Welcome to Episode 85 of Special Situation Investing.
Before we begin, I’d like to mention that today’s episode will be a bit shorter than normal. We like to keep our podcast between ten and fifteen minutes in length, but today’s will probably run a little short. Two episodes ago my co-host and I were able to sit down in person for a sort of investing fireside chat and that opportunity was in part the result of my moving out of state. As I’m now in the area where I plan to settle down, I spent the majority of this week getting oriented and finding housing and didn’t have as much time as I’d hoped for podcasting. In any event, I hope that you still find the following update useful and hope to see things settle back into a routine again soon.
In Episodes 12, 22, 29 and 74 we discussed our investment thesis for Garrett Motion, a company that was restructured through bankruptcy proceedings in 2021 and which has subsequently outperformed all of our debt repayment and restructuring expectations. Along the way, we also discussed how the company BorgWarner provides a good valuation comparison to Garrett Motion and how that valuation might inform our sell decision for Garrett Motion stock, which we hold. We still believe that BorgWarner is a good valuation yardstick against which Garrett Motion can be measured and we believe that the company’s recent spin-off may further refine our valuation estimates.
As of Wednesday July 6th, BorgWarner completed the spin-off of its fuel systems and aftermarket business segments via a tax free 1-for-5 distribution to Borg shareholders. Leading up to and following the spin-off transaction, BorgWarner’s share price traded up from the $40 range to its current two year high of nearly $45 dollars. Phinia, the BorgWarner spin-off, spent its first week trading in the $33 range with a market cap of about $1.6 billion. With Phinia’s market cap well below the cutoff threshold for S&P 500 inclusion, we would expect heavy selling pressure on the stock in the weeks to come as funds that have to hold, S&P 500 constituent, BorgWarner, are forced to follow their charter and indiscriminately sell, non S&P 500, Phinia Inc.
Though parent companies sometimes give up valuable assets in spin-off transactions, the transactions can also allow them to shed unwanted or low margin business segments and debt. This is exactly what we believe took place in this case. BorgWarner retained its highest margin business segments, namely its aftermarket and air management divisions, which according to their 2022 10k, each generated 15% in operating margins, while at the same time shed their fuel supply business into the spin-off. Allowing the company to rid itself of a 10% and below margin business. Phinia’s pro-forma financial statement attests to this fact, reflecting single digit margins for the spin-off going back two years.
Additionally, following the spin-off, Phinia will owe former parent BorgWarner $800 mm in prearranged debt obligations. This funding will help to reduce BorgWarner’s $4.4 billion debt load by nearly 20%. BorgWarner’s potential debt reduction from $4.4 billion to $3.6 billion against a market cap of nearly $11 billion coupled with improved operating margins should revalue the parent company’s stock upwards.
By comparison, Garrett Motion is carrying just under $3 billion in debt against nearly $2 billion in market cap and trades at a P/E of 10. If we use the oversimplified comparison metric of P/E ratios, we see that BorgWarner trades at a current P/E of just under 12 and a five year average P/E of 14 against the lower 10 P/E of Garrett Motion. Granted, Garrett is carrying a higher debt to earnings ratio than BorgWarner and, all things being equal, that would justify a lower P/E multiple but it must also be noted that Garrett has maintained greater than 18% operating margins over the last several years despite pandemic lock-downs, supply chain disruptions and bankruptcy proceedings. Even though BorgWarner is shedding its low margin business segments in the spin-off and should see improved margins going forward we still believe that Garrett’s management team boasts the better track record and justifies the same if not a higher P/E than does BorgWarner.
Assuming that BorgWarner trades up to its 5 year average P/E ratio of 14 following the spin-off and that Garrett’s P/E rises to only 12, it would yield a share price of $8.64 for Garrett stock and an additional 14% return to investors from this point. We believe that Garret should command an even higher P/E multiple and that returns from this point could be even better for investors but we aren’t making a price forecast, we’re simply highlighting the utility of comparing BorgWarner and Garrett Motion to each other.
A simple P/E comparison between the two companies provides investors with a valuation reference point and helps inform them as to when they should exit their Garrett position. Most of the returns in Garrett stock have already been made by those who owned the preferred shares out of bankruptcy and received the dividends and common conversion that accompanied the early part of the thesis.
But picking your exit from an investment can be just as difficult as is making the investment in the first place.
The difficulty in picking your exit point without the benefit of a Garrett/BorgWarner style duopoly can be illustrated by revisiting the XPO Logistics spin-off. We covered the XPO spin-off of RXO Logistics in episodes 15, 19, and 34 and made our initial investment in XPO in early April of 2022, prior to the spin-off. Our initial purchase price of about $60 per share entitled us to one share of XPO and one share of RXO for every XPO share purchased.
Today, a year and three months after the initial investment XPO Logistics trades at $61.55 and the spin-out, RXO Logistics, trades at $22.07 for a combined value of $83.26 or a 38% return on investment. Not bad for 15 months of just waiting around but the question now becomes how much longer do you wait and what exactly are you waiting for?
With spin-offs, investors have to first determine if any part of the investment is worth holding for the long-term. In Garrett Motions case we don’t plan to hold for the long term. It’s tempting given managements exceptional track record but in the end the business itself is in the highly commoditized auto OEM industry, a business with a terrible track record for long-term investors. XPO is in the equally terrible logistics business but also benefits from a strong management team with a proven record. In fact, Brad Jacobs, the owner/founder of XPO Logistics, and chairmen of both XPO and RXO, still holds a significant interest in both companies. Of all of these companies, only RXO benefits both from good management and a low cost broker business model. But even that company must be compared to other opportunities that are available to the investor.
Once an investor determines to sell a spin-off, versus hold it for the long-term, he must construct a valuation model that will inform his exit decision. That valuation model is made easier when a duopoly partner like BorgWarner is readily available but is much more challenging when other valuation metrics must be applied. In the absence of a good comp, investors must consider broader economic conditions, industry specific factors, and the particulars of the company they invested in along with consideration of other investment opportunities available at the time. All of this to say, in Garrett’s case, BorgWarner provides us an excellent valuation reference point and should be consider buy anyone looking to exit their Garrett position.
With that, we wrap up this condensed episode of the podcast and hope that despite its shorter-than-normal format you still gained some insight into the investing world.
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