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Freightcar America Inc

July 12, 2007 | About:
The Business

The company is the leading North American manufacturer of coal-carrying rail cars. They manufactured 81% of the coal carrying rail cars delivered over the three years ended December 31, 2006 in the North American market. The company has been producing rail cars for over 100 years.

The majority of the company's business is to it's top 10 customers. These included many of the major railroad shippers (Norfolk Southern, BNSF, Canadian Pacific, CSX and Union Pacific), financing companies and the remainder are major utilities. The company maintains long range customer relationships with these companies and the chances of one of their customers moving their business to a competitor is low because of the high costs of switching manufacturers.

Coal-carrying rail cars need to be replaced about once every 25 years so most shippers buy infrequently. Combine that with the fact that the company has only about 10 customers that make up about 70% of its sales and you get a company with very choppy earnings.


The company's prospectus from 2005 has good information to help investors learn about the industry.


A Company facing a temporary obstacle

The company delivered 18,764 coal cars last year compared to 13,031 in 2005 and 7,484 in 2004. As you can see the company had a huge spike in deliveries last year and that corresponded to a huge gain in earnings. There are two reasons for the large number of deliveries last year: First, this is a very cyclical industry and it happens to be a time when the industry is doing well. Second, many of their large customers made very large purchases.

Since their customers loaded up last year, the company's deliveries will be considerably lower this year compared to last year's record. Investors dumping the shares in anticipation have caused the share price to fall below intrinsic value. At the end of the first quarter backlog of unfilled orders was at 6,006 compared to 17,794 in the comparable period last year. Earnings and car deliveries for the first quarter were about the same as last year. But, the results in the coming quarters will be much lower then last year.


Why it's cheap

The company's results will suffer for the next few quarters but they will return back to normal soon. The companies results have varied widely from year to year in the past so last year's spike is nothing new. What would make most sense is this situation is to calculate normalized earnings. Normalized earnings is an average earnings figure that helps the investor to see past Freightcar's lumpy results.

First I'll start with a normalized order rate which includes the replacement rate of current fleets and the growth factor. There are 250k coal cars in the North America. Coal cars have a useful life of about 25 years. So that yields a replacement rate of 4%. Besides replacement, there is also a growth component for the normalized order rate. Energy demand in the US is expected to grow by about 2% a year and much of this will be met by coal. So with the growth factor of 2% and the replacement rate of 4%, 6% of the total coal car fleet or 15,000 coal cars will need to be manufactured every year. Since the company will most likely maintain its 80% market share, 12,000 of those cars will be produced by the company. Also, historically 15% of the company's orders were from non coal-cars. That would add 2,000 cars to the company's yearly production. In all, the company's normalized order rate is 14,000 rail cars. This will be used to calculate normalized earnings.

The replacement rate and growth factor assumptions are very conservative and I believe that for reasons mentioned in the catalyst section below that they will be a few percentage points higher. But nonetheless the company is cheap anyway and because of my extremely basic knowledge of the industry, it's probably intelligent to err on the conservative side.

In 2005 the company delivered 13,031 cars. The margins will most likely be similar if the the company delivers 14,000 cars, so this can be the basis for calculating the company's normalized earnings. The company earned 45 million in 2005 but that includes 11 million in interest expense and all this debt has since been paid off. So 11 million will be added to this figure which yields earnings of 56 million. 150 million in cash has since been added to the balance sheet and if the cash returns 5% that would add 7.5 million to earnings. Now we're at 64 million in earnings. Since the company delivered 13 thousand cars in 2005 and not the 14 thousand figure that were looking for it's safe to assume that with this extra 1,000 cars and the added efficiencies that have been realized since 2005 Freightcar America should be easily able to make 67 million a year in normalized earnings. With a market cap of 610 million the company trades at about 9 times normalized earnings. But, there are still a few significant pluses that haven't been added in.


The Catalysts

1. Mohnish Pabrai invested in the company.

2. There will be a surge in the number of coal power plants scheduled to open beginning around the first quarter 2009. The utilities that own these plants will begin to order cars for these plants about 6-9 months before they are scheduled to open. Thus we’d expect to see a surge in new coal car shipments beginning in the second half of 2008. Here is a article in the Washington Post about this boom in plant construction. The article focuses around MidAmerican Energy's activities and David Sokol is quoted often.

The Washington Post:

"At this bend in the Missouri River, with Omaha visible in the distance, the new MidAmerican plant is the leading edge of what many people are calling the "coal rush." Due to start up this spring, it will probably be the next coal-fired generating station to come online in the United States. A dozen more are under construction, and about 40 others are likely to start up within five years -- the biggest wave of coal plant construction since the 1970s."

3. The current fleets of coal cars are at the higher end of their useful lives. The average age of the 250,000 coal cars in North America is about 17 years old and coal cars typically need to be replaced at 25 years of age. Shippers looking to replace older fleets will be a significant plus for Freightcar America. This is already the case with Norfolk Southern. They announced last year that they will replace their 33,000 coal cars over the next ten years.


4. The company has a significant cash hoard. Over 30% of their market cap is cash. The company could expand their share repurchase program, increase dividend, make an acquisition or expand their operations overseas.

5. The company is repurchasing shares. They repurchased 1/8 of the shares outstanding in the first quarter. They can repurchase a further 1/8 of shares with the current program.

6. The company returned nearly 100% on capital last year. If my calculation of normalized earnings is used the company returns about 60% on capital (after taxes are added back in). Because of this the company is on the magic formula list. The company has no debt on its balance sheet!

About the author:

Alex Bossert
Alex is a senior at the Carlson School of Management and will be graduating in December 2013. He started investing in the stock market at age 10 and payed for college by working as an analyst for a Minneapolis Minnesota based hedge fund. He focuses on the investing methods of great investors such as Benjamin Graham, Warren Buffett, Seth Klarman, Joel Greenblatt, Mohnish Pabrai.

He was featured in a Forbes Magazine article in May 2013 that can be read here: http://www.forbes.com/sites/chrystanpaul/2013/05/19/meet-one-of-the-youngest-and-brightest-hedge-fund-analysts-that-isnt-on-wall-street/

http://www.linkedin.com/in/alexbossert

https://twitter.com/alexbossert

https://www.facebook.com/abossert1

Alexbossert.blogspot.com

Visit Alex Bossert's Website


Rating: 3.5/5 (16 votes)

Comments

ccyork
Ccyork - 7 years ago


could we have a wunderkind among us?

harison
Harison - 7 years ago
Excellent research. Have done this level of detailed work on anyone else? By the way, RAIL is a huge buy.
Salvatorre
Salvatorre - 7 years ago
This is an excellent article. The logic and details behind this recommendation are compelling.
musto
Musto - 7 years ago


Excellent writeup.

Can I adopt you?

Failing that can I buy the rights for %10 of your all your future earnings? ;))

Please post this article in the sticky "Give us your single best idea" thread, so we

can all appreciate the progress and run a postmortem on it within a year.

kfh227
Kfh227 premium member - 7 years ago
I took a peak at RAIL today and I don't see the attraction.

And wow, 16 years old! I think we have the next Buffett among us! Very well done Alex!

EDIT: I like it more than I used to, but I just don't see the growth prospects unless share repurchases become the norm. If they can make it habitual to repurchase 20 of their stock each year, then I'm all ears. Increase the dividend 10% each year while their at it.

OK, now I'm starting to think about it. I'll actually look into it a bit deeper this weekend. Maybe this thing is a slam dunk.

Future earnings don't look so hot. I don't see how share repurchases can continue in the future in a manner to suggest significant impact.

So, how many coal cars are needed per new power plant? 10,20,100?
peter123
Peter123 - 7 years ago
This is an awesome write-up with clear logic, well done. Alex, keep up the great work.

I could not get my arms around RAIL for the following reasons:

1) Looking into past earnings, we see

1998: 22.8M, 1999: 11.7M, 2000: 0.8M, 2001: -4.5M, 2002: -9.7M, 2003: -8.4M, 2004: -25.9M, 2005: 45.4M, 2006: 128.7M

Averaging these earnings results in $17.9M 'normalized" earnings.

I have not done all the homework/reading on RAIL yet. If the earnings over the last 9 years are not representative, please point out the flaws in this Graham-like earnings average.

2) I understand that Monish looks for 50% discount. Since he would probably value RAIL at PE of 12 isn't the PE of 9 mentioned above on the "high" side?
marco.guerreiro
Marco.guerreiro - 7 years ago
I can see they have 420k shares aprox in treasury. The shares outstanding has decreased from 12.68 to 12.26. Only 3.3%, so the repurchase is not that big yet. This could give it some more potential.

I hope the earnings are lower than expected by analysts on 26 Jul so the stock gets a bit cheaper to buy some. :)
flash24
Flash24 - 7 years ago
-------------------------------------------------------

> Does RAIL really have a moat in the coal car

> sector that will be sustainable or will some of

> the larger rail car manufactuers start to invade

> their territory?

>

> What technolgy ,etc, gives us the assurance that

> as the numbers that many of you have extrapolated

> into the future regarding the coal car replacement

> cycle and growth of the caol indusrty will go to

> rail.

> Thanks for helping me evaluate the merits of an

> investment in RAIL.

> Cheers,

harison
Harison - 7 years ago
The "moat" is one of the most overrated premises their is. Sure it is important if you have to buy and hold forever, but I've never met anyone with those restrictions. A moat is no guarantee of success either by the way. As I've mentioned before, CSG, BUD, HSY, DIS, KO and many other companies deemed impervious to competition have stumbled in recent years. What moat does GE have in any of its businesses? What moat does BAC have? I'm not saying not to think about competitive advantage, but it can be a very flawed way to go about choosing investments. Price is most important, this is evidenced by the fact that so few of the DOW stocks have moved in the past 7 years in spite of their great earnings. When you go about doing analysis, always consider price first, then go from there.
flash24
Flash24 - 7 years ago
Harison.

Thank you for your insights regarding the "overrating premise regarding moats".Your points are valid.

Price without a doubt is always a most important consideration.

Maybe I should ask my questions differently .

Can rail sustain their marketshare?

Are there any competitiors that can duplicate the products that RAIL is offering its "10" customers.Not a great diversified customer base.

Lets try being a bit more cynicial and see what can go wrong instead with rail .

Thanks for anyone insights.

Cheers,

M
flash24
Flash24 - 7 years ago
Harison.

Thank you for your insights regarding the "overrating premise regarding moats".Your points are valid.

Price without a doubt is always a most important consideration.

Maybe I should ask my questions differently .

Can rail sustain their marketshare?

Are there any competitiors that can duplicate the products that RAIL is offering its "10" customers.Not a great diversified customer base.

Lets try being a bit more cynicial and see what can go wrong instead with rail .

Thanks for anyone insights.

Cheers,

M

rayuwish
Rayuwish - 7 years ago
I also thought this article was interesting. Alex please do an analysis of Bed Bath and Beyond or Walmart's continuing flatlining (as Joel Greenblatt has had his money in this forever) and Good Job! I've also noticed RAIL on various other boards/charts in the past months (Magic Formula, Mohnish Pabrai). This analysis seems fairly compelling except as others have mentioned, what's to say its going to rise 50% and when?

If you take a look at the charts, RAIL has remained fairly steady around the $50.00, low of 20.45 in June of 2005 and highs up to 75.00 after Buffet's announcements. I guess its a wait and see game to see if it explodes or simply continues to flatline at 50.00. Thank you for the educated analysis.
Alex Bossert
Alex Bossert - 7 years ago
Thanks for your question Peter123,

There are two reasons for the decreased earnings you mention. First, orders follow the general health of the economy. In 2001-3 during the recession companies scaled back on orders and in 2006 the opposite happened and the company had record orders. Second the company had a large debt load during that time instead of a large surplus of cash as they do now.
musto
Musto - 7 years ago
If you think the orders had anything to do with the general economy you probably don't

know much about the major expansion that's been going on with the railroad capacity.

There has to be a better explanation than that.

DaveinHackensack
DaveinHackensack - 7 years ago
Not to nitpick a prodigy, but I'm not sure it makes sense to calculate earnings from a peak production year for RAIL, adjust for interest expense, and consider those normalized earnings. Demand for rail cars is apparently cyclical, so it may be years before RAIL delivers 14k cars in a year.

Also, there is a lot anti-coal political sentiment out there today, which (according to an article in last week's WSJ, if I remember) has led to the cancellation of over 100 new coal-fired energy generation plants.

I own RAIL as part of my magic formula portfolio and think it's a good company. The bullish case for it, IMO rests not on an overly optimistic view of the near-future demand for coal cars but on the likelihood that RAIL's stellar balance sheet will enable it to weather the lean times well, so it's able to deliver when demand comes back.
musto
Musto - 7 years ago
I think you remember it wrong from that article. There were a few cancellations

of power generators but I doubt it was 100. 100 was more like the number of generators in the construction pipeline.

Politicians can talk a lot of hot air but at the end they'll see there is no better alternative than coal.

valuefan
Valuefan premium member - 7 years ago
It's not just that the present fleet of rail cars is old. The new cars are aluminum and the

carriers can save up to 20% with these more efficient cars.

highroi
Highroi - 7 years ago
I am doing my due diligence on RAIL.

I have two questions:

Alex Bossert: What is your source for useful life of 25 years for Aluminum Rail Cars??

I ask because according to management's presentation of the 264,000 rail cars out there

approximately 50% of the cars are over 25 years old. Some as old as 50 years.

Value Fan: What is your source for 20% efficency for Aluminum?

According to my due diligence based upon management's presentation:

The future demand for coal cars is two fold: fleet expansion and replacement of existing fleet.

Fleet Expansion (New Coal Fired PLants Coming Online):

264,000 Cars (Current Fleet) * 1.5 % CAGR (From now until 2012) * 80% Market Share

= 3,289 Cars if you take the average over the next six years


Replacment:

264,000 * 3% (Historical Replacement Rate) * 80% market Share

= 6,336

Total Cars = 9,625 Cars

With fixed costs RAIL's margins decline significantly when shipments decrease.

With the average car selling for 77,000

Revenue would be 741 Million

In 2005 with higher sales their margins where around 10% (Let's say with the employed cost cutting measures they are able to maintain these margins with fewer sales)

Gross Profit = 741 Million * 10% = 74 Million

Selling is approx 3% of Sales = 2.2 Million

Operating Income = 71.8 Million

Say they earn 5% on 184 Million in Cash = 9.2 Million

Income Before Tax = 81 Million

Say Tax is 40% = 32. Million

Net Income is 49 Million

We would be trading at 10 X Enterprise Value.

To me this isn't deep value. I wish I could see what SAC Capital and Mohnish see that I don't.





valuefan
Valuefan premium member - 7 years ago
highroi,

My source for the 20% efficiency improvement with aluminum is 'Capital and Crisis', Chris Mayer.

Mayer is really smart and does deep research.

By the way, hopefully any day now we will get Pabrai's 2nd quarter moves here and it will

be interesting to see if he added to the position.

highroi
Highroi - 7 years ago
Thanks Value Fan

That is a very significant value. I will look into that. I would assume he takes a cradle to grave approach on his analysis. I hope too that he added because thus far he hasn't invested alot in RAIL. He seems to be betting big on CRYP.

HighROI
ndl11
Ndl11 - 7 years ago
Doing my DD on Rail and I am trying to figure out if RAIL will maintain its marketshare National Steel is openng a brand new plant in Alabama in early 2009. Seems like a new plant would make it the low cost producer.

Any help or thoughts owuld be appreciated.
rayuwish
Rayuwish - 7 years ago
I had commented before here but I just noticed that "RAIL" has laid off 200 employees citing decreased demand. Here's the article: http://www.tribune-democrat.com/local/local_story_208001537.html Does this in some sense fly in the face of all the highfallutin analysis. When a company lays off this many employees and cites less demand, my intuition goes up against buying. Any other thoughts here?
JJINVEST
JJINVEST premium member - 7 years ago
The guy who initially recommended RAIL on Valueinvestorsclub.org, said the following on in Feb 2007, "I'm closing out my recommendation of RAIL at approx $54.10. After listening to the conference call, I'm less optimistic about their 2006 order flow. More

importantly, management seemed much less forthcoming than in previous calls. That did not give me a warm and fuzzy feeling. I think the risk/reward ration has degraded a lot.

Life is too short."
expectingrain
Expectingrain - 7 years ago
Layoffs at the mills in Johnstown? Its Slapshot all over again!


rayuwish Wrote:

-------------------------------------------------------

> I had commented before here but I just noticed

> that "RAIL" has laid off 200 employees citing

> decreased demand. Here's the article: Does this

> in some sense fly in the face of all the

> highfallutin analysis. When a company lays off

> this many employees and cites less demand, my

> intuition goes up against buying. Any other

> thoughts here?


buffetteer17
Buffetteer17 premium member - 7 years ago
On laying off 200 employees. Seems like a logical move to me. It is a very cyclical business. Are you going to pay those employees a salary to sit around and play checkers?
expectingrain
Expectingrain - 7 years ago
Wouldn't it be cheaper to keep them on for 6 months or so until things pick up, rather than pay the cost of rehiring and retraining other workers?
harison
Harison - 7 years ago
Don't know if business will be good in six months, might take longer. You can't burn cash, and salaries are a variable cost, thus employees have to go(I don't mean to sound unsympathetic).
vooch
Vooch - 7 years ago
Alex Bossert,

> They manufactured 81% of the coal carrying rail cars delivered over the

> three years ended December 31, 2006 in the North American market.

> The company delivered 18,764 coal cars last year

> There are 250k coal cars in the North America. Coal cars have a useful life

> of about 25 years. So that yields a replacement rate of 4%.

So what you're telling me is:

18764 / 0.81=23165

23165 / 250000=0.92

0.92 / (4/100) = 2.31

which means RAIL helped flood the market with 231% (read as, 2.31 years worth) of production during a one year period. In essense, they helped saturate the market and explains why the stock has tanked -15% since your post. Correct?

Am I missing something besides the flood of products onto the market?

- Vooch

musto
Musto - 7 years ago
vooch,

not to nitpick on your analysis, but

your math is wrong.

alex said 81% of total cars last 3 years.

You assume 81% of last years production.

Those two things are not neccessarily the same thing.

Also

> 23165 / 250000=0.92

is not the correct answer.

It's 0.092

Miracalously, your last line calculates to the right answer though..

>0.92 / (4/100) = 2.31

that is if you put 0.092 instead of 0.92

Btw, I do not own RAIL, and I don't intend to own it either.

vooch
Vooch - 7 years ago
Thanks musto. It was a typo.

- Vooch

jpenni1
Jpenni1 - 7 years ago


I hesitate posting links, it seems as though I am trying to prove my point BUT check this link out. It is the best written analysis on RAIL that I have read. I think RAIL is a solid buy. It is the basic premise that buffetter17 has been preaching on his post about RAIL.

http://biz.yahoo.com/seekingalpha/070731/42958_id.html?.v=1

alanb9
Alanb9 premium member - 7 years ago
That would be the first post in this thread. :)
buffetteer17
Buffetteer17 premium member - 7 years ago
And the source of my wisdom. ;)
ndl11
Ndl11 - 7 years ago
Anybody with any idea as to what prevents a customer from buying a coal car from another manufacturer? I understand the "swithching costs" maybe high but what are those costs?
jpenni1
Jpenni1 - 7 years ago
That is why I should have hesitated longer lol

10q out today nothing to write home about, one key point that stuck out to me 99% of revenue comes from coal cars. I wish they would explore other types of cars.
DaveinHackensack
DaveinHackensack - 7 years ago
I think we all agree that RAIL is a solid company with a great balance sheet and a strong position in its industry. Most would also agree that it is in a cyclical industry, and it is on the downward slope of one of those cycles now in terms of demand for its products. If I didn't already own this stock in my MF portfolio though, I don't know if I would buy it right now. In fact, I am in the process of freeing up cash for my last five MF positions and I don't know if I'm going to double down on RAIL. Maybe, if it dips below 40 in the next week or two, I don't know. I just don't see what the rush is to be in this stock, because it could be a while before cyclical demand increases. RAIL's balance sheet gives me confidence it can stay in business until that happens, but what are the catalysts in the meantime?

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