Activist investor Carl Icahn has been betting on the rail industry for some time now, holding a majority stake in up-and-coming railcar manufacturer American Railcar (NASDAQ:ARII). Should investors bet on more upside ahead for this small cap?
Since cratering in 2009 and 2010, demand for railcars has been on a solid upswing. An ongoing equipment refresh cycle by the major railroads has allowed American Railcar to double sales over the past three years. Best of all, the industry is dominated by an estimated five or six companies, capable of providing an integrated platform of services including manufacturing, maintenance, and leasing programs.
What's the value?
Founded in the late 1980's, American Railcar has transformed itself from a components manufacturer and repair shop into an integrated supplier of railcars to the global railroad industry. The company's relatively strong financial profile allowed it to survive the recent financial crisis, ultimately enabling it to expand services in the current economic recovery. This expansion was highlighted by an aggressive move into leasing in 2011. American Railcar also gains leverage from its relationship with Icahn's related companies, providing sourcing advantages and accounting for a healthy percentage of its annual railcar deliveries.
American Railcar has generated solid financial results in the 2013 fiscal year, with a 9.8% top-line gain and a double-digit increase in its operating income. While external railcar shipments were down year over year, the company continued to sharply ramp up its lease fleet, a high-margin source of recurring revenues that counter-balances its cyclical manufacturing operations. More importantly, American Railcar generated a sizable increase in operating cash flow during the period, which provided more funds to further its expansion in the leasing area.
Gauging the competition
Of course, American Railcar does have healthy competition in the sector, starting with industry stalwart Trinity Industries (NYSE:TRN). Like its smaller competitor, Trinity has benefited from higher industry shipments and a stronger pricing environment; this owes partially to rising demand for higher-priced tank railcars, which has been a byproduct of America's recent oil production renaissance. It also boasts a large fleet of more than 75,000 leased railcars, as compared to American Railcar's roughly 3,800. This provides Trinity with a meaningful, fairly stable source of recurring cash flow.
Trinity has similarly reported solid financial results in the 2013 fiscal year, led by its rail segment, which posted a 37.1% top-line increase and higher operating profitability. While the company's other segments (including construction materials and energy equipment) posted generally mixed results for the period, they provide much-needed diversification to offset the rail industry's traditional cyclical nature. Trinity is also indicating more growth ahead in 2014, with its backlog up 27.8% to approximately 40,000 railcars as of September 2013.
Another competitive threat is Greenbrier Companies (NYSE:GBX), an integrated manufacturer of freight cars and marine barges that Icahn briefly tried to merge with American Railcar last year. Unlike its main competitors, Greenbrier has been reducing its operating footprint over the past year, and cutting the size of its leased fleet and service locations, in a bid to improve its financial profile.
Greenbrier's rightsizing activities have had a noticeable impact on its top line, which fell 2.8% for the 2013 fiscal year amid lower results across its business units. Management's actions led to a slight improvement in the company's adjusted operating profitability for the period, although its margin still significantly trailed that of both American Railcar and Trinity. More importantly, Greenbrier's smaller operating base requires relatively less capital; this frees up operating cash flow to improve its balance sheet. With a large and growing third-party fleet management unit and a sharply higher backlog as of August 2013, Greenbrier looks poised for a return to overall growth in the 2014 fiscal year.
The bottom line
While the railroads have shifting underlying demand sources, as falling coal shipments are offset by rising oil and grain shipments, the overall trend is still positive. This is supported by the Association of American Railroads' November report, which shows a 1.3% gain in year-over-year total shipments. As such, the railcar manufacturers can be reasonably expected to maintain a growth trajector,y given the railroads' need to continue modernizing their fleets. With the lowest overhead of these three named competitors, the most room to expand its lease fleet, and an activist shareholder watching the bottom line, American Railcar is a good sector bet for investors.