Wabtec Corp (WAB) is a very interesting business. The company provides equipment to the general railroad industry. While the North American freight business faces significant headwinds at the moment, Wabtec benefits from geographic diversification and exposure to overseas markets.
The nice mix between OEM and aftermarket sales and dominant market positions allow for stable margins, as the bolt-on dealmaking strategy has created a lot of value in the past. Following a recent sell-off since last year's highs, on the back of declining sales and deal uncertainty, I think that current levels start to look appealing.
Wabtec develops products and technologies which are used by trains and the related infrastructure. The company is quite innovative, owning many patents and through both organic growth and dealmaking has grown into a very large rail equipment company.
This is a specialized business and Wabtec plays a leading role. For example, Wabtec estimates to have a 50% market share for breaking related equipment in North America. Other key product lines include transit products, re-manufacturing and overhaul, as well as specialty products and electronics.
This equipment can be found on locomotives, freight cars and also on subway cars and even buses. This diversification is comforting for investors, as are long-term favorable trends. Continued urbanization trends as well as increasing environmental awareness continues to favor transit by rail.
The company posted record revenues of $3.31 billion in 2015 and is very profitable, with operating profits amounting to $608 million. Operating margins came in close to records at over 18% of sales, supported by the dominant positioning. Roughly, $2 billion of the annual sales come from the freight segment, being under pressure at the moment in North America and other parts of the world. Transit sales continue to grow however.
An Incredible Growth Story
Wabtec came into its current existence in 1999 when WABCO merged with MotivePower Industries. Organic growth and continued bolt-on deals have allowed the company to grow rapidly ever since. Sales broke the $1 billion mark in 2006 and have steadily grown to $3.3 billion by 2015. This is a solid achievement as the outstanding share base remained stable.
The diversified nature and large aftermarket exposure results in stable operating margins, coming in anywhere between 12 and 18% over the past decade. This is even the case during the economic crisis.
The reported growth has to an important extent been driven by dealmaking, with M&A activity totaling roughly $2 billion over the past decade. Wabtec has closed over 40 acquisitions over this time frame, often involving small bolt-on additions. Despite the strategy to grow by acquisitions, Wabtec has maintained a very strong balance sheet with leverage ratios often being very modest.
Current Headwinds & Deal Uncertainty
In July of 2015, Wabtec announced its intention to acquire French-based Faiveley Transport S.A. for $1.8 billion. This equipment and service provider to the railway industry generates sales of $1.2 billion and is active in energy & comfort, access & mobility, and brakes & safety equipment, as well as service categories. With the majority of sales being generated in Europe, Wabtec will significantly boost its footprint in the "old" Continent.
The deal is still pending and marks a "break" with the tradition to make bolt-on deals, as this is a sizable transaction. Wabtec has already put $303 million into escrow accounts, as 75% of the $1.8 billion deal tag will be financed in the form of stock. Investors in the French business will get 1.125 shares of Wabtec for each share they own.
As Faiveley is a publicly traded business itself, it is possible to track its operating performance since the deal has been announced. The company did post sales of EUR 1.1 billion in 2015 and reported actual operating profits of EUR 79 million, with adjusted operating profits amounting to EUR 108 million. These 9.8% margins are lagging compared to Wabtec. For this reason and others, Wabtec sees the potential to take out EUR 40 million in annual costs. If these synergies are taken into account, Wabtec pays a 1.5 times sales multiple and 11 times operating profits.
The fact that the deal has not yet closed, and the North American freight railroad business is suffering from severe volume declines, has weighed on Wabtec's stock. Shares have fallen from a peak at around $100 in the summer of 2015 to current levels around $65. With a large portion of the Faiveley deal taking place in Wabtec's stock, this decline could potentially complicate or delay the deal going forwards.
The Pro-Forma Basis & Current Trends
Wabtec derives the majority of its sales from the Freight Group and this business is hit hard by declining volumes, particularly in North America. While many of Wabtec's services are taking place in the aftermarket, these sales come under pressure as well amidst lower miles being driven.
Wabtec reported a 10% decline in sales for the first six months of the year, marking a rare revenue decline. The company now guides for sales of $3 billion this year. It is important to stress that transit revenues are up by mid-single digits, as the Freight Group sales fell by 25% in the second quarter, driven by the harsh conditions in that industry.
Despite the fall in sales, the margin performance is very strong with operating margins being stable at more than 18% of sales. This stable margin base and the buyback of many shares actually results in flattish earnings per share developments so far in 2016. The poor headline sales developments did prompt management in cutting the full year earnings guidance to a still respectable $4.00-$4.20 per share.
Net debt stood at just $435 million by the end of the second quarter, not taking into account escrow cash balances for the Faiveley deal of little over $300 million.
Wabtec is still comfortable that the deal will close later this year. The 25% cash component suggests that escrow balances will need to increase by another $150 million, for a net debt load of roughly $600 million. The remaining 75% portion of the purchase price will result in roughly 16 million shares to be issued to Faiveley's shareholders, diluting the shareholder base to 106 million shares.
These shares now trade at $66, for an equity valuation of $7.0 billion as the net debt load increases the enterprise valuation to $7.6 billion. The pro-forma business posts sales of roughly $4.2 billion, operating profits of $520 million (or $570 million after factoring in synergies).
Wabtec's earnings now come in at roughly $360 million going forwards. If we add a $150 million operating profit contribution from Faiveley (including synergies), pro-forma earnings should come in around $450 million at a minimum. That would be equivalent of roughly $4.25 per share, with potential upside to this number.
Wabtec is a very nice business with a great track record. While sales can be somewhat cyclical, the long-term performance is good. The exposure to the US freight railroad business is hurting the business at the moment, as the continued diversification efforts abroad and into transit create real diversification benefits for the business.
While French deals can be difficult, Wabtec is buying its French rival at 1.5 times sales while its own business trades at close to 2 times revenues. The discount results from lower margins reported by the acquisition target, although that can in part be offset by the anticipated synergies. Given the great track record of Wabtec in making deals, and the fact that leverage remains less than 1 times sales, I feel comfortable with the deal, even as 2016 is a somewhat difficult year.
If earnings of $4.25 might be achieved going forward, shares trade at just 15 times earnings, even as these are difficult days for the freight group business with top line sales falling by a quarter. The strong margin performance, very modest leverage employed and great track record certainly act as potential drivers to unleash upside potential.
One has to take into account the huge momentum run from $20 in 2011 to $100 in 2015. After this huge run, investors have surely incurred some losses over the past year. At current levels in the mid-to-high sixties, appeal is certainly to be seen. This is certainly the case as long-term favorable trends continue to be intact as the market positioning of Wabtec is very strong. On any pullback towards the low sixties, you can count on me as a buyer of the stock.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.