- 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.
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
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.
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.
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.
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.
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.
This article was written by
Gold Panda has been working as an M&A analyst for over 11 years. He's been investing since 2007. Preferring value to growth, he tends to take a relatively conservative approach in his investing. His focus is on small and micro-cap stocks, which he believes is the area which offers the greatest opportunity to exploit market mis-pricings.Gold Panda is part of the team that runs the investing group Microcap Review. He provides a real-time portfolio to the group. Microcap Review focuses on three areas of opportunity in the micro-cap space: arbitrage and special situations, net-nets and undervalued stocks. Learn more.
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