Sunday, October 7, 2012

Wabtec Equity Research


It’s always interesting to run the slide rule (whatever that is) over your portfolio in order to keep it ‘honest,’ particularly when it is doing well. I decided to take a closer look at one of my core holdings Westinghouse Air Brake Technologies Corporation $WAB which is (thankfully) more commonly known as Wabtec. In summary, I like what I see here. Despite the significant outperformance, I think the stock has further to go. A series of guidance upgrades have taken the stock price higher, so the rise is justified on a fundamental basis and I think it deserves a premium based on its long term prospects.



Once Upon a Time in the West

The underlying theme of Sergio Leone’s classic Western film is the cultural change ensuing in America following the development of the railroad. Of course, the true heart of American intercity mode of transport actually lies in the motor car and I guess it would take a European movie director to place such emphasis on the railroad. Any visitor to Northern Italy cannot help but notice that the rail stations are almost nouveau Cathedrals in homage to fin de si├Ęcle technology.

There is a key cultural difference here. Europeans tend to use rail for intercity transit and the US tends to use it for freight. But what does this have to do with Wabtec?

With regards to the US, Wabtec can look forward to a long term expansion in its core market of freight transport. Rail freight is cheaper and more energy efficient and, developments in rail car technology are ensuring that bigger loads can be carried. For example if you look at how sales trends are developing at FedEx Corporation $FDX and UPS $UPS both companies have a similar story to tell in terms of customers trading down to the cheaper option of deferred delivery (rail) in an economic slowdown.

US rail’s long term prospects look good and longer term there is the opportunity for transit to take a share of intercity transport. Ok, Obama’s plans for high speed rail have been scaled back significantly, but California recently approved spending on a high speed rail line and Amtrak, in June, announced plans to upgrade the North East with a $150 billion high speed rail line.

Another area where energy is having an impact is with shale gas infrastructure, where increased investment is directly benefiting the rail companies. Unfortunately, this is coming at the expense of carloads originated from coal. Grain carloads have been weak this year too but neither of these issues is particularly related to the strength of the economy. According to the Association of American Railroads, North American carloads are down this year, but if you strip out coal and grain, they are actually up a couple of percentage points. In addition, intermodal transport is growing at a healthy clip.

All in all the underlying picture is stronger than the headline carload numbers suggest.



Trans Europa Express

When German uber-band Kraftwerk were asked to deliver a hit album for the US market, they decided to go full force and release a seminal classic eulogizing over theTrans European Express (TEE) and containing the refrain ‘Europe Endless.’ The TEE doesn’t exist in its former glory anymore, but Europe’s transit rail network is still its pride and joy and Wabtec is seeking to grow revenues here. The point is that despite Europe growing weakly and Governments having to make austerity measures, there is still an opportunity for Wabtec to grow share in transit; some countries in Europe are spending on rail and let's recall that public sector unions are strong in the industry and can influence political decisions.



Wabtec Challenges?

Having dealt with the longer term opportunities it’s time to focus on a couple of things to look out for with Wabtec.

Firstly, working capital (WC) requirements increased in the quarter and this is probably a sign that cash flow conversion will weaken as Wabtec grows its international revenues. This is something to look out for in the future because larger a WC/Revenue ratio will hold back growth and lead to downward adjustments to the assumptions for discounted cash flow evaluations.

Secondly, positive train control (PTC) offers strong long term prospects for Wabtec, not least because railroads are supposed to meet a deadline to implement these systems by 2015. Other key winners in this move include the usual suspects of AlstomFaiveley, Ansaldo-STS, Siemens $SI and GE $GE within its transportation division. The good news for Wabtec is that these companies are not necessarily competitors. For example, Wabtec bought GE Transportation's aftermarket business in 2011 and is a supplier to GE's rail business. From an investment perspective Siemens and GE are set to benefit but the step change in revenues from transportation is not going to be a game changer for the stocks. The best way to get direct exposure to PTC is through something like Wabtec or Ansaldo.

However, it is affected by political considerations and the Federal Railroad Administration (FRA) is arguing for an extension to the deadline. All of which creates uncertainty over timing. PTC revenues were $50 million in the quarter and Wabtec expects them to rise to $200 million (8.4% of total revenues) in 2012. Since Wabtec don’t expect the US PTC spending to ramp up until the second half of 2013 and Brazil makes up a big part of current spending, there are some doubts over what the numbers for PTC will be for next year.



Where is Wabtec Headed?

In conclusion, I think the long term story remains very positive here. Rail is an attractive industry to be positioned in both in freight and transit. The economics make sense. In addition, Wabtec is a highly regarded company with a history of delivering returns to shareholders, and I think it is attractive as a core holding. After delivering positive returns for shareholder every year since 2000, I would bet on it doing the same again.