WABCO is a BUY. I believe WABCO’s intrinsic value is $71, which translates to 43% upside. I believe the risk/reward range is between $46 (8% downside) and $80 (61% upside).

I believe WABCO is a BUY for the following reasons:

1.       WABCO is a market leader in an industry with high barriers to entry

2.       WABCO is well positioned for growth due to positive secular trends and new market opportunities (presenting additional revenue sources and potential for margin expansion)

3.       WABCO is attractively valued – inexpensive on absolute valuation (EV/EBIT multiple and DCF), inexpensive to its history (its parents’ history, in this case), and inexpensive to peers. Given its high growth (double digit EBIT growth) and stellar ROTC (~100%), I believe WABCO is worth $71, which translates to 43% upside

 

WABCO is a leading provider of advanced auto parts products and solutions (specializing in braking, stability, suspension and transmission control systems) to commercial truck, trailer and bus OEMs.

 

·          Innovation Leader: WABCO dominates in a sub-sector where innovation is a key demand driver. Contrary to popular belief, the auto parts industry goes beyond the typical commodity products. Commercial vehicle OEMs, more than ever, are seeking ways to build more fuel efficient, more reliable and safer vehicles. OEMs have, thus, been increasing technical content – by sourcing technically advanced products from players such as WABCO – in commercial vehicles with each successive platform introduction. To meet such demand, WABCO maintains a strong innovation pipeline (examples of franchise products include: pneumatic anti-lock braking systems (ABS), electronic braking systems (EBS), automated manual transmission systems and air disk brakes).

 

·          Captive Audience: WABCO’s customers are loyal to the company in part due to the high switching costs of finding a new sourcing partner. Advanced auto parts products are typically built into the vehicle during the early stages of the vehicle’s development cycle.  As such, WABCO has been able to develop long-standing and collaborative relationships with its customer base. In addition, commercial vehicle OEMs are averse to switching to a new sourcing partner due to stringent safety regulatory requirements and the risk of sourcing from a new player lacking a proven track record.

 

WABCO has successfully built a large moat around its castle filled with crocodiles (strong innovation pipeline) and snapping turtles (captive customer base). Not surprisingly, WABCO’s products are included in 2 out of 3 commercial vehicles with advanced control systems.

 

·          Positive Secular Trends: Key value propositions of WABCO’s products and solutions are that they reduce overall vehicle operating costs and improve vehicle safety. As such, WABCO has been a beneficiary of two secular trends – growing demand for higher efficiency vehicles and increasing stringency in safety regulation. Commercial vehicle OEMs have been responding to the growing demand for more efficient and reliable vehicles as rising fuel costs put pressure on commercial vehicle operators (drivers, fleet owners). Further, the bar-on-safety has been rising over the years, requiring higher levels of compliance from OEMs. In Europe (where WABCO’s business is most weighted) and in Asia (where WABCO’s business is growing the fastest), regulatory oversight is even more prevalent than in the US.

 

·          New Revenue / High Margin Opportunity: The aftermarket currently represents a small part of WABCO’s business (22% of sales). However, the aftermarket presents a large opportunity as increasing number of vehicles in use have WABCO products in them, which drives demand for replacement parts and services. Not surprisingly, WABCO’s aftermarket business has grown twice as fast as the OEM business in the past 3 years. WABCO has stated its intention to beef up the aftermarket business, which should benefit the company in several ways. First, the aftermarket business will not only bring in additional revenue stream but will help to leverage fixed costs in the business (aftermarket business does not require much additional expenses as the products being sold are already part of the company’s product mix). Second, aftermarket business often commands higher margins because aftermarket customers are more fragmented than those in the OEM business (regional fleet owners, auto body repair shops, and individual truck owners).

·          Share Repurchase: The company has announced a share repurchase program, whereby it will repurchase $500M (11% of market cap), which should provide some near-term support for the stock.

 

My valuation consisted of several methods: (1) EV/EBIT multiple (Exhibit 2), (2) DCF (Exhibit 3), (3) historical P/E multiple of parent company (Exhibit 1), (4) P/E multiples of peers (Exhibit 4).

 

My final derivation of the intrinsic value (Exhibit 1) was determined by a weighted average calculation of the four methods with substantial weights given to the absolute valuation methods and smaller weights given to the relative valuation methods. This resulted in an intrinsic value of $71, presenting 43% upside to the current price.

 

In combination with the valuation, the healthy returns (ROTC in 100% range) and strong margin potential (double digit EBIT margin over the last 5 years) of this business lead me to believe that WABCO is an attractive investment opportunity.

 

Like most opportunities, WABCO is not without its share of potential risks:

 

·          An unfavorable outcome in its pending litigation with the European Commission Investigation (this is a litigation that WABCO has inherited as a result of its previous affiliation with American Standards)

·          A rise in warranty claims of its products or solutions (which historically has been in the range of 1.1%-2.6% of sales)

·          A significant mismatch between supply and demand as WABCO’s products typically require long lead times and thus the company needs to plan for capacity in advance

		2007	2008		Derived Price
Absolute Based on EV/EBIT
High					$80.36
Mid					$76.72
Low					$60.05
Absolute Based on DCF					$67.54
Historical P/E (of ASD) + 10% Premium		EPS
3-Yr Mean	14.3x	$3.06	$3.81		$54.44
2-Yr Mean	12.1x	3.06	3.81		$46.06
1-Yr Mean	13.3x	3.06	3.81		$50.67
Relative P/E		EPS
Comp High	16.5x	$3.06	$3.81		$63.03
Comp Mean	15.3x	3.06	3.81		$58.16
Comp Low	13.4x	3.06	3.81		$51.12
Fair Value Calculation					Weight
Absolute Based on EV/EBIT					45%
Absolute Based on DCF					45%
Historical P/E (of ASD) + 10% Premium					5%
Relative P/E					5%
Derived Intrinsic Value					$70.55
Price as of:	30-Dec-07				$49.75
Upside / (Downside) to Intrinsic Value					42%
Margin of Safety					29%

		Low	Mid	High
EBIT ('09)		$366	$385	$405
EBIT 2yr CAGR		13%	16%	19%
Multiple		12.0x	15.0x	15.0x
EV		4,387	5,779	6,082
- Net Debt (Trainling ('06))		40	40	40
+ Cash Build ('07-09)		667	667	667
Equity Value		5,013	6,406	6,709
FD Shares ('07)		69	69	69
Intrinsic Value		$72.66	$92.84	$97.24
Discounted '07 @ 10%		$60.05	$76.72	$80.36
% Upside		21%	54%	62%

		Fiscal Year Ending December 31,
		2002	2003	2004	2005	2006	2007	2008	2009
Free Cash Flow
NOPAT				$190	$147	$151	$213	$248	$285
Depreciation & Amortization				32	40	49	57	64	72
Gross Cash Flow				$222	$188	$200	$270	$313	$357
Change in Working Capital						15	(8)	(7)	(8)
Cash Flow Before Investment						$215	$262	$306	$350
Capital Expenditures						(65)	(82)	(106)	(118)
Operating Free Cash Flow						$150	$181	$200	$231
NOPAT Growth					-22.3%	2.7%	40.7%	16.7%	14.7%
WACC and Growth Assumptions
	WACC	10.0%
	Terminal Growth	5.0%
DCF Valuation
	PV of Free Cash Flows	$1,828	40.2%
	PV of Terminal Value	2,722	59.8%
	Implied TEV	$4,550	100.0%
	Plus: Excess Cash & Equivalents	35
	Less: Debt	75
	Less: Preferred	0
	Equity Value	$4,660
	Avg. Diluted Shares Outstanding	69
	Equity Value per Share	$67.54
	Recent Price	$49.75
	Potential Upside/(Downside)	35.8%

		Price	Mkt Cap	EV	EPS (2007)	P/E (2007)	EPS (2008)	P/E (2008)	EBIT (2007)	EV/EBIT (2007)	EBIT (2008)	EV/EBIT (2008)	Implied EBIT Margin (2007)	Implied EBIT Margin (2008)
Johnson Controls Inc	JCI	$40.07	23,922	28,482	$2.10	19.1x	$2.53	15.8x	1,817	15.7x	2,134	13.3x	5%	6%
BorgWarner	BWA	$93.64	4,916	5,546	$4.80	19.5x	$5.66	16.5x	422	13.2x	494	11.2x	8%	9%
Autoliv Inc	ALV	$62.08	4,414	5,468	$3.84	16.2x	$4.63	13.4x	523	10.4x	604	9.0x	8%	9%
Mean						18.3x		15.3x		13.1x		11.2x		8%
WABCO	WBC	$49.75	3,338	3,390	$3.06	16.3x	$3.81	13.1x	288	11.8x	336	10.1x	12%	13%

		Actuals					Expected
		2002	2003	2004	2005	2006	2007	2008	2009	2010
Sales		$1,057	$1,358	$1,724	$1,831	$2,015	$2,335	$2,639	$2,958	$3,242
COGS		768	972	1,252	1,313	1,464	1,693	1,911	2,140	2,341
Gross Profit		$290	$386	$471	$519	$552	$641	$728	$819	$900
SG&A		141	176	213	234	255	288	318	351	381
Product Engineering		52	64	66	74	72	93	106	118	130
EBIT		$115	$166	$213	$236	$248	$288	$336	$385	$429
Other Expense, Net		9	17	0	5	11	14	16	18	19
Net Interest Expense (Income) - Related Party		(7)	(4)	(5)	(6)	6	0	0	0	0
Interest Expense		0	3	3	4	5	(3)	(11)	(11)	(12)
EBT		$112	$149	$215	$233	$226	$277	$331	$378	$421
Income Taxes		$31	$37	$23	$87	$88	$72	$86	$98	$110
Net Income		$82	$112	$191	$145	$138	$205	$245	$280	$312
Shares - Basic		67.1	67.1	67.1	67.1	67.1	67.1	64.4	58.5	56.3
Shares - Diluted		69.0	69.0	69.0	69.0	69.0	69.0	66.3	60.4	58.2
EPS - Basic		$1.22	$1.67	$2.85	$2.17	$2.05	$3.06	$3.81	$4.78	$5.54
EPS - Diluted		$1.19	$1.63	$2.77	$2.11	$2.00	$2.97	$3.70	$4.63	$5.36

				Expected
		2005	2006	2007	2008	2009
Cash And Equivalents		$40	$35	$47	$53	$59
Accounts Receivable		145	204	236	267	299
Inventories		116	138	160	180	202
Deferred Taxes		19	15	15	15	15
Other Current Assets		29	36	36	36	36
Total Current Assets		$349	$427	$493	$550	$610
Net PPE		$260	$300	$324	$366	$412
Long-term Investments		79	85	85	85	85
Goodwill & Other Intangibles		312	344	314	279	241
Other Intangibles		40	37	39	39	39
Deferred Tax Assets, LT		14	42	42	42	42
Other Long-Term Assets		42	42	42	42	42
Total Assets		$1,095	$1,277	$1,339	$1,404	$1,471
Excess Cash / (Required Funding)		0	0	185	396	643
Accounts Payable		128	147	170	192	215
Accrued Exp.		136	177	205	232	260
Short-term Borrowings		7	18	18	18	18
Curr. Income Taxes Payable		39	66	66	66	66
Other Current Liabilities		55	69	69	69	69
Total Current Liabilities		$365	$476	$527	$576	$627
Long-Term Debt		$37	$57	$57	$207	$557
Minority Interest		10	11	11	11	11
Pension & Other Post-Retire. Benefits		323	366	366	366	366
Def. Tax Liability, Non-Curr.		18	19	19	19	19
Other Non-Current Liabilities		32	32	32	32	32
Total Liabilities		$785	$962	$1,013	$1,212	$1,613
Common Stock		298	306	306	306	306
Additional Paid In Capital		0	0	$0	($150)	($500)
Retained Earnings		0	0	$196	$423	$686
Comprehensive Inc. and Other		12.8	9.2	9.2	9.2	9.2
Total Shareholders' Equity		$311	$315	$511	$588	$501
Key Statistics
Cash And Equivalents		2.2%	1.7%	2.0%	2.0%	2.0%
Accounts Receivable		7.2	9.2	9.2	9.2	9.2
Inventories		8.1	8.6	8.6	8.6	8.6
Accounts Payable		8.9	9.2	9.2	9.2	9.2
Accrued Exp.		7.4%	8.8%	8.8%	8.8%	8.8%
Total Debt		$44	$75	$75	$225	$575
Debt to Captal		12.5%	19.3%	12.8%	27.7%	53.4%
Net Debt		5	40	(157)	(224)	(127)
ROTC Calculation
EBIT		$236	$248	$288	$336	$385
EBIT Margin		13%	12%	12%	13%	13%
Current Asset		349	427	493	550	610
- Ex-Cash	1.50%	12	5	12	13	15
-Current Liab		365	476	527	576	627
+ Curr Port of LTD		7	18	18	18	18
Net Working Capital		(21)	(36)	(29)	(21)	(14)
Net Fixed Assets		260	300	324	366	412
Total Capital Employed		238	264	296	344	398
ROTC		99%	94%	97%	98%	97%

					Expected
		2004	2005	2006	2007	2008	2009
Net Income		$191	$145	$138	$205	$245	$280
Depreciation & Amort.		32	40	49	57	64	72
Amort. of Goodwill and Intangibles		38	36	33	38	43	48
(Gain) Loss From Sale Of Assets		0	0	2	0	0	0
(Income) Loss on Equity Invest.		(9)	(10)	(5)	0	0	0
Stock-Based Compensation		0	0	3	0	0	0
Other Operating Activities		9	(10)	(16)	0	0	0
Change in Acc. Receivable		(28)	8	(38)	(32)	(31)	(32)
Change In Inventories		(17)	(8)	(10)	(22)	(21)	(22)
Change in Acc. Payable		(2)	(1)	5	23	22	23
Change In Other Working Capital		4	(7)	15	28	27	28
Net Cash from Operating Activities		$218	$195	$175	$297	$350	$397
Capital Expenditure		(58)	(62)	(65)	(82)	(106)	(118)
Sale of Property, Plant, and Equipment		1	1	0	0	0	0
Sale (Purchase) of Intangible assets		(11)	(8)	(8)	(9)	(9)	(9)
Net Cash from Investing Activities		($68)	($70)	($73)	($91)	($115)	($127)
Short Term Debt Issued		$8	$5	$20
Short Term Debt Repaid		(7)	(8)	(9)
Short Term Debt, Net		1	(4)	10	0	0	0
Long-Term Debt Repaid		(0)	(0)	(53)
Long-Term Debt Issued		0	0	65
Long-Term Debt, Net		(0)	(0)	12	0	150	350
Share Issuance, Net		0	0	0	0	(150)	(350)
Total Dividends Paid		0	0	0	(9)	(18)	(16)
Other Financing Activities		(143)	(107)	(133)	0	0	0
Net Cash from Financing Activities		($143)	($111)	($110)	($9)	($18)	($16)
Foreign Exchange Rate Adj.		1	(1)	2	0	0	0
Misc. Cash Flow Adj.		(0)	0	0	0	0	0
Net Increase/(Decrease) in Cash		$9	$13	($5)	$197	$217	$253
Cash & Equivalents at Beginning of Period			27	40	35	232	449
Cash & Equivalents at End of Period		$9	$40	$35	$232	$449	$702
Total Cash & Equivalents (B/S)			40	35	232	449	702
	Check:		(0)	(0)	(0)	(0)	(0)
Capex / Sales		-3.4%	-3.4%	-3.2%	-3.5%	-4.0%	-4.0%
FCF Yield		4%	4%	3%	6%	7%	8%