This Week’s Best U.S. Bond: American Railcar 6.164% YTW due on 03/2014
American Railcar is a leading North American designer and manufacturer of railroad cars from flatbeds to specially designed cars for products including grains, chemical and ore transportation. They have vertically integrated their offerings to include fleet repairs, parts, maintenance, refurbishing and leasing. Based in St. Charles, Missouri, American Railcar can trace its roots back over 100 years. In the late 1980’s, they were spun off to their own entity.
Yield Curve at 3-7 Years Out
The corporate bond market has been on quite a tear in the recent term. As investors seek more yield, lower rated bonds have become more expensive especially relative to the treasury. As is with most fixed income investors, inflation is a real fear in the market. Energy and food prices have rise as of late, unemployment has been yo-yoing and housing prices seem to continue to be suppressed, depending on what one looks at inflation may or may not have arrived. We still believe that inflation may be coming just not sure if it has in all aspects. With the inflation worries justified, we are limiting our fixed income horizon to issues that mature in the next seven year.
Of great concern to investors regarding bond issues is current yield. Finding notes in this market that offer investors current yield while not paying large premiums to par has become more difficult. We reviewed a Netflix (NFLX) offering and while this note has a current yield of 8.5% per year, last we checked one must pay a 14.5% premium over par. Although this American Railcars note is trading slightly over par, $102.4, the 7.5% current yield is attractive. Overall, the yield to worst for this note is 6.164% were it to be called in two years at par. We seek these shorter term notes that present investors with a higher current yield.
We are stretching here a bit. They were not profitable in 2010. In 2009, they earned $0.73 and $1.47 in 2008. One should look at the overall macroeconomic environment over the last couple of years. The onset of the financial crisis occurred in late 2007 and some industries have not fully recovered.
Big ticket items being purchased are often planned well in advance. When one buys a house, it takes time to plan, shop, and finance a purchase of this magnitude. Railcars are big ticket items. The economic cycle is longer, often requiring time and planning to purchase thus the industry is what economists consider to be lagging.
In 2009, American Railcar manufactured over 3690 railcars while in 2010 this number was just over 2090. The company announced that 1050 railcar orders were in the books for 2011 as of 12/31/2010 and said “order activity has begun to increase significantly thus far in 2011”. American Railcar is in a lagging industry and this can be seen in the sales numbers. Orders taken during the onset of the economic crisis in late 2007 and early 2008 may have taken a year or two to manufacture and deliver thus being reflected in 2009 books. Therefore, 2010’s losses are due to the crisis of 2007-2009 as orders for the later half of 2010 were rising.
One interesting item to note is that over the last two years the repairs and services industry has been strong. In 2010, the segment grew revenues 16%. James Cowan, President and CEO of ARI said during the latest reporting announcement that “our railcar services segment grew by 16% in 2010 over the prior year, with 2010 revenues of $67.5 million which accounts for 25% of the $273.5 million total revenue. Repairing is one of two major strategies to diversify away from the deeply cyclical nature of railcar manufacturing business."
The second major strategy the company has adopted is the addition of railcard leasing options. This makes good business sense and may become a material part of the overall business. After the last deep recession and its effects on American Railcar’s bottom line, this might provide a valuable annuitized income stream.
How about those interest coverage ratios?
Earnings before interest tax depreciation and amortization (EBITA) may be one of the more important profitability metrics due to how earnings are reported through an income statement. Interest expenses are paid on a pre-tax basis allowing the issuer to use interest expense to lower its tax footprint. This issue has a $275 million face value and a coupon of 7.5% meaning the company owes interests payments to note holders of $20.625 million per year. In 2010, EBITA was $4.5 million meaning they had to utilize existing cash to pay for interest expense. There was an EBITA/interest expense of less than one, which is not sustainable in the long term. In 2009, EBITA was $40 million meaning there was as $19 million surplus after interest was paid but before taxes were paid. Overall, this last year was not strong however management has taken what may be considered a proactive approach by reducing selling and administrative overhead for 2011. This lower cost along with a continued recovery and successful leasing segment may return EBITA to sustainable levels in 2011.
Debt to cash ratio.
American Railcar has a strong debt to cash ratio. This is one of reasons why we chose to review this bond in depth. Cash and equivalents as of the end of last quarter, Dec 31, 2011, were $318.76 million. The debt issue being review is the only issue on the books and was issued for $275 million. If the need were to arise, American Railcar could pay off the long term debt with the cash on hand. The balance is quite high when you put into perspective that it is two years after a major recession that caused a heave cycle down turn to the railcar industry. American Railcar has a similar cash to long term debt position as Blyth Inc. We are attracted to issuers that have the large amounts of cash on hand as cash is king.
We like companies that have flexible balance sheets
Finding firms that have a understandable liabilities ledger is desirable. During our review process, we found firms that have multiple layers of debt and it is hard to decipher who is on the top rung of the lien ladder.
American Railcar currently has only one corporate bond outstanding and this helps us to believe that this superior position class of debt in times of trouble would not be competing against many other layers of debt holders were liquidation to occur.
The company currently has a market cap of about $435 million. With the $275 million of outstanding long term debt, they have a 1.58x equity to long term debt ratio. Having a ratio above one means that the firm has more market value of equity than long term debt. They have some flexibility to raise capital should they need but this also is below our norm.
There may be some hidden value for bond holders in the balance sheet. Mature industries such as railroads and services have been established for quite a while. American Railcar can trace their history back over 100 years although they have been independent since the 1980’s. 100 years ago, the rail industry developed on the outskirts of towns. On the books, American Railcar has over $181 million in property, plant and equipment. Typically these numbers are below market prices due to when they were purchased and depreciation. Without going into to much detail, the property may be able to return fixed income investors capital were ongoing fiscal health to become a problem. Either way, the book value of the property alone covers about 65% of the outstanding debt.
We like high yields
This issue from American Railcar is priced to yield to worst of 6.181% should it be called at par on March 1, 2013. The yield to maturity for this issue is 6.594% maturing on March 1, 2014. Similar maturing US T-Notes are yielding about 1.57% meaning American Railcar is yielding about 4 times as much.
This bond has more risks associated with it than others we have reviewed in the past. Having not had positive net income in the recent quarters and having to use cash reserves to make interest payments is not sustainable.
There is one person that controls a majority of the equity. His name is Carl Ichan and owns about 54% of the outstanding equity last reported. Although this may or may not be a negative item, it is material. Majority share holders have a larger voice regarding how the business is run. The business appears to be making several strides in the right direction to return to profitability.
Numbers included in this report were taken from American Railcar’s quarterly and yearly reports that were released on February 23, 2010. Data presented is believed to from a reliable source and to be true. Sometimes information may be misstated causing valuation metrics to change drastically.
This issue has been given a Caa1 rating by Moody’s and a B+ by S&P. This issue may not be of proper credit quality for individuals portfolio based on credit quality. Just because the coupon the note is 7.5% does not guarantee that this will be realized. Should cash flow problems arise, interest and principal returns may be curtailed, reduced, or eliminated.
This is not by any means an all inclusive risk list. An individual suitability review should be conducted for each prospective purchaser.
We believe that we found a good bond here. With a generous cash position, flexible balance sheet, property values, and being in a lagging industry, this bond could be considered for one’s fixed income portfolio. The ability for the investor to generate over a 6% yield for under four years is also quite attractive. Although this issue is has a Caa1/B+ rating, we believe it is well positioned and have included it as a position in selected fixed income portfolios.
Yield to Worst (Call 03/01/2013) 6.164%
Yield to Maturity 6.586%
|Issuer Information |
|Issue Date ||02/28/2007 |
|First Coupon ||09/01/2007 |
|Next Coupon ||09/01/2011 |
|Last Coupon ||09/01/2013 |
|Frequency ||Semiannually |
|Original Issuance |
|Delivery: ||Book Entry |
|Underwriter || |
|First Settle Date || |
|Original Size ||$275,000,000 |
|Outstanding Size ||$275,000,000 |
|Min Amount ||1,000 |
|Denom Amount ||1,000 |
|Collateral ||Note |
|Blue Sky Restrictions || |
|Moodys Rating Information |
|Long Term Rating ||Caa1 effective 09/28/2009 |
|Short Term Rating || |
|Creditwatch || |
|S&P Rating Information |
|Long Term Rating ||B+ effective 07/02/2010 11:38:36 |
|Short Term Rating || |
|Outlook || |
|Creditwatch || |
|Security Type Features |
|Type ||Corporate |
|Category ||Industrial |
|Issuer Full Name ||American Railcar Industries, Inc. |
|Listed || |
|Symbol ||ARII |
|Call/Sink/Put Features |
|Conditional Put Reason ||Change of control |
|Continuously Callable starting at firstname.lastname@example.org || |
|Next ||04/04/2011 at 103.75 on 30 days notice |
|Par ||03/01/2013 |
|Call Schedule ||03/01/2012@ 101.875 03/01/2013@ 100 |
Disclosure: I am long ARII.
Additional disclosure: Durig Capital's clients currently own these bonds.