Welcome to Episode 74 of Special Situation Investing.
Today’s episode is an update on a special situation we’ve covered in the past that is nearing its finish line.
Situation recap
As a quick recap: Garrett Motion, an OEM producer of vehicle turbo chargers, was spun out of Honeywell back in October of 2018. Honeywell took the opportunity to jettison a burdensome asbestos liability by spinning it off with Garrett. Due to the weight of paying off this debt, combined with the drastic, yet temporary, slowdown during 2020, Garrett voluntarily declared bankruptcy in September of 2020 in order to restructure. Upon exiting bankruptcy, which it did in 2021, Garrett was supported by two investing companies, Oaktree and Cornerstone, which were both allocated hundreds of millions in an 11% dividend paying Series A prefered share. Garrett emerged from bankruptcy free of the Honeywell asbestos liability, with a complicated capital structure, but as a cashflow production machine.
From the beginning, our bullish thesis for Garrett was in regards to its Series A prefered shares:
Over time, we believed Garrett would allocate its immense cashflows to simplify its capital structure and redeem the preferred Series A shares. At which time, Garrett would rerate higher and trade comparable to its industry peer, and duopoly counterpart, BorgWarner. Until that occurred, 11% was a handsome dividend to be paid for waiting.
Garrett has done just that. Today’s post provides an encouraging update as we believe the special situation nears its completion. For further background on our thesis and Garrett’s journey since bankruptcy, please check out our previous posts listed below:
Garrett Motion Series A Prefered (here)
Garrett Motion Q1 Earnings Call (here)
Garrett Motion Amended S-1 (here)
Updates - Office Depot & Garrett Motion (here)
Update #1
Since the beginning of April, Garret has published three press releases. In the first, posted on 4 April, the company announced better than expected year-to-date performance due to “strong industry volumes in key regions, the successful ramp-up of new programs, operational excellence, and favorable foreign exchange.” At the time, Garrett claimed that the improved results could allow it to meet the consolidated EBITDA requirement to fully redeem its Series A shares as early as Q2 of this year. If that proved the case, the only remaining requirement would be for a 75-day VWAP (volume-weighted average price) or greater of $7.875 just slightly higher than the then current VWAP of $7.70.
Translation: performance was better than expected leading to higher earnings and an accelerated timeline for share redemption as long as price followed the good news higher.
Update #2
Nine days later, on April 13th, Garrett posted a press release announcing a transformation to the agreement between the company and the Oaktree/Centerbridge duo. The highlights, direct from the press release with a few added comments of our own, are listed below:
The Series A Preferred Stock is amended to automatically convert into common stock on or about July 3, 2023. This automatic conversion removes the previously mentioned EBIDTA and price hurdles.
Following the conversion, Garrett will have one class of shares outstanding, the common stock. This will create greater liquidity and an enhanced cash flow profile from the elimination of the 11% Series A Preferred Stock dividend, which will be partially offset by an incremental increase in interest expense.
The Company has agreed to repurchase a total of $570 million of Series A Preferred Stock from Centerbridge and Oaktree. This will reduce Centerbridge’s ownership from 22% to 15% and Oaktree’s ownership from 23% to 15%.
These repurchases are subject to obtaining funding of approximately $700 million of new debt, which is expected to be in the form of a new term loan B under the company’s existing credit agreement.
Centerbridge and Oaktree have also agreed to certain changes to their governance rights, including a reduction of their existing board nomination rights to no more than one director each, down from three each at current ownership levels. Centerbridge and Oaktree have also agreed to lock-up restrictions on their equity, including 50% of shares for six months and the remaining shares for twelve months. Centerbridge and Oaktree have also agreed to certain limits on their ability to purchase additional stock, and voting limitations, for a period of up to eighteen months.
Additionally, and importantly for those of us who are owners of Series A shares, as part of the transaction, all holders of such shares will receive the following:
$0.17 per share, which is the preference dividends that will accrue through June 30th of this year;
Approximately $0.6835 per share, which is the accrued and unpaid dividends on the Series as of June 30th, 2023; and
Approximately $0.144375 per share, which is the dividends that would have accrued through September 30th, 2023.
And to top it off, Garrett announced an increase in the company’s share repurchase authorization to $250 million.
To summarize the changes announced in this press release: The redemption of the Series A prefered shares will simplify Garrett’s capital structure and increase liquidity and now has a date and isn’t dependent on earnings and price hurdles. Garrett is taking on $700 million in debt to buy back $570 million worth of Centerbridge and Oaktree’s prefered shares. These two company’s percentage of stock owned and number of board members are being reduced and they are submitting to stock sale and purchase lockups. Lastly, Garrett laid out the amount of dividends it will pay to Series A share holders and announced an additional $250 million in buybacks
Alongside this announcement, Garrett held an investor call which was accompanied by an updated presentation that provided a lot of information and shed light on what the company would look like with its simplified capital structure. We used the data provided to update our expectation for Garrett’s share price appreciation. More on that in a bit.
In all, this was encouraging to hear we now have a date for when we will receive our Series A dividends and we expect Garrett’s stock to rerate higher as the capital structure simplifies, liquidity increases, and shares are bought back.
Update #3
The final update was provided on April 17th when the Garrett announced its preliminary Q1 results and an updated full year 2023 outlook. The numbers were generally up showing solid growth year-over-year. The only number that was down was net income which the company said was “primarily due to unrealized marked-to-market gains on our interest rate swaps in the first quarter 2022.” The full year outlook is summarized in the table below. Once again, increases across the board except for an expected decrease in net income.
Garrett plans to provide full first quarter and 2023 outlook numbers and provide further color on progress with its transformation on 24 April at its company quarterly call and earnings release.
Why we’re still interested
In our first episode covering Garrett back in February 2022, we estimated that after Garrett simplified its capital structure its share price could reasonably appreciate to $15.00. This was based on a comparison to BrogWarner, the other member of the turbocharger duopoly. With the most recent announcements and numbers from Garrett, we believe an updated estimation is warranted.
The above table, taken from Garrett’s investor presentation, puts the company’s current market cap around $2.778 billion and that, after its upcoming transformation the market cap, should reduce to $1.976 billion. This is a result of the $570 million of Series A that Garrett will buyback from Cornerstone and Oaktree. What this tells us is, post transformation, we can expect the total shares outstanding to be 239,515,151.
An estimate of EPS can be obtained by taking the midpoint of Garrett’s 2023 guidance ($231-$268 million) of $150 million for net income and divide it by projected shares outstanding and we get an EPS of 1.04. In contrast, our comparison company, BorgWarner, currently has 233,736,917 shares outstanding, a PE of 12.21, and an EPS of 3.97.
Multiplying our projected EPS for Garrett (1.04) by its peer’s PE of 12.21 gives us an estimated stock price of $12.70. Taking it a step further, Garrett following through and repurchasing an additional $250 million in common stock could increase its EPS to around 1.19, leading to a price in the range of $14.53.
Let’s compare a different metric, free cashflow (FCF) per share, to get another estimate.
Garret’s 2023 guidance projects FCF in the range of $315-$415 million whereas BorgWarner guidance indicates a range of $550-$650 million. Taking the mean of both estimates (and adding back in $150 million that BorgWarner set aside for its upcoming spin-off) gives $365 million for a FCF/share of $1.52 for Garrett and $750 million for a FCF/share of $3.21 for BorgWarner. Calculating BorgWarner’s price to FCF ratio produces 15.22, and multiplying that by Garrett’s FCF/share, gives a projected price for Garrett’s common share of $23.13
So as we can see, its rational that as Garrett simplifies its capital structure on or by July 3, that Garrett will rerate higher to trade comparable to its duopoly counterpart.
Conclusion
To sum it up, we’re encouraged by Garrett’s recent results and announcements and believe the stock still has considerable upside. We look forward to watching this situation cross the finish line in the months ahead.
With that we’ve concluded another episode of Special Situation Investing. Thanks for listening. Also, thank you for the feedback and support you guys have sent us lately. As a reminder, there are two easy ways you can support our work. The first is by simply becoming one of our free subscribers on Substack and the second is by sending Bitcoin boosts while using the Fountain app. It’s all much appreciated.
We’ll see you all next week with another episode.
SUBSTACK-ONLY BONUS
Here are our three favorite podcasts/interviews we listened to over the past week. One from Luke Gromen and another with Zoltan Pozsar and the last from the world’s most famous green chicken. Enjoy.
1.
Part one
Part two
Part one
Part two
Garrett Motion accelerates to the finish line (GTX)