Faiveley Deal In Current Form Is Probably Dead
WAB’s 1Q 16 earnings release and call were notable because of what they did not contain: a clear explanation the favorable decremental margin (materials are likely to prove mean reverting) and a disclosure that Faiveley was under significant scrutiny by antitrust regulators. Given those omissions, we are interested to hear more about the Siemens PTC suit. A failure to be forthcoming is deceptive, in our view. We have met with several larger longs in WAB that place significant faith in this management team, and we wonder if those holders noticed those omissions.
Should Have Been Discussed: Given reports of DoJ concern that the Faiveley merger would reduce the number of passenger-train brake systems manufacturers from three to two, some management commentary was due on the call. It is now increasingly clear that divestitures may be needed for LEY FP & WAB US to close. Faiveley’s Braking & Safety Systems – the area most likely to generate overlap concern as we understand it – is about a quarter of LEY sales. Divestitures would almost certainly undermine at least part of the strategic rationale for the transaction.
Is The Faiveley Deal dead? Probably, or at least the good part of it. Various obligations in the Exclusivity Agreement cease to apply 15 months after the agreement was signed, as we read it, and closing is likely to drag out longer than that now. We have yet to hear about DoJ concerns, which raised the initial flags in the press. Agreement modifications should follow, particularly if divestitures enter the picture. Fees on break-up are minor, and we suspect the Faiveley family is unhappy about the public discount anyway.
When A French Manufacturing Acquisition Is Your Bull Story: When a bull story hinges on the acquisitions of a French manufacturing company, we think investors should recognize a problem. When undue investor faith is placed in a management team that, we think, is aggressively spinning a bullish narrative by leaving out bad news, investors should look to the exits. After Wabtec reported last week, investors were likely hoping that favorable decrementals would bridge profitability to the Faiveley merger, allowing for a new narrative and focus for the shares. Of course, this view is already a thesis drift from the “Freight will be fine” reply. The revelation that the 1Q WAB EPS print was due to lower materials costs and a debt funded buyback leaves that bridge rickety at best. Now that bridge would need to hold up all the way until fourth quarter to reach a likely different merger deal, if the deal happens at all. Realistically, that is not much of a bull story in the face of 16.5% organic sales declines at the unit that represented 76% of 2015 operating profit.
What about buybacks? Can WAB offset the failure of Faiveley with a huge repurchase? Sure, but levering up at a major cyclical inflection point is incredibly risky, we think, and would leave us more optimistic about our short view. Investors don’t usually pay a big multiple for debt fueled financial engineering. Covenants restrict them to a bit over $2 billion in debt at current profitability – capacity the company likely needed to fund the cash portion of Faiveley. We should expect a big repurchase or similar move if Faiveley fails more formally. It would likely be a good opportunity to fade a rally.
Important Questions For Large Longs To Answer: Was the favorable decremental from “[management’s] ability to respond to changing marketing conditions, with actions to decrease cost and increase efficiencies” per the chart below? Will Faiveley really close in its current form by 4Q?
Upshot: We continue to see WAB as a promising short, and expect 2016 EPS ex-Faiveley below $4/share as the company’s core freight market enters a multi-year downturn.