Westinghouse Air Brake Technologies: Good Growth Prospects (NYSE:WAB)

Investment Thesis

Westinghouse Air Brake Technologies’ (NYSE:WAB) growth should benefit from the strong underlying demand, healthy backlog levels, and the recent $2bn plus MOU with Kazakhstan’s national railway company. Moreover, the continued need of customers for more reliable, productive, and efficient locomotives and megatrends like urbanization and decarbonization should drive the longer-term demand. Further, the margin outlook is good, and it should benefit from volume leverage and the continued expansion of Integration 2.0, a cost-saving initiative. The valuation is also reasonable. So, I have a buy rating on this stock.

Revenue Analysis and Outlook

The company has seen strong revenue growth in recent quarters, driven by strong global demand and healthy backlog levels.

The company’s revenue for the third quarter grew 22.5% Y/Y to $2.55 billion, driven by strong growth across both the Freight and Transit segments. The Freight segment sales were the strongest since the COVID-19 pandemic, as the segment revenue saw a Y/Y growth of 23.4% to $1.89 billion, primarily driven by the segment’s Equipment business, which expanded 38.8% as compared to the prior-year quarter due to higher locomotive sales and increased demand for the mining products during the quarter. Other businesses of the Freight segment, such as Components and Services, also contributed significantly to the company’s revenue growth, as higher North American OE railcar build and share gain in freight car products benefitted the Components sales. Higher modernization deliveries and increased part sales benefitted the Services business of the Freight segment, while the Digital Intelligence side was down 3.2% Y/Y due to softness in the signaling business.

The Transit segment, on the other hand, benefitted from strong growth in both its OE and Aftermarket businesses as compared to the prior-year quarter, driven by the execution of a growing backlog, easing supply chain disruption and easier comps, resulting in a Y/Y growth of 20% to $660 million in the segment’s revenue during the third quarter of 2023.

Looking forward, I am optimistic about the company’s revenue growth prospects.

The company’s 12-month backlog at the end of last quarter was $7,091 mn or up 13.1% Y/Y. This gives good visibility on the company’s revenue growth entering 2024. In addition, the company has signed a strategic MOU with KTZ, the national railway company in Kazakhstan for orders over $2 bn, including delivery of locomotives in 2024. This order is not yet included in the backlog and should add to the strength of already solid backlog levels. The demand outlook in Kazakhstan is expected to remain strong in the coming years as the railway freight traffic from China to Europe, which was earlier transferred through the Russian route, is getting diverted to Kazakhstan post-Russian sanctions.

In addition to healthy backlog levels, the company should also benefit from the upcoming interest rate cycle reversal, which should catalyze economic recovery and freight volumes. Increased freight volumes result in more maintenance requirements, helping the company’s aftermarket business, while lower interest rates also improve return on investment on new locomotives and locomotive modernization, increasing their demand.

The company is also well-placed to benefit from megatrends like urbanization and decarbonization which are driving the need for reliability, productivity, safety, fuel efficiency, and lower emissions. Rail transportation is more efficient than road transportation and should see increased investments in the coming years both on the Transit and Freight side. In addition, the new locomotives are much more powerful, have higher fuel efficiency, and result in lower emissions, which should drive replacement and modernization demand. So, I believe the company is well-placed to see multiyear secular growth globally.

Margin Analysis and Outlook

The company reported strong margin performance in the third quarter of 2023 with 150 bps Y/Y expansion in overall adjusted operating margin to 17.9%. This expansion was driven primarily by higher volumes during the quarter across both segments, improved productivity, and cost management, partially offset by manufacturing inefficiencies driven by the strike at our Erie facility.

The Freight segment posted an adjusted operating margin of 21.2%, up 130 bps as compared to the prior year’s quarter, benefiting from strong volumes and lower SG&A as a percentage of sales. The margin in the Transit segment improved by 150 bps Y/Y to 12.5%, driven by strong sales volume, favorable mix, and easier comps due to cyber impact in Q3 2022.

Looking forward, I expect the company’s margins to benefit from volume leverage as the company is expected to post good sales growth in 2024 driven by healthy backlog levels. Management is expecting incremental margins in the 25% to 30% range.

The company is also expected to benefit from the continued expansion of the Integration 2.0 initiative, a 3-year cost-saving plan that is ramping up. This is a three-year plan started in 2022, with the company planning $135 mn to $165 mn investment over the three years to achieve a run rate saving of $75 mn to $95 mn by 2025. Usually, these plans are front-end loaded in terms of investment profile, with savings realized toward the back as the cost-saving projects get executed. The company has already invested $100 mn out of the expected $135 mn to $165 mn spend, and as we move toward the back half of this cost-saving plan, the investment required should decrease while the cost savings should ramp up, helping margins.

Valuation and Conclusion

The company’s stock is currently trading at a P/E of 18.29x based on FY24 consensus EPS estimates of $6.67 and a P/E of 16.50x based on FY25 consensus EPS estimates of $7.40. Over the last 5 years, the company has traded at an average forward P/E of 18.35x.

The company’s near-term revenue outlook is favorable due to strong underlying demand for the company’s products and solutions and strength in the 12-month backlog. At the same time, the long-term also looks good due to the company’s large installed base as well as favorable megatrends. The margin outlook is also positive as the company benefits from operating leverage and its savings from cost reduction initiatives ramp up. The company’s EPS is expected to grow in double digits for the next few years, and assuming the valuation multiple remains in the high teens, given good growth prospects, I believe the stock can deliver double-digit annual returns over the coming years. Hence, I have a buy rating on the stock.

Risks

Wabtec operates in a cyclical end-market where railroad companies have deferred their capex in times of slowdown. So, if my thesis about eventual economic recovery in the coming years as the interest rate cycle reverses doesn’t prove correct, the company’s business may see a cyclical slowdown.

The company’s client base is quite concentrated, with its major customers including tier-1 railroads in the US and state-owned companies in countries like India and Kazakhstan. Any deterioration in the relationship with any key customer could negatively impact its business.