FreightCar America: Turnaround Story Trading Below Net Cash

Aug. 29, 2019 10:16 AM ETFreightCar America, Inc. (RAIL)ARII, GBX, TRN25 Comments5 Likes
Corey Yeap profile picture
Corey Yeap
225 Followers

Summary

  • RAIL is a rare Graham net net.
  • Cash burn has peaked and should moderate going forward.
  • The company is at an inflection point in their turnaround. Gross margins inflected positively for the first time in a year.
  • RAIL is likely to be acquired for strategic reasons.

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FreightCar America (NASDAQ:RAIL) is a turnaround story trading below net cash. Historically, RAIL specialized in manufacturing coal railcars, but got into trouble when they diversified into building other types of railcars. They are having operational issues producing a wider range of railcars with the right cost structure.

Two years ago, the company hired James Meyer, a CEO with operational expertise and extensive experience manufacturing vehicles, yachts, and recreational vehicles. He was the Chief Operating Officer at Allied Specialty Vehicles, a manufacturer of specialty vehicles for the fire and emergency market, held various leadership potions at Brunswick, an RV manufacturer, and spent 16 years at Ford holding various executive positions. His background manufacturing various vehicles has many parallels to railcars because they involve efficient production on an assembly line.

Progress has been underwhelming, and as a result, the stock has fallen from $18 to $4 over the last year. The stock is currently trading below net cash per share of $4.83 and has an additional $3.83 per share in railcars on lease, which can be converted to cash. Their net cash position is made up of $70 million in cash and $10 million in debt backed by their leasing fleet, equating to a net-cash position of $60 million. The company does screen for higher leverage due to recently adopted accounting standards for leases, which creates a liability line item on their balance sheet for operating leases, but also an offsetting asset. These changes are cosmetic in nature, and doesn't take away from their net-cash position.

The market is valuing the company substantially below their net liquid assets because of concerns around their cash burn. However, RAIL is at an inflection point in their turnaround as they are now able to profitably manufacture railcars and their cash burn should moderate over the next few quarters. Once achieved, the market will likely value the company’s assets accordingly, providing 94% upside. Furthermore, the company is likely to be acquired.

Company Background

RAIL manufactured coal railcars for most of its history, but took steps to diversify into a broader array of railcars in response to coal’s decline. In 2014, they opened up a factory in Alabama to manufacture other types of railcars such as intermodal and box cars. They last sold a coal car in 2016, but the industry downturn in 2017 revealed that they couldn’t profitably manufacture other types of railcars at this facility. Their operational issues arose from not having the right processes in place to produce a diverse set of railcars. They also didn’t have the right portfolio of products to serve the market. Two years ago, the company began a complete overhaul of this facility from sourcing to production, but still had negative gross margins in 6 out of the last 8 quarters.

Industry downturn

The downturn in the railcar industry is exacerbating RAIL’s turnaround efforts. The railcal industry is highly cyclical. After falling 19% in 2017, the industry rebounded 12% in 2018, but 2019 is on pace to decline due to tariff concerns, a slowing global economy, and Precision Scheduled Railroad, an initiative by the railroads to increase the utilization of their equipment, which could lower demand for railcars. While the industry is cyclical, replacement demand should be maintained at 40,000-50,000 railcars, of which, RAIL should capture 10% based on their historical market share, providing baseline volumes of 4,000-5,000 units.

RAIL is on track to sustain positive gross margins

RAIL achieved positive gross margins for the first time in a year, and is on track to sustain it. When the company began their operational turnaround two years ago, it cost them about $90,000 to build a railcar with 75% of the costs coming from materials. By the end of the year, RAIL will have removed $5,500-6,000 of material costs per railcar since implementing operational changes, allowing them to remain positive on gross margins.

RAIL’s gross margins are more sensitive to product mix. In 2018, they lost $3.6 million from building railcars (before overhead), with product mix hurting them by $11 million. RAIL was missing out on segments of the market because they didn’t have certain car types in their portfolio or couldn’t manufacture them to be competitive in terms of price and quality. Their redesigned intermodal cars, which have been a strong category, achieved savings of 10% on material and 20% on labor. Management expects to be profitable on 24 car types by the end of the year, up from 12 at the end of the first quarter.

RAIL has the potential to achieve 15-20% gross margins, in line with their competitors. The current downturn in the railcar industry will make it harder to accomplish because they lose leverage on labor. RAIL is on pace to deliver 2,300 railcars this year based on management’s guidance, a 45% drop from 4,200 units last year due to a slowing economy and share loss. RAIL has delivered 1,370 units in the first half, and should easily hit their annual guidance even assuming a steeper decline in the back half.

Despite an industry downturn which will likely extend into 2020, RAIL is well positioned to grow their volumes next year and achieve 10% gross margins. They recently received an order for 1,050 units to be delivered next year. This order is significant because it makes up almost half of this year’s volumes, and gives us confidence that they are executing on profitably making other types of railcars. While we don’t know for sure if this order is for higher margin railcars, it probably isn’t a coincidence that they received such a large order after highlighting that on their last earnings callthat “we are now in production with a key new product, we have the proper cost structure to produce this product and several others in our pipeline on favorable economics.”Management also mentioned “we are continuing to have much deeper conversations with customers around our evolving portfolio and believe we will be in a substantially better position to compete as we enter 2020,”which further supports the theme of higher-margin products going forward. RAIL is positioned well to get more orders as they are now participating in new categories and customers will support them to prevent their larger competitors from gaining too much pricing leverage.

Cash burn should moderate

RAIL has been burning cash through the turnaround, but their losses will moderate going forward. In the back half of this year, I estimate that the company will burn $10 million in cash, $4 million of which will come from restructuring costs. They won’t lose money building railcars, but can’t make enough to cover their overhead of $8 million per quarter. Inventory was built up last quarter, partially cushioning their cash burn.

Management took steps to reduce their fixed costs by consolidating from two factories to one. They will incur $4 million in restructuring costs which will reduce their $32 million in annual SG&A rate by $5 million next year. Furthermore, they amended their lease on their remaining facility to reduce their factory floor by 40% effective in 2022.

Looking into 2020, I estimate that the company won’t burn cash. Assuming a 10% gross margin driven by a higher product mix, a leaner cost structure, RAIL can generate positive EBITDA and cash flow even at depressed volumes.

Valuation

I am valuing RAIL at $7.88 based on their projected net cash balance at the end of this year plus their railcars on lease because the company doesn’t have reliable earnings. The company currently has $60 million in net cash, I estimate that they should burn $10 million in the second half, ending the year with a $50 million balance or $4.05 per share. RAIL has a fleet of 645 railcars, all out on lease, valued at $47 million or $3.83 per share based on their stated book value. These railcars on lease currently generate cash, but can be easily liquidated. Last quarter, management sold 195 railcars on lease for $11 million.

RAIL is likely to be acquired

RAIL stock offers optionality because they are an acquisition target. RAIL is in a desperate situation because of their operational challenges and the industry downturn. They are likely to become irrational on pricing, which will cause a disproportionate amount of damage to their competitors.

Greenbrier (GBX), one of the largest railcar manufacturers also suffering from the industry downturn, has 16% gross margins. Every one percentage point in margin Greenbrier suffers from a potential price war equates to $25 million in gross profits. Acquiring RAIL would make strategic sense and be cheaper than risking margin erosion as RAIL only has a valuation of $50 million and can be liquidated for more. Greenbrier recently acquired the manufacturing assets of American Railcar Industries (ARII) for $430 million, which could raise antitrust issues due to their large and growing market share. This puts more pressure on Trinity (TRN) and National Steel Car to consolidate the industry. It’s likely that National Steel Car makes a bid for RAIL given that they have manufacturing facilities near RAIL, providing opportunities for synergies.

Conclusion

With stock trading at $4 with close to $8 in cash and other assets, RAIL offers asymmetric risk-return with 94% upside and limited downside. The company faces challenges, but they aren’t insurmountable. What they do isn’t complicated, they make steel boxes with wheels. The shareholder base has given up on their story, but they have made real progress and are well positioned for next year. As their progress becomes more explicit in the subsequent quarters, the wide gap between their stock price and liquid assets should narrow.

This article was written by

Corey Yeap profile picture
225 Followers
Buy-side analyst with a focus on small cap industrials.
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Disclosure: I am/we are long RAIL. 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.

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