Wabtec (WAB) has certainly lost the benefit of the doubt it enjoyed for so many years, at least in terms of how the market viewed its growth potential and the multiples that growth potential was worth. Between worries about the quality of the business it acquired from GE (GE), management’s ability to integrate the deal, and underlying market/business trends in both freight and transit, expectations are certainly quite a bit lower now than a year or so ago, and the shares have lost about a third of their value since my last article on the company in early October.
Although I think there are still valid arguments for a fair value above $90, there’s a lot that Wabtec has to prove before that will resonate with the Street, and Wabtec needs to deliver some clean quarters before the market will pay 12x or more for forward EBITDA.
Some Growth In Freight, But Ongoing Challenges In Transit
I thought freight capex would bottom out in the first half of 1H’18 and then start a somewhat cautious recovering, and so far that seems to be what is happening. Full-year freight capex did improve around 6% or 7% in 2018 and is on pace for a slower low-single-digit continuation in 2019. For its part, Wabtec saw 2% organic growth in freight revenue in the first quarter, with modest improvement in segment-level margins.
On the other side, while transit growth was much stronger (revenue up 11% in organic terms in Q1’19), Wabtec continues to have margin challenges in this business, with segment-level margin declining about two points to a little over 8%. This has been a persistent issue ever since the completion of the Faiveley deal in 2016, and I think it speaks more to the differences in the freight/transit market and Wabtec’s over-ambitious expectations for share growth and synergy post-deal.
Freight Is Changing, But Not All Of The Changes Are Bad
The freight train capex market continues to change and evolve, and while some of those changes are potential headwinds for Wabtec, not all of the changes are bad.
On the negative side, the ongoing decline in coal as a fuel for electricity generation in the U.S. continues to have a significant impact on the industry. Coal is one of the heaviest cargoes rail operators carry, with coal trains requiring more locomotives and coal cars experiencing more wear – according to Greenbrier (GBX), coal cars go through one set of wheels on average per year, whereas intermodal cars require new wheels every 18 months, and other cargo types require even less frequent replacement. Likewise, oil shipments are no longer a source of growth for the industry and oil-by-rail is more of an intermittent and volatile aspect of carloads now.
Also on the negative side, at least in terms of perception, is the ongoing adoption of “Precision-Scheduled Railroading”. Through a combination of improved logistics (loading/unloading, turnarounds, tracking, scheduling, etc.) and different train designs (longer, heavier trains with more vertical stacking), rail operators like CSX (CSX) (arguably the most aggressive Class I adopter so far), rail companies are running fewer trains, but running longer and heavier trains with more precise departure and arrival times, partly to accommodate growing intermodal traffic.
Fewer trains would mean fewer locomotives and possibly fewer cars for Wabtec’s equipment and service offerings, but those locomotives and cars are getting worked harder (creating aftermarket part and service demand), and PSR creates more automation equipment demand, including systems like Trip Optimizer and GE’s Locotrol Distributed Power.
If the trend toward fewer-but-heavier trains continues, I believe it can be a net positive for the locomotive assets Wabtec acquired in the GE deal. About two-thirds of the 40K-unit North American locomotive installed base is older DC diesel technology and about 45% has a horsepower rating of 4,000 or below, both of which should help support demand for Wabtec’s more modern higher-HP AC locomotive offerings.
Ongoing Challenges In Transit
The GE deal pushes Wabtec’s exposure to transit rail back down toward one-third, which looks like a positive given the significant segment-level profit margin differences and Wabtec’s ongoing challenges to really compete effectively in this business.
On the freight side, I’m pretty comfortable where Wabtec sits with respect to rivals like Caterpillar (CAT) in locomotives and rail car equipment rivals. Likewise, I’m generally favorable on the content growth opportunities in automation/automation-enabling technologies and higher-performance locomotives, as well as growth/fleet refurbish opportunities in markets like Brazil, India, and perhaps China.
I’m not as favorable on the transit side. With Knorr-Bremse (OTCPK:KNRRF) (KBX.DE) now public, it’s easier to compare these two companies, and Wabtec definitely has its work cut out on the transit side. More than 80% of Knorr’s rail revenue comes from its transit rail business, and it enjoys around 50% share in braking systems (versus about 15% share for Wabtec), where it generates two-thirds of its rail revenue, and healthy share in entrance systems (25% vs. 20% for Wabtec) and HVAC (15% share versus 10% for Wabtec). Knorr isn’t as competitive in electronics subsystems or signaling/automation, but it is improving at a quick pace, with 6% of sales going into R&D and the recent acquisition of a stake in RailVision, a leader in cognitive vision sensor tech that I’d have liked to have seen Wabtec acquire.
Just as Wabtec wants to expand its transit content share, Knorr has some ambitions in freight. Still, I think Knorr is pragmatic about where its best opportunities lie, and while I think Wabtec will have its work cut out to build its transit business into one that rivals Knorr in terms of share and profitability, I don’t think Knorr is as big of a threat in freight outside of signaling and automation (where it’s a more level playing field in these early days).
I’m more cautious on the GE deal than before, largely given the fact that other businesses GE has sold off have seemingly been in worse-than-expected shape at the time of the deal announcements. I’m also a little more cautious given Wabtec’s challenges with the Faiveley deal, even though that was a different set of challenges (horizontal versus vertical expansion, et al), and with the new incoming CEO (who has led Wabtec’s Freight business for some time).
I reduced my revenue expectations due to changing trends in freight and longer-term challenges in share gains in transit, and I’m being more cautious now on the expected cost synergies and also trying to be more realistic about the longer-term margin opportunities on the transit side. I still believe a longer-term FCF margin in the mid-teens is doable, but it will take longer to get there. I’ve also chosen to bump my discount rate higher, mostly to reflect the fact that Wabtec hasn’t been as immune to cyclical factors or integration risks as previously supposed.
On the EV/EBITDA side, Wabtec currently trades around 11.5x its forward EBITDA estimate, versus a 10-year average of just under 12x and a five-year average under 14x. What’s “fair”? If Wabtec were a regular industrial company, its near-term margins, ROIC, and other metrics would support a multiple of around 12x. Knorr currently trades at around 12.5x, but has higher margins, while Stadler (an iffier comp given its different business mix) trades just under 12x forward EBITDA. With Knorr trading just below where my margin-driven model says it should, I’m comfortable with that as a secondary approach, and a 12x multiple on my 2019 EBITDA estimate gives me a fair value in the mid-$70’s.
The Bottom Line
With my DCF-based fair value in the high-$80’s now, I’m certainly expecting Wabtec to improve its profit margins and returns (ROIC, ROA, etc.) in the coming years, but it’s clear that Wall Street is reluctant to give much benefit of the doubt today. Some of that skepticism may be justified, particularly relative to the GE deal, but it is interesting to me how much this company has fallen out of the Street’s good graces. I’d definitely keep a careful eye on the next few quarterly reports, particularly as they relate to the real state of the GE assets, but I think these shares look worthy of further due diligence given where expectations seem to be.
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.