Genesee & Wyoming Inc. (GWR) is a short-line and regional freight railroad owner and operator with 111 railroads in 11 regions in the US, Canada, Netherlands, Belgium and Australia. It operates more than 14,000 miles of owned and leased track, 2,500 miles under track access arrangements and services a total of 36 ports.
As with all US railroads G&W is well protected from potential competitors in the areas it services. The capital intensive nature of its business along with the fact that it's nearly impossible to create new tracks, prevents potential railroad competitors in G&W's service corridors. The only competition G&W really faces is from alternative modes of transportation, mainly over-the-road trucking.
However, just as railroad competitors can't enter G&W's service corridors neither can G&W enter theirs. As a result, G&W has based its growth over the years on increasing business in its local markets and acquisitions. G&W has a very decentralized structure with each regional railroad functioning almost as an independent company. This allows for effective focused marketing and coupled with a constant focus on lowering operating costs it increases the income G&W would get from its existing markets. Furthermore, the company is well entrenched in its local markets and has developed very strong ties (and exclusivity agreements) with local customers and the local communities making difficult for new competitors to emerge.
But the bulk of G&W's growth over the years is due to acquisitions. Usually that's not a good thing since "serial acquirers" (companies that use acquisitions as their main source of growth and make many of them regularly) have a well-deserved reputation for overpaying and for destroying shareholder value.
Nevertheless, things are very different as far as G&W is concerned. First of all the company doesn't pursue growth for the sake of growth. On the contrary the company has a very disciplined approach and doesn't hesitate to stay out of the merger and acquisition game if prices are not right. It did so during the 2007 bubble and was vindicated in 2008 when it was one of the very few short-line operators with a balance sheet healthy enough to obtain financing and buy several short-line operators that were up for sale.
Since 1985 G&W has made more than 35 acquisitions domestically and abroad. Thanks to its decentralized culture, regional managers play a key role in the due diligence process of a potential acquisition. This way the process is more strict and rigorous since it is done by the man that will be responsible for running the newly acquired tracks. This simple fact and the company's culture of cost discipline are the main contributing factors behind G&W's long and successful acquisition history.
The latest company that G&W acquired was RailAmerica which almost doubled the size of G&W from 66 to 111 railroads and from 7,600 miles of track to more than 14,700. This acquisition brings more to G&W than the extra tracks and revenue. With this acquisition and the greater operational scale it brought, G&W will have more purchasing power with its suppliers (resulting in lower operational costs) and more visibility in the marketplace, which in turn will bring more business for commercial and industrial projects as well as more acquisition opportunities.
However despite the company's stellar acquisition record the market fails to incorporate future acquisitions into G&W's valuation. During the last decade G&W has grown its revenue at a 15% average annual pace and its operating income at little less than 20% annually. Given its newfound scale and the fact that there are 560 regional and local railroads in the US alone, G&W is better suited than ever to continue its acquisition-growth strategy without compromising neither its discipline or the speed of its growth.
G&W's run rate after the RailAmerica acquisition has it set to generate more than $1.5 billion in revenue and around $300 million in net income for 2013. This amounts for approximately $5.5 of earnings per share for 2013 and at its current share price of $95 the company is trading at 17 times its current earnings. However analysts seem to be more pessimistic predicting only $4.5 of EPS for 2013 and $5.5 of EPS for 2014. However, excluding a very rough winter season analyst numbers seem way too pessimistic, setting the stage for a probable positive surprise in Q3 and Q4, 2013 which could serve as a catalyst unlocking the company's value.
I believe that G&W will continue to grow at a 15% rate and based on discounted cash flow analysis (with a 5% discount rate) its fair value is between 17 and 23 times its 2013 earnings or $93 and $126 per share. This means that at its current $92 price the stock has up to 30% upside potential.
Unfortunately this opportunity isn't without some risk. More specifically G&W faces two kinds of risk, legislative risk and macro risk. The legislative risk is about the U.S. short-line tax credit which was extended for 2012 and 2013 as part of the fiscal cliff legislation and remains to be seen if it will be renewed going forward. If this tax-credit expires G&W may face some moderate tax increases (around 5% to 10%). Although it is a credible risk I expect lawmakers to continue to renew this tax-credit since both parties have incentives (GOP wants low taxes, Democrats want to boost the economy) to keep renewing this piece of legislation for as long as possible.
The macro risk that G&W faces has to do with the economies of the countries G&W has operations into. Although the US is recovering political bickering could push the country back into recession in no time. Furthermore the slowdown in China could significantly affect G&W's business in Australia where mining companies are some of the biggest customers G&W has and they are affected too. Unfortunately this isn't a risk that we can measure and prepare for easily.
The best and only protection an investor might have against those risks is to be extremely careful about the price he pays to buy the stock. I believe that if one buys G&W below the lower end of its fair value he would have his capital easily protected for the legislative risk and he would still enjoy a decent amount (20%+) of upside potential even if lawmakers don't renew the tax credit for short-line railroads.
As far as the macro risk is concerned I believe that the best approach is to "ride it out" even if a recession occurs and the company is caught in a cyclical downturn this will only be temporary and will probably be offset by the acquisition opportunities that a recessionary environment always brings.