Riding the Rails
Editor’s Note: ACCESS YIANNIS AND ELLIOTT’S PRELIMINARY RESEARCH. Elliott contributes regularly to SeekingAlpha.com and has started to publish some of his preliminary Cocktail Stocks research on the site. He encourages you to follow him (select the “Follow” button in left margin) and share your take on his preliminary picks. Your input could help determine which investment idea becomes the stock of the month. Of course, the final pick is reserved only for loyal Cocktail Stocks subscribers. Yiannis and Elliott look forward to hearing from you.
The Trade: Greenbrier Companies (NYSE: GBX)–Buy < 27.50.
Why Now: Greenbrier Companies stands to benefit from booming demand for railcars capable of transporting oil, petroleum products, petrochemicals, and the sand and ceramics used in hydraulic fracturing.
Elliott walks into BLT Steak in Washington, DC, and spots Yiannis at the bar. He grabs the seat next to Yiannis and orders a glass of Malbec.
Yiannis: You’re 30 minutes late. Did you get lost?
Elliott: No, you know I don’t drive in DC. For some reason, I took the Metro instead of a cab and walked here from the station. The DC Metro can’t match the efficiency of the London Underground. I’m definitely taking a cab home.
Yiannis: There’s nothing worse than being stuck in a crowded Metro car that’s experiencing technical difficulties. Let’s take these drinks to the table.
Elliott eagerly scans the wine list and selects a bottle of the Chateau Segla 2000 Margaux.
Elliott: I love Margaux, and 2000 is a great vintage. It will go well with the 22-ounce, bone-in rib eye I’m about to eat.
Yiannis: The Margaux love-fest continues. Why don’t you ever order something other than a bone-in rib eye?
Elliott: Why mess with perfection? Nothing matches the flavor of a well-marbled rib eye broiled to medium-rare at 1,700 degrees Fahrenheit. You can order an 8-ounce petite filet if you want; I’ll stick to the rib eye.
Yiannis: Now that I know how you feel about the petite filet, I’ll order the bone-in New York strip steak. Anyway, let’s get down to business; I don’t want work to interrupt my meal. We’ve narrowed down our list of potential picks to three stocks: Equinix (NSDQ: EQIX), Imperva (NYSE: IMPV) and Greenbrier Companies (NYSE: GBX). What’s your take?
Before Elliott can respond, the waitress arrives with the Margaux and takes Elliott and Yiannis’ orders.
Elliott: I love the Equinix story almost as much as I love this Margaux. The world’s largest network-nutral data center provider, Equinix provides physical space for networks to exchange critical information. Instead of building and maintaining their own data centers, customers lease capacity from Equinix and locate their equipment in one of the firm’s international business exchanges.
Data centers are the heart of the Internet. For example, Facebook exchanges data with online games company Zynga (NSDQ: ZNGA) and other key partners at Equinix’s data centers. As Internet traffic grows, demand for reliable capacity in data centers will increase.
Yiannis: I like Equinix, too. All the hype about Facebook’s upcoming initial public offering could attract investors to the stock. But the share price has run up another 10 percent in the past two weeks.
Elliott: That’s exactly why I’m hesitant to make Equinix our February pick. The stock market suffered a short-term correction in early February 2010 and 2011, and the pattern could hold in 2012. Shares of Equinix look overbought at these levels and would be vulnerable to a pullback.
The stock could fetch between $150 and $160 per share, but I’d prefer to buy in at $115 to $120 per share.
Yiannis: Agreed. I also like this newly listed Internet security company that you found. Imperva (NSDQ: IMPV) offers products that enable companies to monitor how their data is accessed in real time and identify any anomalies. Some of the firm’s senior managers came from Check Point Software Technologies (NSDQ: CHKP), one of the leading players in Internet security.
Elliott: Shares of Imperva also appear reasonably priced at these levels; the stock has pulled back from its high of almost $36. The company completed its initial public offering in November 2011, so the shares trade in relatively low volumes.
Two factors give me pause. Imperva will release its first quarterly earnings after the market closes on Feb. 9. The stock price could fluctuate substantially before and after the company reports results for the quarter ended Dec. 31, 2011. We also have a position in Internet security firm Symantec (NSDQ: SYMC); buying Imperva would double our exposure to this theme. That being said, I still like Imperva’s long-term growth story.
Yiannis: Ok. What’s your take on Greenbrier Companies? I trust you won’t let your experience on the Metro color your evaluation of the railcar manufacturer.
Elliott: Greenbrier Companies specializes in freight railcars and related equipment, not moving people inefficiently. The stock is an outstanding play on the ongoing growth in rail traffic.
Yiannis: But isn’t rail traffic cyclical?
Elliott: Thanks, Yiannis. You’ve just demonstrated a common misconception. Although many investors regard rail-related names as cyclical, the S&P 500 Railroads Index has blown the S&P 500 out of the water in 10 of the past 12 years, including the recessions of 2001 and 2008.
Yiannis: That’s news to me. Greenbrier Companies must be a good stock if you prefer it to Equinix and Imperva. I’m not entirely familiar with the firm’s business. Perhaps you can provide a quick refresher before our steaks arrive.
Elliott: Greenbrier Companies operates three primary business lines: manufacturing, leasing, and wheel services, refurbishment and repair.
Manufacturing accounted for roughly two-thirds of the firm’s revenue in the fiscal first quarter ended Nov. 30, 2011. Greenbrier Companies manufactures a wide variety of railcars; the firm’s most popular model, the double-stack railcar, accommodates standardized containers that can also be transported by cargo ships and long-haul trucks.
Greenbrier Companies has grown its share of the North American market for intermodal railcars to 64 percent. Imports and exports account for about 60 percent of US intermodal volumes, so demand for these railcars depends to some extent on international trade.
The firm also manufactures traditional boxcars, which are used to ship forest products and automotive parts, and hopper cars, which transport grain, cement and other commodities. Management estimates that Greenbrier Companies has supplied an average of 56 percent of the boxcar market and 18 percent of covered-hopper cars over the past five years.
After forming a strategic relationship with General Electric (NYSE: GE) in 2009, Greenbrier Companies began producing tank cars capable of holding as much as 30,000 gallons of chemicals, ethanol, vegetable oils, crude oil or about 60 other liquid commodities. At the end of 2010, the company had grown its share of this market to about 11 percent.
Yiannis: I’m surprised you haven’t mentioned coal-carrying railcars. I’d always thought coal cars were the industry’s bread and butter.
Elliott: You’re right–coal shipments account for a great deal of volume on the nation’s railroads. Greenbrier Companies doesn’t manufacture coal-carrying railcars, but management has indicated that the firm may enter this lucrative market after securing an initial test customer.
Yiannis: That could be an upside catalyst for the stock.
Elliott: Management indicated that demand for coal cars has strengthened, but adding this product category is only one of the company’s near-term catalysts for earnings growth.
Yiannis: Before you delve into these other catalysts, I want to know more about Greenbrier Companies’ other operating segments. But let’s get another bottle of wine first.
Yiannis flags down the waiter and orders a second bottle of Margaux.
Elliott: Wheel services, refurbishment and repair chipped in about 30 percent of Greenbrier Companies’ revenue in the fiscal first quarter. This business line reconditions wheels and axels and refurbishes and maintains railcars.
The company’s smallest operating segment owns roughly 9,000 railcars that it leases to railroad operators, primarily under full-service contracts that also include maintenance and repair.
These three business lines complement one another. For example, when the leasing business offers favorable returns, Greenbrier Companies often adds some of its newly manufactured railcars to the fleet. The firm also periodically sells railcars from its leased fleet when their contracts expire. Meanwhile, the company’s maintenance operations serve the in-house fleet and third-party operators.
Yiannis: Ok. Let’s get to the good stuff. What are the near-term upside catalysts for the stock?
Elliott: Freight traffic drives demand for railcars and car maintenance services. The volume of shipments on the nation’s railroads continues to increase steadily because of economic growth, international trade and the superior efficiency of freight rail.
A train can move 1 ton of freight about 480 miles on a single gallon of diesel fuel–about four times further than a truck could carry the same cargo on 1 gallon of diesel. Moreover, a single train can carry the same amount of cargo as almost 300 trucks.
With America’s highway system already congested and traffic costing businesses billions in wasted fuel, the superior efficiency of railroads continues to win market share. If all freight rail traffic were shifted to trucks today, shippers would face about $100 billion per year in additional costs. At last count, railroads accounted about 43 percent of all US ton-miles (a ton of freight shipped one mile)–more than any other mode of transport.
In January 2012, total railcar loadings were up 0.3 percent from year-ago levels, while intermodal traffic has increased 2.5 percent.
Yiannis: Those numbers aren’t that impressive.
Elliott: This modest year-over-year growth obscures substantial growth in specific categories. For example, January shipments of petroleum products soared 16.3 percent from year-ago levels, while the volume of crushed stone, sand and gravel surged 13.7 percent. Shipments of motor vehicles and related auto parts jumped 10.8 percent. At the same time, railcar loadings of grain slumped by 11 percent.
Yiannis: I’ve read about the rising demand for tank railcars in The Energy Strategist. Surging production of oil and natural gas liquids (NGL) in the nation’s prolific shale plays have overwhelmed existing takeaway capacity and forced operators to transport these commodities via rail. The Bakken Shale in North Dakota, in particular, faces a daunting shortage of midstream capacity, prompting EOG Resources (NYSE: EOG) and other producers to book capacity on railroads.
Elliott: You’ve done your homework. Greenbrier Companies is one of four outfits that produce tank cars, compared to the eight major manufacturers of traditional railcars. The complexity of building tank cars also serves as a natural barrier to entry for smaller competitors. A shortage of tank car capacity gives manufacturers pricing power, which translates into higher profit margins.
The stock could receive a boost when management announces a comprehensive strategy to capitalize on the booming energy and tank car businesses. The company continues to study the energy business and speak with potential customers to determine how to capitalize on the trends under way.
Management also hinted that the firm could move to expand its capacity to build tank cars at its facility in Mexico.
Yiannis: This growth story keeps getting better and better.
Elliott: It doesn’t stop there. Rail shipments of petrochemicals are also booming. Thanks to America’s abundant shale gas reserves, US petrochemical plants enjoy some of the lowest input costs in the world. Not only are US natural gas prices about one-quarter of what Europeans pay, but rising production of NGLs such as ethane, propane and butane also provides US petrochemical plants with a huge advantage over competitors in Asia that use naphtha and other oil derivatives as feedstock.
As a result, major chemical producers have announced plans expand existing plants or build additional capacity. The resurgence in US petrochemical output has also boosted demand for tank cars.
Yiannis: I assume the 13.7 percent year-over-year increase in sand, crushed stone and gravel is also related to the shale oil and gas boom.
Elliott: Correct. Hydraulic fracturing enables producers to extract oil and gas trapped in shale fields. This process involves pumping huge amounts of liquid into the field until the reservoir rock fractures, creating channels that allow the hydrocarbons to flow into the well. Producers also mix sand and ceramic material into the fracturing fluid; this “proppant” prevents the fractures from closing once the pressure is removed. Much of this sand and ceramic material is delivered by rail.
Yiannis: I imagine that Greenbrier Companies would also benefit from the ongoing recovery in US car sales.
Elliott: That’s true. The average car on the road is more than 10 years old, so replacements should boost sales in coming years.
Yiannis: Before we decide to hitch our car to this train, we need to talk about any challenges the company faces.
Elliott: Well, the decline in grain shipments is a case of difficult year-over-year comparables rather than a worrisome trend.
Greenbrier Companies also manufactures ocean-going barges, a business that has struggled from an oversupplied market and weak demand in recent years. Nevertheless, management noted that conversations with potential customers suggest that this business may improve. This unit has weighed on results for so long that any uptick in orders would be welcome.
Some analysts have expressed concern that the firm only booked orders for 1,200 new cars in its fiscal first quarter, a decline from year-ago levels. But railcar orders tend to be lumpy. Shortly after the quarter ended, Greenbrier Companies received an order for 2,400 cars at an average selling price (ASP) of $100,000. In the previous fiscal year, the firm’s ASP was $80,000 per car. This upsurge reflects an improved sales mix that includes more tank cars and other higher-margin models.
Yiannis: Are any gremlins lurking in the company’s other business lines?
Elliott: Manufacturing will continue to drive Greenbrier Companies’ earnings growth, but its other business lines have performed reasonably well.
Maintenance-related revenue jumped from $95.3 million in the fiscal first quarter of 2011 to $117.7 million in 2012. This business line faces an unexpected challenge: a shortage of skilled labor. As new employees are trained, efficiency can suffer.
The leasing business is Greenbrier Companies smallest operating segment by revenue but does boast high profit margins. Management has indicated that rates on longer-term leases have improved.
Yiannis: I’m looking at the stock’s price history.
Elliott: On my iPad.
Yiannis: Well, you had to contribute something to the discussion.
Yiannis: As I was saying before you interrupted, the stock sold off last fall amid fears of a global recession. The stock has regained this lost ground quickly. I also see support at about $22 per share. The first stop on any rally would be the 2011 high of $30–a 20 percent gain from current levels.
Elliott: The stock has the potential to rally to $35 or $40 over the next six months.
Yiannis: How much should readers pay to ride this train?
Yiannis: Greenbrier Companies rates a buy under $27.50.
Updates on Open Positions
August 2010: Vale (NYSE: VALE)–Buy < 30
Although commodities prices will moderate if the global economy slows, blue-chip miners are the place to be for a potential turnaround. Spot prices of iron ore have firmed up recently because of weak supply and stronger steel production. The latter is important as US steel production was also up by nine percent in the last quarter of 2011. Vale’s long-term growth story remains intact, though it may take a few quarters for demand to strengthen in China.
September 2010: Teekay Tankers (NYSE: TNK)–Buy < 10
A 21 percent yield is Teekay Tankers’ only saving grace. We have been in this trade long enough that all the bad news has been priced into the stock–including lower day-rates on the spot market in 2012.
February 2011: ProShares UltraShort 20+ Year Treasury (NYSE: TBT)–Buy < 30
Betting against US Treasury notes has been a losing proposition. This position could recover some lost ground when investors rotate funds from safe havens to equities, which is gradually happening with the recommendation up six percent this year.
May 2011: TAL International (NYSE: TAL)–Buy < 32
TAL International is the top company in the shipping industry, and the stock will rally if global trade doesn’t collapse. Demand has remained fairly resilient, while container prices have stabilized. The latest statistics from the ports of Los Angeles and Long Beach on container growth have also rebounded in positive territory after a two year decline.
June 2011: iShares MSCI Italy Index (NYSE: EWI)–Buy < 15
This play on Europe’s turnaround is less risky than our Greece-related bet. The Greek experiment has forced the EU to deal more decisively with Italy’s fiscal challenges. The position is up 10 percent this year but it has a long way to go if it is to come back.
July 2011: TransGlobe Energy Corp (NSDQ: TGA)–Buy < 12
This small-cap oil producer has been coming back strong as oil demand remains more resilient than was originally thought. This speculative stock tends to outperform bull markets and underperform in bear markets. The company also closed its West Bakr acquisition in Egypt in late December, a project that looks promising.
July 2011: Market Vectors Gulf States Index (NYSE: MES)–Buy < 23.50
This exchange-traded fund has held its own since we featured it in the July issue, especially given the performance in the global markets over the same time frame. That said, this year it has not performed as well as we would like it to. We’re holding out for a powerful upsurge.
August 2011: National Bank of Greece (NYSE: NBG)–Buy < USD6
This stock is our most speculative play to date and is only appropriate for aggressive investors who can stomach a bet that’s based solely on a turnaround in Greece. Although the stock is down substantially since the original recommendation it has rallied more than 80 percent this year, and any orderly resolution to Greece’s sovereign-debt crisis can take it higher in a hurry.
September 2011: China Cord Blood Corp (NYSE: CO)–Buy < 4
Don’t let near-term volatility shake you out of this stock. Shares of China Cord Blood Corp have rallied in the new year. Expect more as the industry’s fundamentals turn.
October 2011: Infosys (NSDQ: INFY)–Buy < 55
Although we have a double-digit gain in the stock, Infosys could rally even further if the Indian market holds up. Investors should adhere to our buy target and only add to their positions when the stock dips below 55.
November 2011: Melco Crown Entertainment (NSDQ: MPEL)–Buy < 12.75
This casino and hotel operator remains the best way to gain exposure to lucrative gaming market in Macau. The stock has performed well in the new year. The firm has USD1 billion in cash on its balance sheet, and estimates call for the company to generate USD600 million in operating cash flow this year.
December 2011: Symantec Corp (NSDQ: SYMC)–Buy < 17.50
Internet security is a major growth market, and Symantec should continue to benefit. Industry consolidation is also in the cards; with USD2.3 billion in cash, Symantec Corp is looking for acquisitions in its core markets of security and storage.