Description

Investment Thesis

I realize this is a dangerous time to make an investment in a company with significant European exposure, but it is also an opportunity to purchase a good business at a reasonable price.

WABCO is a case of a secularly growing business trading at a depressed multiple due to the overhang of European exposure and a weak near-term (2012) outlook. At current prices, the shares trade for 11x 2012E EPS and 9x 2013E EPS – for a company with a dominant market position and returns on invested capital of near 50%. My one-year target price is $73 (13x 2013 EPS), or ~40% above current trading levels. Even if 2013 earnings are flat compared to 2012, the expected share count reduction and a multiple reversion to the mean results in a mid-60s stock.

The company is positioned to increase its content per vehicle pursuant to rising global safety and fuel efficiency standards, specifically increasing standards around emergency braking, stability control and anti-lock brakes*. These tailwinds coupled with consolidated high technology braking markets and a low cost country manufacturing footprint should allow the company to grow in excess of the industry and maintain or expand margins.

*Braking systems account for 1.5% of truck content.

Company Overview

WABCO (originally Westinghouse Air Brake Company) was spun-off from American Standard on July 31, 2007.

WABCO offerings consist of advanced braking, stability, suspension and transmission control systems for commercial vehicles (OEM and replacement). The company’s main products include anti-lock braking systems (ABS), electronic braking systems (EBS), automated manual transmission systems, air disk brakes and various conventional products (actuators, air compressors and air control valves). Most products are installed on heavy-and-medium-sized trucks, trailers and buses with a growing passenger car and SUV business. See appendix for parts definitions (per 10K).

More simplistically, the products improve vehicle performance and lower vehicle operating costs. For example, WABCO’s stability control system helps prevent accidents as vehicles are automatically slowed down if instability is detected (i.e. swerving). Adaptive cruise control uses sensors to monitor proximity to other vehicles and automatically adjust speeds. Automated transmission controls reduce gear shifting which lowers physical effort for the driver and reduces wear and tear, while improving fuel efficiency and safety. The c-comp technology disengages the air compressor from the engine when the air system reaches full pressure. This provides fuel savings on long haul trips and reduces CO2 emissions.

Truck and bus OEMS represent 64% of sales, trailers are 9% and passenger vehicles are 4%. The remaining 23% of sales comes from aftermarket services, a fragmented and diverse group of customers. Key customers include Daimler (12% of sales) and Volvo (11%) with the top ten customers accounting for 52% of sales.

From a geographic perspective, Europe is the major market at 62% of sales (57% of truck and bus sales). Within Europe, Germany, France and Sweden account for 44%, 6% and 14% of sales. Asia, North America, South America (mostly Brazil) and other are 19%, 9%, 7% and 3%, respectively. Asia is weighted towards Japan (20%), China (31%) and India (34%).

From a cost standpoint, 68% of the manufacturing workforce is located in low cost countries vs 10% in 1999.

Competitors include Knorr-Bremse (Bendix), Haldex, Bosch, TRW and Takata. WABCO has gained share since 2006.  Knorr (private) is the main competition (market share in mid-to-high 40s vs low 40s for WABCO).

Business Drivers

Commercial truck and bus production / replacement demand

Content per vehicles / regulatory safety standards / environmental sustainability (fuel efficiency and emission reduction)

Capital Structure

R&D expenses of $105 MM in 2011

NOLs of $526 MM ($494 MM have unlimited life)

Company Guidance

Use of FCF is for share buybacks ($170 MM remaining on authorization) and for acquisitions

On 1Q call, management indicated they expected to be on the upper end of the range

Stable order book compared to 4Q 2011, but 2Q for Europe is 5% lower yoy

WABCO’s products are included on an estimated 67% of commercial vehicles with advanced vehicle control systems. These parts of provided from design/development and in the aftermarket. Therefore, revenues will track truck and bus production with upside from the shift to electronics content and the aftermarket which is tied to vehicle age and miles driven.

WABCO has demonstrated an ability to grow in excess of commercial production by increasing the amount of content on each vehicle. For example, over the past five years, WABCO’s European sales outperformed the market by 300 bps. On a global basis, WABCO outperformed by 800 bps in 2011. Going forward, the company is guiding to 800-1,000* bps of total (not just Europe) industry outperformance due to an increased focus on safety and performance (increasing value per vehicle from air disk brakes, transmission automation controls, electronic stability and driver assistance systems).

*2011 European production @ 2004 levels, but down 20% from peak (30% as of 2012E)                                                                  

*2011 US production @ 2008 levels, but 30% short of peak in 2006

*New European emission standards in 2014 (Euro IV)

*Brazil anti-lock braking standards

*Trend towards increased use of automated manual transmissions (Volvo / Daimler)

*Adoption of ABS in China (and enforcement of standards)

* Shift toward fuel efficient direct injection

Emerging market growth is a key opportunity as China, India and Brazil accounted for 58% of the world’s truck and bus production in 2011. Braking product costs in Europe are >10x higher than India and China, 2x greater than Brazil and 6x more than Eastern Europe.

Aftermarket sales have grown 6% annually over the past five years.

Unless the company finds an acquisition candidate, free cash flow will be used to repurchase shares. At the current stock price, this implies a share reduction of ~5 MM annually. Assuming fully diluted shares in the 62 MM area and net income at of $350 MM (near consensus) in 2013, EPS is ~$5.60. Using the year-end share count, the effective EPS is over $5.75.

In light of recent turmoil, a flat or declining 2013 is a real possibility. Assuming a flattish 2013, earnings should be in the $310 MM area, which based on share shrinkage implies EPS of $5.00. If I take sales down 10% and 20%, I calculate EPS of ~$4.00 and ~$3.00, respectively. I realize this is not as much as the 42% sales decline post Lehman, but inventories are lower and any decline should hopefully be short-lived as vehicles age and safety and fuel standards increase.

Historically, WABCO traded between 13-15x earnings. This multiple has compressed in light of the uncertain economic backdrop, but I believe the company will again trade at those levels as it demonstrates its superior growth prospects and we get more clarity on Europe. My target price is $73 (13x $5.62), or ~40% above current levels. At my low case of $3.00 (assuming a 20% revenue decline), the shares are worth $40-$45 at the low-end of the historical multiple range.  

The under-leveraged balance sheet represents another source of potential value, although management intends on remaining debt-free so this is more of a hypothetical exercise. If leverage is increased 1x-2x, the company could issue $450-$900 MM of debt. If shares were purchased at an average price of $55, the potential reduction would range from 8 to 16 MM shares. Assuming a coupon of 5% ($450 MM) and 6% ($900 MM), 2013E EPS would jump to $6.10-$6.60 range. The miracles of leverage.

One reason for a lower multiple is the exceptionally low “performance” tax rate of ~16.5%. Using tax planning strategies and NOLs (currently $526 MM), WABCO is able to keep taxes low. This is the expectation for the medium term. Per discussions with the company, without NOLs the tax rate would be closer to 20%. Over the longer term as NOLs are exhausted, I assume a tax rate in the mid-20s. Apply this higher rate results in 2012E and 2013E EPS of $4.26 and $5.05, or multiples of 12x and 10x, respectively.

Summary

At the end of the day governments are trying to reduce accidents and increase efficiencies and the high technology braking products market is highly consolidated. Increased penetration should allow WABCO to grow well in excess of the truck and bus market. Even in a tough year for Europe, performance is expected to be flat. Share shrinkage provides another potential lever and a cheap multiple (11x 2012E EPS) makes the investment even more compelling.

Risks

1. High European sovereign debt loads/austerity measures. European exposure (62% of sales); Euro exposure.

-If demand is weaker-than-expected, WABCO should be able to cut costs as 30% of the European (50% in “best cost countries”) direct labor workforce is temporary.

-Precautionary measures from OEMs/distributors suggest that current inventories are already reasonably lean, so destocking should be limited.

  -Volvo and Scania noted destocking was ending and reported increases in orders and production rates

-Not all Western European sales are based on demand in Western Europe as 20-25% is exported to Eastern Europe, Russia, Africa and the Middle East.

2. Heavy-duty truck sales represent a larger portion of company sales and are more cyclical than medium-duty.

3. Similar to #1, cyclical downturn magnified by lack of fixed cost absorption (see 2009).

-Achieved 27% incremental operating profit margin in 2011 vs operating margins in 13-14% area.

4. Concentrated customer base in the developed world.

-Truck buyers will resist product upgrades and may fight regulatory mandates.

  -More of a factor in the US.

-Price reductions. As with all automotive suppliers, price erosion is typical.

  -WABCO expects 1-2% for 2012. 

5. Low tax rate. Concerns on sustainability and repatriation of cash.  

-Excluding the use of NOLs, the tax rate is closer to 20% per discussions with the company.

Appendix

1. Actuator - Converts energy stored in compressed air into mechanical force applied to foundation brake to slow or stop commercial vehicles
2. Air Compressor and Air Processing/Air Management System - Provides compressed, dried air for braking, suspension and other pneumatic systems on trucks, buses and trailers
3. Foundation Brake - Transmits braking force to a disc or drum to slow, stop or hold vehicles
4. Anti-lock Braking System (ABS) - Prevents wheel locking during braking to ensure steerability and stability
5. Conventional Braking System - Mechanical and pneumatic devices for control of braking systems in commercial vehicles
6. Electronic Braking System (EBS) - An electronic signal replaces the air signal sent by the brake pedal to activate the brakes, improving stopping distances and braking system performance
7. Electronic and Conventional Air Suspension Systems - Level Control of air springs in trucks, buses, trailers and cars
8. Transmission Automation - Automates transmission gear shifting for trucks and buses
9. Vehicle Electronic Architecture (VEA) - Central electronic modules integrating multiple vehicle control functions
10. Vehicle Electronic Stability Control (ESC) and Roll Stability Support (RSS) - Enhances Driving Stability

Catalyst

Share repurchases ($170 MM authorization remaining)

Continued strong earnings performance and reaffirmation of guidance       

Favorable ruling on infringement case (already paid €326 MM) related to ASD and assumed upon spin (1H 2013)