Description

WABCO (WBC)

$76.47

Investment Summary

Wabco is a very well-managed company that manufactures and sells advanced braking and stability control systems primarily to heavy duty commercial truck manufacturers and related aftermarket parts to truck fleets. The company competes in a cyclical yet growing duopoly with approximately equal share (mid-40%) with its main competitor, Knorr-Bremse. Wabco has a strong competitive position and earns high (30%) returns on invested capital. At $76/share, Wabco’s stock trades at 13X normalized P/E while maintaining net cash on its balance sheet. Assuming 1-2% global trucking unit growth and 5-6% content per vehicle growth, Wabco will likely grow revenue 7-9% over the next 5 years excluding any cyclical truck market rebound. With operating leverage, productivity gains and effective capital allocation (i.e. buying back stock and making select attractive acquisitions), the company should grow EPS 15%+ over the same time period. Assuming these growth rates, no change to the unlevered capital structure and 15X P/E at exit, Wabco stock would generate compelling returns with minimal risk of capital loss over a 5 year holding period.

The Business and History

Wabco was founded in 1869 as Westinghouse Air Brake Company and developed the air brake for locomotives. In the 1920s, Wabco began making air brakes for commercial vehicles. The company was purchased by American Standard in 1968, separated from its locomotives-focused business unit, and the new commercial vehicles-focused division operated as the Vehicle Control Systems of American Standard until Wabco was spun off in July 2007 as an independent public company.

Wabco primarily sells advanced braking and stability control systems to heavy duty commercial truck manufacturers, although the company’s products also include transmission and suspension systems and its products are sold for buses, trailers and cars as well. The company’s products include anti-lock and electronic braking systems, collision-mitigation control systems, automated manual transmission systems, air disk brakes, actuators, air compressors and air control valves. Wabco also supplies advanced electronic suspension controls and vacuum pumps to the car and SUV markets in Europe, North America and Asia. Wabco sells replacement (i.e. aftermarket) parts to OEMs, distributors, repair shops, and fleet operators and provides remanufacturing services.

The company’s products are included in approximately two-thirds of commercial vehicles with advanced vehicle control systems. The company’s customers include large OEMs such as Daimler, Volvo and Paccar as well as independent distributors. The company is based in Brussels, Belguim and has manufacturing facilities Germany, Brazil, China, India, Korea, France, the Netherlands and the United States. The company’s revenue breakdown by geography is below.

Approximately 75% of the company’s sales are to OEMs and are driven by new truck builds while the remaining 25% is generated in the aftermarket. Wabco’s aftermarket business is more stable and higher margin than its OEM business. Truck parts’ usual wear and tear requires replacement. We estimate that Wabco’s aftermarket margins are 25-30%. (The company does not disclose the number specifically.) This implies that 40-55% of Wabco’s operating income is generated from its aftermarket business. The aftermarket sales are more predictable than OEM sales since repairing an existing truck is generally less discretionary than purchasing a new truck. Note that many aftermarket parts in the U.S. and Europe require certification.

Wabco’s business is very sticky with high retention rates over the 10 year life of a truck platform. Wabco braking products are designed into a truck platform and the contract lasts for 1-5 years. Within a contract period and at the time of renewal, pricing can change depending on raw material costs and volumes. For example, if raw material costs are increasing, Wabco tries to recoup at least some of those costs. Once Wabco’s products are on a platform, it is costly and unlikely for the OEM to switch brake or stability control systems, leading retention rates to be ~99% over the life of the platform. The braking systems are mission critical parts and recalls are very costly, so product quality is of key importance. Generally, switching mid-platform is a high risk / low reward option.

Competitive position

Wabco has a strong competitive position and is gaining share in a duopoly with barriers to entry. OEM customers view both Wabco and Knorr as reputable companies that have generally similar technical capabilities. That said, Wabco has historically been the technology leader while Knorr has been a fast follower. Haldex has 10% market share and the remaining 2% is made up of small competitors in China that compete in the aftermarket.

Wabco has gained share from both Knorr and Haldex as shown by the comparison of revenue growth from 2005-2011/12.  (Note 2006 was a significant growth year in North America, where Knorr has greater share. Moreover, 2012 was a dismal year in South America, where Wabco has greater share. Because 2012 was a notably good year where Knorr is relatively stronger (North America) and a notably bad year where Wabco is relatively stronger (Europe and South America), it’s worth noting the cumulative growth comparisons from 2005 through 2011 as well as through 2012.)

Note that Haldex is in a weak position competitively. Due to its scale disadvantage, Haldex must spend higher capex as a percent of revenue (5% vs. 3.5% for Wabco) and has a materially lower operating margin (5%) as compared to Wabco (13%) and Knorr (11-12%). Over time, Haldex will likely have a difficult time taking share from the two market leaders as will any potential new entrant.

The threat of successful new entrants is quite low given the importance of product reliability to OEM customers and the mission critical nature of advanced braking and stability control systems; embedded, long-term customer relationships in which Wabco passes on a portion of productivity improvements through lower prices; Wabco’s low cost structure; OEMs’ general satisfaction with a dual-supplier strategy; and the 10 year, staggered nature of OEM trucking manufacturers’ platforms. Wabco has spent over $1 billion in the last 8 years on R&D and capital expenditures. The technological know-how required, large up-front development costs and difficulty in displacing Wabco or Knorr within OEM customers combine to make a reasonably formidable barrier to entry.

While the aftermarket business is more stable than the OEM business, it is also more competitive. Fleet owners generally are very cost conscious. That said, the penetration of Chinese and other low cost competitors in Wabco’s key products is less than 5-10%. Importantly, Chinese competitors have been around for over a decade, and there is no evidence of a changing trend now such that the Chinese are likely to take share from the market leaders. Rather, as Wabco has moved manufacturing capabilities and materials sourcing to low cost countries, the company has materially decreased the likelihood that a Chinese competitor would have a significant cost advantage. Additionally, reliability is very important for braking and stability control products. The aftermarket is highly competitive for more standard products but not as much so for Wabco’s key products.

Lastly, the threat of OEMs vertically integrating Wabco’s key products seems very low. Car and truck OEMs have a history of being tough negotiators with their parts suppliers, brutally pushing prices down over time. Typically, suppliers have reasonably undifferentiated products (and thus many suppliers bid for an OEM’s contract) or the OEMs themselves threaten to vertically integrate the product. The prime example of this is the engine. Trucking OEMs aim to vertically integrate a product where they a) have the development and manufacturing expertise and b) can capture aftermarket parts/services revenue.

We have talked to a number of OEMs for some time now, and none currently have plans to attempt to vertically integrate advanced braking and stability control systems. There are several reasons for this. First, advanced braking and stability control systems are mission critical products that require technological know-how and expertise. Product reliability is extremely important for fleet owners (downtime costs are a top concern), and supplier reliability is key factor for OEMs. Second, the development costs would be very high. (As noted above, Wabco has spent over $1bn in the last 8 years on R&D and capital expenditures.) Most OEMs have high debt loads and 5 year plans that involve significantly improving returns on capital, so investing to vertically integrate this highly engineered product seems inconsistent with their business plans. Third, advanced braking and stability control products are a low percent of the total truck unit costs, typically less than 3%. Even if OEMs believe they could save 20% by vertically integrating, this would only represent 0.6% of the total truck cost. Fourth, Wabco and Knorr earn ~11-13% operating margins (and only 7-9% on the OEM sales excluding aftermarket business), so this is not an obvious product segment in which OEMs could achieve cost savings. Lastly, vertically integrated OEMs would not likely successfully sell their product to competitors, limiting the sales opportunity. The combination of these factors illustrates why vertically integrating Wabco’s products is a high risk, low reward endeavor for a trucking OEM.

Industry

The trucking industry generally can be divided into three groups: truck owners (owner-operators, fleets and leasing companies), truck manufacturers (OEMs such as Daimler and Volvo) and components/systems suppliers. Across the value chain each group consists of a number of competitors who struggle to differentiate themselves. Trucking fleets are generally not so large that they have negotiating leverage over the manufacturers but also are not so small that OEMs have significant pricing power. Note that most trucking manufacturers’ ROIC is less than 10%. In Europe (Wabco’s largest geography), there are ~7 large OEMs each with market share between ~10-20%, with smaller manufacturers making up the remaining 5%. With low returns on capital and little differentiation amongst products, the truck OEMs are highly competitive and apply pricing pressure on commoditized parts/components suppliers, which in turn have a history of very low returns on capital, thin margins and numerous bankruptcies. Wabco truly stands out as an extremely well-positioned business within the industry.

On top of this quite competitive industry structure, heavy duty truck units are very cyclical. Over the long-term, new truck unit demand is largely driven by GDP (and specifically cargo shipments). New unit demand growth has historically been ~1.5% in Europe, ~2.5% in the U.S. and much higher in emerging markets such as China, Brazil and India. Units can fluctuate enormously year-to-year based on economic conditions as well as the timing of new regulations, which generally spur a “pre-buy.” When a new regulation is going into effect, fleets pre-buy new trucks in advance of buying the more costly truck after the regulation takes effect. An example of this is the 2007 EPA mandate in North America: both 2005 and 2006 were strong years while units declined 44% in 2007. Notably, pre-buying is not a major driver of incremental unit demand in Europe, where emissions costs (e.g. “dirty tolls”) aim to mitigate fleets from gaming the regulatory system.

In the short-term, a new truck purchase is largely discretionary but in the long-run trucks wear down and need to be replaced. After examining truck unit data by geography, we believe the overall unit demand in 2011 looks to be a reasonable yet conservative proxy for normalized global demand. Overall, global unit demand growth should likely be 1-3% over the long-term from replacement demand levels. See graphs of Europe and North America below. 

Western Europe Heavy-Duty Truck and Bus Production

Source: WABCO

North America Class 8 Heavy-Duty Truck Production

Source: ACT Research

In analyzing the significant fall off in new truck units in 2009, it’s important to note that the cyclical problem was exacerbated by inflated inventory levels. In 2008, there were ~80,000 excess trucks in the European and U.S. supply chains. In 2010, that number was ~10,000. At the end of 2011, that number was quite small and remains so.

In addition to considering the cyclicality of the trucking market by region, it’s important to note that the price of a truck and the Wabco-related content per vehicle varies significantly by region. As shown below, the content per vehicle is highest in Europe largely because of more stringent regulations (i.e. stopping distance and emissions controls) as well as less a-la-carte selling by truck manufacturers (i.e. higher quality trucks include advanced braking and stability control systems whereas in the U.S. fleets can buy a similar truck and choose not to buy the Wabco-related content). Both factors have led European fleets to adopt disc-brakes and more advanced stability control systems whereas North American fleets have largely adopted drum-brakes, which require higher maintenance costs and longer stopping distances although are more than $2,000 cheaper. That said, North American fleets are increasingly adopting air disc-brakes although ultimate long-term penetration is tough to predict.

As more stringent safety and emissions standards are enacted, content per vehicle should increase 5-6% over the next 5 years. While Wabco has little visibility into truck unit demand, the timeline of new regulations and OEM’s product cycles allows one to make reasonable estimates of the revenue given a particular level of truck unit demand. The key recent and upcoming regulatory changes are below:

Increased content per vehicle is primarily driven by regulatory requirements in the short-term although total cost of ownership analysis drives fleet owners to buy safer, more fuel-efficient trucks as well. Sophisticated fleet owners make purchasing decisions based on a truck’s total cost of ownership, and repair/maintenance (11%) and fuel (25%) are the 2nd and 3rd largest costs behind personnel (28%) costs. Buying brake and stability systems with shorter stopping distances, more sophisticated driver-assistance products (e.g. radar) and higher fuel efficiency can save on collision-related and fuel costs as well as insurance costs. Advanced collision mitigation controls reduce accidents significantly (some sources cite ~80%), and most fleets are self-insured so the cost savings are quite real. Note that acquisition costs are only 10% (i.e. the cost to buy new trucks). So personnel, fuel and repair/maintenance costs far outweigh the cost of new trucks for fleet owners. See figure below:

The annual maintenance cost of a truck increases significantly in the truck’s 6th year, which is a key factor in driving replacement after year 5 and illustrates why the average age of the fleet in Europe has historically been ~6 years. Note that the current age of the European fleet is ~7.5 years, and the fleet has been aging every year since 2008. At some point, the fleet age should decline back to historical levels (i.e. unit production greater than solely replacement), which will provide a nice tailwind for unit growth.

While the trucking industry is cyclical, we find the long-term unit demand, cyclically low current production levels, and increased content per vehicle to be nice tailwinds.

Management

Wabco is led by a strong CEO, Jacques Esquiler, who is focused on operational efficiencies and buying back stock, and he has established a well thought-out management compensation system that properly aligns incentives.

Jacques was previously President of American Standard’s Vehicle Control Systems before that division became an independent public company in July 2007 and was re-named Wabco. At that time, Jacques became CEO of Wabco and was elected Chairman in May 2009. When he took over the company, there were manufacturing quality, customer relationship, and management issues. Under Jacques’ leadership, product quality issues and OEM customer relationships have improved markedly. Warranty expense has declined ~30-40% and customers such as Volvo who were threatening to no longer use some Wabco products on new platforms are now in good standing. One plant in Europe now operates with a 39 PPM (parts per million) error rate, down from greater than 1,000 PPM a number of years ago. One key issue was that too much of Wabco’s manufacturing process was automated, making errors time-consuming to identify and costly to correct. Regarding customer relationships, Wabco had begun creating products without focusing smartly on customer needs. This failure allowed Bendix/Knorr to take share in several North American OEMs’ stability ABS products. Now Wabco is in a position to take back some share in the North American market.

Jacques has done an excellent job revamping the incentive structure. Within American Standard, the then Vehicle Controls division did not have accountability for its own P&L. Since management cannot control the total sales dollars in this cyclical business, management’s annual comp is based on market outperformance (including increasing content sales), incremental operating income margins and free cash flow generation. EPS and ROIC are also factors in management’s long-term compensation plan.

Jacques has proved to be a savvy capital allocator over the last few years by choosing to buy back cheap stock. Management is looking for acquisitions but has been prudent based on price and very selective based on business quality. Jacques is focused on continuous operational improvement and increasing shareholder value through revenue growth, incremental margins, share buybacks and opportunistic acquisitions.

Some of the key members of Jacques’ team are below.

Nik Varty, who joined Wabco in 2001, was promoted in March 2012 to Vice President, Americas and is also now responsible for Mergers & Acquisitions globally. Previously, Nik was Vice President of Wabco’s Compression and Braking global business unit. He is based in Rochester Hills, Michigan, at Wabco North America, the company’s newly created regional headquarters for North and South America. Mr. Varty has 21 years of experience in various business leadership, finance and consulting roles at companies including Great Lakes Chemical Corp., AlliedSignal (now Honeywell) and Coopers & Lybrand.

Ulrich Michel has been CFO since July 2007. Prior to July 2007, Uli served as CFO of Wabco’s predecessor division since April 2005 and joined American Standard in 2003. Prior to joining American Standard in 2003, Uli spent 6 years in financial leadership positions at AlliedSignal/Honeywell with areas of focus including mergers and acquisitions, the Specialty Chemicals business, and the Control Products business in Europe. Before joining AlliedSignal/Honeywell, Uli spent 8 years at Price Waterhouse.

Price

Wabco currently trades at 13X normalized P/E, which we believe is a meaningful discount to intrinsic value. Since being spun out of its old parent company, American Standard, Wabco has not operated in anywhere near a “normal” market environment, and the cyclicality of the business should decrease somewhat as the aftermarket businesses continues to grow.

The current price does not reflect Wabco’s strong position in a duopoly with strong growth prospects due to increased content per vehicle, aftermarket growth and global trucking unit growth. Furthermore, the current valuation does not factor in the company’s high quality management team who will likely drive attractive incremental margins and deploy capital in value-accretive ways over the next 5 years. While Wabco competes in the trucking industry, which is highly cyclical and fraught with intense competition, low returns on capital and few companies with any sustainable competitive advantage, we believe Wabco is a standout in its market niche. Over a 5 year time horizon, we believe Wabco’s stock represents an excellent risk/reward.

Risks

Eurozone collapse: A structural collapse and/or economic depression throughout the Eurozone would adversely impact Wabco’s business. While this is a risk, it’s worth noting that only ~20-25% of Wabco’s profit is generated by European OEM sales. In company filings, Wabco discloses that 60% of sales are generated in Europe. However, 33% of that 60% are aftermarket sales, and 15% are sales generated in Europe but then shipped to the Middle East and Africa. After factoring in the higher profit margin on the aftermarket sales, we estimate that ~20-25% of the company’s profits (not sales) are in fact driven by European OEMs.

Increased competition in the aftermarket from Chinese competitors: If Chinese competitors reverse engineer Wabco’s highly technical products and compete aggressively on price, Wabco’s high margin aftermarket business would be adversely affected. Note that Wabco is currently increasingly winning awards amongst Chinese truck manufacturing customers, so this threat is not materializing at present. Moreover, as discussed in the “Competitive Position” section above, this risk is mitigated by several factors including the importance of product reliability, highly engineered nature of Wabco’s key products, and the company’s low cost position. The Chinese are generally not developing new truck products; rather, they are primarily attempting to copy through reverse-engineering mechanical products (i.e. rather than electronic products such as Wabco’s). To the extent that Wabco continues to develop more and more advanced products, competition will likely remain at bay.

Safety and emission regulations become delayed: If regulations were delayed or cancelled, this would likely slow Wabco’s content per vehicle growth in the future. While this is a possibility, regulations are almost never delayed once put into law, especially in Europe. There are enforcement issues in some developing countries, most notably in China, yet enforcement is becoming more stringent.

Product recalls: While rare, product recalls can happen. Wabco’s primary competitor went through a modest recall at its U.S. subsidiary, Bendix, in 2012.

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