Description

FreightCar America is a slow growing coal car manufacturer with wildly cyclical revenues and earnings. Both the business and the stock are well into the down portion of the current cycle. I believe this stock is worth somewhere between $40 and $66 base case, and possibly more if numerous plans for coal plant construction truly result in many new coal plants coming on line in the next few years.

As detailed below, RAIL’s annual shipments over the next decade will be 12,300 cars per year, plus or minus 2,000. This translates into normalized annual earnings in the range of $3.25 to $6.50 (2005 is an example of a typical year). All this conservatively assumes so many cancellations or delays of announced coal plant construction projects that coal plant construction merely keeps up with population growth. Following is a link to a report which justifies taking a conservative approach towards new coal plant announcements:

http://www.netl.doe.gov/coal/refshelf/ncp.pdf

If you assign a slow growth P/E of 8 to these earnings and combine that with $14/share cash, the stock should trade between $40 and $66 once backlog begins to show 2 or 3 quarters of growth. The recovery to average or above average volumes could take anywhere from 1 to 5 years, so the annualized return on this investment will depend on how long it takes for this to happen. Assuming typical market behavior, the stock price will rise at least to the middle of this range after 2 or 3 quarters of backlog growth.

It’s hard to peg an exact downside for this stock as cyclical stocks can get awfully cheap, but the company currently has $14/share in cash.

This name was written up once before on VIC so I will not repeat the excellent background information included within that report which discusses the industry, RAIL’s strong position within that industry, and prospects for expanded coal production. My biggest numerical difference is the assumed replacement cycle – I chose to use 30 years instead of 25, as the presentation currently on the website notes a 3% replacement rate and the S-1 from a few years ago states 25-30 years as typical. My more conservative assumption combined with a different methodology leads to the lower 12,300/year freight car delivery average, as follows:

(See p.21 of presentation on RAIL website, “U.S. Coal Car age profile.”)

Assume all coal cars aged 31-50 are replaced (48k cars)

Assume 1/3 to 1/2 of cars aged 20-30 are replaced (30k to 45k cars)

Assume 1% to 2% annual growth in total coal cars (25k to 50k cars)

Total over next decade: 103k to 143k cars (10.3k to 14.3k per year)

Though RAIL ships other kinds of cars as well, coal car deliveries (of which RAIL ships 80%) serve as a good approximation for RAIL’s total deliveries each year, if you look back a number of years.

Railcar manufacturing is a high fixed cost business. My crude model (which roughly conforms to actual results of the past 10 quarters) shows breakeven operating earnings at approximately 6,000 cars per year, and EPS of $3.25 for a 10,300 shipment year, and $6.50 for a 14,300 shipment year, assuming no more buybacks. Note that the breakeven point is higher than from several years ago, because the company has the extra costs of being public (SG&A), and because of a union settlement detailed in the S-1 (COGS). Also note that the company has three plants, one with substantially higher variable costs. At a run rate beyond 7,000 railcars per year or so, the company must produce out of its more costly Johnstown plant.

As described in the last write-up, the competitive landscape is fairly stable despite various attempts by RAIL and its competitors to extend product lines and/or services. So despite the big ups and downs for orders over several years time, this is really a very predictable business when one thinks in terms of the next decade, as the business grows too slowly to attract new entrants. However, there are a few additional opportunities and risks to consider with this business:

Opportunities

Many utilities have an intention to build new coal-fired plants, in conjunction with track capacity expansion in the Powder River Basin due for completion in 2009 (portions of the expansion have been completed already). Assuming this all comes to fruition, new coal cars will need to be built and the numbers described above are significantly understated. U.S. currently has 313GW of capacity from coal plants and it seems likely that this will be increased by at least 1%/year for the next few years, and possibly higher than 2%/year. See prior VIC report on RAIL for more detail, as well as the report referenced by this link again provided:

http://www.netl.doe.gov/coal/refshelf/ncp.pdf

The company is currently negotiating with the union for the Johnstown plant. Production has dropped drastically (and may soon be zero) at this plant, so the company has extra leverage in the negotiations. At some point, the union will make concessions or the company will close the plant altogether and outsource production to a less expensive manufacturer. Last CC, management indicated that an announcement on this should come soon.

Rail legislation (H.R. 2116) has been introduced (but not yet debated) which promotes expansion of rail capacity. Nothing in the bill has a direct impact on RAIL, that I can see, but it seems possible that tax breaks beneficial to RAIL could be added to the bill as it winds its way through congress.

The company is already buying back stock – obviously the lower the stock price, the greater the benefit of these buybacks.

Risks

Railroads have been increasing efficiency over the past few years, meaning fewer cars are needed to move the same amount of coal. For example, BNSF increased railcar velocity by 9% in 2006, the equivalent of adding 7,600 railcars to their fleet, and expects further improvement in 2007. Eventually, a plateau will be reached beyond which further efficiency gains are very hard to attain, but I’m not sure when that point is. On the other hand, if coal cars are spending a greater percentage each year in transit, then presumably they will wear out faster which could lead to a shorter average life.

The competition appears to be chipping away a little bit at RAIL’s market share of late. Not sure if this is just quarterly fluctuation or the beginning of a long-term trend.

The coal industry is often a big target of various types of federal or state legislation and local resistance, due to carbon emissions and other forms of pollution. Federal legislation is not a risk in the near term as two major pieces of legislation favorable to coal are about to pass: The Global Warming bill (if passed) will award over 300 billion dollars worth of auction proceeds to the coal industry for efforts associated with carbon sequestration (which does not yet exist) and the Energy bill contains no provisions hurting the coal industry. Neither bill contains any provisions promoting any form of renewable energy. However, the tide could easily turn under a new congress and/or presidential administration in 2009, and many states/locales take matters into their own hands, which causes delay or in some cases cancellation of new coal plants.

The company has frequently discussed rail-related acquisition possibilities for the last two years. Discussion for the last two quarters has centered on India. While the fact that the company is taking a long time to make an acquisition is a good sign, there is always the possibility that they will convert cash into a disastrous acquisition.

There are several factors that can cause demand for coal to slump. If some or all of these factors came into play for several years in a row, then this would lead to a multi-year slump for orders of new coal cars. 92% of coal use in the U.S. is for electricity generation and the amount of electricity needed is driven by growth in the economy and weather (moderate weather means less electricity needed). Coal competes with other energy sources – it is currently by far the most economical but that could change, especially if natural gas prices stayed low for many years.

The short term risk is that shipments fall below 1,500 units per quarter, which causes EPS to go negative. Consensus estimates for next couple quarters seem high to me, and the shares may go down in reaction to the company missing earnings estimates. In other words – the bottom for this stock might be a lower price 1-2 quarters from now.

Catalyst