The Greenbrier Companies, Inc: A Value Stock With An Unjustified Correlation To Oil

| About: The Greenbrier (GBX)

Summary

The market has priced in a full cyclical decline in demand in the railcar manufacturing industry; this decline is unlikely to be as severe as most expect.

GBX has a competitive advantage in product innovation and is diversified towards non-energy product lines that are seeing rising demand, and these factors will help it offset declining demand.

A strong balance sheet and liquidity profile, coupled with a track record of operational excellence, will help GBX capitalize on all available opportunities and gain market share going forward.

GBX is trading at an attractive price from a value-oriented investor’s perspective, with the stock currently trading at a 23.0% discount to a conservative 1-year price target of $33.00.

Author's Note:

I am very grateful for the assistance of Thomas Beevers, the CEO and founder of StockViews, who provided substantive suggestions that greatly improved this article. The fault for any errors or omissions is, of course, my own. The format of many of the worksheets in my "Valuation Analysis" excel document was largely influenced by a book entitled "Investment Banking: Valuation, Leveraged Buyouts, and Mergers & Acquisitions," written by Joshua Rosenbaum and Joshua Pearl.

This article was originally published on my website, LGR Analytics, and it was sent out to my Newsletter subscribers approximately 24 hours before it was published anywhere else. If you want to sign up to receive my free Newsletter, you can can do so on the homepage of my website.

Company Description and Segment Breakdown

The Greenbrier Companies, Inc. (NYSE:GBX) is a designer, manufacturer and marketer of freight car equipment and a provider of wheels, parts, and leasing & management services. GBX's operations are mainly located in North American (95.5% of total assets in FY 2015 were attributed to North America) and Europe (4.5% of total assets in FY 2015 were attributed to Europe), with manufacturing facilities located in Oregon, Mexico, and Poland, but it also has a 19.5% stake in the leading railcar manufacturer in Brazil with an option to acquire an additional 40.5% (which must be exercised before December 30, 2017). GBX went public in July 1994 and operates in four reportable segments: Manufacturing (84.3% of LTM sales); Wheels & Parts (12.5% of LTM sales); Leasing & Services (3.2% of LTM sales); and GBW Joint Venture (an unconsolidated 50/50 joint venture with Watco Companies, LLC, and reported as part of "Earnings from unconsolidated affiliates" on GBX's Consolidated Statements of Operations). The chart below provides basic information about GBX; Appendix Exhibit #1 provides a historical breakdown of GBX's total sales by segment for FQ1 1997 - FQ1 2016, with projections for sales by segment for FQ2 2016 - FQ4 2017.

Click to enlargeInformation Sources: SEC Filings For GBX, Company Website, and Bloomberg

Industry Background and Oil's Impact On The Industry

The railcar manufacturing industry produces a variety of railcars that can transport many different products including commodities (e.g., oil, natural gas, coal), chemicals, building supplies, agricultural products, automotive vehicles, consumer products, and waste. GBX manufacturers every type of railcar except for coal gondolas, and it is the second largest of four publicly traded Original Equipment Manufacturers (OEMs) in the U.S. railcar manufacturing industry that collectively account for approximately 92% of the industry's total backlog as of September 30, 2015. The three other publicly traded companies in the railcar manufacturing industry are Trinity Industries Inc. (NYSE:TRN), American Railcar Industries Inc. (NASDAQ:ARII), and FreightCar America Inc. (NASDAQ:RAIL). In addition, there are two other privately-held OEMs who have reputations for manufacturing tank cars: National Steel Car (Private) and Union Tank Car Company (Private - owned by Berkshire Hathaway). Appendix Exhibit #2 compares GBX to its three publicly traded competitors based on market share, profitability margins, and return on investment percentages.

Railcar demand is cyclical. North American railcar orders fluctuate with changes in rail traffic, which is largely driven by the expansion or contraction of the U.S. economy. However, railcar demand can also be highly dependent on demand for the transportation of commodities by rail and thus fluctuations in commodity prices can have a significant impact on railcar demand. Recently, demand for the transportation of crude oil by rail was driven by the boom in domestic oil production; the rise in U.S. field production of crude oil from 3.98 million barrels/day in September 2008 to 9.43 million barrels/day in December 2014 led to a surge in the amount of crude oil transported by rail from 2009 to 2014, which can be seen in the chart below:

Click to enlargeChartSource: Association Of American Railroads

This Crude By Rail (CBR) phenomenon drove demand for pressurized tank cars designed to haul crude oil, and for small covered hoppers designed to haul sand used in hydraulic fracturing (fracking). Pressurized tank cars generate higher margins than most other types of railcars, which caused manufacturers to prioritize production of pressurized tank cars over that of the other types of railcars in their backlogs and, as a result, deliveries for tank cars overshadowed deliveries for non-energy-related railcars. This demand shift caused orders for new railcars to rise faster than production, leading to a sharp increase in backlogs and an industry average quarterly book-to-bill ratio of 1.5 from Q1 2009 to Q4 2014. According to data from the Railway Supply Institute, in 2014 annual U.S. railcar orders and year-end backlog hit new all-time highs of 138,293 units and 142,837 units, respectively, after being at only 9,250 and 10,462, respectively, in 2009, and annual U.S. railcar deliveries reached an all-time high of 82,335 in 2015 after being at only 21,713 in 2009 (and a low of 16,535 in 2010).

Summary Of Price Target

Sentiment towards railcar manufacturers turned extremely pessimistic over the last eighteen months. The four major railcar manufacturers saw their share prices fall by 60.3% on average from their respective highs in September 2014. GBX was hit the hardest, with its share price falling by 65.8% from its all-time high of $78.38 on September 19, 2014 (according to historical price data from Tradestation). With this decline, GBX's current share price of $26.83 has already discounted a sharp cyclical decline in demand for new railcars and, with a conservative 1-year upside price target of $33.00/share (+23.0%), GBX is trading at an attractive price that makes it a buy candidate for value-oriented investors.

Additional detail regarding my 1-year price target and GBX's implied Potential Return/Risk ratio can be found in subsection 4f, which is at the end of this article.

Analysis

1. The market has priced in a full cyclical decline in demand in the railcar manufacturing industry; this decline is unlikely to be as severe as the drop in GBX's price indicates

GBX is a highly cyclical stock, due to the cyclical nature of the railcar manufacturing industry. The market is currently pricing GBX as though the industry has already experienced a full cyclical decline in demand due to the drop in oil prices. However, while falling demand for energy-related railcars has driven lower quarterly orders in the railcar industry, it does not follow that demand for all non-energy railcars has also peaked. Demand for railcars in these other categories responds to completely different drivers than demand for energy-related railcars. Further, I believe there has been an "overdone" selloff in GBX's price due to excessively pessimistic expectations for total industry orders and backlog, which derives from an unrealistic association formed between oil prices and total railcar demand, leading investors to believe that orders for non-energy railcars will decline at the same pace as orders for energy-related railcars.

1a. GBX has priced in an expectation for a full cyclical decline in demand in the railcar manufacturing industry, due to the drop in oil and its impact on energy-related railcar demand

GBX's stock price reached an all-time high of $78.38 on September 19, 2014. This high was 4,114.0% above its all-time low of $1.86 on March 06, 2009, and was driven by record margins and new all-time highs in adjusted gross and operating margins, as shown below:

Click to enlargeData Sources: Bloomberg and SEC Filings For GBX

  • Note: Data was adjusted to exclude non-recurring items and to incorporate implied interest from capitalized operating leases, which was calculated as described in McKinsey & Company's book "Valuation: Measuring and Managing the Value of Companies."

Industry orders for tank cars began to decline after crude oil spot prices fell from their highs of over $100/barrel in June 2014. Share prices of all railcar manufacturers followed crude lower based on the market's expectation for lower demand for tank cars, but they were also driven lower by the belief that overall railcar demand (i.e. demand for both energy-related and non-energy-related railcars) had also reached its cyclical peak and begun a major decline.

The cyclicality of railcar demand is demonstrated in the chart below, which shows that when the number of new railcars ordered in a single quarter (blue line) has historically risen above 35,000 units (marking a "cyclical peak" in demand) it has subsequently fallen by an average of 37.1% (q/q) the very next quarter and by an average compound annual rate of 20.0% over the three quarters thereafter. Notably also, whenever the 35,000+ units ordered peak is reached it has taken anywhere from 2-5 quarters (3.5 quarters on average) for industry deliveries (red line) to experience a quarter-over-quarter decline. The inevitable delay in deliveries adjusting lower after a peak in orders is due to the fact that railcar manufacturers cannot easily scale-up or scale-down production.

Click to enlargeData Source: Bloomberg (Sourced from The Railway Supply Institute)

In early CY 2015, market participants looked at industry orders from CY 2014 and concluded that the industry had reached a natural peak. In retrospect, this conclusion was supported by significant data:

  • Industry orders remained above 30,000 units for three quarters in a row, from Q2 2014 to Q4 2014 (the first time that ever happened since at least CY 1987).
  • Orders peaked in Q3 2014 at an all-time high of 42,900, which was extremely high considering the fact that a "normal" level of quarterly orders is in the 10,000 - 15,000 range (Note: From Q1 1987 to Q4 2015, quarterly industry orders averaged 12,886).
  • Annual railcar orders hit a new all-time high of 138,293 in CY 2014, approximately 2.7 times the CY 1987-2014 annual average of 51,518.
  • U.S. rail traffic began experiencing year-over-year declines in early CY 2015 and, in mid-2015, its 10 week moving average began experiencing its first repeated year-over-year declines since early CY 2013 (see Appendix Exhibit #3).

When expectations for future earnings began to trend lower in late CY 2014, market sentiment had already followed industry orders lower, and the share prices of the four major railcar manufacturers were already falling.

1b. The decline in industry demand is unlikely to be as severe as the drop in GBX's price indicates

Given the coincidence in timing of the peak in the price of oil, industry orders, and GBX's stock price, some market participants concluded that falling oil prices were driving this contraction phase of the railcar manufacturing cycle. The current selloff of GBX therefore must be viewed in the context of the assumed correlation between its stock price and the price of oil. This assumption is not justified.

Historically, the most reliable driver for GBX's price has been industry backlog, not industry orders, industry deliveries, or oil prices. The correlation between GBX's quarterly average of adjusted daily closing prices from Q4 1994 (the first full quarter after the Company went public) to Q4 2015, and quarterly industry backlog over the same period, is 0.90. This correlation is not only extremely high, it also significantly exceeds the correlations to industry orders (0.57), industry deliveries (0.51), and an average quarterly WTI Crude Oil spot price (0.50) over the same period (Note: If end-of-quarter stock prices are used instead of average closing stock price for the quarter, the correlations between GBX's price and industry backlog, orders, and deliveries are 0.86, 0.61, and 0.47.). Interestingly enough, the correlation between GBX's quarterly average stock price and quarterly industry backlog from Q4 1996 to Q4 2015 (0.91) is also higher than the correlation between GBX's quarterly average stock price and its own backlog(0.87) from FQ4 1996 to FQ1 2016.

Most importantly, however, over shorter (yet still substantial) periods of time the positive correlation between GBX's average quarterly stock price and an average quarterly WTI Crude Oil spot price disappears completely; the correlations over the last 10, 20, 30, and 40 quarters were -0.17, -0.42, -0.03, and -0.08, respectively. This is depicted in the chart below:

Click to enlargeData Sources: Bloomberg (Sourced from The Railway Supply Institute) and Yahoo Finance

  • Notes: Quarterly stock price was calculated by taking the average of adjusted daily closing prices for all trading days in each quarter. The quarterly stock price for Q3 1994 was calculated by taking the average of GBX's adjusted daily closing prices from 7/14/1994 to 9/30/1994, which is only 56 trading days, because GBX went public on 7/14/1994. The calculated correlation figure was not impacted by the fact that the quarterly stock price figure for Q3 1994 incorporated fewer trading days than any of the other quarterly stock price figures shown in the chart. The quarterly average stock price for Q1 2016E uses actual daily price data from 1/4/2016 to 3/31/2016, and the quarterly average stock prices for Q2 2016E are equally spaced price intervals from GBX's average stock price of $25.61 for Q1 2016 to my 1-year price target of $33.00. The "past 4 quarters" correlation figures are for Q1 2015 to Q4 2015.

As one can see from information presented at the bottom of the chart above, GBX's correlation to the price of oil has only recently risen to very high levels, which is inconsistent with historical correlation figures and leads me to conclude that the positive correlation between GBX's price and the price of crude oil will eventually weaken.

The chart above also includes estimates for industry backlog over the next 10 quarters in two operating scenarios: "No Recession (NR)" and "Recession (R)." My projections for industry backlog in each of the two scenarios were made without additional inputs or changes once they were calculated by using the slopes of previous contraction cycles in the railcar manufacturing industry to project the slopes of the declines in industry backlog during the current contraction cycle for each scenario:

  • The "No Recession" scenario used an average of the peak-to-trough slopes in industry backlog from Q3 1998 to Q1 2002, Q3 2006 to Q4 2009, and Q4 2014 to Q4 2015 (the 4 quarters of the current cycle) to project the level industry backlog would bottom at in Q2 2018 and then used a slope from industry backlog's current level to that projected bottom level to project industry backlog over the next 10 quarters.
  • The "Recession" scenario assumed that the slope of the decline in industry backlog from Q4 2014 to Q4 2015 will continue through Q2 2018 (Note: All calculations can be made available upon request).

Both scenarios assumed the industry backlog would bottom in Q2 2018, resulting in a peak-to-trough decline lasting 14 quarters, to be consistent with the peak-to-trough declines that took place during the past two contraction cycles (i.e. from Q3 1998 - Q1 2002 and Q3 2006 - Q4 2009). In the No Recession scenario industry backlog reached 56,440 in Q2 2018 (a peak-to-trough decline of 60.5%), while in the Recession scenario industry backlog reached 30,938 (a peak-to-trough decline of 78.3%). The DCF Analysis for GBX, described in section four of this article, uses more conservative projections for annual deliveries than those implied by the quarterly projections for industry backlog shown in the chart above.

Projecting industry backlog for the remainder of the current contraction cycle also helps in determining whether the selloff in GBX's current share price is "overdone." As one can see in the following chart, the market appears to have already factored a full cyclical decline in the railcar manufacturing industry's backlog into GBX's current price:

Click to enlarge

Data Sources: Bloomberg Terminal (sourced from The Railway Supply Institute) and Yahoo Finance

  • Notes: The only difference between Current Contraction (A) and Current Contraction (E) is that Current Contraction uses GBX's actual average adjusted daily closing price for Q1 2016 (i.e. closing price on March 31, 2016), and a projection for industry backlog in Q1 2016 instead of using actual backlog data for Q4 2015. The peak-to-trough declines in GBX's stock price are measured by looking at the peak and trough quarterly average prices, and not intraday highs and lows.

As the chart above shows, the peak-to-trough decline in industry backlog for "Projected Contraction" is only 3.2% smaller than the peak-to-trough decline in backlog from Q1 1995 to Q4 1996. The contraction cycle from Q1 1995 to Q4 1996 was the first of three major contractions in industry backlog that occurred while GBX was publicly traded, and it was the only one of the three contraction cycles that was not accompanied by a U.S. recession. (Note: The chart above excludes the contraction cycle in Q1 1989 to Q3 1991, which caused a peak-to-trough decline of 55.5% in industry backlog, as GBX was not publicly traded at that time).

Regardless of what level one projects that industry backlog will reach at the trough of the current cycle, the chart above shows that the percentage change in GBX's price has outperformed the percentage change in industry backlog in all three of the "Contraction" phases of the business cycles, with the average outperformance variance being 18.9%. In addition, the chart indicates that GBX's current price decline is not only roughly in-line with its average historical peak-to-trough decline in price during the "Contraction" phases of past cycle it is also already 1.1% larger than the projected peak-to-trough decline in industry backlog for the No Recession scenario, and together these factors indicate that GBX's price appears to have declined too far too fast.

2. GBX has a competitive advantage in product innovation and is diversified towards non-energy product lines that are seeing rising demand, and these factors will help it offset declining demand for energy-related railcars

GBX has a competitive advantage in product innovation, with a history of producing superior designs of select products. According to the company's Investor Presentations in February 2016, GBX has won TTX Company's Excellent Supplier Award for the past 21 years, and it is the only railcar manufacturer to have done so (TTX Company is GBX's largest customer - accounting for 17% of total sales in FY 2015). The evidence supports GBX's competitive advantage in product innovation. For example, although the first double-stack intermodal railcar had been designed and tested in 1977, GBX did not enter the market until 1993, however, it was able to quickly dominate that market by introducing new products that allowed it to capture an astonishing estimated "100% of total market share" for double-stack railcars in 1996 (GBX 10-K Filing For FY 1996). GBX's market share in the intermodal railcar market averaged approximately 64% over the five years prior to the company's Fiscal Year 2011 (according to GBX's 10-K filing for FY 2011), and by 2013 GBX's dominance had grown and it won 90% of all orders for double-stack railcars. In the five years prior to FY 2011, the last year that the company reported market share figures in its 10-K filings, GBX reported an average market share of "approximately 56% in boxcars, 30% in flat cars and 18% in covered hoppers" (GBX 10-K Filing For FY 2011). By Q4 2014, GBX has acquired roughly a 20% market share of the total industry backlog in small covered hoppers (Note: This figure was approximated using information from GBX's FQ1 2015 earnings call from financial data reported on November 30, 2014, and the number of small covered hoppers in the industry backlog as of December 31, 2014).

2a. GBX is leveraging its innovative designs to meet new safety regulations

In 2009, GBX became a major player in the tank car manufacturing market, and after only a year of producing tank cars it acquired a market share of 11% (GBX 10-K Filing For FY 2011). At the end of FY 2013, GBX's management team set a goal of acquiring a normalized market share of 20-25% of the tank car manufacturing market by the time that the market reached a "steady-state," which it anticipated to be "12,000 to 15,000 cars" and to take place "somewhere down the line after 2015." Although GBX's management team was confident that the company could continue to acquire share in the tank car manufacturing market it wanted to remain conservative. After allowing tank cars to account for "upwards of 50%" of the company's backlog in FQ2 2013, GBX's management team never let tank cars' percentage of total backlog rise above 50% in FY 2014, and (in its FQ2 2014 earnings call) it even pointed out that the company's percentage of backlog dedicated to tank cars was "probably the lowest [percentage] of any car builder." Despite management's conservative stance, GBX was still able to acquire roughly an 18% market share in tank cars by the end of 2014. GBX was able to quickly acquire such a significant market share so quickly because its innovative design for a "Tank Car of the Future" gave it a first mover advantage following the new, recently finalized, safety regulations for tank cars instituted by the Department of Transportation (DOT). The safety regulations were established in response to numerous high profile tank car accidents and affect a total of 154,528 tank cars in the industry (41.5% of the total number of tank cars in the North American fleet, as of January 01, 2015), requiring updated safety specifications (DOT-117P) for new tank cars built after October 1, 2015 and the retrofitting of older tank cars (to meet DOT-117R specifications) on a prescribed timeline ranging from March 2018 to May 2029 (as shown below).

Click to enlarge

ChartSource: GBX s Investor Presentations in February 2016

GBX claims its Tank Car of the Future is more than 8 times safer than DOT-111 legacy tank cars and twice as safe as the previous state-of-the-art tank car for transporting hazardous materials. As a result, the new safety regulations and GBX's innovative design should help the company continue to gain share in the tank car market over time.

While the new safety regulations certainly benefit GBX, it is likely that the company will not see a financial benefit soon, because customers are currently willing to delay the purchase of new tank cars (and the retrofitting of old ones) in the hope that the prices for new tank cars will decline due to current oversupply of tank cars in the market. In addition, given an estimated $70,000 - $110,000 cost differential per car when comparing purchasing a new tank car to retrofitting an old one (according to information from GBX's Investor Presentation in December 2015), customers are more likely to retrofit than replace older models. GBX is well-positioned to help tank car owners comply with the new DOT regulations, by offering its Tank Car of the Future to customers looking to replace old tank cars and by having significant tank car retrofit capacity through its GBW Joint Venture (GBW has annual retrofit capacity of 2,000 - 3,000 tank cars, according to GBX's Investor Presentations in February 2016), and these factors give GBX a competitive advantage going forward.

2b. Diversification towards non-energy railcars and replacement demand aids GBX

In recent quarters, GBX has made a significant push to diversify its backlog away from energy-related railcars and towards other types of railcars. According to data from GBX's earnings calls over the last two years, energy-related railcars (i.e. tank cars and small covered hoppers) accounted for well over 50% of the company's backlog two years ago and now account for only 27% of total backlog. As one can see in the chart below, tank cars accounted for "less than 11%" of GBX's backlog in FQ1 2016, after accounting for as much as 47% of the company's backlog two years ago:

Click to enlargeData Sources: Earnings Calls, Supplemental Slides For Earnings Reports, and Press Releases

  • Notes: The number of tank cars and small covered hoppers in GBX's backlog are approximations calculated by multiplying percentages of total backlog mentioned in earnings calls by the actual number of units in GBX's backlog at the end of the indicated quarters (as reported in the company's financial filings). The "<" symbols were used whenever management specifically used the words "less than" in the company's earnings calls.

Some of the apparent "diversification" away from energy-related railcars is likely the result of a natural shift in industry demand. As oil prices declined over the last five fiscal quarters, the number of energy-related railcars that GBX delivered was likely much higher than the number of new orders for them (i.e. a book-to-bill ratio below 1.0), causing the percentage of total backlog attributed to these railcars to decline. GBX and its competitors are all seeking to shift focus towards producing non-energy railcars that should see higher demand in the future. With that in mind, the fact that GBX's current exposure to energy-related railcars is lower than that of most of its competitors puts it in a good position because it will have significant capacity to dedicate to manufacturing non-energy railcars that should see higher demand (Note: Recent reports indicate that tank cars and covered hoppers accounted for 31% and 49% of total industry backlog, respectively, as of December 31, 2015, which coupled with information from recent earnings calls implies that GBX likely has a significantly lower percentage of its backlog dedicated to energy-related railcars than most of its competitors do - with TRN being the only possible exception).

As noted above, the Crude By Rail phenomenon caused railcar manufacturers to prioritize producing high-margin tank cars over other types of railcars, causing the number of old non-energy railcars in the North American fleet to increase rapidly through 2014 due to delayed replacement. As one can see in the chart below, out of the 1,583,865 railcars in the North America fleet as of January 1, 2015, 325,501 (20.6%) were between 31 and 40 years old and 83,559 (5.3%) were over 40 years old, with the vast majority of the old railcars being non-energy-related:

Click to enlargeData Source: ProgressiveRailroading.com

Railcars typically have useful lives of around 40-50 years and are usually replaced at 40 years, depending on rail traffic (a recession causes rail traffic to decline significantly, delaying replacement of old railcars). The average age of railcars in the North American fleet was 19.8 years at the end of CY 2014, which is only slightly below the long-term average of approximately 20.0 years and indicates that a strong replacement cycle has already begun. The 409,060 railcars in the North American fleet that were over 31 years old at the beginning of 2015 will likely be replaced over the next 10 years; when smoothed, this leads to an average "replacement demand" of 40,906 units per year.

As noted above, the fall in oil prices reduced demand for tank cars, leading to an estimated tank car fleet surplus of 80,000 units and a drop in fleet utilization to 77% from nearly 100% in mid-2014. Since the beginning of FY 2015, 80% of GBX s new railcar orders "have been for non-energy related applications like automotive transportation and intermodal." GBX is focusing on three main product types: covered hoppers, box cars, and automotive racks. The factors driving higher demand for each are as follows:

  • Covered Hoppers - GBX's management stated in the FQ1 2016 earnings call that low natural gas prices caused an increase in infrastructure investment by chemicals companies: "North American chemical and plastics production will double by 2020, generating $67 billion in new chemical industry shipments" and increasing future demand for large covered hoppers designed to carry plastic resin, petrochemicals, and fertilizers. In July 2014 GBX introduced a new 6,250-cubic-foot plastic pellet car GBX delivered 300 large covered hoppers in 2014, and the company is expected to dedicate more production lines to this railcar type over the next 1-2 years, as demand for plastic pellet cars is expected to be "around 33,000 cars" through 2018 "with a peak in 2016 of 10,480 units." In addition, transportation of grain is expected to rise going forward, which would increase demand for medium covered hoppers designed to haul grain.
  • Box Cars - The number of box cars in the North American fleet has declined significantly due to retirement and decreased replacement demand. GBX's management team believes that replacement demand has bottomed. GBX obtained an average market share in box cars of 56% for the five years prior to FY 2011 and, according to the company's FQ1 2016 earnings call, it currently has two production lines dedicated to producing "high margin" box cars.
  • Automotive Racks - Demand for automotive racks is expected to increase due to increased shipments of cars throughout the United States (over 70% of all new vehicles are transported via rail from plants to dealerships) and further replacement demand. Over the past five years, GBX invested in improving the efficiency of its automotive rack cars and this increased the margin that it is able to generate by manufacturing them. On May 28, 2013, GBX introduced Multi-Max, an innovative and proprietary new automotive railcar that it believes will help it gain market share in this category. Although some believe that auto sales are near a cyclical peak, even if auto sales were to decline significantly in the near future demand for automotive railcars should be sustained (at least partially) by the replacement cycle, and recent comments from railcar manufacturers' management teams indicate that the outlook for automotive railcar demand is positive.

In summary, the rise in Crude By Rail caused railcar manufacturers to prioritize the production of high-margin tank cars to haul crude oil and small covered hoppers to haul fracking sand over the production of other railcar types. However, demand for specific non-energy railcars types is expected to increase substantially in the coming years, and coupled with overall replacement demand this increase should significantly offset the decline in demand for energy-related railcars. A competitive advantage in product innovation and an ongoing diversification away from energy-related railcars positions GBX well to target all areas of rising demand in a low commodity price environment.

3. A strong balance sheet and liquidity profile, coupled with a track record of operational excellence, will help GBX capitalize on all available opportunities and gain market share during the current industry contraction

Since the peak of the last industry cycle, GBX has managed to significantly improve its financial position while also gaining market share. GBX currently has a very strong balance sheet and this, coupled with the company's history of operational excellence, should give it the financial flexibility to navigate the current industry downturn and continue gaining market share. As one can see in the chart below, GBX's current financial position is not only stronger than it was at the peak of the last cycle (Q3 2006) it is also stronger than the current financial positions of most of the company's competitors.

Click to enlargeData Sources: SEC Filings For GBX, TRN, ARII, and RAIL

  • Notes: The debt figures used above include the asset value of operating leases, and both the asset value of operating leases and ROIC were calculated using the methods described in McKinsey & Company's book "Valuation." All income statement figures for GBX were "calendarized" to account for its Fiscal Year ending August 31 st and to ensure that a realistic comparison was done. The balance sheet figures used in GBX's figures were for its most recent fiscal quarters as of the indicated date Calendar Year (i.e. balance sheet figures for FQ1 2016, ending 11/30/2015, were used along with calendarized income statement figures to calculate GBX's efficiency ratios for CY 2015).

Currently GBX's balance sheet appears much stronger than the respective balance sheets for each of its major competitors, except for RAIL. GBX's leverage metrics (Debt/Capitalization, Total Debt/LTM EBITDA, and Net Debt/LTM EBITDA) are all lower than the respective metrics for TRN and ARII, while GBX's interest coverage metrics (LTM EBITDA/Net Interest Expense and LTM EBIT/Net Interest Expense) are higher than the respective metrics for TRN and ARII.

GBX's liquidity metrics (Current Ratio and Quick Ratio) are lower than the respective metrics for TRN, ARII, and RAIL, for several reasons. First, GBX typically does not hold as much cash and short-term investments on its balance sheet as its competitors do; for example, during its last four fiscal quarters, cash and short-term investments as a percentage of GBX's current assets and total assets averaged 15.4% and 9.0%, respectively, and it did not have any short-term investments in any of those four quarters, however, those average figures were for the most part were much higher for TRN (31.5% and 8.0%, respectively), ARII (53.5% and 16.6%, respectively), and RAIL (33.4% and 24.0%, respectively). Second, as one can see in the chart below, GBX has lower Inventory Turnover and Receivables Turnover ratios than ARII and TRN do, which might be due to differences in business focus (i.e. higher turnover ratios associated with leasing & management services, which both TRN and ARII have a much larger focus on than GBX does).

Click to enlarge

Data Source: SEC Filings For GBX

  • Notes: Ratios were calculated using an average of each balance sheet figure at the beginning and end of the indicated year, and the Asset Turnover Ratio and Fixed Asset Turnover ratio include the Asset Value of Operating Leases in their calculations. All income statement figures for GBX were "calendarized" to account for its Fiscal Year ending August 31 st and to ensure that a realistic comparison was done. The balance sheet figures used in GBX's figures were for its most recent fiscal quarters as of the indicated Calendar Year end (i.e. balance sheet figures for FQ1 2016, ending 11/30/2015, were used along with calendarized income statement figures to calculate GBX's efficiency ratios for CY 2015).

Despite the fact that its Inventory Turnover ratio and Receivables Turnover ratio are lower than the respective ratios for its competitors, GBX's Asset Turnover ratio and Fixed Asset Turnover ratio are higher than the respective ratios for TRN and ARII; all of its turnover ratios have improved steadily from CY 2013 to CY 2015.

GBX's liquidity position and leverage ratios have improved substantially in the past seven years and over the last twelve quarters in particular. As one can see in the chart below, in FY 2015 GBX's Debt (Including Leases)/LTM Adjusted EBITDA and Net Debt (Including Leases)/LTM Adjusted EBITDA ratios reached their lowest levels in the past 10 years (1.0x and 0.6x, respectively) and total available liquidity was only $80.1 million below its all-time high of $530.0 million in FQ3 2014. In FQ1 2016 GBX's leverage ratios rose slightly (to 1.1x and 0.7x, respectively), however, the company was able to increase the aggregate amount potentially available for borrowing under the three components of its senior secured credit facilities to $625.1 million from $366.1 million at the end of FY 2015 (only $289.7 million of the $625.1 million was available to be draw down under the committed credit facilities as of FQ1 2016, leaving $487.3 million in total available liquidity - including cash & equivalents).

Click to enlarge

Data Source: SEC Filings For GBX

  • Notes: The debt figures used above include the asset value of operating leases. "Currently Unavailable Liquidity" is additional liquidity that was potentially available for GBX to draw down upon under its committed credit facilities but it did not have access to those funds because the "defined levels" of some of its financials were not high enough at those points in time. "Currently Unavailable Liquidity" was calculated for each period by taking the total aggregate amount of GBX's senior secured credit facilities then subtracting total available lines of credit and the outstanding revolving note balance presented on the balance sheet.

Having sufficiently low leverage and high liquidity to capitalize on available opportunities will be extraordinarily helpful to GBX through the industry downturn. GBX currently is exploring three such opportunities:

Opportunity #1: Purchasing the remaining 40.5% of Amsted-Maxion Hortolandia. On January 07, 2015 GBX entered into an agreement to "acquire a 19.5% ownership in Amsted-Maxion Hortolandia, the leading railcar manufacturer in South America, for $15 million" with "an option to acquire an additional 40.5% ownership interest, to be exercised no later than September 30, 2017" (that exercise deadline has since been extended to December 31, 2017). This agreement was very advantageous for GBX because "Amsted-Maxion Hortolandia [held] an estimated 70% annual market share in the South American new railroad freight car market" when the deal was announced, and the option gives GBX the ability to continue to expand its international footprint. When GBX entered the deal, demand for railcars in Brazil was "forecasted to exceed approximately 4,000 new railcars annually for the near term and potentially through the end of [the] decade," driven by infrastructure investments and an aging railcar fleet in which "more than 60% of rail freight rolling stock is 30 years or older." The recent downturn in Brazil's economy makes the outlook for Amsted-Maxion Hortolandia far more uncertain. Seeing as the iShares MSCI Brazil Index has fallen 24.8% since January 07, 2015, the value of GBX's initial investment in Amsted-Maxion Hortolandia may have fallen, however, the recent decline in Brazil's stock market and general economic contraction might give GBX the opportunity to acquire the additional 40.5% at a discount. Regardless, based on comments from CEO Furman in the company's FQ1 2016 earnings call, GBX plans to exercise its right to purchase the additional 40.5% of Amsted-Maxion Hortolandia, which will likely cost somewhere in the realm of $30-45 million (assuming there has been no meaningful change in Amsted's value since January 2015).

GBX has historically had more international exposure than any of its competitors; international sales as a percentage of total sales averaged 9.6% over the last four years for GBX, which compares to 3.0%, 6.4%, and 8.6% for ARII, RAIL, and TRN, respectively. By continuing to expand its international presence, in Brazil and in countries that are part of the Gulf Cooperative Council (namely Saudi Arabia), GBX has the opportunity to offset declining demand in North America.

Opportunity #2: Funding working capital requirements to quickly shift production lines. GBX plans to focus resources in the second half of FY 2016 on shifting production lines towards railcar types that should see higher demand and it will likely need to draw down on its committed credit facility to fund working capital requirements. Based on responses to analysts' questions in GBX's FQ1 2016 earnings call, the change in production rates towards box cars and automotive racks is already underway. After an initially higher requirement for working capital associated with increasing production for certain product lines, GBX will likely begin to reduce overall production capacity to align itself more closely with expected demand and this should free up cash as inventory and accounts receivable levels begin to decline (Note: In the Base Case DCF model, depicted in section #4, Net Working Capital is expected to increase by $5.0 million in FY 2016 before decreasing by $104.8 million and $20.6 million in FY 2017 and FY 2018, respectively).

Opportunity #3: Potential acquisition of RAIL. This prospect would certainly be a major event in the industry, benefitting both companies over the long-term. RAIL is the smallest railcar manufacturer by both market cap (currently $187.3 million) and sales ($772.9 million in CY 2015), however, its share of industry backlog as of September 30, 2015 (10%) was larger than ARII's (7%) at the same point in time. RAIL manufacturers every type of railcar except for tank cars; its failure to respond to the rise in tank car demand caused its stock price to significantly underperform relative to the other three major manufacturers over the last five years. GBX would benefit most from acquiring RAIL's "Shoals" facility in Alabama, which makes large cube covered hoppers. RAIL historically has specialized in manufacturing coal gondolas, the only type of railcar that GBX does not manufacture; however, it has diversified in recent years, with coal gondolas accounting for only 38% of total deliveries in CY 2015 (down from 57%, 68%, 91%, and 93% in CY 2014, CY 2013, CY 2012, and CY 2011, respectively), a trend its management expects to continue as its backlog was "almost entirely comprised of non-coal cars" at the end of CY 2015). Although the market for coal gondolas is extremely weak, increased replacement demand in the coming years should benefit RAIL.

RAIL is the only railcar manufacturer that has consistently had lower leverage ratios (RAIL had $110.0 million in cash and short-term investments and no debt, if you don't include capitalized operating leases and unfunded postretirement benefits, at the end of CY 2015) and higher operational efficiency ratios than GBX, which adds to its attractiveness as a potential acquisition. Acquiring RAIL would likely be most appealing for GBX at a price under $200.0 million, but GBX would likely need to make equity a significant portion of the offer to appease RAIL's legacy shareholders, who have seen the company's stock price decline by 59.5% from its high in September 2014.

4. GBX is trading at an attractive price from a value-oriented investor's perspective, with the stock currently trading at a 23.0% discount to a conservative 1-year price target of $33.00

While GBX looks like an attractive value-investment at first glance, with its extremely low trading multiples, a closer inspection is needed to determine whether the company is truly undervalued. Conventional wisdom states that the best time to invest in highly cyclical companies (like GBX) is when their P/E ratios are high not low, because cyclical companies often have high trailing P/E ratios towards the end of a contraction cycle (due to depressed earnings) and low trailing P/E ratios towards the end of an expansion cycle (due to "over earning" relative to future earnings potential). Concluding that GBX represents a good value investment at this point in the cycle counters conventional wisdom and requires a substantial amount of supporting evidence.

The subsections below present two different valuation methodologies, a Comparable Companies Analysis and a Discounted Cash Flow (DCF) Analysis. These analyses support the conclusion that GBX is trading at an attractive price from a value-oriented investor's perspective, with a 23.0% upside potential based on a very conservative 1-year price target of $33.00.

4a. Background Information On Comparable Companies Analysis

Three companies were selected to be compared against GBX for the Comparable Companies Analysis: ARII, RAIL, and TRN. As previously mentioned, collectively these four railcar manufacturers currently account for approximately 92% of total industry backlog, and they are the only publicly traded railcar manufacturers based in the United States. All three of the comparable companies have at least two business segments (ARII has three, RAIL has two, and TRN has six) and, on average, they generated 75.3% of their total sales from manufacturing railcars in CY 2015 (ARII generated 78.7% of its total sales from manufacturing railcars, RAIL generated 96.5% of its total sales from manufacturing railcars, and TRN generated 50.6% of its total sales from manufacturing railcars).

4b. Comparable Companies Analysis: Valuation

The Comparable Companies Analysis was done using the following valuation multiples; EV/Sales, EV/EBITDA, EV/EBIT, and P/E. All valuation multiples for each company were calculated based on financial metrics for the Last Twelve Months (CY 2015A) and projected financial metrics for both CY 2016 and CY 2017 (CY 2016E and CY 2017E). All figures used for the 2016E and 2017E financial metrics are analyst consensus estimates as found on a Bloomberg terminal. These valuation multiples are reflected in the following chart:

Click to enlargeData Sources: Bloomberg and SEC Filings For GBX, TRN, ARII, and RAIL

The ranges for each valuation multiple were determined for the comparable companies by defining an approximate multiple range within which each is currently trading. Although the best range for each valuation multiple is open to interpretation, the "Multiple Range(s)" depicted in the chart above were selected so as to be conservative, and incorporated the fact that GBX's EBIT, EBITDA, and Net Margins are all lower than the average respective margins for its three comparable companies.

As one can see in the chart above, the EV/EBIT multiple and implied share price ranges are highlighted by a blue box because they were ultimately the multiples used to determine GBX's Weighted Implied Price and Final Implied Share Price under this valuation methodology (see subsection 4f below). The EV/EBIT valuation multiples were deemed to be the most relevant multiples calculated after reviewing analyst estimates, industry dynamics, and the implied share price ranges presented in the Football Field (see subsection 4f), and because they are a measure of profitability, incorporate differences in capital structure (by using Enterprise Value), and incorporate differences in each railcar manufacturer's ability to use their capital efficiently (Note: Analysts' consensus estimates for the Comparable Companies Analysis were used for objectivity). According to data provided by Bloomberg, GBX's average trailing twelve-month EV/EBIT multiples from FY 1995 to FY 2015, FY 1998 to FY 2002, and from FY 2006 to FY 2010 were 12.2x, 7.2x, and 12.5x, all of which are significantly higher than its current trailing twelve-month EV/EBIT multiple of 2.8x.

4c. Background Information on DCF Analysis and Operating Scenarios Approach

A five-year projection period drives the DCF model used to value GBX. Over the next five years, GBX's financial performance will be driven primarily by the state of the U.S. economy and, to a lesser degree, by the effect of commodity prices on rail transportation. Like other railcar manufacturers, GBX depends on Capex spending from major railroads and other private customers who buy new railcars to expand their fleets, and who take advantage of expected increases in U.S. rail traffic to replace old railcars that need to be taken out of use (Note: According to data from ProgressiveRailroading.com, as of January 01, 2015 30.0% of the railcars in the North American were owned by railroads and the remaining 70.0% were owned by private companies, including TTX Co.).

A top-down analysis focusing on the U.S. railcar manufacturing market was used to derive the sales projections for GBX's Manufacturing segment in the DCF model. There were three main variables in particular that were forecasted and used to derive the manufacturing sales figure for each year of the projection period:

  1. Total annual industry-wide units delivered;
  2. GBX's annual percentage of industry-wide units delivered (i.e. market share); and
  3. GBX's manufacturing sales per unit delivered.

The estimates for total annual industry-wide units delivered, as incorporated into the DCF model, were derived from industry estimates for annual industry-wide deliveries through CY 2019. The industry estimates were depicted in GBX's investor presentations for February 2016, which in turn used estimates taken from FTR Associates' Rail Equipment Outlook report for December 2015. The annual delivery estimates used in the DCF Analysis were made so as to ensure that the final year of the projection period (i.e. CY 2020E) is as close to a mid-point in the railcar delivery cycle as possible for the Base Case operating scenario.

As one can see in the chart below, the final year of the Base Case operating scenario projects that annual industry deliveries will reach 50,000 units, which is almost exactly in the middle of the two long-term averages (for the CY 1987 to CY 2015 and CY 1995 to CY2015 time periods - the exact middle is 50,043 units) and marginally higher than the exact middle between the lowest and highest figures shown on the graph (the highest figure on the chart is 82,335 units, for CY 2015, and the lowest figure is 13,645 units, for 1987 - the exact middle is 47,990 units):

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Historical Data Source: Bloomberg (Sourced from The Railway Supply Institute)

  • Notes: Estimates for annual deliveries were made after taking into account data and information from a variety of sources, and are intended to allow one to value GBX at a mid-point in the railcar manufacturing cycle; they are intended to be more theoretical than precise.

In order to project GBX's Annual Percentage Of Industry-wide Units Delivered (i.e. market share) and Manufacturing Sales Per Unit Delivered, three factors were taken into account: 1) historical data; 2) GBX's competitive position within the industry; and 3) overall industry trends in terms of unit pricing and product mix trends (i.e., which types of railcars would see higher numbers of units ordered and delivered). Industry trends and GBX's competitive position were discussed previously, and historically the company has gained market share during a contraction cycle (see market share figures for CY 2008 - CY 2010 in the picture below). The results of this analysis and the different assumptions for each of the four operating scenarios are depicted below:

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Historical Data Source: SEC Filings For GBX

  • Notes: All historical figures for each calendar year have been calendarized and all projected figures have been converted from Calendar Year figures into Fiscal Year figures for GBX. The figures highlighted in yellow are Base Case estimates for each year of the projection period.

Over the next five years, GBX's company-wide gross and operating margins will be mainly driven by three factors: 1) product/segment mix; 2) pricing/general competition with other railcar manufacturing and leasing companies; and 3) GBX's ability to control costs during the industry downturn.

Product/Segment Mix: Previously in this article it was described what types of railcars are likely to see either higher or lower demand in the near future, and the types of railcars ordered and delivered will certainly impact the Company's margins going forward. Although learning the specific margins GBX generates from each type of railcar is impossible, one can estimate margins of specific railcar types relative to others based on comments from management. In the past, GBX's management team (either in earnings calls or investor presentations) has given the following suggestions regarding historic relative margins and average selling prices (ASPS) for the following types of railcars: tank cars (high margin and high ASP); intermodal cars (low ASP); box cars (high margin and high ASP); automotive racks (high ASP); and small/medium/large covered hoppers (high margins and high ASPs). Although demand for tanks cars and small covered hoppers is certainly going to be weak in a low oil price environment, the negative impact on margins that this will cause should at least be partially offset by rising demand for other relatively high margin railcars such as automotive racks and medium/large covered hoppers; however, going forward competition for new orders in covered hoppers and automotive racks will likely be fierce and this could drive down ASPs for these products. Segment mix will have a significant impact on margins going forward, because the margins generated by each of GBX's three business segments are vastly different. If, for example, GBX's Leasing & Services segment begins to outperform both the Manufacturing and Wheels & Parts segments then that would support company-wide margins by having the company's segment with the highest margins hold up better than the two segments with lower margins.

Pricing/General Competition: Competition for new orders will increase significantly over the next five years, as the four major publicly traded railcar manufacturers have all indicated in their respective earnings calls that they intend to position themselves to manufacture some of the same types of railcars that they believe will see meet rising demand. Increased competition will hurt overall profitability in the industry and put pressure on GBX to differentiate itself by introducing innovative designs. The table below provides a simple breakdown for each of the four publicly traded railcar manufacturers by Average Selling Price Per Unit and Manufacturing Sales Per Unit:

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Data Sources: SEC Filings For GBX, TRN, ARII, and RAIL

  • Notes: The Average Selling Price Per Unit figures were calculated by taking the value (in U.S. dollars) of each company's respective railcar backlog and dividing by the number of units in that backlog. Those figures are "forward looking" and subject to change based on a finalization of product mix and the terms of the contracts with customers. The "Current" Average Selling Price Per Unit figures are for the most recent fiscal quarters for each company and the "Current" Manufacturing Sales Per Unit figures were calculated using sales and delivery figures for the last twelve months. GBX's "Current" Manufacturing Sales Per Unit figure includes the impact of manufacturing sales related to marine barges, and if one excludes the $80.0 million in sales that management has attributed to manufacturing marine barges (over the last four quarters) from the calculation, its Manufacturing Sales Per Unit figure drops from approximately $102,300 down to approximately $98,900.

As shown in the table above, GBX's Average Selling Price Per Unit and Manufacturing Sales Per Unit figures are higher than the same figures for its three closest competitors, but over the last ten years that has not always been the case. GBX has increased these metrics over that period at a significantly higher CAGR than its competitors, which can be attributed to its customers' willingness to pay higher prices (for more innovative, value-adding products) and its focus on increasing market share in product types with relatively higher ASP per unit. Notably, when pricing pressure increases dramatically and units delivered declines sharply in a short period (for example, during a recession), GBX's Manufacturing Sales Per Unit will skyrocket above Average Selling Price Per Unit, because many of its sales contracts include fixed prices per unit -- and the impact of changes in the pricing environment on the Manufacturing Sales Per Unit is delayed (see Appendix Exhibit #4; this factor was taken into account when projecting the Manufacturing Sales Per Unit figures for the Worst Case scenario in the DCF Analysis).

GBX's Ability To Control Costs: GBX's ability to control costs will have a significant impact on its margins over the next five years. GBX will be forced to scale down production capacity (and potentially reduce the size of its workforce), depending on the severity of the ongoing decline in railcar demand. In GBX's FQ1 2016 earnings call, CEO Furman reported that the company has already made adjustments to production capacity for tank cars, but projected no closing of production lines until 2018 because management "would prefer to keep stable workforce and slow production as [it sees] things through this cycle." Failure to keep production capacity in-line with demand would hurt GBX's margins in the short term, and reductions in the size of the workforce would negatively impact GAAP operating margins (but not Adjusted operating margins) due to "one-time" severance costs.

These factors are taken into account in each of the four different operating scenarios used in the DCF Analysis. These scenarios, including descriptions of the different projections for market share (as a percentage of total industry deliveries) and Manufacturing Sales Per Unit, are presented below:

  1. Base Case: Railcar deliveries and pricing are projected to decline towards a mid-point in the cycle for the railcar manufacturing industry, with the final year of the projection period being the assumed mid-point in the cycle. The nearly five year period of the decline is longer than all historical contraction phases of cycles in the railcar manufacturing industry (as noted, the contraction phase of a cycle in the industry has, on average, historically lasted for 13 or 14 quarters as measured by declines in backlog). However, a significantly protracted decline is used to effectively value GBX at a midpoint in the cycle. The mid-point in the cycle represented in the Base Case scenario is assumed to be the most accurate approximation of a mid-point in the cycle, and the Bull Case and Bear Case adjust the assumed midpoint either higher or lower (in terms of projections for total units delivered by the industry) by moderate amounts. The Base Case scenario assumes that GBX will be able to acquire additional market share in CY 2016 (up to 33.0% from 29.2% in CY 2015) and then maintain most of those gains throughout the remainder of the five year projection period (with market share falling to 32.0% in CY 2020 from 33.0% in CY 2016). The large market share gain from CY 2015 to CY 2016 is expected to be driven by GBX's commitment to a more aggressive schedule for working through its backlog than its peers; the company's current guidance indicates that it will deliver approximately 20,000 to 22,500 units in FY 2016 and the Base Case DCF model includes the assumption that the company will deliver 20,100 units in CY 2016 (compared to 21,100 units delivered in FY 2015 and an estimated 24,067 units that were delivered in CY 2015). While the number of units that GBX is expected to deliver in CY 2016 is projected to decline by 16.5% year-over-year in the Base Case, guidance from GBX's competitors indicates that they are going reduce deliveries in CY 2016 by significantly larger year-over-year percentages than GBX; TRN's guidance for 27,000 units delivered in CY 2016 is down 21.3% year-over-year from 34,295 units delivered in CY 2015, ARII reported in its Q4 2015 earnings call that deliveries were maintained their current trend they would be down "25% to 30%" year-over-year in CY 2016, and RAIL's guidance for "between 6,000 and 7,000" units delivered in CY 2016 indicates that deliveries are going to fall between 22.0% and 33.2% year-over-year. In CY 2017, GBX's market share is projected to decline to 29.5%, driven by expected reductions in production capacity and a more moderate backlog burn rate, and from there it is projected to rise each year until it reaches 32.0% in CY 2020 (a relatively conservative assumption given GBX's historical ability to increase market share during the past contractions). Manufacturing sales per unit delivered is expected to increase from approximately $103,200 in CY 2015 to $109,000 in CY 2016 before declining each year to reach $92,000 in CY 2020, driven by a deteriorating pricing environment and a progressively unfavorable product mix.
  2. Bull Case: Railcar deliveries and pricing are projected to decline towards a mid-point in the cycle for the industry that is slightly above the assumed mid-point in the Base Case scenario. The Bull Case scenario assumes that GBX acquires additional market share in CY 2016 (up to 34.0% from 29.2% in CY 2015) and is able to keep its market share at a slightly higher level throughout the remainder of the five year projection period than the market share figure for the Base Case scenario (reaching 33.0% in CY 2020 vs. 32.0% in CY 2020 for the Base Case scenario). Manufacturing sales per unit delivered is expected to increase from approximately $103,200 in CY 2015 to $110,000 in CY 2016, before declining each year to reach $94,000 in CY 2020, which is expected to be driven by a deteriorating pricing environment and a progressively unfavorable product mix. Manufacturing sales per unit in the Bull Case are projected to be roughly $2,000 higher than the projected figures for the Base Case in each year.
  3. Bear Case: Railcar deliveries and pricing are projected to decline towards a mid-point in the cycle for the railcar manufacturing industry moderately below the assumed mid-point in the Base Case. This scenario assumes that GBX will acquire additional market share in CY 2016 (up to 32.5% from 29.2% in CY 2015), but lose most of that gained share over the remainder of the five year projection period (falling to 30.5% in CY 2020). Market share in CY 2020 is still assumed to be higher than historical levels, which is consistent with the Base and Bull Case scenarios, but it is projected to be 1.5% less than the projected market share figure in the Base Case for CY 2020. Manufacturing sales per unit delivered is expected to increase from approximately $103,200 in CY 2015 to $107,000 in CY 2016 before declining each year to reach $90,000 in CY 2020, which is expected to be driven by a deteriorating pricing environment and a progressively unfavorable product mix. Manufacturing sales per unit in the Bear Case are projected to be roughly $2,000 lower than the Base Case in each year.
  4. Worst Case: This scenario assumes that the U.S. enters a recession, causing demand for new railcars to decline substantially, while the pricing environment worsens considerably. This scenario assumes that GBX will acquire market share in CY 2016 (up to 32.0% from 29.2% in FY 2015), which then erodes until it reaching 29.5% in CY 2020. Manufacturing sales per unit delivered is expected to rise from approximately $103,200 in CY 2015 to $104,000 in CY 2016 before bottoming at $100,000 in CY 2017 and beginning to rise thereafter to reach $130,000 in CY 2020. Manufacturing sales per unit in the Worst Case are projected to rise above the manufacturing sales per unit figures in the Base, Bull, and Bear Cases in CY 2018 due to the delay in changes in pricing vs. units delivered phenomenon (described previously) that is depicted in Appendix Exhibit #4.

4d. Conclusions For The DCF Analysis By Operating Scenario

A summary of the DCF analysis for GBX under each operating scenario is as follows:

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  • Note: The Implied Share Prices were calculated using the Perpetuity Growth Method to calculate Terminal Value.

The summary above lists important CAGRs, a few other key variables, and Implied Share Prices for each of the four operating scenarios that were performed for the DCF Analysis.

The subsections below provide results of the DCF models under each of the operating scenarios as well as descriptions of key assumptions used to project sales and margins over the five-year projection period. Appendix Exhibits #5-7 present the full sets of assumptions for GBX's Income Statement, Cash Flow Statement, and Balance Sheet used in each operating scenario for the DCF Analysis, while Appendix Exhibit #8 depicts quarterly Base Case estimates for all of GBX's most important financials through the end of FY 2017.

Operating Scenario 1: Base Case

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Historical Data Sources: SEC Filings For GBX and Bloomberg

Sales: Total sales are projected to increase 6.4% (y/y) in FY 2016 to $2,771.6 million, which is lower than guidance (for total sales "exceeding $2.8 billion") provided by GBX's management team and higher than consensus estimates of $2,756.0 million, before declining at a compound annual rate of 9.6% from FY 2016 to FY 2020. Sales for the Manufacturing segment are expected to increase 8.5% (y/y) in FY 2016 before declining at a compound annual rate of 10.7% from FY 2016 to FY 2020. The main driver behind sales for the Manufacturing segment is railcar deliveries, which are expected to hit an all-time annual high of 22,400 in FY 2016 (20,100 in CY 2016) before falling to 18,400 in FY 2017 (15,635 in CY 2017) then bottoming in CY 2018 at 15,600 and rising each year thereafter through CY 2020 (hitting 16,000 in CY 2020). Sales for the Wheels & Parts segment are expected to decline 6.5% (y/y) in FY 2016 before declining at a compound annual rate of 3.9% from FY 2016 to FY 2020. The main driver behind sales for the Wheels & Parts segment is U.S. rail traffic, which is currently down 6.2% (y/y) YTD and is projected to decline at a smaller compound annual rate through FY 2020 than sales for the Wheels & Parts segment (very conservative assumptions were used when projecting sales growth rates for the Wheels & Parts segment because the segment has performed very poorly in recent years). Sales for the Leasing & Services segment are expected to increase 8.8% (y/y) in FY 2016 before declining at a compound annual rate of 6.9% from FY 2016 to FY 2020. The main drivers behind sales for the Leasing & Services segment are the number of railcars on lease and average lease rates, and while GBX's number of railcars on lease is projected to increase in FY 2016, the number is expected to fall along with lease rates thereafter.

Margins: Company-wide adjusted gross margin is expected to increase from 20.6% in FY 2015 to 21.0% in FY 2016, which would be a slight decline from 21.8% for the last twelve months, and then to decline by an average of 130 basis points per year for the next four years to reach 16.0% in FY 2020. Company-wide adjusted operating margin is expected to decrease slightly from 15.2% in FY 2015 to 15.1% in FY 2016, which would be a significant decline from 16.8% for the last twelve months, and it is then projected to decline by an average of 150 basis points per year to reach 9.0% in FY 2020. These projections assume that GBX's manufacturing segment will be faced with a substantial amount of pricing pressure and an unfavorable product mix through FY 2020, which will cause the segment's adjusted gross and operating margins to decline from 22.3% and 20.3%, respectively, in the last twelve months to 15.8% and 12.1%, respectively, in FY 2020. Adjusted gross and operating margins for the Wheels & Parts and Leasing & Services segments are also projected to contract through FY 2020, with gross margins for the Wheels & Parts and Leasing & Services segments falling from 9.0% and 58.4%, respectively, in the last twelve months to 7.0% and 52.5%, respectively in FY 2020 and operating margins falling from 6.3% and 43.2%, respectively in the last twelve months to 4.1% and 37.5%, respectively, in FY 2020. Adjusted corporate operating expenses are projected to rise slightly from 2.8% of total sales in the last twelve months to 2.9% of total sales in FY 2020, which assumes that GBX's management team will refrain from significantly reducing the size of its workforce throughout the industry downturn in order to prepare the company for the start of the next expansion cycle.

Operating Scenario 2: Bull Case

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Historical Data Sources: SEC Filings For GBX and Bloomberg

Sales: Total sales are projected to increase 11.7% (y/y) in FY 2016 to $2,910.5 million, which is substantially above guidance provided by GBX's management team and consensus estimates of $2,756.0 million, before declining at a compound annual rate of 8.3% from FY 2016 to FY 2020. Sales for the Manufacturing segment are expected to increase 14.6% (y/y) in FY 2016 before declining at a compound annual rate of 9.0% from FY 2016 to FY 2020. The main driver behind sales for the Manufacturing segment is railcar deliveries, which are expected to hit an all-time annual high of 22,100 in CY 2016 before falling to 17,385 in CY 2017 then bottoming in CY 2018 at 17,360 and rising each year thereafter through CY 2020 (hitting 17,820 in CY 2020). Sales for the Wheels & Parts segment are expected to decline 4.5% (y/y) in FY 2016 before declining at a compound annual rate of 4.4% from FY 2016 to FY 2020. The main driver behind sales for the Wheels & Parts segment is U.S. rail traffic, which is projected to decline at a smaller compound annual rate through FY 2020 than sales for the Wheels & Parts segment (very conservative assumptions were used when projecting sales growth rates for the segment to account for its recent poor performance). Sales for the Leasing & Services segment are expected to increase 10.0% (y/y) in FY 2016 before declining at a compound annual rate of 5.9% from FY 2016 to FY 2020. The main drivers behind sales for the Leasing & Services segment are the number of railcars on lease and average lease rates, and while GBX's number of railcars on lease is projected to increase in FY 2016 the number is expected to fall along with lease rates thereafter.

Margins: Company-wide adjusted gross margin is expected to increase from 20.6% in FY 2015 to 21.8% in FY 2016, which would be in-line with 21.8% for the last twelve months, and it is then projected to decline by an average of 120 basis points per year for the next four years to reach 17.0% in FY 2020. Company-wide adjusted operating margin is expected to increase from 15.2% in FY 2015 to 16.5% in FY 2016, which would be a slight decrease from 16.8% for the last twelve months, and it is then projected to decline by an average of 160 basis points per year to reach 10.0% in FY 2020. These projections assume that GBX's manufacturing segment will be faced with a substantial amount of pricing pressure and an unfavorable product mix through FY 2020, which will cause the segment's adjusted gross and operating margins to decline from 22.3% and 20.3%, respectively, in the last twelve months to 16.7% and 13.0%, respectively, in FY 2020. Adjusted gross and operating margins for the Wheels & Parts and Leasing & Services segments are also projected to contract through FY 2020, with gross margins for the Wheels & Parts and Leasing & Services segments falling from 9.0% and 58.4%, respectively, in the last twelve months to 8.0% and 53.5%, respectively in FY 2020 and operating margins falling from 6.3% and 43.2%, respectively in the last twelve months to 5.1% and 38.5%, respectively, in FY 2020. Adjusted corporate operating expenses are projected to rise slightly from 2.8% of total sales in the last twelve months to 2.9% of total sales in FY 2020, which assumes that GBX's management team will refrain from significantly reducing the size of its workforce throughout the industry downturn in order to prepare the company for the start of the next expansion cycle.

Operating Scenario 3: Bear Case

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Historical Data Sources: SEC Filings For GBX and Bloomberg

Sales: Total sales are projected to decrease 2.1% (y/y) in FY 2016 to $2,550.7 million, which is below guidance provided by GBX's management team and consensus estimates of $2,756.0 million, before declining at a compound annual rate of 10.9% from FY 2016 to FY 2020. This scenario assumes that management will decide to deliver significantly fewer units this year that it initially expected to, which also assumes that the order environment will remain extremely weak throughout the remainder of CY 2016. Sales for the Manufacturing segment are expected to decrease 1.6% (y/y) in FY 2016 before declining at a compound annual rate of 12.4% from FY 2016 to FY 2020. The main driver behind sales for the Manufacturing segment is railcar deliveries, which are expected to be 17,875 in CY 2016 before falling to 13,965 in CY 2017, then falling to 13,630 in CY 2018, then bottoming in CY 2019 at 13,570, and then rising in CY 2020 to 13,725. Sales for the Wheels & Parts segment are expected to decline 7.0% (y/y) in FY 2016 before declining at a compound annual rate of 5.0% from FY 2016 to FY 2020. The main driver behind sales for the Wheels & Parts segment is U.S. rail traffic, which is projected to decline at a smaller compound annual rate through FY 2020 than sales for the Wheels & Parts segment (very conservative assumptions were used when projecting sales growth rates for the segment to account for its recent poor performance). Sales for the Leasing & Services segment are expected to increase 5.0% (y/y) in FY 2016 before declining at a compound annual rate of 5.0% from FY 2016 to FY 2020. The main drivers behind sales for the Leasing & Services segment are the number of railcars on lease and average lease rates, and while GBX's number of railcars on lease is projected to increase in FY 2016 the number is expected to fall along with lease rates thereafter.

Margins: Company-wide adjusted gross margin is expected to increase from 20.6% in FY 2015 to 20.8% in FY 2016, which would be a significant decrease from 21.8% for the last twelve months, and it is then projected to decline by an average of 160 basis points per year for the next four years to reach 14.5% in FY 2020. Company-wide adjusted operating margin is expected to decrease from 15.2% in FY 2015 to 14.9% in FY 2016, which would be a significant decrease from 16.8% for the last twelve months, and it is then projected to decline by an average of 190 basis points per year to reach 7.5% in FY 2020. These projections assume that GBX's manufacturing segment will be faced with a substantial amount of pricing pressure and an unfavorable product mix through FY 2020, which will cause the segment's adjusted gross and operating margins to decline from 22.3% and 20.3%, respectively, in the last twelve months to 13.8% and 10.3%, respectively, in FY 2020. Adjusted gross and operating margins for the Wheels & Parts and Leasing & Services segments are also projected to contract through FY 2020, with gross margins for the Wheels & Parts and Leasing & Services segments falling from 9.0% and 58.4%, respectively, in the last twelve months to 6.5% and 51.0%, respectively in FY 2020 and operating margins falling from 6.3% and 43.2%, respectively in the last twelve months to 3.6% and 36.0%, respectively, in FY 2020. Adjusted corporate operating expenses are projected to rise slightly from 2.8% of total sales in the last twelve months to 3.0% of total sales in FY 2020, which assumes that GBX's management team will be unable to effectively control corporate overhead costs throughout the industry downturn.

Operating Scenario 4: Worst Case

Click to enlargeHistorical Data Sources: SEC Filings For GBX and Bloomberg

Sales: In this scenario, total sales are projected to decline by 61.1% from FY 2015 to FY 2020, which is a significantly larger percentage decline than the 41.4% decline in total sales that GBX experienced from FY 2008 to FY 2010 but also takes into account the fact that total sales will be declining from an all-time high (in FY 2015) that was 101.9% higher than the company's level of total sales in FY 2008. Total sales are projected to decrease 7.1% (y/y) in FY 2016 to $2,419.8 million, which is significantly below guidance provided by GBX's management team and consensus estimates of $2,756.0 million, before declining at a compound annual rate of 19.6% from FY 2016 to FY 2020. The only way for GBX's sales to fall so significantly below management's guidance for sales to "exceed $2.8 billion" in FY 2016 would be for the U.S. economy to significantly and immediately worsen and for management to substantially scale back on the number of units that it intends to manufacture and ship this Fiscal Year, and this is what is expected in the Worst Case scenario. Along those lines, sales for the Manufacturing segment are expected to decrease 7.2% (y/y) in FY 2016 before declining at a compound annual rate of 24.0% from FY 2016 to FY 2020. The main driver behind sales for the Manufacturing segment is railcar deliveries, which are expected to reach 16,640 in CY 2016 before falling each year thereafter through CY 2020 (hitting 5,015 in CY 2020). Sales for the Wheels & Parts segment are expected to decline 8.0% (y/y) in FY 2016 before decreasing at a compound annual rate of 5.4% from FY 2016 to FY 2020. The main driver behind sales for the Wheels & Parts segment is U.S. rail traffic, which is projected to decline at a smaller compound annual rate through FY 2020 than sales for the Wheels & Parts segment (very conservative assumptions were used when projecting sales growth rates for this segment to account for its recent poor performance). Sales for the Leasing & Services segment are expected to decrease 1.0% (y/y) in FY 2016 before declining at a compound annual rate of 5.5% from FY 2016 to FY 2020. The main drivers behind sales for the Leasing & Services segment are the number of railcars on lease and average lease rates, and GBX's number of railcars on lease is projected to decrease along with lease rates in FY 2016 and thereafter.

Margins: In this operating scenario, company-wide adjusted gross and operating margins are projected to decline to reach 9.4% and 3.3%, respectively, in FY 2020, which are the same levels that they were at in FY 2009. Company-wide adjusted gross margin is expected to decrease from 20.6% in FY 2015 to 19.0% in FY 2016, which would be a significant decrease from 21.8% for the last twelve months, and it is then projected to decline by an average of 240 basis points per year for the next four years to reach 9.4% in FY 2020. Company-wide adjusted operating margin is expected to decrease from 15.2% in FY 2015 to 12.5% in FY 2016, which would be a significant decrease from 16.8% for the last twelve months, and it is then projected to decline by an average of 230 basis points per year to reach 3.3% in FY 2020. These projections assume that GBX's manufacturing segment will be faced with a substantial amount of pricing pressure and an unfavorable product mix through FY 2020, which will cause the segment's adjusted gross and operating margins to decline from 22.3% and 20.3%, respectively, in the last twelve months to 7.1% and 4.4%, respectively, in FY 2020. Adjusted gross and operating margins for the Wheels & Parts and Leasing & Services segments are also projected to contract significantly through FY 2020, with gross margins for the Wheels & Parts and Leasing & Services segments falling from 9.0% and 58.4%, respectively, in the last twelve months to 5.0% and 45.0%, respectively in FY 2020 and operating margins falling from 6.3% and 43.2%, respectively in the last twelve months to 1.8% and 29.0%, respectively, in FY 2020. Adjusted corporate operating expenses are projected to fall from 2.8% of total sales in the last twelve months to 2.2% of total sales in FY 2020, which assumes that GBX's management team will cut corporate overhead costs as the U.S. economy goes into a recession (just as it did from FY 2007 to FY 2009).

4e. Other Key Variables

The following key variables underlie the DCF analysis, and apply to the company as a whole and not to individual business segments.

WACC: GBX's WACC was calculated using 5.66% as the company's pre-tax Cost of Debt. The pre-tax Cost of Debt figure is the "BofA Merrill Lynch US Corporate BB Effective Yield" as of April 1, 2016, which is consistent with GBX's BB- LT Local Issuer Credit rating from S&P and BBB LC Senior Unsecured rating from Egan-Jones Ratings Company (credit ratings were found on a Bloomberg Terminal and are as of April 1, 2016). Cost of Equity was calculated using the basic CAPM formula, as described below:

  • Cost of Equity = Rf +BL x (Rm - Rf) + Sp
  • Rf = Risk-free Rate = 2.20%. This is the Daily Treasury Yield Curve Rate on a 20-year Treasury as of April 1, 2016.
  • BL = Levered Beta = 2.32. This is a 15-year monthly beta that was calculated manually using price data from Yahoo Finance from March 01, 2001 to March 01, 2016.
  • (Rm - Rf) = Market Risk Premium = 5.15%. This is the Implied Equity Risk Premium (ERP) as of April 1, 2015, as calculated by Professor Damodaran at the Stern School of Business at New York University.
  • SP = Size Premium = 0.50%. The concept of a Size Premium is discussed in Joshua Rosenbaum and Joshua Pearl's book entitled "Investment Banking: Valuation, Leveraged Buyouts, and Mergers & Acquisitions." On page 157 of the second edition of the book it says "the concept of size premium is based on empirical evidence suggesting that smaller-sized companies are riskier and, therefore, should have a higher cost of equity." A size premium of 0.50% was chosen because it was large enough to make a difference on the WACC calculations, but not so large as to significantly increase GBX's already high Cost of Equity (without the Size Premium, Cost of Equity = 14.2% and WACC = 10.1%).

To obtain a conservative WACC calculation, I assumed that GBX was already at its "target capital structure," although it is reasonable to expect that the company will likely reduce its debt burden in the coming years when decreasing production capacity frees up cash that can be used to retire debt (as seen in Appendix Exhibit #8, total debt is projected to decline from $488.6 million in FQ1 2016 to $370.5 million in FQ4 2016 and reach $238.9 million in FQ4 2017). In the short term, given the company's high cost of equity and current capital structure, if GBX were to reduce its amount of total debt outstanding it would actually increase its WACC, given that equity would then be a larger portion of the capital structure.

A full breakdown of all of these calculations is depicted below:

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4f. Football Field & Final Implied Share Price

The "Football Field" chart below shows different ranges for GBX's implied share price using both Comparable Companies Analysis, with ranges for every valuation multiple included, and DCF Analysis, with ranges for every operating scenario included:

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  • Note: The blue line denotes GBX's stock price as of its close on April 1, 2016 and the green line denotes a price target of $33.00/share.

The conservative nature of my 1-year price target of $33.00 is clearly depicted in the Football Field, because most of the valuation ranges for the Comparable Companies Analysis and the valuation range for the Base Case of my DCF Analysis are significantly higher than my price target.

As previously mentioned, the EV/EBIT valuation multiples were deemed to be the most relevant multiples to use when determining GBX's Weighted Implied Share Price using Comparable Companies Analysis and its Final Implied Share Price. The calculation of GBX's Weighted Implied Share Price using Comparable Companies Analysis can be seen below:

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  • Note: The "Implied Prices" used for each Method are the median implied prices from the share price ranges shown in the Football Field.

As one can see in the picture above, GBX's Weighted Implied Share Price derived from the Comparable Companies Analysis is $35.70. A 33.3% weighting was assigned to each Method in order to equally weight the results at using three different ranges of time (CY 2015, CY 2016E, and CY 2017E).

The chart below depicts the Weighted Implied Share Price derived from the DCF Analysis:

  • Note: The "Implied Prices" used for each Operating Scenario are the median implied prices from the share price ranges shown in the Football Field.

As one can see in the picture above, GBX's Weighted Implied Share Price derived from the DCF Analysis is $32.62. Probabilities were assigned to each Operating Scenario, with the Base Case being assigned a 50.0% Probability, the Bull Case and Bear Case being assigned 15.0% Probabilities, respectively, and the Worst Case being assigned a 20.0% probability. The 20.0% Probability assigned to the Worst Case scenario, which assumes that a major recession takes place in the U.S., was chosen after carefully reviewing data from a variety of sources and taking into account estimates made by major banks. It is worth noting that the Worst Case is the only Operating Scenario that attempts to project the impact that a major macroeconomic event would have on GBX's financials. In contrast, the Base Case, Bull Case, and Bear Case all are more "theoretical" in nature and incorporate projections that were intended to be used to value the company at a mid-point in its business cycle (i.e. the financial projections for those three Cases are not designed to be exact estimates for GBX's financials over the next five years, but instead they are designed to give a conservative estimate of company's value at a mid-point in its business cycle). An important thing to note about the Weighted Implied Share Price derived from the DCF Analysis is that the Worst Case scenario was included so as to be extremely conservative when deriving a Final Implied Share Price (see below), because if the Worst Case was excluded from the calculations (i.e. the Probability was decreased to 0.0%) and the Probabilities for the Bull Case and Bear Case were each increased to 25.0%, respectively, then the Weighted Implied Share Price derived from the DCF Analysis would be $38.35.

The chart below depicts the Final Implied Share Price calculated by assigning a weighting to the Weighted Implied Share Prices from the DCF Analysis and the Comparable Companies Analysis:

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A weighting of 85.0% was assigned to the DCF Analysis because it is believed to be the most accurate valuation methodology, and weighting of 15.0% was assigned to the Comparable Companies Analysis because it serves as a good baseline upon which the results of the DCF Analysis could be compared. One of the main reasons why the Weighted Implied Price from the Comparable Companies Analysis was significantly higher than the Weighted Implied Price from the DCF Analysis is that I used very conservative projections in my DCF models (particularly by incorporating the Worst Case scenario into my Weighted Implied Price for my DCF Analysis).

As one can see in the picture above, GBX's Final Implied Share Price is $33.08, which indicates that GBX is currently trading at a 23.3% discount to its implied price. The Final Implied Share Price was used to support my 1-year Upside Price Target of $33.00/share, and the Weighted Implied Share Price derived from the Bear Case scenario of the DCF Analysis was used to support my 1-year Downside Price Target of $21.00, both of which can be seen below:

  • Note: My Upside and Downside price targets were rounded to the nearest $0.25.

Timing:

GBX will be releasing its FQ2 2016 financial results pre-market on Tuesday, April 5 th, and the results should have a significant impact on its price; according to data provided by Bloomberg the average absolute percent change in GBX's price the day after releasing earnings each of the past eight quarters is 5.84%, and the implied one day move after the FQ2 2016 earnings report is 7.80% (implied price change is estimated from option volatilities).

As one can see in Appendix Exhibit #8, I have provided a full set of projections for FQ2 2016 - FQ4 2017. The tables below present how my estimates compare to analysts' consensus estimates over that period of time:

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Data Source: Analysts' Consensus Estimates From Bloomberg

  • Note: Any apparent inaccuracies in the variances are due to rounding.

The tables above show that while my estimates are more bullish than consensus estimates over the longer-term, my projections for FQ2 2016 are actually below consensus - principally because my total sales estimate of $709.8 million is $16.4 million below consensus. This conclusion derives from factoring in management's guidance (from its FQ1 2016 earnings call) for deliveries in FQ2 2016; management guided deliveries of 20,000 - 22,500 units in FY 2016, with 55% of deliveries taking place in the first half of the year, indicating that GBX should deliver approximately 11,000 - 12,375 units in H1 2016 and 9,000 - 10,125 units in H2 2016. Given that 6,900 units were delivered in FQ1 2016, according to management's guidance, GBX would deliver 4,100 - 5,475 units in FQ2 2016, and I projected that it would deliver 5,400 units in the quarter.

With my projection for Manufacturing Sales Per Unit Delivered being $109,000 in FQ2 2016, which is high relative to historical figures (I assume a large number of tank cars in GBX's backlog will be delivered in FQ2 2016), I derived a projection of $588.6 million in total sales for GBX's Manufacturing segment. I used fairly optimistic estimates for sales for GBX's Wheels & Parts and Leasing & Services segments ($94.5 million in sales for the Wheels & Parts segment and $26.7 million in sales for the Leasing & Services segment), ultimately deriving a total sales projection for FQ2 2016 that was below consensus. I concluded that the most likely outcome for FQ2 2016 is that GBX misses analysts' consensus sales estimate and EPS estimates; however, I expect Diluted EPS to be ahead of my projections if margins end up being even slightly stronger than I expect them to be.

Given that GBX currently has a potential return/risk ratio of approximately 1.1 to 1 with my very conservative 1-year price target of $33.00, and given that I project GBX's financial results to come in either in-line or below consensus estimates for FQ2 2016, investors may want to take a conservative approach and await the release of the FQ2 2016 earnings report. A more ideal entry price range to maximize GBX's conservative potential return/risk ratio is $24.00 - $26.00, because in that range GBX would have a potential return/risk ratio of between 1.4 to 1 and 3.0 to 1. Given how conservative my 1-year upside price target is intended to be, investors willing to accept a higher degree of risk could consider an entry at GBX's current price.

Risks:

This section highlights the most significant company-specific risks currently facing GBX, with counterpoints provided where appropriate.

Risk due the poor timing of major capital structure decisions:

  • GBX has a history of making poor capital structure decisions when facing unfavorable macroeconomic conditions, hurting legacy shareholders. This could occur again in the future if similar economic conditions present themselves.
  • For example, in 2009 GBX decided to recapitalize under unfavorable terms with WL Ross & Co., LLC. This situation was described in GBX's 10-K filing for FY 2009 as follows: "on June 10, 2009, the Company entered into a transaction with affiliates of WL Ross & Co., LLC (WL Ross) which [provided] a $75.0 million secured term loan with the potential to increase the loan to $150.0 million. In connection with the loan, on June 10, 2009, the Company also entered into a warrant agreement pursuant to which the Company issued warrants to WL Ross and its affiliates to purchase 3,377,903 shares of the Company's Common Stock with an initial exercise price of $6.00 per share" (GBX 10-K Filing For FY 2009). The warrants had a five-year term and the loan "contain[ed] no financial ratio covenants and [had] a variable interest rate of LIBOR plus 3.5%" (GBX 10-K Filing For FY 2009), with the principal of the loan being due on June 10, 2012.
    • According to GBX's 10-Q filing for FQ3 2009, the company had 17,094,234 shares outstanding as of June 26, 2009 (and roughly the same amount as of May 31, 2009), which means that when the warrants were exercised they would have increased the company's total number of shares outstanding by approximately 19.8% (based on the number of shares outstanding at approximately the same date as when the deal was entered into). The "initial exercise price of $6.00 per share" was extremely advantageous for WL Ross & Co., LLC but very detrimental for existing shareholders, because (according to price data supplied by Tradestation.com) GBX's price closed at $7.97 on June 10, 2009, which indicates that the warrants gave WL Ross & Co., LLC the ability to purchase shares of GBX at roughly a 25% discount to its share price when the deal was entered into.
    • Such a deal was by no means uncommon at that time, given that many companies were starving for cash and faced extremely unfavorable terms from those willing to lend them money. The disconcerting part of this deal with WL Ross & Co., LLC was that GBX could have probably survived the cash crisis without it and, as a result, the outcome from the deal was that the company destroyed value for legacy shareholders.
    • In the end, it is impossible to put oneself in the position of GBX's management team and to know what difficult decisions they were faced with in the first half of 2009, especially given the fact that U.S. economy was contracting and the company had already reduced its number of full-time employees by 1.5% (y/y) in FY 2008 (and it would later reduce that number by an additional 11.5% year-over-year by the end of FY 2009). However, in retrospect, GBX's deal with WL Ross & Co., LLC was certainly very dilutive to legacy shareholders, and it also appears to have been the first in a series of dilutive actions that ultimately caused the company's number of shares outstanding to rise from 17,094,234 (as of June 26, 2009) to 28,596,821 (as of December 31, 2015).
      • Note: Wilbur L. Ross, Jr., founder, chairman and chief executive officer at WL Ross was made a director of GBX as a result of this deal.
  • Counter Point: GBX's management team did what it believed was necessary to ensure the company's survival and unless the U.S. goes into another recession, it is unlikely that management will enter into similarly unfavorable contracts going forward.

Risks due to poorly timed share repurchases:

  • As one can see in the picture below, from FQ1 2014 to FQ1 2016 the aggregate amount of share repurchases has been at least $50.0 million, with a range from $50.0 million in FQ1 2014 to $225.0 million in FQ1 2016; the company has repurchased shares for prices ranging from as low as $30.47 to as high as $73.07. As a result, GBX has not timed its share repurchases well over the last two years and it repurchased shares when its stock price was at or near all-time highs. Poorly timed share repurchases are a risk given that they indicate that management might not be able to gauge what point in the current business cycle the company is at.

Data Source: SEC Filings For GBX

  • Notes: In October 2013 (i.e. the second month of FQ1 2014), GBX's board of directors authorized a share repurchase program, and prior to that point debt covenants had limited the company's ability to repurchase shares.
  • Counter Point: Poorly timed share repurchases are a common phenomenon, and timing is particularly difficult for highly cyclical companies like GBX. The fact that GBX is repurchasing shares, and steadily increasing the aggregate size of its share repurchase programs, indicates that it is shareholder friendly and focused on returning money to shareholders (GBX also has a solid dividend that it recently increased and currently provides an annualized yield of 2.98%). As one can see in the chart above, I projected that GBX would repurchase $20.0 million worth of shares (equal to 745,434 shares at GBX's closing price on April 1, 2016) every quarter through FQ4 2017, which is larger than the average quarterly amount it has spent on share repurchases in both the last four and eight quarters but is also consistent with the projection that the amount of Free Cash Flow generated by the company will increase going forward. To come up with this projection, it is assumed that an additional $50.0 million will be added to the share repurchase program in FQ2 2017.

Risks due to customer and supplier concentration:

  • Like many manufacturers, GBX typically has a few large customers that collectively account for a large portion of its total sales, and a few large suppliers that collectively account for a large portion of its total inventory purchases. The chart below provides data on GBX's customer concentration from FY 2006 to FY 2015 and supplier concentration from FY 2012 to FY 2015 (Note: Prior to FY 2012, GBX did not report supplier concentration data):

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Data Source: 10-K Filings For GBX

  • High customer concentration can be a risk because it can give those customers too much bargaining power, which would hurt GBX's margins. High supplier concentration is a similar risk. While these risks are certainly not unique to GBX, they would become even more pertinent in the event of a U.S, recession.
  • Counter Point: GBX typically has good relationships with both its customers and its suppliers, and over time the company has continued to diversify its customer and supplier base. In general, railcar manufacturers do not appear to suffer from a high degree of customer bargaining power, likely due to the fact that the railcar manufacturing industry is very concentrated (with only four major players). GBX has been able to increase its Average Selling Price Per Unit and Manufacturing Sales Per Unit Delivered figures at CAGRs of 4.0% and 3.1%, respectively, from FY 1994 to FY 2015, which indicates that the company might actually have some degree of pricing power (although inflation and changes to railcar type might explain a large part of those increases). Historically GBX also has done a good job of diversifying its supplier base, and (if anything) supplier bargaining power has likely weakened in recent years as steel prices have fallen.

Risks due to backlog cancellations:

  • After having compiled and analyzed data on GBX's backlog for each quarter and year from FY 1997 to FY 2015, my research has shown that in at least five quarters GBX has had more units cancelled from its backlog than new units ordered during the same period. This is based on "net new orders," which can be calculated for a specific period (i.e. a quarter or a year) by taking the number of units in GBX's backlog at the end of the current period then subtracting the number of units in the backlog at the end of the last period, and adding the number of units delivered between the two periods. If in any given quarter or year net new orders were negative, the number of units cancelled from its backlog was higher than the number of new units ordered during the same period. I calculate that the number of "net new orders" has been negative during five quarters in GBX's entire history of being a publicly traded company (FQ1 2002, FQ1 2006, FQ2 2008, FQ3 2009, and FQ1 2010):

Click to enlargeData Sources: SEC Filings For GBX

  • Order cancellations are a major risk for GBX; unlike TRN's backlog, GBX's backlog is not reported as being comprised of "non-cancellable" orders. Significant order cancellations would certainly have an adverse impact on GBX's financials and, as a result, on its stock price.
  • Counter Point: It is extremely difficult for one of GBX's customers to cancel an order. Historically order cancellations only appear to have taken place during a period of significant economic turmoil. For example, in 2009 General Electric Railcar Services Corporation (NYSE:GE) attempted to cancel an order with GBX for 11,900 railcars (worth $1.2 billion). GBX got Congress to intervene on its behalf to block the order cancellation. Although GE was ultimately able to modify the terms of the contract so as to only receive 6,000 railcars (leading to the negative "net new order" figure in FQ1 2010), it also had to pay penalties to cover some of GBX's costs related to building a new manufacturing facility. GBX's management team has been quick to point out that the company has not yet had any order cancellations and none are expected. However, the terms of some of the contracts with its customers have been changed in ways that caused either the product mix or delivery schedule (or both) to change. Order cancellations are extremely rare and they would likely only happen in the worst possible future scenario for the entire industry, and the U.S. economy.

Risks due to backlog burn rate:

  • Based on GBX's guidance for deliveries for FY 2015 (20,000 to 22,500 units) the company will begin to burn through its backlog at an extremely fast rate unless orders begin to pick up. There is a risk that management will remain too optimistic about the industry's outlook for too long and refrain from cutting production capacity (i.e. reducing deliveries), which would cause GBX to burn through its backlog at an unsustainable rate and result in the Manufacturing segment's sales suddenly "falling off a cliff."
  • Counter Point: This entire scenario hinges on two factors: 1) management's ability to at least somewhat accurately gauge the direction of demand trends, and 2) operational execution. GBX's management stated in its FQ1 2016 earnings call that it has historically operated with a significantly lower backlog and doing so again in the future could be beneficial for the company because it would allow it to quickly switch production lines from one type of railcar to another. As a result, there is good evidence to support the conclusion that because GBX's management team has been able to operate effectively with a small backlog in the past it should be able to do so again in the future if it needs to.

Appendix Exhibits:

Appendix Exhibit #1: Historical and Projected Breakdown Of Total Sales By Segment

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Historical Data Source: SEC Filings For GBX

  • Note: GBX's acquisitions of Meridian Rail Holdings Corp. and Rail Car America during FQ1 2007 resulted in growth of the repair, refurbishment and parts portion of the company's business to the point that it was then reported as a separate segment: "Refurbishment & Parts." The results of the "Refurbishment & Parts" segment (later known as "Wheels, Repair & Parts" and now "Wheels & Parts") were included in the Manufacturing segment before FQ1 2006.

Appendix Exhibit #2: Greenbrier vs. Competitors

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Data Sources: Bloomberg and SEC Filings For GBX, TRN, ARII, and RAIL

Appendix Exhibit #3: U.S. Rail Traffic

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Data Source: YCharts.com

Appendix Exhibit #4: Historical Quarterly Deliveries and Unit Pricing/Sales Statistics

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Data Source: SEC Filings For GBX

Appendix Exhibit #5: Income Statement Assumptions

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Historical Data Sources: SEC Filings For GBX and Bloomberg

Appendix Exhibit #6: Cash Flow Statement Assumptions

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Historical Data Sources: SEC Filings For GBX and Bloomberg

Appendix Exhibit #7: Balance Sheet Assumptions

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Historical Data Sources: SEC Filings For GBX and Bloomberg

Appendix Exhibit #8: Quarterly Financial Projections Through FY 2017

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Historical Data Sources: SEC Filings For GBX and Bloomberg

  • Note: More detailed projections for Income Statement, Cash Flow Data, and Balance Sheet Data are available upon request.

Disclosure: I/we 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. I have no business relationship with any company whose stock is mentioned in this article.