Description

Garrett Motion (GTX) is a leading producer of turbochargers.  Turbochargers are centrifugal compressors driven by an exhaust gas turbine and employed in engines to boost the charge air pressure. Turbocharger performance influences all important engine parameters, such as fuel economy, power, and emissions.  In short, tubrochargers enable smaller, lighter and more efficient engines.  The turbocharger is dominated by GTX and BorgWarner who have ~33% and 29% market shares respectively.  In the late 2000’s two large global auto suppliers (MAHLE and Robert Bosch GmbH) set up a joint venture with the goal of cracking the GTX/BWA duopoly.  Despite spending hundreds of millions of dollars, the JV never gained meaningful market share and was ultimately sold to Chinese private equity in 2017.  Please see previous VIC writeups as others (and several have been generous with their time as I looked into this business) have written more extensively on the business and know the business/industry dynamics far better than me.

So, in summary, a duopoly type business, albeit in the amazingly difficult auto supply industry.  Of course, the real opportunity in GTX has occurred because of secular concerns over the transition to electric battery car sales as well as the company’s recent tumultuous history and current illiquidity.  GTX was spun out of Honeywell (HON) in September 2018 but saddled with legacy asbestos liabilities related to brake pads sold prior to 1985 and entirely unrelated to GTX’s current turbocharger.  At the time of the spinoff, many investors believed that the cash flow from the turbocharger business would be more than sufficient to offset any asbestos related reimbursements.  Post spinoff, however, GTX struggled as its margins were adversely impacted by a faster than anticipated decline in diesel turbochargers (concentrated in Europe) and towards less profitable gasoline turbochargers.  And then COVID hit and global car volumes temporarily plunged.  GTX voluntarily filed for bankruptcy in September 2020 to address the contingent asbestos liability and improve the company’s longer-term capital structure.  

I will not detail the full chapter and verse of the complicated bankruptcy process – again, see previous write-ups who gave great detail  -  but to summarize:  two well regarded institutional investors (Oaktree and Centerbridge) led an equity/debt financing which ultimately led to the reduction of ~$2.7 debt/legacy obligations and investors .  Importantly, HON signed off on the plan and GTX’s asbestos liabilities was transferred into a preferred security with ~$585 million discounted value, whose terms were modified in October of this year (more on this in a bit).  It is worth quickly noting that competing bids did not have the support of HON and therefore the inability for other groups to quantify this liability distorted the ultimate price others would bid for the business.  All prior creditors were repaid in full and GTX has $1.25 billion of new debt at close (1.37x net leverage/2.7x including Series B preferred as of 06/03/21).  The debt payback was partially funded by a ~$1.3 billion convertible Series A Preferred Stock (GTXAP) which pays 11% in either deferred cash or stock starting in January 2023 and ultimately converts into common shares at $5.25 – while highly illiquid, I believe the GTXAP is the better security to own currently.

Business Summary

GTX is leveraged to global light vehicle sales.  As shown below, at the beginning of 2021, IHS had been expecting rebounds to pre-COVID levels sometime in the 2023/2024 timeframe.  Following the well-publicized semiconductor shortage, global sale estimates have fallen for 2021 and 2022, with IHS revising its 2021 and 2022 estimates to ~76 million and ~83 million.  Even with the drop, it is expected that turbochargers’ share of total light vehicle sales should rise as should the continued share of hybrid vehicles.  Hybrids generally require higher value turbochargers and therefore the expected increase in their share of total vehicle sales should be margin accretive to GTX.  

GTX’s primary risk is how quickly electric battery share can jump between 2025-2030.  Deloitte forecast that electric vehicles can gain ~32% share by 2030, with 85 percent of this attributed to electric batteries where GTX will likely not be a participant.  

Even in this scenario, it is possible that increasing turbocharger and hybrid share will keep sales growing for most of the decade and possibly at margins above current levels.  It is also possible that another technology (such as hydrogen fuel cells) emerge as a more substantiative part of the electric vehicle share despite Elon Musk dismissing this technology as “mind-bogglingly stupid.”  On the downside, it is certainly conceivable that continued technology breakthroughs could allow a faster ramp in battery powered electric vehicles than even current upside estimates – i.e., the ice cube melts faster than anticipated.  GTX bulls would quickly note that cobalt constraints make it difficult to believe that battery production can be sufficiently scaled to even hit the 30 percent market estimates.  Pessimists could counter that technological innovation will allow other components outside of cobalt to allow battery scaling.  As would be expected, GTX believes hydrogen fuel cells offer more promise than Elon suggests.  The company also notes that its aftermarket and commercial vehicle sales (roughly 30% of total revenue) give it a decent growth path outside global light vehicle sales.  GTX notes that heavier battery components are a particular challenge for commercial vehicles and limit opportunities to gain meaningful share.  In terms of 2030 market share, GTX simply notes that a portion of the outcome could hinge on whether emissions standards are defined by drops in absolute emission levels (encourages hybrids, multiple technologies – “good” for GTX) or whether dictated by technology (must move to battery electric vehicles – “bad” for GTX).   

Diesel car sales, which carry higher turbocharger margins, have meaningfully declined over the last several years, particularly in Europe.

GTX has admitted that the diesel declines occurred faster than the company anticipated at the time of the spinoff but believes GTX volumes should stabilize despite diesel’s declining overall share of total vehicle mix.  

Generally, there is less technology in the typical gasoline turbocharger, with most volume skewed towards so-called waste gate technology.  But, gasoline turbochargers are moving more towards higher value added variable nozzle technology – the company has outlined this change in its investor materials – and GTX and BorgWarner are the only two players in this newer technology.

Given the roughly 4 years between quoting and winning business, it will take time for this margin upside to be reflected in GTX numbers and therefore the mix of diesel sales and commercial/aftermarket (which have higher margins) will likely determine overall margin levels for the next several quarters.   It should be noted that this longer lead time also gives GTX exceptional visibility into forward sales, with GTX already having nearly 80% of its 2024 core turbo business awarded.   

GTXAP:  Hoping for Double Dip

While there is certainly a credible case for the common equity, GTXAP offers the better risk/reward, especially considering the current spread and optionality on common dividends.  GTXAP pays interest at an 11% cumulative annual rate on outstanding principal and any accrued but unpaid dividends.  Four “disinterested” directors determine whether the payment will be cash paid or paid in-kind.  The Series A automatically converts 2 years after effective date (04/30/23) assuming:

• Series B Balance <$125 million

• GTX is 150% of conversion price ($7.875 or 1.5*$5.25) 

• LTM EBITDA for the last two quarters is >$600 million 

In July of 2021, the terms of the Certificate of Designations of the Series A Preferred Stock (Series A Certificate) was amended that allowed a ratable dividend on the Series A and Common stock prior to December 31, 2022 so long as the full Board approves the opinion of the disinterested group.  Previously, the Series A Certificate would not allow common dividends while the A is accruing.  Page 26 (using rather confusing language) of the second quarter 10Q states that no standalone dividend payments can be made to Series A holders prior to December 31, 2022 unless a ratable payment is made to common holders and such payment is allowed under the credit agreement.  After following up with the company, the change was made with the intention of ultimately amending the credit agreement to allow ratable payments to Series A and common holders – in other words, to allow a “double dip” common dividend payment as GTXAP holders continue to receive preferred cash distributions.  After taking into account better than anticipated results in the first half of 2021, it appears that GTX has the capacity to make ratable payments sometime during 2022 and therefore the double dip possibility looks real, assuming the required changes to the credit agreement can be made.  

Even if the double dip payment does not occur, the preferred looks cheap relative to the common.  GTXAP holders receive one share of GTX plus over one dollar in dividends, assuming a cash payment on January 1, 2023.  

PIK payments could be even more lucrative for preferred holders (PIK done at the greater of price on declaration date or the 30-day volume weighted average or if LTM EBITDA <$425 million), but I assume the independent directors require cash pay absent a meaningful downturn in the business.    

GTXAP has traded well within $1.00 of the common stock for large portions of the last several months, giving no value to the possibility of ratable dividends, possible PIK and/or general preference rights over the common.  Obviously, the illiquidity of the preferred is likely the primary reason – GTXAP is closely held and shares traded OTC until recently.  Centerbridge and Oaktree control 6/9 Board seats and therefore will dictate the direction of capital allocation decisions.  It stands to reason that both investors would greatly benefit from common dividends prior to 12/31/22 as such payments would likely lock a lucrative payday on whatever carry they have with their limited partners.  Certainly, buybacks are also a possibility and perhaps there could be some balanced strategy of dividends, buybacks and smaller deals – the latter sounds scary but, again, the financial interest of Centerbridge/Oaktree would work in GTXAP holders’ favor.  In that spirit, I completely ignore the software/cybersecurity businesses – they are small and despite management enthusiasm for their prospects, it is best to ignore for valuation purposes.  And, if the big 2 are planning to screw everyone in some anticipated way, well, better to own what they own.

As previously mentioned, GTX gave detailed financial projections in February of this year (prior to the effective date), but obviously there was no incentive to come out of the gate with aggressive numbers at that time.  Conversion/Redemption of the Series A and Series B preferred was predicated on achieving run rate EBITDA of $600mm, originally projected sometime in 2023.  GTX has already exceeded these levels in the first two quarters of 2021 and margins are above projected levels.  As there currently is no sell-side coverage, GTX’s outperformance relative to original projections has not been widely publicized.  Additionally, the much-discussed semiconductor shortage has impacted sales and GTX forecasted a slowdown in the back half relative to first half results.  Even accounting for this, GTX appears to be at least one year ahead of the original forecasts provided in February.  

Originally, Honeywell could put the Series B securities to GTX if EBITDA exceeded $600 million for two consecutive quarters suggesting the put could be executed sometime this year.  This arrangement was modified on September 30 whereby the put rights were extended until 12/31/22.  GTX will redeem $213 million of Series B securities on January 1, 2022 and the previously scheduled $34.8 million due April 30, 2022.  This leaves $400 million of discounted notes as of January 1, 2022.  We assume GTX funds the $213 million and $34.8 million payments are funded out of current cash and GTX raises debt to fund the balance, thereby keeping ~$480 million of cash on its balance sheet at all times.  From conversations with the company, it sounds like carrying cash levels were still being discussed and this could easily prove to be overly conservative.

Acknowledging Huge Uncertainties…Risk/Reward Still Looks Attractive 

As a first pass, we just take current year guidance and update this starting point for assumptions given back in February.  It also seems reasonable to assume some margin benefit given the transition from wastegate to variable gate turbochargers as well as the likely increased hybrid volume.  Certainly, one could argue that this type of performance would warrant a rerating, especially as GTX’s closest competitor trades ~9/11x earnings/free cash flow.  That said, it is entirely possible the multiple does not move, and therefore an investor is dependent on intelligent capital allocation – Centerbridge/Oaktree’s presence gives comfort here.  We assume available cash is returned as dividends – even at a 6x multiple 15-20% IRRs seem possible.  Certainly, the big 2 could opt for buybacks versus dividends and therefore the name becomes a more leveraged bet on GTX’s position holding – but, again, the preferred provides some downside benefit in this scenario.

Of course given that ~70% of GTX’s business is leveraged to global light vehicle sales, GTX is exposed to nearly every single market risk imaginable (recessions, chip shortages, currency changes, geopolitical headlines, etc.).  The long-tailed nature of securing new business provides fairly strong revenue visibility for the next 4-5 years, but certainly a faster than anticipated move towards electric vehicles (including breakthrough technology not dependent on cobalt inputs) is possible.  We consider a bear case where sales begin declining mid-decade with more rapid declines towards 2030.  We assume the company needs to roll debt starting in 2026 at twice current rates and the company slashes its payout to 50 percent to conserve cash.  While this scenario with a 4x 2030 multiple is no fun and not a successful outcome, it would still generate a small positive return and this assumes they end up holding over $1.5 billion of cash to self fund debt maturities.  Certainly, one can create a far more draconian scenario – we are giving the company the benefit of a recovery through 2024 and unexpected recessions are possible.  Additionally, any modeling assumptions used in such a dynamic industry need to be taken with more than a grain of salt.  That said, the below (I show 2025-2030) provides some comfort when thinking about whether this turns into a value trap.   

Interestingly, many of the Tegus reports that came out shortly after the original spinoff focused on assessing GTX’s technology versus BWA (Some said better…others said no), assessment of management actions/characters and overall competitive positioning in an industry moving towards electric vehicles.  With the benefit of distance and hindsight, it appears that most would have walked away from several of the reports with generally favorable impressions of the company’s positioning. albeit with eyes wide open about the challenges of operating within the auto supply business – squeeze whoever to meet OEM component cost cut requirements.    Unfortunately, the real risk was the most obvious one – the sustainability of asbestos reimbursement payments:  fixed costs are hard enough in a cyclical industry but become business killers when the truly unexpected occurs (COVID).   At least now, GTX enters the next several years with a cleansed balance sheet, business momentum and an economically aligned Board – all of which should make the expected unexpected more manageable.   

In summary, GTXAP appears to offer an attractive return profile even assuming no valuation improvement.  If the industry changes even faster than anticipated, current valuation levels and assumed intelligent capital allocation offer downside protection.  Finally, it is possible that the industry evolution occurs slower than anticipated and investors reassess the duopoly nature of the business – even modest revaluation could drive IRRs closer to 25-30%+.  

Risks:

-Every macro risk imaginable

-Non-Cobalt breakthrough on EV or worldwide mandates on EV vs. other technologies 

-Stupid acquisition 

-Preference for buybacks over dividends and company positioning deteriorates 

Catalyst

-Double Dip Common Payment

-Sell Side Initiation 

-Aggressive Capital Return