- Wabtec continues to suffer the impact of major changes in the North American rail freight market, including dramatically lower locomotive demand and high levels of stacked equipment.
- Transit is looking better from a growth perspective, but management needs to maximize the margin potential of this business to really take advantage.
- Wabtec may be washed out from a sentiment perspective, and I can see a path to a $100 share price in 2023, but investors will need to be patient.
When I last wrote about Wabtec (NYSE:WAB), my call was a pretty tepid “neutral”, as although I saw some undervaluation in the shares, I didn’t have much confidence in the rail freight outlook, nor in management’s ability to drive internal outperformance. Since then, the shares have risen about 5%, more or less tracking the S&P 500, but lagging the Dow Jones Transportation Average by about 10%.
Unfortunately, I still don’t see many reasons to be positive in the short term. Rail freight is shaping up poorly for Wabtec in 2021, with virtually no demand for new locomotives, inadequate demand for locomotive overhauls, and weak freight car build rates, and while the outlook for transport is brighter, it’s a lower-margin business.
I can respect the idea of buying into stocks at the point of “maximum pessimism”, and maybe Wabtec is near that point. Likewise, I can see Wabtec as a $100 stock in 2023, but investors are going to need some patience here.
Freight Continuing To Struggle
There were some glimmers of hope in the fourth quarter of 2020 as rail freight carload traffic started to improve, but it didn’t really deliver any benefits to Wabtec.
Freight revenue declined 20% in the fourth quarter (to $1.3B), contributing to a 3% miss in Freight revenue for Wabtec and the eighth straight quarter of declines. Basically everything was bad, as equipment sales declined 32%, digital electronics sales were down 22% (the second straight quarter of declines), and service revenue was down 4%. With poor overhead absorption, segment profits dropped 31%, with margin falling 250bp to 16.3%.
I don’t believe that Wabtec is losing meaningful share in the market, but rather that the market has changed in ways that are bad for Wabtec. For starters, precision scheduled railroading has led to dramatically reduced locomotives in service, as railroads run fewer (but longer and heavier) trains, and Wabtec expects no new locomotive deliveries in North America in 2021.
Second, railroads continue to see more and more demand for intermodal service, which don’t require freight cars. Coupled with declines in demand for other categories of freight, about one-quarter of the U.S. rail car fleet is currently in storage, and management expects a further decline in new car builds (from 30K to 25K) in 2021.
Third, management isn’t seeing the hoped-for demand in digital electronics sales, including the Trip Optimizer product which allows for an autonomous cruise control that maximizes fuel efficiency.
Honestly, a 6% decline in the freight backlog (and an 8% decline in the one-year backlog) is actually pretty benign for Wabtec relative to some of the industry metrics. While locomotive demand is looking better outside the U.S., and I’m still expecting to see increased locomotive modernization and overhaul revenue in 2022 and beyond (and perhaps some new locomotive sales), this is a business under strain now.
Transit Looking Better, But Profitability Is A Challenge
Wabtec reported an 8% organic revenue decline in the Transit business in the fourth quarter (to $684M), but this business is on the upturn. Profitability improved significantly, with 40% segment-level profit growth and a 340bp margin improvement to 11.3%. Better still, the one-year backlog grew 14% and the overall backlog grew 6%, the first such growth in nine quarters.
Demand for Wabtec’s transit offerings is improving after a prolonged effort on the part of the company to grow and improve this business, coupled with fundamental end-market improvement. Governments around the world continue to invest in transit rail as a cost-effective and more environmentally friendly transportation option, and while usage has already improved from pandemic lows (as people either learn to adapt to the new circumstances or have no choice but to adapt), I expect further improvements as global vaccination rates climb.
I do see a good growth outlook here, particularly with the possibility of a meaningful U.S. infrastructure initiative. The challenge for Wabtec, then, will be to continue to deliver better margins. I don’t think the Transit segment will ever be as profitable as Freight on an apples-to-apples basis given the difference in product mix, but I do believe it can be better, as Knorr-Bremse (OTCPK:KNRRY) generates considerably better margins in its transit-dominated rail business (over 21% this fourth quarter and almost 21% in Q4’19). To be clear, I’m not calling for parity, and there are important differences in the businesses, but rather making the point that there are opportunities for Wabtec to do better.
I do think there’s some chance that Wabtec could see better than expected locomotive overhaul demand in 2021 in North America, and I likewise do think that overall rail freight conditions should continue to recover. The EIA expects coal production to increase 12% in 2021 and Caterpillar (CAT) has guided to some growth in mining in the year, so that should help that category, and strong grain prices should incentivize a healthy planting season.
Still, there’s no escaping the fact that the North American rail freight market has changed and the international market isn’t going to fully offset that. More growth in the Transit business can help, but I want to see better profitability here.
I’m still expecting less than 3% long-term annualized revenue growth from Wabtec, but I’m also still expecting margin and asset utilization improvement to drive higher FCF margins over time (from the 9% to 10% range to the mid-teens) and mid-single-digit FCF growth. In the short term, I expect operating margins around 16% and ROICs in the 6% to 7% range
The Bottom Line
Neither discounted cash flow nor margin/return-driven EV/EBITDA suggest to me that Wabtec is a clear-cut bargain today. I do think there’s a mid-to-high single-digit total annualized long-term return potential at today’s price, though, and I could see Wabtec as a $100 stock in 2023. I also think that expectations and sentiment are pretty washed out now. That’s typically not a bad time to buy in, and I’m generally a fan of the idea of buying in at a point of “maximum pessimism”, but this is a name that will take patience.
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