GTX - Garrett Motion: Electric Vehicles Are Just The Next Chapter

2023-10-11 21:16:17 ET

Summary

• Garrett Motion is a leading automotive technology company specializing in turbocharging and electric boosting solutions.
• Although they play an important role in internal combustion vehicles, they are actively involved in developing solutions for electrified powertrains and vehicle electrification.
• Despite the industry's sensitivity to economic cycles, the company is currently trading at a very low multiple of 5x EBITDA, presenting a compelling deep-value opportunity.

Investment Thesis

Since its IPO, Garrett Motion ( GTX ) has outperformed the S&P 500 significantly. This achievement is particularly noteworthy given the somewhat cyclical nature of the sector in which it operates and the generally negative perception of automotive component manufacturers. However, despite the clear shift towards electric vehicles, the company offers products that will remain relevant in this evolving landscape.

In this article, I aim to explore the role Garrett Motion will play in an electric future and provide a valuation to justify why I believe it deserves a ' buy ' rating.

Business Overview

Garrett Motion is an automotive technology company that excels in delivering turbocharging, electric boosting, and connected vehicle solutions. Renowned for their proficiency in automotive propulsion systems, they hold a prominent position within the automotive industry. In fact, they stand as the leading player in turbo-related technology, leveraging their dominant market position to introduce zero-emission products that are poised to become highly significant in the near future, as we will explore further below.

Garrett Motion has long-standing relationships with some of the sector's leading OEMs, including Ford, General Motors, Honda, and Caterpillar. This attests to the reputation it has built over its history. Furthermore, the company estimates that more than 80% of its projected 2026 revenues have already been secured with OEM suppliers, ensuring a high degree of revenue visibility.

The Risk of Electric Vehicles

When a company is related to internal combustion vehicles, it's impossible not to consider the risks associated with the shift to electric vehicles. These concerns are evident in the market's valuation of companies in this sector. However, there are two important aspects to note in this context.

Firstly, despite the expected decline in the percentage of total vehicle sales represented by internal combustion cars, studies predict that between 40% and 50% of global vehicle sales will still consist of these vehicles by 2030. This suggests that there's a significant runway ahead for companies tied to this sector.

More importantly, the company, known for its expertise in turbocharging and traditional internal combustion engine technologies, has been actively involved in the development of solutions for electrified powertrains. Specifically, Garrett Motion has been working on electric boosting systems designed to enhance the performance and efficiency of electric powertrains. These systems encompass electric compressors and other components aimed at improving power delivery and responsiveness in electric and hybrid vehicles.

Furthermore, Garrett Motion is engaged in various aspects of vehicle electrification, including the development of technologies for energy recovery systems, thermal management, and connected vehicle solutions. These innovations are designed to enhance the overall efficiency and performance of electric vehicles. This not only extends the company's lifespan but also positions it to be a part of the EV transition story, as revenue sources will persist, albeit in the form of different components.

Key Ratios

Since 2016, revenues grew 3%, while EBITDA grew only 1.7% in that same period. This is a very unexciting growth, although I also think that the thesis is not focused on this, but on the valuation that we will see later.

Significantly, in Q2 2023 , the company achieved an 18% YoY revenue growth and subsequently raised its guidance for FY2023, targeting growth between 7% and 11%. This growth is noteworthy, especially considering the challenging macroeconomic conditions. It highlights the resilience of the company's revenues, which can be attributed to the predictability provided by its secured contracts.

The average EBITDA margin has been between 16 and 17%, while the Free Cash Flow margin has been around 5%. I will take this into account for the valuation. During the most recent quarter , the adjusted EBITDA margin was 16.8%, compared to 16.1% a year ago and the most recent guidance expects margins around 16.5% as well.

The company has been quite conservative with debt, which is positive for a business that is in transition. If we exclude the peak that occurred during 2020, caused by the drop in EBITDA caused by the COVID-19 pandemic, the Net Debt/EBITDA ratio would have remained around 2x, the same ratio that the board of directors aims for this FY2023.

In Q2 2023, the company held $1,048 million in cash and cash equivalents, marking a significant improvement compared to the $766 million in cash in Q1 2023. This results in a Net Debt/LTM EBITDA ratio of 2.3x, which is considered acceptable.

Valuation

The strong point of this thesis lies in the current valuation of Garrett Motion. When we quickly compare it to other companies in the sector, a noticeable difference in EV/EBITDA valuation becomes apparent. Typically, companies of this kind trade at a ratio of 8 to 10x, which, although lower than the market average, is, in my opinion, well justified. Currently, Garrett Motion, a leader in turbocharging technology, is trading at less than 6 times EBITDA.

To gain a better understanding of the potential return from current prices, I will perform a valuation using multiples. I estimate that revenues can grow at an annual rate of 5%, which is slightly lower than the recent guidance provided by the board, where they mentioned that revenues would grow between 7% and 11%. Assuming we maintain historical EBITDA margins of 16% and apply an exit multiple of 6x EBITDA, we could anticipate a return of 17% per year. This return is excellent, especially considering the conservative estimates we have used compared to the company's guidance.

Without delving into extensive details and as a double check, when performing a Reverse DCF, we find that to justify a 15% annual return over the next 10 years, the Free Cash Flow would need to remain at its current level, indicating that the current valuation already accounts for a scenario with no growth.

While Seeking Alpha indicates that there are 75 million shares outstanding, it's important to note that the company is presently in the midst of a capital structure transformation , a move endorsed by various investment funds, including Howard Marks' Oaktree. As part of this process, the company is converting all of its class A and class B shares into pure common stock. The final outcome of this ongoing process is expected to result in 264 million common shares.

Final Thoughts

It seems to me that the terminal value of the company is still quite distant. This is not only because the transition to electric vehicles (EVs) will be relatively slow, but also because its current products will continue to be used in this scenario. Furthermore, the valuation appears reasonable to me, even though the company is one of the most significant players in the vehicle components sector.

Now, there are certain risks we must consider , both in the short and long term. Firstly, in the short term, it is impossible not to mention the strikes in the automotive sector, where workers are demanding a considerable increase in salaries for all companies in the sector. This could directly affect Garrett Motion's customers and potentially lead to a halt in orders in the short term, as they will need to adjust their costs to compensate for this 40% wage increase demanded by the striking workers. Looking at the long term, it is essential to remember that the automotive technology sector is highly competitive, with numerous companies competing for market share. Additionally, it is a market sensitive to economic fluctuations. Changes in global economic conditions, consumer purchasing power, and demand for automotive products can significantly impact Garrett Motion's sales and revenue.

Nevertheless, I believe that the risk/reward ratio fully justifies these risks, and that's why I am giving the company a ' buy ' rating.

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