In this week's small-cap spotlight, Frank and Larsen look at
, a manufacturer of railcars, consumer products and energy equipment. The company sports a market cap of $3.8 billion and is currently trading at $45 a share. But with the stock up more than 30% this year, does Trinity still have steam, or should investors avoid the stock?
Curzio: Growth Off the Rails
The railroad industry is arguably in a secular bull market because of rising fuel prices -- which make trains a cheaper alternative than transporting goods by trucks -- as well as deregulation. Add in ethanol demand -- which is transported by rail as opposed to pipeline -- and some recent investments in the industry by two top gurus, Warren Buffett and Carl Icahn, and there is not much to dislike.
However, after taking a closer look at Trinity Industries, its growth potential extends far beyond railcars, and that's why I'd be a buyer here.
Trinity operates in five segments: rail group, railcar leasing, inland barge, energy equipment and construction products. Rail group -- its largest segment -- accounted for 47% of revenue in 2006 and has seen almost a 50% jump in backlog last quarter, to 37,791 railcars. This is the largest fleet in the sector and almost half of the industry's total.
Also, Trinity announced June 28 that it made a 20% investment in a newly formed entity called TRIP Rail Holdings. TRIP will provide railcar leasing and management services in North America and will purchase about $1.4 billion in railcars from Trinity over the next 24 months, highlighting the long-term growth potential in its core business. But Trinity's other segments are where the hidden value can be found.
Trinity's energy equipment segment -- which accounted for 10% of total revenue last year -- saw a 34% rise in sales in the most recent quarter. This unit is a leading manufacturer of liquefied petroleum gas containers, but the real growth stems from structural wind towers -- the fastest-growing segment of the energy sector. One only needs to read the quarterly transcripts from
to see the enormous long-term potential in this market.
Revenue for Trinity's construction products segment -- 20% of total revenue in 2006 -- rose a modest 10% last quarter. But this segment has growth potential over the next few years on the basis of a 30% increase in the Federal Highway Bill in 2005, which includes $286.5 billion in funding over a six-year period. Trinity should receive a portion of this money, considering it is the largest highway guardrail manufacturer in the U.S. and also provides crash cushions and protective barriers for highways.
Trinity's Inland Barge segment is one of its fastest growers; sales increased 33% in the past quarter. Inland Barge manufactures dry-cargo barges that transport coal and petroleum products in the U.S. This segment's backlog leaped 74%, and management said that it's increasing capacity to meet demand. Operating profit more than doubled, and margins rose 6% to 16% last quarter; this segment should maintain these trends as cost advantages outweigh time constraints for customers compared with other means of travel.
Trinity's railcar leasing segment -- which accounted for 9% of 2006 revenue -- grew 24% last quarter while lease fleet utilization is nearly 100% and over 97% for competitors, indicating positive trends. Since this is a high-margin business, management is committed to growing this segment -- as is evident by the increase in fleet by more than 7,500 railcars since 2006.
On the valuation front, Trinity trades at just 14 times earnings, but analysts are expecting growth of just less than 10% over the next 12 months. I believe these numbers are very conservative, given that Trinity could be viewed as a metal fabrication or infrastructure play and that the stock could command a higher premium based on the growth potential within these industries.
Trinity's growth in all of its segments creates hidden value in the stock and the reason why shares have high price appreciation potential that goes far beyond the secular growth of the railroad industry. I believe shares could trade up to $54 over the next 12 months or 20% higher than the current price.
Kusick: Separate the Stock from the Company
I'm going to agree with Frank that Trinity is a great company with very solid financials. However, this is a situation where I like the company but don't like the stock.
I first came across this name last summer, when shares of Trinity were pulling back after an amazing run during which the stock doubled between October 2005 and May of 2006. At the time, demand for railcars was in an uptrend, and other segments such as energy equipment and inland barges were also healthy.
But as the market pulled back on economic concerns, shares of Trinity lost a third of their value in about a month (May 10 to June 13, 2006), without a single negative data point or earnings announcement to drive the decline. This I believe is a great illustration of why investors need to separate the stock from the company. A cyclical stock will always be vulnerable to shifts in sentiment regarding the economy. It's a very dangerous strategy to chase these kinds of stocks when the rally has already happened.
Frank is 100% right about Trinity's solid fundamentals and attractive businesses, such as the energy equipment segment, which should remain strong for years into the future. But the fact is, two-thirds of Trinity's revenue comes from the rail segment, which has been firing on all cylinders for the past year and a half, driving a record increase in backlog during that time.
What concerns me is that 61% of this backlog is destined for Trinity's own leasing fleet, according to Longbow Research. The company's leasing division has benefited from strong demand recently, but any slowdown would result in Trinity effectively buying a large number of cars (from itself) that would either be leased at lower rates or even end up sitting unused because of overcapacity.
As Frank said earlier, Trinity's recent quarterly results have been excellent, beating analyst estimates handily, thanks to strong demand and operating margins. But when the company reported first-quarter results on May 2 -- beating consensus estimates by 10 cents -- shares actually fell the next day. The takeaway -- expectations are already high for this company, providing limited upside for investors even if financial results remain healthy.
At recent levels around $45.50, I believe that shares of Trinity already have the majority of the upside priced into them. Moreover, it's worth noting that a significant number of market players are betting on a potential drop in share price. The number of shares shorted has nearly doubled since the beginning of the year, going from 4.6 million in December to 8.3 million in June.
According to the most recent numbers from June, 10.7% of Trinity's outstanding float is being held short. That's a lot for a cyclical, in my opinion, although not comparable to the 30% or more that we've seen in stocks such as
before they made their large runs. More importantly, I can't say that the shorts are wrong here; they could make a nice profit if it looks like Trinity is indeed at the peak of the cycle.
Normally I look at a significant short position as a boon for investors, beacause of the potential for short-covering to refuel the rally's fire. But on most occasions I'm looking at stocks with some kind of competitive advantage or a new product line with huge potential. In this case we're talking about a cyclical stock that's capitalizing on demand for railcars. Yes, I do like some of the smaller segments, but the fundamentals in this case are tied primarily to the railcar business.
If there is no sign of a slowdown in railcar sales, investors could still see 10% of upside, maybe a bit more. But any sign of a broad economic slowdown -- as well as a drop in railcar demand -- could bring Trinity down 20% or more in rapid fashion.
. Remember that shares today are at about the same level as before their large one-month selloff last year. I would definitely pass on this name, as the risk/reward just isn't right for small-cap investors.
In keeping with TSC's editorial policy, Frank Curzio doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. Frank X. Curzio is a research associate at TheStreet.com, where he works closely with Jim Cramer and and writes
. Previously, he was the editor of The FXC Newsletter and senior research analyst for Greentree Financial, and passed his Series 7, 63 and 65. He appreciates your feedback;
to send him an email.