Monday, August 11, 2008

Freightcar America Down 23% after Releasing 2nd Quarter Earnings

For Back ground Information please read my prior posts on RAIL:

My original thesis for investing in Freightcar America from July, 07:

August, 07 update:

Freightcar America (FCA) released earnings on Monday and sending shares down 23%. They missed analyst estimates by 32 cents, reporting a loss of 8 cents a share compared to estimates of 24 cents. FCA had its IPO in early 05 at $19 per share and in 06 the stock was at $78 at the peak of the secular boom in coal car orders. But since 06 the company has been hit by inevitable slowdown that was sure to follow. Investors are focusing on falling orders and the disappearing backlog as they look ahead to a possible recession that could further hurt results. But coal car orders will bottom out and return to normal. At $28 FCA has nearly $13 per share in cash and management is actively looking to put it to work either with a possible acquisition or international opportunities. There are signs that the coal car market is bottoming out and that orders will pick up in 09. The export of coal out of the U.S. is booming. Coal cars will need to continue to travel longer distances to eastern ports as the mining of coal deposits in the Appalachian region declines and the activity in the Powder River Basin in Wyoming and Montana increases. 75 coal-fired power plants are expected to begin construction in the next 6 years. 52 of the 75 are currently in the construction phase. FCA’s 80% plus market share in the North American coal car market is protected by high switching costs and 100 plus years of market share and technological dominance. Only one company, Trinity Industries competes with FCA in the coal car market. Foreign companies are prevented from importing cars because of very high shipping costs and familiarity with the market. FCA is conservatively worth $40 to $61 per share.

Earnings for the first and second quarter

For the first quarter FCA had an operating loss of $16.3 million which includes an $18.3 million charge as a result of the May 6th arbitration ruling with the United Steel Workers over the closure of the Johnstown Pennsylvania Plant. FCA announced the closure of the plant in December 07 because of its high manufacturing costs. FCA will have no more impairments related to the United Steel Workers lawsuit. With the lawsuit concluded the Johnstown plant will be closed when the courts approve the settlement. This will allow FCA to move manufacturing to its two remaining low cost facilities and reduce operating costs. Without the settlement net income would have been about $1.5 million.

Second quarter earnings came in at a loss of $900 thousand. As raw materials prices continued to increase, specifically steel and aluminum, some of the company’s fixed price contracts in backlog were no longer profitable. Most of these cars will be delivered during 08. A contingency reserve of $2.7 million after tax was recorded in the second quarter to reflect the unprofitable contracts. Since May the company has quoted variable price contracts to customers and thus the reserve likely represents the total cost of unprofitable contracts. Also, part of the drop in the second quarter 08 backlog was due to a cancelled order of 970 units. All management would say about this is that it is due to one customer and one order.

Industry Fundamentals
The coal industry is booming driven by growth in export demand for coal world wide and the large number of coal-fired power plants currently scheduled to come online. U.S. and Canadian coal loadings in the first and second quarter were up 2.8% and 2% respectively while commodity car loadings overall were flat and down 1.6%, respectively from the same period last year.

Coal export activity is booming. Coal export activity was up 19.2% in 2007 vs. 06 and up 67% in the second quarter 08 compared to the same period last year. For the first half of 08 export tonnage for coal was up 57% from the first half of 07 and managements expects that it will continue at this rate through 08. On July 24 Union Pacific CEO Jim Young said in a Reuters article that "Global demand for U.S. coal should stay strong for at least 2-3 years.....Everything we hear suggests that coal will continue to be strong at least in the mid-term horizon." According to a July edition of Railway Age a trade magazine, Norfolk Southern is exporting 20 million tons of coal annually up from 12 million tons just a few years ago due to world wide demand. Norfolk Southern’s coal revenue is up 34% in the second quarter. Wick Moorman, Norfolk’s CEO said "The problems were encountering are on the supply side. The mining companies can barely keep up with demand." FCA’s CEO Chris Ragot said "Demand for export coal has significantly increased as global supplies tighten." The increase in foreign demand is being driven by industrialization and attendant demand for coal fired electricity generation in the developing world including India and China.

Coal inventories are declining. Currently coal inventories are high in the electric power industry however recent data shows that inventories at eastern utilities is falling because of increasing domestic and international demand. Ragot said that inventories will continue to decline.

In addition to the increasing use of coal internationally, there is a large number of coal-fired power plants coming online in the next few years. In the next six years 75 coal fired power plants are expected to come online. These 75 plants will require about 40,000 new coal cars. Of these 75, 52 are currently under construction, near construction or permitted for construction. These 52 plants are expected to add 27,000 mega watts of capacity and will require about 20,000 coal cars. 29 of these 52 are under construction at this time which will add 16,500 mega watts of coal-fired capacity.

Coal will be an increasing large source of the power needs of the U.S. and internationally. The U.S. is referred to as the Saudi Arabia of coal. We have more in terms of energy units in coal reserves than Saudi Arabia has oil. The U.S. has 250 years of coal reserves at the rate we’re using it now. Clean coal technology will continue to advance. The Energy Department is working on what’s called the FutureGen Project, a project to built a carbon sequestering plant. A demonstration plant with carbon sequestering technology is expected to be built by 2015. In addition China is set to build its first clean coal plant in 09 and Germany has coal plants in the middle of major cities with zero emissions. Compare that to nuclear plant takes 10-20 years to commission, I believe coal will continue to serve a large part of the power needs of the U.S. and the world.

An Obama victory in November could be trouble for the industry. Although Obama supports clean coal and coal to liquid if they can emit 20% less carbon over their life cycle then traditional fuels. He is strongly opposed to traditional coal plants and would use whatever means necessary to stop new plants from being built, including a ban on new traditional coal facilities. McCain would be more favorable for the coal industry. He supports coal power for electric utilities. But, he wants to find cleaner ways to use coal. Clearly, both candidates see the need for development of clean coal technology.

How long will it take before coal car orders pick up?

If coal export volume is booming and plants are beginning to come online the why hasn’t FCA’s orders and production picked up? It’s because the amount of coal activity doesn’t overlap demand for railcars. With the oversupply of cars in 05 and 06 the downturn was inevitable. In 05 and 06 the replacement rate spiked above 3% and some of the surplus of coal cars were put into storage.

The cycle in rail car orders from peak to trough is seven years in duration. In 1998 total industry wide rail car deliveries peaked at 75,704 and bottomed out in 02 at 17, 736. Over the same time FCA production went from 9,000 to 4,067. Then industry wide railcar deliveries peaked again, peaking in 06 at 75,729, 07 deliveries were 63,156 and deliveries for 08 are expected to be around 56,000. FCA’s deliveries in 06 and 07 were 18,764 and 10,282. Orders in peaked in 05 at 22,363, in 06 orders were 7,350, and in 07 orders fell further to 6,366. Backlog has declined from 20,729 units in 05, 9,315 units in 06, 5,399 in 07 to 4,917 on June 30th. Clearly the rate at which orders and backlog is headed doesn’t bode well for FCA. FCA is hit even more at the bottom of the cycle because selling prices decline, currently price declines are in the high single digits. Investors are focusing on the plummeting backlog and looking to worse sales next year.

There are signs that orders will pick up again soon. Strong export activity and the number of new coal plants under construction will soon lead to a pickup in orders. In the first quarter conference call FCA’s CFO Kevin Bagby said "It appears as though we’re at or near bottom. It’s difficult to pick that point but there does appear to be some improvement going forward at this point." In the second quarter conference call he said that he expects order activity to pick up in 09. The reason orders should be headed upwards include, a decreasing number of coal cars in storage, many new utilities coming online, increased coal car loadings and increased domestic and international demand. During the first quarter FCA idled one of its plants but in the second quarter due to a pickup in orders the plant was reopened. In the last five weeks there’s been orders placed for 1130 units and management said this is encouraging. In addition they said that they are benefiting from a return in order activity and they expect that to continue for the rest of the year with 95% of the units currently in backlog being delivered over the next two quarters.

Diversification Initiatives
In addition to the positive fundamentals for coal and the likely pickup in orders come 09, FCA is also diversifying its operations by developing non coal rail cars and an active exploration of international opportunities. In January FCA announced a joint venture with Titagarh Wagons Limited of Kolkata Indian to use FCA’s designs to develop freight cars for the Indian market. In second quarter release management said that the joint venture is progressing on schedule with production to start next year. FCA sent over some of their engineering staff to assess market conditions and so far things are going very well. Also, FCA signed a licensing agreement with a rail car manufacturer in Brazil and they manufacture coal-carrying rail cars for export to Latin America and have manufactured inter modal rail cars for export to the Middle East. We should expect more international opportunities to come. The CEO said during 1st quarter conference call that "we expect to begin working with additional overseas partners in coming years".

FCA is also trying to diversify its revenue base by introducing new rail car types including, an autorack car and a new design for its open top hopper for aggregates and taconite. In addition, FCA entered the leasing business in the first quarter. FCA has historically shied away from leasing because they would be competing with their own customers. But in the short run it makes sense to maintain production and market share. FCA has $46 million in "leased assets held for sale" on its balance sheet. Also, FCA closed on its first refurbishment order in the first quarter and currently has 200 cars in backlog related to refurbishment contracts. This should be a good avenue to increase business and even out the cyclical nature of the company’s orders and at the same time provide better margins.


I believe the sell off is way over blown. The time to invest in a cyclical company like FCA is when orders and falling and everyone’s looking to even a worse future. Soon orders will begin to pick up and investors will see the light at the other end of the tunnel. Coal will continue to have very positive fundamentals in the U.S. and abroad. The joint venture in India is the wild card with no risk because FCA provides the expertise (car designs and operating experience) and no capital. Titagarh will provide the capital. The expansion into different rail car types and the new refurbishing and leasing business will further benefit FCA. FCA is also working to cut costs at every level of the company and the closure of the Johnstown plant will further reduce operating costs. Coal cars will need to travel longer distances to eastern ports as the mining of coal deposits in the Appalachian region declines and the activity in the Powder River Basin in Wyoming and Montana increases. With $162 million in cash FCA can sustain a few bad years and with that cash they could buy back more stock or make an acquisition which they have recently said they are exploring.

There are 250,000 coal cars in North America. The replacement rate is around 3% and growth in coal use can be conservatively estimated to be 1%. FCA will continue to control 80% of the market. In addition, about 15% of FCA’s revenue comes from non coal cars. Based on these assumptions we can expect FCA’s order rate to be about 9,200 cars per year on average. Based on results from prior years, FCF per car is between $2,800 to $4,000. This equates to FCF of $25.8- $37 million not including interest income. This compares to an average FCF over the last 7 year cycle of $36 million per year. With a 12-15x enterprise value/ FCF and $162 million in cash, FCA is worth between $40 and $61 per share. Think of it another way, in the last 7 year cycle FCA had an average FCF of $36 million a year, and now FCA is expanding into different rail cars types and the refurbishment/rebuilt market, more gigawatts of coal fired power plant capacity will begin construction in 09 then was build in the last 7 years and FCA has $162 million in cash from the 05 IPO. It is highly unlikely that FCA will earn less than it did in the last coal car cycle.