Wabtec Makes Its Third-Largest Deal, And Rail Continues To Recover

 

Writing about Wabtec (NYSE:WAB) a month ago, I did see some near-term risks to the business from the freight business, but more so from sell-side expectations that I thought were a little too high. I also saw an opportunity to buy into a large player in freight and passenger train equipment and services at a time when pessimism was still running high.

A month isn’t much of a window for evaluating performance, but the shares have modestly outperformed the S&P 500 since then (while almost matching the Dow Jones Transports). More interesting to me are the revisions in sell-side expectations, the announcement of the Nordco deal, and some opportunities tied to federal infrastructure stimulus. Between them, I believe Wabtec has upgraded the business and expectations are a little more reasonable for the near term.

I still believe that Wabtec could be a $100-plus stock in 2023 and in normal markets, that’s not a bad prospective return. I’m expecting long-term adjusted revenue in the low single-digits, reflecting challenges and changes in the freight market, as well as mid-single-digit FCF growth and margin improvements over the next three to five years.

 

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Wabtec Makes Its Third-Largest Deal, And Rail Continues To Recover

Wabtec Struggling With Weak Freight Demand And Poor Operating Leverage

When I last wrote about Wabtec (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.

 

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Wabtec Struggling With Weak Freight Demand And Poor Operating Leverage

Wabtec Doing A Little Better Than Expected On Margins In A Swift, Brutal Downturn

It's tough to make much headway as a supplier of equipment for freight and passenger trains when about a third of North American railcars are idled and passengers either don't need to get onto trains (because they're working from home) or just don't want to. And yet, Wabtec (WAB) has managed to generate pretty good decremental margins on a sharp decline in revenue and the backlog really isn't in too bad of shape.

When I last wrote about Wabtec, I said it was "not my favorite industrial", and the shares have risen around 13% since then - less than the S&P and less than other heavy machinery names I liked better including Cummins (CMI) and Deere (DE). Operationally, it's hard not to still prefer a company like Cummins, but that's also an apples-to-grapefruits comparison where Wabtec is concerned. On its own merits, I do believe that Wabtec is undervalued, and that's an increasingly rare thing to find in this market.

 

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Wabtec Doing A Little Better Than Expected On Margins In A Swift, Brutal Downturn

Margin Improvement, Electronics, And Aftermarket Offer Some Opportunity For Wabtec

The last 12 months haven't been particularly easy for Wabtec (WAB), but the shares have more or less kept pace with the larger industrial sector, as well as peers/rivals like Caterpillar (CAT) and Knorr-Bremse (KNRRY). At the same time, management has built some early credibility on its margin-improvement story, as well as its ability to drive growth from digital electronics and aftermarket.

Wabtec is not my favorite industrial, and the freight market is going to remain challenging for a while, but it's a little strange to me that Wabtec should trade at a wider discount to fair value than many other heavy machinery names. I don't see stellar return potential here, but I do see some relative undervaluation, and I think Wabtec may be poised to outperform expectations as railroad and transit operations normalize after the COVID-19 outbreak, leaving some opportunity for upside to numbers and multiples.

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Margin Improvement, Electronics, And Aftermarket Offer Some Opportunity For Wabtec

Wabtec's Better-Than-Expected Performance Has Shrunk Some Of The Fear Discount

Once a Wall Street darling, Wabtec (WAB) had lost a lot of that luster, as the company’s expensive foray into transit via the Faiveley acquisition hadn’t really produced the hoped-for benefits and investors worried about the size, quality, and growth potential of the large GE Transportation deal, particularly with the looming changes in how Class 1 rails operate. While those concerns were, and are, valid, the shares have managed to modestly outperform the S&P 500 since my last update, with better-than-expected execution apparently easing some of the fear discount.

The company’s revenue outlook remains challenging, with near-term pressures from weak rail traffic growth and stacked locomotives and uncertain share growth potential in international markets. Margins are looking stronger, though, and I think Wabtec is on pace to get to mid-teens FCFs margins a little sooner than I’d previously expected (three, possibly four years, earlier). With the shares offering okay appreciation potential on discounted cash flow and seemingly undervalued on the basis of margins and returns, this is still a name worth considering for 2020 given the overhang of uncertainty if not outright skepticism.

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Wabtec's Better-Than-Expected Performance Has Shrunk Some Of The Fear Discount

Wabtec Looking At A Value-Creating One-Two Punch

Accustomed as I am to thinking of Wabtec (WAB) as perennially richly-valued, which for a long time it was, it's a strange thing to be continuing to advocate for buying the shares and thinking that the market is underrating this one. I understand some of the market's skepticism and worry that the assets Wabtec is buying from GE (GE) aren't in great shape, but I believe this will be a transformative acquisition for Wabtec, and I also believe the timing couldn't be better, as the company is starting to see its freight rail markets recover.

Up about 10% from when I last wrote about the stock (and when I thought it was undervalued), I've since revised my estimates for the benefits of the GE acquisition and the ongoing recovery in the freight business (as well as some challenges in the transit business). The net effect is to boost my fair value range toward $115, with potentially more upside beyond that depending upon the strength of the freight recovery and Wabtec's ability to drive synergies from the GE deal.

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Wabtec Looking At A Value-Creating One-Two Punch

Wabtec Biggest-Ever Deal Should Be Transformative

Wabtec (WAB) has always been unusually acquisitive, but in merging with/acquiring General Electric’s (GE) Transportation business, Wabtec is bagging the biggest target available to the company. While big M&A carries big risk, Wabtec knows how to integrate deals and GE is an uncommonly opportunity-rich deal for Wabtec, as it brings the global leader in locomotives and a very strong player in services and digital/electronics to one of the leaders in components and equipment for trains. In addition to rich revenue cross-selling opportunities and expense synergies, I believe Wabtec is doing this deal at an attractive point in the cycle.

Modeling Wabtec’s post-deal financials requires more than a little guesswork, but I believe there is a solid chance that this company will be an enterprise with $10 billion in revenue and low-to-mid teen FCF margins in 2022, with mid single-digit revenue growth beyond that point. If those estimates are the right ballpark, Wabtec shares look undervalued below the triple digits.

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Wabtec Biggest-Ever Deal Should Be Transformative

Wabtec In A Value-Growth Tug-Of-War

Wabtec (WAB), one of the leading suppliers of parts, components, and systems to the freight and transit train sectors, continues to see turbulent conditions both in its operating results and its share price performance. The stock has gone basically nowhere since I last wrote about the company, but there’s actually been some pretty wide swings between the peak and trough (roughly 35%) over the past year as investors seem to be struggling with a strong “want to like” instinct and some rather spotty financial results.

The shares still leave me a little uneasy. I think Wabtec is well-run and I believe the Faiveley deal will add value both through expense leverage and broadening the company’s horizons (in transit and in non-U.S. markets). But I also believe that freight spending could be weaker than bulls expect, and these shares often react poorly to disappointment. I do believe that mid-to-high single-digit growth can support a fair value in the $80’s, but investors considering these shares need to be aware of that ongoing tug-of-war between the bull and bear camps and the impact it can have on the share price in the short term, and especially around events like earnings reports.

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Wabtec In A Value-Growth Tug-Of-War

Weak Freight And Iffy Organic Growth Remain Issues For Wabtec

Wabtec (NYSE:WAB) runs a business model that has long relied on serial M&A and that is not going to change. What has changed, though, is that the company's key North American freight rail market has weakened considerably and is likely to stay in the doldrums for some time. That puts even more pressure on management to execute on the opportunities available in growing the transit business, growing its freight business outside North America, and continuing to execute on margins.

Not many businesses generate steady double-digit ROIC, and for all of the (valid) concerns about Wabtec's reliance on M&A, I think that detail should not be ignored. What's more, even amid a sharp downturn in its freight business, margins have remained quite solid. If management can execute on long-term opportunities in transit and freight, particularly overseas, there is enough potential business out there to support a higher fair value for the stock.

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Weak Freight And Iffy Organic Growth Remain Issues For Wabtec

Seeking Alpha: Wabtec Pivoting Away From Freight Weakness, But At A Price

The overall weakness in industrial and machinery markets has undermined a lot of stocks that were once bulletproof (or nearly so), and Wabtec (NYSE:WAB) has gotten caught up in that as well. The shares have lost almost 30% of their value since the last time I profiled the company, as investors have grown more and more concerned about the growing weakness in the North American freight rail sector and the potential margin consequences of the expensive takeover of France's Faiveley (OTC:FVLTY).

I have more than a few concerns about the price Wabtec is paying to acquire a business that has only very rarely posted double-digit FCF margins or returns on capital. I freely allow that financial ratios don't always capture the full picture and value of a business, but overpaying for M&A is a time-tested means of destroying shareholder value.

That said, I understand why Wabtec is pursuing the deal, as larger exposure to the international transit rail market seems like a reasonable move to make today. Wabtec's shares could still merit a fair value in the high $80s if you believe the company will eventually grab significant share of the international freight and transit markets. Keep in mind, though, that that has been the story for a while now, and the company's progress in organic terms hasn't really helped support it all that much.

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Wabtec Pivoting Away From Freight Weakness, But At A Price

Seeking Alpha: Wabtec Looking To Leverage Mandates And Grab Foreign Share

Value investors have nightmares about stocks like Westinghouse Air Brake Technologies (NYSE:WAB) (or Wabtec). The shares are expensive by most conventional metrics, but the company has roughly doubled its margins over the past decade and only scratched the surface of its market share opportunities outside of North America. Skilled at both product development and M&A, Wabtec has tied itself to the ongoing growth and use of both freight and transit rail - arguably as close as you can get to a sure thing in the industrial world.

Valuation remains a challenge when it comes to this stock. On one hand, projecting double-digit annualized revenue growth for a company that is already generating more than $3 billion a year in revenue and has more than 50% share in its core market is aggressive. On the other hand, while replicating such impressive share outside of North America is by no means guaranteed, getting only half that would still be more than enough to support 10%-plus revenue growth.

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Wabtec Looking To Leverage Mandates And Grab Foreign Share

Seeking Alpha: Wabtec Is High-Priced And High-Quality In Equal Measure

Westinghouse Air Brake Technologies (NYSE:WAB), or Wabtec, is the sort of company that chronically only looks cheap in the rear view mirror. Wabtec has strong share in the relatively concentrated U.S. market for technologies and components that go into rail cars, locomotives, and transit cars/locomotives, and is moving to replicate that share overseas. Add in a willingness to acquire its way into new markets and an increasing mix of electronic components, and the basic market opportunity looks appealing.

Now, what do you want to pay for it? Wabtec already trades at more than 13x forward EBITDA and appears to price in mid-to-high teens annual FCF growth for the next decade. There's little argument that Wabtec is a leader in large markets and produces strong returns on capital, despite an aggressive ongoing M&A policy. For investors who can take a "don't worry, be happy" view on valuation and/or make a credible argument that Wabtec's growth rate will exceed that which is already implied in the valuation, Wabtec could still be a name to consider but value-focused investors may find it a harder case to make.

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Wabtec Is High-Priced And High-Quality In Equal Measure

Seeking Alpha: Wabtec Remains A Frustrating Mix Of Quality, Opportunity, And Expectations

Locomotive and train car components manufacturer Wabtec (WAB) has missed revenue expectations for four straight quarters, but it hasn't done any harm to the sentiment on the stock. These shares are up more than 60% for the past year and over 100% over the past two years, as investors continue to play their enthusiasm for a rail infrastructure build-out in the U.S. and the potential for Wabtec to replicate its "components on almost every car" market share in North America, in Europe and Asia.

Wabtec also remains a frustrating company to evaluate from a valuation perspective. If Wabtec could hold 20% overseas market share by 2023 in those areas, where it has roughly 50% share in North America, a fair value above $100 is definitely reasonable. On the other hand, these shares already trade with significant near-term expectations, and it could take more than a decade to build significant share in markets like Russia or China.

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Wabtec Remains A Frustrating Mix Of Quality, Opportunity, And Expectations

Seeking Alpha: Just How Far Can International Markets Take Wabtec?

Wabtec (WAB) is one of those uncommonly well-run industrial companies that just does not provide an investor with many opportunities to "buy the dip". Yes, there have been pullbacks along the way of 25% or so, but the company seldom looks cheap on conventional metrics.

On the other hand, here's a company with strong share in about 50% of its business, and a long record of generating high single-digit or double-digit revenue growth and improved operating margins in a cyclical industry. Although I don't want to get carried away with this bull market and a stock that is already up more than 50% over the past year, the argument for a fair value in the $70's doesn't seem ridiculous if you believe the company can replicate its success in North America in other parts of the world.

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Just How Far Can International Markets Take Wabtec?

Investopedia: Wabtec Winning On The Rails

Sometimes it makes less sense to figure out who will strike gold and more sense to invest with the companies selling the picks and shovels. While North American Class 1 rails have definitely seen improved operating conditions, there are still variations between the companies when it comes to traffic growth, pricing and efficiency.

Why not consider Wabtec (NYSE:WAB), then? Not only does this rail equipment company supply virtually every North American railroad operator, it also serves the transit markets, international carriers and manufacturers of cars and locomotives. Though the stock has done well already, the financials and backlog here are such that it may not be unreasonable to hold out hope for more to come. For related reading, see A Primer On The Railroad Sector.

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