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Garrett Motion Is Attractive Based On Value And Spin Dynamics

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About: Garrett Motion Inc. (GTX), Includes: HON, REZI
by: Rational Expectations
Summary

Garrett Motion is a cheap stock trading at 6.4x EV/EBITDA.

The high correlation with the other recent Honeywell spin-off in a separate industry suggest technical issues may be driving pricing to current lows.

Yes, it's an automotive supplier, but it has a superior market position with technology leaderships and its products may grow share over time.

The business operates in a duopoly market, suggesting some pricing power, and new products are being launched to better position the company for hybrid vehicles.

The worst of the spinoff dynamics may now be over, creating a runway for stock appreciation on the back of valuation support.

Garrett Motion (NYSE:GTX) is cheap and one of only two global suppliers of turbochargers. Turbochargers need to be installed in more cars in the coming years to help meet emissions targets. Hence Garrett may see much stronger growth than its valuation suggests. Also, current weakness may be due to uninformed spin-off related-selling that isn't reflective of the company's value.

Garrett Motion was spun off from Honeywell (HON) in 2018. Garrett Motion manufactures turbochargers for vehicles and intends to continue to innovate in delivery of vehicle technology.

Garrett Motion Jan 2019 Presentation source: GTX Jan 2019 Presentation

Not A Commodity Product

Garrett's products are not commodities. In fact, Garrett is one of only a handful of primary providers of turbochargers who have spent billions on R&D over recent decades. Indeed, Garrett has 1,400 patents. The need for these components to operate at high speed and high temperatures makes it challenging for new entrants to offer turbocharger technology. Garrett and BorgWarner are the primary global providers of turbochargers today.

This matters because it suggests pricing power. There are few substitutes for Garrett Motion's products giving them a degree of control over pricing.

source: GTX Jan 2019 presentation

A Growth Market

Below is the data on U.S. vehicle sales. There are some concerns that in a weaker consumer environment, U.S. vehicle sales will decline. Indeed, sales overseas, notably in China, are already soft. Furthermore, there are risks from electric vehicles taking share, which have less need for Garrett Motion technology today.

Chart Data by YCharts

Yes, U.S. car sales will likely decline in the next recession, but car ownership in the U.S. is at 8 cars for every 10 people. In contrast China has 2 cars for every 10 people and the number for India is lower still. Thus, the global car market still has potential to grow, even if the U.S. is subject to macroeconomic declines. So we are already seeing softness in car sales globally, but it is likely this is cyclical decline, not a secular one.

Gaining Share

However, perhaps more important is that turbochargers have the opportunity to gain share of vehicles sold over time. There is a broad trend towards 'engine downsizing' as a result of emission standards. Turbochargers help here. A turbocharger can improve engine performance and efficiency. This has caused strong growth of turbocharger adoption in vehicles in recent years. This is a trend that looks set to continue. It means that Garrett Motion's sales will likely ramp ahead of vehicle units as turbocharger penetration increases. The main risk here is fully-electric vehicles. Garrett is working on developing tech for these vehicles, see here for one example. However, for now, Garrett's products are primarily present in combustion engines with an increasing focus on hybrids, as their recent product announcement shows. Unfortunately, historically Garrett had disproportionate share in diesel engines. Diesel is in decline, yet Garrett's share of non-diesel is improving.

Turbochargers main gain share over time Source: GTX presentation Jan 2019

Thus, it appears Garrett has a superior position to many automotive suppliers. Its products are oligopolistic, suggesting some pricing power and turbochargers should enjoy increasing share of vehicles, improving volumes.

Strange Correlations

Hopefully I've made the case that Garrett is worthy of consideration as a company in your portfolio, due to structural attractiveness and growth dynamics. This assumes you can look past current automotive softness. Now let's talk about pricing and valuation.

Below we're looking at Garrett Motion and the other company that spun-out of Honeywell at the same time, Resideo Technology (REZI). The latter makes things such as thermostats for the home, and therefore has little to do with the automotive market. Yet the correlation with Garrett appears somewhat robust, strange right?

Chart Data by YCharts

For comparison, let's look at Garrett Motion against other automotive stocks. Here we'll take Ford (F) and GM (GM). If you look back and forth between the two charts, it appears that Garrett Motion is trading more on post spin-off dynamics than industry fundamentals. That is to say Garrett Motion is, over the past 6 months, following an unrelated company that spun-out at the same time, namely Resideo, more than its automotive peers such as Ford and GM.

Chart Data by YCharts

How could this be? Well often spin-offs can ultimately be a source of value for investors. However, spin-offs are dumped by investors for reasons independent of valuation. For example, Honeywell investors may dump these companies due to lack of knowledge. Even sophisticated investors may have had reason to own Honeywell but find these spun-out entities to be ugly ducklings in their portfolios. Fortunately, these unfavorable dynamics typically don't last forever. Generally the spun-out companies pick-up their own investor base over time, but it can take a while (Joel Greenblatt details this line of thinking in You Can Be A Stock Market Genius, 1997).

Therefore, in Garrett, we may have good company that's become too cheap due to spin-off dynamics. Let's look at the valuation.

Valuation

Unfortunately, Garrett has cut guidance this year. This doesn't help things, but let's say they do around $500M of EBITDA, which seems unduly pessimistic on current guidance. That puts the company at 6.4x EV/EBITDA, when I take the full value of company's asbestos liabilities (again quite a punitive interpretation, since they may come in lower, but cannot come in higher as it's a pass-through structure that Honeywell created). It's also not unreasonable to see the company producing $300M in net income in the medium term, that has the company trading at 2x net income today. These are relatively low valuation levels. Though of course it should be noted that the company's sales are currently declining, due, in part, to a slowdown in diesel production, where their products are over-represented, and China market weakness.

Price Target

Assuming Garrett delivers $600M of EBITDA at a 8x multiple. Then we can back out $2.8B of debt and liabilities to Honeywell, creating a $2B equity valuation. With 76M diluted shares outstanding, that's a $26/share valuation. That's 182% upside from the price at the time of writing. Plus that feels relatively conservative. This is because the company may deserve a multiple above 8x and over time the Honeywell liabilities are being paid down from cashflow. For example in 8 years time it's reasonable to expect the Honeywell liabilities for tax and asbestos to be paid off in full, in which case the same valuation is $42 (although we'd have to discount that valuation back to today's dollars, of course).

Risks

So what are the risks here? Well it seems at the current valuation a lot of bad news may be in the price. Nonetheless if the internal combustion engine loses share in vehicles more rapidly than Garrett can develop similar tech for electric vehicles then the stock will be challenged. This seems improbable given current vehicle sales and trends. Indeed, turbochargers appear a necessary component of vehicles adapting to global CO2 targets.

In addition, if the current softness in automotive sales proves deeper and lasts longer than expected, that could start to stress the company's balance sheet. Were EBITDA to dip below roughly $400M a year, then the company would be challenged in paying interest, Honeywell liabilities and meeting sustainable capex targets. Such an EBITDA drop appears unlikely from current levels. Per the 10K the low-point of adjusted EBITDA over the past 3 years is $544M in 2016.

Summary

Garrett Motion appears a well-positioned company in a relatively attractive market set to see growth over the next few years as more vehicles are equipped with turbochargers.

The current valuation of the company appears too pessimistic and may be due to technical factors associated with the spin, given the company appears to be trading closer to its peer spin-off company rather than other automotive names. Yes, the global automotive market is in decline right now, but you have to make pessimistic assumptions to justify Garrett Motion's current valuation. In the medium-term it appears that this company will be rewarded for its technology and see sales growth reflecting the ability of turbochargers to help reduce vehicle emissions.

Disclosure: I am/we are long GTX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.