Deviations, aberrations, and exceptions get my attention when I’m looking at companies and stocks, and Westinghouse Air Brake Technologies (NYSE:WAB) (better known as ”Wabtec”) stands out as one of the relatively few heavy machinery companies logging annual and sequential growth in its backlog. While rail traffic has been volatile of late, overaged equipment and healthy Class 1 rail businesses, not to mention emerging alternative power/fuel options) and public transit expansion projects, are supportive for capex and management has been executing well here.
It’s been a while since I’ve written about Wabtec, but the shares have outperformed in the interim, more than doubling while also handily outperforming the broader industrial space, not to mention its closest direct peer Knorr-Bremse (OTCPK:KNRRY). Wabtec has been coming on strong of late (2021 and 2022 earnings were very close to my estimates, while 2023 outperformed), but my biggest concern now is how much of that is priced into these shares today.
Old Equipment Should Drive New Investment
Rail traffic has been mixed of late, with Q1’24 carloads up 1.8% after a 2.8% improvement in Q4’23 and declines in the second half of 2023. So far, this year, traffic is trending weaker when excluding intermodal, and this is worth watching.
Although rail traffic is an easy metric to follow, it can be misleading as Class I railroads (major national operators like CSX (CSX), Norfolk Southern (NSX), and Union Pacific (UNP)) don’t really make capex decisions based on short-term traffic. True, the pandemic did lead to significant weakness in rail demand and weak demand for locomotives and railcars, but I’d argue that was an exceptional circ*mstance. Now, with relatively healthy balance sheets and aging fleets, railroads are looking to reinvest, and it looks as though capex will grow at a low single-digit rate for a few years.
Railcar builds have been below replacement levels since 2020, with 2023 builds of 44.8K just above the low end of the estimated 42K to 50K level needed to maintain the fleet. With those below-replacement orders, the average age of the fleet is now over 20 years and the highest it has been in a decade.
Looking at locomotives, the North American fleet has shrunk about 5% from the 2017 peak (to around 37.6K), but the average age of 27.4 years is now the oldest in recorded history. While locomotives have a theoretical useful life of 75 years old, they become less efficient and cost-effective as they age and companies have been turning to modernizations – modernizing a locomotive costs about half as much as a new locomotive, but offers more than half of the benefits in improved performance.
Wabtec got an order for 110 new locomotives from Berkshire Hathaway’s (BRK.A)(BRK.B) BNSF in 2023 (with about half built in 2023), as well as large modernization orders from UP (600 units) and CSX (200) and a small number of orders for new Tier 4 (the most efficient) locomotives. Given the costs of operating old locomotives (not just in fuel, but in breakdowns/reliability, maintenance costs, speeds, et al), and the demands of precision scheduled railroading, not to mention the ongoing shift to AC-powered locomotives (39% of the fleet versus 26% in 2009), as well as new regulations like California banning locomotives older than 23 years old as of 2030, I believe Wabtec is still in the early innings of a newbuild/modernization cycle.
Technology Still Offers Opportunity
Relative to the company’s equipment and service operations, Digital has been something of a disappointment. Digital sales declined 6% in Q1 (against 17% overall growth in the Freight business) and is still only around 10% of revenue despite expectations that railroads would invest more into digital capabilities to enhance efficiency and profitability. Along similar lines, only about 20%-30% of Digital revenues are recurring, which is below the 60% average.
Wabtec is not giving up on this business, but they’re also not losing sight of the bigger picture. Management believes (and I agree) that there is still a future for more digital and automation adoption among rail operators, but it will take time and management isn’t looking to over-invest.
More promising is the outlook for alternative fuel/power approaches. Management has already built systems that can use LNG and the company is at work on hydrogen-based systems including fuel cells. Importantly, these systems are reversible and adjustable – operators can switch between fuels as circ*mstances require and in some cases can use blends. While there is a lot of work to do to build out hydrogen infrastructure, this could become a more significant driver in the future.
Likewise with electrification. We’re a long way away from full battery-electric freight trains (it certainly may not happen in my lifetime), but Wabtec’s FLX systems can work on short line and local freight trains and here again Wabtec is developing systems that aren’t “either/or”, but instead hybrid systems (including brake recuperation) that can offer some of the benefits of electrification (including lower fuel consumption and emissions) without full reliance on battery-based systems.
The Outlook
While I do have some concerns about the U.S. economy for the remainder of 2024, and weaker rail traffic is a risk, I don’t think a short-term economic slowdown will lead to major changes in Class 1 capex plans. With that, I expected higher spending on locomotives and cars for a few years, and I’d note that many players in rail (freight and transit) like ABB (OTCPK:ABBNY), Alstom (OTCPK:ALSMY), and Siemens (OTCPK:SIEGY) have talked about favorable trends even in the face of some short-term volatility in orders.
I expect around 8% revenue growth for Wabtec in 2024, slowing to 5% to 6% for a couple of years thereafter. Long term, I believe Wabtec can generate 5% long-term annualized revenue growth. Management has made laudable progress on margins, and I expect the 2024 EBITDA margin comfortably above 20%, growing to 22% or higher in 2026. With that, I expect mid-teens free cash flow margin, with some upside toward the high teens over time, and free cash flow growth of around 10%.
Unfortunately, neither discounted cash flow nor margin/return-driven EV/EBITDA suggest that Wabtec is particularly undervalued now. Even with a mid-teens EBITDA multiple that reflects the improvements the company has made in margins and above-average near-term growth potential, I struggle to get much above today’s price. Of course, I don’t rule out beat-and-raise quarters that can drive further re-rating, but it seems like expectations are already quite healthy.
The Bottom Line
I don’t like to downgrade or avoid good stories and fundamental setups just because of valuation. I do think the North American rail equipment sector is coming up off from a cyclical trough, and I think the odds favor better than expected performance for Wabtec. Likewise, with the company set for mid-teens annualized EPS growth through 2026, this name should be a standout among its machinery peers.
Still, even the best cyclical stories have their limits, and I have my qualms about chasing this one. I’d definitely reconsider on a pullback and I may well regret getting too concerned about valuation today, but this looks more like a quality hold than a name I’d want to dive into today with a full position.
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Stephen Simpson
Stephen Simpson is a freelance financial writer and investor.Spent close to 15 years on the Street (sell-side, buy-side, equities, bonds).
Analyst’s Disclosure: I/we have a beneficial long position in the shares of ABBNY either through stock ownership, options, or other derivatives. 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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