In this column, we discuss with our followers a railcar name that is now down over 50% from recent highs. It is a stock we have successfully traded at BAD BEAT Investing in the past, and one that is currently a hot topic of discussion among our traders. We believe it is important to put this stock on your radar. Can this name which has been crushed of late be traded once again in our favor?
As we move forward in 2019, we believe the Greenbrier Companies (GBX) is performing admirably, but competition remains strong. The company is operating in a time where the economy is solid and demand for railcars remains high. Make no mistake, there are concerns over declining industrial production and rail volume which are indeed prevalent risks moving forward, but we think the stock has cooled off too far based on what we are seeing and suspect there is upside in the name. Overall, the company is delivering. Our present thesis is that after this decline, shares look set to bounce back toward equilibrium. We think you can let the stock fall a bit more in case there are concerns about being early on the name, but the chart suggests there should be some support in the low to mid $30 range.
To reach the doldrums of early 2016 when industrials were in the toilet, the stock would have to fall another 6-7 points. However, the stock now at $32.25 is down 50% from its highs last summer. This attracts our attention as the market is pricing in total implosion. We think the fear is somewhat warranted, but is likely overdone in the interim. Moreover, you can get paid to wait with the stock yielding 3.1%. The bottom of our target entry brings the yield even higher:
Target entry $31-$34
Target exit: $40-$41
Stop loss $28
Although we are traders at heart, we do so based on technicals, momentum, and most importantly, strong underlying fundamentals. Let us first summarize the most recent quarter which set the tone for the year. It is worth understanding where the company has been and what 2019 looks like. After reviewing the reported earnings, there are clear fundamental strengths and weaknesses for the company that you must be aware of.
There is no doubt that back in 2016-2017 when we were very bullish on the name, we saw many positive catalysts coming that would benefit the stock, such as improved oil prices, higher demand, and increased service revenue. We believe that the positive catalysts that the name experienced over the past few years had been initially realized. That is a fact. But we are down 50% and the valuation is entirely different.
The market has valued the name lower thanks to the backlog and fears orders would slow. These same fears have been cited for years. Is it another fear-mongered opportunity?
Well, in Q2, so much of the company's efforts to transition to a more efficiently run operation to drive performance was somewhat reflected in the results, but there remains some work to be done. Greenbrier is focused on delivering its railcar orders, working down the backlog, improving service revenues, working to expand margins, and continuing efforts to spread its influence internationally. It had been struggling a bit domestically and with margins, at least versus our expectations, and some of those struggles continued in Q2.
First we looked at sales which were above our expectations considering the market dynamics in late 2018 and early 2019. Revenues came in above expectations despite some weakness domestically. Take a look at the recent trend in revenues for the last few Q2s:
Source: SEC filings, graphics by BAD BEAT Investing
Revenues came in up 5% year-over-year to $658.7 million, above our expectations for $650 million. We were surprised a little by the beat considering the market action. The market sold the name off, but not before bidding the stock up. We believe the market is skittish about the future of the economy, and not necessarily the prospects of GBX on its own.
As we dig deeper we see the strengths emerged. This performance is a nice reversal from much of the bearish momentum in 2017 and early 2018. You will recall that for the fiscal year 2017, revenues came in at $2.17 billion, which badly missed our expectations of $2.35 billion for the year. Last year, in fiscal 2018, they were $2.52 billion and the company surpassed expectations. In fiscal Q2 2019 a continued bullish trend in revenues was present. Much of the sales were driven by incredible international expansion.
The fact is that Greenbrier's international expansion is significantly contributing to each quarterly result now as these new markets are providing the company with new sources of revenue and a diversification of the backlog. What we found impressive is that order activity was strong in the first quarter and comprised of a broad range of railcar types including double-stack intermodal units, tank cars and heavy-duty flat cars. One important trend to note is that around 20% of all new railcar orders are being received from markets outside North America. We believe it is important to examine the backlog to further understand the company.
What’s up with backlog?
The backlog is a key concern for many with this company. One major concern the Street has for the company is prolonged low volume of orders and deliveries. In fact, the Street for a long time kept the stock range bound. It seems that the market is now pricing in continued pressure on orders because of a sizable backlog, with fear of big declines in future orders.
However, orders remain strong, at least so far. That is why we were genuinely surprised the stock got slammed. The market bid the name up initially following earnings and then the stock got hammered. While time will tell in the next two quarterly reports where things are going, right now, the market is solely trading on fear. The market is usually correct, but not always. We think in this case, perhaps a lower valuation was justified, but 50% down in the last year seems steep without too much in the way of supportive earnings data to justify such a fall.
Domestically, we still believe there are headwinds from strong competition, but this is being offset by the international expansion we noted above. In the quarter, the company delivered 5,100 railcars, a bit above our expectations of 4,750, which we had surmised would reflect strong international deliveries. We expect the number of deliveries to continue to grow in strong international markets where rail is growing, and GBX is expanding.
We know order volume can be tough to predict, but we were looking for at least 3,500 in the quarter. While that was a conservative estimate, new orders came in at 3,800. This follows 5,400 last quarter and 9,300 the quarter before that. In our opinion, this is bullish. Order activity continues to be broad-based and diversified, originating primarily in the North American market which management noted recently is "improving," despite pressure on industrial production. Looking forward, we expect to see continued order strength in North America and internationally, until there is confirmation that order volume really does fall off. Right now, it does not seem to be the case.
Backlog is a key indicator, and reflects future cash flow generation and earnings. Railcar backlog had been declining before mid-2018 as the company chipped away at the backlog while seeing new orders of 3,000-4,000 a quarter. This time, the company knocked 1500 rail cars off the backlog:
Source: SEC filings, graphics by BAD BEAT Investing
For quite a time, backlog was falling. Back in May 2018, railcar backlog 24,200 units, valued at $2.3 billion. Here in the end of fiscal Q2 railcar backlog is higher again at 26,000 rail cars, valued at $2.7 billion. The interpretation of this trend can be one of two ways in our estimation. It can be both bullish and bearish. A large or growing backlog can either represent a significant inability to meet demand, or it can reflect a significantly improving demand. In some cases, it can represent both. For a time we were looking at a falling backlog, but order volume picked up recently. All the while the stock has been getting crushed in recent months. We think there is room for a bounce.
Some of the decline from efficiency work?
We think part of the decline we have seen may be due to the company having taken steps to improve efficiency, leading to increased order completion. One bearish trend in 2018 was slightly lower than historic order volumes, but volume surged in Q4 2018 and was high in fiscal Q1, and above expectations in Q2. There is concern that this surge may naturally lead to a decline in H2 2019, so the market could be pricing this in. But the trading is all off of expectation and fear it seems, and not so much true performance or performance/delivery expectations, so we think this is an opportunity.
Looking forward, you must watch for trends in new orders. That said, the orders that are being delivered have been costly, so margin erosion is one actual data point that justified some revaluation lower.
Margin power and earnings
Gross margin in the quarter fell 380 basis points to 8.2% from Q1's 12.0% thanks to the product mix. There were also some higher cost inputs, and repair costs, as well as contract loss accruals. The hit to margins could be why the market is not pleased, as margins have declined in recent quarters. Sadly, margins were down in every segment.
Gross margin fell to 6.9% from 11.4% in the manufacturing segment, mostly from manufacturing inefficiencies. The wheels, repairs, and parts segment took it on the chin with just a 5.4% margin, down due to repair volume inefficiencies. Finally, leasing and services saw major declines to 24.4%, down from 45.4% last quarter, mostly driven by externally sourced railcar syndications. A sliver of good news: controlling for these costs, gross margin here would have expanded to 51.3%.
The key question is whether this pressure will continue. Margins have trended lower in the last year, so that is problematic. Thanks to higher revenues, earnings saw a boost, but the Q2 trend is absolutely lower:
Source: SEC filings, graphics by BAD BEAT Investing
Although sales were higher and there were better tax rates than in the past, lower-than-anticipated gross margin on sales led to earnings per share of $0.22. This resulted in Greenbrier essentially meeting our expectations of $0.21-$0.23 per share, but the extra penny in earnings helps! Our earnings prediction stemmed from our sales expectations a touch higher than the Street consensus, but we also surmised that margins were going to be better. So, the higher sales saved the day here.
Looking ahead and basic valuation
So the market has cut the stock 50%. Some justification is over margins. But what about earnings potential. What can we expect from the company this year? Here is where we think there is opportunity. The company did trim GAAP earnings to reflect the fact that Q2 saw margins get hit and operational challenges that could continue this year. Assuming catastrophe does not strike and the company delivers at $3.80 EPS, at $32 per share the stock trades at just 8.4 times forward earnings. In our estimation, this is an attractive level to consider entry.
We thought the quarter was strong, with the exception of operational inefficiency weighing short-term on margins. All things considered, we believe you can acquire shares of Greenbrier, a quality company, at a fair price of 8X forward earnings at present levels. There are a lot of risks now baked into the price. The market is pricing in severe declines, but we suspect that the stock has fallen too far, too fast. The key is to watch new rail car orders. It pays a dividend now yielding 3.1% while you wait. We like the play here.
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Disclosure: I am/we are long GBX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.