Please see Siren81’s timely write up on ARII for some background and context on the idea. Siren81 made a great call, but the short story has evolved and is equally as strong as it was in August 2014. This is an update to supplement his work and provide evidence as to why ARII is a compelling and timely short with 40% downside.

Thesis Summary: American Railcar has been one of the biggest beneficiaries of two unsustainable booms in the railcar manufacturing space – tank cars for crude by rail and covered hoppers for moving frac sand. Despite significant current oversupply for both these cars, tank cars and small cube hoppers still represent 50% of the total industry backlog. As these two combined booms continue to rapidly unwind – cancelations and deferrals are happening now (according to ARCI and industry participants) – ARII faces a massive earnings cliff in late 2016 or early 2017, possibly sooner. ARII is currently trading at a 60+% premium to peers (TRN and GBX) despite 1) a shorter backlog and 2) falling behind TRN in the railcar manufacturing hierarchy. EPS should fall to <$3 in 2017 (vs Street at $4.60) and normalized EPS is in the $2-3 range (a significant amount of demand has been pulled forward even if energy prices rebound). I expect ARII to trade down to $25, which is 10x normalized EPS as the industry heads into a multi-year downturn. This is a ~40% return from current levels.

Why does the opportunity exist today?

ARII reported marginally better than expected backlog growth in 3Q15 due to order wins with food hoppers and plastic pellet hoppers. The company reported a 3Q15 book to bill ratio of 0.73x vs. the industry at 0.43x. Of note, this was the industry’s third straight quarter with a book to bill below 1x as small cube hoppers (frac sand) and tank cars orders have drifted towards zero (yet, again, still represent 50% of the backlog). Despite ARII having less than 4 quarters of production in backlog (vs. competitors at 6+) and increased uncertainty around the strength of their backlog, these results squeezed ARII back to the upper $50’s (levels the stock reached during the peak of the cycle in 2014), which was up 70% for the month and continuing the early October short squeeze.

Bulls were also emboldened by the company’s aggressive stock repurchases. ARII’s board had approved a $250mm stock repurchase plan on July 28th 2015, and the company proceeded to spend $51mm and purchase 1.34mm shares over the next two months alone. At 250k volume per day, and 40 trading days, that’s 13% of the total volume! The company had continued ‘firing at will’ and purchased an additional $6.1mm of stock (167k) subsequent to quarters end. With Icahn holding ~12mm of ~20mm shares out, 2mm shares short already, and 5mm shares that could potentially be purchased ($200mm buyback/$40 stock price), this was enough to send some bears quickly to the sidelines.

So why short now?

The short thesis is stronger than ever and bears are even closer to a massive earnings cliff. What has changed?

• 4Q15 ARCI data (came out January 28th) points to continued industry headwinds. Book to bill ratio of 0.45x (orders 9,169 vs. deliveries of 20,296). This is the first time since 2009 that the book-to-build ratio has been below 1x for four straight quarters.

• Crude by rail is structurally impaired. Spreads have collapsed (WTI has recently even traded at a premium to Brent), production is declining, rail volumes are declining, rails are cutting rates, pipeline capacity is increasing, and now the ability to export oil has structurally impaired crude-by-rail, which is considered the highest cost and most dangerous way for transporting crude. The only companies still using crude by rail are in a select few “stranded oil markets” or because they are trying to minimize economic losses (they would lose more money paying their contracted capacity (loading, unloading, and leases) than what they would save using pipelines, for now). Over 20% of the tank car fleet is currently idle (http://www.ft.com/cms/s/0/ff7d4f20-b64d-11e5-8358-9a82b43f6b2f.html#axzz3wwlJ4sjB) yet backlog represents an additional 50%increase to supply.

• Small cube covered hoppers are in significant oversupply. Sand hoppers were ordered to support 2-3x increase in sand volumes from peak 2014 activity (50k were ordered in 2014 alone when Morgan Stanley estimated ~30k cars could support doubling of sand demand – and that was using, in part, an inefficient manifest transport process – now the industry standard is to use turn unit trains – so your asset turns and productivity significantly increase and you need less cars). Sand demand is set to decline 20-40% in 2015 and decline even more in 2016 (some E&Ps are cutting budgets 50+%). Lease customers and customers holding the orderbook (public and private) should be under significant distress in 2016 and the market is getting worse. EMES and HCLP, two MLPs set to take a lot of leased hoppers going forward, are at risk of bankruptcy and are struggling to find places to park cars.

• Rail cycle facing headwinds from all angles. Rail stock prices and suppliers like Wabtech (WAB –another great write up on VIC) highlight current pressures on the industry. The industry is unlikely to see demand materially strengthen in the face of so many headwinds.

• Greenbrier confirm bull’s worst fears. GBX discussed the change in industry dynamics on their recent call (1/7/16) and the stock experienced a 15% intraday swing lower. Cancellations and deferrals are happening. Backlogs and lease contracts are not as firm as expected. The industry was building some railcars on spec and manufacturers now have inventory risk. This is a supply overhang for the entire industry and a significant risk to TBV. GBX has reiterated guidance of ~$6 of EPS in 2016 and has $24 tangible balance sheet value, yet GBX trades at TBV and ~4x earnings because of the markets rightful skepticism of both earnings and balance sheet value.

• ARII is laying off workers. On Jan 22nd the company announced plans to lay off 52 workers at one of its manufacturing plants in St Charles, MO (http://www.stltoday.com/business/local/american-railcar-to-lay-off-workers/article_2f6b5fa0-4eaa-5c23-ab49-bb8898afeb51.html).

• Retrofit demand is dead. With massive oversupply of tank cars, and declining demand for crude by rail, industry participants continue to highlight non-existent retrofit demand – a key element of the bull thesis.

• Stock repurchases will have to slow. ARII has $129mm of cash and over $600mm of debt (primarily for lease fleet). The company will ultimately have to slow stock repurchases to preserve dry powder for the coming downturn (also needs capital for lease fleet additions in 2016). Also, with 30-40% of ARII’s lease fleet devoted to sand cars and tank cars, these cars are at risk of significant impairment in the future and ARII will need to be prepared. Buying stock at current levels and at the current time does not appear to be the best capital allocation decision for ARII shareholders, but this won’t be the first or last management team to buy stock at the wrong time.

Our industry checks have produced various antidotal data points that are consistent with the short thesis:

Some key data points from industry contacts:

• People are trying to unload their DOT-117 tank car orders (these are the brand spankin’ new ones) for $30-50k less than their order price. Buyers are taking measurers to not take delivery as an unused car now becomes a costly liability.
• Over 10k new DOT-117s tank cars have never been loaded and have gone right into storage.
• Over 30k small cube covered hoppers are in storage and there are an additional 25k in industry backlog.
• Railcar storage prices are up 10x (from $1/car/day to $10/car/day) and storage availability is scarce. Some industry participants have said they don’t know where all the cars coming off track, and cars expected to be delivered, will physically be able to go.
• Retrofit costs are coming in double the initial estimates and most rails are not even accepting retrofitted cars, killing demand.
• Competition for the limited remaining demand (large cube covered hoppers, specialty tank cars, etc) is fierce as the industry now has excess capacity and is willing to swap orders. ARII will struggle to compete against low-cost producer TRN for incremental orders.

Comp sheet and historic valuation: