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.
A Record-High Backlog, With Freight Getting Better
I had previously written that I thought the freight rail market was bottoming out in the first half of 2018, and I continue to believe that to be the case as locomotives come out of storage and Wabtec sees a resurgence in orders. Freight revenue rose 16% on an organic basis in the second quarter, after barely any growth in the first quarter and over a year prior of contraction, and orders jumped 15%, with the 12-month backlog growing 12%.
I don’t believe this is the start of a huge expansionary cycle in freight rail spending, but I do see ample room for Class I rails to refresh their rolling stock and accommodate growing traffic, as carloads have recently climbed to a multiyear high.
I’m particularly curious to see what happens with the demand for locomotives. The number of idle locomotives in North America was down 31% year-over-year in the second quarter, but I’m not sure there’s all that much room to return substantial numbers of parked locomotives back into service. Most of the locomotives that are parked lack PTC compatibility and I don’t think it would be cost-effective to attempt to retrofit them relative to buying new locomotives. That should be good for the new locomotive business for the GE business Wabtec is buying, though it will reduce some of the locomotive refurbishment opportunities for Wabtec. Then again, I would expect those parked locomotives to be converted over to rail yard switchers or refurbished and sold overseas, so there may be more opportunity there than I currently model.
Wabtec exited the second quarter with a record-high backlog. Although that sounds good, and to some extent it is, the large bulk of that backlog is in transit, and Wabtec’s margins have been suffering lately from weaker margins booked in its transit business. The acquisition of GE’s business, though, will once again shift the balance back towards freight, and those lower-margin orders will eventually run off. As far as synergy-driven improvements go, though, the Faiveley deal is pretty much fully integrated at this point, so I don’t expect tremendous synergy-type savings at this point.
Acquiring GE Transportation Systems Still Looks Smart
I continue to be bullish on the acquisition of GE Transportation Systems (or “GETS”), as I believe this is a unique opportunity for Wabtec to gain significant exposure to complementary assets and product categories, including locomotives and aftermarket services (a potentially high-margin segment where Wabtec has been under-exposed).
The market hasn’t been exactly steadfast in its view of the deal, though. There was a freakout not so long ago when Wabtec presented revised financials and assumptions that showed lower earnings from GETS, and it’s worth remembering that other companies that have recently acquired businesses from GE have reported that the businesses were in generally worse condition than they’d originally assumed as GE pulled back on reinvestments in the businesses. In the case of the financials, at least, I’m not concerned as the revisions were a product of putting the company’s numbers into compliance with Wabtec’s reporting policies and the underlying cash flow contributions weren’t changed for the worse. In fact, what Wabtec has presented thus far with respect to the expected contributions of GETS is more bullish than my initial expectations, and I’ve revised my numbers up as a result.
I do expect the GETS integration to be smoother than the Faiveley integration. Not only should cost reductions be easier (not having to deal with French/European labor laws, among other issues), but I believe it will be easier for Wabtec to integrate a vertical M&A transaction that expands the company’s businesses in markets it already knows very well, as opposed to the Faiveley deal that horizontally expanded Wabtec’s exposure to transit markets that weren’t quite as familiar or at least weren’t areas of well-established strength.
As I said before, I also think the timing on this deal is good. The freight rail capex environment is starting to improve after a nasty correction, and I believe Wabtec will be integrating this deal at a time of improving end-market demand for locomotives and cars, as well as a final rush to get into compliance with PTC signaling requirements.
The Opportunity
I’m expecting over $9.4 billion in combined revenue in 2019, with over $1.8 billion in EBITDA and $1 billion in free cash flow, growing to over $11 billion in revenue and close to $1.7 billion in free cash flow in 2022. With mid-single-digit revenue growth thereafter and further room for margin and FCF improvements, I expect the new Wabtec to exceed $2 billion in FCF 2024 and get close to $2.5 billion in 2028.
Discounting those cash flows back, I believe $115 to $116 is a fair value for the shares today (including the debt and share dilution for the deal and assuming a 1H’19 close). The EV/EBITDA-based valuation approach is a little more convoluted, as it’s harder to reward the company for future margin and EBITDA improvements and you have to project ahead and then discount back. Even so, I think the shares will see a low-to-mid teens EBITDA multiple a few years from now.
The Bottom Line
At this point, I think most investment factors are pointing in favor of Wabtec. I understand investors being skittish about Wabtec buying some of GE’s problems, but I think the underlying rail equipment assets are high-quality and I believe Wabtec will do well with them in the coming years. I also believe that the freight rail recovery will be a healthy one and will help offset some ongoing margin challenges in transit. All told, I think Wabtec shares are still undervalued enough to be worth consideration.
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.
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