Honeywell (NYSE:HON) is scheduled to spin off its transportation systems unit on Oct. 1, calling the new business Garrett Technologies in honor of one of the company's earliest turbocharge developers. Investors will receive one share of Garrett for every 10 shares of Honeywell that they own; in the future, the new company will trade under the ticker symbol GTX.
What is Garrett? Garrett designs and manufacturers turbochargers for OEMs and the aftermarket, along with electric-boosting and connected-vehicle technologies. The company has 13 engineering facilities and 13 factories around the world, and it has local presences in many fast-growing countries, including India and China, helping situate it close to its major customers, the OEMs.
While Garrett has been under the Honeywell umbrella for years, many investors may not know that much about the company. Here are three things that you should know as the company is spun off.
1. Turbochargers are a key engine component for the future
Turbochargers aren't just for accelerating quickly -- they actually improve engine function in a number of ways, including improving drivability and increasing power. But they're also useful for decreasing CO2 emissions and boosting fuel economy, two key areas where consumers and governments are demanding improvements. Those demands are only going to grow in the future, putting Garrett in the driver's seat.
Such demands have helped Garrett put up 7% organic sales growth in the first half of 2018, and should help the company continue to grow over the next half-decade.
Management anticipates sales growth of 4%-6% through 2022. This revenue visibility is helped by the long lead times required to become established as a supplier, and the fact that OEMs set up only one supplier per engine because of the highly customized nature of turbochargers -- so getting "locked in" to a product is important, since it provides a more defensible position.
Moreover, Garrett also benefits from favorable tailwinds from the growth of cars and the increasing use of turbochargers, even taking advantage of the sharp rise of the electric hybrid segment.
2. Financials looked mixed for now
Despite its attractive operating characteristics, especially for an incumbent provider, Garrett has a mixed bag in terms of its financials. The good news: The company has negative operating working capital. In other words, its suppliers provide the working capital needed to run Garrett's business. That's a very attractive feature.
For most businesses, growth requires investing more money into working capital. In Garrett's case, however, suppliers more than offset its investments in inventory and accounts receivable. For the first half of 2018 Garrett had net negative working capital of $425 million.
On the negative side, Garrett has a fairly high level of debt coming out of the spinoff. The company is taking out $1.66 billion in debt, and kicking up a dividend of $1.63 billion to Honeywell. With consolidated EBITDA of $513 million over the last four quarters, Garrett's debt-to-EBITDA is a bit too high at 3.25 times. So one of the company's priorities over the next couple of years is to move gross debt down to around two times EBITDA. That puts a buyback or dividend on the back burner for now.
3. Garrett is on the hook for asbestos payments
Here's a nasty little surprise, though: Garrett must make quarterly payments to Honeywell as part of Honeywell's ongoing asbestos liability. Garrett currently carries a liability of $1.32 billion on its books, representing 90% of Honeywell's asbestos obligation.
It's important to note, though, that while Garrett is footing much of the bill, the legal liability remains with Honeywell. The two companies have a 30-year agreement, and Garrett will not have to pay more than $175 million in any one year.
While this is a surprise, it's useful to think of it as another expense on Garrett's income statement. However, these payments will not be tax-deductible. So that's another wrinkle in the situation.
Is Garrett a buy?
Whether it's a buy is not clear yet, because regular trading has yet to establish its price. However, the stock is now trading in the "when issued" market at the price of $16.76, and the company has an enterprise value of about $2.8 billion -- so the stock's trading at 5.5 times EBITDA. That multiple is broadly in line with the multiples of peers; but Garrett looks like a better business, at least on the surface, with management expecting EBITDA margins of 18%-20%, better than those of rivals.
Still, for the moment, the when-issued stock is very thinly traded, and whether it goes up or down in the short term has a lot more to do with post-spinoff trading dynamics than the company's long-term success.