Description

Come hell or high water railroads have to spend on track maintenance to ensure that goods and people are moved about smoothly and safely.  This is precisely what makes Portec Rail Products a good business.  As a leading producer of rail maintenance supplies the company enjoys stable demand for its products and has an advantage over competition since Portec's products are perceived as more reliable by the railroads.  The other ingredient of a good investment is also present - PRPX is available for approximately 7X NFY FCF.

Portec Rail Products (PRPX) is a century-old Pittsburgh-based corporation engaged in manufacturing and distribution of rail maintenance products, such as rail lubricants, rail joints, rails spikes, wayside detectors, and others.  Rail supplies market in North America amounts to approximately $7 billion, and while PRPX accounts for less than 1.5% of the industry sales, the company is one of the leading players in the market and occupies #1/#2 positions in most of its products lines.  Rail maintenance products market is a fairly stable one, as rail maintenance must to be performed on a regular basis in order to comply with federal regulations and to preserve operating efficiency. 

Due to PRPX's industry leading position, the stable nature of the underlying business, and depressed valuation, the Company's stock currently represents a highly attractive investment opportunity as evidenced by: 

• PRPX's leading positions in most of its products lines, which enables the company to generate 30%+ returns on tangible book value;
• Solid financial condition, as PRPX enjoys debt payback (Net Debt/FCF) of less than one year;
• High degree of interest alignment between management and shareholders, as insider ownership stands at approximately 30%; further, several insiders recently bought the shares for their personal accounts;
• Substantial long-term growth potential stemming from the highly fragmented nature of the rail products industry;
• Dirt-cheap valuation, as PRPX's stock is selling for approximately 7X NFY FCF.

THE BUSINESS AND ITS COMPETITIVE ADVANTAGES

Rail maintenance supplies is a business, in which industry leaders such as PRPX, enjoy solid profitability and a high degree of stability.  As railroads' safety compliance and operating efficiency are directly impacted by their choice of maintenance products supplier, the operators have an incentive to stick with the reputable vendors.  Further, delaying track maintenance is generally not an option either because railroads have to comply with federal regulations or because they have to ensure that no costly infrastructure damage occurs.  For example, a railroad has to immediately replace track components, which are determined to be worn out by federal inspectors.  Even the products which are not federally regulated, such as, for example, rail lubricants, have to be regularly re-applied in order to avoid permanent damage to the rails, which are the most expensive part of the track infrastructure.  Therefore, railroads normally have to purchase railroad supplies regardless of the prevailing economics conditions, thus providing a degree of resiliency to the industry.  As a result of the dynamics described above, the owners of the most reputable brands can, in most cases, charge a decent mark-up vs. competing products, while enjoying a stable demand for their goods.  The ability to extract a premium is a major factor that helps ensure the leaders' dominance by keeping incumbents starved of profitability.

The aforesaid economics of the rail maintenance supplies industry imply that PRPX's major competitive advantage is the strength of the Company's brand name.  As the PRPX name stands for a high quality product, railroads are normally inclined to purchase from the Company despite a somewhat higher price point.  As track maintenance supplies directly impact both safety and efficiency, while comprising a small portion of the overall railroad capital budget (less than 2%), railroad operators have every reason to stick with leading vendors.  For example, a $2 million investment in a lubrication program by PRPX for a roughly 1,000 mile mainline results in over $30 million of rail and fuel savings in the course of four years.  You can probably find a small vendor of unknown quality willing to offer its lubrication program for $1.7 million, but why would you put $30 million at risk to save $0.3 million?  As a result, PRPX can generally charge a mark up ranging from 2-5% to 10-25%, depending on the product line, vs. competing products.  In addition, the Company can normally pass through price increases without much resistance from its customers.  For example, when raw materials prices escalated in the summer of 2008, PRPX had no trouble putting through a price increase, even though railroad traffic was going through a period of decline.  It would be fairly hard for a new entrant to replicate PRPX's brand name advantage within the Company's product niches due to the highly fragmented nature of the rail maintenance supplies market.  The market is comprised of a large number of very small product line niches, and both the engineering effort and the brand building effort required to enter these niches are significant.  Such a niche entry would generally make little economic sense, if a dominant player is already present.  For example, an entrant into the friction control market, which is a $35 million market in North America, would have to spend quite a few million dollars on R&D and would have to underprice PRPX by such a margin that the incumbent's profit prospects would be very distant and highly uncertain at best.

The second competitive advantage that PRPX has is the company's broad product line up and distribution capability.  PRPX offers a wide array of railway maintenance products, such as track components, friction management supplies, wayside data collection devices, and others through its extensive distribution network.  Such distribution and product range capabilities make PRPX an attractive partner to the railroads, who can reduce their costs by consolidating purchases with fewer vendors.  At the same time, few of the Company's competitors offer a comparable capability in terms of distribution and product range.  Due to their much smaller scale, most of PRPX's competitors would find it hard to replicate the company's distribution footprint and product breadth without substantially impairing profitability, which is not something they can afford.

Another advantage PRPX has is the company's new product development capabilities.  Track maintenance supplies manufacturing is an engineering-intensive business, whose long-term success is highly dependent on new product development.  Therefore, PRPX management is committed to investing heavily in new product development regardless of the short-term macroeconomic situation.  For example, PRPX ramped up R&D spending by 25% in 2008, despite the decline in the company's end markets.  PRPX's new product development efforts enable the Company to continuously widen the competitive moat between itself and the rivals, many of which spend less on R&D both on a % of sales and absolute dollar basis and simply cannot afford to keep up with PRPX product development efforts.

In addition, PRPX sets itself apart from competition through top-notch customer support.  As the company works closely with the railroads on developing new and improving existing products, it is essential that customer inquires and concerns are addressed in a timely and effective fashion.  In addition, it is critical for railroads to receive a rapid and detailed response to whatever questions may arise during the component replacement and utilization process.  To that end, PRPX's customers can rest assured that if they have a component issue, the Company will address it promptly, either via phone or through an engineer field visit, if needed.  At the same time, few of PRPX's competitors have the scale and the resources to maintain the number of engineers necessary to ensure prompt and effective response to the railroads' track component inquiries.

Lastly, PRPX's solid financial condition represents another competitive advantage.  As a result of the low capital intensity of its business model PRPX has been able to finance its growth primarily through internal sources in recent years.  Thus, the company enjoys a solid balance sheet with a debt payback period (Net Debt/FCF) of under one year.  The Company's strong financial position enables PRPX to pursue attractive expansion opportunities and spend on its product development even during major economic downturns.  In contrast, quite a few of the company's rivals are in a shaky financial condition, which puts them at a competitive disadvantage in terms of financial strength vs. PRPX.

FUTURE GROWTH POTENTIAL

PRPX boasts substantial future growth potential due to the fact that rail maintenance supplies is a large, growing, and highly fragmented market.  While the Company is one of the largest suppliers in the industry, PRPX accounts for less than 1.5% of the market, speaking to the high degree of fragmentation of the maintenance products market.  Given its advantages vs. most rivals PRPX should be able to take market share from smaller less established competitors by entering the underserved niches of the market.  For example, in 2004 the Company entered the wayside data collection systems market, and was able leverage its distribution and R&D capability to significantly expand the business over time.  In addition to taking market share from weaker rivals PRPX should be able to grow by expanding the market through using its R&D capabilities to develop product niches which haven't existed before.  For example, a couple of years ago PRPX introduced a top-of-the-rail lubricant (prior to that, lubricant was applied to the side of the rail only) that enables railroads to increase their efficiency substantially.  The size of the potential market for the top-of-the-rail product is in the neighborhood of $150 in North America alone, which compares to PRPX current revenues of approximately $110 million.

It is important to highlight that the Company's growth is not likely to be significantly impacted by economic slowdowns which are certain to occur from time to time.  As rail maintenance generally cannot be deferred due to either federal compliance regulations or efficiency requirements, PRPX future growth should be relatively consistent.

MANAGEMENT

PRPX has a solid management team at helm.  The Company's CEO, Rich Jarosinski, has been with PRPX since 1975, and prior to assuming his current position in 2006 he was the president of the Company's flagship Railway Maintenance Products Division.  Since his appointment Rich has done a good job continuously improving existing products while also expanding PRPX's product line to include higher value added products, thus further deepening the moats around the company's competitive position.  Overall, PRPX management team has a good track record of creating shareholder value through accomplishing industry leadership in product quality and innovation.  Notably, PRPX executive team scores well both with respect to operations and with respect to capital allocation.  In terms of operations, PRPX management is committed to devoting ever increasing amounts of funds to quality assurance, new product development, and building its distribution network.  The Company generally maintains its commitment even during tough economic times, as the executives understand that maximizing long-term value should take precedence over maximizing short-term financial results.  PRPX's management has a satisfactory track record with respect to capital allocation as well.  Over time the company widened its competitive moats significantly through a number of acquisitions, which were smart strategically and effected at prices resulting in solid returns on invested capital.  At the same time, management is very selective with acquisitions and subscribes to the philosophy that "the best deal is the one you don't make."  In addition to using cash flows to finance growth, PRPX has historically returned a substantial portion of its cash flow (nearly 30-35%) to shareholders via dividends.  Given that the Company has not, historically, repurchased its shares, some may argue for a share buyback program.  However, as PRPX can acquire quality rail supply vendors, which are complimentary to its core business, at below the company's own valuation (less than 4-5X EBITDA vs. more than 6X EV/EBITDA, respectively), it appears that investing in external growth initiatives is a reasonable approach.

Executive compensation at PRPX is rather modest by industry standards.  For example, CEO's total comp is below $300,000 and CFO's total comp is below $200,000.  At the same time, the Company has a significant percentage of insider ownership, as directors and executive officers owns approximately 31% of the shares outstanding.  A number of insiders have been buying PRPX shares personally the past few months.  While the absolute dollar amounts of these purchases were quite modest, the purchases were decent size as a percent of the purchasers' net worth.

VALUATION

In PRPX's case valuation is relatively straightforward. The calculation of the Company's NFY FCF is presented in the table below:

(* The substantial difference between D&A and CAPX is mainly due to goodwill amortization and also due to the fact that PRPX recently completed a major expansion program, which contributed to the increase in D&A.  Given current utilization rates no additional capacity will likely be needed in the next few years, thus keeping a lid on CAPX.)

At $8.00 PRPX's market cap net of cash is approximately $71 million, resulting in NFY FCF multiple of approximately 7X.  Given the quality of the company's business and its growth potential, it appears that the stock is significantly undervalued at current levels.

Catalyst

• Sheer cheapness of the stock, as it sells far below the intrinsic value;
• Continued growth through expanding into the related niches of railway maintenance supplies market both organically and through acquisitions.