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

Good afternoon, everybody, and thank you for joining us for this session with Garrett Motion as part of Deutsche Bank's Global Automotive Conference. My name is Emmanuel Rosner, and I'm the senior U.S. autos analyst at Deutsche Bank. Garrett is a leading automotive powertrain supplier focused on turbocharging technologies and electric boosting, who has spin out of Honeywell in late 2018. We are very pleased to host this afternoon Garrett's Interim CFO, Peter Bracke; as well as Investor Relations, Paul Blalock, for discussion. Peter was also just named Chief Transformation Officer of the company. So the format of this session will be a fireside chat using some of my prepared questions as well as questions from all of you on the call. To submit a question, please type it in the box, on the left side of the webcast window. I highly encourage you to do so, and to get involved in this discussion. Only I will see your question, but I will ask them on this call without mentioning your name or affiliation. So with this, let's get right into the discussion

So Peter, maybe just to get started, could you give us an overview of how the restart in production is going for you around the world, what kind of capacity utilization trajectory you're seeing?

Yes. Starting with China, we'll do it region by region. China, you probably heard it before, it's really doing well in Q2. I think the automotive industry, overall, has rebounded very strongly. On top of that, we have a lot of tailwind from new product launches that we started specifically for gasoline in the second half of 2019, and some more are coming through this year. So Q2 has rebounded, first of all, well beyond expectations for auto production, and we have the new product launches on top of that. And also the commercial vehicles business in China is doing really strong. So we're trying to understand what it means for the second half of the year. We believe it's going to slow down to some extent from the run rate that we are seeing in Q2. We might see some kind of a correction, but our local team does believe it's going to be too much of a correction. So it should remain a pretty solid story for the rest of the year. Europe, we have seen sales down 80% in April, very much in line with the car sales decline in Europe. May has been a little bit better, but not substantially better. But demand from customers is picking up in June at better rates, obviously, still significantly below the forecast or the actual numbers that we have seen in June last year. But glad to see that the OEMs are producing again in all their car assembly plants in Europe, and that they increase the demand for turbochargers as a result of that. We never really shut down our factories in Europe. Just so you know, we are producing 85% of the turbochargers for the European market in 2 factories in Eastern Europe. And we kept them open on a very flexible basis during the quarter even in the month of April, but only 2 days per week and only 1 shift per day instead of 2 or 3 shifts per day and 5 to 7 days per week. But I believe we have been able to flag that very well and to adjust to very big swings in customer demand. In the U.S., car sales were not down that much in April. You have seen down 50%. SUV is actually only down 20%. May was a little bit better, and June is now picking up as well. Just as in Europe, we have been impacted, to some extent, by the fact that we are producing in Mexico for the U.S. market and that the Mexican authorities forced us to close down the operations completely during several weeks in April, and then they allowed to restart gradually from the end of April to the middle of May. But now operations are back across all product lines, still at much lower levels than what we were planning and that -- than what we have seen in June last year. But I think everything picks up from very depressed levels in Europe and in the U.S. We believe the low point is beyond us now. It's -- the question is what does it mean for the second half of the year? We believe that Q3 and Q4 will still be down substantially versus last year. We believe that total car production, auto production, for the year might be down between 25% and 30% still. We would be able to outperform that by at least 500 basis points, driven by the new product launches, specifically in the gasoline segment and in line with the outgrowth that we have seen last year. But there is still a lot of uncertainty around the second half. I think everybody gets that. The demand from the OE customers is volatile. It's -- even in the short term, June is picking up, but then July and August are going down a little bit. But that can change again next week, so we need to lift with some volatility here. And we are trying to understand that we are working through the remaining few weeks of Q2, what it means for the second half.

That's a great overview. Are you seeing any meaningful delays in some of your important launches for this year?

No. The short answer is no. We are very sensitive to that because we assumed that delaying a launch is an opportunity for an OEM to reduce cost and cash in a crisis. But we -- so far, we have seen little to no delays.

And then, I guess, still in terms of state of things around the world. Has -- I think you're involved in the commercial vehicle market as well. Is that -- as an end market, has that been more resilient during this downturn?

Yes. It has been a little bit more resilient. So first of all, as I said, the commercial vehicles business in China has been holding up well. And then in Europe and North America, the decline has been lower. It's still very significant year-over-year, negative sales, as you can imagine. But the decline has been not as much as pronounced as what we have seen in light vehicles.

That's good to hear. And then just focusing on China just for a second. So obviously, you mentioned things have rebounded there first. Do you believe the recent improvement is sustainable? Are there some risks over there?

We believe there are some risks because the rebound way beyond expectations in Q2 is, we believe, is driven by very significant stimulus programs so that people are incentivized in a big way to buy a new car. That's also what our team in China is telling us. We believe that the Chinese government has done this with a good reason because there were some still big concerns about the growth of the China economy after the very big hit by the coronavirus crisis in the first quarter. There might not be a need to do as much as they have done over the last few months during the whole second half of the year, and that would probably result in somewhat of a correction. That is our current baseline view. No correction in a way that it would fall off dramatically again. That's absolutely not what we expect, but probably run rate volumes that are a bit lower in the second half of the year than what we see now in Q2.

Understood. Shifting maybe a little bit to industry dynamics. What's your latest view on diesel penetration going forward?

So our diesel business was down substantially in 2019, 17% organic decline. We said before the year started that we would expect that decline to be more moderate, to be not as aggressive in 2020. And that's also what we have seen in the first 2 months of the year. As you know, most of the diesel business is European business, and the coronavirus crisis didn't hit Europe yet in January and February. And the rate of decline was certainly only half as high as what we have seen in 2019, because in '19, we had the 17% decline. You could get that, you could go back to our earnings at least every single quarter, so very consistent. So we saw a step change there. But then, of course, that rate of decline was completely irrelevant starting in March because with the overall car production going down, the rate of decline and our sales was going down. Therefore, it might make more sense to look at diesel penetration in European car sales. And it looks like it went down approximately 5 percentage points for Europe last year, and it's currently expected to be down another 3 to 4 percentage points this year. But I think it's still very difficult to say, as hopefully the industry is getting somewhat out of the crisis in the second half of the year, what the impacts on mix are going to be. There are a lot of dynamics there because there were some expectations that the OEs would probably push a bit more diesel sales in 2020 because a diesel engine contribute better than a gasoline engine to meeting the CO2 emission norms. And these norms in Europe, specifically, are new and much more stringent starting in 2020. So a bit of a higher diesel penetration would help the OEs to get there. But we also don't know if that was their game plan mostly for the first half of the year only and that they would come back on that in the second half of the year once they have more hybrid engines or more hybrid vehicles and also some more battery electric vehicles ready for launching in the second half of the year. All of this is a little bit more unclear, I think, with the crisis. But the short answer to your question is we expect for declines in diesel. There's no doubt about it this year and also in the coming few years. We think that the diesel penetration can go down to probably around 20% in Europe by 24%, 25% from just over 30% probably this year.

And can you just remind us on the shift impacts here?

Well, the shift impact us in a way that the shift has a negative mix impact on margins, because margins on gasoline products are lower than on diesel products for 2 reasons. First of all, the gasoline turbochargers have more metal content, specifically nickel. And that is required because the temperature and the gasoline turbocharger is much higher than in a diesel turbocharger. And you cannot make your average margins on pure metal because the shoot cost themes at the OE customers understand that and get that. And we'll give you feedback on this when you are quoting. Second, there is less technology content, at least today in a gasoline turbocharger compared to a diesel turbocharger. It's more basic, what we call waste gate turbo technology. There is a trend change there that gasoline turbochargers are evolving towards the same technology as diesel turbochargers, which is called the variable nozzle technology. So that would increase the average sales price, that will increase the average sales price of a gasoline turbocharger, and that will also be accretive to the overall margins and reduce the gap of margins between gasoline and diesel over time. But that's going to take a few more years. Many of the gasoline programs currently bet, or I would almost say most of them that we are currently betting on globally are these VNT, these variable nozzle technology programs. But we know there is a gap of approximately 4 years between quoting or winning a business and starting production. So it's definitely a trend, but it's going to take a few more years before we see the benefits from that.

Okay. And I guess then shifting gears through margins specifically in the near term. How are you thinking about decremental margin in the second quarter and over the rest of the year?

We've done a lot of efforts, honestly, in the second quarter to flex the cost as much as possible, as everybody would expect us to do given the decline in revenue that we have seen specifically in Europe and the U.S. There has been a need to flag the cost, also the fixed cost as much as possible by implementing short-week schedules, by reducing contract service workers, all kinds of professional services and all kinds of discretionary spend as much as possible and the short work schedules probably being the biggest contributor there. So we believe that the decremental margins, year-over-year and sequentially, are going to be much better than what we have seen in Q1. And we also mentioned that basically during the Q1 earnings release. As we go into the second half of the year, we should continue to see benefits, probably less from these short work schedules because you cannot keep put people on furloughs or force them into state-funded layoffs if volumes keep picking up. Because even if you are dealing with negative growth year-over-year, there are some limits to what extent you can drive that. And on the other hand, we are looking into more structural cost reductions, some restructuring programs, obviously, because it's going to take time before the overall industry is coming back to 2019 programs. So we are targeting to implement some structural cost reductions in the second half of the year. But most of these benefits are going to come, I think, in Q4 and in 2021.

And you've historically trended in this 18% to 20% EBITDA range. What should we expect as normal going forward if volumes don't bounce back to these historical levels?

Yes. Let's project ourselves in 2022, where we believe we are comfortable with more new launches coming and assuming that the industry is gradually going to further recover, probably the auto industry might not be back yet at 2019 levels in 2022. There is a wide range of forecast there. But let's assume the auto industry is not yet back. We are comfortable to say that at least our sales should be well above 2019 again by 2022 with new product launches. But at the same time, you will have some of these mixed shifts further working through and these mixed headwinds. Because, as I said, we expect the diesel sales or the diesel penetration in Europe to further decline, and we also expect that the gas launches are going to add more volume. So the overall mix headwinds will remain. I think if you mix the two by 2022 with higher volumes than in 2019, we should probably be back at the average margins that we have seen, as a minimum, I would say, in the second half of 2019. And our margins in the second half were 17%, 16.5% on adjusted EBITDA. Maybe with a little bit of volume leverage, depending upon where we end with the top line and with our volumes in 2020, maybe more on the high end of that. That's how we currently think about the rebound in margin.

That's very helpful. Let's shift maybe to some of your covenants discussion and as well like some of discussions with Honeywell. What is the latest status regarding you covenants release discussion? How has the Indemnification and Reimbursement Agreement with Honeywell impacted that process with your lender?

Yes. So we launched the credit agreement amendment process about 3 weeks ago, and we are very glad that we brought it to conclusion very recently this week. So I think there will be an external communication tomorrow that we basically concluded the credit agreement amendment pretty much in line, I would say, with how we target it and how we propose it to the banks and to the lenders 3 weeks ago. During that -- what does it mean basically? It means a few things. It means that the overall leverage covenant is going to be redefined and that the leverage ratios are going to be reset, taking into account the reality of the recession and the crisis in the overall industry. That's one thing. There are a few other changes to the credit agreement that are maybe more detailed in the big picture. But the amendment also means that we are deferring our payments to Honeywell for the indemnity obligation, the asbestos indemnity obligation. Still, we are not breaching the original covenant anymore, and we believe that this could take up to 2 years. That's the way how it has been positioned at least. It can be faster if everything comes back faster than we currently projected, but it might take up to 2 years. So Honeywell obviously picked that up, that this is part of the amendment, and they didn't react for a while to that because they thought that by doing this, we are creating what they call a cross-default in the indemnity agreement from changing our credit agreement, which is something that we really didn't understand why they reacted as such. They even issued, as you might have seen, a notice of default to Garrett. Because of that, we tried to explain them that the whole credit agreement amendment has nothing to do with that and that the deferring -- the deferral of the payments, basically, during the amendment process just was included as such in the original agreements between us and them. It took them some time, I believe, in order to agree and to accept that. In our understanding, they will withdraw officially the notice of default once we come out with our credit agreement amendments probably as soon as tomorrow. So that is basically what we have been going through. And that is basically what it means with respect to the indemnity obligation payments to Honeywell.

Okay. That totally answers a few other questions. So in terms of latest status regarding those payments to Honeywell, so the idea is potentially up to 2 years until the next one. And these would essentially be consistent with your new covenants.

Yes. That's right.

Okay. And I guess, separately, or maybe it's not all that separate, but what are the latest development in respect to Garrett's lawsuits against Honeywell? How will this -- does this ongoing litigation impact your financials or -- especially in the current environment?

The lawsuit was filed at the beginning of the year. There were in preparation to that, of course, quite a bit of legal costs incurred in 2019 mostly. There has not been a whole lot of activities since the beginning of the year because with the coronavirus crisis, taking into account that the case is treated by the State Court of New York, there has not been a lot of activity since March, I would say. Honeywell also suggested that we would basically bring the litigation to a standstill during the whole amendment period, which would be 2 years. We didn't agree with that because we strongly believe that there is no connection between the credit agreement amendment and the litigation. We just agreed with them that, from both sides, we would limit the spending on the case to a small number and, as such, not add more financial impact on a difficult business year as 2020. But overall, the discovery process can develop from here. We will continue with it. And that's how we expect it to develop during the rest of the year.

I appreciate the updates. One other question from investors on the line. Can you provide any updates on your liquidity and expected cash burn for the remainder of the year? Do you view your current liquidity levels as sufficient? Would you look to raise additional capital if necessary?

Yes. Yes. The answer is a simple no. We believe we have the right liquidity to manage through the crisis. We said that during our Q1 earnings release on May 11, and we can confirm that today with everything that we know. We have a very strong handle on forecasting cash and liquidity on a weekly basis for the rest of the year. So we truly believe that this is correct. We are going to burn quite a bit of cash, though, in Q2. There is no doubt about that, specifically from working capital. We are running the company with very low working capital levels normally, even negative at the end of last year if you take the addition of trade receivables, inventory and trade payables. And having such a low working capital level is great. But when your revenue drops substantially, working capital becomes a use of cash. And that's what we are seeing specifically in Q2 because our collections from customers are going down substantially with the drop in sales starting in March in Europe and in North America. Our collections in May and in June are going to be much lower, obviously. That will be partially offset by lower disbursements to suppliers. But that benefit is only going to come in the third quarter because we have longer payment terms with suppliers than what we have with customers. And also on inventory side, this piece of working capital remains a headwind on cash because, I said it before, managing inventory with all the uncertainties is suboptimal. You have less forecast accuracy from your customers. You're trying to find the right balance between not ordering too many components but ordering enough so that you could definitely still produce and deliver the turbochargers in case the demand is there. We also are having too much of raw material or components inventory because of what we ordered basically at the beginning of the year before everything went down substantially. Starting in March, we have a pretty long supply chain, by the way, from China to Europe and to North America, to the most extent, as we are sourcing a large percentage of our components from China. So I'm saying that we definitely are confident to manage through with the liquidity that we have. Q2 is going to be a difficult quarter from a cash perspective. But it should gradually get better again, assuming that the business and that the demand picks up, as I described, at the beginning of the conversation in the second half of the year.

Great. And I guess maybe to conclude, just a couple of questions on the technology side. It seems fuel cell is garnering quite a bit more traction, especially in Asia this year where we hosted the CEO of Nikola for a presentation yesterday. And I think that's very close to 3,000 investors tuned in to listen in. What are you doing to position the company for this potential opportunity? And when do you think you could see some business booking?

Yes. So we are definitely believers into fuel cell. Since many years, we are working together with a Japanese OEM on producing fuel cell compressors, which is the main component for, call it, a fuel cell power train. And the compressor needs a very specific technology based on air bearings, which is something that we inherited from the Aerospace Division when we were part of Honeywell. So I think we have an advantage there on the technology side compared to many other companies we are looking at. So we are working together with a few OEMs, mostly in Asia, both on the LV and on the CV side, because we are believers. As I said, we are developing the product and bringing it to, what I would call, the second-generation by taking out cost and making it ready for not a high volume but higher volumes than what we have done so far. Also some of the European OEMs, I think, like BMW, has been very vocal that they are believing into fuel cell as the technology for the future. So it's small now. It's probably still going to be slow in all transparency and 5 years from now, but fuel cell definitely could be something bigger by 2030 and beyond. And not too many companies are ultimately going to be successful into it. So it's worth investing some reasonable R&D dollars into it given the edge that we have, again, from the inheritance of the technology from Honeywell -- from Aerospace and Honeywell. We also have some customers who are willing to support us with some R&D funding. So we -- it's one of the key technologies that we want to keep going for in the future given our current position.

And then maybe just finally in terms of future technology, hopefully not quite as far out. Do you remain on track for the launch of the E-Turbo in 2021? How does this technology differ from what is currently in the market?

Yes. It's -- and E-Turbo is basically kind of a turbocharger with an electric motor. And it's really mostly made for hybrid vehicles, for plug-in hybrid vehicles and, in a first phase, probably more for the high-end plug-in hybrid vehicles. So the more luxury part and the more expensive engines in that segment. And that's where we are planning a launch beginning of next year. We are working on a few other programs that could be higher volumes with high-end hybrid application customers at this point in time. It's going to be a little bit of a niche product for a few years to come for sure. But typically, what you see is once you get an adoption rate in that segment, it can further develop probably to the mid segments of the plug-in hybrids. And I think it's -- as far as we know, it's only us and BorgWarner, for the time being, working on it. So if it develops, it could be accretive, both on the revenue side and on the margin side. So I think what I want you to know is that it's moving. Some customers are really believing into it. It's not going to be a huge needle mover again in the coming 5 years. But just like fuel cell, this could definitely be something that is interesting on the technology and, therefore, on the margin side in -- between 5 and 10 years from now.

That's great color. Listen, looks like we're just about out of time. So Peter and Paul, I really want to thank you so much for being with us at our conference, for all your insights and answering the questions. I want to thank all the investors on the line for participating, for submitting your questions. Stick with us. Our next presentation is in 10 minutes with Sarens. And again, to the Garrett team, many, many thanks.

All right. You're welcome. Thanks for your questions.

Thanks, Emmanuel. Bye.

Thanks, everybody. Thank you. Bye.