Bakken Update: American Railcar Has A Great Quarter As Increased Leasing Demand Skews Revenues

Jul.26.13 | About: American Railcar (ARII)

American Railcar (NASDAQ:ARII) rebounded nicely, posting a significant earnings beat. It reported a Q2 EPS of $1.11 versus the Street's $.82. Railcar missed on the top line with revenues of $154.9 million, which missed the Street's estimate by $8.92 million. There was some angst going into this quarter, as Railcar posted a Q1 EPS of $.84, which missed estimates by $.12. Revenues were light at $195.1 million versus the Street's estimate of $193.94 million. I bought Railcar after the earnings miss. The miss in Q1 had little to do with demand, as North America continues to see more railcars ordered than delivered. In Q1, the book-to-bill ratio was 2. 85% of industry backlog was for tank railcars. American Railcar's miss was more to do with a significant increase in its railcar leasing segment. It is important to note, revenues for railcars built for its lease fleet are not recognized in consolidated revenues as a railcar sale, but are recognized monthly over the term of the lease. This will negatively impact initial revenues, but provide a long-term income.

The market did not like American Railcar's Q2 as much as I did. There are some worries in both margins and demand of tank cars. Also, it is difficult to model a company that gives little by the way of information on its railcar sales versus leases. I think the market had this wrong, and today should have been a buying opportunity. American Railcar seems to be in a great position as the United States continues to increase railing domestic crude to refineries. EOG Resources (NYSE:EOG) was the first to do this with its Bakken crude by rail in St. Charles. This allowed EOG to get LLS pricing for its North Dakota crude. Since then, many other operators have followed suit, and now about 70% of all Bakken crude is sent via the rails. Those who believe this trend will stop may be disappointed, as there are advantages to this type of transport. There is no doubt pipeline capacity will continue to increase in the coming years, but these projects take time and significant capital. The upside to crude by rail is that contracts are of shorter duration. For some refiners, the rails are the only conduit to receive crude, as it is not serviced by pipe.

The leasing business is attractive for the same reason. The average railcar lease runs from 5 to 7 years. Many of the crude by rail deals run that same timeframe. This is important, as it removes some risk for those buying tank cars. Not to be insensitive, but Railcar may also see increased sales as regulations are tightened after the train derailment that leveled Lac Mégantic, Quebec, which killed 35 people and left 15 more unaccounted for. It is alleged that the Montreal, Maine and Atlantic Railway was negligent for transporting crude oil in flawed DOT-111 tanker cars. The safety of these tanker cars has been called into question by the U.S. National Transportation Safety Board since a 1991 study found that they were known to rupture at a high rate during derailments. It is very possible, these tank railcars will be taken off the tracks. This means an even greater demand.

American Railcar reported record operating margins in Q2, of 25%. Tank railcar orders remained strong with weakness in hopper railcar orders. A total of 1,850 railcars was ordered, resulting in a backlog of 6,940 railcars as of June 30, 2013. Total consolidated revenues increased 3%, mostly from its leasing and servicing business. This was offset by lower manufacturing revenues. 30% of Railcar's shipments were for its leasing business. It now has around 3500 railcars in its lease fleet, which is an increase from 1870 in Q2 of last year. It has a backlog of 6940 railcars. The backlog's estimated value is just under $890 million. 2620 are for lease. Lease revenues increased to $8 million in Q2 of 2013, from just $3 in Q2 of last year.

American Railcar saw huge demand for tanks in the first quarter, with a slight decline in Q2. Hopper demand has been low. It looks like tank orders could slow some in the second half of the year, but this is occurring as demand picks up for hoppers. The worry isn't as much demand as that American Railcar has lost some market share. It is still able to maintain price discipline, as there is still good demand. Railcar states prices are still high on the tank side and should continue for some time. Crude tank lease rates are still very good, although it has dropped some since the first quarter. Hopper lease rates have improved to a more normal rate. Revenue per car load was up significantly, but this was due to a much larger percentage of high end tank cars.

In summary, this was a great quarter. I believe Q3 will see tank railcar sales close to that of Q1. There may not be as many high end tank cars, which could hurt margins some but nothing drastic. Revenues will be bolstered by increased hopper car sales. Increased hopper car sales will hurt margins as a percentage, but overall it should be a better quarter. Margin dollars will be higher because of increased shipments. The problem with American Railcar is its leasing/sales mix. Leases look to be about 40% going forward, which are back end loaded with respect to dollars. Keep in mind, its leasing fleet continues to grow, and demand for leases remains strong. At this time, there is no certainty as to older tank cars being retrofit for safety reasons. I think about half of the tank cars out there would need this done, if it happens. There is a misconception that American Railcar will have to retrofit its own lease cars. Currently, it does not own any of these, but would benefit in repair revenues as it would be several thousand per tank railcar. More importantly, the oldest will need to be scrapped, increasing demand. I believe we will see increased demand for tank cars with emphasis on high end models. Q3 hopper railcar demand will increase to Q1 numbers. Revenues will improve substantially, especially when you consider 40% of sales are leases. I believe EPS estimates will continue higher through the quarter, as total railcar sales continue to improve.

Disclosure: I am long ARII. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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