Thursday, October 18, 2012

FreightCar America -- Railcars



FreightCarAmerica (“RAIL”) makes and sells 80% of the coal cars in the United States. Its customers are railways, power companies, and leasing firms. 

RAIL has a couple of competitive strengths: 

  • many railcar purchasers prefer to maintain a standardized fleet of railcars, making RAIL, the incumbent, the preferred supplier of coal cars; and 
  • it has the capacity to manufacture 15,000 units a year in its plants at Danville and Roanoke, meaning that, in most years, it operates below capacity. 

Competition based on design is therefore as unlikely as competition based on cost.  And, given the high cost of transporting railcars across the ocean, competition from provenances with low cost labor is not a concern  

Looking back

The business has generated an average of ~$34 million per year in operating profit on average operating assets of $96 million, for an average return on invested capital of 35% -- a fair reflection of its competitive position

18% of this operating profit was used to close down a unionized plant, a nonrecurring expense, and 45% was paid out to owners. 15% of the operating profit was reinvested for growth.



The story in railcar units:



Looking forward

Core business – replacement coal cars

There are currently 270,000 coal cars in operation in the US and 3.7% of them – 9,950  – have needed to be to be replaced in an average year, 7,950 of which have been manufactured by RAIL.

At an average selling price $75,000 and an average gross margin of 11.75%, this recurring, though lumpy, business of replacing old coal cars has generated $590 million in gross profit since 2005. 

The coming business cycle calls for approx. 79,000 coal cars – those aged 30 or more years old today – to be replaced. Moreover, the coal cars to be replaced are made of steel and need to be exchanged for the more efficient aluminum cars which are RAIL’s specialty. The average replacement rate, therefore, is going to be comparable to the past eight years: 9,875 cars per year, perhaps 85% of which will be supplied by RAIL at an average price of $80,000 per unit. 

After overhead expenses and taxes (net of the NOL carryforward), the average annual operating profit from this core business is therefore going to approximate $36 million a year. 

Leasing

In order, it says, to smooth revenues across the business cycle, RAIL entered into the railcar leasing business in 2008. Setting aside the long-term wisdom of competing with its customers, the minimum revenue schedule over the next few years from this segment is knowable – about $5 million per year. 

Services

RAIL has also, via acquisitions, strengthened its commitment to providing railcar maintenance services in the busiest rail traffic corridors in the US. We can expect this segment to contribute another $4 million per year in after-tax profit.


RAIL’s total minimum earning capacity over the next business cycle, is therefore, about $45 million per year ($3.78 per share). Bearing in mind that RAIL pays out what it doesn’t reinvest for growth, we can project that, in the absence of the an incident like the closing of the Johnstown plant, it will pay out its excess cash and at least 75% of its operating profit, for an average of $3.10 per share per year, which is not bad for a stock priced at $18 and change. 

More conventionally:

It's a wildly cyclical stock, so everyone tries to time it. Some brokers even have a sell rating on it. The only real risk with this stock -- the only one that I can see --  is that it might be acquired at $25 or so by an outfit like Berkshire. The concerns over the near-term death of coal are founded more on hope than fact. 

Disclosure: No position 

Edited for typos on Oct 19th

4 comments:

  1. How do you think through cyclicals? This is a problem i've been having in other areas as well.
    1) where did you get more macro info about the rail cars?
    2) Timing...you say everyone tries to time it...you don't? How do you decide to buy a cyclical?

    Thanks!
    Nikhl

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  2. I pay attention to 3 questions:
    Is it really (just) a cyclical?
    How long is the cycle?
    and
    Will it survive the downturn?

    If interest cover at bottom is less than 4x, I'm not interested.

    I don't try to time investments. If the yield is okay and the underlying, cyclically adjusted, fundamentals are good & improving, I'll buy it. If the fundamentals are just good, but not improving, I want a great yield, say > 30%

    The company provides market data on its IR page. One can cross check it with info provided

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  3. One thing I have wondered recently is if there's a certain extra attraction in industries perceived to be dying - it seems a remarkably easy way of warding off competition in businesses which otherwise would have 'unsustainable' returns on capital.

    Regarding RAIL specifically, do you think there was much putting off of replacement during the bust? Where I'm obviously going with that is whether we'll actually see a level of sales well above replacement rates when confidence picks up. Given the valuation at 'replacement rate' isn't particularly high, I wonder whether that's another potential bonus.

    Great article as always.

    ReplyDelete
  4. Hi Lewis,

    I agree with you that if there is a perceived risk of long-term decline, it might put potential new entrants off. Still, I think the real threat to new entrants is the excess capacity at RAIL's two manufacturing facilities, a strategy that I believe (hope!) is a deliberate one on the part of management: the marginal cost of producing a 1000 coal cars in a plant operating at 2/3 capacity is considerably less than the marginal cost of producing one's first 1000 coal cars. Attempting to compete as a fresher/newbie would therefore be virtually suicidal.

    A return on average invested capital of 35%, for a manufacturing firm (a real manufacturing firm, not a fake one like Apple or Nike) using American labor is really unusual, and I think that it can only be explained by the really high perceived risk in entering this line of work.

    As for the timing of coal car replacement, I suppose that, in a recession, energy companies and railroads (and therefore leasing firms, too) suffer from the fear factor as much as consumers or investors and delay their purchases in order to smooth out their operating cash flow. It seems to me that the bottom of the cycle is when one wants to be buying coal cars (the dramatic gross margin compression on coal cars sold in 2010 is entirely due to price-cutting) but rare is the manager who can step up and take the long view; they'd rather pay premium prices at the top of the cycle.

    I am sanguine about the long-term prospects for the US coal industry. (1) I don't think Nat Gas is going to cut into coal-fired plants all that much over the medium term; (2) new coal excavation west of the Mississippi is further away from power plants, requiring longer car trains over greater distances, meaning slower coal car utilization rates (i.e. asset turns) and therefore requiring more coal cars; and (3) world demand for coal will certainly rise over the next fifty years, any excess coal in the US will therefore be shipped, and that coal must be somehow transported to sea ports.

    I like this stock because so much effort is spent on predicting what will happen in the next two quarters. No (professional) investor wants to look the fool, so they expend a lot of energy in trying to time it. So it has these large movements up and down, which, in turn, raise the equity's beta and make it more "expensive" to hold (from a CAPM perspective). By my calculations, RAIL's beta is 16.88%. If you calculate RAIL's normalized operating profit and capitalize it by 16.88%, you'll get to the current market value of the enterprise, and by implication, to RAIL's current stock price. To the penny.

    So buying RAIL would essentially involve nothing than an arbitrage between real risk (based on the fundamentals) and fake risk (based on beta).

    Or so I believe.

    ReplyDelete