Greenbrier Companies (GBX)

[Enterprising Investor]

Riding the Railcars (5/30/15)

Companies that manufacture freight railroad cars have profited handsomely off of the surge in U.S. oil production over the past five years.

By Avi Salzman

Companies that manufacture freight railroad cars have profited handsomely off of the surge in U.S. oil production over the past five years. Oil drillers used railroads to ship the commodity throughout the country, and received deliveries of fracking sand by rail, too. Industry leader Trinity Industries (TRN) shipped 30,255 railcars last year, up from 4,750 in 2010.

But investors now fear that the oil-driven boom is over. Railcar orders fell 57% between the fourth quarter to the first, and industry backlog—the number of railcars that have been ordered but not yet delivered—was down 3%, after hitting record levels in the fourth quarter.

The fear is not unwarranted. The railcar business is highly cyclical, and periods of rapid activity are often followed by much slower production. Once the order backlog declines, the stocks tend to follow closely behind.

But the counterargument—that the railcar boom still has a ways to go—is persuasive. The stocks of companies that make railcars are now trading at very attractive valuations, and haven’t had such clear earnings visibility in many years. Trinity trades at 7 times forward earnings; Greenbrier (GBX) trades at 9.5 times; and American Railcar Industries (ARII) at 9.9 times.

At current production rates, which are the highest since 1999, the current backlog for the entire industry should last for seven quarters, according to Susquehanna Financial analyst Bascome Majors. Trinity’s railcar backlog at the end of last year was worth $7.2 billion, nearly equal to the company’s entire enterprise value.

Several catalysts could sustain the trends, and defy analyst expectations for slowing earnings growth.

Following a series of oil-car explosions, the U.S. and Canada have released new standards for railcars carrying highly flammable material. The changes could affect almost 155,000 railcars. Majors says that “only a fraction of those are likely to be replaced prematurely.”

But the Street may be underestimating the opportunity from tank car replacements and retrofits. Ryan Thibodeaux, president and portfolio manager at Goodwood Capital Management, says that the dropoff in new tank car orders in the first quarter had a lot to do with companies taking a wait-and-see approach before the regulations were announced. He expects much more robust orders in the second half of the year, and sustainable demand for several more years. In just the next three years, railcar owners and lessors could be forced to replace or retrofit as many as 80,000 cars, with full replacements costing about $150,000 each, he argues. He sees a revenue opportunity worth as much as $8 billion to $10 billion.

The Street has also underestimated the benefits to rail companies from a boom in chemical production, which has expanded rapidly in the past few years as companies take advantage of cheap natural gas, Thibodeaux says. “All of the new chemical and plastics capacity on the Gulf Coast will add production that will have to be shipped,” he says. “The industry backlog will remain elevated longer than analysts think.”

Goodwood owns shares in both Trinity and Greenbrier. While Trinity is cheaper, the company lost a False Claims Act lawsuit over its highway guardrails and could be liable for as much as $709 million in civil penalties. It’s also facing a Department of Justice investigation into the guardrails. Eric Marshall, a portfolio manager at Hodges Capital, which owns 2 million shares of Trinity, says his company has studied the suit extensively. “It’s muddied things up for investors, but we don’t think these guys did anything wrong,” he says. “It’s created an opportunity to buy Trinity at a multiple that’s well below its historical norm.”

For investors who want better guardrails for their investment, Greenbrier also trades below its historical range and could benefit from similar trends.

http://online.barrons.com/articles/riding-the-railcars-1432948441