Description

GATX Corp. is the industry leader in the railcar leasing industry. It has generally been a well-run company and a stock we have owned in the past when it was clear it had strong tailwinds which would power earnings for years to come. Today the exact opposite is true and as such we are recommending it as a short. These uncontroversial earnings headwinds are likely to depress profitability not just during the lockdowns necessitated by the COVID-19 pandemic, but for several years to come.

Our view is based on four factors which will almost certainly negatively impact earnings going forward.

1. Aircraft engine leasing. 36.4% of pre-tax earnings are derived from a passenger aircraft engine leasing joint venture GATX entered with Rolls Royce. The JV also accounts for 30.4% of tangible book value. Not only is this a tough business currently given the dramatic decline in commercial aviation, but the nature of the GATX JV is particularly exposed to the exact types of engines which will be the fastest to stop cash flowing and the slowest to recover.
2. Pricing. GATX came into 2020 warning that lease renewal pricing was likely to be down 10-20% this year. This was before the COVID-crisis hit. It is now reasonable to assume the low-end of their beginning of the year expectation range is not a floor. Lease renewals at dramatically lower rates effect earnings at an increasing rate and for years to come as more and more cares are subject to downward repricing.
3. Utilization. GATX came into the current environment with an impressive 99% utilization rate for rail cars. This kind of performance is to be commended, but also implies this very important metric has only one direction to go. Pressure on utilization effects non-earning assets, pricing and expenses…all in the wrong direction.
4. Gain-on-sale of rail equipment. The highest margin revenue line at GATX is selling depreciated equipment for significant gains. This source of income is also likely to be severely pressured in a massively oversupplied market.

For purposes of this examination we will use the first quarter of 2020 as the unaffected baseline to which we will measure the likely impacts to profitability of GATX various headwinds. For what it is worth, the direction and magnitude of the conclusions would be very similar if we used 2019 or the last 12-months as a baseline.

GATX Baseline:

The pre-tax income results displayed above equated to $1.31 of reported operating earnings. While the $1.05 consensus analysts have predicted for the next two quarters may seem like it reflects the soft environment in which we find ourselves at the moment, we suspect the impact on GATX will be significantly greater. But what is more important is that we believe the current headwinds, combined with challenges GATX faced pre-pandemic will combine to restrain earnings for years into the future.

Aircraft Engine Leasing

In the wake of the COVID-19 pandemic and the impact it has had on passenger air traffic, the stocks of aircraft leasing companies such as Aercap (AER), Air Lease and Fly Leasing (FLY) have been devastated, leaving each trading at near half of tangible book value or lower. What has gone less noticed is the fact that a very significant portion of GATX’s income is derived from aviation leasing, specifically in the form of a 50/50 joint venture the company entered into with Rolls Royce Holdings (RR.LN) called Rolls Royce Partners Finance (RRPF). GATX has $532 million or $15.23 of book value invested in the JV. Per GATX’s most recent 10Q, the JV owns 478 aircraft engines with a net book value of $5.0 billion, compared to $1.06 billion in equity (including Rolls Royce’s 50% ownership) suggesting the RRPF carries significantly more leverage than each of the three dedicated aircraft lessors mentioned above.  

Higher leverage is not the only aspect of the GATX JV that suggests the business is riskier than those of the public aircraft lessors. The JV is solely focused on 1) spare engines for 2) two aisle jumbo jets serving exclusively 3) passenger airlines. This is an unfortunate combination given the nature of the current economic crisis.

1. Spares. Airlines lease spare engines to replace engines which periodically must be overhauled, a process that can take several months. Rolls Royce is in the engine maintenance business so it makes sense to have a captive that leases engines to their customers to replace the engines on which they are working. RRPF faces several issues based on it focus on spare engines. By their very nature, spare engine leases are short-term implying a significant number of leases will expire during the current shutdown. Further, since very few planes are flying, very few engines are “burning green time” (the hours an engine can fly before requiring maintenance). Finally, as it is likely that a return to pre-COVID flight schedules is many months away, if not longer, for quite some time airlines will be able to swap engines from planes which are not yet flying when a particular engine is due for maintenance rather than needing to lease a spare.
2. Jumbo jets. Rolls Royce builds engines for wide body planes including the Airbus A330, A340, A350 and A380 as well as the Boeing 777 and the 787 Dreamliner. These are planes which fly primarily long-haul, international flights. Most experts reasonably expect domestic travel, dominated by narrow body, single aisle planes will be the first to return to service with demand widebody routes put off for an indefinite amount of time.
3. Passenger airlines. Not all types of flights have been grounded during the economic shutdown. Freight carriers have been doing robust business getting supplies to people and businesses all over the world, in part because the supply normally provided by the cargo bays of passenger jets have been taken offline.  Freight carriers significantly lease rather than own their planes and have therefore proved a reliable source of revenue for the dedicated aircraft lessors over the last several months. Unfortunately, the GATX aviation JV has no such reliable lessees as it  exclusively serves passenger airlines.

Further, like the GATX rail business, a significant portion of RRPF’s income is derived from selling used engines. In a market that is currently massively over-supplied with engines and will be for sometime to come, a drop in lease revenues is not the only hit RRPF’s revenues will take as a result of the pandemic.     

There is some good news for the JV. It leases a significant number of its engines to Rolls Royce who then re-leases them to their airline customers. Rolls Royce is not an immediate credit risk and is likely to perform on its leases. However, GATX investors should not take too much comfort in this arrangement. On March 20th, the Rolls Royce Civil Aerospace division announced it was laying off at least 9,000 employees in response to the dislocation in the industry. While it will likely meet its contractual obligations to the JV, there is little chance it will renew leases it has no chance of re-leasing to struggling airlines. As such, whatever impact the aviation leasing business has on GATX earnings in Q2, it is almost certain to get worse as time passes. 

RRPF accounted for 36.4% of GATX’s pre-tax income in Q1 (33.9% in 2019). How much will it decline in future quarters? It is tough to say. GATX’s 10Q indicates they are deferring lease payments for some customers, but just because they are deferring payments does not mean they won’t accrue revenue for payments that should have been paid but were not. What seems certain is that this earnings contributor will start to decline in Q2 and continue to decline, likely at an accelerating rate as leases mature and cash flow dries up.

Pricing and Utilization

Pricing and utilization are somewhat two sides of the same coin and as such we’ll discuss them together. They are both currently headwinds. The economic impacts of the COVID-19 pandemic are only intensifying the significant downward pressure pricing was under at the beginning of the year. Utilization was at 99% at March 31st suggesting there is only one direction to go as demand deteriorates. The two items are tradeoffs. It is possible to maintain a high level of utilization by cutting price or to maintain discipline on pricing by being willing to let utilization slip. GATX management has generally chosen utilization.

GATX publishes what they term their Lease Pricing Index or LPI. The LPI measures the marginal lease prices the company expects to achieve against rates of leases rolling off. Before we were aware of COVID-19 and the impact it would have on the economy, GATX management guided the LPI to -10% to -20% for 2020. This was largely due to the roll-off of premium pricing GATX was able to achieve 5 and 6 years ago when oil was trading near $100 per barrel and cars to carry oil, fracking sand and piping were in heavy demand. In 2014 and 2015 the LPI averaged a positive 35.2%, pricing which has buoyed earnings for the last five years. But that boost is expiring and those cars will now have to be re-leased into the current market.

Given how much softer demand for cars is now (total carloads down 25-30% year-over-year depending on who’s measuring and with demand for energy-related cars down significantly more) we believe the low-end of the guidance range is highly hopeful at best. As mentioned, GATX management has generally determined it would rather compromise on price than allow utilization to slip. This may be the correct policy as it preserves cash flow and avoids the expense of storing idle cars, but it does have longer term consequences as it locks in lower pricing for at least the next several years. Lower pricing takes a while to have its full impact on results as only about 5% of the fleet comes up for renewal each quarter, but the effects of a prolonged downturn are cumulative and long-lasting.  

Despite GATX’s best efforts, we still expect utilization to decline at least modestly. With upwards of 30% of cars in North America idle and in storage, it is difficult to imagine GATX will find a paying lessee for every car that is returned at the end of its lease.

As shown in the baseline table above, we estimate every percentage point decline in utilization equates to approximately 5% of pre-tax earnings and utilization declines hit results immediately.

One last note. Above we have outlined the dynamics of GATX’s North American Rail business which accounts for 78% of its total lease revenues. The other 22% is International  Rail where we believe the fundamentals could be incrementally worse than the US and where GATX does not hold market leader status as it does in North America.                         

Gain on sale

Another significant revenue item for GATX is the income it earns from selling or scrapping old cars. As indicated above, “Net gain on asset dispositions” accounted for 43.1% of pre-tax income in Q1. Given the glut of idle cars in North America in 2020, there will be little demand to buy older cars from GATX at an attractive price. This is not to say GATX will not be able to generate any income from the disposition of older cars. The company does have the option of cherry-picking fully depreciated cars and either selling them at a low price or scrapping them for their steel content, both of which will generate some income, but much like accepting lower leasing prices, selling your cheapest assets is trading future income for current income and will lengthen the deep earnings recession we expect for GATX.   

What is GATX worth?

GATX currently trades at 13.8x a 2021 consensus estimate of $4.56 which implies EPS growth over 2020. We clearly do not believe 2021 will be an earnings growth year as the negative impacts of the aviation engine JV profitability and negative rail car lease pricing will take a compounding toll on results over time. In fact, given the demand destruction, particularly for those cars serving the US fracking industry, we don’t see a clear route for 2022 earnings growth relative to 2021. Given the multi-year negative earnings trajectory, we believe 12x a perhaps overly generous $3.75 estimate for next year is reasonable, implying a $45 per share value.

To be clear, $3.75 is not a floor for where earnings could go. The argument could be made (and has been) that long before we ever heard of COVID-19 earnings were significantly lower for a myriad of reasons including:

1.       Precision scheduled railroading materially decreasing demand

2.       Historically low interest rates attracting competition in an already commoditized business

3.       The industry was materially overearning given the historically high lease rates of 2013 through 2015 and

4.       The decline of the US fracking industry was further sapping demand from a relatively price insensitive customer

There is every reason to believe the current situation only accelerates these trends. We chose to focus on only the most obvious and immediate impacts to earnings, but acknowledge significant downside.   

We anticipate some pushback from long-time GATX observers who will point out that the stock has traditionally found a valuation floor at or around book value in previous periods when fundamentals were lined up against the company.  Tangible book is currently $50.11. The logic is appealing as railcars are long-lived assets which will retain value until headwinds subside. This may have been true in the past, but the aviation business was never such an important component of earnings and book value when this valuation thesis has been previously tested. The JV comprises 30.4% of GATX’s tangible net worth and as we documented above, would likely trade at a discount to the public aircraft leasing companies given higher leverage and significantly worse assets and customers given current industry realities. If we only marked the JV to 50% of book, GATX’s pro forma tangible book value falls to $42.50, implying our $45 value is still 106% of tangible book, a valuation that is well within the historical range when earnings have been under pressure.

 These aircraft leasing comps are better positioned than the GATX JV   

Catalyst

Earnings disappoinments relative to consensus.

Significant writedown to the value of RRFP.