Description

I like Rosco’s piece on Wabtec and it sounds attractive (and I like his style of thinking in general), but for Wabtec specifically, his long piece is a good illustration of why we’ve been short the company.  So I figured I'd post the rebuttal.  There is a ton of complacency here and a general perception that this heavily cyclical company is not cyclical.  Management has tried to pitch this as a stable, secular grower, reality is it has been a stable grower for 6 years, a period which coincides with a massive boom in railroad spending which now sits at record peaks.  In other words, it was just the upcycle.  In the downcycle, EBIT could easily be cut in half, and we think the downcycle may be upon us.

I didn’t update this piece for the recent earnings, but you can take a quick look – was their first miss in a long time and they reduced guidance.  I was somewhat surprised as I thought they’d be fine through this year as it takes quite a while to change railroad capex budgets, deliveries should still be great this year on old orders etc.  This quarter was only a modest miss and guidedown, but I think it is just the start of what could be a lot of downside.  Investors continue to value this stock very richly at the peak of the cycle. 

Piece is uploaded below, but quite a few charts that didn’t seem to make it, can also view PDF here:

https://drive.google.com/file/d/0B6RZm3GPDn8nX2Vjdm12QjE3VzQ/view?usp=sharing

Wabtec (WAB) - Short Sept 2015

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“Demand for our freight related products and services in North America is driven by a number of factors, including rail traffic,

and production of new locomotives and new freight cars.” – WAB 10-K

 

Misperception

WAB’s track record is very impressive -- the only US listed company whose stock price has increased every year for the last 14

years! Investors and the sell-side are anchored to past performance and incorrectly believe WAB is a non-cyclical, high-

growth business. In reality, WAB has benefitted from the crude-by-rail boom and other more recent 1x events, and we are

now at / near the peak of the rail equipment cycle. Each of the 3 key drivers that WAB discusses in its 10K -- 1) production of

new freight cars, 2) production of new locomotives, and 3) rail traffic -- are beginning to turn the wrong direction.

 

WAB’s core freight segment (75% of current EBIT and 60-65% of EBIT pro-forma for the LEY acquisition) is not immune to the

cyclicality of the rail equipment industry. Industry freight car deliveries are one metric for the cycle and we can see there is a

high correlation with WAB’s organic growth. Note industry freight car deliveries are currently ~70% above normal levels and

expected to decline over the next few years:

 

 

 

 

Key Thesis Points

1) Investors incorrectly believe WAB is not cyclical

 As the chart above shows, that is not the reality for the core Freight segment which makes up 75% of EBIT

 Additionally, 15% of WAB’s total revenue comes from other industrial end markets (non-rail), and half of that “other

industrial” bucket (7.5% of total revenue) is O&G related -- selling heat exchangers for drilling rigs

 

2) The rail equipment cycle is currently at / near peak

 We discuss the cycle below in detail

 North American freight car deliveries in 2015 are expected to be ~83k units vs the LT average of ~50k (including CBR)

 

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 North American new locomotive deliveries in 2015 are expected to be ~1,300 units, vs the LT average of ~1,100.

There has also been a large rebuild cycle over the past few years that WAB has benefited from

 Rail volumes have been negative since April 2015, driven by declines in commodity carloads. Coal volumes (31% of

carloads) are down ~12% yoy in the past 6 months, and petroleum volumes (6% of carloads) are down 4-5% yoy in

the past 6 months

 

3) ~15% of WAB’s earnings are from “PTC”, a 1x regulatory driven benefit which should decline in the next few years

 As of August, the NA freight industry is ~60% through its total expected spend on PTC (positive train control) and the

industry projects total spending will peak in 2015, then decline -10% in 2016, -35% in 2017, and -45% in 2018 as the

project gets completed

 

 

BUSINESS OVERVIEW

WAB is a leading provider of equipment and services for the global rail industry. Their products are found on locomotives,

freight cars, passenger transit cars, and subway cars. WAB has high market shares in North America for its leading product

lines -- braking-related equipment (50% share) and train control equipment & railway electronics. WAB also provides these

products internationally although market share is lower. WAB has an active acquisition strategy and has acquired over 40% of

current revenue since 2006. Management targets “double digit EPS growth through the cycle” with half of that coming

organically and half from deals.

 To be clear, this is a high quality business (albeit a cyclical one) playing in duopolistic markets for some of its core

products. WAB currently does a 30% pre-tax ROIC including g/w, although the margins are likely elevated given the

cyclical peak

 In July 2015, WAB announced they are buying Faiveley Transport ($1.8bn TEV). We discuss the deal below in detail

and how it changes the mix/thesis

 

WAB Overview (stand-alone WAB, pre-LEY)

 Freight Segment – 63% of revs, 75% of EBIT

o North America is roughly 75% of WAB’s Freight segment

 So North American freight (the piece that we think is at a cyclical peak) is ~58% of WAB EBITA

o Key customers here include TRN and GBX (freight cars), GE and CAT (locomotives), and the Class I, II, and III

railroads

o For background, railroads carry 40% of all intercity freight in North America and the Class 1 railroads

represent over 90% of the industry

 55% of rail volumes are commodity carloads, and 45% is intermodal freight (combination of truck

and rail)

 Of the commodity carloads, coal = 30%, metals+ minerals = 22%, ag/food = 14%, chemicals =12%,

autos = 7%, petroleum products = 6%, forest products = 5%

o Given WAB’s high market share in many products in North America, the freight segment is WAB’s highest

margin and ROIC segment, and margins have grown from the mid-teens to the low 20s over the past few

years (the company admits margins are high given the cycle)

o The Freight business is highly cyclical, as the chart on p.1 shows

o 55% of the segment is “aftermarket,” per WAB’s definition

 

 Transit Segment – 37% of revs, 25% of EBIT

o In Transit, WAB is selling to governments and passenger train manufacturers. This is a slower growth, lower

return business vs Freight. It grows GDP-ish with overall ridership growth and is lumpy / project driven

o Funding is largely dependent on federal, state and local grants & driven by fare box rev

o Key customers here include all of the major transit OEMs (Siemens, Bombardier, Alstom, CSR/CNR) as well

as governments / local transit authorities

o 45% North America

o 65% “aftermarket”

 

 Product Breakdown – WAB’s product breakdown is broad and opaque due to the acquisitions

 

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o 46% Specialty Products & Electronics - on-train electronics like black boxes and end of train devices, PTC

(computers + software), electronic braking technology. Industrial products like heat exchangers are

included in here

o 22% Brake Products

o 20% Remanufacturing, Overhaul & Build – new or overhaul of full locomotives. Typically specialty

locomotives like commuter locos or railyard locos (ie not competing with GE and CAT)

o 6% Other Transit Products – components for buses and subway cars – doors, handicap lifts, cooling systems

o 6% Other Products – hodgepodge

 

 Geographic Breakdown

o 72% North America -- 50% US, 6% Canada ,6% Mexico

o 18% Europe -- 12% UK, 6% W. Europe

o 4% Australia, 3% China, 3% Brazil

 

 “Aftermarket” – 63% of revenue per WAB, but that is misleading...

o WAB says 63% of total revenue is from aftermarket and that stat is very comforting for investors

o However, WAB’s definition of “aftermarket” is not what we traditionally associate with the category (i.e.

highly predictable stream of service/spare parts activity). WAB’s definition captures all product sold onto

the existing fleet, including upgrades/retrofits, overhauls, and replacement products & services. Basically

anything that is sold to the OEMs is considered OE and everything else is considered AM

o For example, if a Class 1 railroad is pulling old locomotives out of storage to meet a surge in demand /

congestion and upgrades that locomotive with new brake parts and electronics, WAB would call that

“aftermarket.” This is exactly what happened in the past 2 years and we can see the % of revenue coming

from “aftermarket” per WAB has gone from ~55% in 2009-2013 to ~64% in 2Q15

o WAB also classifies PTC revenue as aftermarket because it’s product that is being sold to an existing train /

network, even though it is all new equipment for a 1x regulatory initiative and has little true service

associated with it

o The SEC has corresponded with WAB about this definition in the past, although not much has come of it

 

 Competition

o WAB’s primary global competitor is a German company Knorr-Bremse AG (“New York Air Brake Company”

in the US), and WAB also competes against Amsted Rail and Faiveley Transport

o For MRO work, WAB competes against the rails’ in-house repair shops, as well as Knorr and OE’s GE and

CAT (Electro-Motive Diesel or “EMD” division)

 

 

NORTH AMERICAN FREIGHT CYCLE (58% OF EBIT TODAY, ~45-50% POST LEY)

 

“Demand for our freight related products and services in North America is driven by a number of factors, including rail traffic,

and production of new locomotives and new freight cars.” – WAB 2014 10-K

 

 Because WAB has been so acquisitive and sells so many different products, it’s difficult to size the different buckets

and quantify when and how much things should turn for WAB

 What we do know is that each of the 3 main drivers that WAB discusses in its 10K – rail traffic, production of new

locomotives, production of new freight cars – are now turning toward the wrong direction, yet consensus expects

WAB to continue growing organically

 

1) Freight car backlog deliveries are at / near peak:

 The 10 yr average for new freight car deliveries in North America is ~50k / yr (normalized ex-CBR may be ~30k)

 2014 deliveries were 67k units and we’re on pace for 80-85k deliveries in 2015 – there’s 40% downside to deliveries

to get back to “normal” demand, although we could see a period of lower demand given the younger age of the

fleet today

 

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 The current industry backlog is ~136k freight cars, comprised of ~50k frac sand covered hoppers (from 0k in 2011)

and 46k tank cars, both solely used in the transport of oil/petroleum products and directly driven by US shale

development

 

 

 

 

 

2) Locomotive deliveries are also elevated:

 The 10 yr average for new locomotive deliveries in North America is ~1,100 / yr

 2014 deliveries were 1,450 units benefiting from the Tier 4 regulatory (1.1.15) pre-buy, strong cyclical demand

(boosted by crude-by-rail activity), and increased congestion on the rails that forced them to order new equipment.

Note there was also significant rebuild activity (see chart below)

 2015 deliveries are expected to be around ~1,300 locos (-10%) and 2016 should be even lower

 

 

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 GE (~65% share of the US freight loco market) discloses quarterly orders / deliveries, and you can see orders spiked

in 3Q14 driven by Tier 4 regulatory pre-buying and congestion on the rail networks. Orders have since decline

precipitously, with GE booking just three locomotive orders in 3Q15:

 

 

 

 GE’s VP of Global Operations summarized the dynamic in 2014 very well during GE’s 2015 Investor Day:

 

So now let me fast-forward for you. It is the beginning of 2014…Our customers tell us they don't need any

locomotives for 2015, they aren't seeing the demand. They can wait out this new development. In fact, one customer

told our CEO, I suggest you stop investing, slow that down, we don't need it. So again, we took a deep breath but we

persevered and something happened from the beginning of 2014. The market changed. Through the tough winter

of 2014, railroads took a big hit in velocity which is their key metric, that is throughput for them. At the same time

they saw their demand start to increase, demand for transporting crude, intermodal with the US economy

improving, grain; there were headlines that they were worried that grain wood rot in the field before it could get

to processing. Suddenly our customers were facing a lack of power. But we were there for them.

 

 

GE LocoData

Unit Unit

Orders yoy Delivs yoy

12/31/13 70 (20%) 171 46%

3/31/14 259 224% 178 24%

6/30/14 138 130% 165 (3%)

9/30/14 1,131 249% 219 49%

12/31/14 284 306% 234 37%

3/31/15 190 (27%) 215 21%

6/30/15 120 (13%) 191 16%

9/30/15 3 (100%) 259 18%

 

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3) Zooming out, total Class 1 capex is at record highs while the average age of rail equipment is at record lows:

 Class 1 capex is at an all-time high in constant dollars (post de-regulation in the 1980s):

 

 

 

 And the average age of US railroad equipment is now at all-time lows:

 

 

 

 

4) Congestion on the rail networks was a significant tailwind for WAB, but that is now reversing:

 

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 The backlog growth above was driven by strong demand for tank cars and covered hopper cars (used to transport

frac sand) directly tied to US shale development. As deliveries increased in recent years, the US network became

congested which reduced train speeds and increased dwell at terminals (both increasing demand for additional cars

to support the shipment of more goods). This congestion is now easing:

 

 

 

 

5) Freight rail volumes (carloads) have also been declining more recently – led by Coal and O&G

 Carloads growth is a good indicator of rail capex and demand for WAB’s products. As volumes grow, rails need more

equipment to meet demand. As volumes decline, we expect to see the opposite

 

 

 

 

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Faiveley Transport (LEY.FP) Acquisition, announced July 2015

 In July, WAB made an offer to buy Faiveley Transport (LEY.FP) for $1.8bn (43% premium to LEY.FP equity)

o On CY16, WAB is paying 14.8x status-quo EBITA and 11x fully synergized EBITA

o The $1.8bn USD purchase price will be a still unknown mix of cash and stock – the Faiveley family (51%

owners) is taking 75% / 25% stock / cash and the public shareholders (49%) have the option to do either

 Pro-Forma WAB

o The deal will dilute WAB’s EBITA exposure to the North American Freight business from ~58% down to

45-50% -- diversifying WAB away from the piece we think is over-earning

o Accretion and PF leverage depend on the cash/stock mix which is unknown – more cash = more accretion,

more leverage

o We assume 75% of the public SH’s accept cash (the stock is illiquid preferred stock) -- in that scenario the

deal would be 55c accretive to EPS (ex-A) by 2018 if synergies are realized

o PF WAB would have 1.5x of net debt

 LEY business overview

o 95% transit, 5% freight

o 58% OE, 42% AM

o 61% Europe, 22% APAC (16% China), 16% Americas

o 24% OE brakes, 20% OE energy and comfort (A/C, power), 14% OE access and mobility (passenger access

systems, doors), 42% services

 Positives

o Overall – we think this is the right deal for WAB to do as LEY is a Europe/Asian focused transit player…

this diversifies WAB away from the North American Freight market which is the crux of the short thesis

o Besides the diversification, this deal gives WAB runway for cross-selling and cost synergies. It also opens up

new geographies for tuck-in acquisitions

 Negatives

o This moves WAB further into the lower growth, lower ROIC, lower multiple transit business

o There is also a question as to why the Faiveley family was willing to sell now. Faiveley has a concentrated

customer base -- per the LEY Annual Report, the top 5 customers = 40% of total sales. But with 58% of sales

coming from “OE” and 42% “Services”, it’s likely the majority of the OE side comes from the top 5

customers ie Siemens, Bombardier, Alstom, CNR/CSR, Ansaldo, etc.

 

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o Over the past 12 months many of these customers have been merging or are rumored to be merging –

Siemens is rumored to be in talks with Bombardier, Alstom is rumored to be looking, CSR and CNR merged

in China, Hitachi bought Ansaldo

 

 

What Can We Make?

 Because of the opacity here, it’s difficult to quantify the downside with confidence

 The street expects continued earnings growth for WAB (forever…) so any organic declines would be very surprising

here and potentially cause a re-rating

 We model HSD/LDD organic declines in the freight segment in 2016 and 2017 which gets us to $3.50 of core earnings

in 2017. Then there will be 40-55c of accretion from the LEY deal (55c assuming full synergies which per

management won’t be until Y3 or 2018)

 Note WAB earned $1.85 in 2011, $2.58 in 2012, $3.00 in 2013, and $3.63 in 2014. There’s been some small tuck-in

deals since then but our $3.50 of core earnings seems to be on the forgiving side

 16x a $4 number would be a $64 stock, or ~30% downside, but again our $3.50 of core EPS may be too generous

 Consensus expects $5.30 of EPS in 2017 (up from $4.14 in 2015); however that $5.30 doesn’t include the ~40-55c

accretion from the LEY deal

 

 

RISKS / CONCERNS

1) LEY deal dilutes exposure to the over-earning NA freight business

o The biggest issue with this short now is that post LEY, NA freight is only 45-50% of WAB’s EBIT and at least

some piece of that should be aftermarket

o However, by doing this deal WAB is diversifying into the low growth, lower ROIC transit segment which we

don’t believe deserves a 20x+ multiple

2) WAB is an M&A machine

o Management targets DD total topline growth, half organic and half M&A – they’ve been successful

executing on this. WAB has acquired over 40% of revenue since 2006

o WAB deploys all of FCF into deals, yet as we’ve seen with other accretive companies the sell-side doesn’t

fully model deals – thus WAB always beats estimates

o Deals are accretive and WAB has done a good job extracting synergies – management says they typically

pay 7-8x EBITDA and reduce the multiple 1-2x through synergies

o Typical deals are tuck-ins in the $50-$100m in revenue and WAB historically does 3-5 deals / year

o Looking at each deal since 2006, you can see that beginning in 2013 WAB began acquiring in end-markets

outside of rail (power gen, marine, O&G, motorcycle brakes in Brazil (!), electrical, E&C), which may suggest

the roll-up strategy has matured and WAB may not be able to replicate its past M&A success

o LEY is the largest deal WAB could have done and we understand there isn’t another big deal out there.

However, LEY gives WAB a very strong position in Europe and Asia and presumably there’s plenty of tuck-in

opptys over there

o In recent deals, ~60-85% of the purchase price has been allocated to goodwill & intangibles