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This article is part of our Rising Star Portfolios series.

Blame Warren Buffett, that octogenarian superinvestor of Berkshire Hathaway (NYSE: BRK-A  ) (NYSE: BRK-B  ) fame. A few years back, he let the cat out of the bag: Railroads are tremendous businesses. Our folksy friend's blessing drew investors to railroads like cats to catnip.

I hate him for it. Railroads haven't looked cheap since, and they never found a place on my watchlist.

But today, that changes: RailAmerica's (NYSE: RA  ) our ticket, folks. A previously mismanaged business, the lingering and onerous debts from a leveraged buyout, and seemingly feeble profits mask a burgeoning cash machine -- with multiple means of value creation. And all of a sudden, I'm just a little less bitter that Buffett blew it for us. This is a classic value.

The business
RailAmerica is a short-line and regional railroad. Where the major (Class I, as the pros call them) railroads' tracks end, RailAmerica's lines connect them to customers. The mind-numbing intricacy of replicating a rail system, and huge cost, affords meaty competitive advantages. The advent of newfound technology and persistence of $75 oil make railroads a no-brainer compared to trucking, a la YRC Worldwide (NYSE: YRCW  ) . They're virtual monopolies, really.

Class I railroads are hip to these economics, and they've taken advantage, consistently passing price increases in excess of inflation, sometimes as high as 7%. The majority of RailAmerica's and peer Genesee & Wyoming's (NYSE: GWR  ) lines hook up to Class I railroads, and they've followed the Class I's lead on pricing, consistently passing higher-than-inflation price increases. It's basically a license to print cash. So then, why is RailAmerica so cheap?

Why buy?
Three years ago, a horrendously managed RailAmerica was taken private by Fortress Group (NYSE: FIG  ) . At the time, the company's operating margins were running in the 10%-13% range, where Genesee's -- widely held to be the best-in-class short-line operator -- were around 17%. Making matters worse, the company's pricing was badly lagging its peers.

Fortress saw that. It installed a new management team, made vast operational improvements, and took it public again. But the market didn't take notice: RailAmerica's profitability still lags its peers, and the Fortress buyout left it strapped with high-rate debt ($710 million of 9.25% notes at IPO), rendering the company unprofitable on paper and positively ugly on a cursory glance at its financials.

That leaves an investment with great potential, value-oriented friends. I see four specific sources of value, in fact.

1. An unheralded turnaround and burgeoning earnings power
RailAmerica's management -- a group of old railroad hands with a lot of turnaround experience -- have improved operating margins some 10 percentage points, and brought average revenue per carload in line with Genesee. If its peers, most notably Genesee, are indicative, there's still significant room for improvement. Despite paper losses, RailAmerica actually produced free cash flow in the past 12 months -- a function of accounting arcana associated with previous debt repayments.

Moreover, industry dynamics afford rail operators great potential. Class I railroads have passed some meaty price increases in recent years, in the 5%-7% range, dramatically bolstering their earnings power. I'd wager that for the foreseeable future, that's apt to continue: For example, Union Pacific (NYSE: UNP  ) increased revenue per carload 5.5% last quarter. Because 90% of RailAmerica's rails hook up to Class I's, that spells pricing power and growing margins.

2. Debt reduction and refinancing
That debt is ugly, but RailAmerica's got cash to burn and plenty of cash flow, and if it chooses, it can refinance its debt in 2013. To wit: Management's paid down $150 million of debt since coming public and has committed to ongoing debt reduction. At a 9.25% rate, every bit of debt reduction accrues value straight to shareholders.

Looking out toward 2013, I'd wager RailAmerica's margins and cash generation will be meaningfully higher, giving management a good shot at refinancing for attractive rates. And that could accrue a lot of value for shareholders.

3. Possibility of acquisition(s)
The short-line space is populated by a lot of small, inefficient operators, and RailAmerica's management seems a shrewd, value-oriented sort. At the right price, an acquisition can make a lot of money for shareholders, and management's looking.

4. Not-so-hidden tax assets
RailAmerica's market cap is approximately $635 million, and the company was possessor to $127 million in federal tax credits and $95 million worth in rail-specific tax credits. Reflect on that for a moment: That's $222 million in tax credits against a $635 million market cap. Huge. No surprise, management estimates that it won't pay significant cash taxes for seven to eight years.

So add it all up. I see significant unrealized earnings potential, pricing power, potential for margin expansion, and debt reduction. Though recent price increases have been in the 4% range, I'd wager management can sustainably increase prices in the 4%-5% range (perhaps a little higher), if Class I peers and recent results are any indication. I anticipate ongoing pricing strength coupled with productivity initiatives will drive operating margin improvements. Add in a little debt reduction and the possibility of debt refinancing, and I get shares worth $15-$20.

Because transaction costs can get a little prohibitive on position sizes much smaller than $500 (unless the potential for reward is great), I'm opening a $500 position, or 2.9% of our first year's capital, and will look to add as conditions warrant.

I see three risks here. The first falls in the realm of high impact and low probability. The short-line rail credit, which affords short lines meaty tax benefits, is currently up for renewal. Congress indicated widespread support, and it's likely to pass. But in a world where budget deficits dominate the headlines, it's possible that it won't. Today's prices afford some protection against downside, but that'd take cash out of RailAmerica's coffers. Not good.

The next risk is the very same reason we have our opportunity: Fortress. The hedge fund still owns 55% of RailAmerica. That means its interests should be aligned with ours, but it could use that influence for its own purposes. The answer, here, isn't to avoid RailAmerica altogether, but position-size appropriately.

Last is the debt. RailAmerica's improving cash flow position it well enough to cover interest obligations, and it doesn't have significant principal payments until 2017. But that's a lot of debt. I think it's unlikely, but if sales and/or profitability fall too much, it could spell trouble.

My Foolish bottom line
In my experience, it's a rare day when you can find a stellar business, depressed valuation, and accompanying value catalysts. But today's the day. RailAmerica's a train I'm going to hop aboard, and I suggest you think about joining me.

This article is part of our Rising Star Portfolios series, where we give some of our most promising stock analysts cold, hard cash to manage on the Fool's behalf. We'd like you to track our performance and benefit from these real-money, real-time free stock picks. Click here to see all of our Rising Star analysts (and their portfolios).

Michael Olsen owns shares of Berkshire Hathaway. Berkshire Hathaway is a Motley Fool Inside Value selection. Berkshire Hathaway is a Motley Fool Stock Advisor pick. Genesee & Wyoming is a Motley Fool Hidden Gems choice. The Fool owns shares of Berkshire Hathaway. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Read/Post Comments (9) | Recommend This Article (49)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On November 01, 2010, at 2:11 PM, prginww wrote:

    RA's debt reduction over the last year looks like it was mostly funded by the issuance of about 11 million shares.

    Considering that RA is paying 9.25% on its debt, this move makes perfect sense. However, I doubt that they will continue with this strategy, since Fortress will not want to give up their controlling stake (now at 55%) by issuing too many shares.

    Without this share issuance, I am skeptical of RA's ability to pay down its debt effectively.

  • Report this Comment On November 01, 2010, at 2:32 PM, prginww wrote:

    Fair point Parker, and you're right. But I don't think the good times are over.

    First, it's worth noting that RA has additional cash on the books, which they could use to reduce debt. Of $110 million on the books, I estimate they only need $30-40 million for operating purposes. Using that cash for debt reduction will reduce interest expense, which in turn improves their ability to pay down debt.

    Next, RA's earnings power is dramatically improving: The company's taken steps to improve its cost structure and increase prices, and continues to. To that end, its trailing operating margins are meaningfully lower than its competition, meaning opportunity exists. In addition, railroads have the ability to increase prices in excess of inflation, which should [quite logically] result in ongoing margin expansion. Viewed in context, the confluence of factors results in tremendously improving cash generation.

    That gets to one last point point: A look at profitability miof last year's stated interest expense, $26.9 of the $86.9 million is a non-cash expense related to debt retirement. By my math, I estimate that RA will generate $27 - 33 million in free cash this year, and as time wears on, it should dramatically improve--for the reasons I've mentioned in my article.

    Taken in context, that looks [to me] like a compelling value cocktail.

  • Report this Comment On November 01, 2010, at 5:05 PM, prginww wrote:

    I'm not sold on RA's valuation, which seems to depend in part on assuming significant earnings growth over the next few years.

    I think investors should look outside the US for rail opportunities, for example Vossloh, Faively, Delachaux, and CAF in Europe. All are trading under 12x earnings with very healthy ROI over the last 5 years. You can't find that level of value in North America, although CNI comes somewhat close.

  • Report this Comment On November 02, 2010, at 10:28 AM, prginww wrote:

    There is a degree of growth implied in my valuation MegaEurope, but it's not the sort that's contingent upon an economic recovery. Instead, it depends upon effective utilization of assets with some compelling moat dynamics--ensuring they earn to their potential, price in accordance with their peers, removing redundant costs, and so on. In that regard, this measure seems fairly attainable.

    The opportunities you speak of look interesting, but they're of a different variety: They supply parts to the rail industry. In this regard, the moat dynamics are quite different, as is their pricing power. These players must compete to retain business. That's a somewhat windy way of saying that while they may be interesting, a strict comparison of valuations between these companies is not exactly apples-to-apples. Thanks for the comments.

  • Report this Comment On November 02, 2010, at 10:56 AM, prginww wrote:

    One of the other cool things about the model for shortline railroads is that I believe their rolling stock spends most of their time on other carriers' lines...the class 1's...and they actually get paid by these carriers for the mileage and time spent there. So effectively, their rolling stock investment is highly subsidized.

  • Report this Comment On November 02, 2010, at 1:47 PM, prginww wrote:

    You're absolutely right, Scott. As example, RA "operates" 7,393 track miles on its railroads. Of those miles, 2,848 are leased and 1,038 operated under trackage rights. The leases involve a one-time upfront payment, and trackage agreements basically confer the right to use tracks at little cost. That means that for almost half of its track, RA has little in the way of ongoing cash commitments.

    Now as you're also aware, railroads are a very capital-intensive business: Class Is invest up to 15% of sales as capex. This creates a degree of scalability (to free cash flow) that's not immediately evident: For incremental increases to free cash, capex does not coordinately increase. It's a great gig.

  • Report this Comment On November 03, 2010, at 4:23 PM, prginww wrote:

    The Fortress Ownership: Their exit strategy from this investment matters much. From your narrative, it sounds like they've done what they set out to do; take a mismanaged asset and see that it is managed appropriately. Just guessing here, but the deal sounds ripe from their perspective. Getting out would work for them quite nicely, thank you. Most likely would be a sale to another RR, assuming that antitrust wouldn't get in the way. Or issue equity. Or (and this one kinda scares me) load the thing up with debt and declare themselves a big one time div.

    Do you have a sense of their previous deals? What can a potential investor expect?

  • Report this Comment On November 05, 2010, at 2:13 PM, prginww wrote:

    The Fortress Ownership, a hedge fund, is not a healthy partner....they hold too many marbles.

  • Report this Comment On November 05, 2010, at 4:33 PM, prginww wrote:

    GA and Scoop,

    I agree, the concerns are valid. But I don't think that's a reason to eschew the investment altogether. Rather, it's a reason to size the position appropriately, in the context of a diversified portfolio, and be mindful of the valuation. At today's prices, I believe we're afforded some margin of safety against downside risks. Moreover, I think Fortress is a motivated shareholder.

    With respect to Fortress' exit strategy, I'd say the most likely outcome is via equity issuance. There's a clause in the proxy that stipulates Fortress is allowed to piggyback equity issuances and/or "demand" an issue. Ideally, Fortress would engage in an orderly sale: That is to sell its onwership to public markets via a secondary offering, thereby keeping the share count stable. For my part, and I could be wrong, I think that's the most likely outcome.

    In terms of timing, I'm not sure we're at a point where Fortress is about to exit. By my measure, there are still some pretty significant operational improvements that can be made. In addition, Fortress invested [in RA] at an implied equity value of $642 million, of which Fortress invested $464 million equity and borrowed $178 million. That makes their leveraged return (before interest expenses) just 6.4%.

    As we know, these funds don't invest for 6.4% returns. And given the possible upside, if my numbers are even close to correct, I think it makes sense for Fortress to stay invested for the time. Looking at public market valuations, there aren't many glaringly obvious values. And so Fortress's opportunity cost isn't that great.

    Of course, I could be totally wrong. But that's why I'll own other stocks in my portfolio. Great questions/comments, and keep 'em coming.

    One last bit, I've got my own discussion board: So bring questions one and all there, please.


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