Railcars & Transports – Value Opportunities Not Value Traps

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SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES

Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

August 31st, 2015

Railcars & Transports – Value Opportunities Not Value Traps

  • We continue to search for value opportunities amid the market volatility while avoiding value traps associated with secular and cyclical pressures emanating from China – see our initial research highlighting those stocks most insulated to these pressures (value opportunities) and our follow up highlighting those most at risk (value traps)
  • Railcar and Transportation stocks have a protective moat against these global pressures
    • It would be highly uneconomical to ship railcars across the Pacific, and the Trucking and Rail industries are necessarily domestic by nature
  • Several names in these sectors have screened well on our small-mid cap framework
    • TRN and ARII have been among the top 5 since we began publishing our monthly smid cap rankings, and LSTR remains in the top 10 despite its relative strength over the past several months (+8% since we highlighted what was then the top screening smid cap stock)
    • The railcar makers score particularly well on our optimism analysis in this framework, and LSTR is a standout from a return on capital perspective due to its asset light business model
  • LSTR looks more or less fairly valued on our normalized earnings framework (Exhibit 1) but TRN and ARII are both trading at statistically significant levels of discount
    • KSU is the valuation standout among the rails
  • While these stocks are unlikely to present value traps in the way of the more commodity exposed names, the timing of upside catalysts is indeterminate
    • ARII was expecting the new regulations for tank cars to result in an immediate demand bubble, but this was not the case – the timeline for retrofits is from 2017 to 2025 for various models, but the bulk of the crude carrying cars are required to be refit by 2018 at the latest
    • TRN continues to endure probing of the ET Plus, the highway guardrail that has been a distraction from an otherwise strong, diversifying industrial growth story
    • KSU, with 50% of its operations and revenues south of the border in Mexico, has ample growth opportunities in its future – Mexican energy reform will likely be slow, but should further enhance the country’s already strong manufacturing competitiveness
  • A US recession is the main risk to these sectors
    • With energy related headwinds absorbed in 2015, ’16 sets up with relatively easy comps

Exhibit 1

Source: Capital IQ, SSR Analysis

Trinity Industries (TRN)

TRN is a fundamentally positive story unfortunately wrapped in an optically negative one:

We note that TRN’s mark in Exhibit 2 is not distorted by one large beat, as the company has the second lowest standard deviation around these results. Trinity maintains the belief that no guardrail-related loss is forthcoming but the federal investigation has spoiled the sentiment towards the stock and driven it back to its lows – Exhibit 3. There is also some concern that railcar demand has peaked, but forecasts call for shipments to remain above 2014 levels out through 2018 – Exhibit 4.

Exhibit 2

Source: Capital IQ, SSR Analysis

Exhibit 3

Source: Capital IQ, SSR Analysis

Exhibit 4

Source: Railway Supply Institute, Global Insight, Economic Planning Associates, SSR Analysis

American Railcar Industries (ARII)

ARII currently looks as cheap as it ever has in its relatively abbreviated history – Exhibit 5. The company has a focus on tank and hopper cars, and sold off sharply when the expected demand windfall from new tank car regulations failed to materialize in Q2. The bulk of the current tank car fleet (DOT-111 models) for crude oil service have requirements to be retrofitted by May 2017 for non-jacketed cars and March 2018 for jacketed cars. Ethanol carrying cars have a considerably longer timeline – May 2023.

Exhibit 5

Source: Capital IQ, SSR Analysis

Kansas City Southern (KSU)

KSU is the smallest of the US Class I Railroads, but runs a key vein from the American Midwest down to the Mexican Pacific, with offshoots into the Gulf Coast. The Gulf Coast lines should benefit from US basic chemical investments in the region (one plant is being constructed quite literally on one of KSU’s lines), but the major growth opportunities for the company lie south of the border. Mexican energy reform will likely be a slowly evolving theme, but besides the direct opportunities should also provide a boost to the country’s manufacturing competitiveness, which has already attracted high levels of foreign direct investment (most prominently in the Auto space where nearly every major car manufacturer has announced a large scale facility). Intermodal growth is another opportunity. Cross border rail intermodal currently has a very low penetration and should continue to win volumes from highway to rail conversions. Expansions at the port of Lazaro Cardenas, which KSU has sole access to, will make it the largest port in Mexico and threatens to steal import volumes from LA/Long Beach on freight destined for the US Southeast.

Exhibit 6 summarizes KSU’s growth opportunities and Exhibit 7 shows the stock has not been this inexpensive since the financial crisis.

Exhibit 6 – KSU Growth Opportunities


Exhibit 7

Source: Capital IQ, SSR Analysis

Landstar System (LSTR)

LSTR has a unique model in the Trucking industry – the company is very asset-light (Exhibit 8) and provides a system for matching shippers with capacity operators via company agents (through either its network of independent BCOs – business capacity operators – or its relationships with the numerous smaller truck brokerage companies around the country). The BCO story is a compelling proposition for former professional truckers and LSTR’s employee retention is considerably above average for the industry, but the majority of the company’s growth moving forward will come from the truck brokerage side. Volume growth has remained strong for LSTR in 2015, and the company expects the current modestly tight capacity environment to persist into 2016. LSTR benefits when capacity is tight due to its fixed contract structure, receiving a fixed percentage of a higher base price.

The stock is up 8% versus the S&P since it screened at the top of our first smid cap rankings update. We believe our smid cap framework is a better tool to analyze LSTR, as our traditional return on capital based valuation model is less applicable for asset-light companies. Exhibit 9 shows the company’s positioning among our top smid cap names and its quintile rankings on each factor. LSTR scores well here mainly because of its high ROC (which we assign a 20% weight), a function of its low asset base. The only change for LSTR since mid-April, when the stock screened at the top of this list, is its EV/EBITDA multiple has moved from the second quintile to the third after demonstrating relative strength since that time.

Exhibit 8

Source: Capital IQ, SSR Analysis

Exhibit 9

Source: Capital IQ, SSR Analysis

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