Description

Trader Talk: Dirt cheap auto supplier at 4x 2022 and 3x normalized FCF with a capital return plan, aligned ownership, and catalysts from cycle improving, analyst day, and capital returns

GTX has been written up three times on VIC, so this write up will only briefly cover the fundamentals and instead focus more on the current setup. We are large shareholders and believe it to be a unique opportunity. There is also a GTXAP line, which is the better security but 1) GTX more liquid and 2) the difference is not that big of a deal. In a down 50% auto production quarter, GTX had a 14% margin when most others burnt cash, so we are not overly worried about being more senior in the capital structure. However, most of our bet is in GTXAP.

GTX is a high-quality Tier 1 auto supplier that is currently in growth mode but in the next few years will enter secular decline as battery electric vehicles (BEVs) increasingly come to dominate the auto industry. For more details please refer to the other posts, but GTX operates a duopoly in turbo chargers (TB) which are designed into auto engines years in advance, giving GTX outstanding visibility. In addition, GTX is a lean business and management are excellent operators. As part of HON, GTX consistently received HON’s highest internal rankings for efficiency and the business was restructured before the spin to eliminate the remaining high-cost plants. The duopoly structure plus visibility and lean operations makes GTX an easy company to model and thus predict, with auto-production the only large variable management cannot know ahead of time.

In February, GTX guided to 2022 FCF of $400-$500MM assuming 7% auto growth, with roughly 300MM shares outstanding (a little higher now, but they are actively buying back stock), or ~$1.50 at midpoint vs. current share price of $6.50. While their commercial and aftermarket businesses have returned to trend and account for 30% of sales, passenger vehicles are still well below trend, largely due to semiconductor issues. I estimate an incremental $800MM-$1B in auto sales in a normal environment, which at a 30% incremental margin adds an additional ~$0.70 of FCF, driving normalized FCF/sh of ~$2.20 which we expect to be reached by 2024. While BEV fears are on the horizon, GTX is currently growing above market and has an active buyback, so normalized FCF is moving higher while we wait. GTX net debt stands at ~$1.1B at present, or a reasonable 2x owners’ earnings. We typically would prefer higher leverage on an equity with this kind of visibility and resilience at trough (~$440MM in 2020 EBITDA) but given the secular concerns around BEV, we think lower leverage is warranted.

As GTX is clearly statistically cheap and the business resilient in bad macro-outcomes (will touch on UKR/RUS later), the critical questions are thus not minor changes in earnings outlook but 1) what is happening to the cash and 2) will BEV blow this model up? On Point 1, the largest shareholders are Centerbridge and Oaktree, who acquired a roughly 50% control stake during the bankruptcy process. While the capital is from funds with theoretically long-time horizons, they get paid just like we do and their job is to maximize their exit price. At present, we believe C&O are comfortable buying back stock and waiting for the cycle to turn. However, if the shares do not improve once the cycle turns, we would not be surprised to see GTX put up for sale. The recent LBO of TEN implies a $11-$12 price, and if rolled forward to normalized EBITDA-capex (an admittedly questionable assumption), yields a $18 target. Alternatively, given the debt packages floated for TEN and GTX in BK, I believe C&O could add an additional $1.6B in leverage, which including this years FCF of $450MM implies GTX could dividend its entire market cap by YE2022. On Point 2, there are many bull and bear debates on BEV but unless you think BEV massively beats IHS forecasts, the stock is simply too cheap and the capital returns too large. Given the state of certain battery inputs, particularly lithium and cobalt, I simply do not believe enough raw materials are present globally for BEVs to disrupt the GTX story in the next 5 years.

Given our view that BEV will take longer to arrive, we view something like an 8-10x lev FCF multiple as a reasonable target, yielding $17-$22 once the cycle normalizes.

State of Auto and Ukraine-Russia Conflict

Since 2020, global auto production has been in a deep recession. Two years of auto production at ~75MM units, a large hole vs trend of 100-110MM, is the largest auto recession in post-WWII history. However, unlike previous auto recessions, the culprit is supply, not demand. While various components have faced issues, the largest problem has been semiconductors. Autos tend to run on several generation old semis (you can’t have a failure with many parts of the car, so they need longer approval periods) and the snap back in demand following covid just depleted the system. As a result, there is currently a strong mismatch between demand and supply, with various indicators such as used car prices, OEM incentives, and dealer days of inventory supporting this. Before the current troubles in Eastern Europe, most OEMs and suppliers felt that autos had finally troughed, were expecting rising auto production in H1, and a stronger rebound in H2 as the semi issues alleviated. Semis still seem on schedule to significantly improve by H2 and certainly into 2023; however, the Ukraine-Russia conflict has again cause concerns for this forecast.

We divide the UKR/RUS concerns into two buckets: demand destruction due to soaring energy/commodity costs and further supply chain disruption. On the former point, there is no doubt that, if prices were to remain high, the energy/commodity inflation we are seeing will cause some level of demand destruction. However, auto is already at a recession with demand clearly above supply, and we believe auto production would prove resilient in the face of a modest demand shock, particularly one that is short in duration. On the latter point, Ukraine and Russia are relatively small parts of the global auto supply picture. There are production facilities in both that export to the rest of Europe, but they are typically Tier 2 and 3 suppliers, and the OEMs and Tier 1 suppliers always have multiple sources. If the conflict continues, it will likely be a short-term headwind, but the companies will be able to diversify away from the UKR/RUS in a reasonable time frame, say by YE 2022 at worst.

Regarding GTX, the conflict certainly puts GTX forecast at modest risk. The company is about half European sales. Having said that, given where GTX is priced, we just do not think it matters all that much. Could it make the stock trade down? Of course. We have nothing much to add besides if it trades down significantly, we will just add.

GTX Commodity Inflation

Another potential issue arising from the RUS/UKR war are surging prices for certain GTX inputs, such as nickel, pig iron, and aluminum. While something worth watching, and GTX could certainly see issues in H1 2022, GTX is a cost-plus business where raw material costs are passed along to the OEMs. For certain commodities like nickel, the contracts include explicit cost pass through mechanisms. For others, this is where GTX’s long lead visibility and smart hedging operations help. As GTX knows several years in advance what programs they will be on, they begin hedging far in advance. For instance, if GTX wins a bid and knows their turbos will be on all Mercedes AMGs starting in 2022, they find that out in 2019 and begin hedging metals and materials immediately. Something like 50% in 2019, 15% in 2020, and another 15% in 2021 as they leave wiggle room in case auto forecasts disappoint. GTX’s margins are thus fairly insulated from the current commodity shock. We fully expect there to be some issue in Q1/Q2, but we do not think is a major enough issue to materially change numbers over the next few years.

BEV Outlook

BEVs are absolutely the future of auto, at least in certain parts of the world, and their growth is a direct threat to GTX’s business. However, we believe GTX’s 3-4x FCF valuation (5-6x on EV basis) versus BEV sales at roughly 5% of the normalized market is simply too wide a discrepancy for BEVs to materially derail the GTX story. Unless capital allocation is stunningly bad (discussed in next section) or BEVs show truly explosive near-term growth, GTX should eventually work.

While there are numerous headaches to BEV adoption, including range anxiety, lack of charging infrastructure, and BEV price tag, we believe one could be a bull on all those points yet still run into what we believe is the largest gating factor stopping BEV growth in the near term: the lack of raw materials for batteries. BEVs require significantly more of certain materials, such as lithium and cobalt, that ICE cars, and there simply is not enough material available to hit the kind of aggressive targets that would derail the story at 3-4x FCF. Look at the charts above for cobalt and lithium – even before UKR/RUS, the prices were soaring. For BEVs to be an issue for GTX in next 3-4 years, it would require lithium and cobalt supplies to increase by 5x, while simultaneously lithium and cobalt prices fall 90% to stimulate low end car demand. Does that seem reasonable based on those charts? This is mining, not software, and you cannot just build a railroad or dredge a port overnight. If BEV penetration is not above ~40% of cars by 2026, GTX will generate its entire market cap in cash before the business even enters secular decline.

Longer term, roughly 1/3rd of GTX’s sales and closer to 40-50% of EBITDA are commercial vehicle and aftermarket, which will not see a BEV impact for 10+ years. We think BEV penetration is likely to plateau at 60-70% somewhere in the late 2030s, and there are many markets and use cases where we think a high-quality ICE, using a GTX TB, will still be used for years to come. For instance, Poland is 100% powered by coal, and until it switches to renewables, there will be no point in BEVs as ICE is more CO2 efficient. GTX is also spending ~$100MM/yr on R&D for products other than turbos, which over time could lead to products that exist in the car going forward.

C&O and Capital Returns

Given GTX’s statistically cheap equity and long-term BEV fears, capital allocation is top of our minds for this investment. If this were some management team hell bent on acquiring their way out of secular decline and buying nascent BEV businesses at 10x or 20x sales, we would have a very different view on the investment. However, we take a great deal of comfort in C&O running the show, along with other noted value investors like Sessa.

C&O et. al. are smart, competent investors coming from a value background who understand basic capital allocation. They are not VCs dreaming the dream, nor are they earning large fees to manage the investment as is. They are motivated just like other third-party shareholders to maximize exit price. Since the recapitalization last April, the board has made steady progress. HON has largely been paid off and the company has announced a stock buyback. We were particularly pleased with the pacing of the buyback, given the shares illiquidity. We expect further news on the capital allocation front when GTX updates the market with Q1 results and at their analyst day, which we believe will be sometime in June.

We think C&O has a rational playbook: buy back stock and wait for the cycle to normalize. If the market reweights GTX inline with auto peers like BWA, which pre-UKR was trading ~10x FCF, they could opt to sell in the open market. However, we think given their sizing at ~50% of the company, and particularly if the market fails to reweight GTX, it makes most sense to pursue a sale. The recent TEN LBO provides a clear template for valuation at ~8.5x EBITDA, and we would strongly argue GTX is a superior business. There are numerous private equity funds explicitly highlighting the opportunity to roll up legacy ICE auto assets, and we expect that 

Catalyst

• Potential analyst day in June where GTX explains capital allocation policies and potentially R&D spend and BEV projects
• Auto cycle normalizes - unlikely we stay down 25-30% forever
• Capital Returns - $2.1B company likely at target leverage generating $450MM in cash in not great auto environment. Will be difficult to buy back stock without seeing price go up.