Garrett Motion Inc. Q3 FY2021 Earnings Call

My name is Towanda and I will be your operator this morning. I would like to welcome everyone to the Garrett Motion conference call. This call is being recorded and a replay will be available later today. After the Company's presentation, there will be a Q&A session. I would now like to hand the conference over to Paul Blalock, Garrett's Vice President of Investor Relations. Sir, you may begin.

Good day and welcome everyone. And thank you for joining the Garrett Motion, Third Quarter 2021 conference call. Before we begin, I would like to mention that today's presentation and earnings press release are available on the Garrett Motion website at garrettmotion.com, where you will also find links to our SEC filings along with other important information about our Company. Turning to slide 2, we note that this presentation contains forward-looking statements within the meaning of the Securities Exchange Act. And we encourage you to read the risk factors contained in our filings with the SEC, become aware of the risks and uncertainties in our business and understand that forward-looking statements are only estimates of future performance and should be taken as such. The forward-looking statements represent management's expectations only as of today, and the Company disclaims any obligation to update them. Today's presentation also includes non-GAAP measures to describe the way in which we manage and operate our business. We reconcile each of these measures to the most directly comparable GAAP measure and we encourage you to examine those reconciliations which are found in the appendix to both the press release and the slide presentation. Also in today's presentation and comments, we may refer to light-vehicle diesel and light-vehicle gasoline products by using the terms: diesel and gasoline only. With us today is Olivier Rabiller, Garrett's President and Chief Executive Officer, and Sean Deason, Garrett's Senior Vice President and Chief Financial Officer. I will now hand it over to Olivier.

Thanks Paul. And welcome everyone to Garrett's Third Quarter 2021 Conference Call. I will begin my remarks on Slide 3, where we provide our Q3 highlights. During the third quarter, we continued to benefit from the strong demand for Garrett differentiated technologies and showed demand gains. Market activity and demand for our differentiated technologies continues to accelerate as the industry has rebounded from the suppressed levels we saw last year as a result of the COVID-19 crisis. Our reported net sales for the quarter totaled 839 million, an increase of 4% year-over-year. And on a constant-currency basis, our net sales increased by 2% year-over-year, significantly outpacing global auto production by approximately 19 percentage points, driven by shared demand gains in gasoline, primarily in China and North America. While we continue to see positive momentum in the demand environment from our customers on a year-over-year basis, volumes in the quarter were impacted by the widespread supply chain disruptions being felt across the global auto industry. In particular, global semiconductor shortages remain a headwind across all product lines as many OEMs were forced to slow their production. These global supply chain challenges are further compounded by inflationary pressures driving raw material transportation and logistics costs higher. We anticipate these headwinds to persist in the near term before stabilizing at some point in 2022. And we intend to mitigate the supply-side constraints by leveraging our global operating platform as we have done in the past. For the Third Quarter, we delivered an adjusted EBITDA of 174 million representing a margin expansion of 105 basis points to 16% as compared with last year. Our success in preserving robust industry-leading margins in a volatile macro-environment reflects an improved mix, as well as our unmatched global footprint supply base and valuable cost structure. These early months enable Garrett to quickly adapt to market disruptions and ensure our production levels are in line with any changing customer activities. Going forward, we will continue to build upon our long-standing track record of operational excellence to optimize our performance globally and further distinguish Garrett amid the current macro headwinds. On September the 30th, we announced amendments to our Series B preferred stock, which is a first step in liberating our balance sheet while enhancing our financial flexibility. The more favorable terms provide us with additional flexibility to optimize our capital deployment strategy as we remain focused on creating long-term shareholder value by pursuing organic and inorganic growth opportunities. We also eliminated any near-term liquidity concerns and refinancing risks, and we expect to redeem approximately 213 million of Series B shares prior to the end of the First Quarter of 2022. On the slide, Garrett continues to win in a volatile macro-environment, even with significant short-term headwinds in the global supply chain as Sean discussed. Indeed, we are continuing to monitor raw materials as well as transportation and energy costs. And we expect this disruption and higher inflation to carry into 2022. We remain focused on execution in this difficult environment while maintaining our technology leadership. I mentioned earlier our industry outgrowth for the quarter, and this is reinforced by the continuation of a solid new business win rate, which has exceeded 50% year-to-date, aligned with previous years. The continuation of a strong win rate ensures continued growth of our share of demand in the years to come and the predictable outlook for revenue and cash flow. We are also investing more and more in electrification and software. In fact, approximately 40% of our year-to-date R&D spending has been dedicated to new technologies as we pivot our unmatched capabilities to electrify vehicles. Last quarter, we mentioned that our innovation was acknowledged by Automotive News, and we were announced as a winner in September. We are proud of this recognition from Automotive News for our advanced capabilities in high-speed motors, high power density and switching frequency investments, as well as motor control software, providing a launching pad into the electrification arena for Garrett. This technology is expected to be introduced next year for the first time in Mercedes AMG premium hybrid vehicles, demonstrating our capability to bring advanced electrification technology to market. As new technology continues to drive the industry transformation, Garrett's long-standing story of pioneering new technologies will spell new growth opportunities for the benefit of the Company and shareholders. With that, I will now turn you over to Sean to provide more color on our Q3 results.

Thanks Olivier, and welcome everyone. I will begin my remarks on Slide 5. During the quarter, Garrett reported net sales growth of 4% on a reported basis and 2% at constant currency. Our performance for the quarter reflects strong growth in commercial vehicles and aftermarket volumes, which were partially offset by lower diesel volumes. As Olivier mentioned earlier, volumes across all product lines were adversely impacted by the global semiconductor shortage. These global shortages resulted in major OEMs being forced to alter their production levels causing Garrett's net sales to decline on a sequential basis by 10%. Adjusted EBITDA for Q3 2021 increased 12% year-over-year to 134 million, which equates to an adjusted EBITDA margin of 16% and 105 basis points of margin expansion, as we were able to improve our profitability due in part to favorable mix while managing through a volatile macro environment. In Q3, our adjusted free cash flow was a use of cash driven by a use of working capital as global chip shortages led to lower unit growth. We will discuss the factors impacting our working capital in the quarter on a later slide. Our year-to-date adjusted free cash flow conversion rate is 77%, equating to nearly $200 million of free cash flow, reflecting our ability to generate cash in a volatile macro environment. Lastly, we reported adjusted net income, which excludes reorganization items, debt exposure, restructuring costs, and stock-based compensation for the third quarter of 2021, of 65 million, an increase of 8% year-over-year. Overall, Garrett's strong Q3 results demonstrate our ability to grow while managing the various headwinds in the supply chain-challenged inflationary environment. Turning to Slide 6, we break down our net sales bridge for the third quarter and provide net sales by product category. In Q3, gasoline products were essentially flat compared to the prior year, representing 39% of reported net sales. With a ramp in volumes in North America and other regions, partially offset by semiconductor shortages in Europe. Sales of diesel products decreased by 5%, mainly driven by the impact of semiconductor shortages also primarily in Europe. Sales of commercial vehicles increased by 10%, primarily driven by the continued recovery in demand following the pandemic-related disruptions experienced in 2020, including a ramp-up in volumes driven by new product launches in Europe and increased off-highway business in North America, which offset a market decline in China following the implementation of China 6A Emission Standards for heavy trucks, which became effective last July. Aftermarket products grew 22%, primarily driven by North America off-highway business along with service replacements following the pandemic-related disruptions. We continued to see the impact of limited chip supply on OEMs, which have placed greater emphasis on producing larger, more profitable vehicles that generate higher margins. This trend, while we believe to be temporary, led to the delivery of fewer products for smaller gasoline and diesel engines in Q3, while our higher-margin businesses in commercial vehicles and aftermarket performed well despite the challenging environment. The overall FX impacted 18 million in Q3 was primarily driven by a stronger dollar to euro exchange rate versus Q3 of 2020. On slide 7, you see our adjusted EBITDA walk for Q3 2021 as compared to Q3 2020. For the quarter, Garrett's adjusted EBITDA increased 12% year-over-year to 134 million due to improved profitability as a result of a more favorable product mix and productivity gains, which more than offset pricing impacts. In the third quarter, our volumes totaled 3.1 million units, down 1% compared to the prior year, and down 8.8% sequentially as a result of global chip shortages. Our adjusted EBITDA margin in the quarter of 16% represented a year-over-year improvement of 105 basis points. In addition to improved profitability from sales made, the Q3 2020 also benefited from temporary cost control actions totaling approximately 5 million to mitigate the impact from COVID-19 disruptions. Productivity remains a priority in this environment as we are seeing higher freight costs as a result of supply chain disruptions and rising commodity costs. We continue to mitigate the impact of rising inflation through our customer pass-through clauses for commodities, especially for nickel, but less so for aluminum and steel. For the quarter, our SG&A expense increased 3 million after adjusting for approximately 44 million in strategic planning costs for the third quarter of 2020, leading up to our Chapter 11 filing. In addition to the 5 million in 2020 of cost control actions I just mentioned. R&D expenses increased 5 million as we continue to invest in new growth opportunities, our FX was a 2 million benefit to adjusted EBITDA versus the prior year. Turning now to Slide 8, you can see the walk from adjusted EBITDA to adjusted free cash flow in the quarter. At Garrett, it's important to note that our normal working capital balance is negative. While working capital was a source of cash in Q4 last year and in Q1 of this year, the impact on volume from a global chip shortage resulted in working capital becoming a use of cash in Q2 and Q3 of this year. As a reminder, Garrett's high working capital turnover historically provides a source of cash on an annual basis. However, in the current environment with rapidly declining volumes, our customer collections were down in Q3 and were only partially offset by lower disbursements to suppliers. The benefit from these lower disbursements will most likely take effect in Q4, given the payment terms for us suppliers are longer and typically extend approximately 60 days over collections. So the timing of payments between our customers and suppliers had a significant impact on our working capital in Q3. To a lesser extent, our adjusted free cash flow in Q3 was impacted by higher capital expenditures as investments increased by 18 million year-over-year as our business continued to recover from the COVID-19 lows. For the current fourth quarter, we show how our adjusted free cash flow is expected to total approximately 110 million based on the midpoint of our updated 2021 guidance, which we will discuss in more detail shortly. Turning to slide 9, we ended the third quarter with available liquidity of 752 million, including 456 million in restricted cash and approximately 296 million in undrawn commitments under our 300 million revolving credit facility. As a reminder, on September 30th, we announced the amended terms on the Series B preferred stock, which results in the holders agreeing to defer their rights to require Garrett to repurchase all of the Series B shares until December 31st, 2022. These amended terms provide Garrett with improved short-term financial flexibility, as we utilize our strengthening financial position to pursue organic and inorganic growth opportunities. In connection with the amendment, Garrett will partially redeem the Series B shares prior to the end of the First Quarter of 2022, resulting in a cash payment of approximately 213 million as of January 1, 2022, and helping to further improve our leverage ratio. Following this payment, the present value of the remaining scheduled redemption payments on the Series B shares will be approximately 400 million. All other material terms and conditions of Series B remain unchanged, including the scheduled redemption payment by Garrett of 34.8 million due April 30, 2022. As of September 30th, 2021, our net debt to consolidated EBITDA ratio was 1.32 times or 2.55 times, including the Series B preferred stock. This represents a notable improvement compared to 4.08 times as of June 30th, 2020. Lastly, in the market capitalization table, you could see the recent 2.5 billion of value comprised of our Series A securities and our common shares, positioning Garrett Motion as a solid mid-cap Company. On October 1st, our convertible Series A preferred stock commenced trading on the NASDAQ global select market under the ticker, GTXAP, which we believe will improve the liquidity of the security. We are excited by the progress made to date after emergence from our restructuring and we continue to strengthen our capital structure. Garrett is well-positioned as the market continues to recover in the near term while we focus on our investments in innovative and new products and solutions to address the future needs of the automotive industry. Turning to slide 10, we provide an update to our forecast for the full year 2021. Although we continue to see the demand for new vehicles, inventory levels remain at or near historical lows as we continue to experience the impact of the COVID-19 pandemic and the semiconductor shortage on a global automotive supply chain. As a result, we are marginally revising our forecast for the full year 2021 based on our new planning assumptions. All revised industry outlook accounting for the global supply disruptions assumes global light vehicle auto production growth of 1% to 2%, previously 10% to 11%, global commercial vehicle production growth of minus 1% to 0%, previously 3.5 to 4.5%. Reflecting these new assumptions for global vehicle production, we now see 2021 net sales in the range of 3.6 billion to 3.7 billion compared to our previous guidance of 3.7 million to 3.9 million. This would represent an increase of approximately 14% to 17% at constant currency, compared to growth of 18% to 22% under our previous guidance range. Our revised guidance still supports mid-double-digit industry outperformance. Adjusted EBITDA for the year is less impacted and is now expected to range between 590 million and 620 million as the low end of our adjusted EBITDA range remains unchanged. In addition to chip shortages reducing global vehicle production volumes, we expect raw material and energy costs to remain elevated through the end of the year and into 2022. Despite these challenges, our implied adjusted EBITDA margin for 2021 remains strong, ranging between 16.4% and 16.8%. Our R&D budget as a percentage of net sales remains consistent at approximately 4.5% for the year, while capex is currently expected to range between 2.5% and 3% compared to approximately 3.5% previously due to the timing of non-essential capital expenditures. As a result, we now anticipate adjusted free cash flow to be between 280 million and 340 million compared to the previous range of 300 million to 400 million as ongoing chip shortages contribute to unit contraction and increased working capital levels. Despite the revised outlook and reduced profitability outlook, we are confident in our ability to generate healthy cash flow conversion and expect adjusted free cash flow conversion of approximately 100%. We will continue to invest in our strategic growth initiatives, and we do not expect the near-term industry challenges to dampen our long-term outlook and focus on enhancing shareholder value. With that, I will now turn the call back to Olivier.

Thank you, Sean. I will close with some final thoughts. Garrett's strong net sales performance for the quarter demonstrates the continued demand for our advanced technology and ongoing share of demand gains highlighted by a customer win rate exceeding 50%. Our Q3 net sales growth of 2% at constant currency outpaced global auto production by 19 percentage points. Although our volumes for the quarter were impacted by global supply chain disruptions, we drew upon our flexible operations and global capabilities to mitigate these macro headwinds and push through the robust Q3 adjusted EBITDA margin of 16%, a testament to our strong business model. We also took steps to further strengthen our balance sheet on favorable terms and show flexibility by amending our Series B preferred stocks under favorable terms. Although the challenging macro environment led to a revised forecast for 2021, the low end of our adjusted EBITDA guidance remains unchanged. Our focus remains on execution, and I am encouraged by our strong ongoing win rate, which we see as both a driver of our future performance while we continue to invest in new technologies. I really want to share my appreciation for our teams around the world, who have done exemplary work under such difficult conditions. With that, I will hand it back to Paul.

Thank you, Olivier, and operator, we are now ready to open the call for questions.

Thank you. As a reminder, ladies and gentlemen, that star one to ask a question. To withdraw your question, press the pound key. Again, it's star one to ask a question. Please stand by while we compile the Q&A roster. Our first question comes from the line of Hamed Khorsand with BWS Financial. Your line is open.

Good morning. So I just wanted to get an understanding of what you're seeing from an ordering standpoint from your customers and OEMs. Is it really just everyone's telling you just hold off on orders or are they still planning different products with you? What's happening now that given this kind of pause in production?

That's a very interesting question. What we usually get from car makers is a forecast over a few months, and that forecast gets revised every week and sometimes multiple times a week. What we have seen for the past at least six months is very high volatility between what they say they will do and what they actually do. So what we are doing, and so far we have done quite well at that, is to second-guess the forecasts of the car makers, so that we do not get trapped into these situations where they overestimate what they will produce. As a result of that, we end up producing too much, and they are not picking up the goods. So we have been entering into that second-guessing exercise for the last months. What we see is that our focus seems to be reliable and more reliable than what we gather from the market.

Okay. And then as far as the discussion on next year's concern, where is the industry going as far as your turbochargers are concerned? Are you seeing still a continuation of elevation of your higher-margin turbochargers in discussion? Or is it more on a lower-end side?

So first of all, for us, we have very strong underlying macros supporting our demand and share demand gains. As you can see, we are strongly overperforming versus the industry, and this is evident in the increasing percentage of turbochargers on vehicles. The crisis is not impacting the turbocharger industry. The turbocharger industry is performing relatively better than the rest of the industry. And we are performing better than that because we have strong demand. All of that obviously will come back; it's just delayed demand, and we see it coming back stronger than the industry later on as the industry normalizes. What we are seeing for next year is consistent with what we hear from others in the industry. We estimate that the first half of 2022 will be significantly impacted by the semiconductor shortages. However, once again, this is temporary as underlying demand remains strong. The regions vary: in the U.S., there is still a favorable trend towards producing higher-margin products; however, in some other regions of the world, the focus is less pronounced than what we've seen in the U.S.

Okay, great. And my last question is just given your commentary about the current productions stoppage and pause, what's leading to your Q4 revenue being implied that it's going to be up sequentially?

It's mostly due to launches that we've scheduled. We've indicated that from the beginning of the year. We are seeing these launches, and therefore, the increased demand is making our volumes go up, even if the overall industry stays relatively flat in Q4 in comparison to Q3.

Thank you. Our next question comes from the line of Chris McIntyre with McIntyre Partnership. Your line is open.

Hey guys. I was just curious if we could talk a little bit or you guys could provide a little color on the D&T launches into 2022. How should we think about the cadence or any impact there might be on margins?

That's an interesting question, Chris. Thank you very much. We are gathering volumes and are optimistic about that. The reason is that those recaps are more optimized from a CO2 perspective. As you see, Garrett's focus today is on optimizing our operations globally, particularly outside the U.S., to maximize those opportunities. We are pleased to see strong demand, especially in Europe and China.

Okay. Would you say, do you think you're coming in on the plan with that sort of estimate or above or below?

We're on track with those plans.

On point. Okay. And then, just separately, when we think about capital allocation and changing how we're going to pay out for shareholder value, it makes some sense, but at some point in the next 12 months, we should be rolling forward on cycle. It's a rather de-levered, high cash flow generative business that's growing rapidly above market. When should we expect further guidance around that?

Hi, this is Sean Deason. For capital allocation, as we announced prior to this call, we are partially calling the Series B, and that will take place in Q1 of 2022. That's just a testament to the strong cash flow generation. This quarter, obviously, the working capital had an impact, but the business fundamentally is strong, and I would note that cash flow use this quarter is temporary. We will see a bit of a rebound in Q4, as Olivier mentioned, with some product launches, so volumes will be slightly up versus Q3. And in 2022, it will be slower in the first half but stronger in the second half. We will get that working capital back. The partial repayment is a strong first step toward an ultimate goal of moving to a one class of share and one class of debt; a very normalized capital structure. Currently, if we look at things, we expect things to happen at the latest by April 30th, 2023, when we meet all of our necessary covenants to automatically convert the Series A, assuming that the Series B is fully repaid at that stage. In general terms, our first priority is from the business; we are ensuring that we're investing in new technologies that will differentiate us as the industry electrifies. The second priority is to normalize our capital structure, and the third priority is, and this is what we discuss with the board regularly, is to determine our best alternative for returning the remaining value to shareholders. We continue to have those discussions, and the partial repayment is a good first step. We'll update you regularly each quarter in these calls.

Okay. Do you guys have thoughts around an Analyst Day at all? Just kidding.

There will be opportunities for us to explain more of the strategies we have from an investment standpoint when it comes to the product, and to differentiate the technologies we are working on. We want to share this with a broad range of people, but it's a little bit too early to specify when we will do that.

Okay. Cool. Great. Well, I appreciate the call. Thanks.

Thank you. I'm showing no further questions in the queue. This concludes today's conference call. Thank you for your participation. You may now disconnect. Have a wonderful day.