Garrett Motion Inc. (GTX) Earnings Call Transcript & Summary

Good morning, everybody. Thank you for joining us for this session with Garrett Motion as part of Deutsche Bank's Industrials Conference. My name is Emmanuel Rosner, and I'm the senior U.S. autos analyst at Deutsche Bank. Garrett is leading automotive powertrain supplier focused on turbocharging technologies and electric boosting. It was spun out of Honeywell in late 2018. We are very pleased to host Garrett's interim CFO, Peter Bracke, for a discussion with us this morning. He was also just named Chief Transformation Officer of the company. Peter, thanks a lot for being with us.

Yes. Thank you, and good morning, everybody. Yes, I'm Peter Bracke. I'm the interim CFO at Garrett since September last year. Actually, yesterday, the announcement came out that a new CFO has been appointed. His name is Sean Deason. He will start towards the end of the month of June. And I will transition in a different role after having done some time of transition together with him as he gets into his new role. So what we plan to do here is that I'm going to spend a few minutes to give you a very high-level overview of Garrett for those of you who are not that familiar with the company. And then obviously, we will open it up for Q&A. So assuming everybody has access to the light slide deck that has been made available. I will switch to Page #2, which is basically Garrett at a glance, an overview of the company with some key metrics. Revenue last year was $3.2 billion, as you can see on the upper left, 17.9% adjusted EBITDA and the reconciliation from EBITDA to adjusted EBITDA can be find in appendix of the deck that is currently shared. So the company has a legacy of more than 60 years in producing turbochargers, mostly. So we are going back to the late '50s, basically when the company was started in California. And since then, has developed to a company doing global business with 60 OEMs, almost every single OEM in the world. 13 different manufacturing plants, 5 engineering centers, a lot of patents basically in the turbocharging technology for the automotive world, both for passenger vehicles, as well as commercial vehicles. And there is also an aftermarket division in the company as well. Switching to Page #3, you have a little bit more specifics on what we believe are the core differentiators for Garrett as a key player in the turbocharger industry. First of all, starting with technology. Our core business is making turbochargers basically for light-vehicle diesel engines, light-vehicle engine, gasoline engines, commercial vehicles and aftermarket, as I said, but there are a few new technologies that we are actively working on and that are in development. One of them is the -- is electric boosting. That's basically a turbocharger with an electric motor, which is a product that fits very well on a hybrid engine. And we are also developing some new technologies in the software space as well as more specifically for fuel cells. We are developing fuel cell compressors, which are a key technology piece of an overall fuel cell vehicles. As I said, still in the early stages, but we are real believers in some of these technologies on top of our core business, which is producing turbochargers. I talked a little bit about what we believe is our differentiated presence and what are the differentiated capabilities we have across the 13 manufacturing plants. I think operating excellence is absolutely one of them. We worked till 2018, part of Honeywell, and driving manufacturing excellence, overall operational excellence under Honeywell has been one of the key success factors of Honeywell overall. I know of this division under Honeywell specifically. That includes also a lot of focus on supply base development and advanced supply based management, as we call it, which is very important in the industry that we are in. Switching to Page 4, you have a little bit more specifics on what I mentioned before. Maybe I'll mention a few of the highlights mentioned at the bottom of the page. We are a company with a highly variable cost structure. Almost 80% of our total costs are variable, 79% to do the math precisely on 2019 actuals. That includes material costs. Material costs or the bomb of the product, obviously, is a purely variable cost, and that accounts for more than 75% of all the variable costs. We are not vertically integrated. We are just focusing on the assembly of the end product where we believe the differentiation is basically. We have a very high focus on what we call high-growth regions. So we are not manufacturing in the traditional old industrial world. Our major factories are in China, 2 large factories in China, 2 major factories in Eastern Europe for the European customers. And then we are producing for the U.S. out of Mexico, basically. Also, most of our supply base is located in these countries. Approximately 70% of everything that we are sourcing is coming from low-cost countries or developing countries with our supply base in China being very significant and accounting for more than 50% of everything that we are sourcing. We are running the company with very low working capital, turning working capital more than 20x per year. At the end of last year, we were closing the year with negative working capital. And I define working capital here as a sum of trade receivables plus inventory minus trade payables, and also a relatively low capital expenditures. Every single year, over the last few years between $80 million and $100 million, if you do the math, it's typically between 3% and 3.5% of total sales. With that, switching to the last slide, I'm trying to wrap up basically the overall introduction. I think we are focusing on 3 elements. That's how we develop the company internally, how we set targets internally. Obviously, the most important part is at the top there. It's core turbo, but on top of that, putting investments on the R&D side in new technologies around electrification and software. And on top of that, keeping -- keep developing another level of technology for the longer-term in addition to everything else. So with this, I hope it gives you -- it gave you a good overview of Garrett Motion as a company, and I suggest that we open it up for Q&A.

Great. Yes. Thanks a lot, Peter, for this overview. So we're going to turn to Q&A now using some of my prepared questions, but also -- and mainly questions from all of you on the call. [Operator Instructions] But I guess to get it started, from my end, maybe we can get out of the way some of the questions around your relationship -- current relationship with Honeywell. I guess what is the latest status regarding the scheduled payments to Honeywell? Can you give us maybe a little bit of background on these statements for those who may not be as familiar for the conditions -- around the conditions surrounding the spinoff? And then maybe also although probably a second question, what are the latest developments in respect to Garrett's lawsuit against Honeywell?

Yes. Okay. Well, first, with respect to the payments to Honeywell, for those who are familiar with the company, you know that there is an indemnification agreement in place between Garrett and Honeywell. For Garrett to indemnify Honeywell for 90% of the asbestos settlement costs that Honeywell is incurring plus the defense cost, the legal cost that Honeywell is incurring on top of that. It has been kept at a maximum annual number of $175 million per year. And last year, we paid approximately $152 million. This year, the number that Honeywell provided as an estimate was $143 million. But at the same time, at the beginning of the year, Honeywell also told us that we overpaid last year by approximately $35 million. So the number for this year is $143 million, minus $35 million, approximately $108 million. The amount is due every single quarter at the end of the first month of the quarter. We paid at the end of January. We didn't pay at the end of April because we indicated to Honeywell that given the crisis, given the coronavirus crisis that most likely we would be breaching our leverage covenant at the end of the second quarter And the indemnification agreement clearly states that if you are breaching the leverage covenants to your credit agreement, that the payments get deferred. Now in April, we were officially breach -- not yet breaching. We were expecting to breach. Nevertheless, Honeywell first agreed for us to delay the payments until the end of May. And now recently, they have agreed to delay the Q2 payments until the end of December this year. What is more important though is that at the same time, we started negotiating with our lenders and with our banks, some amendments to our credit agreement that we hope to announce soon and target to announce soon. Clearly, I believe we are on track for that. And during that period, we would breach the original covenants of the credit agreement, and we would defer any payments for the indemnification per the indemnity agreement to Honeywell until we are out of breach again, which we believe might take up to 2 years. So in summary, to answer your question, the -- we paid in Q1, the Q2 payment has been delayed till the end of the year. Actually, Q2 was a very small number because that was the quarter where in the overpayments for 2019 of $35 million was netted. And then starting Q3, we expect to defer the payments until later in the future for the whole period that the credit amendment is going to be put in place.

Okay. That's very helpful detail. So your covenants relief discussions, that's still ongoing, but you sound generally optimistic?

Yes. We believe we are really on track to close that and we are hoping to announce that and targeting to announcement. Hoping is never a good word. We are targeting to announce that definitely that next week.

Okay. Great. And then I guess regarding that lawsuit against Honeywell, is that ongoing litigation impacting your financials? Is that an issue in the current environment?

No, not a whole lot has happened basically over the last few months because of the lockdown. And it's a case before the State Court of New York. So you can imagine that not a lot of activity happened between March and today, basically, but it's gradually restarting. And Honeywell filed a motion to dismiss after we filed our claim in January. Honeywell filed a motion to dismiss in March. But I don't think that's going to change anything in the discovery process, it's probably going to kick off in the near future now.

Understood. And I guess -- yes, go ahead.

Yes, you asked what is your impact on the financials? I think overall, it's pretty limited. Obviously, any lawsuit is coming with some legal expenses as it did in -- already in 2019, as we were preparing for the lawsuit. We are obviously at a different level today, given the crisis and the fact that the legal system almost came to a standstill, but it will come with some costs moving forward.But that is something that we are taking into account in our planning, obviously.

Understood. And I guess since we spoke about the covenant discussion, how do you think about your current liquidity level? Are they sufficient? Would you look to raise additional capital if -- would that be necessary?

Obviously, we are looking very closely to that. We mentioned that during our Q1 earnings release call, May 11, that we truly believe we have enough liquidity to manage through the crisis from how we looked at that at that point and how we looked at it again more recently and how we look at it today. So we don't believe there is a need to raise more capital.

Okay. That's very clear. All right. So then maybe switching gears to sort of industry conditions and sort of your restart of production post the worst of the crisis. Can you give us an update on how your various operations around the world are restarting? Where are you in terms of capacity utilization trajectory? What are you seeing there?

Yes. So I think you have to split the world into pieces. Starting with China, which is a case by itself because China has been hit very badly by the coronavirus crisis, as we all know. Already in January or end of January basically, and then going into February, there was almost no activity there. We have one of our 2 major plants in China, one of them is in Wuhan, which was obviously in the worst possible location in China. The plant was shut down for more than 6 weeks from the end of January until the middle of March. We also have a plant in Shanghai where we had a bit less of an impact, but also pretty bad. Now China rebounded very, very quickly and strongly starting in March, and went back, I would say, to pre-crisis levels in April. And what we see in Q2 is clearly production levels far beyond what we would have expected after such a crisis in the first quarter. We keep asking the question how sustainable is that? Is there going to be another drop later in the year? And the answer from our China team is maybe not a huge correction, but probably the levels that we have seen in Q2 might get corrected to some extent in Q3 and Q4. And I believe that the auto industry and also the commercial vehicles industry has been very, very strongly supported by stimulus, local stimulus in China, as China got out of the crisis in March. So overall, China, a good story, rebounded very quickly back to pre-crisis levels. Switching to Europe. Europe has started to drop off, as you all know, in second half of March. You have seen the April sales numbers for vehicles for cars in Europe. They were down 80% year-over-year. May is looking -- the month of May is looking a little bit better, but not a whole lot better. But June is picking up again to some extent. Obviously, still very significant negative growth versus June last year, but clearly, getting to a better place than the disastrous April and May. Most of the OEMs, or I should say, all the OEMs have restarted production between end of April and the middle of May. So their engine plants or their car assembly plants are all running. But obviously, with less shift, with lower output levels than what we have seen before. The dropoff in numbers in the U.S. for car sales in April was not as bad as Europe, was approximately 50%. That's also the kind of drop in CV in the U.S. in the month of April. So overall, the market was a little less impacted there, still pretty bad year-over-year. But we are producing out of Mexico and the impact for us for the U.S. end market was more driven by the local regulations in Mexicali in a way that manufacturing activities were asked to shut down completely early in April, no matter what. Then they could start again for what was called essential business and commercial vehicles was defined as part of what was defined essential business. So we could only produce for CV during a certain number of weeks. And then it's only 2, 2.5 weeks ago, that the green light was given by the Mexican authorities to restart production for light vehicles, for parts for passenger vehicles as well. So I think the overall impact to us has been more driven by the regulations in Mexico than the end demand or the consumer demand and as such in the U.S. But what we see from a demand perspective is a little bit similar as in Europe. So it looks like maybe the worst is behind us, and that June is picking up quite a bit after what we have seen in April and May. Still very difficult to say what does it mean for the second half of the year, of course, at this point.

Okay. That's great color. And then in terms of your own important launches this year, new business, are you seeing any delays or cancellation? I guess how is the schedule of those shaping up versus initial expectations?

Yes. Very little changes so far, but we keep asking our customers, the OEMs because you would expect that delaying or potentially even canceling a launch as an opportunity to save cost and to save cash from their perspective. That's also a little bit what we have seen in 2008, 2009. So we keep asking, but we have seen very little changes at this point.

That's certainly encouraging. And so I guess, maybe moving a little bit to the powertrain mix. As this crisis distorted the trends in terms of shift either from diesel to gasoline or electrification versus previous expectations? And how should we think about this in the context of the impact on your own business?

Yes. I truly believe it's too early to say. There are 2 schools of thought on that. One would say a crisis like this is always an opportunity to accelerate a shift change. And the shift change could be the shift to battery electric vehicles or plug-in hybrids. And that could be because that -- of course, that is some direction that the car industry is going. The question is, though, who is going to pay for it? Because an electric car costs significantly more than a car with a traditional ICE engine. And between the end consumer who has been impacted with lower disposable income this year or the governments who have to make decisions allocating their stimulus between all possible industries. You're wondering where the money is going to come from to accelerate basically the shift? So I think nobody knows really and nobody has a strong opinion on the fact that the mix shift between traditional ICE engines, hybrids and battery electric vehicles will be impacted by the crisis. It might become a little bit more clear in the coming few months, but it's too early to tell.

Understood. Maybe switching over to costs and margins. You were highlighting how you have a highly variable cost structure, which is already a strong advantage. How are you thinking about decremental margins in this kind of environment, both in, let's say, this quarter, where production is down a ton and then the rest of the year. How should we think about that for Garrett?

Yes. So when you look at our Q1 earnings, you probably noticed that our decremental margins year-over-year were down significantly. And that has to do with the fact that between the first half and second half in '19, we have seen a very significant mix shift in a way that diesel declined a lot and that the growth in gasoline has been exponential, basically. The overall growth in the fourth quarter basically was 6% organic growth for the company. And that's despite a 70% organic decline in diesel. So we have seen a big mix shift basically between first half and second half in 2019, which is one of the reasons of the pretty high decremental margin decline first quarter this year versus first quarter last year. When you do the same calculations of decremental margins sequentially, so from Q4 to Q1, you get to 34%. And that's very much in line basically with the overall contribution margins, the overall variable contribution margins of the company. And between Q4 and Q1, there was much less of a mix shift than when you look at it year-over-year. Moving to Q2, we definitely should be able to do better on the decremental margins. We have put in place a lot of actions as everybody, basically trying to protect income and cash and margins in the second quarter. The most important actions are all around short work schedules. We have asked basically everybody in the world in all the plants in all the engineering centers to the sales offices, even in the headquarters, just to work less and people got paid less and it could be 3 days per week, 4 days per week, 3 weeks per month. And then the remaining weeks, people got compensated partially by the government with state-run relief programs or not, in case there are no state-run relief programs in place. In addition to that, we have obviously taken out a lot of contractors, a lot of interims. We have approximately 15% of the labor force in the plant is working on an interim basis. So that was a very fast cost action that we could implement. And then you're focused on everything else, reducing professional services as an example, reducing your CapEx expenditures pretty rapidly and dramatically for everything that is not needed without jeopardizing any new product launches. So with all these actions, specifically in the second quarter, our decremental margins should look better because I think we have been able to mitigate some of the very significant revenue decline to some extent. Going into the second half of the year, we will continue to be extremely cautious with costs. Some of the actions that we have been driving hard in the second quarter, specifically around state-run relief and short work schedules will probably not be as broadly implemented anymore in Q3 and Q4, assuming the recovery continues because some of them are also dependent on the availability of the state and relief programs. And we expect that several countries will probably stop these beyond the month of June or July. So in summary, good efforts in Q2 that will pay off with the actions. Second half of the year, some of the benefits of these actions will be lower. But at the same time, we are starting to develop some effort on restructuring as well because we all know that it's going to take some time before our production levels will be back to 2019. And this crisis is obviously also an opportunity or a challenge. It's probably a better work to take out some more structural costs. So that's also something that we are taking a look at and try to implement as soon as possible.

Okay. Great. And so historically, your EBITDA margins have trended in the 18% to 20% range. What should we expect as normal going forward if volumes sort of stabilized but don't necessarily go back to previous levels immediately?

Yes. So the 18% to 20% range at the beginning has been impacted by 2 things. First of all, there is the accelerated mix shift from diesel to gas. And margins on gasoline products are lower than on diesel products for 2 reasons. First of all, there is just more metal content like nickel in a gasoline turbocharger. And it's more difficult to take any margins on pure metal in your product. And second, there is -- at this point, at least, there is less technology in a gasoline turbocharger. That's going to change over time. And we believe that the gasoline -- and we truly see that the gasoline technology is shifting more to the diesel technology, but it's going to take another 5 years before we see a substantial contribution there. So there is a mix headwind that has accelerated. Second, the overall industry, obviously, is going to be down a lot this year. But let's not forget that the that the auto production industry was down already 600 basis points or 6% last year. So we were already in some kind of recession if you want from that perspective. So assuming that we get out of this crisis here and we get back to 2019 production levels, at least for the turbo industry, not for the auto industry, but for the turbo industry by 2022. And if we can continue to grow, to some extent, our share in gasoline as we have clearly done in 2019, and which will continue in 2020. And as a result of that, our production levels by 2022 should be above 2019. I don't think we will be all the way back to the 18% to 20% range, but maybe in the 17%, 17.5% range. I think that's the way to think about it.

That would be a pretty decent outcome. Maybe in the final 5 minutes of this presentation, let's shift a little bit to future technology. It seems fuel cell is getting a little bit more traction, especially in China maybe this year. What are you doing to position the company for this opportunity? And when do you think we could see some bookings or more material business?

Yes. We definitely see most of the traction in Asia, both in Japan as in China. And we are developing fuel cell compressors, basically what we call Gen1 for some Japanese OEMs since probably 3 years now. And we are shifting to the 2nd generation, which is a significant change in terms of cost and which allows a much broader rollout, basically, both with some Chinese OEMs, as well as in Korea, as well as in Japan. It's still relatively small revenue in the low single-digit million dollars. But the interest is high, specifically on the CV side of the overall automotive landscape. I think that is where probably there is an even higher interest for fuel cells on light vehicles because clearly, purely battery electric vehicles will always be a challenge for commercial vehicles, but the fuel cell might be a technology that is applicable here. So the interest is very high from what we see. There are not too many players focusing on this, which is something we like, I think, on the supplier side, is what I mean by this. So it's still relatively small, but we are definitely seeing more positive feedback and interest today than a year ago. And a year ago was already much better than 2 years ago. So it's -- I think we believe we have something on the technology side, and it's going to be a matter of pursuing it with first systems as we believe into that technology as being part of the overall automotive landscape and more and more OEMs, and specifically in Asia at this point in time, but also some Europeans basically are becoming more and more vocal about it, seem to believe into it. Is it going to be a needle mover in the coming 5 years, probably not. But when we talk 2025 to 2030, there can be something really nice there. That's our point of view on few of them.

Okay. And I guess, maybe finally, in terms of somewhat near-term future technology. Do you remain on track for the launch of the E-Turbo next year? How does that product differ from what is currently on the market?

Yes. It's a completely different product. We're definitely on track to launch the product. I think at the beginning of 2022, prototypes have been delivered. The product has been tested by the customer. It's a complete step change. The amount of boost that you can get out of this product as a turbocharger is bringing it to a completely different level. Most likely for the foreseeable future, it's going to remain a kind of a niche technology, as I said, probably more for the high-end plug-in hybrid engines. That is where it fits the best. But at the end, that's a trend that won't be stopped. I think as you see very often in the auto industry, it has started in the Formula One technologies where we are working together with Ferrari. And once it is tested and it has proven some sustainability in that environment, it is gradually rolled out at a broader scale, and we are super excited about launching the product beginning of next year.

Yes, that sounds exciting. Look, I really appreciate the discussion and your participation in our conference. I look forward to continuing our discussion, I think, in a couple of days at the Deutsche Bank Global Automotive Conference. Same thing for the audience, if you're involved in autos, we have about 45 companies that we're hosting over the next 2 days at the autos conference. But in the meantime, I want to thank everyone for being here. Peter, thank you so much for all the insights. Take care, and speak to you soon.

Thank you.

Thank you very much.