The Future Of Garrett Motion Still Looks Bright Despite The Coronavirus Impact

Summary

• The coronavirus is expected to knock down $80-100 million in EBITDA and $45-60 million in free cash flow in 2020.
• However, the company’s long-term prospects still look compelling, and its valuation is low compared to BorgWarner pre-Delphi announcement.
• A favorable conclusion of the legal battle against Honeywell is a major potential tailwind.

Investment thesis

Europe-focused turbocharger maker Garrett Motion (NASDAQ:GTX) released amazing Q4 2019 results on February 27, with GAAP EPS of $1.79 beating analyst expectations by $1.04. Revenues came in at $830 million, beating estimates by over $28 million.

However, all eyes were on the 2020 guidance in light of the impact from the coronavirus on the business and the numbers are much worse than I forecast just a month ago in my previous SA article on Garrett.

Still, the coronavirus is a temporary event and doesn't erase any of the reasons why Garrett represents a compelling investment opportunity in the auto sector. The company reminds me very much of Boeing (BA) as it's a very high-margin debt-laden player in a growing duopolistic market. Like Boeing, it also has negative equity and is plagued by temporary issues.

Effects from the coronavirus on the 2020 guidance

(Source: Garrett)

As I mentioned in my previous article, Garrett has a total of 13 manufacturing facilities across the world, with two of them located in China. The one in Shanghai was opened in 1994, and the one in Wuhan was inaugurated in 2014 when Garrett still formed part of Honeywell (HON).

Garrett's Chinese arm accounts for around 16% of its sales, and it generated revenues of $530 million in 2019.

In my last article, I mentioned that Aptiv (APTV) CEO Kevin Clark said that motor vehicle production in China was expected to decline by 15% in Q1 2020 and by 3% for the full year. This seems to be a massive understatement as car sales in the country crashed by a record 80% during February.

(Source: Bloomberg, with data from China Passenger Car Association)

Looking at Garrett's operations in China, the plant in Wuhan is still closed, with production scheduled to gradually restart in the middle of March. The Shanghai plant is operating at around 50% capacity and is expected to return to full production by the end of March. However, I think these timelines are dependent on the development surrounding the spread of the coronavirus.

Looking at the guidance, Garrett forecasts that the coronavirus will erase $80-100 million in EBITDA and $45-60 million in free cash flow.

(Source: Garrett)

One point on which I was wrong in my last article was that Garrett would be able to mitigate a significant part of the damage thanks to its cost structure, as 80% of its costs are variable. The reason I was wrong is because there is no such thing as a furlough in China, and the company needs to keep paying its local employees full wages even when the factories are closed.

Why Garrett still presents a compelling investment opportunity

1) Increasing turbocharger penetration rate

The auto industry has been facing tough times even before the coronavirus outbreak, but the turbocharger market is actually growing, thanks to tougher global CO2 regulations.

(Source: Garrett)

This bodes very well for Garrett as its win rate is around 50%.

2) Leading margins

The company has amazing margins for an auto supplier, with the adjusted EBITDA margin standing at 17.9% in 2019.

(Source: Garrett)

Critics of the company will point out that the margins are deteriorating, but you have to take into account that they have improved by some 300bps since 2015 and that Garrett's own long-term goal is for a margin of 18% to 20%.

The main reason for the decreasing margins is the shift from diesel sales to gas sales on the world stage. Gas turbos have lower margins, and the reason for this is that the materials used in them are more expensive. However, the margin difference should be closed down over time.

3) Asbestos liability fears are overblown

Garrett was spun off from Honeywell and is responsible for making 90% of the latter's settlement payments, legal fees and some small environmental payments related to the Bendix asbestos liabilities. Bendix used encapsulated asbestos for its brake pads from the 1930s until 2003, and the whole liability was estimated at $1.09 billion based on the indemnification and reimbursement agreement between the two companies. Payments are capped at $175 million per year and can potentially run until 2048. Critics of Garrett are calculating those $175 million payments for the full 30 years, but they are missing three very important points.

First, the payments stop if the annual amounts fall below $25 million for three consecutive years.

Second, the payments are much lower than $175 million per year. The estimated payment for 2020 is $142 million, but Garrett will pay only around $108 million. The reason is the company overpaid $34 million in 2019 when the payments came in at $153 million.

Third, the two companies are not exactly on good terms and are already fighting in court about the asbestos liability. I think it's likely that they reach a settlement, which would decrease Garrett's obligations or at least allow the company to transfer them to another party just like its competitor BorgWarner (BWA) did in 2019.

4) Attractive valuation

I view the Bendix asbestos liabilities more like payables than debt as they don't have an interest rate. Still, if we treat them as debt for multiples calculation purposes, Garrett had net debt of $2.35 billion at the end of 2019, and the adjusted EV/EBITDA ratio without the coronavirus effect stands at 5.19x. It's very hard to find comparables to Garrett as its only real competitor is BorgWarner, which is a much more diversified group. Also, comparing Garrett to BorgWarner wouldn't be appropriate, considering the latter's valuation has taken a very significant hit following the announced acquisition of Delphi Technologies (DLPH).

Also, I think duopolies like Garrett or Boeing deserve a premium as they are leaders in markets with high barriers for entry. Sure, you have IHI (OTCPK:IHICF) and Cummins (CMI) as competitors to Garrett and BorgWarner, but those are minor players and are the equivalent to something like Embraer (ERJ) and Bombardier (OTCPK:BOMBF) in the aircraft industry.

Let's do a comparison anyway to illustrate the amount of undervaluation. Analysts like Oppenheimer are basing their BorgWarner valuations using 6.5x EV/FY20 EBITDA estimates. Ex-coronavirus, a 6.5x multiple would put Garrett's EV target at $3.58 billion, which translates into a share price of around $16.5.

This multiple seems reasonable, considering BorgWarner was valuing Delphi at 6.4 times EBITDA ex-synergies when the acquisition was announced. Before the announcement, BorgWarner itself was trading at 5.9 times EBITDA. This 5.9x multiple would put Garrett's share price target at around $12.1.

Conclusion

Garrett had a great quarter, but I have severely underestimated the impact of the coronavirus outbreak on the company's 2020 results. Still, the compelling long-term prospects for the company remain intact, and there are several tailwinds beyond 2020.

Excluding the coronavirus effect, I think that Garrett's shares should be worth at least $16 apiece. A very strong potential catalyst is a favorable conclusion of the legal battle against Honeywell as it could add several dollars to the company's share price.

Analyst’s 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.

I am not a financial adviser. All articles are my opinion - they are not suggestions to buy or sell any securities. Perform your own due diligence and consult a financial professional before trading.

Comments

[bazooooka]

I think this one will be a double digit stock again. Maybe 2022 at the latest but likely earlier.

[Gregg Miller]

The trouble with forecasting is that we cannot predict events like the corona virus. You did well with your prediction. Each black swan event seems to include something else mankind failed to see. I wonder however, if the corona virus is simply the catalyst that will cause the debt cycle to reset. This makes me think that we are in for more than just a few bad quarters and that car manufacturing will be included in the weakened economy with 2nd and 3rd order effects on car sales and supply chain disruption. Thanks for the article.

[TheSilentMan]

How do you see GTX at the end of the tunnel?

[Gregg Miller]

I think GTX will be a multibagger. However, it will be interesting to see.

[value_vulture]

insider buying isn't an absolute must, but it would be nice if at least one bought on the open market...even if it were only $20K.

[heth247]

How low can this go? This is trading at 2X normalized FCF (after HON payment). Unless you think ICE + Hybrid cars are dead within 5 years, market is pricing it for BK. But I just cannot see how it will BK given the liquidity they have, the low interest payment on their debt, and the flexibility of deferring the HON payment.

[Trembling With Greed]

Per the article, guidance is $45 to $60M of FCF. Using the high end of the range, $GTX is trading anywhere from 6x to 9x FCF. Not the 2x you mention. Market cap is ~$370M.

[heth247]

@Trembling With Greed My emphasis is "normalized", not 2020, which has been greatly impacted by Covid-19. But even with that, the 2020 guidance is $85M~$110M FCF, not the 45-60M numbers, which are the impact from the virus. It is possible that they underestimated the impact but when one look out for 2 years or more, it is still extremely undervalued.

[Trembling With Greed]

Ok I’ll “bite” to build your FCF forecast what are your assumptions for revenue and EBITDA

[Gold Panda]

Btw due to the impact of the coronavirus, I'm focusing at the moment on investing in companies that won't be affected severely and the decline in their share price is actually good due to share buybacks. Eg Aercap and Foot Locker

[WOW - Wolf Of Wallstreet]

Good idea! Though I preferred to put my money on the industry that got affected the most, airlines, cruises, oil, DIS and Auto etc. it’s bargain everywhere.

[value_vulture]

indexes up 4%, BWA up 6% and GTX down 7.7% today....what is going on???

[Trembling With Greed]

@value_vulture re-read my article lol

[jrnpanther]

There is nothing that's going to be temporary about the Covid-19 Virus. Thus you can revisit this name next year at the same time for an update on its status.

[Gold Panda]

@jrnpanther take a look back at history for ebola, swine flu, bird flu, sars, mad cow etc and get back to me

[MMEC]

None of which were anywhere near as contagious. That's the real difference here.

[Gold Panda]

@MMEC you do realize that Ebola spreads through direct contact, right?

btw the common flu kills 30-60k people in the US alone every single year
www.cdc.gov/...

the coronavirus has so far killed 12. don't see anyone flipping due to the flu

[User 11850101]

Good job. The asbestos obligation is unique and confuses people. Many incorrectly consider it debt. It is actually an acturial calculation based on current assessment of case loads and settlement prospects. The lawsuit has merit as judges abhor self-dealing which HON's attorney clearly and unmistakeably did when he acted as GTX's sole mgt. I expect a future arrangement adjustment but it is not part of my valuation. Interested parties should read the entire litigation filing, 10K w/ footnotes, listen to the conference call, review the Form 4's and review the presentation. Also compare GTX to BWA which is not an apples-to-apples comparison but will give good industry background. GTX sales are up in constant $$ despite auto industry decline. I do not calculate EBITDA as GTX does; they include items that don't belong there. Normalized sales of $3275 @ 17.2% EBITDA margin less 1% Maintainance Cap-ex less $160 HON obligations yields a normalized EBIT of $370. There is excellent EBITDA to FCF conversion. Fixed assets plus WC equals Invested Capital of $240 and thus a phenomenal 150% ROIC. EV of Market cap + $1414 debt yields a EY (EBIT/EV) of 19% in a world of 1% ten-year notes. The stock is clearly undervalued and should be a triple in 2-3 years for investors with a long-term time frame and the uncertainty of the industry and better understanding of the HON relationship is better understood. Stocks are partial ownership of a real business; not stuff that fluctuates, often wildly w/o logic, in price.

[User 11850101]

Forgot to mention the interest rate on the debt is quite low. Creditors deal with the downside of business and the fact they have determined a low interest rate for GTX is somewhat comforting. Read the 10K.

[Gold Panda]

@SpinoffDude actually I think it's quite high at 5.125% for the eight-year senior notes. I'm also following Schaeffler and they got 2.875% for their eight year senior notes in 2019

www.schaeffler.com/...

[Gold Panda]

@SpinoffDude as you can see, I've compared Garrett to BWA pre-Delphi announcement

[Double Vision]

Thank you for your analysis but I think there are some assumptions being made here.

They are on the hook for asbestos related medical liability through 2048 up to 175 million a year which amounts to almost $5 billion. Maybe the cost will be less, but maybe not, just depends on how many claims are made and the medical expenses involved. Its a giant drain on the company's bottom line where the actual amount owed is unquantifiable.

I am not a lawyer but I would not bank on a settlement reducing their huge liability. Honeywell will fight them tooth and nail in court and the outcome is by no means certain and could drag on for many years with potentially lots of litigation costs and in the end no favorable outcome.

As to the fallout from the Coronavirus I would say the impact on revenue and profit is going to be much worse than the company is anticipating and I would not trust their numbers at all. No one really knows how long it will take to fully contain the virus or when all the factories will be back to normal.

Finally, the world economy could be heading for a recession due to the virus, which will devastate the auto industry.

Too many unknowns at this juncture to make this company investable.

[value_vulture]

surprised no one is bringing up the debt covenants...will brush up against the leverage ratio covenant at the low end of ebitda guidance. hopeful that won't happen. agree that there's no way they can know with any accuracy whether guidance will be met for 2020...but they didn't hide that they don't have much visibility on how the covid 19 fallout will play out.

[heth247]

@value_vulture my understanding is that their debt covenants leverage ratio is based on "consolidated ebitda", which is adjusted ebitda minus the HON payment. The ratio needs to be <3.75 by Sept 2020.

Here is my math: with $440M ebidta and 108M HON payment, this means their consolidated ebidta will be $332M for 2020 at the low end of guidance. Currently their net debt is $1256M, assuming they pay off another $100M debt, then at 2020 end, their consolidated leverage ratio will be ($1256-100)/(440-108)=3.48. Although it is < 3.75, there is little room for error as you suggest.

However, here is the catch, facing the danger of violating the covenant, GTX can choose to defer the HON payment, which means essentially a boost to the "consolidated ebidta" by up to $108M. That will lower the ratio to ($1256-100)/440=2.62.

[User 11850101]

The actuary determined cost for 2020 asbestos is $152, not $175 and $34 of that has been prepaid in 2019. Few understand what is going on with the asbestos agreement. Read the court filing.

[heth247]

"A favorable conclusion of the legal battle against Honeywell is a major potential headwind."

Perhaps you meant to say "tailwind" here?

[Gold Panda]

@heth247 yes, my bad

[User 1569741]

Hey Panda. GTX is definitely one on my watchlist. Waiting for the "right price".

"A favorable conclusion of the legal battle against Honeywell is a major potential headwind."

"Still, the compelling long-term prospects for the company remain intact, and there are several headwinds beyond 2020."

I think you meant tailwinds.

[Gold Panda]

@Steffon_Mahalik yes, my bad

[d0d0ramefasolated0]

Headwind is probably appropriate. The SEC should get involved in how gtx was spun off not just a civil lawsuit. Gtx would be investable if hon settled.

[coaster kid 13]

I don't have much of a comment right now, but I don't have Premium, so I'm leaving this here so I can come back later and look at the comments if the story gets locked.

I listened to the teleconference and looked over the presentation materials and this company is very impressive, as is its future, long term outlook.

Long GTX

[Gold Panda]

@coaster kid 13 just write an article and you get three months of premium. that's what I do