Is Greenbrier an Undervalued Cyclical or a Value Trap?

I am always hunting for undervalued businesses that are being ignored by the market due to short-term problems. I prefer to find businesses that provide products or services that are necessary for maintaining our way of life and standard of living.

One often overlooked but critical aspect of maintaining our standard of living is distribution of the products we want and require. Trucks and trains are two of the primary methods by which goods are transported around the country. Distribution by truck is faster and often the only option for the last leg of the journey. Distribution by rail is much cheaper but also slower and unable to complete the final leg in most cases.

Both methods of distribution have their place and fill a critical need for both businesses and consumers. Both of these businesses are also very capital intensive. The difference between them is in the way the replenishment cycle tends to work.

The difference In capital flow

Tractors and trailers in the trucking industry have long lives, but the existing fleet tends to reach its life expectancy at approximately the same percentage each year. It produces a somewhat level annual requirement for capital investment. The major component of the capital cycle occurs when the major carriers sell off their old equipment to the smaller haulers and replace those units with new ones.

In the railcar industry, the capital cycle is made up of two major components: the purchase of new cars and the refurbishing of older inventory. Due to the limited number of players in the rail industry, there is not a large domestic market for used equipment. The refurbishing cycle tends to be on a 20-year time frame and for some reason hits in surges. The only reason I was aware of this particular cycle is that I used to manufacture a component used in the refurbishing process.

The new railcar market in the U.S. is mature and mostly for replacement cars to replace those that cannot be economically refurbished or have been somehow damaged.

The businesses that build and refurbish railcars have earnings and prices that revolve around these cycles. For value investors, cyclical businesses like this can provide compelling long-term opportunities when shares are purchased at the right part of the cycle.

A business worth a look

The Greenbrier Companies Inc. (GBX, Financial) designs, manufactures and markets railroad freight car equipment in North America and Europe. It manufactures a full line of car configurations to meet the varied needs of the carriers and cargo. This includes the type of cars with which we are all familiar and double-hull tank barges and cars for carrying pressurized contents.

The company’s Wheels & Parts segment provides repair, refurbishing and replacement of wheels and axles. This includes new axle machining and finishing and axle downsizing and reconditioning. It also manufactures railcar cushioning units, couplers, yokes, side frames, bolsters and various other parts and produces roofs, doors and associated parts for boxcars.

The Leasing & Services segment offers operating leases for a fleet of approximately 9,300 railcars. In addition it offers management services comprising railcar maintenance management, railcar accounting services, fleet management, administration and railcar remarketing. This segment owns or provides management services to a fleet of approximately 269,000 railroads, shippers, carriers, institutional investors and other leasing and transportation companies.

Its GBW Joint Venture segment offers heavy railcar maintenance, repair and refurbishment to third parties. It serves railroads, leasing companies, financial institutions, shippers, carriers and transportation companies.

What stage of the cycle is industry in now?

2016 appears to be the last stage of the current refurbishing cycle that has taken place over the last few years. This is reflected in the current earnings and revenue projections from the analysts covering the stock.

The projected end of the current cycle is also reflected in the forward growth estimates for the business as compared to the past five years.

When Wall Street analysts are projecting a forward growth rate 80% below the actual rate of the last five years, it is easy to conclude that this bunch believes the current cycle is quickly coming to an end.

Is now the time to buy?

As a value investor considering a cyclical business, one must always question the timing of an investment. This is particularly important when dealing with an industry that has such a long cycle. After all, when we talk about a 20-year cycle that is just heading into the lean period, this is pretty much a buy-and-hold-forever type call.

How can any investor hope to effectively time the proper entry point for a new position in such a long cycle? In the case of the railcar industry in general and Greenbrier in particular, we have pricing that has actually reflected the forward prospects of the businesses while the peak of the earnings have yet to hit the financial statements.

Earnings for Greenbrier are expected to be $5.99 per share for the fiscal year ending in August. However, for the year ending August 2017, those earnings are projected to plummet by 37.7% to only $3.73 per share. This is a stunning drop for a year-over-year projection. But it is not an unreasonable projection for such a large capital item with an exceptionally long life and such a concentrated refurbishment.

Interestingly enough, for once, the market seems to have properly priced an asset based on both the short-term and long-term fundamentals. As I write, Greenbrier is trading at $24.29 per share. This reflects a drop of 63% from its 52-week high of $66.50.

It would be easy to see a 63% drop in the share price compared to a 37.7% drop in projected earnings and believe the stock must be currently undervalued. However, that would be making the assumption that the stock was not overvalued when it was trading at its high. I believe it was.

The railcar industry is a slow-growth, capital-intensive industry with a long product cycle. Most investors are incapable of buying a stock and actually holding it for 20 years. I am, unless I die. But just because I am capable of doing so doesn’t necessarily make Greenbrier the investment I want to do that with at today’s valuation.

Greenbrier is currently valued at only 6.51 times its projected earnings for fiscal 2017. Even though this sounds really cheap, you have to consider the industry and long cycle times involved. Even considering that, the forward growth rate projected for the next five years is 9.50% annually.

Based on this metric, Greenbrier’s share price would have to rise by almost 50% to trade at a price to earnings growth multiple of 1. This is a good indication that the current valuation of the business could be excessively low.

When looking for undervalued businesses, the balance sheet is always one of my favorite stops in the process. I always like to look at what I consider to be the liquid assets of the business compared to its liabilities. I don’t like to buy businesses that might go broke. I consider “liquid assets” to be cash and short-term investments, receivables and inventory.

As of Nov. 30, 2015, Greenbrier had liquid assets of $1.127 billion. The total liabilities on its balance sheet were only $1.309 billion. Of those liabilities, $861 million are long term. This is a rock-solid balance sheet and should provide almost any investor with assurances that the company will be in business for a long time to come.

The company is also managed frugally. Total SG&A expense is an efficient 5.6% of sales. For a heavy manufacturer, I generally view anything below 7% as indicative of good management. I also like to see top management that is efficient but not full of itself. Greenbrier’s top five executives have combined compensation that equals 0.32% of total sales, or $8.328 million. Their salaries are also equal to only 4.3% of net profits. These guys are good at what they do. They are running the business efficiently and are compensated fairly. Most management groups like to richly reward themselves whether they deserve it or not. I prefer managers who treat my money like it is my money and I am watching. I have that in Greenbrier. I don’t mind paying for exceptional talent.

Based on these facts, I believe a valuation that reflects a PEG ratio of 1 is quite reasonable. That calculation would place a current fair value of $35.43 per share on the stock. Based on the current stock price of $24.29, this would require an increase of 45.8% from today’s price.

Time for a sanity check

No matter how good a potential investment looks, I always hope to find more support for my views. One of my objectives in evaluating investments is to find the reasons I should not buy the stock.

One of the great tools provided by GuruFocus is the ability to run stock charts and apply a valuation based on the criteria of some of the great value investors of our time. Benjamin Graham is generally considered to be the father of modern value investing. The chart shows that, based on a version of his criteria, Greenbrier has a current value of $54.40 per share.

I like businesses that appear to be cheap and where I can find confirmation from one of the greats. I also applied the Peter Lynch criteria to this stock, but the number it came up with was excessively high so I chose not to include it.

Final thoughts and actionable conclusions

The opportunity that exists in Greenbrier today is there because we have a cyclical business entering the downside of its profit cycle coupled with a weak overall market.

Can the stock get cheaper from here? Yes. Is it likely to get cheaper from here? Yes. Is it cheap enough to buy at today’s price? Absolutely but only if you are willing to be patient.

This is a stock position that could well test your true metal as a value investor. The price could fall much further from here although it might not. The other big potential negative is that, because of the timing of its business cycle, this position has the potential to languish for quite some time before it ultimately moves higher to reflect its intrinsic value. Many investors simply do not invest with a sufficient time horizon for Greenbrier to present a good reward/risk ratio for them.

On the other hand, as with any undervalued business, the market can decide to assign fair value at any time. I have never professed to be a market timer; I can never know the mind of another.

For value investors with a seven- to 15-year time horizon, the opportunity today appears to be compelling. This could easily fit into my granddaughter’s portfolio very nicely as she doesn’t agonize over the short-term gyrations of the market; at the ripe old age of 11, she has other, more pressing things on her mind. She trusts her Poppy to find long-term value positions to add to her buy-and-hold portfolio.

Greenbrier fits well with the investment objectives of my granddaughter. Only you can decide whether this cyclical business might align well with yours.