Is GE's Loss Wabtec's Gain

Summary

• Wabtec is embarking on a transformative acquisition.
• It has much experience in acquisitions, although not this large.
• The diesel-electric locomotive business has been hit hard.
• I believe the locomotive business will turn around.
• Urban transit is also a growth market.

Wabtec (NYSE:WAB) started as Westinghouse Air Brake in 1869! It's first product, the automatic air brake, revolutionized the railroad industry. WAB is one of the few companies of that era to survive in more or less its original form. It now supplies a variety of components and supplies to the world railroad industry, freight, passenger and transit.

The railroad supply industry was historically somewhat fragmented, like the railroads themselves. As the North American class I railroads have merged into eight companies, their negotiating power has increased relative to their suppliers. Wabtec has slowly been attempting to rationalize the supply industry by means of multiple acquisitions. Many of these were small or medium sized, although it merged with Faiveley Transportation (a French company) in 2015. This was closer to a merger of equals. It is now embarking on what could become a transformative acquisition, purchasing the RR motive power business of General Electric (GE).

WAB is firmly in the mid-cap space and not widely researched. Here are some basic facts:

All values in $US and as the latest reported.

EPS	$3.11
Annual Revenue	$3.3 Billion
Transit %	64%
Freight %	36%
US %	34%
ROW %	66%
P/E	15.3
P/Book	2.2
EPS CAGR 2007-2018	9.7%
Sales CAGR 2007-2018	11%
Net Debt as % of Total Assets, Latest	45%

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The full table of the latest financials is at this link.

At first glance I found it surprising that WAB was able to grow so quickly in a mature industry. The reason of course is their acquisitions, particularly Faiveley. As part of this process WAB has levered up. Net debt was actually negative 10 years ago.

Before I give the bull case, I want to address a valuation issue. The company has a tangible book value of negative ($674MM). This would normally be a deal-breaker for me, but not here. The main reason is Faiveley, which created $1.2 billion in goodwill. I believe this is OK. Faiveley is a long-time major factor in the European transit and railroads, and its earnings power justified the price paid.

OK, here's why I like the company:

Great timing in entering the locomotive business

The North American large diesel-electric locomotive business is essentially a duopoly: GE Transportation and Caterpillar (Progress Rail). Not only that, but these companies export to much of the world. Even China's production is made in concert with GE. Note that much of the world uses pure electric power, so this does not mean a full locomotive duopoly.

The N. American locomotive market has been weak for several years, even though freight railroad volumes are up nicely. GE Transportation's sales have fallen from $5.9B in 2015 to $4.2B in 2017.

Two reasons:

- More efficient use of locomotives. N. American railroads have gone on a rationalization of assets in recent years. This goes by many names, most popular being Precision Scheduled Railroading. This has led to faster trains, less dwelling in yards or terminals and fewer locos ready but unused. However, this is a one time reduction, not a change in the rate of growth. The important point is that locomotives have a limited useful miles/hours of life until replacement or rebuild. Being worked more intensively does not change this. So new orders will reach a higher plateau once this process is done. The railroads that embarked on this process earlier, especially Canadian National (CNI), are already stepping up orders.

- Timing of emission standards. The federally mandated Phase IV emission controls became fully effective in 2015. These controls added significant costs. In order to get ahead of them, the US railroads ordered extra locomotives under the old standards. This curtailed new sales for several years. Again, I believe this is a temporary hurdle. The federal rule is quite strict; even locomotives that are rebuilt will have to be upgraded according to a set formula. So I believe this headwind is dying as we speak.

There is also a large non-US opportunity. Although many of the centralized countries, like the EU and China, have gone the way of electric locomotives, many of the growing emerging markets are using diesel. This is far more efficient of capital, and puts less strain on overburdened power grids. GE received the largest locomotive order ever from India, for 1000 locos. In many cases these will not be built in the US, but I believe Wabtec will be able to monetise this.

Continued urbanization and transit installations

Many readers may not be aware that urban transit is a nicely growing industry. In the US we note people moving to dense urban centers on the coasts, but this is true around the world. Urbanization makes transit necessary and possible. Wabtec is involved in heavy rail (subways, commuter rail), light rail and busses.

Here is a table of world transit rides. Currently, most of WAB's business is in N. America and Europe, although that is shifting.

Note: all transit data from the UITP at this link.

Billion Rides	Asia/Pacific	Europe	N. America
2013	20	9.7	3.3
2013	19	9.5	3.4
2014	21	9.9	3.5
2015	22	10.3	3.6
2016	24	10.5	3.6
2017	26	10.7	3.7
% growth 13-17	+27%	+11%	+11%

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So I expect that transit will continue to be a growing and profitable segment.

The GE acquisition and share count

GE Transportation is a big bite, and will have major effects on WAB's financial structure. The deal is complicated, and has been well discussed before on SA. Since my addition to this conversation is mostly about the business economics, I will not elaborate. The important point is that both debt, preferred stock and common share counts will be up substantially. So this makes WAB a riskier company. Size your positions accordingly.

Readers wanting to get into the weeds on this should link here.

Potential for unusual selling of Wabtec

A risk that may or may not come to fruition is blind selling of WAB by GE holders. It is possible that some holders of GE will not want to have WAB. After all, GE is a large cap, highly discussed company. WAB is the opposite. A pension fund say, who has a certain exposure to the transportation sector may not want to increase it. So he might just sell his WAB. The result is downward pressure on the stock.

GE Risk

All the normal risks of an industrial company with a big merger apply here. Railroads are highly cyclical. The GE acquisition may involve culture shock. And so on. There is one more that must be considered. GE has been a badly run company for many years, maybe decades. It has squandered several incredibly valuable franchises, and there have been operational problems in some of its businesses. From the outside GE Transportation seems to be OK operationally, but who knows. Maybe the GE rot has infected it as well. Hopefully Wabtec has done their due diligence and are convinced things are OK. Time will tell.

Analyst’s Disclosure: I am/we are long GE, WAB. 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.