Description

Investment Thesis

WABCO presents a compelling opportunity to invest in a secularly growing company which is currently trading at a discount to its long term value because of fears of an economic slowdown caused by Brexit.  WABCO’s secular growth is driven by regulators requiring safer and more efficient trucks along with fleet operators requiring increased productivity and fuel efficiency.

At its current $98/share stock price (as of Aug 2, 2016), WABCO is a $5.5bn market cap company.  Run conservatively with less than $100mm of net debt the total enterprise value is $5.6bn.  WABCO is currently trading at 17.1x 2016 sell-side earnings estimate of $5.73/share.  

Assuming no global economic shocks, WABCO’s end markets (global truck production units) can grow 4-6%/year through the mid to long term.  In such an environment, WABCO can grow revenue in the double digits and more than double its earnings to $12.35/share by 2020.  WABCO has traded 12-20x P/E historically.  Assuming the midpoint of 16x, you can see the stock at $198/share in three years, double from today’s price.

From a downside perspective, even if you assume that end markets are stagnant through 2020, WABCO’s product penetration improvement allows it to grow its topline and we see earnings getting to $9/share by 2020 (growth of 57% from 2016 sell-side estimate), which would imply 10.9x P/E, which seems reasonably cheap for a secular grower.

Description

WABCO is a supplier to global truck OEMs with a portfolio of technologically advanced products.  Their products can be categorized into three main categories:

1. Safety-related products used in braking systems, stability control and accident mitigation/prevention

2. Efficiency-related products used in fuel efficiency, emissions reduction, energy recovery and weight reduction

3. Connectivity-related products that currently help with driver monitoring but will eventually lead to autonomous driving  

WABCO’s Outgrowth

The three product categories described above are generally growing much faster than the overall growth in global truck volumes.  This is driven by two key reasons:

1. Regulatory tailwinds.  Regulators around the globe are generally looking for safer and more efficient trucks.  European regulators have generally led the way in setting standards.  Regulators in the US, China, Brazil and India are playing catch-up, which will be a tailwind for WABCO for years to come.  See chart below (source: WABCO investor presentation).

2. Technology adoption by fleet operators.  Fleet operators are looking to cut operating and maintenance costs.  This has led to an increased penetration of WABCO’s products in trucks as OEMs produce more technologically advanced vehicles for fleet operators.  While the upfront purchase price of the vehicle is higher, the lifetime cost is lower with a longer replacement cycle and lower operating costs.  This increased technology adoption will be another tailwind for WABCO in all major geographies for years to come.  See chart below (source: WABCO investor presentation).

Clearly, the two reasons described above make a compelling case for WABCO’s ability to outgrow its end markets for the foreseeable future.  But the proof is also in the pudding.  Over the last five years, WABCO’s revenue growth has outgrown its end markets on average by 8-10 percentage points.  See chart below (source: WABCO investor presentation).

WABCO Value Creation Model

Mathematically, WABCO’s ability to outgrow its end market creates compelling financial returns.  Let’s assume the global truck market is flat and WABCO can outperform it by 8 percentage points.  WABCO’s current annual revenue run rate is ~$2.8bn.  8% outperformance leads to $224mm in revenue growth for WABCO in a flat end market.  At management’s targeted incremental margins of 18% that translates to $40mm of additional operating income.  At a tax rate of 18.5% and with 56mm shares outstanding that translates to an additional $0.58/share in EPS, which is 10% EPS growth on top of 2016 sell-side estimate of $5.73.  This would be before any buybacks, which is conservative since management has historically used the majority of its free cash flow to buy back stock.  On average WABCO has bought back $250-300mm of stock per year over the last five years, which translates to ~5% of the current market cap.  So, with buybacks, EPS can grow almost 15% in a flat end market.

WABCO Management

WABCO’s management is generally known to be very strong operationally.  The CEO is very well-respected in the industry, runs a tight ship and is known for his cost controls.  He has strict incremental margin targets at various revenue growth levels and has generally delivered on them year in and year out.  The CEO has localized WABCO’s production in its various geographies and has created a culture of sharing best practices which has allowed WABCO to lower its cost of production versus Knorr, its primary competitor.  This cost advantage has enabled WABCO to gain share and win new customers at the expense of Knorr.

WABCO’s management is also shareholder friendly returning the majority of its free cash flow to shareholders.  Over the last five years, free cash flow has averaged 88% of net income and the vast majority of this free cash flow (87% to be exact) has been returned to shareholders in the form of buybacks ($1.2bn of buybacks in the last 5 years, which is 22% of current market cap).  See table below.

WABCO 2020 Numbers

Assumptions:

• WABO revenue outgrowth of 8 percentage points vs industry

• Incremental margins of 18% to 24% depending on end-market growth

• Capex 3.5% of revenue

• Tax rate of 18.5%

• Majority of free cash flow used for buybacks at ever increasing stock prices offset by dilution from stock comp leaves 49mm shares outstanding by 2020 (from 56mm today)

Output:

Risks

• Significant decline in global truck demand especially in Europe (58% of revenue)

• US, China and Brazil are already experiencing significant downturns and so most likely approaching bottoms

• Delay in adopting new regulations or dilution of existing regulatory regimes

• Continued volatility in exchange rates

• Technology risk

Catalyst

Earnings.

Continued European recovery.