Westinghouse Air Brake Technologies Corporation (WAB) Earnings Call Transcript & Summary

Let's start over with the next presentation. So for those that don't know me, my name is Felix Boeschen, senior machinery and trucking analyst here at Raymond James. Today, very happy to have Wabtec with us. Presenting will be the company's CFO, John Olin. Before we kind of jump into a true maybe fireside chat format, John, I was just hoping you could give 5, 10 minutes on Wabtec, maybe the company, what you guys do, markets you play in, and I'll kind of take it from there.

All right. Excellent. Hello, everyone. Again, my name is John Olin, and I couldn't be more excited to be in sunny Orlando with you, and I couldn't be more excited to be the CFO of Wabtec and what a great company it is. I'm going to give a brief high-level overview. We're about $8.5 billion in revenue, 16% on ZIP code in terms of margin. And we are a conglomeration of 3 multinationals that came together in the last several years, one that bears our name, Wabtec goes back 154 years, and George Westinghouse started it, and Wabtec stands for Westinghouse Air Brake Technology. 2016 -- late 2016, the size of the company was about $2 billion. It doubled when it purchased a company called Faiveley Transport, a French company. And couple of years went by and the company over doubled again when a $4 billion combined company merged with GE Transportation, which is about $4.5 billion and that created the company that we have today. And as I'm sure we'll talk about some of the opportunity that's come about by putting one of the oldest industries -- and one of the oldest companies in America together and the opportunities that's created. We are organized in 2 segments, very simple of Freight, that does everything freight and Transit that does everything transit. Our Freight segment, we break into 4 different groups. One is equipment, call it, about $1.5 billion of revenue, and it makes locomotives. It makes mining equipment and submarine engines and all uses the same technology, the technology to pull 200 railcars full of coal also help to get a massive truck, the size of a 2-story house out of a big hole, right, in terms of the attractive effort that it has. We have a service business, about $2.5 billion, very high profit, high-margin business. And it does the servicing of the locomotives that we have around the world. It also has a modernization business in it. We'll talk a lot about, and that's a substitute for a new locomotive, it is one that we pulled off the rails after 20 years, put all new vital organs in it and new engine and checked the motors and so on and so forth. And it runs as good as the new -- not as long as a new, but as good as new. We've got a digital business, and it does onboard train stuff. It's a trip optimizer. It basically is cruise control for just like your car on tracks. We've got software that talks to different locomotives [indiscernible]. We do dispatch systems. We do port systems. We do rail yard systems. Anything that has to do with digital aspects of the freight business, we do it. And then the fourth area is components. We sell components into locomotives. We sell components into rail cars. And we have a part of that as a regular industrial businesses that leverages some of the things that we're very good at in the train business, whether that be turbos, heat exchangers and those types of things. Then that freight side is 2/3 of our revenue and 3/4 of our profit. Then the Transit side is 1/3 of our revenue and about 25% of our profit, and it does not make rail cars, but it makes all the highly engineered systems that go into them. So think about braking systems, think about the door system, HVAC, heating and cooling, passenger information systems, it does all of that, okay? When we think about the company, we've got 5 core strategies. I think they'll tell us a lot about who we are, what we do and how we're getting there. The first one is to lead the world in decarbonization, right? In 20 years, there will not be carbon -- diesel locomotives out on the tracks. One nice thing is that all of our locomotives are electric. The diesel is just there to run through an alternator to create the electricity. So it's not far-fetch for us to move into batteries, and we'll talk a little bit about that. But so number one is to decarbonize the world on rail. The second one is to drive technology and everything that we do. [ 154 ] years old -- we spend more on technology than the average industrial company does. 6% to 7% of our revenue is spent on engineering and technology. After we get my head around that, right? We've been on forever. And there's so many opportunities to invest in technology and a lot of that digital technology. The third area is to grow the installed base. With the acquisition or the merger with GE, we picked up 23,000 locomotives around the world. And as a locomotive runs, it needs to be serviced. It's got maintenance. It's got spare parts. It's got digital assets that need to be updated. Some of those are SaaS model. It needs an overhaul. It needs to be modernized. And the whole company feeds off the installed base that we have, whether it's locomotives or transit cars on the other side. The fourth area is to build recurring revenue and to grow that. And as of 2022, 44% of our revenue was recurring. 60% is aftermarket but 44% is coming to us. No matter what, when they buy, it's coming to us. And we were up 3 percentage points in 2022, and I'm certainly very focused and proud of that. And then finally is to drive improvement in everything we do and to be a culture of continuous improvement, certainly lean within our factories and so on and so forth. So those are the 5 main strategies that we're marching to. Quick results 2022. If you take out currency, which was a big headwind, sales were up 10.8%, revenue up 10.8%, margin up to 16.2%, up 30 basis points and EPS up 14.5%, 14.4% to be exact. When we look to the future, we would expect mid-single-digit revenue growth. We would expect margins to grow 250 to 300 basis points over a 5-year period of time. That includes 2022 and we would expect EPS in the double digit and cash at over 90%. All right. Felix, I think that was it.

Yes. That was great. Short and sweet.

All right. We're going to sit, stand?

I'll stand. You could sit, up to you.

Okay.

John, this might be an unfair question, but I'm new to Wabtec, relatively new, we launched last year. In a way, you are new to Wabtec as well. And when I first started looking at the name, I just thought, wow, there's a lot going on. You got rail equipment cycle, you've got 2 big deals, you got international. So maybe help us understand maybe what surprised you since joining the organization? And then secondly, what are you most excited about?

Great. Surprised and excited, so surprised. So I've been with the company 1.5 years. I came -- the company before this, I had a lot of heritage as well and a lot of longevity. And the biggest surprise was, by far, the opportunity that's in front of us. And it goes back to 154 years old, there are very few industries that were up back then that are still here today, and we're one of the oldest companies in America. So with that, my expectation wasn't a stumble over opportunity in every respect. And I think, Felix and the rest, it goes back to probably several months and it really dawned on me, and it explained a lot about Wabtec to me and the things that I was seeing is that we are a 154-year-old company, that's a 3-year start-up, right? And with that has come tremendous opportunity in taking 3 multinationals and beginning to integrate them in an industry that is also benefited by the ESG push, right? We are inherently much more clean than other modes of transportation, safer and cheaper. So all of those elements, 154 years later are coming into our stride in terms of putting these companies together. In terms of most excited about, I guess, is the latter is really the power of ESG and the inherent benefits that we have as an industry and then the particular advantages that we have as a player within that industry. We are, by far, the leader in technology. Our locomotives are inherently more efficient, about 5% at the engine level, another percent when you add that to our track of motors and that's 6% advantage. And then if you look at the digital assets that adds 12 percentage points, 12 to 18. And so we're 18% advantage. So anybody that buys our product, it's not gratuitous to the environment that they're cleaning it up by taking an old one that [ plouts ] more off the rails. It is a tremendous return on investment that they have because we've driven a lot of technology into that and pushed down fuel costs and other operating costs for them.

And maybe that's a good place to start. But you've talked about 16,000 locomotives, average replacement cycle, I think, 25 years, very long term. Where are we today if you kind of add up your modernization to newbuilds relative to that? And how do you think you get to replacement demand? Is it an efficiency story? Is it tied to carload growth? Maybe help investors understand how you think about that opportunity?

Let's start with the latter part of it, Felix, is when we look forward, we are not counting on a lot of inherent and underlying growth. I said is that the same guy that just said, look at the opportunity that we have to take share from trucks and so on and so forth. But in the last 10 years, the rail industry has not really increased their share of that space. They focused on cost reduction and have done an extraordinarily good job at it. So as we look forward, I think that if the rail industry chooses to compete for share, they'll be very successful given the inherent advantages of our -- over truck. But we haven't really built that into our going-forward piece. And I guess as you guys, as investors, I would first make 2 cases to you as to why it is a good investment. The first 1 is where Felix was alluding to is that the industry has been significantly underinvested in, maybe I shouldn't use significantly. It's been underinvested in. So when you look at, there are 16,000 locomotives in North America. And just speaking of North America right now, which is our biggest market, about 16,000 locomotives do the heavy work of moving goods around the country, around North America. There's probably double that, but they're in rail yards and they're not pulling 200 railcars, right, and our equipment lasts 20 to 30 years, so call it an average of 25 years. So that's a replacement value without any growth of 640 units. Well, we got a chart that shows what 10 to 15 -- I'm sorry, 5 to 15 years ago, the average was about 600 units a year. In the last 5 years, that has dropped significantly to 300, a little bit less than 300. And that's due to a term, you'll hear, [ PSR ] and COVID and all the other headwinds and the industry largely focusing on profitability and really sweating the assets a little bit more. Well, I haven't been with Wabtec too long, but I think there's only 2 things that make up a railroad. And one is the track and the other is a locomotive. And so that investment has got to come back and that's without any growth assumption. And so that's number one is to make the case to you as an investor that there has been underinvestment and by virtue of holding volumes flat that, that's got to come back in a pretty meaningful way. The second piece, natural question is as well when they just showed that they can wait out 5 years, right? When is it going to happen? And I think that's the most exciting part of the entire story is I believe it's going to happen in the -- which is in the time frame of most of the investors in our stock. They've all got ESG targets. And I'm not just talking North America, the whole world, every railroad's got ESG targets and all the mining companies that would tell them to have ESG targets. And I will tell you, unless biofuels comes back at a very low price and there's a significant quantity of it in the next 7 years, there's only 1 company on the face of this planet that can help the railroads get to those targets, and that's Wabtec. And they're going to do it through a multitude of things, but the first 1 is, again, going back and replacing old locomotives. They don't haul as much. They pollute more, and they use a lot more fuel. And we can either modernize them or we can sell a new. And with that, it will clean up a lot of that and help them get to their targets, which are mainly in the 30% range for 2030. The second way is biofuels. Our locomotives will take any biofuels, but nobody is using more than 5% at this time. And we can go up to 20%, 25% mixture. And then we're working on battery electric. So we're in the commercialization phase of putting a boat load of batteries into a locomotive and having it do the same thing as those diesel engines did in creating the electricity that we need to pull 200 railcars of coal. And the first 1 will be shipped about a year from now, and we're very excited about that. So the combination of those 2 things. One is there's a need. And secondly, is that need is bound by time. I don't think that the railroads are going to look to not make those targets. And again, that kind of puts us in a pretty good time frame.

Yes. So that's maybe a good point for me here. But so on the modernizations, can you, first of all, maybe explain to everybody what is the modernization? How does that work? And how do the unit economics stack up versus a new locomotive? And then secondly, they have 2030 targets out there. Can you remind us how long does it take to get a modernized locomotive? What are the lead times today? How long do they have to plan for that?

So from a railroader's perspective, they need power, right? And they can buy a new locomotive. And let's talk in big generalities that would cost $3 million to $3.5 million. And a lot of the differences on the digital assets that might be on that locomotive and other things a railroad might require or would ask for or you can modernize and it is simply that they drop off an old locomotive, call it, 20 years old, and we will strip it down. And all the vital organs, we will replace. So they're brand new, and it will come out doing a lot of what a Tier 4 would do or a new locomotive would do. And for that, it costs about $2 million to $2.5 million. Doesn't last as long. A new locomotive last 20 to 30 years, and modernized probably 10 to 15 years. So they've got that choice to make. When we look at it from their perspective, there's a good return on their investment for that, probably a little bit better on the new side because it lasts longer, but very attractive and over their cost of capital, a fair amount of their cost of capital. The other question, Felix?

Lead times?

Pardon me?

Lead Times on a new model.

Yes. So lead times for either a locomotive or a modernization has typically been in the 9 to 12 months for us to get the parts ordered and all the subsystems and that type of thing. Certainly, with the supply disruptions that has increased a fair amount, probably 50% to 75% longer than that. So call it up to 18 months now. Now we're starting to see that get a little bit better. So we've got that lead time in there.

Got it. And one of the things that I think is fascinating about Wabtec is just the earnings power of the model at presumably fairly low-capacity utilization levels. Can you maybe talk about that since the GE deal, what have you done to the footprint? And when we do see either mods accelerate or newbuilds accelerate, how do you think about those incremental margins coming into your business?

So when we look at Wabtec and how kind of the structure -- our cost structure works out, 15% to 20% of our cost of goods sold is fixed, right? So very easy to leverage that. Two ways that we can do that. One is to put more throughput through and the other is to reduce that capacity. And we're looking to do both. In terms of some of the orders that we've taken in, we had a very good year in terms of building the backlog in 2022. That will start to drive higher incremental margins. We'll talk about that in a second. And the other is, we've got a program called Integration 2.0. And after kind of the first garage of putting these things together, we got a lot of opportunity to take out additional footprint. And as those costs go away, obviously, margins will go up. So 10% to 15%, let's call it, fixed manufacturing costs, and then we get a little bit of leverage out of -- or a fair amount of leverage out of the SG&A side, while SG&A will inflate in terms of what you need in terms of growth, it's probably about 80% fixed, 75% to 80% fixed. But if you take those and you look at our margin at 16%, and that an extra dollar of revenue that runs through given that same existing base of assets that we have that derives about 25% to 30% incremental margin.

Okay. And then you mentioned Integration 2.0. Can we talk about the time line of that, sort of where you are in terms of what maybe you could see in 2023 versus what's to come in '24 or '25?

So we announced Integration 2.0 about a year ago, year ago about right now. And what that is, it's an investment that we're making, the tighten up that system and continuing to integrate. And the investment is about $135 million to $165 million. And at the end of that, we would expect that the savings to be $75 million to $90 million ongoing from that point after the 3 years. So that would be the run rate that we come out in 2025 would be $75 million to $90 million. Where we sit today after the first year, we've invested, what, about $70 million -- $60 million to $70 million. We have $5 million of savings on our way to $75 million to $90 million. And we've got 2 more years to get to that run rate. And so we would expect to see those savings ramp quite a bit. Most all the savings that we need -- or most of the projects that we need to get those savings have been approved and they're in various stages of announcement and delivery.

Okay. And you did give 2023 guidance not too long ago. Can you maybe talk about the current environment? And what I'm specifically curious about is, if I look at the announcements on the modernizations, it seems like that's going to be up quite nicely for you all into next year. Maybe help us understand what's embedded on the core service business? Just one of the pushbacks we get is this idea of maybe more locomotive parkings. Could you maybe talk about that what's embedded? How do you think about that into '23?

Maybe if you don't mind, Felix, I'll expand it a little bit. When we look at our plan for 2023, some of the key assumptions that we've got in it. One is on GDP. We expect GDP to slow down a fair amount in '23 versus '22, but we are not planning on -- we haven't forecasted a recession within those numbers, but a significant slowdown more in the back half of the U.S. and front half in Europe of that. The second is the supply chain, big assumption, right? We've got a fair amount of products still backed up. We would expect the supply chain to ease over the next 4 quarters. We've seen a little bit of easing on a lot of the supply chain, majority of it for the last 3 quarters. Computer chips, which we use a lot in our digital business, the first -- fourth quarter of last year was the first time we saw any easing there. So we would expect that to continue, and that will be a tailwind for 2023. When we look at railcar, I'm sorry, car loads, there's not a direct correlation. But over time, we certainly like higher carloads than lower carload growth, but we're expecting carloads by the railroads to be flat, flat to down a little bit. And with that, we expect the railroads to considerably improve their speeds as well as their dwell times. So if you take flat carload growth and improve the efficiency, we would expect there to be some excess capacity in terms of their locomotive needs, right? At least in the short term, we would expect their focus on growth, provide a big benefit going forward, having forecasted it, but we would expect that. So in 2023, we are planning for the part of the locomotives that are kind of off the rails because they're not needed to grow. And that would be a headwind in terms of our service revenues.

Okay. And so the other thing that's obviously been a factor for, frankly, all of my machinery companies is the idea of cost inflation, certainly ramping up in '21 and '22. Could you maybe talk about just price cost at Wabtec. It's unique in the sense that your backlog is much longer than many of my other companies. Could you maybe just talk about how you think about pricing? What percentage on long-term contracts and how we should think about that?

So I think to that point, Felix, one of the things that we're a little bit unique is about 60% of our revenue is tied up in a long-term contract. That could be a long-term contract to deliver equipment, to provide service for the equipment that we do sell, and we got a backlog of about $23 billion. Again, about $8.5 billion of revenue and a backlog of $23 billion. When we look at...

Price cost and long-term contracts?

I'm sorry. When we look at that 60% of long-term contracts, the majority of those have price escalators because they're long-term contracts, right? Majority. Vast majority have price escalators in them. And basically, that takes several elements of our cost structure, puts it into indices, and we track that. And so if the contracts 2 years, 3 years, 10 years, we've got a way that it goes up and down for us both to be happy with that. And typically, they run around metals. So on a locomotive, we would take how much copper, aluminum, steel, nickel and all those has made up, the percentages. We would agree on targets or indices, and we would run it that way. Labor is always in there as well. So there's a constant labor piece of it, labor typically goes up over time. And then you got an all other CPI type of catch-all. But about 60% of our revenue is in long-term contracts. So a lot of that is protected. And we saw those work -- they worked well through history. And they certainly worked well in the supply chain disruptions that we saw in 2021 and 2022. And with that, by the second quarter of 2022, we were at price/cost equilibrium. We've held that for the last 3 quarters, and costs are still rising. And the reason they're still rising when we're starting to see metals go down and some other costs go down is because they were all put into inventory and they have to cycle through inventory. So in the fourth quarter, we saw significant cost increases as many companies did. And again, we had -- our pricing of that was actually a little bit in excess of what we saw in terms of rising costs.

Got it. Interesting. I think we have 5 minutes left. I wanted to make sure I ask on the Transit business as well. What I'm trying to understand about Transit is there's a lot going on FX, international exposure. I think you exited some U.K. aftermarket business. Can you maybe talk to us about what you think the long-term growth outgo looks like in Transit and sort of what you're expecting for 2023?

For those not completely familiar, when we look at our Transit business and revenue was down 9%. But currency adjusted, it was actually up about 0.5%. And again, I talked about the company, we were up 6.9%. Currency adjusted, we were up 10.8%. So the question is, what's really the underlying growth in our Transit business? And I would say that it's been very consistent over time, not only for us but for the industry, in that 3% to 4% range. And so when you take 9% down, add back currency, we're up 0.5%. And as Felix mentioned, we did some things. We exited low-margin contracts as we focus on our profitability of that segment. We had a cyber incident that affected revenues a little bit in 2022, and then the supply disruptions of our business. Two areas of supply disruption really hurts the hardest. One was in the transit side of it and the other was on computer chips in our digital business. And so when you strip away those, you would find that in 2022, the underlying growth was in that 3% to 4% range. And going forward, we don't see a big change to that. Governments are investing in the Transit system. There's 2 megatrends that are pulling that forward, one being urbanization, right? And then trying to keep their cities decongested in terms of traffic. And then the other is the ESG, and I'm trying to keep that down. So we see a constant drumbeat of investment in those assets. And when we look at backlog, our backlogs have risen quite a bit in 2022 as have the car builders that are drawing parts from us and systems from us.

And if I think back to 4Q earnings, actually, what stood out most to me was your Transit margins. I know you were coming out of the cyber attack. And so can you maybe help us understand those margins, I think, mid-teens? How sustainable is that? How do you think about transit margins sort of over the long term?

So going back to when we did the GE merger, the Transit margins were 18, 19 -- I'm sorry, 8% to 9%. And today, they're 12%. We finished the year at 12%. With that revenue down 9%, our margins were down only 10 basis points. So we were very pleased with that, but it was a fight all year long in terms of holding on to the margin. We have provided guidance over our investment horizon. We would expect that to get around 15%. And so we've got various plans in place. One is the underlying growth. We would expect that to continue. That will drive some level of absorption and productivity. The other is of that Integration 2.0 money, more of it is over shared to the Transit. There's a lot more opportunity to consolidate some of the facilities there. And between those 2 big drivers and the technology that we bring out on a regular basis, we had, again, expect to see that at around 15% over the next 4 to 5 years.

Got it. And I think we have 60 seconds left, and I have to ask you about capital allocation. M&A has been a big part of the Wabtec model in history. You've recently stepped up some buybacks. I guess, holistically, I'm curious how you think about use of capital, just broadly, yes.

Five straightforward priorities. Number one is protect the balance sheet. So we're looking to keep our net debt leverage ratio at 2x to 2.5x. We finished the year at 2.2x in 2022. The second one is to continue to provide an increasing dividend, didn't have a clear dividend strategy coming out of the merger, and that is to grow dividends in line with net income on a consistent basis. Number 3 is to invest in the best investment that we have, and that's ourselves in terms of that technology at 6% to 7% of our revenue as well as capital. Now we're a little bit under what the industrial average would be on capital at about 2% of revenue, over shared on technology a little, but undershared on overall capital. So with that, 2022, we had over $1 billion of operating cash. You take out the dividends and the CapEx, you're around $700 million and $750 million. And with that, we would prioritize M&A above share repurchases, but we're only going to do highly accretive M&A. And in 2022, we did 3 acquisitions totaled $89 million. And with that, we're not looking to build cash on our balance sheet in any way. The rest of it comes back in the form of share repurchases. We repurchased about [ $434 ] million, if I remember the number right. We expect that to continue into the future. If we've got good M&A, we will prioritize that first. Otherwise, it comes back in the form of share repurchases.

John, I appreciate. We're out of time already. So I'm going to say thank you everyone.