RealMoney Silver - Rail Stocks Are Still off the Track

Rail Stocks Are Still off the Track
By Chris Versace
RealMoney Contributor
11/28/2007 9:57 AM EST

With the year-end holidays quickly approaching, we were wondering what we should get my son. He loves his cars and trains, and talking over what we may get him reminded me that it was time to check in on some of the publicly traded railcar manufacturers. Granted, I talk a lot about wireless, but I got my start on the sell side as a junior guy in the capital goods sector.

While there are many types of railcars -- box cars, gondolas, intermodal cars, covered and open hoppers, auto carriers and tank cars -- there are only so many publicly traded railcar companies to choose from. They include Trinity Industries (TRN) , Greenbrier (GBX) , American Railcar Industries (ARII) and FreightCar America (RAIL) . Of these, Trinity is the largest in terms of railcar production, market share and breadth of product offering.

These four stocks peaked earlier in 2007, and I was either smart enough or lucky enough to have shorted some of them during the summer months. Since then, all four have continued to trend down, which likely reflects the expectations for lower industry volumes in 2008 than 2007.

But have these stocks bottomed, or is there more downside from here?

Per the Railway Supply Institute, railcar industry orders have been below production levels for the last four quarters, and industry backlog levels consequently fell 24% to 67,000 railcars for the quarter ended September 2007 from a recent peak of 88,116 in the year-ago quarter. Current estimates call for 50,000-55,000 railcars to be delivered in 2008, down 15%-23% from the 65,000 expected in 2007.

This looks very similar to the 1998-2000 period, when industry railcar production peaked at 75,704 units in 1998, dropped slightly in 1999 to 74,589 units and then fell to 55,821 units in 2000. The drop, however, did not stop in 2000 -- it continued until industry production levels bottomed at 17,736 units in 2002.

During the 1998-2002 period, TRN and GBX shares went from peaks to troughs as revenues and earnings compressed. As revenues fell from more than $2.7 billion in 2000 to $1.49 billion in 2003 and EPS slipped from being in the black to a per-share loss of 22 cents over the same period, TRN shares fell from $34.35 in April 1998 to a low of $10.09 in October 2002. That bottom valuation equated to 0.8 times 2002 revenue on an enterprise-value-to-sales basis.

By comparison, shares of GBX fell from $18.62 in May 1998 to $4.45 in October 2002 as its revenues and EPS fell dramatically as well; GBX posted a loss per share of $1.21 in 2002. The shares bottomed at 0.5 times 2002 revenue on an enterprise-value-to-revenue basis in October 2002. During these years, both companies also made measurable cuts to respective dividends paid.

As industry volumes rebounded in 2003 and grew in 2004-2005 before peaking in 2006, these two companies saw a dramatic turn in revenue, which benefited from operating leverage and resulted in strong EPS improvement. TRN reported EPS of $3.37 in calendar year 2006, while GBX delivered in EPS.

The expected 15%-23% drop in industry production will likely be widespread and cause competitive pricing among manufacturers to garner incremental share in order to keep production lines moving. Margins tend to benefit from longer production runs of certain railcar types given production efficiencies; changing production lines also reduces uptime. Should competitive pricing come into play, operating margins will likely be pressured for the railcar manufacturers. In recent years, the closest level of railcar production to the 50,000-55,000 range was in 2004, when 46,000 railcars were produced. In that year, TRN posted an operating loss of 18 cents per First Call and GBX posted EPS of $1.18.

If we look at 2007 and 2008 EPS expectations put forth by the Street, the aggregate forecasts for TRN, GBX, ARII and RAIL total $11.03 in 2007 and $9.93 in 2008. The aggregate number, while in sync with the industry trend, hides that the largest drop comes from RAIL -- the Street expects EPS to fall to $1.89 from $4.07. Excluding RAIL, the Street is looking for higher earnings at GBX and ARII and only a 6% EPS drop at TRN in 2008.

To be fair, ARII's backlog in production schedule equates to more than 10 quarters of production using the September quarter build level and quarter-end backlog level; this should give some degree of EPS stability for the next several quarters. By comparison, GBX has five quarters of production, TRN has 4.4 and RAIL has 2.6. Remember that the last two downturns in railcar demand (1995-1997 and 1999-2002) each lasted for a few years.

Industry shipments are trending lower in the coming year -- as seen in third-party forecasts, weak industry orders and declining industry backlog levels -- and given the likelihood of decreasing margin leverage and using history as a guide, it seems the risk outweighs the reward for TRN, GBX, RAIL and ARII over the coming quarters. Moreover, I am not the only one with this notion: The percentages of the respective floats that are short total 18% for GBX, 13% for TRN, 19% for RAIL and 7% for ARII.