Wabtec is a Good GARP Stock Exposed to Increased Rail Spending

 

Wabtec $WAB is the sort of stock that should be bought in these uncertain times. The company is a provider of a range of products to the freight and passenger transit rail markets. As such, its demand drivers are increased car load traffic and the new production of railcars. The former is usually caused by increased economic activity and the latter by new investment in rail and/or new investment in railroad infrastructure.

Wabtec is the only company on the New York Stock Exchange which has seen its share price rise, every year, for the last ten years. It is highly cash generative and boasts an impressive track record, combining cycle growth and the ability to cut working capital in a downturn. Over the last few years Wabtec has used its cash flow generation to make accretive acquisitions and the business has longer term prospects to expand internationally and benefit from emerging market growth.

Within the last few years in the US, freight has grown strongly whilst transit has been flat and this is largely a consequence of budget issues at transit agency customers. Obama has been asking for additional funding and has been aggressively pushing plans for high speed rail. That said, it is probably better to think of these initiatives (high speed rail etc) as potential upside rather than baking them into forecasts

Wabtec Long Term Growth Drivers

Firstly, increasing urbanisation (particularly in emerging markets) should fuel growth in intercity rail investment. Similarly, greater globalisation and production shifts will encourage the necessity for increased mobility in both transit and freight markets.

Secondly, railways are a more energy-efficient way to move people around. The US is such a huge consumer of gasoline partly because it was built on highways rather than railroads.

Thirdly, railway infrastructural spending is a great way to secure job growth and also encourage greater efficiency in transport.

Fourthly, Wabtec's freight demand should see increases with the expected growth in transport of bulky materials like grains and coal in the US. Not only are food and energy requirements growing, but the US looks set to export more (wheat etc) and this requires transportation to external hubs.

Finally, there is a clear need for ongoing infrastructure investment in railroad networks in emerging markets.

Wabtec is well placed in the service, renewal and replacement market and the continued global expansion of rail networks should see increases in the global fleet. A quick look at sales and earnings growth over the last few years reveals that margins have grown well...

(m)	2006	2007	2008	2009	2010	2011E	2012E
Sales	1,088	1,360	1,575	1,402	1,507	1,690	1,840
growth		25.1%	15.8%	-11.0%	7.5%	12.1%	8.9%
Gross Profit	197	370	427	393	449	490	534
Gross Margin	18.1%	27.2%	27.1%	28.1%	29.8%	29.0%	29.0%
Net Income	85	110	131	115	123	141	165
EPS	1.76	2.23	2.67	2.39	2.56	2.94	3.44
growth		26.7%	19.7%	-10.5%	7.1%	14.8%	17.0%

Source: Company Results, Analyst Estimates, Earnings View

...and as discussed previously, Wabtec does a great job in cash flow conversion...

(m)	2006	2007	2008	2009	2010	2011E	2012E
Operating Cash Flow	151	143	159	162	176	200	234
% Net Income	178%	130%	122%	141%	143%	142%	142%
Capex	21	20	20	18	21	25	27.6
Free Cash Flow	130	122	140	144	155	175	207
growth		-6.1%	14.4%	3.1%	7.8%	12.8%	18.0%

Source: Company Results, Analyst Forecasts, Earnings View

Wabtec Evaluation

 Any stock needs to be evaluated on a risk/reward basis and it is no different with Wabtec. However, this stock represents a relatively safe way to acquire an earnings and cash flow stream. It should be compared to a US ten year note and a risk premium attached to it. That said, if Wabtec hits targets than there is a strong case for it being fairly valued at present...

 

Ratio	2006	2007	2008	2009	2010	2011	2012
P/E	32.7	25.8	21.5	24.1	22.5	19.6	16.7
FCF/Sales	12.0%	9.0%	8.9%	10.3%	10.3%	10.4%	11.2%
FCFYield	4.7%	4.4%	5.1%	5.2%	5.6%	6.4%	7.5%
FCF/EV	4.5%	4.2%	4.8%	5.0%	5.4%	6.1%	7.2%

Source: Company Reports, Analyst Forecasts, Earnings View

...and ‘fairly valued’ is fine because if it hits earning forecasts then the stock price should be able to ‘do its earnings’.

Wabtec was added to the portfolio at $56 with a $64 price target.

Fastenal Set for Good Growth but What About the Evaluation?

Hardware wholesaler and retailer Fastenal gave results recently and, the market bid the stock down, they beat on revenues but earnings were slightly shy. For Q4 Fastenal reported revenues of $573.8m and EPS of 44c. Analysts forecasts were for $563m and 45cents respectively.

Before I get into more detail on Fastenal, I want to outline the Co’s main objectives as laid out in the ‘pathway to profit’. I do these write-ups to serve as a reference point for future research and I find this sort of benchmarking useful.

Fastenal Pathway to Profit

This is a set of strategic end points that was originally laid out in 2007, but it has seen adjustment due to the effects of the recession.

1.  to continue growing our business at a similar rate with the new outside sales investment model
2. to grow the sales of our average store to $125 thousand per month in the five year period from 2007 to 2012
3. to enhance the profitability of the overall business by capturing the natural expense leverage that has historically occurred in our existing stores as their sales grow, and
4. to improve the performance of our business due to the more efficient use of working capital (primarily inventory) as our average sales volume per store increases
5. 85% of earnings in operating cash flow

As a consequence of the recession the Co reduced the growth of new store openings and headcount additions. Furthermore in 2010, Fastenal pushed out the $125k a store target until 2014 but announced that it was possible to hit the profit objectives (23% operating margin) anyway, thanks to cost cutting.

Scorecard on the Pathway to Profit

Firstly, I want to outline how Fastenal is now increasing the share of sales force outside the store…

	Q1 2007	Q3 2008	Q4 2009	Q1 2010	Q2 2010	Q3 2010	Q4 2010
Store Personnel	6383	8280	7007	7004	7118	7450	7611
Non-Store Sales	616	599	597	594	591	639	712
Percentage	8.8	6.7	7.9	7.5	7.7	7.9	8.6

 source: Fastenal, Earnings View

Secondly, as discussed earlier the aim of sales of $125k per month per store has been pushed out by two years but, they think they can hit the 23% operating margin target early.

Thirdly, the development of leveraging up on sales has been held back by the recession. I want to highlight the percentage of pre-tax profits generated by stores with sales of over $100k a month.

Stores Selling over $100k per month	2008	2009	2010
Percentage of Stores	20.7	12.7	19.1
Percentage of Pre-Tax Profits	53.3	48.8	52

 source: Fastenal, Earnings View

Again, there is a return in the numbers but they are still not back to 2008

Fourth, looking at working capital as a percentage of sales tells a similar story.

	2008	2009	2010
Accounts Receivable	244940	214169	270133
Inventories	564247	508405	557369
Working Capital	809187	722574	827502
WC/Sales %	34.6	37.4	36.5

source: Fastenal, Earnings View 

In essence, Fastenal have been held back from achieving the ‘pathway to profit’ objectives but look set to get there in future.

Fastenal End Demand is a Combination of Industrial and Residential Construction

In these results, Fastenal has benefited most strongly from a cyclical recovery in industrial production and less so from ongoing demand from maintenance. However, commercial residential construction customers (which usually represent 20-25% of their business) are still in a funk, despite the recorded growth. I would guess that this growth is coming of a very low base and, until the US housing market recovers, it will not come back in a meaningful way.

Fastenal Revenue Growth

On the conference call, Fastenal argued that

‘think it's a reasonable target. Some of the puts and takes would be if you look at the historical patterns, we normally touch start our January at or above where our October daily average was, which puts us in the 20% range in January. If you start out there, even if it slowed down a little bit, you should be able to hit the 15% to 20% for the year. Right now, we do not predict that it will be slowing down. So we're pretty confident in the 15% to 20% sales range at this point.’

Looking at the October number for stores opened for more than two years, it is 18.8% growth. Considering that most analysts have 2011 GDP growth to be similar to 2010, they could hit this again in 2011. Moreover, they are opening 150-200 new stores in 2011. Assuming $10k per month for 175 stores over the year gives another 21m or about .9% to 2010 revenues. Adding these two numbers together gives 19.7% for the year.

On top of that, 2010 saw very weak housing starts data. I think this will continue into 2011 as there remains a substantial amount of shadow inventory. However, the market has stabilised and I think there could be stronger activity in the second half. In addition, increasing employment and discretionary spending should aid Fastenal. I think they could achieve 16% revenue growth next year. I’ve shaved off 2% points to reflect on the slowing in the rate of growth of industrial investment spending.


Fastenal Evaluation

This would give $2.62bn in sales, which could give $2.20 in EPS or $324m in net earnings. If operating cash flow is again around 85% this gives $275m in operating cash flow, if capex is around $70m (new stores etc) this gives $205m in free cash flow.

I would want to buy it at a forward FCF/EV of around 4% which would give it a share price of $35. I find myself in a curious position of thinking forecasts are too light but that the company is overvalued. Frankly, I don't buy the analysts forecasts of 20% growth for next five years. Fastenal maybe recovering, but we are not going back to a housing boom anytime soon.