Investment Recommendation: Wabtec Corp (WAB) can Surprise on the Upside
Wabtec Corp (Westinghouse Air Brake Technologies Corp) (NYSE: WAB) manufactures technology-based products for locomotives, freight cars, passenger transit vehicles and power generation equipment. The company caters for both the original equipment and aftermarket applications.
- Dynamically growing revenues
- Strong and growing margins
- Bullish technical position despite a cyclical downturn in the segment
- Targeted strategic acquisitions provide base for diversified growth
- Recommendation: Buy
The Company’s History
Though the current company – Wabtec Corporation – was incorporated in 1999 with the merger of Westinghouse Air Brake Company(WABCO) and MotivePower Industries Inc, the roots of the company through WABCO date back to 1869. A company in operation for about one and half centuries instils confidence.
Nevertheless, in this age, one cannot make decisions based on a century old history alone. A more acceptable approach would be to look at the company’s performance in the past decade and then extrapolate it with the prevailing economic conditions to arrive at an investment decision.
Company’s performance in the last decade
Source: – Wabtec Investor Presentation March 2017
From 2006 to 2016, the company’s revenue increased from $1088 million to $2931 million. That’s a Compound Annual Growth Rate (CAGR) of 10.42%. However, it is not enough if the company only sells goods, its ability to earn a profit on the sales is equally important.
Therefore, analyzing the management’s ability to generate income, we find that it has increased from $85 million in 2006 to $352 million in 2016. That’s a CAGR of 15.27%, which is better than the sales growth. This shows the management is continually looking to improve performance. They have improved the operating margin from 11.9% in 2006 to 17.5% in 2016.
The markets have rewarded the strong performance of the company accordingly.
Source: 2016 Annual report Wabtec Corp.
If we compare the cumulative return on investment of Wabtec with that of the S&P 500 index, its peer group (both old and new) between 2011-2016, we find Wabtec to be a clear outperformer, as seen above.
Though the long-term picture looks good, if one looks at the company’s performance in 2016 – it has deteriorated on almost all fronts. This shows that the business environment has changed, which has caused a drop in revenues and net income.
Headwinds in the freight rail market
In 2016, NAFTA freight rail traffic was down by about 5%. This forced the railroad companies to cut down their CapEx, which declined by about 15%. As a result, Wabtec’s sales and net revenue fell compared to the previous year.
For 2017, the company expects the headwinds to continue, which will reduce the revenues by about $120 million.
Acquisition of Faiveley Transport in 2016
Wabtec has continued to diversify its markets and products to reduce the cyclical impact of the US freight market. In that effort, Wabtec successfully completed majority acquisition of Faiveley Transport, which will add new products and technologies and diversify the business model.
“We estimate synergies to be about $15 million to $20 million in 2017, and we expect the long-term annual synergies of at least $50 million to be achieved by year three,” said Al Neupaver, Executive Chairman during the Q1 2017 earnings call on April 15, 2017.
However, because of higher interest cost due to increased debt, stock dilution and purchase price accounting charges, the numbers will not be EPS accretive on a net basis in 2017.
Management is moving in the right direction
We believe that the management is taking the right steps to diversify their portfolio and expand operations into high growth markets – Asia Pacific, India, Australia, Western Europe, Germany, France and the UK – through acquisitions.
The management did not stop their acquisitions after Faiveley. Wabtec continues to make small-ticket strategic acquisitions to increase its existing market share or expand its product portfolio.
So far in 2017, the company has acquired Aero Transportation Products, Thermal Transfer, and Semvac. However, these acquisitions are all very small compared to Faiveley.
Nevertheless, while comparing the Q1 2017 results with Q1 2016, the readers should keep in mind that the latest numbers are inclusive of operations from Faiveley and other acquisitions.
Performance in the first quarter of 2017
The company continued to struggle with its performance in the Q1 2017. The comparisons are given below.
|Measure||Q1 2017||Q1 2016|
|Gross profit as % of Net Sales||29.40%||33.10%|
|Operating expenses as % of Net Sales||16.90%||14.60%|
|Income from operations as a % of Net Sales||12.50%||18.40%|
However, there were no surprises in the earnings, as the management had forecast that its first quarter will be the weakest and the results would improve each quarter for the rest of the year. Though the company sees challenges ahead in the freight segment, it expects the growth in the transit segment to offset most of it.
After the Q1 2017 results, the company has stuck to its full-year guidance of revenues of $4.1 billion and earnings per share of $3.95-$4.15, excluding restructuring and transaction charges and non-controlling interest related to the Faiveley acquisition.
We expect the company to beat its yearly guidance
We believe that the company has been conservative in its guidance for 2017 and has not factored in a few positives.
The US rail traffic is showing signs of revival and the US carload traffic this year is up 6.8% over the previous year, while the intermodal units are up 2.3% during the same period. Though the figures are still well below the 2014 and 2015 numbers, the trend change is positive for Wabtec.
“All things considered, May was a good month for rail traffic,” said Association of American Railroads Senior Vice President John T. Gray. “Thirteen of the 20 commodity categories we track had higher carloads in May 2017 than in May 2016, including the four biggest categories — coal, chemicals, crushed stone and sand, and grain. Excluding coal, carloads in May were up 4.1%, their biggest monthly increase in more than two years, and May was the best intermodal month of the year.”
If the current government is able to slash the corporate tax cuts, as planned by President Donald Trump, then the railroad companies are likely to increase their CapEx, which should help Wabtec to beat its revenue and its earnings per share.
Though we have proved that the company’s fundamentals are strong and the management is taking the right steps to diversify and shield its portfolio from a slowdown in individual markets, what we pay for the business is also important.
Though Wabtec trailing p/e of 28.57 looks pricey compared to the S&P 500 p/e of 21.2 of and the industry average p/e of 21.8, a historical comparison shows that Wabtec has commanded a higher P/E than the S&P 500 in the past 7 out of 10 years, according to data from Morningstar.
If one compares the forward p/e, the difference is much narrower with WAB at 22.2 and the S&P 500 at 19.9. Hence, at the current price of $88.21, the stock is not overly expensive. If Wabtec can beat its revenue and earnings per share guidance, according to our assumption, the valuation will become favourable.
Risks to our analysis
The global economy continues to be weak and susceptible to a slowdown. A global weakness will also affect US railroad traffic and CapEx plans of the companies. The projects in the pipeline can also get delayed. All these will adversely affect Wabtec’s results.
A sharp fall in the S&P 500 due to unforeseen circumstances can push the stock down, however, that will only be a short-term phenomenon, unless the fundamentals take a turn for the worse.
What do the charts forecast?
The stock has formed a bullish ascending triangle pattern, which will complete on a breakout and close above $90 levels. The breakout gives a pattern target of $102 on the stock. Once the stock breaks out of the triangle, it shouldn’t fall back into it. Therefore, we can keep a stop loss of $84, which is just below the 50-day exponential moving average. Hence, this trade offers us a risk-reward ratio of 1:2.
However, if the S&P 500 corrects, WAB is unlikely to remain unaffected. A fall to $83 and thereafter to $78 levels can be expected, if the S&P 500 breaks below the 2320 levels. Our bullish view on the stock changes only if the stock breaks below the $76 levels. Until then, all dips are a buying opportunity.
Wabtec commands a higher P/E compared to its peers and the S&P 500 due to its strong historical performance and a strong management.
For the short-term momentum traders, we recommend a buy at $90 with a stop loss at $84 and a likely price target of $102.
For the longer-term traders, we advise a buy on dips closer to $83 and $78 with a stop loss of $72 and a target of $104 and higher.