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.
Margin Leverage Despite Sharp Headwinds
Wabtec’s revenue performance in the first quarter was not particularly positive, as revenue contracted about 9% in organic terms and missed expectations by about 6%. The 12% contraction in the Freight segment was well ahead of the underlying 5% contraction in carloads and came despite double-digit growth in the electronics business and 8% growth in aftermarket sales. In the Transit business, revenue contracted 5%, with aftermarket sales hurt by COVID-19-related ridership disruptions.
Despite the revenue erosion, gross margin improved by 560bp, “core” EBITDA improved 32%, and “core” operating income improved 30%, with operating margin up 110bp. That’s a solid improvement in the face of 9% organic revenue contraction and a $15 million hit to op income from COVID-19 shutdowns, and it does build some credibility for the post-GET acquisition synergy story. At the segment level, adjusted margin improved by 510bp in the Freight business and 230bp in the Transit business, with the latter helped by accelerating some lower-margin refurbishment work.
Wabtec ended the quarter with about $4.1B in net debt, close to 3.4x my expected EBITDA number for the year. That’s inarguably a high debt position, but the company had over $600 million in cash on the balance sheet, and I expect the company to remain solidly free cash flow-positive during 2020.
It’s Going To Get Worse Before It Gets Better…
Wabtec’s bookings were down about 20% in organic terms for the quarter, with both Freight and Transit posting sub-1.0x book-to-bill ratios (0.6x for Freight, 0.9x for Transit). Both businesses also saw small sequential declines in their backlogs.
Although Wabtec’s customer base has generally good access to capital, the COVID-19 outbreak is still going to hit the company hard for a few quarters. Lower freight traffic will likely lead to even more locomotive stackings, and likewise lower demand for cars. On the transit side, while social distancing requirements could eventually lead to improved demand (services needing to run more trains and/or trains with more cars), the disruptions to the aftermarket business are likely to continue.
All told, I believe it’s quite likely that Wabtec will see a sharp decline in Q2 revenue and possibly a double-digit decline in Q3, with growth finally reemerging in the first half of 2021.
… And “How Much Better?” Is A Valid Question
Wabtec has seen some significant changes to its market in recent years, with precision scheduled railroading (or PSR) leading to a significant change in how North American railroads use their locomotives, namely a sharp decline in the number of locomotives in service. That, in turn, has led to a significant slump in the locomotive business, and I believe the extent of a future recovery is still debatable. The higher workloads of in-service locomotives will eventually drive more high-margin refurbishment work, but that’s still further off.
On a more positive note, railroads are increasingly embracing automation, and I don’t really see that trend decelerating from here. Digital electronics has been an area of growth for Wabtec recently, and I expect it to remain one of the more significant growth drivers for the business.
Beyond that, I do still see growth potential in the international freight business. Operators in countries like Brazil and India are less likely to pay the higher upfront costs for automation, but many regions are operating with old, inefficient locomotive and car fleets. Not only is this older equipment often less reliable and more expensive to maintain, it typically requires shorter, slower trains, clogging rail systems. Access to capital will be a challenge, but I do expect above-average growth here as operators look to improve their capital stock and take advantage of lower operating costs and improved performance.
The underlying trends for Transit remain positive, particularly urbanization in developing markets and a desire on the part of governments to incentivize public transportation over private car use. A key question remains whether Wabtec can reverse what has been a long trend of lackluster performance. A more rigorous project selection process is certainly a good start, but this is a “show me” story in my mind.
All told, I think the mid-single-digit organic growth target laid out by management at its mid-March virtual investor meeting may now be too ambitious due to the COVID-19 outbreak, and particularly, if the virus lingers on and impacts 2021 more significantly than most currently expect. I do also think, though, that the 300bp operating margin improvement target is achievable, with the company already off to a good start integrating the GET deal.
I’m modeling low-single-digit long-term growth for Wabtec today, but I do acknowledge the potential for upside in the 2022-2024 if Wabtec can execute well on its opportunities in automation, digital products/services, and international freight. I am also modeling operating margin improvement sufficient to drive Wabtec toward mid-teens FCF margins over the next decade, driving FCF growth on the high end of the mid-single digits.
The Bottom Line
Between discounted free cash flow and margin/return-driven EV/EBITDA, I believe Wabtec shares are undervalued. The prospective return seems to be on the order of the high single-digits (long-term, annualized), which is below my typical hurdle, but Wabtec does seem relatively undervalued compared to many heavy machinery companies, and I do also see opportunities for Wabtec to exceed my expectations. With decent return potential on what I think are fairly conservative (or at least not bullish) assumptions, Wabtec could still be worth a look.
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.