In our initiation of coverage of the transport space – June 15th – we wrote about the improved nature of the rail industry and that how, following a period of terrible returns, the industry restructured and has seen improving returns on capital since. This does not apply to GWR, which has had a slow decline to its return on capital since 1995 and is currently showing returns that are on that trend rather than above, which contrasts with the Class 1 companies. RA has more of a flat trend to its return on capital, but we have less history for RA.
The return on capital trends for the regional rails contrast sharply with the Class 1 group (summarized below), which have a very positive slope from 1999. In addition, both GWR and RA are currently below the Class 1 absolute and trend returns on capital.
Source: Capital IQ, SSR Analysis
Our analysis of M&A returns, published in May, did not cover the transport group, but subsequent work shows that the average acquirer in the transport space has outperformed both the S&P 500 and the sector in the 12 months post deal completion, but has underperformed in the 12 months post deal announcement.
While this acquisition might give GWR the opportunity to improve returns and catch up with the Class 1 group, investors have historically not given the benefit of the doubt until the deal has closed. Moreover, our May report showed that in aggregate (for the Industrials and Basic Materials sectors), investors have been much more skeptical about deals since 2008 than they were prior to 2008 and acquirers have generally underperformed their sectors in the last 4 years. The successful and value creative integration of an acquisition is not an easy task.
One further consideration is that our analysis shows GWR valued like the rest of the rail space – well above historic mid-cycle levels. This has happened without the return on capital improvement that the rest of the sector has seen. In our transport piece we indicated that the rail sector had a high Skepticism Index (SSRSI) – valuations high, but not as high as current returns on capital would support. GWR was an outlier in this analysis suggesting that current valuation discounts an improvement in returns on capital that we are yet to see.