Garrett Motion (GTX): Messy Financials, A Peculiar Indemnification Liability, & Typical Spin-off Dynamics Have Obfuscated Garrett Motion’s Attractive Underlying Economics

by Geoff Gannon


Write-Up By JONATHAN DANIELSON (NOT Geoff Gannon)


Overview - Recent Events and Thesis

Garrett Motion (GTX) was spun off of Honeywell in September of last year as part of Honeywell’s ongoing series of divestitures (REZI, GTX, & ASIX). GTX primarily is in the business of designing and manufacturing turbochargers for automotive OEMs. They also design and make E-boosters for hybrid vehicles. As part of the spin-off agreement, Honeywell dumped their Asbestos Indemnification Liabilities on the newly formed entity (approximately $1.4 billion in total liabilities) in addition to loading the newly formed company up with debt that was 3x EBITDA. These dynamics have most likely led the market to view Garrett as a “garbage barge” spin, designed to solely benefit the parent by improving its capital structure and allowing the parent to quietly remove toxic assets off their balance sheet.

Investors in the special situation arena must pay close attention to this possibility, as buying into a garbage barge spin can have devastating results on your portfolio. Nevertheless, assets that the market apparently view as being “garbage”, a closer examination reveals a company that’s an entrenched market leader, possesses a formidably wide moat, earns adequate returns on capital employed, has reasonable growth prospects over the coming years, and is trading at a ludicrous 25% Free Cash Flow yield.  

In addition, the Company is inherently highly cash flow generative, with a proven management team in place, and a business model that lends to a good degree of top-line visibility as car/engine designs are started years in advance.

 

The Company - A Brief History

Founded in the 1930s by Clifford Garrett, GTX was originally an aviation company, supplying the industry with turboprop engines and turbochargers. It wasn’t until the post-war 50s that the Company first started supplying the auto industry with turbos. In 1954 Caterpillar selected Garrett’s T15 turbo for its D9 mining vehicle. Then in the 60s came the Oldsmobile Jetfire Turbo Rocket and the T04 turbo for Deere’s farm tractor. Garrett was gobbled up by Honeywell in the late 1990s and went on to play a significant role in the company’s Transportation Systems segment.

Now, if some of you reading this didn’t grow up with a ‘grease-monkey’ older brother, then you’ll be forgiven for being a bit fuzzy on the specifics the role turbochargers play in enhancing the performance of internal combustion engines. Essentially, in order to increase the power of an engine, you have to pump more air into it (not just more gas). There are really only two ways to do this: by increasing displacement of the engine (which has obvious limitations) or by making the engine more efficient. Here’s a fun video to give you an overview: Turbocharger Basics.

It’s important to note the differences between turbochargers and superchargers as they are very much competing products. The differences between the two products has led to a secular tailwind for the turbocharger market. The way turbochargers increase an engine’s efficiency is by using the engine’s unburned fuel (the exhaust) to power the turbine, which then uses a compressor to funnel more air through to the engine’s cylinder. Which, in turn, also lowers the engine’s emissions. This article on the subject by Explainthatstuff sums up the key differences between turbos and superchargers nicely: “Where a turbocharger is powered by wasted energy in the exhaust” (increasing the MPG) “a supercharger actually steals energy from the car's own power source (the crankshaft), which is generally unhelpful”.

To demonstrate the difference a turbo makes compared to a naturally aspirated engine, as detailed in the Company’s investor day, you can take a 4 cylinder 2.3L engine and add a turbocharger to it and get the the same output as a V6 3.0L engine. These characteristics of turbos have to led to mass adoption of the product by OEMs over the previous 5 years and will continue to do so moving forward, which will be discussed later.

 

 

Business Model

As noted above, Garrett Motion derives revenue from designing, engineering, and manufacturing turbochargers and electric-boosting technology and selling them to automotive OEMs. Additionally, they distribute their products to Aftermarket consumers via 190 third-party distributors. Over 100 million vehicles are on the road today with Garrett turbos.

GTX is a global enterprise which has operations in North America (15%), Europe (56%), and Asia (29%). They also sell E-boosters for hybrid cars and hydrogen fuel cell powertrains. Their customers consist of the major OEM players, including: Ford, Volkswagen, Hyundai, Mercedes Benz, etc. in addition to off-highway manufacturers like Deere and Caterpillar. They have 13 manufacturing plants, 13 engineering sites, and 5 R&D sites.

The nature of this business ultimately leads to a handful of market leaders who have the infrastructure, experience, and relationships to compete - and the rest who don’t. Garrett is the market leader with about 30% of market share followed by BorgWarner and IHI, neither of which are exactly comparable to GTX since Garrett is a pure-play. These industry dynamics lead to Garrett having compelling underlying economics.

There’s a few ways to slice up the company when analyzing the business. Firstly, Garrett has two main endmarkets: selling to auto OEMs (86% of rev) and distributing its products via the Aftermarket (12% of rev). To further break the Company’s operations up, we can look at the various types of automobiles they service within their OEM segment. These include: Light Vehicles (sedans, SUVs, Pickup Trucks) and Commercial Vehicles (construction, agriculture, off-highway trucks, ect.). Light Vehicles accounted for 66% of revenue while Commercial Vehicles contributed the remaining 20%. We can further still break down Light Vehicle revenue by Gas (22%) and Diesel (48%), as the Chart below demonstrates.

It’s important to note that the Company has transitioned from mainly selling Diesel products to Diesel and Gas. While GTX is expecting most future growth in top-line to come from the Gas segment, it’s unreasonable to assume that the Diesel segment is going away anytime soon. The sector of the Diesel market that has been hit the hardest has been smaller engine cars. Larger cars (SUVs, Pick-Ups, etc.) and Sedans have been relatively stable - and these two segments make up 94% of Garrett’s Diesel sales. There’s a lot of benefits that Diesel engines offer to larger cars. They improve fuel economy by up to 20%, have 10%-15% less CO2 emissions than their Gasoline counterparts, and offer drivers more torque and towing capacity. Diesel might be slowing down, but I believe the notion that it’s dying is misconstrued.

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