Is There Anything Safe From Recession?

by Overheard Wall Street

  

Outline
  • Intro
  • Recession Proof Ideas
  • AutoZone
  • Westinghouse Air Brake Technology 
  • Conclusion

Intro

Everyone is talking about a recession. Or food shortages. Or bear markets.

  

But will all of that actually happen the way everyone claims? And if it is going to happen, what is the right way to prepare our portfolios for that?

Do we just sit in cash?

Only to lose 8.7% a year to inflation? Probably not, even though short-term rates have gone up and there is some yield pickup to be had with your cash.

Should we buy gold since it’s a great inflationary hedge?

Again, probably not. Gold worked as an inflation hedge in the 70’s when inflation was running hot. But it failed in the 80s when inflation was high as well. In periods when inflation is not running hot (which is 80% of all periods going back to WWII) gold has provided a negative real return.

If you think you can time the market, get out before inflation starts going back down and believe that Gold will perform well – then go get ‘em, tiger!

Most of us cannot time the market though – so it’s better to think of an investment approach that is going to do well in all periods. Inflationary or not. Recessions or not. Bear markets or not.

This doesn’t mean the investment won’t go decline or lose money, but ideally, it will perform better than the broader market in order to provide a margin of safety to your portfolio.

Investing in a company that can be thought of as “Recession-proof” is an ideal way to build out your portfolio of equities to avoid investing in stinkers like Peloton or 23ANDME. A wild run-up in demand and price acceleration does not make a good company…

   

Recession Proof Ideas

From a very broad perspective, think about the businesses you frequent all the time. Good times or bad. Whether you have that VP job you always dreamed about or you’re stuck flipping burgers with your diamond hands.

Hopefully some businesses come to mind – grocery/consumer product stores, professional services, automotive manufacturers, insurance providers…

There are a lot of different businesses we might consider “recession-proof” and as the economy grows and changes, those companies might grow and change too.

Back in the day, we might have said Revlon or General Electric are recession-proof. And, to be fair, they generally were! But unfortunately, those companies missed the memo from Moore’s Law on technology improvements outpacing everything and cutting costs in half.
  • Moore's Law states that the number of transistors on a microchip doubles about every two years, though the cost of computers is halved.

That should be a solid reminder up front – while some of these businesses may be “recession-proof” today that does not mean they are free from all trouble in the future. 

Technological advancements often cause disruption, in the best way generally, but for disruption to really prove beneficial – it often causes some cannibalization of other businesses.

Let’s take a few examples and dive in to see if they may be a good fit for our portfolios!

Today, we are going to examine AutoZone (AZO) and Westinghouse Air Brake Technology Corporation (WAB).

Past Performance during Bear Markets / Recessions:

  

AutoZone

AutoZone (Ticker: AZO) is an automotive parts and accessory retailer and distributor. They provide original manufacturer equipment and parts for just about every car we drive (except maybe Chad’s Lamborghini Aventador), and their sales staff have the expertise to help you fix your car problems.

Let’s face it: AZO is basically like our collective dad. They have every part you might need for your car, and they have the know-how and tools to fix your car. They only ask that you bring the car to them and hold the flashlight so they can see what they are doing. They might even let you borrow some tools, if you ask nicely and promise to bring them back before next Thursday.

 

AutoZone has been around since 1969 and currently operates more than 6,700 stores across the US.

Bulls
  • Profitability – AutoZone currently runs a solid and profitable business. With fiscal year sales in 2021 reaching $14.6bn, 16% over fiscal year 2020, and maintaining a gross profit margin over 50%, AZO is well positioned to weather recessionary storms. In fact, they have been actively buying back shares, which is a direct benefit to shareholders, with their consistent earnings growth. EPS increased 32% in fiscal year 2021, coming in at $95.19/share and they approved an additional $1.2bn of share buybacks for this year.
    • Estimates have AZO on track to increase EPS by another 20% this year as well, coming in at $115.17 per share with just one more quarter to report for the fiscal year.
  • Inflation may be beneficial to AutoZone – with new car prices up 12.6% and used cars up 16.1% YoY, according to May CPI-U report, more people than ever are holding on to their cars instead of upgrading or buying more. And that means they are going to need to work harder to keep their cars running and serviced appropriately. Who do you think benefits from that? Yes, car parts dealers and manufacturers.
  • Historically, AZO has performed well when the broader market hasn’t – AZO has held its ground through many different market scenarios. With high profitability margins and a steady growth plan, AZO is not a company to look away from in times of market turmoil.

Bears
  • Negative Shareholder Equity – we saw this a few weeks ago when we looked closer at Planet Fitness. A company that is overburdened with more debt than assets, will have a negative equity value in order to balance the books. This may not always be a warning sign, especially for a young company growing exponentially fast, but for a mature and stable business like AutoZone, this is not a great sign.
    • Negative Shareholder Equity also impacts book value, if you are an investor that looks to compare share price to book value, you may want to look away here. Current BVPS is a negative 173 and tangible book value looks even worse at -188.5.
  • Debt Burden is heavy – AZO currently has $8.7bn of long-term debt on its balance sheet. This, coupled with their $6.8bn of Accounts Payable, brings their total liabilities above total assets by about $3.3bn. Not a great sign for a stable and mature company, but on the brighter side, the interest expense associated with this debt is well within the boundaries of being manageable. 
    • And, given the profitability of AZO, not necessarily a hindrance to their future growth. In fact, most of AZO’s LT debt has interest rates below 4% - which is great given the current high and rising interest rate environment.

Key Metrics (as of 6.29.22):
  • Current Share Price: $2,140
  • EBITDA/Interest Expense: 21.1x
  • Altman Z-score: 2.71 (range 0 to 3. close to 0 suggests a company might be headed for bankruptcy, while a score closer to 3 suggests a company is in solid financial positioning)
  • NTM Ratios:
    •  EV/Sales: 3.1x
    • Price/Sales: 2.5x
    •  EV/EBITDA: 13.4x
    • P/E: 17.5x

Westinghouse Air Brake Technology Corporation

Don’t let their name confuse you, Westinghouse (Ticker: WAB) may engage in the manufacturing of air brake technology, but they are much more than that. 

Overall, Westinghouse services the rail industry in all manners – they manufacture and service new and existing freight cars and locomotives, as well as driving technology development and hybridization of rail cars. They also service passenger trains, subways, commuter buses and other vehicles engaged in transportation services.

Now think about this company as it relates to recessions and bear markets: will people still need their goods transported across rail lines? Maybe less than normal if they hold off on regular spending.

Will people continue riding buses and subways to get to work, or find new work? Building new models and growth may slow, but old models will continue to be serviced and fixed.

Westinghouse has been around since 1869 and even though we have seen other old companies get smacked down in this environment *cough* REVLON *cough* WAB is a different story. 

They have been on the acquisition train for many years now, solidifying their position as one of the largest public rail equipment companies in the world and further ingraining new technology and efficiencies into their business.

Bulls:
  • Leading the charge on hybrid trains – Just like automotives, the rail industry is gaining speed on the transition from diesel/gasoline to electric power. Locomotives are ingrained in their ways and the technology is much more customized and expensive than automobiles. 
    • It will likely take longer for trains to transition to EV than for automotives, but for now the rise of hybrid trains is moving in the right direction. And WAB is facilitating that transition in-house as we speak.
  • ESG Powerhouse – WAB’s in-house tech, FLXDRIVE, will slash carbon emissions in trains by up to 30%. It provides electric power for locomotives to travel at 75 MPH for 30-45 minutes and they can go even further with regenerative braking (i.e. when brakes are engaged, it regenerates battery power, a popular feature in TSLA models today). 
  • Solid Financials – WAB stands with a large, asset heavy balance sheet, and a consistent history of profitable business operations. WAB has maintained a solid profit margin for the last decade, keeping a tight range around 30% gross profit. The only hiccup to their growth was after they acquired Faiveley in 2015, the leading global provider of value-added, integrated systems and services for railway, which they integrated very well after a short period. 
    • WAB has been building its asset base as well, currently sitting at nearly a 1:1 ratio of current assets to LT debt (Current ratio stands at 1.6x and Quick ratio at 1.1x, both positive signs). 
    • An interesting metric that WAB provides highlights their revenue/employee and net income/employee – if we look at those numbers going back to the Faiveley acquisition, WAB’s employees have become increasingly more valuable and profitable to the company:

   
  • High Oil prices may be a positive for WAB – as oil and gasoline prices are on the rise, demand for locomotive transportation is higher vs trucking due to a lower cost for transportation of goods. 
    • This ties WAB to an uncontrollable lever as they have no way of impacting the price of commodities and are beholden to its ebbs and flows. Management has taken steps to protect themselves from near term increases in costs by passing those expenses along to customers, which may help mitigate some of the concerns being raised in the short term.
  • Acquisition Powerhouse – WAB is about to complete an acquisition of Collin Aerospace’s ARINC rail solutions business in June of 2022. Earlier this year, they completed an acquisition of India-based MASU’s railway friction business. In 2021, they acquired Nordco to help with their installed base and facilitate growth across international and domestic innovative products business lines. In 2020, they acquired RELCO locomotives… are you noticing the trend here? 
    • Not only are they acquiring all the new up-and-comers and new technology, but they are integrating them into their business and expanding their operations.
  • It may be out of favor, but as a consistent business, it’s hard to see WAB at fault – WAB has proven that even amidst their spree of acquiring companies, they have been able to consistently provide returns for investors year over year. Looking back over the last 10 years, WAB has maintained a positive ROE and ROIC each year. 
    • Providing value to investors is important, but even more important is generating free cash flow through business operations. Each year, whether acquiring businesses or not, WAB has generated positive free cash flow from operations going back 20+ years. That’s the kind of business you want to own in all periods, boom or bust.

Bears:
  • Supply chain issues – if you hadn’t heard this before… supply chain issues have plagued the world as we have started to move past the pandemic and return to a more normal lifestyle. With the increased level of purchases seen in 2021, many are facing supply chain bottlenecks and cost increases. WAB has experienced difficulties in dealing with labor, raw material and chip shortages which have directly impacted the timing component of their revenue generation.
  • Along with supply chain issues, the Russian-Ukraine war has caused issues for WAB as they attributed $40m of earnings in Q1 of 2022 to Russian customers and had assets of approximately $16m related to Russian operations (mainly cash and inventories).
    • Management believes they can recover these assets, but with no near term end in sight for this conflict – these issues could add to concerns over WAB’s future potential.
  • Intangible Asset Level – the consistency of WAB’s acquisitions has continued to improve their reach and services, but the largest and most complex acquisition of GE’s transportation division in 2019, appears to have boosted WAB’s balance sheet in a less than sustainable way. In 2019 WAB’s intangible asset level increased from $3.5bn to $12.4bn due to their purchase of GE’s transportation division.
    • Goodwill broadly means that WAB paid more for their acquisitions than the assets were worth. While this is not necessarily a directly negative sign, it could cause a drag longer term for WAB. In general, history has shown that larger acquisitions lead to larger impairments on assets in the long run. Investors and managers tend to believe that acquisitions will broadly add value but historically, only half of mergers actually end up creating value for companies.  

Key Metrics (as of 6.29.22):
  • Current Share Price:$82.63
  • EBITDA/Interest Expense: 5.8x
  • NTM Ratios:
    • EV/Sales: 2.3x
    • Price/Sales: 1.8x
    • EV/EBITDA: 11.9x
    • P/E: 16.5x

Conclusion:

While things may look bleak across the broader market, with investor sentiment low and market returns flirting back and forth with bear market territory, remember that there are still investment options available.

They may not be as flashy and exciting as crypto DAOs building the next AI grocery store chain where your membership token grants you access and Jimmy just sold his grocery token for a 100x return…

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