Garrett Motion: Cheap Despite Long-Term Headwinds

Sep. 07, 2022 2:04 PM ETGarrett Motion Inc. (GTX)7 Comments
Alexander Vester profile picture
Alexander Vester
23 Followers

Summary

  • Garrett Motion is the market leader with ~32% volume share and ~36% value share in the $10 billion global turbocharger industry.
  • The company looks cheap at ~6 to ~7 times its expected earnings in 2022.
  • Garrett continues to demonstrate strong earnings power despite a current vehicle production slump.
  • The growing number of battery electric vehicles in the global vehicle production mix threatens Garrett’s long-term profitability.

Car turbocharger on black background. Auto part turbo engine technology concept.

Bet_Noire/iStock via Getty Images

Introduction

Garrett Motion Inc. (NASDAQ:GTX) is a leading supplier of turbochargers for light and commercial vehicle original equipment manufacturers ("OEMs") as well as the global aftermarket. In short, a turbocharger is a power-boosting automotive part that improves engine performance by using the exhaust gases from the engine to push more air back into it. That is a very relevant technology given today's environment that has made OEMs subject to extremely stringent vehicle emissions and fuel economy requirements. Generally, the best fuel economy tends to be found in a smaller engine because it has less fuel to burn to produce power. However, a vehicle equipped with a small engine typically lacks the same high speed and acceleration compared to a larger engine. So, if a small engine wants to reach higher speeds, it must work extra hard, resulting in increased fuel consumption and reduced fuel economy. But by adding a turbocharger, the OEMs can use a smaller engine with better fuel economy and exhaust emissions but with the power of a bigger engine.

Even though OEMs use turbochargers as key enablers for meeting the emissions and fuel economy standards, there is a catch; a turbocharger only works in vehicles equipped with an internal combustion engine. As seen over the last several years, policymakers have made huge efforts to push the adoption of electric vehicles - especially battery electric vehicles - thereby threatening the long-term demand for turbochargers. At the current price of between ~6 to ~7 times expected earnings - based on the fiscal year 2022 guidance from Garrett's management - it appears that the market prices GTX as if the company is soon to be ancient history. That may be too pessimistic!

The turbocharger industry is likely to grow in the near term

In 2021, ~43 million turbochargers were sold globally, totaling a market value of ~$10 billion. These include turbochargers for new light and commercial vehicles as well as for replacement use in the aftermarket. However, turbochargers for new light and commercial vehicles represented the vast majority of the total volume. In 2021, this segment was dominated by light vehicles ("LVs"), accounting for 84% of the total volume, while the remaining 16% were commercial vehicles. According to leading industry information providers, the global turbocharger industry is expected to increase to ~49 million units in 2026. While forecasts tell you nothing about the future, the probability that the global turbocharger volume is higher than 43 million units in 2026 seems higher than the probability of fewer than 43 million units in 2026. The market penetration of light vehicles with a turbocharger has increased from ~47% in 2017 to ~51% in 2020. Despite an increased turbocharger penetration, the volume has declined by ~6 million units (or 12.2%) from ~49 million units in 2017 to ~43 million units in 2021. The graphic below illustrates the main reason for this decline:

Total vehicle production

Based on data taken from OICA

The graphic shows a decline in total vehicle production from ~97.3 million units in 2017 to ~80.1 million in 2021. That equals a ~17.2 million decline in total units or ~17.7%. The decline is mainly caused by the drop in the number of light vehicles produced, which decreased from ~95.1 million units in 2017 to ~77.1 million units in 2021 due to COVID-19 and the current chip shortages. This production decline has naturally reduced the demand for auto parts, including turbochargers. All other things being equal, once the chip shortage subsides, it would not be unlikely that an increase in the production of light vehicles could push vehicle production toward those achieved in 2019. Particularly considering the pent-up demand that has been built in recent years. In such a scenario, the production of light vehicles would increase by, say, ~10 million units. Assuming a 50% penetration rate, the demand for turbochargers would increase by 5 million units, totaling 48 million units.

Garrett is positioned to capture unit volume

Garrett's competitive advantages combined with the nature of the turbocharger industry, position the company well to capture more business - especially in a scenario with growing turbocharger volume. In general, the automotive supplier industry is characterized by a "three-tier system." Tier 3 suppliers sell their products to Tier 2 suppliers which in turn sell their products to Tier 1 suppliers like Garrett. Tier 1 suppliers then sell their products to the OEMs. Even though being a Tier 1 supplier isn't a competitive advantage by itself, the turbocharger industry has some advantageous characteristics compared to many other Tier 1 industries. Because the turbocharger is part of the engine, Garrett is able to engage with the OEMs in the early stages of a new vehicle model development which typically takes three to five years. Therefore, Garrett serves more like a strategic partner, co-developing together with the OEMs, rather than just being a "build-to-print supplier." Combining that with the fact that there is only one supplier of turbochargers per engine creates high switching costs because it is quite troublesome for OEMs to change their supplier in the middle of a model cycle.

In 2021, Garrett sold ~13.7 million turbochargers. This indicates a share of unit sales of ~32% based on the total market volume of 43 million units. Additionally, Garrett's revenue of $3.633 billion, indicates a market share by value of ~36%. Garrett is the market leader in both value and volume which gives the company significant scale advantages compared to its competitors. That is further strengthened by high turnover and low-cost manufacturing, providing Garrett with the most advantageous conditions for additional growth by being in the most favorable position when bidding for new contracts. New contract wins, however, are not the only way for Garrett to capture unit volume. Its current contracts expose Garrett to the volume fluctuations of specific vehicle models. If Ford's F-150 is equipped with a GTX turbocharger, then Garrett's contract revenue relies on how many F-150s, Ford produces. In other words; when the current chip shortage improves, Garrett should also experience additional growth from its current contracts.

The current price looks undervalued

In the fiscal year 2022, Garrett's management expects net sales of $3.5 billion to $3.7 billion, adjusted EBITDA of $530 million to $590 million, and net income of $290 million to $335 million. Including an almost inevitable conversion of ~248 million Series A Preferred Stock into common shares, the number of diluted shares outstanding will be ~313 million. The preferreds automatically convert on or after April 30, 2023, if:

  1. Series B preferreds are less than or equal to $125 million.
  2. The stock price exceeds ~$7.88.
  3. The EBITDA for the last twelve months is greater than or equal to $600 million for two consecutive quarters.

Using the ~313 million share count implies an EPS between $0.93 and $1.07. Compared to the current share price of ~$6.60, this equals a P/E of ~6 to ~7. Garrett's guidance for the fiscal year 2022 rests on an essential assumption; A global light vehicle production of ~78 million. This is only slightly higher than last year's production of 77.1 million LVs but significantly lower than the 8-year average of ~87 million LVs. A return to a higher production environment would make Garrett even cheaper. Dividing Garrett's $3.633 billion FY21 revenue by its ~13.7 million unit volume suggests a $265 unit price. While this unit price calculation may be too simplistic, dividing the total $10 billion value of the turbocharger industry by its 43 million unit volume suggests a ~$232 unit price which may imply that the average unit price is around that ballpark.

In a "return to the 8-year average production" scenario of ~87 million LVs, the LV production would need to increase by 9 million vehicles from the 78 million assumption that Garrett's management provided in its 2022 guidance. Assuming a continued turbocharger penetration rate of ~50% would require 4.5 million additional turbochargers. Considering Garrett's market share of unit sales of ~32%, the company would capture 1.44 million of these additional units. That would yield ~$334 million in additional revenue when using an average unit price of $232. The graphic below illustrates what Garrett's earnings could look like in such a scenario:

Garrett Motion earnings

Author's own estimates

Adding the $334 million in additional revenue to the $3.6 billion - which is the midpoint of Garrett's revenue guidance for 2022 - increases the revenue to $3.934 billion. This would yield an EBITDA of $669 million. The 17% EBITDA margin should be achievable - at least compared to its past EBITDA margins that ranged between 18%-20% pre-COVID. The company should spend ~$100 million on CapEx - which is consistent with its guidance - and ~$50 million in interest on its ~$1.14 billion debt. Therefore, in a more "normalized" environment, Garrett could earn closer to $400 million which implies a P/E of ~5.

Risks from EVs

One of the main industry-specific risks for Garrett is the risk from electric vehicles. Even if the total vehicle production increases in the coming years, the big unknown is what the production mix will look like. Although the dominance of electric vehicles on global vehicle production seems inevitable, a fast shift could quickly erode Garrett's business. Typically, electric vehicles consist of both battery electric vehicles ("BEVs") as well as various types of hybrids. The penetration of BEVs poses the biggest risk because of the complete lack of an internal combustion engine. Therefore, BEVs do not demand any of Garrett's products.

On the other hand, the turbocharger industry does not see the increasing production of hybrids as a risk. Instead, it is expecting increasing turbo penetration rates in this segment. Even though the battery in hybrids serves as a booster, making the traditional turbocharger redundant, they may still use electric turbochargers. The electric turbocharger serves the same purpose in hybrids as a traditional turbocharger does in vehicles with an internal combustion engine; to enhance performance and fuel economy as well as reduce exhaust emissions.

However, policymakers seem particularly focused on promoting the deployment of BEVs - especially in Europe and Asia which are Garrett's biggest markets, consisting of 87% of its $3.166 billion in OEM sales. In Europe, battery electric vehicles gained a significant market share, accounting for ~9% in 2021. By comparison, BEVs had market shares of ~5% and ~2% in 2020 and 2019 respectively. Some would argue that this trend has been achieved by picking the low-hanging fruit. But political initiatives like banning the sale of gasoline and diesel vehicles and phasing out plug-in hybrid vehicles could further accelerate the transition to BEVs.

Conclusion

Even though the total vehicle production is down ~12.7% since 2019, Garrett has demonstrated strong earnings power in this challenging market. The company expects to generate $290 million to $335 million in net income which implies a P/E of ~6 to ~7 based on the current market price. Garrett's shares are even cheaper if the vehicle production bounces back towards pre-pandemic levels.

However, the risks from battery electric vehicles are very real, but the question is how long it will take to meaningfully impact Garrett's business. Based on Garrett's current valuation, the market seems to price in a speedy dominance of BEVs in the vehicle production mix. Despite the BEVs' high compounded annual growth rates as a percentage of the global vehicle production mix - especially in Garrett's core markets - most BEVs still offer shorter driving distances, longer charging times, and higher list prices that could slow down the transition pace.

Finally, given Garrett's current cheapness, the main question should be, what the BEV penetration rate looks like in 2024 or 2025, rather than 2030. A 40% BEV penetration in 2030 is not as critical to the thesis as a 40% penetration rate in 2025 because Garrett should likely generate - and return - a lot of cash until then.

This article was written by

Alexander Vester profile picture
23 Followers
I'm an individual investor, trying to find businesses selling below their intrinsic value. My investment framework is heavily influenced by Warren Buffett, and Graham & Dodd.

Disclosure: I/we have a beneficial long position in the shares of GTX either through stock ownership, options, or other derivatives. 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.

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