Welcome to Episode 128 of Special Situation Investing.
Garrett Motion (GTX) remains on the Magic Formula Investing Stock Screener of cheapest stocks with the highest free cash flow despite a string of wins that include emerging from voluntary bankruptcy, simplifying its capital structure, and seeing its stock price increase from a low of about $3.00 in 2020 to $9.00 today. So with all of this success behind it, why does GTX still trade at bargain levels? One key to unlocking this mystery can be found in the company’s credit rating, a place that equity investors rarely spend much time.
In the world of credit ratings there is a line that divides investment grade from non-investment grade credit. According to Investopedia.com:
Investment grade refers to the quality of a company’s credit. To be considered an investment grade issue, the company must be rated at BBB or higher by Standard and Poor’s or Baa or higher by Moody’s. Anything below these BBB or Baa ratings are considered non-investment grade. If the company or bond is rated BB or Ba or lower it is known as junk grade, in which case the probability that the company will repay its issued debt is deemed to be speculative.
Despite Garrett’s many achievements over the last several years, its credit rating remains at the BB-, or junk level, while the rating of its closest comparison company, BorgWarner, sits at an investment grade rating of BBB+. As arbitrary as credit ratings may appear to those of us outside the fixed income market, the ratings do have a real-world impact on a company’s performance. Both access to credit and the rate of interest paid on debt are variables that directly impact a company’s profitability and credit ratings greatly effect both variables.
To better understand why Garrett Motion and BorgWarner receive different ratings from the rating agencies, it’s worth reviewing the highlights of both companies’ reports.
Beginning with Garrett Motion we see that reliance on internal combustion versus battery electric vehicles, along with the company’s recent emergence from bankruptcy, and its debt to EBITDA ratio, are some of the top factors driving its BB- rating.
According to Fitchratings.com:
The loss of revenue and earnings stemming from faster- than-expected growth of BEVs is a risk for Garrett's financial performance. Garrett is expecting to increase its zero emission revenues to USD1 billion by 2030, providing fuel cell, E-powertrain and E-cooling solutions to OEMs. Sales to hybrid technologies and the different electrification ramp-up speed in emerging geographies will provide some buffer, but transition risk and portfolio exposure are major rating constraints. However, Fitch believes that this will not dampen Garrett's ability to pay down debt, given visibility over orders for different engine types in the medium term.
Additionally.
Following the conversion of preferred A shares to common stock, and the signing of a new term loan B (TLB), Fitch calculates that Garrett's EBITDA net leverage will be around 3.5x, which we expect to ease to 2.5x at end-2025, broadly in line with our 'bb' rating median of 2x.
Using BorgWarner as a comparison reveals a few key items worth considering. First, BorgWarner maintains a lower debt to EBITDA ratio than Garrett at closer to 1.5x debt to EBITDA compared to Garrett’s near 3.5x ratio. Although there are no hard and fast rules in the world of credit ratings, a quick survey of BB- companies reveals that debt to EBITDA ratios of 2x or greater are not uncommon and that BBB companies average 1.5x or lower in most cases.
Next, we see that BorgWarner is unlikely to receive a credit rating upgrade due to it being in the OEM business. Fitchratings.com had the following to say on the topic:
Given the inherent cyclicality and potential financial pressures of the automotive supply industry, an upgrade of BorgWarner's ratings is unlikely in the intermediate term.
Based on the above information, GTX’s best path toward a credit rating upgrade is to reduce its debt to EBITDA ratio. Garrett is already working to diversify it product line away from internal combustion engines and has significantly improved its capital structure in the post-bankruptcy years leaving debt reduction as its most powerful remaining lever. Reducing the company’s debt to EBITDA ratio from current levels down to 2.0x or even 1.5x would likely trigger a credit upgrade and cause the stock to be reevaluated by the market.
Over the last ten years, BorgWarner has traded from a low P/E of 6 to a high of 22 and currently trades just over 12. If Garrett Motion traded at 12x the midpoint of its forecast 2024 earnings of $250 million its market cap would be $3 billion or a full 50% higher than its current market cap of $2 billion. Garrett has yet to trade at such a high valuation, however, due to its inferior credit rating and higher debt-to-income ratio.
In order to obtain a BBB or better credit rating, Garrett needs to show less than a 2x debt to EBITDA ratio and preferably a 1.5x ratio. Garrett’s full year 2024 EBITDA outlook falls between $546 and $606 million or roughly a $575 million midpoint. This means that the company’s debt needs to come down to between $1.2 billion and $863 million. With current debt levels at $1.683 billion, the company has to retire between $500 and $800 million in debt to see its credit re-rated assuming that EBITDA remains flat and in line with forecast.
Assuming Garrett does pay down a significant amount of debt in 2024 and beyond then its interest expense should also decline, and all else being equal, contribute to even greater earnings in the future. With interest expenses forecast to be $146 million in 2024 on current debt levels it can be assumed that a 25%-50% reduction in debt could cut that expense down from $146 million to anywhere from $110 to $73 million in the future. Multiplying the low end of that savings range at $36 million in additional earnings by a P/E of 12 adds another $432 million to the company’s market cap and increases an investors return by another 20% from todays levels.
Debt repayment remains a focus for Garrett Motion as evidenced by a 7 May 2024 press release announcing the issuance of $800 million in senior unsecured notes at 7.750% due in 2032. According to the companies website:
The Company intends to use the proceeds of the Offering, together with cash on hand, to repay approximately $800 million of indebtedness under the Company’s existing credit facilities, in accordance with the terms thereof, and to pay related fees and expenses.
If Garrett’s last several years of history are any guide, then these notes too will be repaid early and any remaining debt will be refinanced under even more favorable terms. The real question that remains for investors to work out is how will Garrett’s remaining returns and the timeline for those returns stack up against the other opportunities available in the market?
Personally, I run a portfolio where the vast majority of my investments are in fewer than ten stocks, and often times, less than five. Because of this concentration, I have to make the tough decision to sell things I like in order to buy other things I like even more while at the same time honoring my other tendency which is an extreme aversion to selling anything. That said, the selling is easier to execute for special situation investments like Garrett that were purchased with a limited timeframe in mind. Ultimately, the decision to hold or sell is an individual one and depends on the opportunities available and your assessment of the remaining return potential of GTX.
That brings us to the end of this week’s write-up. We’d love to know how you decide which stocks to keep and which to rotate out of in your own portfolios if that’s something your willing to share in the comments. As always, we will see you again in two weeks time with another investing write up.
Garrett Motion and Credit Ratings