Garrett Motion (GTX)

Disclaimer: I and my funds own common and preferred shares in GTX.

To launch the blog, I’d like to introduce you all to my current top idea – Garrett Motion (GTX), a global auto supplier. Along with the blog, I have launched a website – GTXisacheapstock.com – with a slide presentation to help walk you through why I think the opportunity is so interesting. For simplicity, the blog post is geared towards a “stock pitch” while the website digs a bit more into the fundamentals. I want this blog to be an informal space for ideas, so while I have strong and favorable views on GTX’s long-term business fundamentals and earnings, the tone of this blog post is much closer to a pitch at a dinner with friends rather than a formal presentation.

The basic pitch is that GTX is a high-quality, growing business that went through a non-fundamental bankruptcy to restructure a contingent liability, which has created an opportunity to purchase shares at a 5x 2021 FCF/sh., compared to primary competitor BWA at 13x, into rising earnings and strong technical catalysts, such as GTX’s preferred share listing and brokerage firms reinitiating coverage.

GTX is an excellent business that handled the 2020 recession admirably, with sufficient liquidity and positive EBITDA throughout the downturn. However, GTX had lingering lawsuits with its former parent, Honeywell (HON), related to pre-1985 asbestos liabilities that have nothing to do with GTX’s current business. These lawsuits and liabilities significantly limited GTX’s strategic flexibility and made the stock difficult for investors to understand. To resolve these disputes, GTX filed for bankruptcy in late September, effectively forcing HON to settle. After a long, hard-fought bankruptcy process, GTX and HON have fully resolved their dispute, GTX has completed an equity recapitalization to “cash out” HON, and GTX recently emerged as a cleaner, simplified story. However, due to technical selling pressure from the equity issuance and a lack of analyst coverage, the broader market has yet to realize both how much GTX has transformed and how cheap shares are at present. When GTX filed, it was a highly levered equity with a hard-to-understand liability in the midst of a worrying auto recession. It is emerging as reasonably levered equity into a V-shaped auto recovery in which GTX operations have already fully recovered, with GTX positing record Q1 sales and profits. Despite this marked improvement, I believe GTX is trading at 5x 2021 and 4x 2022 FCF/sh., which compares to its primary competitor BWA which trades 13x and 11x 2021 and 2022 EPS with similar leverage and a slower recovery. As GTX relists, updates numbers, and investors rediscover the story, I believe GTX can reweight towards auto peers, driving >100% upside by YE2021.

Before I dig into numbers, I want to talk about GTX’s business, which I believe is one of the most predictable, deep-moat businesses I have ever analyzed. GTX makes turbochargers (TBs), which are a high-tech, mission-critical component of a car’s engine. The TB market is a duopoly between BWA and GTX. While there are also smaller Asian competitors, GTX and BWA enjoy significant engineering and R&D advantages over peers that create a moat and allow GTX to earn among the highest margins and lowest annual price downs of any publicly traded auto supplier. TBs are basically mini-jet engines that take the exhaust fumes and push that air back into the engine, increasing both power and fuel efficiency. TBs are extremely sophisticated devices – the TB’s turbine spins at up to 150,000 RPMs yet the distance between the spinning turbine and the wall of the TB can be as small as a seventh the width of a human hair. GTX’s years of R&D in the space allow them to deliver products that competitors just cannot match. As a testament to this, Bosch and Mahle, two of the largest auto suppliers in the world, launched a TB joint-venture in the late 2000s with the explicit blessing and support of GTX’s customers, the auto OEMs. A scaled competitor teaming up with your customers to break your duopoly is a business nightmare, yet after a decade, Bosch-Mahle gave up and exited the space. They simply could not match GTX’s products. The duopoly market and barriers to entry give GTX clear visibility into their market share and margins. Further, the TB is a critical component of an engine, which is the critical component of a car. Engines are designed years in advance and, once a product is designed into an engine, it is virtually impossible to design out. Once Volkswagen designs a Garrett TB into a Jetta engine, GTX has an almost guaranteed 100% renewal product with a multi-year life cycle. GTX’s backlog is exceptionally sticky and 90% booked 3+ years out, thus GTX has years of visibility. Further, GTX has broad share of the TB market with no significant geographic, customer, or model concentration. With no significant competitive threats, minimal risk of contract cancellation, and a broad customer mix, the only key variable with any difficulty to model years in advance is global auto production, which I’ll handle in next paragraph. Beyond global auto sales, GTX is one of the most predictable businesses I have ever studied.

Given GTX’s predictability, the key variable in GTX’s earnings are global auto sales. In general, I believe the auto market is cyclical, but not wildly so, with roughly GDP or ~2% type growth at trend. In developed markets, auto is basically a replacement market, whereas emerging markets have lower levels of cars per capita and are in growth mode. In 2018, the global auto market entered a recession due to the tariff wars and the slowdown in China, and in 2020, the covid shutdowns significantly accelerated this. From 2017 to 2020, global autos fell over 20%, the largest peak to trough recession of the post-WWII era. We are now bouncing off this and, if GDP continues to rebound, I believe global autos are entering a multi-year upcycle. IHS estimates low teens growth in 2021 which slows to mid-single digits in 2022. They currently anticipate it will take until after 2025 to reach the previous peak. Personally, I think these estimates are likely to prove conservative – IHS has consistently underestimated the rebound since reaching a trough in 2020 – but I consider a faster than expected auto recovery “icing on the cake” rather than core to the GTX thesis.

One final note on TB’s before delving into numbers. TB penetration of internal combustion engines (ICE) has been increasing over the last few years and there is high visibility into further growth. Globally, rising CO2 standards are forcing auto OEMs to improve efficiency. While battery electric vehicles (BEV) are the most talked about solution, the largest beneficiary in the next few years will be hybrid vehicles, of which TBs are a critical component. Historically, people associate TBs with speed – more Fast and Furious than Captain Planet. However, TBs add power to an engine, which can also be harnessed to decrease engine size and increase gas mileage. As carbon emission standards increase, TBs logically have been gaining share. IHS expects TB penetration of total cars produced to increase from approximately 47% in 2017 to approximately 53% by 2023. GTX estimates this shift will provide at least a 400-600bps per year boost to GTX’s sales growth and GTX has been outperforming their guidance. Ultimately, I believe BEVs will grow to one day overtake ICE and dominate the auto market. However, as I address below, I believe TB’s secular decline is a post-2030 event.

Regarding GTX numbers, the company’s current forecast implies $520MM and $267MM in 2021 EBITDA and FCF, which increases to $596MM and $310MM in 2022. However, the company has been substantially outperforming this, with Q1 EBITDA reaching $176MM vs. guidance of $129MM and sales growth ~1500bps over global auto sales. I believe GTX can earn closer to $658MM and $774MM in 2021 and 2022 EBITDA. The company has ~$110MM in annual capex needs, PF $48MM in interest, and a ~24% tax rate, yielding FCF of $383MM and $461MM, respectively. Assuming 313MM shares outstanding, I believe GTX can earn $1.22 in 2021 FCF/sh. and $1.47 next.

Regarding sharecount, it is a little tricky but not overly so. While I have earlier referred to GTX’s equity raise to repay HON, technically the raise is in the form of convertible Preferred A shares struck at $5.25 per share, and HON has a remaining Preferred B share with a present value of $584MM. While this may seem complicated, it is actually a fairly simple structure. GTX issued $1.3B of the Preferred A shares, which will convert into 248MM shares, and GTX has 65MM current shares outstanding. The structure is designed to collapse when GTX reaches $600MM in EBITDA, with HON fully repaid and 313MM shares outstanding. Originally this was forecast for 2023. However, GTX is already at a greater than $600MM EBITDA run rate and GTX exited bankruptcy with significantly more cash than originally envisioned. I believe HON will be repaid by YE2021. The Pref A will likely continue to trade until 2023, and it should be listed on major exchanges by the end of July. Investors are free to choose between an investment in common or the preferreds, but I believe it makes most sense to think of GTX on an as converted, fully diluted basis with 313MM shares outstanding. GTX management seems to agree and their recent Q1 earning presentation provides similar commentary and math: https://s2.q4cdn.com/726657224/files/doc_financials/2021/04-29-21-Q1-2021-Presentation-Final-1122.pdf

Regarding risks beyond global auto sales, where I strongly believe the 2020 recession marked a bottom and we are entering a multiyear recovery, the key risk for GTX is the inevitable growth of BEVs. While I have no view on high flying BEV stocks, I fully believe auto’s future is battery powered and BEVs will have a substantial share of the car market. However, we are a long way away from it. BEV penetration is currently ~2% of global auto sales and, unlike say software where you can push a button and instantly distribute a game changing product globally, the BEV transition requires enormous changes in physical infrastructure. For instance, for BEV penetration to grow significantly, the supply of certain materials must drastically increase which requires building new mines in frontier locations. Approximately 70% of the world’s cobalt, a key component in the batteries, is sourced from the Democratic Republic of Congo, a country that has in recent memory fought multiple civil wars and large parts of the country are still under guerilla rule.  Further, 15-30% of Congolese cobalt is mined in “artisanal and small scale” mining, which is a polite way of saying unsafe child labor that, in addition to being unethical, does not rapidly scale. We need a 4x increase in cobalt supply to reach even 30% BEV penetration of new car sales. So, while I fully believe BEV is the future of auto, I believe the decline of TBs is a post-2030 event. The market seems to at least partially understands this. For instance, BWA has >90% exposure to legacy ICE yet shares trade at 13x and 11x 2021 and 2022 EPS. While the market is logically applying a discount to ICE exposed auto suppliers, I do not think GTX is likely to trade at such a large discount to similarly ICE-exposed peers once its shares are listed and its fundamental story is better understood.

Given the inevitable secular decline, however, capital allocation is a critical component in GTX’s story. I believe we are in good hands here. As a result of the recapitalization, ~80% of GTX’s shares are owned by private equity and hedge funds, with Centerbridge and Oaktree (C&O) the majority owners. C&O own substantially more preferred shares than equity, something to consider, but the majority of C&Os profits are tied to a higher GTX share price and I believe their interests are aligned with minority shareholders. GTX has not announced capital plans yet, but I believe C&O will soon layout a sensible capital plan, likely emphasizing capital returns and M&A. I believe the legacy ICE space is ripe for consolidation and GTX is likely to play a role in that, either as an acquirer or target.

Finally, while I like many things in the investment, the reason it is my current favorite is I believe GTX has low risk. GTX just admirably handled a horrific auto recession, filed to restructure despite no pressing liquidity or fundamental needs, now has an even safer balance sheet entering an upcycle, and we are getting long at a >50% discount to its closest competitor. Combined with a catalyst rich path forward – investors who would not own a bankrupt equity can reengage; the company will list both the Pref A and equity on a major exchange; the sell side should resume coverage (was covered by 5+ shops previously); C&O announcing capital return plans; GTX increasing guidance, etc. – I believe GTX is an investment where there are many ways to win and few to lose. My favorite type.

Well, there’s GTX. I hope you enjoyed my initial blog post and visit my website GTXisacheapstock.com to further explore the stock. If you liked it, please sign up for the mailing list or follow me on Twitter https://twitter.com/Mc_Partnerships. Thanks!