Description

Talgo S.A. 

Thesis Summary

Talgo is a Spanish-based niche manufacturer of rolling-stock. The company is undergoing an inflection point: after the end of Spanish investment boom in railway infrastructure (2009) Talgo was forced to expand internationally.

Valuation at 8,5x 2016E EPS implies that market is very skeptical about the company doing so successfully. The share price has declined 40% since the IPO in May 2015. The main view of the market is that Talgo is a tiny player compared with the behemoths of Alstom, Siemens, Bombardier or the Chinese (CSR, CNR) without a meaningful reputation in the international markets.

This is not well understood by the market. Our analysis indicates that:

-          The technology of Talgo trains provides the company with a strong competitive advantage and pricing power in certain projects. This gets reflected in Talgo having above-peers profitability (~3x higher EBIT margin).

-          The company has a high probability of winning projects worth € 3-4bn over the 2015-19 period.

This would lead to a ~ 20% EBIT CAGR.  

Business Overview

Talgo has 3 business lines (i) manufacturing of rolling-stocks (i.e. trains) or Original Equipment (OE), (ii) aftersales of rolling-stocks, and (iii) manufacturing of machinery used in the maintenance of rolling-stock.

(i) and (ii) account for 95% of the revenues and have similar profitability (~ 20% EBIT margin) – thus they are the key and the focus of the investment thesis.

A) Manufacturing of Rolling-Stock (60% of 2012-14 EBIT):

In this segment Talgo designs and manufactures 3 types of trains: intercity (200-250km/h), high-speed (250-300km/h) and very high-speed (> 300km/h).

·         Competitive Advantage: Talgo’s competitive advantage lies in the technology of its trains and its strength depends on the type of train. The following table gives an overview of the key design features and their USPs by type of train. 

(i)     Natural Tilting: Tilting means that in a corner the wagon in a train tilts inwards (think of a motorbike), allowing the train go faster through corners and thus reduce travel time.

There are two types of tilting technology: natural (only Talgo) and active (used by Siemens, Bombardier and Alstom – or “the Big 3”):

-          Natural tilting is based on the centrifugal force experienced by the wagon in the corner. This means that wagons are cheaper to produce (as they do not need any mechanical/electrical system to tilt it) and “self-sufficient” (i.e. without any external input from the railway line Talgo trains know when and how much to tilt)

-          The alternative active tilting has better performance - wagons can tilt more and there is overall more control in how much tilt is allowed. But on the other hand it is more expensive than natural tilting both for the wagons and for the railway infrastructure, which needs to be equipped with a signaling system that tells the train when and how much to tilt.

The sweet spot of natural tilting is large countries (i.e. long train journeys), old railway infrastructures and budget-constraint governments which can’t invest into a new railway infrastructure

This technology was decisive in Talgo win in Kazakhstan in July 2012 for the renovation of the entire intercity fleet of the country. Talgo management claims that they only competed with Chinese CNR/CSR in the bid, but that they won as CNR/CSR could not deliver Talgo journey time savings: from Astana-Almaty (1.300km) Talgo trains reduce the journey from 22 to 12 hours, i.e. by 45%.

(ii)   Automatic Variable Gauge System (AVGS): In a nutshell this technology allows a train to operate in routes which have different track width standards without human intervention. The alternatives are for passengers to change trains or a manual change of bogies at the point where track width changes (it takes 2-3 hours) – i.e. which is more costly and less convenient.

Regionally the sweet spot of this technology is in domestic routes in Spain and India (3 different track widths) and cross-border routes (Spain with rest of Europe, CIS countries with Europe).

(iii) Lightweight and Low Floor: in Talgo trains each wagon has 2 independent wheels at the back and is “mounted” into the next train at the front. This is very different from conventional trains which have 2 bogies (front and back) which 4 wheels each and are connected by a railway coupling.

This design features allows Talgo trains to be lighter – which in turns lead to lower energy consumption – and have lower floors – which leads to lower dwell times (time taking for passengers to exit and enter the trains) at stations .

As you can see in the table Talgo strongest competitive advantage is in the intercity trains followed by high-speed trains. For very high speed trains we do not think that Talgo has a competitive advantage against the Big 3 or the Chinese CSR/CNR. This is because very high-speed trains tend to travel in railway tracks specifically designed for them. Talgo will struggle to win projects in very high speed trains.

As a result of these competitive advantages Talgo has some pricing power, which gets reflected in above peer profitability: 20% EBIT margin vs. 5-7% of peers.

·         Sustainability of Competitive Advantage. Talgo technology aforementioned is no longer protected by patents: AVGS was introduced in 1969 and natural tilting in 1980. Nevertheless we think Talgo competitive advantages are sustainable against the large players in the rolling-stock industry because Talgo’s sweet spot and therefore addressable market in terms of projects is too niche for others to justify the R&D required.

For example: in 2012 Talgo had 0,4% global market share and Talgo OE revenues in 2012 was around 5% of the OE revenues of Bombardier and Alstom.

·         Approach to Tenders: Projects in the rolling-stock industry are awarded in tenders. This means that bidders are presented with a request-for-proposal (RfP). Factors such price and technical capability/reputation weight the most in these RfP. In countries that favor the domestic player (or “national champion”) the decision is much more politically based. This will be the case of France, Germany and China where the domestic players dominate the market with > 95% share.

Talgo is very selective in what they bid for. This is due to a combination of costs (making a bid costs € 1-2m) and attitude of not compromising in prices, as the company targets a blended (OE/aftersales) EBIT margin over the life of the project around 20%.

As a result of this bidding concentration, Talgo has historically (2009-14) achieved fairly high conversion rates of ca. 70%. This ratio is much higher in the intercity trains projects which require natural tilting and/or AVGS. According to the company in these projects the customer has pretty much decided – before issuing the RfP – that they need a Talgo train; thus Talgo is more involved in a direct negotiation than in a tender.  This was the case of the win in Kazkahstan.

·         Inflection Point: the company benefited from the investment boom in the Spanish conventional and high-speed railway network. When this investment cycle came to an end in 2009 Talgo was forced to expand outside Spain. Thus the company is undergoing an inflection point. Our variation perception is that Talgo will succeed in the international markets because:

(i)     In Spain the company has a market share of 46% in high-speed and very high-speed trains. In Spain (unlike in France and Germany) there is no open policy to protect the national champion, i.e. Talgo competes with the Big 3. The reason for the high market share lies in the AVGS technology. As mentioned above Spain has 3 different track widths.

(ii)   Over the 2009-14 period Talgo has been fairly successful, with a total order intake (including aftersales contracts) ~  € 3,2bn projects, of which 90% is concentrated in 2 contracts:

-          Phase 1 of the renovation of the intercity train fleet in Kazakhstan (in 2011). As mentioned above this project falls into Talgo’s technology  “sweetest spot”: natural tilting.

-          Very high-speed train from Mecca to Medina in Saudi Arabia (also in 2011). The rolling-stock was ca. 25% of the overall project of € 6,8bn which was awarded as a package to a Spanish consortium, which was estimated to be 20% cheaper than the other consortiums. Thus it is difficult to ascertain whether Talgo was more/less competitive than the Big 3.

(iii) Going forward the company has identified a pipeline of projects worth of € 8-11bn (excluding aftersales) over the 2015-18 period. Based on my analysis 2 projects worth € 3bn lie in the company sweetest spot and thus Talgo has a high probability of winning them:

-          Kazakhstan Phase II of the renovation of the intercity fleet (€ 1bn). Talgo has already set-up a manufacturing plant in Astana and employing local workers. Thus it would a surprise if Phase II could be awarded to another company.

-          Renovation of the intercity train fleet in India (~ € 2bn). The requirements for these trains are similar to those required in Kazakhstan (long-journeys, old railway infrastructure…). To our knowledge Talgo is the only company which has been granted by the Indian government to do test of the trains for that project.

·         Product Strategy: is centred on:

-          Improving the company’s value proposition in the very-high speed train segment by developing a train with 25-30% capacity. In a nutshell this train will be slightly wider than existing ones, which allows train operators to fit one more seat per row, i.e. from a 2+2 to 3+2. This leads to better cost-per-seat economics for operators. Talgo expects to complete the certification of this product (named AVRIL) by mid-2016.

-          Enter the regional commuter market, leveraging the softer-aspects of Talgo’s technology, e.g. lightweight, low floor and wide body (AVRIL). The regional commuter market accounts for ca. 50% of the global rolling-stock market. This market is very competitive, thus Talgo will be unable to sustain 20% EBIT margin in that segment. 

B) Aftersales of Rolling-Stocks (35% of 2012-14 EBIT):

In aftersales Talgo supplies spare parts and does the maintenance on (mainly) its trains; in Germany the company maintains some trains manufactured by a third party – but accounts for less than 5% of the aftersales revenues.

·         Contractual Terms: 100% of the aftersales services are sold under a subscription and are negotiated upfront at the same time as the OE sale. The typical contract is about 12 years. After that they are re-negotiated 1-2 times until the end of the train useful life (30 years).

In terms of pricing, the majority of contracts are based on €/km travelled by the train subject to a minimum level. Prices are indexed to inflection. The risk of margin contraction – in the case of maintenance requirements increasing with age – is low: the requirement for spare parts throughout the life of the train is more or less constant (based on the 20+ years old trains in Spain) and major overhauls of the trains are billed independently.

·         Captivity: management claims that Talgo serves 100% of its installed fleet and that the churn-rate on existing contracts has been close to nil. This impressive high share of captivity is mainly due to the uniqueness of Talgo trains. Our primary research indicated that operators tend to feel “uncomfortable” with maintaining Talgo trains, as they are very different to those of the Big 3.

With this level of captivity aftersales revenues over the life of the train (30 years) equals 1,5-2,0x the original sale price of the train. This provides good earnings visibility for years to come.

C) Compounding Economics

The compounding economics for generating shareholder value are very a Talgo due to:

a)      High ROTCE of 35% (average 2012-14):

(i)     High EBIT margin of 20%

(ii)   Capital-light operations: fixed assets excluding goodwill is 29% of revenues:

-          The company outsources 70% of the production to a large and diversified supplier network. Only components/systems linked to critical functions such as comfort and safety, e.g. wheelsets, suspension towerheads, bogies of the locomotive … are made in-house.

-          The capex requirements for the service network are low. Talgo uses the facilities/infrastructures of its customers to do the maintenance of the trains. Thus capex is limited to small tooling. In terms of personnel, Talgo employees its own people for the high-value added of the services and employees local sub-contractors for the low-value added (e.g. cleaning, minor repairs…).

(iii) Low net working capital requirements: average 0% of revenues over the 2012-14 period. NWC varies depending on the number/timing of the projects (e.g. at the start of a project Talgo gets pre-payments and over the life of the project Talgo gets paid based on milestones).

b)      Revenue Growth is driven by the existing order backlog and the potential project wins. Based on my assumptions (see model below) I estimate revenue growth of 21% p.a. and EBIT growth of 19% p.a. over the 2014-19 period. The main assumptions are:

-          Talgo will win 3 projects: India and Kazakhstan Phase II (as they fall into its sweetest spot: natural tilting and AVGS) and 50% of the expected project in Spain of € 1,4bn (thanks to its AVRIL concept).

-          Profitability varies by type of train to reflect the differences in competitive advantages.

-          The company will sign-in aftersales contracts (as it has done historically) at the time of winning the OE contract. The expected aftersales revenues are worth 1x OE over a 15 years period.

-          Optionality. I have not assumed any wins in very high-speed train besides Spain or in the regional commuter market. The latter is unlikely as Talgo has already a framework contract agreement with KTZ (Kazakhstan Temir Zholy – railway operator in Kazakhstan) worth € 500/700m.

Management

Jose María Oriol (52) has been CEO of Talgo since 2002. He is the grandson of Talgo’s founder and he has worked at Talgo nearly all his life (since 1987). We met him and had a good impression:

-          In-terms of business sense and capital allocation he scores very highly as Talgo is the best-in-class rolling-stock manufacturer in the world: disciplined and selective tendering, very high share of aftersales revenues (35% vs. 10-15% for competitors), high-level of outsourced production….

-          The Oriol family has a 10,4% stake in the company. Thus he is incentivized for the company to keep doing well. He also believes in the company: Talgo IPOed at € 9,25 in May 2015; Jose bought 100k shares at € 6,25 (Aug’15) and then 150k shares at € 4,15 (Sep’15) increase his personal stake in the company by 20% to 1%.

Key Risks

·         Low oil prices:  77% of Talgo’s order backlog was outside Spain, of which the lion share is in Saudi Arabia and Kazakhstan. These two countries have oil as their main source of wealth. Thus low oil prices is really hurting their economies and for Kazakhstan also its currency. The main risk is therefore cancellation of projects or postponement of new tenders (e.g. Kazakhstan Phase II).

-          Saudi Arabia cancelled in July 2015 the second project it had awarded Talgo (worth € 176m) as the Saudi government is cutting on “unnecessary expenditures”. This is what Ibrahim Al-Ssaf (Saudi Finance Minister) said on September 7^th, 2015: “There are some projects like the ones that have been approved a few years ago and haven’t been carried out until now which means such projects are not currently necessary and can be delayed”. The Talgo project cancelled falls under that category.

In my opinion the main Talgo project (Medina-Mecca; awarded in 2011) is unlikely to be cancelled as it is nearly completed: 96% of the infrastructure was completed as of June 2015, according the Saudi Transport Minister.

-          Kazkahstan so far has not cancelled any awarded order for Talgo trains. Talgo contracts are denominated in €, but invoices the customer Kazakhstan Temir Zholy in the local currency (using the exchange rate at the time of the invoice). Thus the devaluation of the Kazakahstan Tenge (KZT) vs. €  (40% since August) should be limited to the exchange rates fluctuations between invoicing and payments.

·         Desert Operations: to our knowledge Talgo very high-speed trains will be the first to operate in the desert. Our  interviews with industry experts narrows down the risk to excessive wear of mainly rotating parts which are in contact with the sand (e.g. wheels). Other parts (such as electronics) are not at risk as they are in hermetic compartments and the high temperatures seem not to be an issue.

Thus the risk is that maintenance costs will higher than those assumed when pricing the aftersales contracts. To minimize this risk Talgo is working on a technical solution (think of an air-pump that cleans the railway track ahead of the wheel) and has added some margin on the prices of the maintenance contracts.

Valuation

At current prices (€ 5,22), the shares are trading at 9.0x/5.7x EBIT (2016E/2017E) and 9,0x/5.7x EPS. Thus Mr. Market remains pessimistic about Talgo’s ability to keep winning projects outside Spain.

For calibration for what is being priced-in. Based on the current backlog of € 3,4bn and a DCF-based valuation (i) the aftersales business is worth ~ € 3/share (ii) the OE business is worth ~ € 1/share. Thus the prospective pipeline (described above) of ca. € 3,9bn (OE only) is valued at only € 2,2/share!

Catalyst

The main catalyst for a multiple re-rating lies on project wins. Unfortunately there are no hard dates of when decisions will be made on the projects in the pipeline.

The first project - € 1,4bn very high-speed project in Spain - is expected in H 1 2016. 

I do not hold a position with the issuer such as employment, directorship or consultancy.

I hold shares in Talgo in my personal portfolio. 

I hold shares in Talgo in my personal portfolio.