Garmin (NYSE: GRMN)
Is There Enough Value for Private Equity?
Download my LBO model of Garmin here
A global leader in wireless and wearable technology, Garmin has been a household name for decades primarily due to its personal navigation devices (PNDs). However larger tech companies have been taking significant market share from Garmin over the last decade, as reflected by the growing popularity of products such as Google Maps and Apple Watches.
Yet, Garmin’s recent financial performance does not reflect these trends. The company has seen accelerating revenue growth pre and post-pandemic as well as operating margins at roughly 20-25% for over five years now, surpassing peers at ~15%. This is due to a diversified business model as Garmin makes money in five ways.
- Fitness: running and sport watches, cycling accessories (31% of sales)
- Outdoor: outdoor watches, golf devices (sensors, simulators), dog training devices (26%)
- Aviation: flight navigation devices (14%)
- Marine: marine navigation and communication devices (18%)
- Auto: PNDs, cameras etc. (12%) -> further segmented into consumer auto (7%) and OEM (5%)
Garmin’s fitness segment has seen signficant growth in part due to COVID-related lockdowns increasing demand for wearable fitness technology. However, I believe the company has little to no sustainable competitive advantage in this segment especially considering that competitors like Apple have capitalized on cross-selling watches to their iPhone customers. Their auto segment is even less promising as I think that the threat of new entrants is simply too high for most investors to be convinced in its long-term viability. The segment, which once comprised 70% of GRMN’s revenue, makes up <12% today and both revenue and margins have been shrinking for years. It comes as no surprise that PNDs are gradually being rendered obsolete given that apps like Waze or Google Maps are more accurate and free to use.
However, the company has many redeeming qualities as well. As reflected by the company’s quick pivot away from PNDs in the last decade, the management team has proven to be extremely adaptable and has continued to optimize for profitable growth by expanding high-margin segments like marine, aviation and outdoor products. Despite making up roughly half of sales, 8 of the last 11 acquisitions have been in these segments. This fast pivot has been possible through vertical integration; the costs of coordination are high when manufacturing Garmin’s products so by controling the manufacturing and distribution of all its products, the company can adapt well and grow nascent segments more aggressively. Furthermore, the company maintains ~30–40% operating margins for these segments, reflecting the superior pricing power and brand name that the PND segment has historically helped the company cultivate.
For Garmin, the
- mission critical nature of marine and aviation communication
- superior supply chain
- first mover advantage with regards to outdoor watches
- ability of these segments to generate stable FCF due to high pricing power
- adaptable management team with high insider ownership (~20% of shares outstanding)
are all appealing in the short term.
I should emphasize that the long-term success of this company is still questionable; it remains to be seen how sustainable the marine, aviation and outdoor segments are with the fitness and auto segments hindering overall profitability. However, I believe this risk can be partially mitigated through the transaction structure which I will explain further below.
LBO Model Assumptions
Entry Valuation
The LBO model assumes that Garmin is purchased at a modest 20% premium to its current share price. This is undoubtedly lower than the precedents such as the premium of 70% paid during Fitbit’s take-private deal in 2019. However, Fitbit’s premium is simply too unrealistic in the current macro environment. This purchase price also implies a 12.3x NFY EBITDA entry multiple; in order to be conservative, I will assume no multiple expansion either. This in line with the average 2022 LBO purchase multiple of 12x. Other notable factors affecting the purchase price include negative existing net debt on the Garmin’s balance sheet which may also be attractive to a sponsor as it effectively reduces the purchase price.
Transaction Financing Assumptions
Debt issuance was limited to a revolving credit facility, term loan A and term loan B. Ultimately, the transaction implied a leverage ratio of 7x EBITDA at close, slightly higher than the 2022 average of 6x EBITDA but justified in my opinion due to the larger size of the deal. However, this is also why the LBO’s debt to total capitalization at close of 55% — while low for most LBOs — cannot go too much higher. The $3500mm revolver commitment was estimated using 90% of the firm’s historical current assets. More interesting, however, was the revolver’s interest rate as the SOFR has risen streadily and credit spreads have widened. For example, last quarter, the average term loan spread was SOFR+514bp and given that revolvers are often packaged with term loans during issuance, I estimated a 500bp spread for the revolver as well. The TLB had a higher spread of 800bp, reflecting the historical average second-lien spread. Steep issuance discounts (OIDs) have also been included to reflect reduced investor appetite for junk debt recently.
The structure of the equity investment incorporates significant downside risk protection for the sponsor. First, the management team which previously owned ~20% of the firm’s equity will be able to rollover the vast majority of their shares. As mentioned above, the management team has been able to successfully navigate a business that operates segments in secular decline so I believe it is in any sponsor’s best interest to retain the management team. This also reduces the check size for the sponsor, which will have to be large due to the size of the target company. A co-investment will likely be necessary as well due to this reason. Finally, the sponsor’s convertible preferred stock investment will further reduce downside risk by receiving payment before management and sponsor #2. Additionally, the 10% preferred PIK rate will increase the chance of earning a high IRR. Although this is wider than the spread of both term loans, I may still be understating this interest rate; however I don’t believe this is a material underestimate as the model’s IRR would not change even with a 20% preferred PIK rate.
Financial Forecast and Returns
Financial Forecast
Although revenue growth has historically increased YoY, it is projected to slow rapidly in the coming years as I expect the decline of the auto segment to occur much quicker than analysts expect for reasons mentioned above. The downside of this segment’s decline is mitigated by the fact that it also has the worst margins; therefore, its decline will actually transition Garmin into a higher margin business while EBIT growth will decline.
FCF is increasing each year despite the mandatory debt repayment driving levered free cash flow into negative territory for the first two years. In order to address this issue, the company will have to draw down their revolver which will be paid down by the end of the forecasting period. I am not concerned by the fact that levered free cash flow is negative either as free cash flow before mandatory debt paydown is positive. Therefore, significant debt paydown is still happening through mandatory amortization in the first two years. The only drawback of this model is that interest expense will increase due to the revolver but may still be a small price to pay in the end. If the sponsor can negotiate lower mandatory amortization requirements, then the lower revolver interest will increase IRR further.
Debt paydown is not ideal however. While leverage and interest coverage ratios are generally improving over time, this is in large part due to signficiant Adj. EBITDA growth and not debt paydown as ending net debt reduces by ~10% in the forecast. This means that the company will be forced to bank on rapid EBITDA growth in the future to repay debt, a fact that most sponsors will likely look at as unfavorable .
Returns
Despite no multiple expansion, a sponsor can still earn a 22% IRR. A shorter holding period will increase the IRR but lower MoM; however, it might be difficult to exit the investment soon. Due to the size of the deal and IPO may be a more viable alternative as there may not be many buyers looking to engage in an M&A transaction of this size in this environment. However, given depressed equity markets, a longer holding period may also be necessary for the sponsor.
Conclusion
Contrary to popular belief, my analysis suggests that Garmin is still a suitable LBO candidate and it may still be possible to generate an acceptable IRR and MoM. Would I personally buy and hold Garmin’s shares in the public market? Probably not. However, there is still enough value for a private equity firm to take the company private for a limited holding period. A convertible preferred investment, PIK interest, sponsor co-invest, management rollover can all mitigate downside risk. Furthermore, the company can still explore a sale of its auto and/or fitness businesses to expand operating margins in the short-term and cash earned from the sale can be used to perform a dividend recap or even repay debt early. I believe that Garmin will likely never go back to the growth trajectory it was once on; however, there is still enough to look forward to in the next five years and a skilled operator can still earn a high IRR on this investment.
