021, and March 2022 detail the GTX bankruptcy and the opportunities that presented themselves during the process. GTX is now past this episode, with a clean capital structure and a management that seems committed to returning cash to shareholders. GTX’s recent conversion of its Series A preferred stock into common stock has made GTX more “investible” by decreasing complexity while increasing trading liquidity. At the time of emergence, GTX had ~65m shares of common stock and 2 classes of preferred stock (one of which was a more actionable and more attractive alternative than the common stock) so GTX common had low trading volume (~300k shares per day). Since the June 2023 conversion of the Series A preferred into common, trading volume has increased to ~1m shares per day and the number of common shares is now 242m. Unlike many companies with ~20% FCF yields, GTX has low balance sheet risk. Their $1.7bn of debt matures in April 2028 and has a 4.7x total leverage covenant. GTX’s total leverage is currently 2.7x, net leverage is 2.4x and management is targeting next leverage of <2x by the end of next year.

When GTX emerged from bankruptcy in April 2021 it had debt of $2.1bn (including the Series B preferred at face) and 313m shares outstanding (assuming the Series A converted into common). As of Q3 23, GTX has $1.7bn in debt and 242m shares outstanding. The ability to retire almost a quarter of shares outstanding in 18 months while reducing debt is a testament to GTX’s FCF generation and shareholder friendly capital allocation philosophy.

Given GTX’s prodigious FCF generation, I believe that over the next several years GTX has the ability (and the desire) to retire over 10% of shares per year while reducing its net debt to well below the <2x target. At the current stock price, GTX could generate enough FCF in a year to pay down $100m of debt AND retire 13% of its shares outstanding. I believe a large and persistent share buyback (at low a valuation) allows GTX to “create its own catalyst” for its underappreciated stock while also mitigating the overhang associated with the 30% of shares outstanding still owned by Oaktree and Centerbridge (the two lead Series A investors during the bankruptcy).

At the mid-point of the most recent 2023 guidance, GTX currently trades at 6.3x EV/EBITDA-CapEx. GTX’s closest peer BWA (who earns about ½ of its profits from turbochargers) currently trades at 8.2x EV/EBITDA-CapEx (based on consensus 2024 estimates). Looking forward 3 years, assuming steady EBITDA-CapEx, $300m of debt paydown ($100m/year), 30% fewer shares, and 7x EV/EBITDA-CapEx, I believe GTX shares can trade at $15/share or 2x the current price. On the downside, if in 3 years EBITDA-CapEx declines ~15% and the EV/EBITDA-CapEx multiple contracts to 5.0x, GTX would trade at ~$6 or ~20% below the current price. On the upside, if GTX’s ZEV products win significant customer orders, the valuation multiple could expand to 8-9x EV/EBITDA-CapEx, resulting in a share price in the low-mid $20s.

Catalyst

Retiring a lot of shares outstanding at attractive prices

Greater visibility given higher trading volume and cleaner capital structure (e.g. sell-side analysts pick up coverage)