Background: Last October, I wrote a bullish Seeking Alpha article about Trinity Industries (NYSE:TRN), a diversified Texas-based manufacturer with a focus on railcar manufacturing and leasing. The article was titled Why There May Be 50% Upside From This Capital Goods Company's Stock. At that point, the stock was around $45. A quarter went by, and all of a sudden, that 50% move had already occurred, way ahead of (potential) schedule. A follow-up article by me was then titled: Why Trinity Is Poised For A Second 50% Jump. This was written following a "beat and raise" first quarter; the article was published on Feb. 23 with TRN at $68. So, another 50% meant it could go to around $100.
Well, here we go again. Trinity has had yet another in a multi-quarter series of beat and raise, which is discussed in detail below. The question investors must ask is whether that bullish thesis remains valid. After all, at the bottom of the bear market in March 2009, the stock traded as low as $6.40. It is now trading in the high $70s. Cyclical stocks are most dangerous following a long string of better-than-expected quarterly earnings associated with improved outlook, so the higher the price goes and the longer the string of great news goes, the more the cautious investor begins to wonder about the downside.
This article updates Trinity's business model, latest results, and correlates it with the macro environment.
Introduction: The company's March presentation describes itself as the leading manufacturer of several industrial segments, including railcars, as well as the leading lessor of railcars (page 6). As I have discussed before, and as slides 8-10 show, the Company prides itself on having improved its operations by developing what it calls "flexible" manufacturing techniques. It points to its profitability at the trough of the Great Recession versus its losses during the much milder 2001 recession period as evidence of its operational strengths.
The company has several segments other than manufacturing of railcars and related parts, and leasing of the railcars and related management services. These other business lines include energy; Trinity is the country's largest manufacturer of structural wind towers. They include manufacturing of inland barges and fiberglass barge covers; Trinity is the country's largest manufacturer of those as well. And they include construction products; Trinity is the country's largest manufacturer of highway guardrail and crash cushions.
All those fine achievements in other fields noted, TRN is primarily a manufacturer and lessor of railcars from a stock trading perspective. This is especially so given that all its segments are pro-cyclical to one degree or another. Trinity has not gone with the old 1960s conglomerate thinking of combining cyclical with non-cyclical or anti-cyclical divisions. It is all in on what it believes it does best and wants to do better. Certainly it is firing on most cylinders now, given the continuing strength of sales and profits in Q1.
Q1 - the results: Trinity reported diluted earnings of $2.85, up 188% yoy. Sales rose 57% yoy. Guidance for 2014 was increased to $7.25 +/- $0.25, from a midpoint prior guidance of $6.65. The earnings beat relative to consensus expectations was $0.35. The increased guidance was $0.65. Thus this was a true beat and raise quarter, and it is consistent with my prior bullishness. This is what happens in booms that follow economic busts, especially when governmental fiscal and monetary policy are both pro-cyclical: the booms carry further than one would think.
Of the 35 cent (all data are per share where relevant) beat in Q1, about 15 cents of that was due to a transitory lowering of the tax rate to 32.5%, the Company has informed us. So, that brings the magnitude of the beat down a moderate amount. The other thing to be aware of is that there was a huge sale of equipment to Element Financial (OTC:ELEEF), which had an EPS impact of around $1.05/share, and which was previously guided for and came through as expected. Sales to Element are going to be going on at generally lower and variable rates. The magnitude of this transaction in Q1 poses a problem for analytic methods that like monotonic growth and preferably acceleration of earnings on a quarterly basis. The "problem" this gain represents is that prior to the Q1 release, the Street was looking for $6.87 in 2014 but only $6.23 in 2015. However, backing out the $1.05 gave a yoy projected increase in 2015 vs. 2014. Yet it's not clear that we should not welcome front-loading of earnings. After all, the Q1 earnings are now in the bank; just in the past three months, shareholders' equity has risen by a substantial $221 million.
In any case, lumpy earnings gains for cyclical companies are commonplace, and we all can deal with the outsized gain due to the Element deal in Q1 as we wish.
On the conference call, the company made minor reference to 2015. Since Q1 is now history, I want to talk about TRN's valuation as well as certain technical features of the stock. I'm going to use Value Line's end-2014 projections adjusted for Q1 results to present thoughts about whether TRN remains a "buy" or "strong hold" for investors.
A few days after the earnings release, Trinity's board approved a 2:1 stock split and an increase in the dividend. The current yield will be right around 1% based on the new $0.80 dividend.
TRN - still headed for $100? My prior article on TRN suggested that it could still have another 50% move up from the $67 range. Now that it has delivered another great quarter and upped expectations for the rest of the year, I want to re-examine that hypothesis. Of course, we can think all we want, and the future will occur as it will. On this topic, it's helpful to look at prior cycles for this company. I'm looking at Value Line data that goes back to 1998. In that cycle, Trinity earnings indeed peaked at 42.62 and $2.77 in 1998 and 1999 before collapsing downward, culminating in three straight years of losses from 2002-4. However, the stock bottomed with the market in late 2002 and again in early 2003, and then surged, more than doubling between March 2003 and January 2004. Presumably backlogs were surging as the housing bubble enlarged and economic growth resumed overall. Earnings then surged, roughly equaling their late '90s high in 2006 and then peaking in 2007 and 2008 at $3.65 and $3.63. The stock, though, peaked twice, first in early 2006 at $48 and again in spring 2007 just under $50. It then collapsed to around $9.30 in 2008 and $6.40 in early 2009. It basically peaked at over 2.5X book value in 2006 (based on year-end book) and somewhat under 2.5X book in 2007, both times peaking somewhat over 1X sales. Peak margins in those peak earnings years were around 18%. (Note that I am using Value Line's data array, and it is not certain that Trinity itself defines operating margin the same way that Value Line does.)
What is interesting is that peak operating margins did not drop at all in the Great Recession or its aftermath, even though earnings plunged to $0.85 in 2010 before beginning to surge year after year until now. Sales fell a great deal, but not margins, speaking to a stronger company under the leadership of then- and current CEO Timothy Wallace.
I'm estimating $70 (per share) of sales, and an ending book value of $42 for 2014. I'm also estimating that the stock is trading around 7.5X cash flow anticipated for this year, not much of which is free cash flow. With the shares up more than eleven times since the bottom five years ago, this looks more like a topping process than a bottom, or at least a resting process.
Comments on the fracking boom: In addition, the macro has a lot of similarities to the fake housing boom of the prior cycle. The housing boom helped to pump up demand for railcars, to move furniture, lumber, etc., only to see the demand vanish in a sea of insolvencies. Now, we have a reblown credit bubble courtesy of trillions of dollars of money printing (aka QE), and we have a specific problem with the fracking revolution which has aided Trinity in at least the two following ways. First, lots of railcars have been added to capacity to bring hydrocarbons out of the Bakken Shale and other remote areas not served by pipelines or refineries. Second, the cheap natural gas fueled by the drilling frenzy has helped energize the chemical industry (among others). However, the usual fly in the ointment is now appearing. As Bloomberg reports in Shale Drillers Feast on Junk Debt to Stay on Treadmill:
Not bad for the Canonsburg, Pennsylvania-based company's first bond issue after going public in January. Especially since it has lost money three years in a row, has drilled fewer than 50 wells -- most named after superheroes and monster trucks -- and said it will spend $4.09 for every $1 it earns in 2014.
The U.S. drive for energy independence is backed by a surge in junk-rated borrowing that's been as vital as the technological breakthroughs that enabled the drilling spree. While the high-yield debt market has doubled in size since the end of 2004, the amount issued by exploration and production companies has grown nine-fold, according to Barclays Plc. That's what keeps the shale revolution going even as companies spend money faster than they make it.
"There's a lot of Kool-Aid that's being drunk now by investors," Tim Gramatovich, who helps manage more than $800 million as chief investment officer of Santa Barbara, California-based Peritus Asset Management LLC. "People lose their discipline. They stop doing the math. They stop doing the accounting. They're just dreaming the dream, and that's what's happening with the shale boom."...
Rice Energy's bond offering this month was rated CCC+ by Standard & Poor's...
"Who can, or will want to, fund the drilling of millions of acres and hundreds of thousands of wells at an ongoing loss?" Ivan Sandrea, a research associate at the Oxford Institute for Energy Studies in England, wrote in a report last month. "The benevolence of the U.S. capital markets cannot last forever."
"The whole boom in shale is really a treadmill of capital spending and debt," Chauhan said.
Access to the high-yield bond market has enabled shale drillers to spend more money than they bring in. Junk-rated exploration and production companies spent $2.11 for every $1 earned last year, according to a Barclays analysis of 37 firms.
Rice Energy will outspend its cash flow through 2015, according to Moody's...
Stock analysts say they like Rice's growth potential.
Here's the conclusion:
"It's a perfect set-up for investors to lose a lot of money," Gramatovich said. "The model is unsustainable."
There is a reason that the major oil companies have written off large sums of money related to natural gas production in the U.S. I seem to recall Total (NYSE:TOT), the French major oil company previously controlled by the French government, taking a large loss and saying that natural gas under something like $6/bcf was not economic from an exploration standpoint.
I think it is clear how this Bloomberg article relates to Trinity, which is a great company but as a capital goods manufacturer, one prone to suffer the lagged effects of bubble finance. It is the nature of booms to get over-exuberant, and this boom is suspect. Besides the non-consensus reasons to worry, such as earthquakes caused by fracking, Barron's recently published an article I found interesting, predicting a lower equilibrium price of oil in the $75/barrel range, with $90 a ceiling and not a floor.
This resonated with me, as I have been cautious on oil prices in the short-to-intermediate term. The basic reason for that fits with the amount of junk bond financing in the oil patch. There is one-way positioning of speculators in the oil futures market for West Texas Intermediate crude. Per FINVIZ, this has now reached a multi-year peak of optimism (complacency?):
The way to interpret this graph is by understanding that the green line represents the commercial hedgers and the red line represents the positioning of the large speculators. The blue line represents the small speculators (traders), who have been insignificant players in this particular market. So what we see is growing, one-sided positioning by the funds to be long oil. Every time that has occurred since 2009, surges in increased long positioning have been followed by brief rises in the price of oil and then playable sell-offs. Now, I do not have any special opinion as to where the price of oil is going long term relative to other prices, but the pattern of crude on this multi-year chart looks like a bearish ascending wedge. A drop in oil prices would harm Trinity.
There is another contradiction that will make a continued boom for railcar manufacturers difficult. This is that the combination of robust oil prices and optimism for continued oil price strength is good for TRN, but so are low natural gas prices, which fuel strength in the chemical industry and support economic activity as well. It is very possible that this happy coincidence will not last, and for all we know it could reverse. Natural gas prices could end up high and oil prices could end up low. What would this do to demand for railcars, and for Trinity's energy businesses overall?
The answer is obvious. Thus there is growing risk at this stage of the game.
Bubble finance fueled by the Fed and the general governmental response to the collapse of Lehman Brothers and associated economic mayhem has led to what looks like a danger to Trinity here. Too much demand for its railcars may be coming from unstable sources, just as seven years ago the bursting housing bubble led to a sharp drop-off in sales of railcars. Instead of junk housing finance, we have junk oil patch finance.
Technical considerations: Here is a five-year chart of TRN:
Splits: Apr 30, 1976 [2:1], Nov 1, 1979 [2:1], Oct 31, 1980 [2:1], Sep 1, 1993 [3:2], Jun 12, 2006 [3:2]
There has been a spring stock price peak virtually every year. (This was also seen in the peaking year of 2006, 2007 and 2008.) Perhaps this ties in with the strange historical fact that over many years, the stock market's gains have entirely come from the October-April time frame.
Outside of that point, the big picture technical condition of TRN is excellent, i.e. bottom left to top right, though extended. The brief consolidation after earnings strikes me as healthy.
Other valuation measures: Judging fair value for an economically-sensitive company that is operating in or related to a field such as domestic hydrocarbon production, which is changing rapidly is quite difficult. Trinity is not a copious free cash flow producer. In fact, on the conference call, management expressed its preference that future acquisitions continue to be in heavy industry. Thus it will be cyclical for the foreseeable future.
Another way to value a company is by looking at the results and trading prices for its competitors. These include Greenbrier (NYSE:GBX), American Railcar (NASDAQ:ARII), and FreightCar America (NASDAQ:RAIL). While I am not an expert on any of these, a general look at their valuations with that of TRN (which is moderately diversified) does not suggest gross disparities. For example, TRN trades at a P/E of 12X TTM earnings, and after a sharp correction, ARII trades at 13X.
Regarding its own past, TRN is trading above 1X expected sales per share for this year and next. In the past, this has been a warning sign of a topping process. A counter-argument here is that Trinity management aggressively asserts that it is inherently more profitable now than in the past, and I do not disagree. On a price:book basis, the Company is above its average valuation, but at less than 2X expected year-end book, it is certainly not overvalued.
Independent stock analysts rate TRN very highly. S&P Capital IQ has a $90 price target and believes that its fair value today, by a different valuation method, is $85. Thomson Reuters rates TRN a perfect 10, and Verus rates it 9/10. Fidelity has a method of presenting analysts' ratings weighted by prior accuracy of their calls; this hardly matters for TRN, as it has been receiving a near-perfect and very rare 9.9 or so from these independents for some time. Also, Value Line's computer rates TRN as a #1 for Timeliness.
What's the business outlook for Trinity?: As stated, Trinity is following a pro-cyclical strategy. If you have a bullish or bearish view on the general economy that you wish to act on, TRN may be a very good vehicle for you, long or short (note that I am a long-only investor). My own guess is that the amount of hot money that has poured into the fracking space could be setting the railcar manufacturers up for a nasty and expensive fall-off in business. Expensive any fall-off would be; for example, Trinity is reopening/expanding a plant in Georgia at apparently considerable expense.
Conclusion: TRN is a hot stock with both price and earnings momentum. Nonetheless, counter-cyclical risks are growing. I remain long TRN, but I now find a number of other stocks more compelling and have therefore sold into the post-earnings rally.
Over the long haul, I admire Trinity's management and expect that it will be a strong performer over time.
Disclosure: I am long TRN. 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.
Additional disclosure: Not investment advice. I am not an investment adviser.