Wednesday, March 26, 2008

Growth Derailed at FreightCar America, Inc

Railcar freight volume in the U.S. totaled 363.6 billion ton-miles in this year's first 11 weeks, up 2.3% from last year—despite weather-related volume shortfalls in January. Survey data suggests that rising diesel fuel prices—i.e. higher freight surcharges—are adversely affecting trucking volumes, shifting shipper freight demand to rail from trucking because of higher total transportation costs in the latter.

As freight demand rebounds (ahead of the broader economy), Burlington Northern (NYSE:BNI), Norfolk Southern Co (NYSE:NSC), and other rail transport companies are expanding capacity on rail infrastructure to meet the expected growing demand.

Specifically, ought investors use the emergence of the aforementioned growth catalysts to either add to (existing holdings)—or initiate positions in—FreightCar America, Inc (RAIL-$35.60), a manufacturer of railroad freight cars (with particular expertise in coal-carrying railcars)?

Cyclical Nature of the Railcar Market

FreightCar specializes in the production of aluminum-bodied coal-carrying railcars, which represented 86 percent and 96 percent of deliveries of railcars in 2007 and 2006, respectively. The company’s
BethGon series of coal-carrying gondola railcar has been the leading aluminum-bodied coal-carrying railcar sold in North America for nearly 20 years.

The North American railcar market is highly cyclical, and trends in the railcar industry are closely related to the overall level of economic activity. Given the current downturn, FreightCar is facing a challenging environment, with its aggregate backlog of firm orders for new railcars falling 42.0% Y/Y to 5,399 railcars as of December 31, 2007, representing estimated sales of $422 million.

Investment Thoughts

FreightCar shed 28.4% in valuation during the past year—the downturn being seen in weakening demand for freight shipments; in turn, softening the company’s Y/Y orders and corresponding EPS. Ergo, one might argue that the share price already discounts the current slowdown in the transportation equipment space.

Bulls present a two-legged argument for a “BUY” on railcar makers like FreightCar and (a competitor) Trinity Industries (TRN-$26.82): (i) replacement demand of aging railcar fleets with newer railcars offering greater capacity and durability, and (ii) average
weekly spot coal prices are strong, which will be reflected in more coal mining –shipping demand increases.

Capital Spending Outlook

The Department of Transportation estimates that the demand for freight transportation will grow from 19.3 billion tons today to 37.2 billion tons in 2035, an increase of about 93 percent. To absorb this growth (and maintain its existing share of the freight transportation market) railroads must add capacity to handle 88 percent more tonnage.

Existing freight railcars need upgrading to handle more capacity. The railway business is capital intensive—and many railways
do not earn sufficient returns to cover their weighted cost of capital. For example, the WACC at Burlington Northern Santa Fe Railway Company is approximately 7.6% versus a 6.7% Return-on-Assets. Consequently, the freight haulers favor lower-cost means of boosting capacity, such as improving signaling systems, improving asset utilization, or better timetable planning.

That said, other infrastructure investments take priority over railcar replacement, too: capacity of freight yards, primary corridor improvements (e.g. investments required to bring the weight-bearing capacity of Class I track, bridges, and tunnels up to code), and capital costs of new rail lines and support facilities.

Concentration of Sales Risk

Revenue from three customers, Burlington Northern, Norfolk Southern Corporation, and TXU Energy, accounted for approximately 37.0% of total revenue in 2007.

A review of these customers’ infrastructure budgets for 2008 supports our thesis that although capital spending will remain strong, most of the demand will be for rail infrastructurenot the replacement of railcars. For example, the planned capital commitments of BNI in 2008 are approximately $2.45 billion, with all but $400 million targeted to rail infrastructure and capacity (track and facilities) improvements.

Coal Outlook

Norfolk Southern, which generates roughly 25 percent of revenue from coal-hauling contracts, is not as optimistic as some FreightCar investors on coal tonnage outlook in the coming year. In 2008, the freight rail operator expects demand for utility coal to be mixed, with declining utility inventories in the Northeast stimulating growth but above normal stockpiles in the Southeast mitigating the growth.

In addition, given legacy contracts (as long as five-years in duration) coal-hauling demand/ volume is independent of short-term price-swings.

Norfolk’s forecast for coal demand is buttressed by a recent assessment by the Energy Information Administration: Slow growth in electricity consumption, combined with increases in hydroelectric generation, will dampen growth in electric-power-sector
coal consumption to 0.3 percent in 2008. Electric-power-sector coal consumption is projected to increase by an additional 0.4 percent in 2009.

Projected weak demand for coal in 2008 and 2009 will result in only a 0.1-percent increase in
U.S. coal production in 2008 followed by 0.2-percent growth in 2009. In the Western region, the Nation’s largest coal-producing region, production is expected to increase by 0.7 percent in 2008, but decrease by 0.6 percent in 2009. Total coal stocks are estimated to have grown by 1.6 percent in 2007 to 190 million short tons. Total coal stocks are expected to rise by 1.1 percent in 2008 and remain at that level (192 million short tons) in 2009.

Coal prices are a necessary but not sufficient reason to argue that demand—and tonnage hauling—will show improvement in 2008.

For example, utility companies, such as TXU Energy, are significant customers of FreightCar’s coal-carrying railcar lines. Should coal prices rise too high, customers might select an alternative energy source to coal, thereby reducing the strength of the market for coal-carrying railcars—adversely affecting FreightCar’s operating results.

Financial Health

FreightCar’s balance sheet looks deceptively healthy, with working capital of $185.17 million and little long-term debt.

Long-term liquidity needs, however, depend to a significant extent on obligations related to the company’s pension and welfare benefit plans, according to regulatory filings.

FreightCar’s pension obligations are currently underfunded by $10.4 million. Pension and post-retirement benefit obligations underfunding would be higher, but were met by scaling back benefit coverage (due to a decrease in the estimated remaining future service years of employees let go when management closed its manufacturing facility in Johnstown, Pennsylvania in December 2007).

Management expects that any future obligations under its pension plans- that are not currently funded- will be funded from future cash flow from operations, which shrank almost $113 million Y/Y to $41.3 million as of December 31, 2007. [Another bad year and CFFO could be negative.]

[Ed. Note. Employees at the Company’s Johnstown, Pennsylvania manufacturing facility filed a
lawsuit alleging that they and other workers at the facility were laid off by the Company to prevent them from becoming eligible for certain retirement benefits, in violation of federal law. As of March 4, 2008, pending appeals by management, the plant is still open.]

We believe that future contributions could be materially higher than the $6.75 million that management expects to contribute to its pension plans in 2008 (vs. the $5.4 million contribution made in December 2007). Why? In 2007, the Company owed $53.1 million in post-retirement benefits to existing retirees.

In addition, management’s expected rate of return on pension assets in 2008 is projected to be 8.25 percent. Optimistic—in light of the fact that whoever is managing the plans lost $4.17 million and $3.72 million, respectively, in the net actuarial values of the pension and post-retirement benefits plans in 2007. And, like in 2007, 72 percent of plan assets are invested in equities.

Investors ought note, too, that because of accounting rules, FreightCar is sitting on $15.5 million in stockpiled losses that as of December 31, 2007, have not shown up as red ink—yet—on the income statement!

Loan Covenant Restriction

FreightCar is limited to maximum capital expenditures of $10.0 million per year, effectively erasing the company’s footprint into other railcar product lines.

Investment Conclusion

FreightCar is not positioned for accelerating growth and does not represent an attractive recovery story in the transportation equipment space. A cursory look at shippers and rail transport operators forward 12-month business plans suggest freight hauling will be weighted to leasing over buying railcars. Less than 5 percent of FreightCar’s $817 million in 2007 sales resulted from leasing operations.

FreightCar shares are fully valued, fetching almost 19 times forward 12-month earnings estimates of $1.87 per share—a peak cycle ratio in a period of weakness! In addition, with the possibility of an additional cut in earnings guidance, we believe the stock is vulnerable, with additional pricing bias to the downside.

Editor David J. Phillips does not hold a financial interest in any stocks mentioned in this article. The 10Q Detective has a Full Disclosure Policy.

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