Ride the Rail Boom With Buffett and Icahn

When old men start doting on train cars it could be that the second childhood is close at hand. Or it could be that they are multi-billionaires who can’t get enough of these lucrative profit engines. Train cars, and in particular the tank cars required to transport the abundance of oil from new fields in the North American interior are all the rage, objects of a production and profit boom that will last years rather than months.

In his annual letter to the Berkshire-Hathaway shareholders released this month, investing legend Warren Buffett devoted several paragraphs to Union Tank Car, a manufacturer tracing its ancestry to John D. Rockefeller’s Standard Oil empire and part of the Berkshire conglomerate since 2008, when Buffett acquired a majority stake in its parent company, the Marmon Group.

Buffett noted that Union Tank Car’s order book extends “well into 2014” as a result of the demand for shale oil transport. “At both BNSF [Berkshire’s railroad] and Marmon, we are benefitting from the resurgence of US oil production,” he wrote. “In fact, our railroad is now transporting about 500,000 barrels of oil daily, roughly 10 percent of the total produced in the “lower 48” (i.e. not counting Alaska and offshore). All indications are that BNSF’s oil shipments will grow substantially in coming years.”

Union Tank Car will certainly benefit from the trend (described in greater detail above), but it won’t be the only asset so blessed, and Buffett won’t be the only billionaire to profit.

Famed investor Carl Icahn has already recouped many times his investment in American Railcar Industries (NasdaqGS: ARII), where he is the majority shareholder and has served as chairman since 1994.

ARII shares have been on an absolute tear, tripling since September of 2011 (when Icahn kept opportunistically buying them) and chugging 43 percent higher year-to-date. Yet the fundamentals of the business have been so good, and are poised to remain so long enough, that the stock still provides plenty of value.

ARII stock chart

It’s priced at 12 times estimated 2013 earnings, closer to 10 times analysts’ 2014 consensus, and just 7 times trailing EV/Ebitda. (This, again, is market capitalization plus net debt divided by cash earnings net of interest and taxes.)

Last month American Railcar reported earnings per share that nearly quadrupled in a year’s time while coming in 50 percent above the consensus estimate. The operating margin tripled, thanks to tank cars. Rail cars leased by ARII accounted for a fifth of the shipments, while leasing revenue jumped more than 10-fold from a tiny base.

The order backlog of more than 7,000 rail cars was valued at $890 million, representing 125 percent of last year’s revenue. That revenue, in turn rose 37 percent from 2011. Fourth-quarter revenue was up a nominal 6 percent year-over-year, but that number is misleading because it does not include the rail cars manufactured for direct lease. Including such internal sales would have revealed a 15 percent revenue boost. And the company has only begun to recognize the revenue from the five- and seven-year leases it has been signing at highly favorable rates, promising plenty of top-line growth in the future.

The industry as a whole delivered some 5.300 tank cars in the last quarter but took in orders for 6,800, for a very healthy book-to-bill ratio of 1.28. And while prices may have peaked last year amid widespread shortages, they’re expected to stay strong since it will take at least two years at the current production capacity to cut the current the industry-wide order backlog of 48,000 tank cars.

Tank car photo
How quickly that capacity might grow, jeopardizing prices, has been a topic of concern among analysts. American Railcar recently entered into a joint venture with another Icahn-owned company looking to get in on the actions, and other competitors in an expansionary mode as well given the lure of strong profits.

But since all of them are, like American Railcar, increasingly leasing rather than selling the equipment, they have added incentive not to overbuild, as has happened in past boom-bust cycles.

Still, it’s important to remember that American Railcar’s CEO, James Cowan, estimate long-run demand at just half the current gold-rush-fever level, and expects a meaningful regression toward those levels in about two years.

Of course, by then the economy might be on firmer footing and in need of more rail transport for a variety of industries. Also, American Railcar might be that much closer to monetizing its ambitious joint venture to modernize India’s rolling stock, an opportunity as exciting as it must be daunting.

More importantly, this year its manufacturing plants will still be going all out, constrained only by management’s choosiness in seeking out the most lucrative orders.The leasing business has a big growth trajectory in front of it. And in the meantime American Railcar has just refinanced all of its modest corporate debt from 7.5% down to 3% annually.

The industry could also benefit from consolidation, such as Icahn attempted when American Railcar bid unsuccessfully for rival Greenbrier (NYSE: GBX) late last year. Greenbrier didn’t like the offered premium, but who’s to say who might want to sell and at what price ahead of a potential slowdown down the line?

ARII map
Source: American Railroad Industries investor presentation

In the meantime, there are two years of good growth ahead, along with the possibility that demand could surprise to the upside in the longer run as economic growth picks up and niche energy plays are exploited.

American Railcar’s current 2.2 percent annual dividend yield amounts to one-sixth of last year’s cash from operations. That gives a hint of how good a business this has been. ARII is a new Aggressive Portfolio pick; buy it below $52.

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