3 Reasons to Buy Trinity Industries

The Messed-Up Expectations portfolio is chugging along, within whispering distance of its all-time highs. After a phenomenal 2013 for the portfolio, where it outpaced the S&P 500 60.2%, to 32.4%, it's managed to hold its lead ahead of the S&P 500 since inception almost four years ago.

After the recent exit from the Western Refining position pushed the cash balance above 10% of the portfolio, it's time to put some of that cash back to work. I think I've found the perfect candidate, and I'm not even straying too far away from oil, as you'll see.

The driver
The shale oil revolution happening right now in North America is affecting many different industries and aspects of the economy. One area affected perhaps more than most is the railroad industry. With all the oil being produced in the midsection of the continent, the problem of moving that oil to where it can be refined, largely on the coasts, is one that is being solved one way or another. Pipelines are slowly being built, but a large portion of the oil is being moved is by rail -- sometimes called crude by rail, or CBR.

As investors, how can we take advantage of that? We could invest in companies like Canadian National Railway (NYSE: CNI  ) or Union Pacific (NYSE: UNP  ) . These companies have seen lots of growth in CBR shipments, up 16%, to 160,000 carloads of petroleum and chemicals in the most recent quarter compared to four years ago for Canadian National, and up 62%, to 35,600 carloads for Union Pacific. Last November, Toby Kolstad, president of consulting firm Rail Theory Forecasts, said total CBR carloads were probably just 50,000 in all of 2010, but would hit 700,000 for 2013. He expects the number to top 1 million within the next couple of years.

Furthermore, despite the spills and fires caused when trains derail on occasion, these shipments are only going to continue to climb, thanks to the huge amount of oil being produced out of the various shale deposits.

The company
I think a better place to invest, however, is in one of the makers of the tanker cars, specifically Trinity Industries (NYSE: TRN  ) . Located in Dallas, Trinity is the country's largest manufacturer of railcars, delivering more than 14,000 cars so far this year -- compared to the 4,750 delivered year to date by American Railcar, its largest competitor.

The company's order backlog stands at 45,350 cars, a level that will take almost two years to work through at the current pace. However, I expect that backlog to continue to grow, at least for a few more quarters. Since Q2 2012, the backlog has grown 48% in cars ordered but 72% in value; including that quarter, orders received have outpaced deliveries in six of the past nine quarters.

The thesis
There are three things driving this trend. First is the increased demand for CBR. Going from 700,000 carloads in 2013 to 1 million by 2015 -- as projected by Kolstad -- is huge growth, and that will require more tanker cars.

Second is the increased demand for rail cars as railroad shipping climbs, in general, thanks to the improving North American economy. Canadian National saw 11% year-over-year growth in total carloads shipped last quarter, covering forest products, grain, metals and mining materials, automotive, and intermodal (moving shipping or truck containers from point to point). U.S. GDP growth of 4.2% last quarter, and a reasonably healthy second half of the year expected, requires lots of rail shipping.

Third is the demand for safer tanker cars. The standard tube-like tanker car, called the DOT-111 car, is unfortunately prone to leaks and crumpling when trains derail. It's bad enough if the car holds milk; worse if it contains chemicals. Spill consequences range from big messes -- and despair among cow herds for the former -- to potentially dangerous situations for the latter. If the tanker car holds petroleum, however, the consequences can be disastrous, as several derailments in the last few years have demonstrated.

In response to the increased CBR demand and the problems derailments cause, both the industry and regulators are looking to improve the safety of tanker cars. The industry has proposed the tougher P-1577 standard for DOT-111 cars, and has pretty much adopted it for new cars. In addition, both the Association of American Railroads, or AAR -- the standard-setting organization for North American railroads -- and the RSI Committee on Tank Cars have proposed enhancements to the P-1577 standard to make tanker cars even safer. The U.S. Department of Transportation is currently reviewing these proposals before issuing new regulations.

According to industry publication Railway Age, there are "approximately 272,000 DOT-111s in the North American fleet. Of these, about 171,000 (63%) handle hazmat" -- hazardous materials such as petroleum and other chemicals. "Roughly 29,000 (17%) meet P-1577 standards." That leaves roughly 140,000 that will need to be replaced or retrofitted, which means a lot of business for Trinity.

So what's the messed-up expectation?
Everyone who's paying attention to this industry pretty much knows the above thesis already. What makes it a messed-up expectation in my view?

The answer is that I believe people aren't expecting enough growth. At Wednesday's close of $49.31, shares are priced as if free cash flow growth would be 14.6% annually for the next five years, 7.3% for the following five years, and 2.5% after that. The five-year average growth for Trinity's FCF is more than 40%. Given its strong financial position, and the way orders continue to come in, I believe that the next few years will see growth closer to that 40% number than the 15% number priced in today.

Furthermore, the railcar-building industry is cyclical, with cycles lasting about five to six years, on average. While there are those who expect the current upswing of the cycle to last longer than that, I don't think they're expecting it to be very much longer. But looking at the above numbers of cars, it will take many more years to replace the current DOT-111 fleet, especially if more railroads and leasing companies follow Canadian National's lead of voluntarily replacing the outdated tankers they have.

Therefore, I'll be opening an initial position in Trinity Industries for the Messed-Up Expectations portfolio with an eye to increasing it in the future if the company performs as well as I believe it can. Come discuss this decision, and all the holdings of the MUE port, on its dedicated discussion board.

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  • Report this Comment On October 13, 2014, at 5:36 PM, LeeDavis wrote:

    I own TRN and plan to keep it. It should not bre selling this cheap.

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