The Bakken Update: U.S. Oil Production Is The Reason For The Tank Railcar Renaissance

Feb.24.14 | About: American Railcar (ARII)

American Railcar (NASDAQ:ARII) has had a nice run since my call back in July. This move culminated in an excellent quarter, not just for American, but also Trinity (NYSE:TRN). Trinity beat both the top and bottom lines. Its EPS of $1.43 was $.02 better than analyst estimates, and revenues were 24.8% better year over year. These results remind us unconventional oil isn't just about resources, but also transport. Production has grown too fast for the pipelines to handle, so the rails have had to pick up the slack. Last year transport of petroleum and its products increased by 31%. The rails have been preferred as shorter-term contracts are required when compared to pipelines.

Warren Buffett saw this coming. This is the reason Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) bought Burlington Northern. As U.S. production grows, the rails will continue to do the heavy lifting. Pipelines take time, and this isn't just to put the pipe in the ground. It is a complicated process, requiring a long list of requirements. A good example is the Keystone XL, where easement terms have been a hold up. Seems like a coincidence that Buffett's home state is the last to sign off. The increased traffic has brought older tanker cars back into service. Burlington Northern's recent planned purchase of 5000 new tank cars with safety features that exceed the latest standards are due to a recent derailment near Casselton, ND. This punctured 18 of the 20 tank cars, and released approximately 400000 gallons of crude. A broken axle and two wheels may have caused the accident. It would seem Berkshire is committed to providing a good image, and safe environment with respect to its railroad. Derailments rarely occur, but there are good reasons to be concerned. The incident at Lac Magantic, Quebec killed 47 people. The accident in Cherry Valley, Illinois killed 1 and caused $8 million in damages. This was different, as it was hauling ethanol. The San Bernardino disaster killed 4. It was carrying trona, and there were no energy related fatalities. Loss of life associated with derailments are rare in present day, but still can happen. That said, companies are motivated to be safe as accidents like the one in Lac Magantic could end up bankrupting those responsible.

Recent rail accidents carrying crude have helped raise safety awareness involving older tank cars. The AAR states 85% of the 90,000 tank cars used to haul crude and other potentially dangerous liquids across the U.S. are outdated. Tank and covered hopper railcars account for over 50% of the North American railcar fleet. The table below provides the percentage of railcars in North America by type.

Break Down Of North American Railcar Fleet By Type 12/31/11

Type Percentage
Covered Hopper 32%
Tank 20%
Gondolas 16%
Open-Top Hoppers 11%
Box Cars 9%
Flat Cars 8%
Intermodal 4%
Click to enlarge

American Railcar's focus is in tank and covered hopper cars. These two are seeing the greatest demand. Tank cars continue to fill company backlogs, while demand for covered hopper cars has improved. In July of 2012, 79% of the 1.5 million North American railcars were in service. Some of these railcars have been in service for an extended period of time. The table below provides the average age by railcar type.

North American Railcar Fleet Age By Railcar Type

Type Average Age Of Railcar In Years
Box Cars 26
Flat Cars 25
Gondolas 21
Covered Hoppers 20
Open-Top Hoppers 20
Tank Cars 16
Intermodal 14
Click to enlarge

Although tank cars and covered hoppers don't have the oldest average, there are still a large number of outdated models. Estimated demand from 2012 to 2017 for railcars differs greatly from one type to the next. Covered hoppers is number one with increasing demand through 2015. The second greatest demand is for tank cars. This type will see demand at the same level with a slight drop in 2015. Even so, demand is still good enough to be firmly placed in the second highest position following covered hoppers. Intermodal is third with increasing demand until 2016. Gondolas are fourth. Freight railcar shipments will increase this year to an approximated 61000. This is 8000 more than in 2013. 2015 shipments should be in line with 2014. 2016 will see decreased demand of 10%. Another 10% decrease will occur in 2017. The table below provides delivery trends for tank railcars going forward.

Tank Railcar Estimated Deliveries 2013-2017

Year Deliveries
2013 16100
2014 16100
2015 14400
2016 13500
2017 12500
Click to enlarge

I believe the above estimates are low, but it provides trending demand. Keep in mind this does not include backlog. These additions will make it difficult to keep up with demand. The table below provides estimated deliveries for covered hopper railcars.

Covered Hopper Estimated Deliveries 2013-2017

Year Deliveries
2013 14000
2014 16400
2015 17200
2016 15200
2017 13300
Click to enlarge

The industry backlog at 2Q12 was mainly tank railcars. These compose 72% of the backlog. Covered hoppers were a distant second at 12%. The remaining 16% was accounted for in the five remaining types of railcars. It is obvious why demand for tank railcars continues. These are used to haul crude from one point to another. These are also used to transport ethanol. Ethanol logistics are important as special pipelines are needed. There are planned ethanol pipeline projects in the United States, but these currently do not meet demand. The ethanol mandate provides significant volumes to be transported by rail. Crude, petrochemicals and ethanol provide the energy demand for tank cars. Hopper railcars additions are also partially due to energy. These are needed for ceramic proppant and frac sand logistics. It is also used to transport cement that is used for completion work.

American has done well over the past year. It has met or beat analyst expectations three straight quarters. Its most recent quarter substantiated the rail car bull run. It had excellent results. For 4Q13, 15770 rail cars were delivered and another 14860 were ordered. The industry has a backlog of 72930 rail cars. 92% of these are tank and hopper cars. These two types of rail cars are the primary movers of its business. This year the estimated number of delivered rail cars are 60310. Tanker cars are 46% of this total, and hopper cars represent 24% of these estimated deliveries. 8440 tank cars were delivered in Q4, while another 4910 tank cars were ordered. The industry has a tank car backlog of 55380. This is 76% of the entire rail car backlog. The industry backlog of covered hopper rail cars is 11510. American has a backlog of 8560 railcars. 2330 of these will be manufactured as firm lease agreements. During 4Q13, it built orders of 2750 plastic pellet hopper railcars for deliveries out to 2016. American estimates it will have significant growth in the plastic pellet hopper car market through 2017, and the same for tank cars in 2014. American sold its interest in Amtek Railcar due to a struggling Indian economy. This had a negative impact to EPS of $.18.

These results backed my premise from July that this is a story of the lease rail car market. Lease revenues are realized on a monthly basis, which has provided lower than expected results over the past couple of quarters. Now that its fleet has expanded, an increasing monthly revenue stream is produced. Consolidated revenues for Q4 were $197 million, which was down 5% year over year. It shipped 2050 rail cars in the quarter with 670 for its lease fleet. In 4Q12, American delivered 2010 rail cars with 410 for the lease fleet. 4Q13 Revenues from the lease fleet were $253 million versus $237 million in 4Q12. The majority of this increase was due to a higher ratio of tank cars. These have a higher margin than hopper cars. Q4 railcar leasing segment revenues increased to $10 million. This compared to $5 million for the same period in 2012. This was due to growth of the lease fleet from 2,590 railcars at the end of 2012 to 4,450 railcars at the end of 2013. Average leasing rates are increasing. In 2014, American is ramping up its hopper car production. Some of these are two and a half years out, so not all will be delivered this year. American expects hopper car deliveries to pick up significantly as we get through the year. This will increase the overall number of rail car deliveries, but it will decrease operating margins. Margins will be better than 2011, which was before the tank car market really picked up. Margins will also be aided by cost containment added in 2014. The rail car service segment revenues were $18 million, up from $15 million in 4Q12. American expects service margins to be around 20%, as a long-term view. With new regulations looming, American is well positioned to take older legacy rail cars and fit it to current standards. American's lease fleet has been built to 2011 standards and shouldn't need any modifications.

Q4 consolidated earnings were $44 million versus $41 million year over year. Earnings in all aspects of its business and operating margins increased to 22% from 20% in 4Q12. Earnings from manufacturing operations before eliminations were $62 million compared to $47 million year over year. This increase was due to good market conditions and a higher percentage of tank car deliveries. Earnings from operations in the leasing segment were $5 million versus $3 million in 2012. Operating margins in the leasing segment were 52%. Railcar services saw an increase in margins to 17% from 13% in 2012. Services continues to see an increase in demand, which has helped to increase margins.

American is vertically integrated. It not only manufactures railcars, but also provides repair and retrofitting of older models. It manufactures components as well. It provides fleet management so customers don't have to worry about regulatory compliance and maintenance planning. American's vertical integration allows for better quality control and reduces costs. It currently participates in two joint ventures. The first is with Axis. It manufactures axles, and provides these worldwide. American owns 42% of this joint venture. It also works with Ohio Castings. This JV produces sideframes, bolsters and other components. American owns 33%. It recently took a loss on the Amtek JV in India. It no longer participates in this JV.

American's consolidated adjusted EBITDA was $52 million versus $46 million in 4Q12. Interest expense decreased by $2 million. Net earnings were $1.14/share, which includes the loss from its Amtek Railcar sale of $.18/share. Adjusted for the loss, it made $1.32/share. Full year consolidated revenues were up 5% in 2014. It managed to do this while delivering 6900 railcars versus 7880 in 2012. 2013 saw 1860 railcars added to the lease fleet versus 2100 in 2012. The revenue increase was driven by a higher percentage of tank car sales. 2013 net earnings grew to $4.25/share. In 2012, this was $2.99/share. Cash flow from operations for 2013 was $165 million. It invested $162 million in its lease fleet and redeemed $175 million of senior unsecured 7.5% notes. American used $194 million to refinance its lease fleet. This resulted in net proceeds of $122 million. American increased its cash dividend by 60%.

2014 will see a strong increase in manufacturing of tank cars and improvements in the hopper car market. The lease fleet will account for 25% to 30% of total rail car sales in 2014. It plans to deliver 2330 lease cars this year, and grow its fleet to 6700 by year end. It will expand its repair capabilities at mid year, as its new facility will be operational. Tank rail car retrofitting and maintenance work should provide growth. Demand is high, and American is doing a good job of adding to its current businesses.

The story continues to get better for American, as it builds a lease fleet. Back in July, I noted that revenues from an increasing number of fleet cars are back end loaded. This means revenues are realized over a period of years. When a fleet car is sold all of the revenues are realized at delivery, but American's lease fleet will generate revenues monthly. It is increasing this number quickly, and will turn American into a cash producing machine. This is probably why American increased its dividend by 60%. American's move to a significant lease base could be due to other companies having success in that area. Trinity Industries now is 75460 lease railcars strong. Its lease fleet has grown 17% CAGR since 2000. Although Trinity's business is bigger than American's, it isn't a pure play. It has business segments in other areas. GATX (NYSE:GMT) has 139000 railcars worldwide. It has 117000 in North America and 22000 in Europe. GATX is the second largest tank car lessor in North America and Europe. This company is interesting due to its ownership of 7300 heavier tank cars in flammable service. There are a total of 64000 in North America. These specialized units may be important when new regulations are passed. CIT Group (NYSE:CIT) also has a large railcar lease fleet. It has a utilization rate of over 98%. CIT is currently signing lease terms of 5 to 7 years, which is attractive. Its fleet has an average age of 11 years. This fleet has more than 100000 railcars and 500 locomotives. It is like Trinity, as it is not a railcar pure play. Greenbrier (NYSE:GBX) has three segments to its business much like American. Its Leasing & Services division has an owned lease fleet of 8300 railcars, and manages 231000. It is positioned well for upgrades that will be added to current tank cars. This includes a stronger housing, head shields, and new operating handles. Greenbrier is also vertically integrated. We knew demand for tank cars would be strong, but this demand could be greater than expected. With the possibility of tighter regulations, customers are holding off and making purchases. This is because companies are unsure of what the regulations will be. If the changes are extreme, a much larger number of rail cars will need to be replaced or retrofitted. Regulation changes will determine the number of tanker cars to be taken out of service. Once this is known, I would guess another influx of orders will occur. At the end of 2012, 700000 Bo/d was being transported by rail. This increases to 1.2 million Bo/d in 2014. American has also increased its service segment, and should be able to address the large number of retrofits that will have to occur to keep some of the older tankers on the rails. All of this provides an optimal situation going forward. Not only is it well positioned for growth, it is also a prime candidate for acquisition.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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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