Westinghouse Air Brake Technologies Corporation (NYSE:WAB) Q4 2022 Earnings Call Transcript

Westinghouse Air Brake Technologies Corporation (NYSE:WAB) Q4 2022 Earnings Call Transcript February 15, 2023

Operator: Good day and welcome, to the Wabtec’s Fourth Quarter 2022 Earnings Conference Call. All participants will be in a listen-only mode. . After today’s presentation there will be an opportunity to ask questions. . Please note, this event is being recorded. I would now like to turn the conference over to Kristine Kubacki, Vice President of Investor Relations. Please go ahead.

Kristine Kubacki: Thank you, operator. Good morning, everyone and welcome to Wabtec’s fourth quarter 2022 earnings call. With us today are President and CEO, Rafael Santana; CFO, John Olin; and Senior Vice President of Finance, John Mastalerz. Today’s slide presentation, along with our earnings release and financial disclosures were posted on our website earlier today and can be accessed on the Investor Relations tab on wabteccorp.com. Some statements we’re making are forward-looking and based on our best view of the world and our business today. For more detailed risks, uncertainties, and assumptions relating to our forward-looking statements please see the disclosures in our earnings release and presentation. We will also discuss non-GAAP financial metrics and encourage you to read our disclosures and reconciliation tables carefully as you consider these metrics. I will now turn the call over to Rafael.

Rafael Santana: Thanks Kristine and good morning everyone. Let’s move to Slide 4, I will start with an update on our business, my perspectives in the quarter, our progress against our long-term value creation framework, and then John will cover the financials. We delivered a strong fourth quarter which is evidenced by strong sales growth, an increase in adjusted earnings per share. We achieved this despite significant headwinds, including a volatile macro environment, supply chain disruptions, and negative FX. Sales were roughly $2.3 billion, which was up 11% versus prior year. Revenue was driven by strong performance across the freight segment, but partially offset by unfavorable FX. Total cash flow from operations was $410 million, which brings year-to-date cash flow to over $1 billion, achieving a full year cash conversion rate of over 90%.

Overall, our financial position remains strong. We continue to allocate capital to maximize shareholder returns by investing for future growth, executing on a strategic M&A, and returning cash to shareholders. Total multiyear backlog was $22.4 billion up $272 million year-over-year and excluding the headwinds from foreign exchange, backlog was up $680 million or up 3% from last year. We continued our progress against our long-term growth strategies. Overall, we have a strong finish to the year despite a number of challenges. As a result of this strong performance and our confidence in the future, our Board of Directors reauthorized a $750 million share buyback and approved the 13% increase in the quarterly dividend. We entered 2023 with strength and momentum across the portfolio and we’re well positioned to continue to drive profitable growth even with near-term uncertainty and volatility in the global economy.

Shifting our focus to Slide 5. Let’s talk about our end market conditions in more details. As we look at key metrics across our freight businesses, we remain encouraged by underlying business momentum and the strong pipeline of opportunities. North America carloads were down slightly in the quarter, but locomotive parkings are down from the same time last year despite lower freight traffic. We continue to see significant opportunities in demand for modernizations and new locomotives as our customers invest in their aging fleets and they also place a greater focus on reliability, productivity, and fuel efficiency. Looking at the North American rail car build, demand for rail cars continued to show strength with industry backlog about 60,000 cars.

Railcars in storage are below pre COVID levels with about 18% of the North American railcar fleet in storage. As a result, industry orders for new rail cars continued to improve and the industry outlook for 2023 is for about 40,000 to 45,000 cars to be delivered. Overall, we believe we have an opportunity to continue building significant long-term momentum with growth in modernizations in new locomotive sales, in rail car builds, and enrolling stock. Internationally, activity has also continued to show positive signs and will continue to execute on a strong pipeline of opportunities. Finally, transitioning to the transit sector, the long-term secular drivers are positive as the globe continues to increase investments in clean, safe, and efficient transportation solutions.

Next, let’s turn to Slide 6 to discuss a few recent business highlights. We recently secured additional Tier 4 locomotive orders in North America. These orders now total over 100 units to be delivered across 2023 and 2024. We also signed two international deals in Asia and South America to deliver new rolling stock and also won two international long term service contracts in South America and in Kazakhstan. Finally, Wabtec’s FLXdrive locomotive was recognized for sustainable innovation by the Business Intelligence Group and awarded The Commercial Technology of the Year by S&P Global. Looking ahead, all of this demonstrates the strong pipeline of opportunities we continue to execute on. Wabtec’s well positioned to continue to capture profitable growth with innovative and scalable technologies that address our customers most pressing needs.

Turning to Slide 7, I want to briefly touch on why we’re strongly positioned to deliver resilience and more predictable earnings in volatile times. We believe our demonstrated execution combined with favorable end markets and our leading technologies and solutions will enable us to remain resilient during times of increasing volatility. This resiliency comes in part from our multiyear backlog and strong base of recurring revenues. Our multiyear backlog of over $22 billion provides visibility and support for both short and long term growth. Similarly, our base of recurring revenues of 44% of total sales, which grew by 3 percentage points in 2022, provides high margin and stable earnings. And finally, we have a track record of strong operating margin expansion across the business, as evidenced by our ability to realize price, deliver productivity, and aggressively manage costs.

Now let’s turn to Slide 8. To further illustrate the point of our ability to drive consistent, predictable earnings I wanted to provide more color about our combined new locomotive and modernization deliveries in North America. Over the past six years, North America and new locomotive deliveries have been challenged due to weak carload growth, PFR and COVID. Over that period, the investment in the fleet has come primarily through modernization of locomotives, but this still remains below historical replacement levels. As we have discussed in past calls, the core North American active mainline fleet of heavy haul locomotives is made-up of roughly 16,000 locomotives. With a replacement cycle of roughly 25 years per locomotive, we estimate the annual replacement rate overtime to be over 600 new locomotives and/or modernizations per year.

As you can see, the industry has been operating at roughly half of that level for the past six years. Yet, looking forward, we expect a growing age for refreshment of that fleet. And with record fleet age and growing obsolescence driven by Next Gen technologies along with the expectation of rail share gains versus truck, and the need to reduce greenhouse gases by 2030 that the demand for reliable and efficient power is increasing. This expected demand provides Wabtec the opportunity to fill our existing capacity for delivery of new and modernized locomotive solutions in an effective and efficient fashion over the next several years. Looking forward, we believe our execution combined with strength of our business, leading products, and technologies result in Wabtec being resilient through economic cycles, delivering more predictable earnings and superior shareholder returns.

And with that, I’ll turn the call over to John to review the quarter, segment results, and our overall financial performance. John.

John Olin: Thanks, Rafael and good morning. Turning to Slide 9, I will review our fourth quarter results in more detail. We finished the year with another good quarter of operational and financial performance despite continued challenges in foreign currency exchange, still elevated input costs, and persistent supply chain disruptions. Sales for the fourth quarter were $2.31 billion, which reflects an 11.2% increase versus the prior year. Freight segment sales were very strong up 17.1%, partially offset by unfavorable foreign currency exchange impacting sales in our transit segment. Q4 sales were negatively impacted by unfavorable foreign currency exchange which reduced our revenue growth in the quarter by 4.5 percentage points.

For the quarter GAAP operating income was $17 million driven by higher restructuring costs. Adjusted operating margin in Q4 was 15.3% down 0.8 percentage points versus prior year. We expect that our margin to be lower in the quarter on both a sequential and year-over-year basis. The key drivers of the year-over-year margin performance include unfavorable mix within business groups, in particular, within equipment and services due to strong sales of locomotives and modernizations versus last year’s performance, some of which pushed from the third quarter to the fourth quarter and higher technology spend associated with investment in future growth and costs associated with the commercialization of the first battery electric locomotives. GAAP earnings per diluted share were $0.86, which was down 15.7% versus the fourth quarter a year ago.

During the quarter, we had pretax charges of $32 million for restructuring, largely related to our integration 2.0 initiative to further integrate Wabtec’s operations and to drive $75 million to $90 million of run rate savings by 2025. I will talk more about our progress on integration 2.0 in a moment. In the quarter, adjusted earnings per diluted share were $1.30, up 10.2% versus the prior year. Overall, Wabtec delivered another solid quarter of results, demonstrating the underlying strength of the business and our ability to navigate through volatile macroeconomic conditions. Turning to Slide 10, let’s review our product lines in more detail. Fourth quarter consolidated sales were strong, up 11.2% excluding foreign currency exchange, sales were up 15.7%.

Equipment sales were up 14.1% from last year due to higher locomotive sales this quarter versus last year. Component sales were up 10.6% year-over-year, largely driven by higher OE railcar build. Digital Electronics sales were up a strong 34.7%, which was driven by robust demand for onboard locomotive products and software upgrades along with revenue contribution from the strategic bolt-on acquisitions of Beena Vision and ARINC earlier in the year. Our services sales grew 16.6% versus last year. The year-over-year increase was driven by higher sales from a larger active fleet versus last year and increased MOD sales. Superior performance, reliability, and availability of our fleet continues to drive increased customer demand for our services and solutions.

Across our Transit segment, sales decreased 1.7% versus prior year to $637 million. Sales were down versus last year due to the negative impacts of foreign currency exchange. Absent the impacts of foreign currency, Transit sales would have been up 9.3%. The momentum in this segment remains positive as mega trends such as urbanization and decarbonization drive increased investments in green infrastructure. Now moving to Slide 11. As forecasted, gross profit margin was lower driven by unfavorable mix, adverse foreign currency exchange, and higher input costs, partially offset by increased pricing and productivity. Pricing actions implemented to recover increased costs positively impacted our margins during the quarter. Mix was unfavorable, especially within our equipment and services businesses behind strong sales of locomotives and MODs. Raw material costs, while down from recent highs over the last year were up again year-over-year.

Foreign currency exchange adversely impacted revenues by 4.5 percentage points and adversely impacted fourth quarter gross profits by $21 million. Finally, manufacturing costs were favorable due to productivity gains, which were partially offset by higher transportation costs. Our team continues to execute well to mitigate the impact of these cost pressures by driving operational productivity and lean initiatives. Turning to Slide 12, for the fourth quarter, as expected, operating margin declined on both a GAAP and adjusted basis, driven by lower gross margins and increased investment in future technologies. GAAP SG&A was up $8 million versus prior year due to higher net restructuring costs related to integration 2.0. Adjusted SG&A was $271 million which was flat versus prior year, but down 1.3 percentage points as a percentage of sales.

Engineering expense increased from last year according to plan. We continue to invest in engineering resources and current business opportunities but more importantly, we are investing in our future as the industry leader in decarbonization and digital technologies that improve our customers’ productivity, capacity utilization, and safety. Now let’s take a look at our segment results on Slide 13, starting with the Freight segment. As I already discussed, Freight segment sales were strong for the quarter, and GAAP segment operating income was $209 million for an operating margin of 12.5%, down 2 percentage points, which was impacted by increased restructuring expenses versus the year ago quarter. Segment adjusted operating income was $284 million, down 1.7 percentage points versus the prior year.

The benefits of higher sales and improved productivity were offset by unfavorable mix within business groups and higher technology investments and costs associated with the commercialization of the first battery electric locomotives. Finally, segment backlog was $18.64 billion, up $139 million or 0.8% and from the end of Q4 last year. On a constant currency basis, segment backlog was up $344 million from last year. Turning to Slide 14, transit segment sales were down 1.7%, driven by the negative effects of foreign currency exchange. Unfavorable foreign currency exchange impacted segment sales by 11 percentage points. GAAP operating income was $63 million, down 2.3 percentage points, which was impacted by increased restructuring expenses versus the year ago quarter, largely related to our integration 2.0 initiative.

Adjusted segment operating income increased by $7 million to $95 million, which resulted in an adjusted operating margin of 14.8% and up 1.2 percentage points versus the prior year, driven by strong productivity, benefits from prior restructuring activities and disciplined cost management. Finally, transit segment backlog for the quarter was $3.8 billion, up 3.6% versus a year ago. On a constant currency basis, backlog would have been up 9.2%. Moving to Slide 15, I would like to briefly touch on our progress against our integration 2.0 initiative. Recall that during our Investor Day last March, we announced a restructuring program comprised of an estimated onetime expenses between $135 million and $165 million that would yield an incremental $75 million to $90 million of run rate cost savings by 2025.

These savings were to be achieved through a combination of actions which simplify, streamline, and consolidate parts of our operations. A great example of the actions we are taking to drive these savings occurred in the fourth quarter, including two consolidation projects across our manufacturing footprint, which will eliminate a total of four facilities and a third project focused on streamlining and optimizing our North American distribution network. With full year restructuring expenses of $46 million in 2022, we achieved an initial $5 million of savings during the year. We expect investment to increase more meaningfully in 2023 and are on track to meet our 2025 goals, positioning Wabtec to drive multiyear margin expansion. Now let’s turn to our financial position on Slide 16.

We had strong cash generation in the quarter. Q4 cash flow was $410 million, bringing total cash for the year to $1.04 billion for a cash conversion rate of 93%. Cash flow benefited from higher earnings but was impacted versus last year by the proactive build of inventories ahead of our 2023 growth expectations and managing supply disruptions of critical parts. Our debt leverage ratio at the end of the fourth quarter declined to 2.2 times, and our liquidity is robust at $2.29 billion. And finally, we returned a significant amount of capital back to shareholders in 2022 with $584 million returned through share repurchases and dividends. And as Rafael mentioned, our Board of Directors approved a $750 million share buyback reauthorization and increased our quarterly dividend to $0.17 per share, up 13%.

As you can see in these results, our financial position is strong, and we continue to allocate capital in a balanced strategy to maximize shareholder returns. Now moving to Slide 17, quickly recapping the year. Overall, the team delivered a strong year for all our stakeholders. Despite challenging dynamics, we drove revenue growth, expanded our operating margins, and generated robust cash flow. The resiliency of the business and strong execution provides us a solid foundation and good momentum as we enter 2023. And with that, I’d like to turn the call back over to Rafael.

Rafael Santana: Thanks, John. Let’s flip to Slide 18 to discuss our 2023 financial guidance. We believe that the underlying customer demand for our products and solutions remain strong across our product lines and our backlog continues to provide visibility into 2023 and beyond. We are committed to driving adjusted margin expansion into 2023 despite FX volatility, a still challenging cost environment, and continued investments in technology. The team is committed to driving strong top line growth while aggressively managing costs. With these factors in mind, we expect 2023 sales of $8.7 billion to $9 billion, which is up nearly 6% at the midpoint and adjusted EPS to be between $5.15 and $5.55 per share, which is up 10% at the midpoint.

We expect cash flow conversion to be greater than 90%. Now let’s wrap up on Slide 19. As you heard today, our team delivered a solid quarter to finish out the strong year. We delivered on our full year commitments despite a challenging and volatile environment, thanks in large part to our resilient installed base, world-class team, innovative technologies, and our relentless focus on our customers. These results were in line with our five-year outlook we provided at our Investor Day last year. With strong momentum across the portfolio, increased visibility through our multiyear backlog, and relentless focus on continuous cost improvement, Wabtec is well positioned to drive profitable long-term growth and maximize shareholder returns. With that, I want to thank you for your time this morning.

I’ll now turn the call over to Kristine to begin the Q&A portion of our discussion. Kristine?

Kristine Kubacki: Thank you, Rafael. We will now move on to questions. But before we do and out of consideration for others on the call, I ask that you limit yourself to one question and one follow-up question. if you have additional questions please rejoin the queue. Operator, we are now ready for our first question.

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Q&A Session

Operator: . The first question today comes from Allison Poliniak with Wells Fargo. Please go ahead.

Allison Poliniak-Cusic: Hi, good morning.

Rafael Santana: Good morning Allison.

Allison Poliniak-Cusic: I want to turn to the services outlook. You noted an uptick in locomotive. Just wondering if you could give us a little bit more context on how impactful you’re thinking about that for 2023, is it sort of a point offset something bigger, I know there’s a lot of moving parts in that business right now, just any thoughts?

Rafael Santana: Yes. With the comment specifically with regards to services, Allison?

Allison Poliniak-Cusic: Yes, yes.

Rafael Santana: Okay. Allison, I mean, we’re certainly when you think about North America carloads being down year-to-date, so we’re continuing to see demand for both MODs and new locomotives. I think a lot of that is really tied to driving productivity, driving efficiency, driving reliability, and is certainly an element if you think about the CAPEX for Class 1s in the U.S. We see that up for the year. So those are potentially some of the headwinds could come with, I think, lower carloads right now, and we’re really planning for flattish in terms of that context. But I think what’s most important is really the element of the backlog coverage that we’ve got for the year. It’s a hedge of what we had a year ago. This is probably one of the highest 12-month backlogs we’ve had since 2019, which really just further strengthens our position to deliver in 2023 and last year, we have signed a number of multiyear orders, I think, for both new locomotives, but for modernizations as well.

So this provides additional visibility not just in to 2023 but in the case of MODs all the way into 2025 for new locomotives beyond that. So we have a strong pipeline of deals and we continue to see good momentum in both the pipeline of deals in North America and internationally.

Allison Poliniak-Cusic: No, that’s great. And then just a point, you mentioned sort of that replacement level for locomotives under the assumption that you probably wouldn’t reach that level this year. But how quickly, I mean, there’s ESG targets and so forth, is it sort of a 2024-2025 that you think you could reach that sort of run rate for replacement there or above, just any thoughts there on how you see this walk towards that level? Thanks.

Rafael Santana: Allison, I wouldn’t speculate how that will progress. But I think it was strongly still coming from the trough. And so when you look at some of the elements of the age of the fleet, continued investment to make sure you have productivity, but you also drive reliability on that fleet and the elements of ESG, I think we have a lot of opportunity here to help customers bridge that existing power into cleaner power. So it comes with upgrades and incorporating technologies like hybrid and things like that. So I think we’re well positioned in that regard.

Allison Poliniak-Cusic: Great, thank you.

Rafael Santana: Thanks.

Operator: The next question comes from Justin Long with Stephens. Please go ahead.

Justin Long: Thanks. I wanted to ask about freight margins. I know you were expecting negative mix and some sequential weakness there, but the magnitude of the weakness was a bit surprising, especially when you look at the different businesses within freight, digital electronics and services revenue was up pretty significantly on a sequential basis and equipment revenue was actually down a bit. So I was wondering if you could give a little bit more color on the mix impact you saw maybe within those different businesses, and I know you called out the tech costs as well, so maybe a quantification of the headwind you saw there?

John Olin: Okay, Justin, this is John. So again, let’s step back in the full year guidance. We expected it to be up in 2022, and we talked about margin growth in the first half and margin contraction in the back half, which you had mentioned, Justin. And that’s exactly what happened. The first half was up 1.4 percentage points and the second half was down 0.7 points. And the fourth quarter was right in line with the second half being down that 0.7 point. So overall, fourth quarter was down 0.8 points. A couple of things driving that is first the unfavorable mix that was the biggest driver of the reduction. And Justin, that was business that was mixed within our business groups. You had mentioned between our business groups, right and some of our higher margin products did grow at a faster rate, but that was offset by unfavorable mix within the groups.

And in particular, that was within the equipment and services group behind very strong sales of locomotives and modernizations versus last year. And to put it in perspective, we sold 30% of all combined locos and MODs were sold in the fourth quarter. So that put that pressure on it. And if you recall, Justin, in the third quarter, mix margins came in a little bit better than what we had anticipated. And at that time, we talked about some of our international local MOD deliveries being pushed from the third quarter to the fourth quarter. So that was why it was a little bit more pronounced maybe than was expected. So that was a big piece of it. The other piece was really our continued investment in the future of our business and decarbonization.

So part of that was the technology spend. And as you can see on the face of the P&L, that was up $8 million on a year-over-year basis. And again, that is our investment in hydrogen and battery electric as well as digital. And the other piece with regards to our investment in the future were costs associated with the commercialization of the first battery electric locomotives. So we — about a year from now, we’ll be shipping out the first battery electrics. We couldn’t be more thrilled or excited about that. And in the fourth quarter, we had costs and as you remember, we wouldn’t have had those same costs in 2021. So that’s what’s driving the negative variance on those. But overall, we’re right where we expect it to be on a full year basis.

And certainly looking forward to moving into a strong 2023.

Justin Long: That’s helpful. And is there a way to quantify the costs related to the battery electric commercialization that you referenced?

John Olin: Well, I would say generally, overall, half of it was mix and the other half was a combination of the investment in both technology as well as the commercialization costs.

Justin Long: Got it. Got it. Very helpful. And then on the 2023 guidance, are buybacks assumed within that outlook? And maybe, John, you could give a little bit of color on the expected quarterly cadence of that guidance because to the point you just made, we can see some fluctuations based on the timing of locomotive deliveries and MODs?

John Olin: Yes. First, Justin, the first question is the use of the generation of cash that we expect to have in 2023 is part of our — included in our guidance. You had mentioned repurchases, again, that could come in the form of acquisitions. It could come in the form of share repurchases. It all depends on if we have the right M&A, we’ll invest it that way. But the cash generation is contemplated in the guidance that we provided this morning. When — the second question is, when we move to revenue and margin cadence. I think the most important part is on a full year basis, we expect our operating margins to be up moderately versus 2022 margins of the 16.2 and to be generally in line with our long-term margin growth framework that we presented at our Investor Day about a year ago, Justin.

So okay, let’s talk about revenue and margin guidance for 2023. I want to start with 2022 because it certainly plays into what we expect in 2023. All through 2022, we characterized our revenue and margin cadence as higher margin growth in the first half and higher revenue growth in the back half. And that’s exactly the way it played out. In 2023, we expect to see the opposite cadence that we had in 2022. Consequently, we expect higher revenue growth in the first half versus the second half of 2023, and we expect our full year margin growth to come largely in the second half of 2023. And as you can imagine, the drivers of this are the cadence that we continue to see with — I’m sorry, the driver of the cadence is the mix impact of our international locomotive sales.

And Justin, as we talked about it, they were pretty pronounced in the back half of 2022 and we would expect more mix headwinds in the front half of 2023 as some — as we execute on some of those international locomotive sales. And then the second reason is that we’re comping against higher 22% margins in the first half and stronger 2022 revenue growth in the second half.