Description

Trinity Industries – Long Common Stock ($30.00)

Price Target $47 or +60%

Thesis / Variant Perception:

• We see an attractive opportunity to buy shares of Trinity Industries at a depressed valuation – shares are off nearly 40% from their September highs – driven by investor fears over peak valuation, low oil prices leading to a downturn in energy-related railcar demand and potential litigation liabilities relating to the Company’s ET-Plus guardrail product (we estimate ~$1.25bn to $1.5bn currently priced into the stock)

• Current share price of ~$30 substantially undervalues the Company based on its current and projected earnings, which have visibility due to the sizeable backlog ($6.8bn or 6.6 qtrs of production) and a mid-teens FCF yield to equity which allows for substantial capital return to shareholders. In addition Trinity is not getting credit for its transformation into an industrial conglomerate over the last cycle which supports earnings and cash flow during railcar downturns and deserves a more full multiple through the cycle
  

• Non railcar related businesses such as Barge, Construction Products and Energy Equipment now account for ~20% of Trinity consolidated Ebitda. These business remain undervalued in Trinity current form and go overlooked by a market that still value TRN as a pure hyper-cyclical, railcar manufacturer.
  

• We see upside to our $50+ / share, Sum-of the-Parts based valuation even under conservative assumptions, providing upside potential of more than 65% from current levels

• Recent insider buying (5/5/2015) with CEO Tim Wallace acquiring ~$600k worth of stock and CFO James Perry acquiring $295k

• Recent US and Canadian tank car regulation substantially lengthens the opportunity for backlog growth with regards to energy related railcars as 3 to 5 year “phase-outs” are now in place. In addition Trinity possess an opportunity to capture “retrofit” business as one of the larger service providers. This should all lead to a re-rating of Trinity’s and the sector’s multiple which has been battered by the crude downturn and fears of peak tank car demand (stock down ~40%)

• TRN is trading at a discount to peers even though it benefits from a stronger leasing platform, which provides more stable earnings, and maintains exposure to non-rail markets through its other divisions (over 20% of earnings outside of railcar manufacturing and leasing)

• Trinity’s ET Plus product passing 8 mandated government cash tests (March 2014) should de-risk the forward path, once more clarity is provided surrounding the recently announced DOJ investigation, paving the way for multiple expansion

• The current DOJ investigation appears to be focused on the FHWA and its relationship with Trinity over the last several years and not Trinity directly. Based on prior precedent fines, we believe the potential DOJ liability is sub-$100mm, well below the +$1.3bn litigation driven market capitalization erosion over the last 6 months. Our base case remains $750mm in total fines and penalties

• Current valuation implies current rail-car cycle is ending, which we fundamentally disagree with given the still positive outlook for the broader economy and new tank car regulations

• Railcar demand continues to be supported by strong economic fundamentals, as rail traffic increased 4.4% in 2014 and continued to post strong volumes into year-end and 2015 even as oil prices decline precipitously; weak Q1 rail volumes are expected to improve through the rest of the year, as GDP growth accelerates, based on recent guidance from rail companies

• New tank car regulations (Canada & US) will drive further re-fleeting needs and thus continued earnings and back-log momentum; Trinity itself maintains a substantial leasing fleet but any new regulation costs are passed on to the customer (price and contract adjustments) thus insulating TRN from any negative re-fleeting capex in its leasing business

• Valuation applied by the market to the shares of TRN, at less than 4.5x EV/ 2015E EBITDA and ~6.5x 2015E EPS, implies substantial doubt about the sustainability of the railcar cycle even though current industry deliveries of ~75k railcars are not overly extended beyond the ~50k replacement rate of the industry, and industry backlogs extend nearly two years

• Certainty of near-to-medium earnings aided by record backlog

• TRN possesses a backlog of 1.8 years of LTM deliveries – 57.2k unit railcar backlog

• We project $1.75bn of EBITDA for 2015 (incl $166m from asset sale income), compared to $1.5bn LTM (incl $73m from asset sale income), and $719m EBITDA at the peak of the last cycle in 2008 (28.2k railcars shipped)

• Leasing segment adds a strong degree of earnings stability, with average lease term of ~7 yrs (3.4 yrs average remaining lease life), and the division contributing $466m LQA EBITDA as of Q115

• The Company generates substantial cash flow that can be utilized to increase returns to shareholders

• We project $719m of free cash flow in 2015, nearly 15% of the fully diluted market capitalization (169m diluted shares accounting for an in-the-money $450m convert)

• Management currently has $194m remaining on a share buyback authorization and annual dividend payout of $60m per year. We expect buybacks to ramp now that the Company’s has additional visibility on the ET-Plus cash test results which came out positive on 3/14

• Given the depressed share price, the certainty of earnings provided by the backlog, and its strong balance sheet (BBB- / Baa3) we believe that management is likely to increase returns to shareholders through an upsized buyback program in order to support the stock price

Litigation Related to Highway Guardrails (ETPlus):

• Trinity is currently involved in litigation related to the ET-Plus product that it manufactures under patent

• Lawsuit was initiated by claims from a whistleblower that worked for a company manufacturing a competing product, which Trinity put out of business with a patent infringement lawsuit

• TRN is alleged to have cut out materials in order to save costs under its model that has compromised the safety profile of the guardrails and led to severe injuries during car crashes

• The product accounts for less than $40m of annual sales and the Company has discontinued the product as of the middle of 2014

• In October 2014, a jury found Trinity liable, with a $175m damage award that automatically gets trebled ($709m potential obligation including civil damages); Trinity continues to be in mediation with the plaintiff and the judge continues to defer a final judgment, with  a subsequent appeal process almost assured once the judge enters a decision

• Several states have filed suits or have indicated the desire to do so, requesting that Trinity be required to remove and replace all the ET Plus units on their roads due to non-compliance with safety standards

• After the adverse ruling, TRN was ordered to conduct crash tests on the ET Plus by the FHWA, with the purpose of recertifying the product; it was announced March 14, 2015, that Trinity passed all eight tests, which were observed by independent third parties including state observers, the FHWA and the media. The Southwest Research Institute, an organization with nearly 300 PHDs  and 1,100 patents, was mandated to conduct the crash tests and opine on their results

• On April 29, 2015, TRN filed an 8K stating that they had been subpoenaed by the DOJ to turns over all documents in regards to the ET Plus and its predecessor product, dating back to 1999; the DOJ investigation was previously broken in a Bloomberg news story and appears to center around Trinity’s relationship with regulators at the FHWA

• Our extensive analysis of recent DOJ actions indicates that it is not an uncommon occurrence for the DOJ to be investigating a number of claims against public companies; our analysis also shows large payouts stemming from such cases are rare, and tend to apply in cases of substantial mortgage fraud or extensive bribery.  Examples:

• Boston Scientific and Subsidiaries to Pay $30 Million for Guidant’s Sale of Defective Heart Devices for Use in Medicare Patients

• Sprint Communications, Inc. (formerly Sprint Nextel Corporation) agreed to pay $15.5 million to resolve allegations it defrauded federal law enforcement agencies when recovering its costs of carrying out court-ordered wiretaps, pen registers, and trap devices

• Robert Bosch GmbH, the world’s largest independent auto parts supplier, agreed to plead guilty and pay a $57.8 million criminal fine for its role in a conspiracy to fix prices and rig bids for spark plugs, oxygen sensors and starter motors sold to automobile and internal combustion engine manufacturers in the US and elsewhere

• Avon Products Inc. and its wholly owned subsidiary Avon Products (China) Co. Ltd. pleaded guilty to violating the Foreign Corrupt Practices Act (FCPA) by making and concealing illicit payments to Chinese government officials to secure business there. The company agreed to pay more than $135M in criminal and regulatory penalties to resolve the charges. According to the government, from at least 2004 through 2008, Avon and Avon China conspired to falsify Avon’s books and records by falsely describing the nature and purpose of certain Avon China transactions. Specifically, the companies sought to disguise more than $8 million worth of gifts, travel, meals and entertainment that Avon China executives gave to Chinese officials. The Avon entities will pay $68M in criminal penalties and another $67M in related FCPA matter it settled with the SEC

• While much uncertainty surrounds this litigation, and we expect the process to continue to be dragged out in the courts, we have modeled a $750mm claim amount to resolve this issue – analyst estimates for total costs, including damages and potential replacement costs range from $500m to $1bn

Rail Segment Overview:

• Earnings from the rail segment are highly cyclical but have set new highs in the recent cycle as booming US energy production has helped drive demand for tanker cars (crude transport) and covered hoppers (sand and other fracking materials transport), which comprise nearly 80% of the industry wide backlog at last year’s high point (50% of existing railcar fleet)

‒ Trinity holds 40-45% market share of all North American railcar production, consistent with the prior cycle; share is higher, at ~50% for tank cars

‒ Railcar pricing is at new highs driven by an improving mix of higher priced tanker cars and tight industry utilization driving pricing power for manufacturers

‒ Backlog covers nearly two years of production

• We expect that orders will subside from their recent breakneck pace but revenues will be supported by a strong backlog and robust economy

‒ Recent tanker orders were likely elevated due to customers looking to take up highly prized build slots amidst tight industry capacity

‒ We expect positive economic conditions to help drive orders for other types of railcars going forward as well as replacement demand (~50k per annum for industry based on 1.75m total fleet estimate and average life of just under 30 years

Rail Transport Fundamentals:

• Rail demand has been strong in recent years

‒ Growing economy has contributed to ongoing growth in rail traffic; up 4.4% in 2014

‒ A near-doubling of energy production, helped by the shale boom and growing oil sands investment in Canada, has contributed to increasing loads of tanker cars and hoppers used to transport sand and fracking materials; petroleum and fracking sand loads up 12.5% and 9.5%, respectively, in 2014

‒ The coal sector, which accounts for a sixth of total rail traffic in North America and has historically been the single largest contributor to rail demand, has actually declined 15% since 2011 and nearly 30% from 2008

‒ Given continued growth in North American oil production – projected to be up mid-to-high single digits in 2015 – and a strong economic outlook, rail transport volume should remain at currently high levels and likely expand further

Leasing Segment Overview:

• Trinity has steadily built out its leasing business in the last decade, now possessing the 7th largest railcar fleet in North America

‒ GATX is the largest publicly listed competitor in the leasing business (trades at ~2x book)

‒ Other large fleets are owned by GE, CIT, Wells Fargo, and Berkshire Hathaway

• Fleet utilization benefits from tight production capacity and a robust need for transport capacity; lessors own nearly all of the tanker car fleet in North America due to the higher maintenance and shorter useful life than standard railcars

• We expect leasing earnings to remain strong as the Company continues to build out its fleet and rail transport benefits from a still growing economy

‒ Leasing division currently accounts for 20% of manufacturing division’s backlog

‒ Lease terms of 5 to 7 years provide visibility on rates, which should also maintain strength due to high utilization levels and tight capacity

Rail Manufacturing Overview:

• Railcar demand has historically been cyclical

‒ Rail transport demand is correlated to GDP and the more economically sensitive sectors of the economy – autos, coal, building materials, chemicals – are responsible for the majority of traffic

‒ Orders are made in advance of an elongated build cycle

‒ Current cycle has been unique as railcar shipments since the 2008/09 downturn have been spurred not just by economic improvement but a near doubling of oil production in the US due to the shale boom

‒ Current backlog stands at all-time highs as manufacturing capacity is very tight

• Railcar shipments are expected to remain above replacement due to the strong economy (boxcar orders have recently started to inflect upwards) and tanker orders potentially spurred by increasing chemicals production and new safety regulations

Railcar regulation:

• We believe the regulations announced by the DOT on May 1, 2015, are bullish for tank car demand and should elongate above replacement deliveries for TRN and the railcar industry as a whole for the next ~3 years

• We estimate that the new regulations should result in ~9,500 tanker orders per annum for TRN, related to crude-by-rail and ethanol carrier demand (replacement due to phase out and cost of retrofits). Total Trinity 2015E deliveries of 35,000 are thought to encompass 10k – 15k of energy related deliveries. Our expectation is that up to 75% of these deliveries can be replaced with new demand stemming for the new regulations

• The demand driven by new regulations should serve as a strong offset to the likely slowing in the recent energy-driven demand for tank cars and frac sand carriers as energy capex is reduced across the space

Valuation:

• We believe the most effective way to value TRN is on a sum-of-the-parts approach given the diverse business characteristics of its segments

• We derive our value from (1) the railcar manufacturing segment (valued on a mid-cycle EBITDA, more than 60% below 2015E segment EBITDA); (2) railcar leasing; (3) barge; (4) construction products (largely aggregates); (5) energy products (wind turbines, steel infrastructure for utilities, and liquid tanks); (6) on balance sheet cash at YE 2016

• We subtract an estimated litigation claim of $3 - $6 per share ($750mm base case liability), acknowledging that while the ultimate payout is more likely to be below our range than above it

• We see substantial upside in the shares to over $53 per share, with a base case of $46.80

• We see limited downside given the backstop value of the leasing segment, $14.27 per share in our base case; nearly $350m in EBITDA from non-railcar manufacturing, $15 per share; and estimated 2016E cash balance driven by the certain of earnings sitting in the sizeable railcar backlog, $9.70 discounted back the present and excluding a minimum cash balance

Catalyst

Catalysts:

• Completion of remaining buyback authorization and ensuing increases in returns to shareholders

• Resumption in backlog growth as stable macro and new tank car regs drive book-to-bill above 1.0x

• Resolution of Guardrail litigation and the DOJ investigation

• Potential interest from activist shareholders and/or private equity given the substantial cash flow generation and sizeable discount to sum-of-the-parts