Description

Industry background

Wabtec is one of the world’s largest providers of value added, technology based equipment and services to the freight rail and passenger transit industry, helping their customers increase their safety, efficiency and productivity. Wabtec’s performance is primarily dependent on the level of activity, financial condition and capital spending plans of the global railroad and transit industries. Many factors influence these industries, including general economic conditions, traffic volumes (as measured by freight tonnage and passenger ridership), government spending on public transportation and investment in new technologies by freight rail and passenger transit systems.

Railroads operate in a competitive environment, especially with the trucking industry, and are always seeking ways to improve safety, cost and reliability. As a result, Wabtec has a very important role in providing its customers with new technologies that will make them more competitive.

UNIFE, the European rail industry association estimates the global accessible market for rail related products and services to be more than $100 billion dollars, with an expected annual growth rate of about 3%. A number of factors are expected to drive this growth, including population growth, urbanization, global trade expansion and an increasing awareness of environmental and sustainability issues (according to industry trade groups, on average, railroads are four times more fuel efficient than trucks).

While the rail industry is dominated by a relatively small number of very large players, the supply chain is rather fragmented. Looking at the long list of acquisitions made by Wabtec (20 over the 2008-2014 period), the supply chain appears fragmented and made up of many relatively small businesses which presents a significant opportunity for Wabtec going forward. Over the period 2007-2014, Wabtec’s revenue has grown at a rate of 12.2% with organic growth coming in at approximately 5.3%.

Competitive Advantage

Wabtec operates in a competitive market; with pricing power limited by the relatively small number of powerful customers it sells its products to. Nonetheless, Wabtec’s financial results show strong competitive advantages. Wabtec has an above average return on invested capital of 18% and a return on new capital invested of 16% (investments over the past 5 years). When excluding goodwill and acquired intangibles, ROIC is about 38%, which is not only very high in absolute terms, but also one of the highest in its peer group.

The high ROIC and return on new invested capital suggests that Wabtec currently has significant competitive advantages. This is further reflected by the fact that Wabtec holds dominant positions in most of their product lines. This is particularly the case in the primary braking division, where Wabtec has been able to maintain a 50% market share over the past 10 years (20% of WAB revenue); we believe this consistency is very much reflective of strong barriers to entry. There is strong evidence that the competitive advantage is durable in, at least, the brake division. This is due to a combination of three factors: The significant market share that Wabtec holds, the small market size (~$1.2bn) and the need for significant R&D spend resulting in significant economies of scale. Due to the limited market size, a competitor would probably need to gain a significant market share before being competitive on a technological front, something that will be extremely difficult. Furthermore, due to the small cost of brakes relative to the total cost of the rail industry and the importance they have in keeping trains safe, customers are unlikely to switch supplier and risk reputational damage, even if a more cost competitive offer is made.

Due to the substantial installed base of Wabtec products, other product areas are also likely to have durable competitive advantages. This competitive advantage is most likely to come from high switching cost as new parts must be compatible with older parts. This is also the case for aftermarket services (61% of revenue) where customers are more likely to purchase safety and performance related replacement parts from the original equipment supplier. The aftermarket service segment requires a local presence and knowledge and so is less likely to be vulnerable to low cost Chinese manufacturers.

Capital Allocation

GAAP income has increased 222% (18% CAGR) over the past eight years, from $109M to $352M. This compares to free cash flow (excluding acquisition related cash flows) which has increased 248% (19% CAGR) over the same period, from $122M to $425M. This consistency between free cash flow and income is indicative of high quality of earnings.

To date, investments (PPE and acquisitions) have been funded from internally generated cash flow from operations ($1.8bn of CFO generated over the past 8 years). Maintenance capex runs at approximately $40m (very close to depreciation). Debt has increased by $360m over this time period bringing net debt/EBITDA to 0.2x.

Over the past 8 years, Wabtec’s management retired $224m worth of shares. This has gone partly to offset the effect of dilution from stock options ($31m inflow from exercise of stock options), but the majority has gone to reducing the number of outstanding shares. Over the same period, dividends per share have increased 12 fold.

Acquisitions have been an integral part of Wabtec’s growth strategy (20 acquisitions with $1.6bn invested over the past 8 years) and a key pillar in Wabtec’s 4 point business strategy. These acquisitions have however been small bolt on acquisitions until this year’s $1.8bn acquisition of Faiveley Transport. Total acquisitions in any one year have rarely exceeded free cash flow before acquisition cost (only in 2012 and 2008). Wabtec has shown over the years that it has the ability to retrieve a lot of value from the consolidation process. Wabtec’s management has stated that all acquisitions share two traits: 1) solid financials and 2) a strategic fit within Wabtec’s portfolio. Management expects that strategic acquisitions will account for about half of long term growth. Historically organic growth has been around 5% and doubling this through acquisitions would be consistent with management’s aim to generate double digit growth in EPS.

WAB generated $114m of free cash flow after acquisitions cost in the last 8 years, causing the company to issue a modest amount of debt (net $136m) to finance working capital and stock buy-backs.  Management has historically used debt very prudently.

Valuation

We evaluate Wabtec’s worth as a straightforward valuation of its cash flows.  The company has been consistent in hitting its forecasts, has proven room to roll-up a fragmented industry and understands capital allocation.  Using a conservative 10% discount rate with a 3% terminal rate (long term GDP) WAB looks to be about 17% cheap using its latest growth and cash production rates.  Discounting either growth or margins by 20% and WAB is about fair value.

We think Wabtec is a high quality company, run by a solid management team that has consistently posted superior ROIC and ROTC.  Furthermore, WAB has treated its shareholders well over just about any historical period.  The growth estimates are within reason, and not necessarily dependent on GDP (acquisitions).  Margins have steadily grown and excess cash has been used wisely.  We think with today’s volatility the market is handing over a quality company and industry at more than a fair price.

Catalyst

Management execution