Wabtec Is Fully Valued After Recent Momentum Run, And Making Progress On Faiveley

| About: Westinghouse Air (WAB)
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Summary

Wabtec is finally making real progress with the $1.7 billion purchase of Faiveley.

This observation and guidance for flat revenues in 2017 reassures investors after a difficult 2016.

The excellent positioning and long term value creation make shares an appealing long term investment, yet after the recent run higher I am not a buyer at these levels.

Wabtec (WAB) is finally making some real progress with the purchase of Faiveley, a deal which has initially been announced a year ago. Following the closure of the deal, while revenues of the core business being anticipated to stabilize in the coming year, investors have been enthusiastic about the prospects for this long term value creator.

After a big run-up seen in recent months, with shares being up a quarter so far this year, the valuation has become full. At these levels the immediate appeal is very limited, while the company remains an excellent long term value creator and investment opportunity of course. If shares potentially retreat towards the mid-seventies, I am attracted to re-initiate a position.

Almost In Business For 150 Years

Wabtec dates back to 1869 when George Westinghouse invented the air brake. Ever since the company has continued to grow its operations, becoming a global supplier of components and systems for rail and selective industrial markets.

The large installed base creates barriers of entry, shielding the company from competition, thereby allowing the company to deliver upon high and stable margins. While high and stable margins are appealing for investors, they are even more appealing as the company has delivered on solid organic growth in recent years, accompanied by solid dealmaking at times.

This made Wabtec a strong value creating vehicle for investors in recent years. Important as well, incentives are aligned as the board and management team holds a combined 5% stake in the business.

Sales have tripled between 2006 and 2015 when they hit a record of $3.3 billion, as operating margins improved some 6 points to 18% of sales, allowing earnings per share to increase by a factor of nearly 5 times. Much of this growth has been achieved organically, although Wabtec has bought some 40 (often small) companies as well over the past decade.

There have been some troubles in paradise however. The plunge in oil and coal prices has hurt rail and transportation volumes in North America and other parts of the world. This has hurt Wabtec as it generates two thirds of sales in the NAFTA area and relies for nearly a similar percentage on freight. These headwinds prompted railroad companies to cut back on capital spending in 2015 and 2016, hurting this year´s results.

That being said long term drivers remain intact as Wabtec has the potential to play a leading role in consolidating a $100 billion railroad equipment market. This market is set to continue to grow thanks to long term drivers including urbanization, improved safety and stricter environmental regulation.

Finally Progress On Faiveley

Wabtec had finally some good news to share about the progress with regards to the purchase of Faiveley Transport. It completed the purchase of the 51% stake held by family. Once completed, Faiveley is anticipated to add $1.2 billion in annual sales, be slightly accretive to 2017s earnings per share, and deliver upon $50 million in synergies by 2020.

The total purchase price of the company amounts to $1.7 billion in a rather complicated deal. The family receives $212 million in cash and 6.3 million shares for their 51% stake in the company. The other investors, who combined hold a 49% stake in the business, have the opportunity to either elect cash or shares.

What About The Outlook?

Wabtec is facing real headwinds of course this year amidst cuts in capital spending. Sales are seen down 10% towards $2.95 billion this year as a result of this trend, with GAAP earnings seen at $3.45-$3.50 per share, as adjusted earnings are seen half a dollar higher.

For the coming year, that is 2017, revenues are seen at $4.2 billion. If we assume a $1.2 billion revenue contribution from Faiveley, that suggests that organic sales are anticipated to be rather flattish. The company furthermore guides for adjusted earnings of 15-16% of sales. The company has not issued a specific earnings per share target, but we will construct the estimates based on the information provided by Wabtec in the following section.

Pro-Forma Implications

Wabtec reported its third quarter results at the end of October, a quarter which was difficult with revenues being down over 16% year-over-year. This was driven by the softness in freight as transit revenues were up slightly on the year before. The company ended the quarter with $250 million in cash and $210 million in escrow deposits, for a $460 million ¨cash¨ position.

Debt, including post-retirement liabilities, stood at $875 million. Including the $1.7 billion purchase of Faiveley minus the +$500 million share consideration to the Faiveley family, suggest a $1.2 billion consideration of cash being forked over to the previous owners, or debt being assumed by Wabtec. That suggests that pro-forma is seen at $1.6 billion, based on the assumption that all the remaining shareholders in Faiveley, who combined hold a 49% stake, elect for a cash consideration.

Based on pro-forma sales of $4.2 billion and 15-16% adjusted margins, operating profits could come in at around $650 million in 2017. After adding back roughly $75 million in depreciation & amortization charges, EBITDA is seen around $725 million, for a 2.2 times leverage ratio. Again, if other investors in Faiveley elect for shares in Wabtec, leverage ratios will come in lower, at the expense of additional dilution.

The number of outstanding shares rises from 90 to 96 million shares following the shares issued to the Faiveley family, assuming that the other 49% shareholders in the company elect for cash. Using a net debt position of $1.6 billion and 4% cost of debt, I see interest expenses at $65 million. That leaves earnings before tax of $585 million which combined with a 30% tax rate results in net earnings of $410 million. Factoring in dilution towards 96 million shares, earnings are seen at $4.25 per share going forwards.

The $50 million in anticipated cost synergies down the road have the potential to add $0.35-$0.40 to earnings per share. Unfortunately, it will take until 2020 before all these synergies are being realized.

Final Thoughts

Back in July I had a lock at the prospects for Wabtec, with shares trading in their mid-sixties at the time. I continue to like the underlying business and management a lot, yet shares have risen by a more than a third since that period of time, now trading at levels around $88 per share. Following this run higher, the valuation is full at 22 times adjusted earnings, while the balance sheet is leveraged at +2 times.

The company now trades at a 20% premium in terms of sales and EBITDA multiples compared to their ten year averages, using the pro-forma guidance for 2017. This does not mean that shares are too expensive, as valuation multiples across the board have increased in recent years in this low interest rate environment. Given the multiple and increase in leverage, I simply do not see real triggers for outsized capital gains in the short to medium term.

Applying a market multiple of 17-18 times on pro-forma earnings of $4.25 per share, I am a buyer if shares unexpectedly retreat towards the mid-seventies, but for now no longer hold a position.

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.