Introduction
According to Joel Greenblatt's "Magic Formula" criteria, Garrett Motion (GTX, Financial) appears as a potential opportunity to unlock value. Investors can screen for stocks that meet these criteria using GuruFocus's Magic Formula screener, a Premium feature.
Garret Motion is a leader in car turbocharger products, which are critical to reducing emissions for any type of engine. A turbocharger uses the engine exhaust gas to drive a turbine wheel up to high-rate angular speeds. The turbine wheel then drives the compressor wheel, which in turn provides compressed air to the engine. The compressed air makes the fuel burn more efficiently. The company also specializes in E-Turbo solutions, which are used in hybrid and electric vehicles.
Garrett motion was formed as a spin-off of Honeywell's (HON) turbocharger business. The spin-off was completed on Oct. 1, 2018.
A duopoly
The turbocharger industry has several players competing for market share, but the two major global players are Garrett Motion and Borgwarner (BWA, Financial).
Garrett has solid customer relationships with all the major global auto producers and has already sold a big percentage of its production for the next three to four years, though they have announced that this will be delayed by Covid-19.
Capital Expenditures are quite low for an auto supplier. For 2019, they were $102 million, which is only about 3% of sales. So here we have a company that is a market leader with an 80% variable cost structure, which will allow it to easily absorb the economic contraction, and very little need for capital expenditures.
For 2019, the company had revenues of $3.248 billion and adjusted earnings per share of $3.86, while free cash flow was $140 million. Garrett Motion does not have significant liabilities to repay in the short-term, at least until 2023:
The asbestos litigation
If this is the case, then what is keeping Garrett´s price so depressed? Let´s go back to the time of the Honeywell spin-off. Garrett Motion directors were practically forced to sign an Indemnification Agreement which “requires Garrett to compensate Honeywell for payments relating to asbestos exposure arising from Honeywell’s legacy Bendix automotive brake business, including payments relating to punitive damages and defense costs” (from GTX IR documentation). The Indemnification and Reimbursement Agreement provides that:
"... we are required to make payments to Honeywell in amounts equal to 90% of Honeywell’s asbestos-related liability payments and accounts payable, primarily related to the Bendix business in the United States [...] The Indemnification and Reimbursement Agreement provides that the agreement will terminate upon the earlier of (x) December 31, 2048 or (y) December 31st of the third consecutive year during which certain amounts owed to Honeywell during each such year were less than $25 million as converted into Euros in accordance with the terms of the agreement” [...] we are responsible for paying to Honeywell such amounts, up to a cap equivalent of $175 million (exclusive of any late payment fees) in respect of such liabilities arising in any given calendar year."
Source: 10-K released on Feb. 27
After trying for more than a year to find a solution with Honeywell's board of directors about these expenses, on Dec. 2, 2019 the company decided to turn to the courts for relief. We summarize the lawsuit rationale in the following four points:
- Honeywell deliberately designed the spin-off to offload its asbestos liabilities to Garrett Motion
- The Indemnification Agreement was not discussed with future Garrett Motion directors
- The indemnification agreement is not compliant to the law
- The indemnification agreement contains covenants which will affect Garrett Motion's corporate freedom (capital allocation) for 30 years (now 28)
While a positive outcome of the litigation is far from assured, the above mentioned points (if confirmed) are shifting the weight towards it. My guess is that, in the worst case, Garrett Motion could reduce the yearly cap or the number of paying years by half.
In my opinion, this is like having a turbo-catalyst hidden in the investment thesis. The picture below, taken from the latest company earnings presentation, describes the current status of the asbestos burden as if it was a liability.
The main difference between it and a real liability is that 1) these expenses do not imply any interest payments and 2) $1.090 billion is just an estimation of the accrued expense (it could be more or less than that).
Conclusion
Garrett released its 2020 Outlook on Feb. 27. Even if it already included some of the potential effects of Covid-19, at that time the virus was only affecting its Chinese plants (which amounts for around 16% of the total sales).
Indeed, on April 7, the company withdraw its previously announced outlook and said that it is currently implementing several actions to reduce the impact of the crisis on the long-term health of the company.
If some of the production plants have already restarted (for example, the manufacturing plant in Wuhan was operative again starting from March 19), we conservatively assign a value of $0 to 2020 free cash flow.
Let's also suppose that Garrett Motion will be back to its 2019 free cash flow from 2021 onwards and that there will not be any growth in the future.
On the asbestos liabilities side, 2019 was a pretty tough one. The company paid $153 million related to its spin-off Indemnification and Reimbursement Agreement. For the next year, they are projecting a payment of $108 million (but for my valuation, I am choosing to ignore this).
Assuming that the company will get back to its 2019 free cash flow rate, we see the current market capitalization is covered by just three years of free cash flow, which is an extremely low price-to-FCF ratio.
Using a discounted cash flow calculation with a weighted average cost of capital of 8% and net debt of $1.256 billion, my intrinsic value estimate for this scenario is $6.95 per share. This is also ignoring the $18 million per year of Mandatory Transition Tax that Garrett will not have to pay anymore from 2026 onwards, as well as the fact that there will not be any asbestos related liability after 2048 (but this is really negligible because of the discounted value of future cash flows).
Now, everything from a fully or mildly positive outcome of the Honeywell asbestos litigation to any growth that the company could achieve in the future will add value to this battered company.
Of course, things could turn out worse than my worst-case scenario. The company could lose market share, the crisis could be longer than expected, etc. However, what is a bad investment at a certain price can be a good one at a lower price.
I believe that, considered the current price ($4.30 as of the writing of this article), Garrett Motion is a good value buy with a margin of safety and a nice embedded turbo-catalyst.
Disclosure: The author owns shares of Garrett Motion (GTX, Financial).
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