Investors who are comfortable with the overall high level of the stock market and a stock at the top of its 52-week range, willing to look at a cyclical company with a fairly high (68%) liability to asset level, and appreciate a quirky, out-of-nowhere growth story should consider buying Trinity Industries (NYSE:TRN), one of the chief US manufacturers and lessors of railcars.
The breakthrough story of 2012 was the emergence of rail to transport US crude oil to refineries, particularly from the North Dakota Bakken/Three Forks formation. While rail is a more expensive form of transport than pipeline, it has three significant advantages in this situation. a) The infrastructure is already built and available now. b) Crude-by-rail offers a wider range of markets. Oil can be shipped to refineries all over the United States - the track is in place to move oil to the East and West Coasts, as well as the MidContinent and Gulf Coast. c) Rail shipping commitments are shorter than for pipelines - typically two years instead of seven.
So like the boom in US oil production, rail shipments of oil have increased dramatically. For example, railroad company BNSF's oil shipping has grown by 7000%, or a factor of 70 in the last five years. Currently, close to 500,000 barrels per day (BPD) of oil is being shipped by rail, and the volume is increasing.
More railcars are being leased and bought by both railroad companies and by oil companies themselves. Of the companies in the railcar leasing and manufacturing business, Trinity Industries is one of the largest and most optimal for investor focus.
Trinity has already experienced an increase in share price, from a low of $21.53/share in July 2012 to its 52-week high and current price of $37.68/share. Its trailing price-earnings ratio (P/E) is 12.6 and its forward P/E is 10.3. As a graph from Trinity itself shows, railcar sales are cyclical.
Trinity's total revenues for 2011 were $2.8 billion and its earnings before interest, taxes, depreciation and amortization (EBITDA) was $616 million. Its last twelve months' (LTM) revenues as of September 30, 2012 was $3.8 billion and its EBITDA was $762 million, providing a return on assets of 5%.
Railcar manufacture ("the Rail Group") is the largest at 37% of revenue, but is only one of Trinity's five business segments. The others are Railcar Leasing and Management Services ("Leasing") at 17% of revenue; the Inland Barge Group, also at 17% of revenue; Construction Products Group at 16% of revenue, and the Energy Equipment Group at 13% of revenue. As discussed below, the railcar manufacture and leasing appears to offer significant upside, despite the increase in share price that has already occurred. Trinity's lease fleet is 71,255 railcars. The barge, construction, and energy services segments are also synergistic.
Rail Group revenue was $1.9 billion for the twelve months ending 9/30/2012, with an anticipated revenue for the fourth quarter of 2012 of $550-$600 million. The operating margin was about 9%. Trinity's Leasing group revenue for LTM ending 9/30/2012 was $523 million, with an operating margin in excess of fifteen percent.
Railcar Manufacturing and US Oil Production
Manufacturing railcars is not new. In the US alone, over seventy-five companies have at some point been in the railcar business. In fact, rail was the original mode of transporting crude oil, until it was supplanted by cheaper pipelines. Today, Trinity is the largest railcar manufacturer. Its main competitors include American Railcar Industries (NASDAQ:ARII), owned by Carl Icahn; General Electric (NYSE:GE) which builds diesel engines and owns a vast fleet of rail equipment; Greenbrier Companies (NYSE:GBX), for which Icahn announced a bid at the end of December 2012; Bombardier, headquartered in Canada; and FreightCar America (NASDAQ: RAIL) which builds and repairs freight cars.
Per the graph, the Energy Information Administration (EIA) projects domestic oil production growth will rise from a 2012 average of 6.4 million barrels a day to reach 7.9 million barrels per day average in 2014, the highest US oil production rate since 1988.
(In this graph the EIA shows separate forecasts for crude oil alone compared to crude oil plus liquefied petroleum gases, or LPGs. This is important because LPGs do not produce transportation fuels comparable to those from crude oil. For the purposes of oil production, the focus should be on crude oil alone.)
North Dakota oil production has grown rapidly, to a high of 750,000 BPD in October 2012. However, pipeline capacity is limited to about 400,000 BPD, and then only to overfull terminals in Minnesota and Wyoming. Oil producer EOG was the first to transport Bakken crude oil by rail, starting in 2009. As of September 2012, rail was used for 56% of Bakken production, pipelines for 44%.
Cushing storage bottlenecks, as well as pipeline limits, exacerbated crude oil differentials between Bakken and Louisiana crude of the same type quality to $20 per barrel or more, hastening the move to rail. Bakken production is now transported by rail to all three coasts as well as the MidContinent. Oil producers like Statoil (NYSE:STO) and refiners like Valero (NYSE:VLO) are buying or leasing railcars, two thousand and nine thousand, respectively. Phillips 66 (NYSE:PSX) bought two thousand railcars to move crude to its Ferndale, Washington refinery. Phillips 66 is also moving 50,000 BPD of crude by rail from North Dakota to a terminal in Albany, New York, where it will be transferred to barges and shipped down the Hudson to its Bayway, NJ refinery. The resuscitated 330,000 BPD Philadelphia Refinery, now majority-owned by private equity firm Carlyle, is building a new rail facility that can unload 140,000 BPD of Bakken crude.
Trinity Order Backlog and Railcar Growth Opportunities
In a November 2012 report, Trinity notes in its rail group highlights, that in the last twelve months before 9/30/2012, it delivered 19,505 railcars, 31% of industry shipments; it received orders for 22,950 railcars, representing 38% of the industry total; it had an order backlog of 31,330 railcars representing 51% of the industry backlog; and that this backlog was valued at $3.3 billion. Note that these are not just oil railcars; Trinity Rail manufactures several kinds of railcars.
Four hundred thousand barrels per day (BPD) of the 1.5 million BPD of growth in US oil production in the next two years are projected to come from the North Dakota Bakken/Three Forks formation. At 750 barrels per railcar and an average round-trip time of two weeks (25 trips per year) in 120-unit trains, if all of the new Bakken production were transported by rail, an additional 7680 railcars would be needed, either for lease or, once at capacity, to be manufactured new.
There appear to be other opportunities to transport oil by rail: production from the Niobrara formation in Colorado; some of the new production from the Permian (West Texas), although a pipeline to the West Coast is rumored; and most importantly, transport of Canadian crude both east and west.
At present, about 60% of the oil used in the 1.3 million BPD of refining capacity in Canada's eastern provinces is imported. TransCanada does not have an east-west oil pipeline to bring production from Alberta to say, Quebec. West Canada Select (WCS), the oil sands benchmark, has traded as much as $40 per barrel less than WTI, itself discounted from Brent by $20 per barrel. Irving Oil is already taking 90,000 BPD of oil at its St. John, New Brunswick refinery, and even more oil could be shipped east by rail.
Another intriguing possibility is moving up to five million BPD of Canadian oil sands crude west, to the Alaska pipeline and/or directly to Valdez for sale into Asia. The TransAlaskan Pipeline System (TAPS) has 2.1 million BPD capacity. The originally-suggested option of building a pipeline from Canadian oil producing areas to Kitimat, British Columbia has met considerable resistance. Interestingly, crude railed to TAPS and then pipelined to Valdez is two to four days closer to Asia than if it is loaded at Kitimat.
Of course, Trinity Industries is not the only supplier of oil railcars; General Electric is a large lessor and in Canada itself Bombardier, headquartered in Montreal, is a well-regarded railcar supplier.
Trinity's Other Business Segments
Trinity's barge business is synergistic with its rail; its construction products group provided $609 million of revenues and a 9% operating margin in the last twelve months ending 9/30/2012, and its energy equipment group, which produces both wind towers and propane tanks, had revenue of $516 million, though operating margins of only 2% in LTM 9/30/2012. Trinity said it shifts excess wind tower capacity to support railcar production as needed. Indeed, a few days ago Trinity said it is changing a wind turbine plant it bought in West Fargo, North Dakota to making propane vessels.
Overall, high oil prices provide the incentive for continued fracking to produce oil from unconventional sources. Oil prices, and those of other commodities, operate inversely to interest rates, so as long as interest rates are kept low through Federal Reserve stimulation (QE3, et al), oil prices can be expected to stay high enough to make unconventional production economic in areas like the Bakken and the Permian Basin (West Texas).
The attractiveness of Trinity Industries for its railcar manufacture and leasing depends on one's forecast for three things: oil prices high enough to continue to incentivize domestic drilling for unconventional oil, the intensity of other railcar competitors, and competition from other transportation modes, particularly pipelines. Note that pipelines, when capacity is available, are a preferred method of oil transport at a cost of one-half to one-third that of rail.
On the downside, in addition to Trinity's high liability-to-asset ratio, investors should also consider that railcar sales are typically cyclical, and that both Trinity and the overall market are trading at the top of their 52-week ranges. Changes in regulations are also a risk; US rejection of the Keystone XL pipeline is an important reason that higher-priced rail transport of oil has become so popular.