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American Railway Industries: Choo-Choo Cha-Ching

I) Overview and History

American Railway Industries (ARII) was founded in 1988 in Missouri and later incorporated in 2006 in Delaware after the acquisition of ACF and began trading publicly in January 2006. ARI is a leader, offering integrated rail cars, railcar components, railcar maintenance services and fleet management services. American Railway is a manufacturer of both general and specialty hopper rail cars. The hoppers are made to carry different resources varying from grain, cement, potash, sand, plastic pellets, food grade starches and flours, clay, ore and high value specialty products.

They are also a manufacturer of tanker rail cars designed to handle a variety of commodities like petroleum products, ethanol, asphalt, vegetable oil, corn syrup and other food products. American Railway also has the ability to produce other railcar types including intermodal, gondola and iron ore rail cars with bottom and rotary discharge.

II) Record

  • From the IPO in January 2006 shareholder equity has quadrupled from $106.76 million to $399.00 million while earnings per share have risen from $0.14 in 2005 to $2.99 in fiscal 2012.
  • Long-term debt is being paid down from $272 million in December 2012 to $191 million in second quarter 2013.
  • Operating earnings, revenues and margins are returning to normalized levels from a recession slump.
  • Retained earnings have increased almost 10 fold in an eight-year period.
  • The five-year average gross profit margin is over 12.5%, but the most recent fiscal year boasts 20.1%.
  • A very impressive ROIC averaged 20.2% over the last eight years. [/b]
Today Carl Icahn is chairman of the board of directors and controls [b]55.7% of the company. He is actively engaged in the company, presumably using it as a vehicle to produce future surplus cash flow that is reinvested in other activist operations. As recently as December he was making efforts to take over a competitor in the space, Greenbrier Companies Inc. The 1994 acquisition of railcar component manufacturing and railcar maintenance assets from American Car and Foundry Company (ACF Industries) was the beginning but surely not the end. The company has roots dating back to before the 20th century and is part of the foundation that helped create America.

III) Business and Competitors

Manufacturing operations consist of hopper rail cars, tank rail cars, rail car leasing, component manufacturing and consulting/contract agreements.

Rail car services are made up of repair services (mobile and full service), engineering and field services, and fleet management services.

The company has 2,643 full-time employees in various locations across the U.S. and Canada. ARI is now incorporated in North Dakota as of 2009. ARI has a joint venture partnership with three other companies, Ohio Castings Company (33% ownership), Axis (41.9%), and Amtek Railcar Industries (50% ownership).

Competitors include Greenbrier Companies Inc, FreightCar America, Inc., Westinghouse Air Brake Technologies Corp, and Trinity Industries Inc. American Railway industries is in the top quartile (top 15%) versus the industry in profitability like EPS growth %, ROIC, ROE, ROA, operating margin, net margin, EBITDA growth and revenue growth.

IV) Operations and Competitive Advantages

The primary customers include leasing companies, industrial companies and those that use rail cars for freight transport, or shippers, and Class I railroads. (Carl Icahn also only buys from ARI for ACF.) "U.S. Class I Railroads are line haul freight railroads with 2011 operating revenue of $433.2 million or more. Two Canadian railroads, CN and Canadian Pacific, have enough revenue that they would be U.S. Class I railroads if they were U.S. companies.” (Associate of American Railroads, 2013)

The leasing operations, integrated rail car repair, general maintenance and after service fleet management provide an opportunity to up-sell/cross-sell as well as penetrate the general market with more efficiency, widening the company's economic moat.

Over half the North American rail car fleet is tank cars and covered hoppers with over 1.5 million North American rail car fleet as of July 2012. (Investor Presentation, 2012)

  • 20%
 Tank Cars
  • 32% Covered Hoppers
  • 11% Open Top Hoppers
  • 16% Gondolas
  • 8% Flat Cars
  • 4% Intermodal
  • 9% Box Cars
ARI is able to make large capital expenditure outlays, increasing future revenue from the leasing operation and manufacturing locations are also strategically placed close to major railroads and customers. The company is NON-unionized and uses it as a major beneficial factor for controlling employee expenses and operating margins. The supply chain is vertically integrated meaning profits are maximized, hold-ups are avoided and common ownership aligns interest of all parties involved.

Joint Ventures

1) Axis LLC – Responsibilities include forging, heat treating, machining and finishing axles for international use. It is located next to a major manufacturing facility of ARII in Paragould, Ark.

2) Ohio Castings LLC – Founded in 2003, it is a manufacturer of side frames, bolsters and other rail car components. Figure 1: an example of a side frame & bolster



3) Amtek Railcar Industries is pursuing the India joint venture and international expansion. Amtek is a manufacturer of flywheel ring gears, automotive part machining, forging, casting iron and casting aluminum. Located globally in various countries, Italy, Mexico, Brazil, India, Germany and the U.K., Amtek is in a position to lead the ARI global expansion.

All joint ventures individually are not profitable currently with Ohio Castings as an exception, swinging to a profit in 2012. (Details below in Figure 5)

American Railway Industries has future plans of strategically exploring and expanding into Russia and Saudi Arabia while maturing the production operations in India as the developmental stage is completed. The cyclically of the business is also a very important factor as it is an art to normalizing earnings. There is an explosive trend working with ARI as the majority of the railcar fleet is 15 to 20 years old and needs replaced as pent-up demand is released and utilization/capacity rates increase to expansion levels (it looks like this may already be occurring when you look at the Capex, cash flow from investments and ISM/PMI trends).

Figure 2: Comparable Companies

Valuation MetricFreightCar AmericaWestinghouse Air Brake Technologies CorpTrinity Industries Inc
P/S0.42.30.8
P/B1.14.01.5
P/E33.420.910.9
ROIC (3-Year Avg. Weighting)15.46%57.6%9.6%


American Railway IndustriesGreenbrier Companies Inc
1.10.4
2.01.6
9.812.4
20.7%10.16%


V) Balance Sheet and Profitability


Debt to equity is relatively moderate, sitting at 0.5 after long-term debt was paid down in the first half of 2013. Backlog is very healthy at the end of December 2012, including approximately 7,061 rail cars with estimated sales value of $889.8 million.

  • Current ratio: 3.23
  • Quick ratio: 2.01
  • Cash and cash equivalents: $94 million from $218 million at the end of 2012, large increase in property, plant and equipment in the most recent quarter
  • Book value per share: $18.67
  • 2.70% dividend yield at a 20% payout ratio
  • 2012 effective tax rate 39.7%
Figure 3: Operating Margin by Segment



As cash flow investing activities are completed and additional revenue streams are pursued as the business expands, I would expect both the dividend to be raised as well as share buybacks based on current price levels. Carl Icahn is a financial wizard and should be watched closely especially when ROIC is surpassing 20% while comparable earnings yield is 10.2% on a TTM basis.

VI) Management and Compensation

Figure 4: Definitive Proxy Statement of Compensation (April 2013)

Carl C. Icahn77Chairman of the Board1994
James J. Unger65Vice Chairman of the Board1995
James C. Pontious *74Director2006
J. Mike Laisure *61Director2006
Harold First **76Director2007
Brett Icahn ***33Director2007
Hunter Gary38Director2008
SungHwan Cho ***39Director2011


President and Chief Executive Officer James Cowan received a salary of $373,333, a bonus of $336,000, another $491,656 awarded as stock and $27,585 from other compensation for a cumulative total of $1.228 million in fiscal year 2012.

Carl Icahn is chairman of the board, and his son Brett Icahn sits on as a director. Both are very smart capital allocators working for future retained earnings and dividend distribution of ARI.

Dale Davies is the senior vice president, CFO and treasurer, earning a salary of $275,000, stock awarded valued at $258,852, and a bonus of $206,250 for a 2012 total of $749,000

Alan Lullman is the senior vice president of sales, receiving $270,200 compensation, a $162,120 bonus and $126,984 awarded in stock.

Other directors earning compensationL $52,000 (Harold First), $47,000 (James Pontious), $47,000 (Mike Laisure) and $65,000 (James Unger) for a total of $201,000

Another 855,476 securities have been set aside for future compensation. I am all in favor of attracting top-caliber management through pay incentives, especially when top capital allocators are working alongside them. Keep top management total compensation under 0.5% of sales and I can't complain.

“If you pay peanuts, you get monkeys.”

VII) Value and Price

At $37 PPS the market cap is $789.95 million with 21.35 million shares outstanding and a $9.45 million share float. Using quick conservative estimates for discounted cash flow at 10% discount rate, 5% cash-flow growth and initial cash flow of $63.82 million. You end up with an estimated Intrinsic value of $62.75 compared to current price of $37 or 58.9% undervalued. With the growing business prospects, stellar ROIC of over 20% and declining debt levels, ARI should trade at a more appropriate multiple of 12x to 14x and more like 1.5x to 1.75x sales. Westinghouse Air Brake Technologies Corp has an even more impressive ROIC and earnings history and deserves the multiple the market has given it, possibly even warranting an expansion in P/E (towards 25x) as cyclical names remain in focus, as the risk free rate has caused downward pressure on alternative asset classes. Joint Ventures are priced to be free (while JVs begin to operate at a profit) as well as the railcar leasing and railcar services businesses, while the manufacturing business would still be trading at a discount. Railcar leasing is the highest operating margin part of the business (55%) and has grown twenty fold since 2010.

Figure 5: Joint Venture Operational P&L

201020112012
Ohio Castings$(1,008)(1,097)$1,280
Axis$(6,281)(5,791)$(685)
Amtek –(India)$(250)$(1,012)$(1,046)
Total Loss from JV$(7,789)$(7,900)$ (451)
Figure 6: table of segmented revenues.



VIII) Catalysts

  • M&A continued with competitors as the corporate raider Carl Icahn is at the helm.
  • Increased growth of the railcar leasing business that is hidden within the 10-Qs and 10-Ks.
  • Improvements to operational costs as utilization rates increase.
  • Expanding backlog and large contracts won due to the aging fleet of American railcars.
  • Cyclical upswing in the manufacturing business revenues as pent-up demand is released.
IX) Specific Risks

The highly cyclical nature of the railcar industry may result in lower revenues during economic downturns. The top 10 customers are attributable to about 80% of overall revenues and a loss of any one of them could result in material impact to the income statement. As the international expansion continues, ARI is subject to government policy risk as well as international economic risk. After railcars are leased the company may not be able to re-market them on favorable terms, impacting ROIC. Environmental and safety regulation is always a wildcard for any business or industry and should be ignored until implemented. Key employees and management are crucial to the performance of the business and without them negative impact may be assumed.

X) Why It Is Cheap

I would not say it is exceptionally cheap (30 or 40 cents on the dollar), but below the company's fair value. The demand for future railcars is not being accounted for correctly by the market as America shifts to energy independence and continues to be the agriculture juggernaut of the world. Growing freight volumes is evident: While commodity prices are being crushed on global growth concerns, when they begin to stabilize and present supply is soaked up, you can expect capital expenditures to once again flood the market. I don’t believe the market is correctly valuing the company and has given a multiple to reflect the core manufacturing business prospects, not the joint ventures, rail car services and leasing business. Keep an eye on the lease expansion through cash flow from investing activities as well as capital expenditures; it should be an enormous component of the future business given the present spending and operating margins on that part of the business. These assumptions are not including share buybacks or any M&A. And as Carl Icahn already owns over 55% of the company, I think it will be a route of interest he and/or his son ultimately pursue[/b]



[b]Disclosure:
This is not a recommendation to buy or sell anything. I have no position in any of the stocks mentioned but may initiate a position in the next 72 hours.

Any and all comments or questions welcome.

About the author:

Tannor PilatzkeI am a self taught investor through Warren Buffett, Charlie Munger, Ben Graham, Peter Lynch, Joel Greenblatt, David Einhorn, Seth Klarman, Howard Marks, Phillip Fisher and Thornton O'Glove. My focus is a bottoms up Value-GARP strategy with a mix of top down contrarianism.

"When you find yourself on the side of the majority, it is time to pause and reflect." - Mark Twain

Visit Tannor Pilatzke's Website


Rating: 4.1/5 (16 votes)

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Comments

kfh227
Kfh227 premium member - 7 months ago
I don't see the value. They have not been FCF positive very often. They haven't been FCF positive in 3 years.

Is there any restructuring occurring? Stream lining? efforts to eliminate debt? I need to see a catalyst. If there is one, I agree. This is wroth alot more. But no catalyst and I don't see it.

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