As one of the bigger players in the manufacture of freight cars, American Railcar (NASDAQ:ARII) is strategically positioned to benefit from increasing demand for tank cars that can aid the transport of oil and gas from the major shale regions. Over the past several years, the supply of oil and natural gas from shale has resulted in a shift in balance of power in the energy industry and significant gains for many of the major players in the region. For many of these companies, there is the risk that much or most of the upside has already been realized, although given the size of the market, this seems unlikely. Rather than trying to capitalize on this booming industry directly, focusing on indirect investments that will benefit from the boom, but that might not have entered the public spotlight, should have better risk-adjusted profiles.
After the company's most recent earnings report there was a sell-off, which saw shares drop from near $70 per share to under $56 per share; the shares have since recovered to around $65 per share and are showing significant upside strength. While the stock was priced for perfection prior to the release, the decline was significantly overblown. A return to the highs seen before the sell-off - around $75 per share - represents a double-digit return from current levels. Given recent strength, the stock has the potential to break this resistance level and trade much higher; solid earnings at the next report could be the catalyst needed to push higher.
The Recent Earnings Results
From a high-level perspective ARII missed earnings and revenue expectations significantly. For the first quarter, the company reported earnings of $1.03 per share, well below the expectations of $1.13 per share. The company reported revenue of $182.1 million against an expectation of just over $203 million. This is largely traced to a year-over-year decline in consolidated manufacturing revenue, which fell from $173 million in 2013 to $154 million in 2014. The $182 million of revenue excludes $64 million of estimated revenue from railcars built for the company's lease fleet. The mix of railcars manufactured for sale versus those directed to the lease fleet is the biggest factor in the earnings miss.
During the earnings call, CEO Jeff Hollister said, "During the first quarter of 2014, we had higher mix of tank railcar added to our lease fleet at favorable lease rates. The investment in more tank railcar for our lease fleet it expected to provide significant future cash flow and earnings for our company."
While the product mix was not favorable for that quarter's results, a shift in the other direction will likely spark a sharp increase in the upcoming results. "I mean in the first quarter I think you are going to see a little stronger mix on the lease side. The second quarter it might bounce back more on a direct sales side."
Other positives from Hollister included comments on the company's backlog and outlook for future orders. "Our March 31, 2014 backlog is at its highest levels since the first quarter of 2008. Additionally, we believe we are in a position to benefit from the potential demand for retrofit work that may result from any new tank railcar regulations. As of March 31, we had 2,840 railcars to be manufactured for lease in our backlog. The majority of which are expected to be delivered in 2014."
The market looks strong, positioning the company well to capitalize on continuing demand: "We expect our manufacturing operations to remain strong in 2014, as a result of the continued strength of the tank railcar market and the ramped up production at our tank railcar manufacturing facility, which is running very efficiently."
Overall, shale oil and gas production has been a strong factor in driving demand in the industry. American Rail will continue to capitalize on this strength and remains a somewhat overlooked play with plenty of upside.
The Chief Competitors
Trinity Industries (NYSE:TRN) - One of American Rail's main competitors, Trinity is bigger and continues to see impressive gains in key metrics. Looking back several quarters, the company saw revenue jump 7% on a year-over-year basis to $1.1 billion, while earnings leapt nearly 24% to $84 million; this sparked a steady run higher that remains intact. At that report, Trinity had grown revenue by an aggregate of 79% and increased its dividend by 22%. Trading at a P/E of 12.4, the stock is priced slightly "cheaper" than American Railcar, just above 15; still American Rail has higher profit potential in the near term, based on recent price action and expected catalysts. Trinity is properly placed to benefit from the continued expansion of shale operations and offer a great indirect option for investors.
Ryder System (NYSE:R) - About a year ago, the company recently unveiled a new logistics and transportation initiative dedicated to the energy sector. In addition to the issue of transporting product from the shale fields to distribution centers, equipment management problems can represent a significant cost to such operations. A report from Zacks suggested that customers expect to reduce pickup and delivery delays by 50%, see a 30% reduction in fleet equipment costs, and realize a 20% uptick in load efficiency. These kind of benefits make the operation attractive to the whole industry. Trading at a P/E above 18, Ryder is more expensive, but has demonstrated a solid trend. Upside potential is there, but not to the extent present with American Rail.
Each of these three companies offers an attractive way for investors to benefit from the shale boom, but American Rail has the greatest potential here. The fact that there has been sustained strength from major competitors is a positive for this trade, because it demonstrates industry strength and stability. American Rail is well positioned to benefit from general industry growth, and you can expect a significant pop after the next earnings release. While this is weeks away, the trend in the stocks favors taking a position at current levels.
A Closer Look at the Shale Oil Industry
The U.S. Energy Information Administration (NYSEMKT:EIA) recently announced that crude oil proven reserves grew at the fastest rate since the agency began publishing such information. The slowing growth in the space that had created a real concern about where we are headed have yet to materialize. Coupled with the rapidly expanding proven reserves (see table below), is that fact that technologies in the space are improving as well. On the other side of the argument is the reality that the decline curve in production is inescapable - production growth will have to significantly contract at some point.
To put the importance of shale-driven crude operations into context, West Texas Intermediate (NYSE:WTI) the U.S. basis price for oil has remained significantly below the price of Brent.
Just because proven reserves have spiked does not mean that production will be able to indefinitely keep pace. Looking at data from the EIA, it is clear that while production is still growing, it is doing so at a much slower pace:
This would suggest that production increases are likely to plateau and slow the expansion we have seen in the market. The takeaway for American Rail is that even is production growth becomes flat, the sustained growth will mean that there are fundamental, market-driven reasons that demand for rail cars will stay solid.
This conflict between expanding availability, but shrinking production growth sets up the push and pull between supply, demand, production and technology. Ultimately, the way to approach this news is twofold. First is to use this data divide between proven reserves and production as a useful metric by which to evaluate continued health in the industry. Without production growth, crude prices are unlikely to fall. It means that while growth might slow, they have a foreseeable play with room for growth from improving efficiency.
The other takeaway is that companies like American Rail are likely to benefit for the foreseeable future: slowing growth is not a lack of growth. Growth for the industry means there will be ongoing demand for rail cars.
The growth of the shale oil industry translates directly into opportunities in the rail space, as a recent article points out: "As shale fields scattered across the Midwest and West Texas produce millions of barrels of crude oil, energy companies are finding the national pipeline network insufficient to transport their output. Railroads are increasingly picking up the slack." This shift has been a major source of growth for the rail industry, and should continue to see expansion.
To quantify some of this growth: "According to the Association of American Railroads, the United States rail system transported 407,642 carloads of crude oil in 2013, up from 9,500 carloads in 2008." A reason for this growth is the tradeoff between price and speed; transporting oil from the Bakken to the Gulf costs only about $5 per barrel but takes as long as 40 days. By rail, the cost is $10 - $15 per barrel, but can be accomplished in five to seven days.
This ongoing demand creates the asymmetric risk/ reward profile of this opportunity. The demand is not likely to fall anytime in the foreseeable future. With oil prices remaining strong, the additional cost is easily justified and will drive continued growth in demand for rail cars. This means that any short-term sources of drag on the stock should be expected to be dwarfed by the longer-term upward pressure, and why, when compared with favorable technical factors, the fundamental strength of this trade is compelling.
The market has largely taken a wait-and-see approach with this stock, missing the near-term potential, despite the reassurances given on the earnings call. For example, Hollister, when asked about the value of the backlog gave a glowing report: "Total value of the backlog at the end of first quarter is $978 million." Additional revenue recognition from the lease side should also improve quarterly numbers. The stock has done fine, but not lived up to its potential as it should soon.
At current levels, American Rail is a buy with plenty of upside. A return to recent higher at $75 per share would represent double-digit returns. The biggest risk factor for the stock is another lukewarm earnings release, but the stock has solid support at $56 and has shown that even a near-term overreaction can be overcome. Any major dips would represent further buying opportunities as long as the support level holds. The general trend is upward and looks solid, making American Rail a strong candidate here.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.