Investment Thesis – American Railcar common stock is a short because:

¦ American Railcar is massively over-earning due to temporary demand for tank cars to ship crude oil

¦ Shares are expensive on even aggressive estimates of normalized earnings

Business Overview

American Railcar manufactures, leases and services tank and covered hopper railcars.  Tank cars are used to haul liquids such as chemicals, ethanol or crude oil over rail lines. Covered hoppers are generally used to transport bulk commodities such as cement, grains or sand. Approximately 80% of sales and 75% operating profit are from sales of rail cars to third parties such as leasing companies, railroads or industrial shippers. The rest of the business relates to leasing and servicing rail cars.

Tank Cars Account for the Vast Majority of Profits

ARII does not disclose the precise breakdown of sales and profits for tank cars vs. hoppers, however making some reasonable assumptions allows us to get close. The company has said that they have capacity to produce 5000 tank cars and are running at capacity. My research indicates that these cars should sell for about $140k and at this price would have about a 26% margin.  As shown in figure 1 below, plugging in these estimates to ARII’s reported numbers implies that tank cars account for about 85% of the manufacturing segment’s profit. 

Figure 1: Most of ARII’s Profits are From Tank Cars

Crude-by-Rail Has Exploded

Since 2011, tank cars sales have exploded beyond any historical precedent. This is almost entirely the result of demand for cars to ship crude oil from the Bakken shale. In 2008 there were only 9,500 crude rail car loadings in the U.S. By 2013 this number grew to 407,642. Until recently, shipping crude oil via rail was rather uncommon since pipelines are generally the cheapest, safest and most efficient way to transport oil and shipping by rail costs 2-3x more than via pipeline.  However, the unexpectedly rapid growth of Bakken oil coupled with a lack of infrastructure has caused production to outstrip available pipeline capacity. 

Figure 2: Crude-by-Rail Shipments and Tank Car Backlog

Tank Car Build Level is Unsustainable

Currently there are approximately 55,000 tank cars used for crude oil transportation in North America. However, the current backlog consists of approximately 30,000 crude cars and the industry is manufacturing about 6,000 crude cars ever quarter which is enough to grow the current fleet by almost 50% every year. However, it is nearly impossible to construct a reasonable scenario where crude-by-rail volumes grow at anything close to this rate.  As shown in figure 2 above, U.S. crude-by-rail shipments appear to have plateaued after a period of rapid growth. This is because the rise of Bakken production was a one-time event that will never be duplicated. While Canadian volumes should continue to grow, even aggressive estimates for Canadian growth implies only modest industry-wide expansion. Even assuming some demand growth from new chemical plants and other tank car uses, it is very difficult to see how the industry absorbs anything close to the current production rate for an extended period.

In the near-term, demand will also be augmented by new safety standards for crude tank cars. In July, the Department of Transportation released initial proposals for the new standards; however it will be several months before the requirements are finalized.  At that point, tank car owners will either have to modify their cars in order to comply with the new standards or scrap the existing cars and purchase new ones. To the extent owners choose to purchase new cars, this will benefit suppliers such as ARII.

Based on the current proposals, it appears that most cars will be retrofitted rather than scrapped. A new tank car will cost $140k+ will take 18mos to be delivered and will last for over 30yrs. The proposed retrofit costs range from $25-$35k and given that most of the cars in service today are less than 10yrs old (built either for the current crude demand or the previous ethanol boom) it would not make sense to buy an entirely new car.  The DOT has said it expects the majority of impacted cars to be retrofitted and that “No existing tank cars will be forced into early retirement.” As such, I believe its reasonable to assume that the new safety standards will result in incremental demand for about 10,000 new tank cars.

ARII is Expensive on Normalized Earnings

Once the new safety standards are fully implemented, the crude tank car fleet will only need to grow as fast as shipment volumes. Industry experts I spoke with said that over the next several years, crude-by-rail volumes would likely growth by about 10-15% per year. This implies industry-wide demand of about 8,000 new crude cars annually. As shown in figure 3 below, if ARII’s tank-car volumes decline in-line with the total market and margins return to normal levels, the company would earn normalized EPS of about $3-$4/share.  

Figure 3: Estimated Normalized Earnings

If anything, I think my estimate of normalized earnings is aggressive for the following reasons:

1)      First, I’ve assumed ARII sells all production externally. Over the last few years however, the company has used significant production capacity to build its internal lease fleet. Internal sales do not contribute to current year earnings. As such to the extent that ARII continues to build its lease fleet, earnings could be lower.

2)      Second, I’ve assumed lease rates do not fall. In reality, lower demand would likely lead to lower lease rates.

3)      Finally, this business is highly cyclical with boom periods (like today) inevitably followed by busts. My estimates of normalized demand assume no excess supply is created in the current boom period

Primary Risks

The obvious risks here are that tank car demand is simply higher than expected either due to more stringent safety standards being adopted or simply higher than expected crude volume growth. While this is clearly possible, it seems unlikely that this impact would be large enough to really cause the short to lose over the long term. What could meaningfully hurt a short is a spike in tank car demand from an entirely new source, possibly something that is not currently shipped by rail at all. I have no idea what this could be, but almost no one foresaw the past two demand spikes (first from ethanol and now from crude) and a new demand source could lead to a permanent capital impairment.