Description

Business Description

Wabtec is a leading global provider of rail parts, supplies, and aftermarket services.  The company sells brakes, HVAC, and monitoring systems, energy exchangers, compressors, overhaul services, etc.  With the recent acquisition of GE Transport (GET), more than half of WAB’s revenues and a slightly larger share of EBITDA come from locomotive sales and servicing.

Pro forma for the transformational GET deal, revenues are split roughly evenly between OEM and aftermarket (with overhauls more conservatively treated as OEM).  Freight is ~2/3^rd of revenue and ~75% of profit; transit is ~1/3^rd of revenue and ~25% of profit, but transit (and GET) margins are currently depressed.  Freight is higher margin, but more cyclical.  Transit is the opposite.  Geographically, revenues are ~45% U.S. and ~55% ROW.

Business Quality

Legacy WAB earned ROICs in the mid-30’s (ex-intangibles) and high teens overall by selling mission critical parts and services that are a small part of a rail operator’s overall cost structure.  The company has a substantial installed base of safety and performance products (most notably brakes), which customers tend to purchase from the OEM (i.e., WAB).  BTE are significant.  New equipment must be interoperable with existing equipment, which favors WAB and its large installed base.  Significant regulatory oversight of the rail manufacturers and operators impose a burden on new entrants.  Furthermore, while the overall rail supply market is quite large ($100b+ globally) most individual product categories tend to be relatively small.  For example, primary braking, a key market for WAB, is only ~$1.2b.  This limits the appeal to a prospective new entrant, particularly given that WAB’s market share is ~50%.  WAB is further protected by significant R&D spending.  WAB employs ~1,500 engineers globally and has >4,000 active patents and nearly 100 annual new applications (pre-GET).  Importantly, the freight biz is essentially a duopoly with Knorr, a recently-listed German company. 

We think GET is a similarly high quality asset.  In most markets, GET operates in a duopoly for locomotive sales and services.  GET generates nearly half its revenue from services on a global installed base of ~23k locomotives, 70% of which is subject to long-term contracts.  Another 7% of revenue comes from digital services that help customers to improve fuel efficiency, network velocity, and volumes.  Coupled with WAB’s PTC (positive train control) technology, the combined company is uniquely well-positioned to offer next generation services like autonomous trains.  We lack precise ROIC data for GET historically, but it should look similar to WAB given a similar margin structure and low capital intensity (capex ~2% of sales).

Investment Thesis

Wabtec is a high quality industrial company with a long history of EPS compounding that we believe is mispriced because of an unusual confluence of structural, technical, and cyclical factors.  The core WAB franchise is a compounding machine with attractive underlying organic growth (MSD through the cycle) and a chassis built for bolt-on acquisitions (another MSD growth contributor historically).  The rail supply industry is large and fragmented, and WAB has excelled at making accretive acquisitions over the years.  WAB’s roll-up of the sector is analogous to TransDigm’s approach in the similarly structured aerospace industry.  More recently, WAB has made two transformative acquisitions: Faiveley, a European rail supply company focused on transit, and GET.  Both were opportunistic.  Faiveley actually used to be part of Wabtec: ~20 years ago it was Westinghouse’s transit and international operation.  As such, it’s quite complementary to WAB.  With GET, WAB capitalized on a distressed seller dumping a marquee asset at a particularly depressed point in the cycle.  These deals have made WAB a much more diversified player by product line and have broadened the company’s geographic footprint, which was historically limited mostly to the U.S.  Importantly, WAB’s former CEO, Al Neupaver, has returned to oversee the GET integration.  During Neupaver’s 10-year run, WAB increased margins 800 bps and grew EPS at a 16% CAGR.

A combination of structural (big M&A), technical (GET-related selling pressure), and cyclical (product cycle, not economic) factors has depressed WAB’s share price following initial enthusiasm for the GET transaction.  The stock is also a popular short for those with rail longs and is routinely flogged by several research houses.  This has provided the opportunity to buy WAB at a 12x P/E on 2020 cash EPS (net of deal-related tax savings), much lower than WAB’s historical valuation.  We project a high-teens CAGR in cash EPS over the next five years with further optionality from future capital deployment.  In addition to being relatively highly shorted, WAB’s ownership profile is uncrowded, with few hedge fund holders.

There are a variety of inefficiencies associated with WAB today, the most notable of which include:

·         GAAP accounting obfuscates reality (headline EPS depressed by material deal amortization that mgmt conservatively includes in its EPS definition)

·        A massive transition in the shareholder base (GE owned roughly half the company either directly or via a spin-off to GE shareholders; those shares are being sold, probably in full)

·         Large scale M&A and complexity (mostly related to GET transaction)

·         Time horizon arbitrage (lots of moving parts today, including weird non-economic cyclical factors).

Key Stock Debates

Was acquiring GET the right thing to do?

·      GET was a once-in-a-lifetime transaction for WAB.  Rarely does a premier asset like this come up for sale, and even more rarely from a distressed seller at a cycle trough.  Giving credit to projected synergies and tax savings, WAB paid ~8x normalized EBITDA for GET, a very attractive price for this asset.

·      GET has an attractive financial profile that is very similar to WAB’s in terms of revenue mix (OEM vs. aftermarket), margins, and (we think) ROIC.  WAB is a long-time supplier to GET, so the asset is familiar.

Has WAB “di-worsified” through large scale M&A recently / was Faiveley a flop?

·       It’s too soon to pass judgment on GET, but the Faiveley deal has had hiccups.  WAB inherited some contracts in the UK that were money losing, which offset other achieve cost synergies.  There was finally evidence of improvement in Q4-18, when transit margins increased 100 bps y/y.  Per mgmt., the UK problems are finally contained.  Q2-19 margins showed even more improvement.

·       It’s true that transit is generally lower margin than freight, but Faiveley’s pre-acquisition ROICs were not far off WAB’s (~16% vs. high teens), and that was for a French-run company.  On the other hand, transit tends to be steadier and less cyclical than freight.  Faiveley also significantly expanded WAB’s geographic footprint, making it a credible bidder for non-U.S. contracts (per our call work, it wasn’t previously).  Our contacts confirmed that Knorr over-indexed in a number of international markets with share as high as 70%.  Customers are keen to find another supplier, and WAB is the logical share taker.

Will PSR be a material headwind?

·    PSR (precision schedule railroading) temporarily reduces a rail operator’s capex and opex.  In the last year, NSC, UNP, and KSU have announced PSR transformations, which will reduce spend for a period of time.  CSX is in year 2 of its transformation.  Collectively, these four rails have guided capex down 4% in 2019.

·       Importantly, we have a good sense for PSR’s impact based on CP and CN’s experience several years ago.  The punchline is that capex fell for a couple of years and then rose sharply.  Bears argue that the U.S. rails will decrease capex without the subsequent increase, which seems at odds with history.  Moreover, the U.S. rails have enjoyed an unrelated holiday on locomotive spending following regulatory-driven pre-buy, which will reverse – and perhaps make the GET deal look genius in time.

·      Despite the dampening effect of ongoing PSR transformations, overall class I capex is projected to increase 11% in 2019.  In 2020, CSX shifts back into a capex spending phase with NSC, UNP, KSU following suit in 2021.

·       Even adjusting for PSR, the market looks undersupplied by a MSD% (~70-100k railcars).  This is based on the in-service fleet divided by carloads, adjusted for speed.  Currently this is < zero, implying under-capacity.

Is the rail supply industry structure changing adversely?

·      Bears have pointed to changes in the tier one OEM landscape, notably Chinese operator CRRC’s emergence and consolidation efforts among other players as worrisome to WAB’s positioning as a tier two supplier.

·       These worries appear misplaced.  Regarding CRRC, the company only manufactures low value-add components, not the complex systems manufactured and serviced by WAB.  CRRC is also evidently pulling back on its global expansion after (a) issues in the U.S., (b) an inability to access the European market, and (c) increasing domestic demand in China.  Meanwhile, the EU blocked the Alstom-Siemens merger, preventing consolidation of WAB’s customer base.

·        At the same time, WAB’s competitive positioning has improved with the GET and Faiveley acquisitions, which have significantly expanded the company’s scale, content per unit, and geographic scope. 

Is something amiss with WAB’s FCF conversion?

·        Recently, a new leg of the WAB bear case has emerged: that the company’s FCF is well below earnings and thus those earnings are low quality.

·        Here are the facts: from 2008-2016, FCF equaled about 99% of adjusted net income according to Bloomberg.  In 2017, this figure dipped to 30% because of poor working capital management and Faiveley-related restructuring costs.  It improved to 60% in 2018 and mgmt is forecasting ~95% in 2019. 

·       We won’t defend poor cash conversion recently, but (a) the long-term results are quite good, and (b) the trajectory is improving – so we don’t think this is particularly compelling bear argument.

Other investment merits / research insights: 

·         Optionality from electronically controlled pneumatic brakes and autonomous trains (leveraging monopolistic PTC technology).

·         Large, growing, fragmented M&A TAM that provides a long runway for additional bolt-ons; Faiveley + GET expand potential.

·         Cycle upside: railcar and locomotive sales should bottom in 2019; both are materially below median (not peak) levels.

·         WAB’s content/railcar is only $4k vs. $16k total and $8k of addressable content/railcar presuming customers dual source.

·         N.A. freight is a well-structured market (duopolistic, regulatory BTE’s) with good LT prospects as rail takes share from trucking, which is higher-priced and less climate-friendly, but accounts for 60% of long-haul freight tonnage.

Valuation / Expected Return:

·       In our base case, WAB earns ~$10.50 in 2024 cash EPS.  This figure includes modest tuck-in M&A spend starting in 2020, and 50% of residual FCF allocated to buybacks starting in 2021.  The remaining FCF goes to debt repayment, leaving WAB ~0.5x levered at the end of 2023.  At 17x (a discount to its peer group), WAB is worth ~$182/share including dividends.  In addition, there’s ~$5/share of discounted future tax savings and ~$21/share in dry powder assuming the balance stays at 2x net leverage.  We discount these by 50%.  The net result is a ~25% IRR over ~4.3 years.

·       In a bear case, WAB earns ~$4.45 of cash EPS in 2019, which is essentially 15% below guidance (giving credit for ~75c in PPA).  Recall WAB’s 2019 guidance includes only 10 months of GET and $20m (of $250m total targeted) synergies.  If we value this at 15x and ignore the NPV of future tax savings, the stock is worth ~$63/share, or -12% from the current price.  It’s noteworthy that this effectively capitalizes GET’s earnings at trough levels of locomotive deliveries, which doesn’t make a lot of sense to us.

To be clear, we’re not advocating a WAB long position with a short-term view.  Railcar volumes have been weak recently, PSR adoption is likely to slow demand for parts and services in the short term, and any merger of GET’s magnitude will have hiccups, though it has not to date.  Our view is premised on the quality of the company’s business model and its underlying cash earnings power, which we believe will materially exceed expectations over a 3-5 year-time frame.    

And now we expect the bears to pounce in Q&A…

Catalyst

Additional improvement in transit margins

Achievement of targeted synergies

Lack of material impact from PSR