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American Railcar Industries, Inc. (NASDAQ:ARII)

Q3 2012 Earnings Call

October 25, 2012 10:00 AM ET

Executives

Dale Davies – SVP, CFO and Treasurer

Jim Cowan – President and CEO

Analysts

Brad Delco – Stephens

Art Hatfield – Raymond James

Eric Crawford – UBS

Matt Brooklier – Longbow Research

Tyson Bauer – KC Capital

Ross Taylor – Somerset Capital

Tim Curro – Value Holdings

Operator

Good day, ladies and gentlemen, and thank you for standing by. Welcome to the American Railcar Industries Inc. Third Quarter 2012 Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will follow at that time. (Operator Instructions) As a reminder, this conference call is being recorded.

I would now like to introduce your host for today’s earnings conference call, Mr. Dale Davies. Sir, you may begin.

Dale Davies

Okay, thank you. Good morning. I would like to welcome everyone to the American Railcar Industries third quarter 2012 conference call. I’m Dale Davies, Chief Financial Officer, and I would like to thank you for joining us this morning. For those who are interested, a replay of this call will also be available on our website, www.americanrailcar.com, shortly after this call ends.

Joining me this morning is Jim Cowan, our President and CEO. Our call today will include discussions about the railcar industry, our operations and financial results. We will also make a few comments about our joint ventures, our business outlook. Following these remarks, we’ll have a Q&A session.

This conference call includes forward-looking statements, including statements as to estimates, expectations, intentions and predictions of future financial performance based on currently available information. Participants are directed to our SEC filings and press releases for a description of certain business issues and risks, as the change in any one could cause actual results or outcomes to differ materially from those expressed in the forward-looking statements.

Also please note that the company does not undertake any obligation to update any forward-looking statements made during the call. EBITDA and adjusted EBITDA are non-GAAP financial measures we will discuss today that are reconciled to our net earnings in our press release, which was issued yesterday. The press release is available through the Investor Relations page of our website.

Now, it’s my pleasure to introduce Jim Cowan.

Jim Cowan

Thank you, Dale, and good morning. Demand in North America for certain railcar types remained strong. The industry reported that approximately 12,300 railcars were delivered and 15,100 railcars were ordered during the third quarter of 2012, producing a book-to-billed ratio of 1.2.

Industry backlog was approximately 61,400 railcars at the end of September, approximately 87% of the industry backlog is for tank and hopper railcars which bodes well for ARI. Going forward, one industry forecast for North America expects new railcar deliveries to be approximately 58,000 cars this year and 53,000 cars next year.

Tank railcars continue to be the dominant car type driving orders in North America. The industry reported that approximately 4,500 tank railcars were delivered and 8,800 tank railcars were ordered during the third quarter of 2012, producing a book-to-billed ratio of almost 2.

Industry backlog for tank railcars was approximately 46,700 at the end of September, or over 75% of the industry backlog. The strength and demand for tank railcars continues to be driven by the oil and natural gas markets, but we also have tank car orders that service other commodities. There continues to be a slowing of orders for hoppers and railcar builders are managing production rates to match demand.

There is interest for certain covered hopper rail types, including plastics, potash and soda ash railcars. As of September 30, 2012, ARI’s backlog of 7,630 railcars, including orders for sale and lease remained strong, driven primarily by orders for tank railcars. Our backlog is at its highest level since the second quarter of 2008. We received orders for 2,290 railcars during the third quarter. Our backlog at the end of September increased by 830 railcars, when compared to the 6,800 railcars in our backlog at the end of June.

On September 30, 2012, we had 1,980 railcars in our backlog to be manufactured for our lease customers. We continue to invest and grow our railcar lease fleet. Our current production schedule has orders for new hopper railcars through the end of first quarter 2013 and new tank railcar orders through the first quarter 2014.

We continue to benefit from vertical integration projects that we put in place over the past several years and from a profitable product mix to more tank railcars, resulting in improved margins as production volumes for tank cars continue to ramp up during the quarter. Sequentially, these benefits have been partially offset by softness in the hopper market.

Our railcar services team has seen a steady stream of work this year even though pain and lining work is lower compared to prior years. We expect a good performance that this group delivers to continue and we are exploring opportunities to expand the business.

In summary, our performance generated a third consecutive quarter of record breaking operating earnings driven by strong industry demand for the railcar types that are core to our business. The increase in operating earnings led to a record quarter for earnings per share. I would like to thank and congratulate all ARI employees for this outstanding performance.

I’ll now turn it back to Dale for a discussion of the third quarter financial results.

Dale Davies

Thanks, Jim. Consolidated revenues for the third quarter of 2012 were $168 million versus $154 million for the second quarter of 2012, up 9% on a sequential basis on strong tank railcar volumes. Revenues for the third quarter of 2012 were up by $42 million, or 33% versus the comparable quarter of 2011 also on strong tank railcar volumes, which were partially offset by lower hopper railcar volumes. Revenues for railcars built for our lease – our railcar lease fleet are not recognized in consolidated revenues as a railcar sale, but are recognized over the term of the lease.

We shipped 1,460 railcars during the third quarter of 2012, including 310 to our leasing customers. This was a decrease compared to the second quarter shipments up 2,200 railcars, including 910 for lease customers. The decrease was primarily due to lower hopper volumes.

Third quarter shipments increased comparable to the 1,340 shipped during the third quarter of last year, of which 90 were to lease customers. Our manufacturing segment revenues including an estimate of revenues for railcars built for our lease fleet were $185 million for the third quarter of 2012 compared to $117 million for the third quarter of 2011. The primary reason for the increase in revenues, or an increase in railcar shipments improved pricing and a shift in the sales mix to more tank railcars.

Revenues for railcars built for our lease fleet are shown at an estimated fair market value as if they’ve been sold to the third-party and were $38 million for the third quarter of 2012 compared to $9 million for the third quarter of 2011. These intersegment revenues for railcars transferred to our lease fleet are eliminated in consolidation.

Our railcar leasing segment revenues for the third quarter of 2012 were $4 million compared to $300,000 for the third quarter of 2011. The increase from 2011 reflects the focus we’ve put on building our lease fleet. Revenues for railcars subject to lease are recognized monthly over multiple years of the lease based on the lease agreement terms. Revenues for our railcar services segment were $17 million for the third quarters of 2012 and 2011.

Consolidated earnings from operations for the third quarter of 2012 were a record $30 million compared to $26 million for the second quarter and $12 million for the third quarter of 2011. Our operating margins were 18% for the third quarter of 2012 compared to 17% for the second quarter and 10% for the third quarter of 2011.

The increase in earnings from operations was driven primarily by our manufacturing segment. Operating earnings for our manufacturing segment were $34 million for the third quarter of 2012 compared to $9 million for the third quarter of 2011. Segment operating earnings include profit on railcars built for our lease fleet, which is eliminated in consolidation and was $5 million for the third quarter of 2012 and less than $1 million for the third quarter of 2011. And these numbers are based on estimated fair market value less the cost to manufacture.

Operating margins from the manufacturing segment were 19% for the third quarter of 2012, compared to 7% for the third quarter of 2011. The increase from the prior year was primarily driven by increased volumes, increased sales mix of tank railcars, improved pricing and operating leverage and efficiency, as a result of strong railcar production volumes for tank railcars, all of which were partially offset by softer hopper railcar volumes. We’ve continued to realize cost savings from the vertical integration projects we put in place over the past several years, as Jim has previously mentioned.

Operating earnings for the railcar leasing segment were $2 million for the third quarter of 2012 compared to $1 million for the third quarter of 2011. The increase was due to growth in the number of railcars on lease.

Operating earnings for the railcar services segment were $3 million for the third quarter of 2012 compared to $4 million for the third quarter of 2011. Operating margins for the railcar services segment were 17% in the third quarter of 2012, compared to 23% for the third quarter of 2011. The decrease from the prior year was primarily attributable to lower demand for paint and lining work at our repair facilities.

Earnings from joint ventures were a loss of $850,000 for the third quarter of 2012 compared to a loss of $2 million for the third quarter of 2011. Compared to last year, our castings and axle joint ventures continue to benefit good demand for new railcars.

Adjusted EBITDA, which excludes stock-based compensation, set a new record of $37 million for the third quarter of 2012. This exceeded our previous record of $34 million for the second quarter of 2012 and was more than triple the $12 million for the third quarter of 2011. Stock-based compensation expense was $1 million for the third quarter of 2012 compared to income of $3 million for the third quarter of 2011. Our stock-based compensation fluctuates with changes in market price for stock. Closing price for stock was $28.34 per share as of September 30, 2012 versus $15.38 per share as of September 30, 2011.

Net interest expense was $4 million for the third quarter of 2012 compared to $5 million for the third quarter of 2011. Interest expense primarily relates to our 7.5% senior notes, which are due in 2014. On September 4, 2012, the company redeemed $100 million of principal on these notes at a redemption price of 101.875%, utilizing available cash on hand.

In conjunction with redemption, the company incurred a $2 million charge shown on the consolidated statement of operations in loss on debt extinguishment. The charge was comprised primarily of early redemption premium paid by the company. The impact of the debt redemption, net cost – net of cost savings related to lower interest expense for the month of September reduced the third quarter 2012 net earnings by $1 million or by $0.04 per share. The early redemption should provide us with significant interest cost savings in future quarters.

Net earnings for the third quarter of 2012 set a record at $14 million or $0.66 per share, compared to $13 million or $0.63 per share for the second quarter and $4 million or $0.19 per share for the third quarter of 2011.

Total consolidated revenues for the nine months of 2012 were $504 million, 56% higher than the $323 million for the same period of 2011. We shipped 5,870 railcars including 1,690 railcars to our leasing customers during the first nine months of 2012. This was nearly doubled to 3,060 railcars shipped during the comparable period in 2011, which also included 90 railcars to leasing customers.

Adjusted EBITDA was $102 million for the first nine months of 2012 compared to $27 million for the same period of 2011. Net earnings for the first nine months of 2012 were $39 million or $1.84 per share compared to a loss of $1 million or a negative $0.03 per share for the same period of 2011.

Our leasing business is becoming more significant as we continue to invest cash in our lease fleet. As of September 30, 2012, we’ve invested $180 million in our lease fleet. As a result for our capital expenditures to build our lease fleet, our $100 million debt redemption, and an increase in inventory, our cash on hand at September 30, 2012 was $99 million. We’ve seen an increase in inventory as a result of an increase in tank production rates and the timing of railcar shipments to customers.

Given our plan to continue to expand our lease fleet, we expected our existing cash balance and anticipated cash on operations will require supplemental financing specifically for our leased railcar fleet.

At this time, I’d like to turn it back to Jim for a few comments about our joint ventures and our international activities.

Jim Cowan

Thanks, Dale. Demand for components produced for our castings and axle joint ventures closely follow demand for new railcars. Given the recent softness for several railcar types, we are beginning to see a sequential drop in production volumes for these joint ventures. On the international front, our India joint venture Amtek Railcar, continues to show good progress. The second and third railcar prototypes were built in country this quarter with painting to be completed in the next few weeks. We now have three different car types in country for display and we’re in the engineering stages for our fourth car type.

Our consulting agreement with the Indian Railways Research Design and Standard Organization also continues to progress. We’ve built two prototypes for testing as part of this project. That combined with the other design work, our engineering group has worked on puts us at approximately 25% complete with this project. The next two prototypes for testing will be built in the fourth quarter 2012. These new railcar designs will be beneficial to our startup over the next few years.

Management and the Board of Directors will continue to look at opportunities that will further diversify and grow our business. We continue to focus on improving operational efficiencies, meeting customer demand for our railcars and significantly increasing our railcar lease fleet. In summary, we will continue to adjust as the business climate shifts and demand fluctuates for our railcars and services.

Now, I’ll turn it back to the operator who can explain how questions can be registered.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from the line of Brad Delco from Stephens. Your line is open.

Brad Delco – Stephens

First question, I guess, Dale you mentioned something about inventories being up in the quarter and is related to timing of railcar shipments. I’m just trying to kind of triangulate were deliveries more in the quarter or may be relative to our expectations and were there any cars basically held closing in the quarter that may be rolled in the fourth quarter?

Dale Davies

Yeah, Brad. There are lots of things going on in the third quarter. Let me kind of start with maybe what is going on in the second quarter. We had some fairly high delivery rates in the second quarter on some hopper cars for the frac sand industry. We were running the plant at a couple of shifts on at least one of our production lines during the quarter. Those deliveries were completed. As we moved into the third quarter, we converted that production line over to building some prototype cars under our Indian RDSO engineering agreement and of course we went off two shifts and went back to just one shift there and we also converted one of our production lines over to producing these ore cars and it was fairly new designed ore cars similar to the one we produced in the past but it did have some new engineering in it.

So we started that production up at a rather slow rate to make sure that all the engineering was working out as we needed it too for the production process. So that car was ramped up slower during the third quarter. We scheduled it into our schedule because work we needed to complete, but we had to put it somewhere. So that was the right time to take it. So we had that going on. We also – we’re building these ore cars which ship in unit trains and we got one trip unit train out in the third quarter. We got another and this is going to go in October. So there were some cars that were built for that, that won’t be shipping until October. And we also had some pellet cars that we had built in the third quarter that we will be shipping into fourth quarter. So we had those things going on and that’s one of the reason why the numbers are little lower on the shipments there.

Brad Delco – Stephens

Got you. And may be to follow-up, could you, I guess – give us some color what maybe your expectations are for deliveries in the fourth quarter given what’s in production and what you have kind of rolling over from third quarter?

Dale Davies

I think the fourth quarter is going to look a whole lot more like the first and second from a numbers standpoint.

Brad Delco – Stephens

Okay. Got you.

Dale Davies

Yeah.

Brad Delco – Stephens

And then – then maybe Jim, you made some comment about exploring opportunities to grow the railcar service business. Is that organic growth or you have opportunities in the market for acquisitions or what’s really the thought process there?

Jim Cowan

It’s primarily organic growth. I mean we are – we are working on our – we have six facilities, working on our seventh right now, which should be a Greenfield. And, in terms of acquisitions, we’ve looked at many, many in the past and it’s just a real hard area to get your arms around, mostly from environmental concerns. A lot of these facilities are very old. We’ve even got a few very old ones as well ourselves, but that’s the main concern, but organic is the answer.

Brad Delco – Stephens

And then, yeah, great. Thank you. That’s good color. And then, Dale, last question, when I look at – you have manufactured railcars that you delivered ex what you put into your lease fleet. The average revenue per unit looked like you got up to about 128,000 versus 104,000 or so in the second quarter. Can you maybe comment as to how much of that was attributed to the mix versus pricing, and maybe with some of those ore cars being delivered in the fourth quarter, how that should trend going forward?

Dale Davies

Well, I think mix is a big driver, and also the size of the cars. As we talked earlier, our production rate for hoppers dropped a lot. We built the India prototypes. We built the ore cars. And so on a percentage of our total production, tank cars were a whole lot more in the third quarter than they were in the second quarter. The other thing that you need to think about is that these tank cars that we’re building now are rather large tank cars, got a lot of steel on them and in some cases some special steel, that’s expensive steel. So the cars become fairly expensive cars that we’re building right now for – particularly for the oil transport service. So you got a mix change. So lot of tank cars. You’ve got big cars and expensive cars on the tank lines.

Brad Delco – Stephens

But is that something we should expect to continue going forward or should we expect that mix to change back to kind of more 2Q and 1Q levels?

Dale Davies

You’re going to continue to see a lot of tank cars, but what you will see in the fourth quarter is our production rate on hoppers will pick back up, because we’re finished with the prototypes for India. And we actually have finished all the ore cars in October. So those are finished and our production on hopper is going to resume with some larger hopper cars that – and the rate will be returned in little higher than it was in the third quarter for hopper. So you’re still going to have a lot of tank cars. We’re not slowing the tank car rate at all. If anything, we may be pick it up just slightly more in the fourth quarter than we had in the third quarter. But you’re going to see the hoppers come back up to and that’s how we get back up to the higher production rates we had in earlier quarters.

Brad Delco – Stephens

Great. Well, thanks guys for the color. I’ll turn it over and get back in queue. Thanks.

Dale Davies

Yeah.

Operator

Thank you. Our next question or comment comes from the line of Art Hatfield from Raymond James. Your line is open.

Art Hatfield – Raymond James

Hey, morning, Jim and Dale.

Jim Cowan

Morning.

Art Hatfield – Raymond James

Thanks for that color on deliveries in Q3 and for Q4. Going into the quarter, if I recall and correct me if I am wrong on this, but my recollection was some of the commentary you had made back on the second quarter call was that you would have some expenses used in the quarter given some of these things that Dale you had mentioned that were going on in the quarter. And relative to my estimates, you came in much better than what I was looking forward, given that commentary. And actually as you mentioned the gross profit margin was pretty flat with Q2. Can you talk a little bit about what you’re able to do to maybe perform better than, I guess, I thought you would do or maybe even better than you thought you would have done in the quarter in that regard?

Jim Cowan

I think, as we went through the third quarter and continue to ramp-up our production on tanks, we’ve done really well. Our plants have done a good job of running efficiently. We had to struggle, so we had a hard summer in Arkansas, where we build these cars and so it was a struggle for them. But they came through that quarter really well.

And, probably the last time we were talking, we were anticipating maybe a little lower level of efficiencies from the ramp-up that we’re growing through and we may have also been anticipating a little bit more of the penalty on reducing our hopper production to make these India prototypes and the start-up of the ore cars. You never know when you start the new car type – how efficient you’re going to be and that actually started up well and we ran well on the ore cars. So I think that’s probably the difference in what actually happened versus what we may have been thinking back when we talked before.

Art Hatfield – Raymond James

Excellent. That’s helpful. So does that imply then that maybe you’ve gotten the efficiencies in the business right now or as you ramp these hoppers back up that there may be some opportunities to continue to improve the efficiencies in the production lines?

Jim Cowan

I think we’re going back to car types, we know very well what’s running right now at the plant. We finished the ore cars, of course, the last couple – two or three weeks at ore cars, we are running at good efficiencies because that was the tail-end of the run on those. But the cars we are producing now and after the ore cars are cars we built a lot of, so the efficiencies will be good on those cars.

Art Hatfield – Raymond James

Great. And, just a couple more things – actually three more things if I’m correct in my count. Quick question Dale. The backlog – I got on the call few minutes late, and if I missed this I apologize, but the current backlog, what percentage of that is committed to the lease fleet.

Dale Davies

Let’s see. I think about – about a quarter of it, about 25% of it.

Jim Cowan

Yeah.

Art Hatfield – Raymond James

And as we think about our modeling going forward, is it fair to say that your eliminations will be pretty consistent in that regard or do you have some unique delivery schedules to lease fleet over the next few quarters?

Dale Davies

It’s been kind of up and down. Second quarter was the high delivery quarter for the lease fleet. The third quarter was quite a bit lower. I think you’ll see us go back up in the fourth quarter.

Art Hatfield – Raymond James

Okay. And then just thinking about, you paid down the debt, that’s portion of your notes in the quarter. And I know you guys are thinking about at some point financing against the lease fleets. Can you – and looking at the balance sheet, the leased cars are those buried in the property, plant, and equipment number. And if so, can you tell us what you have on the balance sheet currently for cars in leased fleet.

Dale Davies

Yeah. Give me a second here – at the end of September about $175 million.

Art Hatfield – Raymond James

And I think when you think about financing those going down the road and putting some debt on the balance sheet relative to those. What kind of leverage are you thinking about as you move forward with that?

Dale Davies

We’re going to build some more cars in the fourth quarter. I kind of indicated we’re going to have a fairly high production rate in the fourth quarter. So we’ll be financing the cars that are out there for the whole year and what we can generally expect is somewhere between 70% to 75% leverage on the fair market value of the cars.

Art Hatfield – Raymond James

Right.

Dale Davies

Now, what’s on the balance sheet is our cost to make those cars. So you can get leverage against the fair value of the cars and these are all new cars.

Art Hatfield – Raymond James

Okay. That actually – so that 70%, 75% is pretty typical and that comment about the costs is helpful. Then I have just final question, Jim, in your comments about the JVs, you had made a comment about the axle and casting business being down sequentially. And I guess due to the lower builds in Q3, but the way I heard it, it kind of came across as somewhat of a bearish comment about the industry going forward. Can you maybe help clarify me on what you’re seeing there and how you think about really the industry in general over the next year or two?

Jim Cowan

Well, yeah. I mean, clearly as we stated from our side the hopper market is a little softer than it was – it certainly a year ago or six months ago. There is still some energy there as I mentioned. There is a few commodities that are starting to see some code activity, so that’s good. The coal market is off the charts, pretty poor there. It’s obviously with just the backlog being about 85% hopper and tank that leaves 15% for everything else. So – and we really haven’t seen a strong order backlog from those other car type stuff, we don’t really make. But certainly for axles and castings, we supply to all the car builders. So we are not shy with that. So anyway the other car types pretty much across the board do have some softness.

Art Hatfield – Raymond James

All right. That’s helpful. Thank you.

Operator

Thank you. Our next question or comment comes from the line of Eric Crawford from UBS. Your line is open.

Eric Crawford – UBS

Good morning. Just actually touching up on that – on that last question and on the softness you’ve seen in covered hoppers. The 3,000 industry orders last quarter were more than half of the year-to-date total. So I’m wondering, if that three quarter order level is what you’d expect going forward or whether you expect to see some acceleration there, any color on what you’re hearing from customers?

Dale Davies

Yeah. No – yeah, certainly I expect to see some acceleration. I mean as we state today, it’s still a little soft, the backlog for hopper is about 6,000 is – in a normal year, you would see deliveries 15,000 to 17,000 for the covered hopper segment. Obviously this year and we’ve delivered over 17,000, probably we’ll end up over 20,000. But again, frac sand was clearly a very dominant part of that in the first half of the year and it’s pretty cold at the moment. But I think we’ll have some life going forward. But – now again, with the pellet market starting to get some interest and then of course the potash area or soda ash, and again frac sand and there are some grain inquiries there that are now starting to percolate. So it’s going to pick back up, but just as we state here with current backlog for hoppers, it’s just a little soft.

Eric Crawford – UBS

That’s helpful. And switching over to leasing, could you talk a bit about the trends you’re seeing there in terms of pricing and duration?

Dale Davies

There is tanks, they’re extremely strong and pricing and of course on durations five, seven year pretty typical, certain specialty tanks will be 10 years or in that range. But the rest, the hopper quotes that we’ve got are just again pretty standard, again more of a five, seven-year type window and pricing has softened slightly, but not dramatically.

Eric Crawford – UBS

Okay. Thanks a lot. That’s helpful.

Operator

Thank you. Our next question or comment comes from the line of Mr. Matt Brooklier from Longbow Research. Your line is open.

Matt Brooklier – Longbow Research

Thanks. Good morning.

Jim Cowan

Good morning.

Matt Brooklier – Longbow Research

Wanted to try to dig in a little bit deeper on the manufacturing side. In the quarter, you mentioned, you potentially had some start-up costs, are you able to quantify those costs?

Dale Davies

Well, I think what we probably would talk about there is the start-up for that ore car and it really wasn’t a major cost, but it was an efficiency factor. We started it at lower production rate, so which means you get a little less utilization out of your facility. And then it takes you – take you through a number of cars, your efficiency rate per car is not up there. So – but we really haven’t sit down and try to quantify that, but it did have some impact, but it probably wasn’t a great impact on the financials.

Matt Brooklier – Longbow Research

Okay. And then when I look at your manufacturing gross profit margin, and then I look at the deliveries in the quarter ticking down a good amount from the 2,200 you did in second quarter, yet your manufacturing gross profit margin was relatively the same or to be fair to assume what’s greater deliveries in fourth quarter, we could see the manufacturing gross profit margin up from that 21% or does it – does it stay roughly the same, what are your thoughts?

Dale Davies

I think we’re running a reasonably high level of tank cars in the third quarter and we’ll be running at that level or maybe little better in the fourth quarter, which is always good because tank margins are stronger than the hopper margins. But we are coming back with more hoppers in the fourth quarter. So to tell you, it’s going to be up – may not be up, because you’re going to see a mixed change now. The revenue numbers going to be higher because we’re producing more cars.

But now you’re going to have a little higher percentage of hoppers in the overall mix. I wouldn’t advise you to raise the average for the company, but I would just probably advise you that we would expect similar margins on the tank cars that we’re making, but we’ll have more earnings on an absolute dollar basis coming off the hopper cars. So – but as a percentage, when you calculate the percentage, it is probably not going to go up.

Matt Brooklier – Longbow Research

Okay. And what’s your sense, I mean, we’ve heard – and we heard starting in 2Q that there is incremental tank car manufacturing coming into the market. Has that had an impact on your ability to price tanks, it doesn’t appear so from the numbers, but I’m just curious if we are starting to see incremental tank car volume coming into the market, having a little bit of a headwind on your ability to continue to raise price?

Dale Davies

No, I wouldn’t say so. I mean, I think the folks that are bringing it on, it’s going to be late this year and/or late next year for the folks that have talked about that. But we’re not expanding on the tank car side. We’ve got some efficiency gains from our last time, we had a strong tank car market back in 2007, 2008. The group – the management team that works on that has done a great job. And anyways, so we’ll see a little of that ourselves through the next year, but now to answer your question, tank car pricing is still very strong.

Matt Brooklier – Longbow Research

Okay. And just quickly your tax rate is slightly up in the quarter what are you expect – what drove that first? And then secondly what are your expectations for fourth quarter?

Dale Davies

Yeah. We got a couple of things that probably are influencing the rate right now and that’s the state tax rate, we’re filing a lot of states and our average state tax is probably a little higher than it was in past years. And then of course the losses we were incurring on India are not deductible at this time, we’ll have to generate profits in India before we can use the expenses we have incurred this year over there. So that influences it a little bit too. So, on a going forward basis, I continue to stay around the 40% number, that’s probably where we’re going to end up.

Matt Brooklier – Longbow Research

Okay. Thank you for the time.

Dale Davies

Yep.

Operator

Thank you. Our next question or comment comes from the line of Mr. Tyson Bauer from KC Capital. Your line is open.

Tyson Bauer – KC Capital

Can you give us a little sense on what the India loss contribution was this quarter?

Dale Davies

We’re probably not going to go into that, but it’s not a real big number. What we’re doing is we’re funding a small staff over there, management staff. The construction is kind of ramping up, these guys have been there oversee in construction and getting everything ready to start producing. We have not yet started incurring major expense over there for our startup activities, we have built the prototypes as Jim mentioned, but that the loss will be just a few hundred thousand. So it’s not a really big number for us at this point.

Tyson Bauer – KC Capital

We thought we might see awards from the India Railways RFP that was put out earlier this summer. Where do we stand there, and also are we seeing any pickup in Saudi activity?

Jim Cowan

In India, they’re about to make some awards. So we who’ve had – we’ve been in discussions with India Railway. We have a very good indication, what there expectation will be for us next year, the two car types and it’s going to fit into our startup plan. So we’re going to shoot for about 800 units next year. So not at all from them, which is good, but anyway, so we’ve got that, it’s not signed seal, but we clearly have from them what their desires are to get us with introductory startup activities.

In Saudi, we have received a preliminary indication of an order there. We’ll have final approval in and about the next two weeks and that’ll be for a gondola car. It’s actually going to service the bauxite market. So this is an area, where Saudi Arabia Railways currently has just under 3,000 units. They’re going to be adding 5,000 units to 6,000 units in the next few years to service bauxite and phosphorous and we’re going to be slugging through it and continue that. Whether that’s delivered out of Arkansas or India, we’ll remain to be seen, but the first order will be made in Arkansas due to the complexity of the car and the startup like you say, I think we’re going to have our plate full in 2013 for India deliveries in India.

Tyson Bauer – KC Capital

That sounds wonderful. You talked about the lease fleet financing. Have you quantified what kind of savings you expect to get out of that on the current market rates for that type of financing? And given your growth in your own lease fleet, are you going to be able to continually roll it forward. So we’re not expected to have outside financing beyond the lease assets themselves?

Dale Davies

The savings are probably going to be in the neighborhood of 4%, coming off that 7.5%. And as far as going forward, I think our plan at this time will be to continue to leverage railcars we put in the lease fleet. We’ve got – by the end of the year, we expect to have a lot of cars that we can put out there and we can finance, and use the railcars as collateral for that financing. And then next year, as we put more cars into the lease fleet, we would expect to do the same, again next year. But we don’t expect to be going out to the market with unsecured financing on the corporation. I think we’re just going to use the financing on the railcars to continue to grow that fleet.

Tyson Bauer – KC Capital

Okay. And quarter’s past, you’ve kind of give us some of the early indication on the quarter order activity, which will be October this time around. You sound a little cautious Jim, are we seeing any kind of slowdown in the activity, or are things continuing to go strong in your main car types?

Jim Cowan

No. For the month of October, it’s been strong. So we’re very excited about that. We don’t have a number to give, but I do like where it has started. I am liking some of the pickup on the hopper car inquiry side. It’s not in the – hundreds or thousands of cars obviously, but there are like I said, four or five commodities that are starting to get some energy. And so hopefully, we can get a hopper market next year that – maybe it’s more historical or about 15,000 units. And again, I think for (inaudible) started this year, but there is – there’s still some energy. I don’t want to sound gloom and doomy, don’t walk away with that.

Tyson Bauer – KC Capital

Okay. Are you expecting another positive book-to-bill for the quarter given where we’re going to have some strongest deliveries?

Jim Cowan

I am, yes.

Tyson Bauer – KC Capital

Right. Last thing, in the quarter, we had a lot of press regarding the possibility of retrofitting tank cars due to some ethanol cars exploding on a very basic design, your thoughts on that as a possibility, which really would be more for your South Centrinity going forward, and any kind of timeline on the federal regulations?

Jim Cowan

Yeah. I hate to say this, but guessing at the timeline for the complexity that’s involved with the tank car committee FRA and others, I don’t know that I could really give you one, I mean if you look at the current crude oil design car, the 31A, that was about a four-year process and of course it’s jumped out of the box in the past 18 months. But – so no, I don’t know I could give you any estimate on that.

Tyson Bauer – KC Capital

Okay. Thank you.

Operator

Thank you. Our next question or comment comes from the line of Ross Taylor from Somerset Capital. Your line is open. Mr. Taylor you may need to un-mute your phone.

Ross Taylor – Somerset Capital

Okay. Well, I was looking for a little bit more color on the India situation and you comment that not all of the cars are coming from them, as you indicated; who is the other indicated buyers for those cars?

Jim Cowan

There is – India Railways historically is a purchaser of about 70% to 80% of the new cars. There’s private owners that would make up the reminder. And now, you’ve got just recently in the past year, year and a half, you can add leasing companies to that list as well. So there are some new entries there. So it’s the private sector to answer your question.

Ross Taylor – Somerset Capital

Okay. And then in your lease fleet when we look at the economics of it when should we start to actually have to model in a meaningful contribution from the cars we have in lease?

Dale Davies

Well, I think they’re making a contribution now for each one we put out there, I mean it’s sort of collecting revenue on that car. There aren’t any real significant cash expenses that I have to come up. We are depreciating the cars over 30 years, so that we have the depreciation expense but beyond that. I think you saw our margins on the lease fleet for this quarter gross profit margins we’re in the mid 50s.

Now there is some interest costs that comes off related to financing those cars, but the contributions there now and if you’re referring to the fact that the company is making the investment by taking part of our production, and not selling that to a commercial customers and taking it into our own lease fleet. There is a trade off there, I mean, we are positioned it’s kind of and we’re going to take maybe 25% of our capacity into our lease fleet. And by doing that, we don’t have the opportunity to sell those cars and generate sales revenue and sales profit from those cars.

So there is a trade off here and our view is it takes couple of years to move the volume of our cars in the lease fleet up to the level where the routine earnings off of the lease business exceed what we’re making as an investment by taking 25% of our manufacturing capacity to our own lease fleet.

Ross Taylor – Somerset Capital

And so basically after that two or three years we should start to see leverage from the fact that you will have built up the lease fleet?

Dale Davies

Yeah, and you have to keep in mind that I mean this is sort of talking about an opportunity of cost here. If the opportunity to sell those cars was to make that money, and but we are making money on the lease fleets just that we are foregoing some of the opportunity we had, if we had just going to ahead and sold every one of those cars.

But a couple of years and then the earnings off the lease fleet far exceed the amount we – I guess forego by not selling those railcars. And that is we continue the strategy, if we ever stop the strategy we still have the earnings off the lease fleet at that point. And if we went back to selling a 100% of our capacity then earnings would immediately return. So and the lease fleet earnings will still be there. So it’s maintaining the strategy and put 25% of our production at lease fleet, it takes a couple of years to get or the numbers are bigger because we’re doing it that way.

Ross Taylor – Somerset Capital

And with what you’re doing there your contract lives on your leases are far exceeding this two, three year type time horizon. So when we’re modeling this we’re looking at saying this is actually over an investment horizon, a much more profitable way for us as in shareholders to view it?

Dale Davies

Well, that the leases that we’re taking right now are generally five to seven year leases, but at the end of that five to seven years, these cars will be put on new leases, because the life of a car is probably 30 to 40 years from a practical standpoint. So I mean, the cars will stay in service or we would expect 30 to 40 years. So that lease revenue continues on, it’s not just a five year or seven year. If you’re looking for a payback on the lease itself, how quick does the lease pay for the investment in the railcar, it’s longer than two years, if that’s the question.

Ross Taylor – Somerset Capital

I was just trying to get an idea (inaudible) obviously, Wall Street tends to be driven by short-term numbers and so ironically they’d probably rather you sell everything and not lease anything, and will reward you with a higher stock price with what I hear you indicating, if the economics are so favorable that this is over the longer term over a three, five year horizon, this is a much more effective and efficient and economically valuable way to do things?

Dale Davies

Exactly. And that’s the way we view things, we understand that there is a desire for immediate returns, but we also look at what’s good for the company and we believe the strategy is really good for this company longer term. And but I mean that’s what we talk about it with investors to help them understand this that there is an investment the company is making. We made significant investment in 2012, we’ll make an additional investment in 2013. And from that point on, I think we’re ahead of the game. And so what we’re trying to help people understand that that the potential could have been greater had we just sold everything we could make, but we get – when you sell a car you make profit one time and it’s the day you sell it. If you lease the car, you make a little profit every month for the next 30 to 40 years.

Ross Taylor – Somerset Capital

Okay. And lastly, the Saudi Arabia any kind of it’s on time horizon and the economics. And is that the situation where it’s your business and there’s no one else they’re really working with, or is just something that we’ll be put up to competitive bid?

Jim Cowan

No, no. As I said, they currently have about 2,500 units. Most of those have been Chinese built; some have been built in North America. But the key point for Saudi is to understand that their rail system is they’ve copied the North American standard, number one. Number two, after they’ve had hundreds of cars fail from Chinese product and Chinese build, they changed their tune just about a year ago where every component and every builder had to be a 100% AAR certified and that kind of blocks out the Chinese. So that’s a key component.

As I said, they’re looking for a 5,000 to 6,000 unit build for freight cars in the next few years. And that’s mostly due to two mining events at the north part of the country out for bauxite and phosphorus.

Ross Taylor – Somerset Capital

It sounds like a great opportunity?

Jim Cowan

It is.

Ross Taylor – Somerset Capital

Okay. Thank you very much.

Operator

Thank you. Our next question or comment comes from the line of Matt Brooklier from Longbow Research. Your line is open.

Matt Brooklier – Longbow Research

Yeah so – of your manufacturing or production capacity within your current India operations. What could that number look like?

Jim Cowan

Well, the 800 units next year, the facility that we’re looking to build as a startup year, the facility has two tracks. One of them we’ve built out it has the capability to build about 2,200 to 2,400 units per year depending on mix. The second track, we have the building in place, we haven’t put the equipment in that would be on additional, $3 million to $4 million to do that, and you could double the capacity of the operation. We’ve setup the painting ability to handle both tracks. But right now, startup year, it’ll be a good 800 units to startup.

Matt Brooklier – Longbow Research

Okay. So 800 units potentially in 2013 on the delivery side and then the capacity looks like it’s somewhat 40 – almost 5,000 cars potentially if you’re up to full strength?

Jim Cowan

You are correct.

Matt Brooklier – Longbow Research

Okay. And just having that particular facility in that part of the world, how do you look at that from a geographic perspective and in terms of potentially selling into other markets?

Jim Cowan

I mean obviously, we’ve positioned it there for the Australian market, Bangladesh is on the India rail, that’s another market, not as big South Africa is market and certainly Saudi Arabia that I’ve just discussed is a market. Actually the whole of Middle East, there will be some – I think some gains there in terms of rail, freight rail over the next five to 10 years, not just in Saudi, but several other Middle East countries as well. So thus we think India is positioned very well. It will not of course move cars to China or Russia, but...

Matt Brooklier – Longbow Research

Right.

Jim Cowan

...the whole – that other portion of the world we’re ready.

Matt Brooklier – Longbow Research

Okay. And last question that the Chinese car failures within Saudi Arabia, and Saudi Arabia going to an AAR approved or standardized car. Is that – are there other parts of the world where that is also happening?

Jim Cowan

Not to my knowledge, no. Most markets whether it would be China or Russia, the other big ones; they kind of have their own internal standard that they require. Lot of them are either copying AAR standards or trying to upgrade to that standard. But the only group I am aware that’s just I’m sure there’s few others, but Saudi has said, they want to get everything AAR certified.

Matt Brooklier – Longbow Research

Okay. Thanks again for the time.

Operator

Thank you. Our next question or comment comes from the line of Steve Barger from KeyBanc Capital Markets. Your line is open.

Tony – KeyBanc Capital Markets

It’s Tony in for Steve. I think you guys might have mentioned this earlier in the call, sorry I missed it, but with regards to the India facility, you guys are saying up to 800 units for fiscal 2013. Are you expecting that to be EPS positive?

Jim Cowan

I really think you’re probably looking at a breakeven of the – setting this whole business plan up, that is right around our breakeven point.

Tony – KeyBanc Capital Markets

Got it. Thank you.

Operator

Thank you. Our next question or comment comes from the line of Mr. Tim Curro from Value Holdings. Your line is open.

Tim Curro – Value Holdings

Backlog value at the end of the period?

Dale Davies

I didn’t get the question. Could you repeat that please?

Tim Curro – Value Holdings

The backlog value for the railcars at the end of the period?

Dale Davies

Okay, backlog....

Tim Curro – Value Holdings

Last quarter (inaudible)?

Dale Davies

Okay.

Tim Curro – Value Holdings

(Inaudible)?

Dale Davies

I didn’t get that voice.

Jim Cowan

$944 million in the backlog at the end of September.

Tim Curro – Value Holdings

Okay. So the value for (inaudible) has gone up. Is that because of the mix?

Dale Davies

Yeah, it is. There is a lot of tank cars in our backlog and there’s a lot of large tank cars in our backlog.

Tim Curro – Value Holdings

Okay. Now one other question, why are deferred taxes running about $8 million per quarter this year, I mean it’s good for cash flow, but I’m – I just like to get an understanding of why that is?

Dale Davies

Yeah, it’s a result of us building the lease cars for our own lease fleet. There is depreciation rules allow you to take accelerated depreciation on railcars. And in 2011 and in 2012 there is additional bonus depreciation that you are eligible for. And actually in 2011, the bonus depreciation was 100%. So that meant you could depreciate 100% of the value of the car in that year.

For 2012, the bonus depreciation it’s 50%. So you can depreciate 50% of the value of the car under bonus depreciation and then you can still take the normal seven-year makers depreciation on the remaining balance on that car. So basically we’re getting 57% depreciation on the cars going into lease fleet this year, so that creates a fairly significant tax shelter, if you will, and sort of offsets the income taxes that would be payable from profits on our manufacturing business.

Tim Curro – Value Holdings

All right. Thank you very much.

Dale Davies

You’re welcome.

Operator

Thank you. (Operator Instructions) I’m showing no additional audio questions at this time, sir.

Jim Cowan

All right. We just want to thank everybody for your continued interest in ARI and we look forward to discussing our fourth quarter results in a few months. Thank you.

Operator

Ladies and gentlemen, thank you for participating in today’s conference. This concludes the program. You may now disconnect. Everyone have a wonderful day.

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