Tuesday, May 31, 2011

2011 Guide to Equipment Leasing

Written by  Tony Kruglinski, Financial Editor
2011 Guide to Equipment Leasing William C. Vantuono

The view from the top 

Before we move on to our CEO interviews, we thought it might be appropriate to reflect upon an event that has been reported in the financial press and that should be of interest to everyone reading this special issue: the potential sale of GE Railcar Services.

According to reports from industry sources, Railcar Services' parent is seeking to exit the industry by selling all of the GE Railcar Services' assets for an amount that is reported to be in excess of $3 billion. It has hired an investment bank to advise it in connection with the sale and this investment bank has a "book" on the street offering the assets for sale. We are told that as many as a dozen prospective buyers have expressed interest in the Railcar Services' assets and will be proceeding with due diligence during the month of June.

What's really interesting, however, is who these potential bidders are—or more important, who they are not!

We have been reliably informed that none of the veteran operating railcar lessors are currently in the pack of bidders chasing this acquisition! Instead, it seems that the bidding group mainly contains financial players like investment banks and venture capital funds.

If this is true, why is this so? And, more important, what does this say about the state of our industry and the prospects for this transaction proceeding?

First of all, players in the North American railcar operating leasing industry are aware that these assets have been rumored to have been on the market once or twice during the past few years. In each such situation, the transactions did not proceed to closing. These rumored potential sales did involve existing operating lessors. It may be that given the size (and financial requirements related thereto) of such a deal, few existing lessors were big enough to pull it off, and those who were have already seen the assets and are not interested at the rumored price.

It's also possible that concerns relating to getting competition clearance from the federal government may be holding some of the larger operating lessors back.

Finally, the challenge of doing diligence on GE's huge fleet of owned and leased-in railcars has to be daunting for any interested party. Doing, or paying for, this diligence has to be a stumbling block for any potential bidder.

But the really interesting aspect of this, assuming the rumors of only financial buyers in the hunt are accurate, is why these financial buyers think they know more than the operating lessors with whom they should be competing but are not!

(We're assuming that if this writer can figure out the competitive situation, the financial bidders for these assets can also do so.)

The next step we expect to see is overtures by the present financial bidders to reach out to one or more operating lessors to suggest partnerships or sales of some assets after closing the main deal.

It will be during these conversations that the financial realities of a used railcar fleet can be expected to be communicated by our market-savvy operating lessor friends to these financial bidders.

We're not opining on the merits of the rumored transaction, its price, or the likelihood of it actually happening. All we will say is that it's complicated, and good luck to all concerned.

Views on today's market

As we said at the beginning of this guide, we've interviewed a selection of operating lessor CEOs on the market they are facing and what they see in the near and longer term future.

Here is what they have to say:

Rich Meyers, President, CK Industries, Inc. CK fields an operating lease fleet of 1,400 railcars, principally covered hoppers (both large and small cube) and boxcars.

"Loadings are staying strong, though certain car types, principally those related to lumber and paper, will remain weak. We expect carloadings to continue to increase, resulting in higher demands for leased railcars. However, we do have a concern with the rapid price increases for new cars. For example, new 3,200 cube covered hoppers were priced in the low $60,000 range last fall. Today they are being quoted in excess of $70,000, subject to escalation for increases in steel and component prices affecting the builder. Another problem is that deliveries for certain car types ordered today will not occur until early 2012. That's a lot of time for escalation to occur. On the other hand, rental rates are up, but because of pockets of used cars available in some car types this makes ordering these cars new problematic."

Gene Henneberry, CEO, Flagship Rail Services LLC. Flagship is the newly minted name for what had been AIG Rail Services. The company owns just over 10,000 railcars on operating lease. Principal car types include general purpose tankcars, covered hopper cars, and open top coal gons.

"First of all, the demand for equipment has improved considerably, though there are pockets of car types that still need to continue to improve. We are pleasantly surprised to see lease rates improve at the rate that they have. However, constraints on new car deliveries due to the inability to ramp up production and the availability of component parts and materials will remain a concern for the next six to nine months. Assuming continued economic growth, I would expect this year's estimates of a new-build level of 38,000 cars to grow to approximately 50,000 cars in 2012. Perella Weinberg Partners is the new owner of Flagship Rail Services and invests in major asset classes including equities, fixed income and asset-based securities. Our ability to keep the entire AIG team in place with our new owners will, I believe, benefit both new and existing customers."

Jack Thomas, President, First Union Rail Corp. First Union has approximately 90,000 railcars on lease to a variety of railroad and industrial customers.

"We are experiencing improving lease rates and utilization for our North American fleet. We see in the marketplace some of the same activities that led to overbuilding of railcars in the past. The current and anticipated demand for "frac" sand cars is one area where buying cars on spec may produce lower than expected returns for investors. The current upswing in the marketplace is not across all segments of the economy. Most notably, lumber and related construction materials (cement, steel) are still lagging behind the rest of the economy. Hopefully these segments will catch up soon.

"The concerns raised by others involving the rising costs of maintaining freight cars have created a number of initiatives to address those issues. Hopefully these initiatives will result in a moderation of this trend. Generally speaking, we and other lessons are seeing improving returns due to the current market upswing. Having said this, our costs are going up. In the past, as our investment in equipment matured our costs were predictable. Today, it is possible to purchase a new car, put it out on lease, and find out subsequently that maintenance and regulatory costs unpredictably rise. This makes the entire investment process very difficult."

Tom Pawlicki, Senior Vice President, Citicorp Railmark. Including significant numbers of full service operating leases, Citirail leases 12,000 railcars and 350 locomotives to operating and finance lessees.

"The market is still down, but we have seen improvement over the past five or six months. Grain cars are hot today. All of our grain cars are out on lease and people are calling looking for more. Rental rates are below the market rates before the crash, but they have been improving as of late. Citirail is an active investor in this industry. We are looking for cars and lease opportunities involving the oil and gas industry's need for frac sand cars. We are also interested aggregate cars—2,400 cube, rapid discharge cars with automatic opening gates. These cars are valuable to the utility industry for moving stone needed for scrubbers as well as rock and aggregates. The present fleet is old and new cars are needed."

Jim Earl, Executive Vice President and COO, GATX Corp. GATX owns one of the largest operating lease fleets of railcars and locomotives in the world, with approximately 110,000 cars and 550 locomotives in its North American fleet. In addition, GATX is a significant participant in the European rail marketplace.

"GATX is cautiously optimistic about the current market, where we see relatively strong or at least improving performance across almost all car types in our fleet. Our North American fleet is performing well, ending the first quarter at 97.8% utilization. In the long run, GATX remains committed to the rail market as evidenced in our five year investment program for 12,500 new railcars from Trinity Industries. Currently our team is focused on improving lease rates, delivering even higher levels of customer service and selective growth in profitable areas.

"We remain concerned about the continuing cost pressures that face private car owners in North America as the Class I railroads attempt to shift a greater cost burden to the private car owners and shippers. In addition, an uncertain regulatory environment is currently making long term investment decisions for certain tank cars challenging.

"Finally, we are keeping an eye on evolving accounting issues related to lease accounting rules. While we are not overly concerned, these proposed changes have the potential to alter client buy/lease behavior with respect their railcar fleets."

Scrapapolooza

(The following was written by Railroad Financial Corp. partner David Nahass, who spent months "mining" the scrap market for an RFC client scrapping railcars at the end of their useful life.)

As the leasing market for used railcars picks up in North America, one other market that has been robust during the past few months is the scrap market for used railcars. Parties lucky enough to have assets that have either reached the end of their useful life (or AAR interchange life) have been on the receiving end of an historical market for scrap steel.

The Chicago #1 Heavy Melt scrap price (the Chicago market is the primary market for scrap metal) for May 2011 is $405 per ton. Scrap prices throughout 2011 have been at this level or better (April's comparable per ton price was $425 per ton). Calls to sources in the scrap industry confirmed that today's scrap price is roughly 47% to 62% above the 10-year average price of scrap metal (approximately $250 to $275 per ton). Our sources note, however, that over the previous 10 years, scrap pricing went from being relatively stable in the first five years to being much more volatile in the second five years.

With the average 40-year-old covered hopper railcar weighing in at 61,000 pounds per car, that would provide a car owner with 27 long tons of scrap. (A long ton equals 2,240 pounds. This is not to be confused with the more traditional reference to a "ton," which is 2,000 pounds and known as a "short ton.") Subtract $50 per ton for the party scrapping the cars (depending on location of the scrap yard) and at today's prices, that 27 long tons delivers $9,585 for that end-of-life asset.

However, that is not the whole story. Depending on your negotiating prowess, you might be able to shrink down the fee that needs to be paid to a counterparty in a scrap transaction. Why? As scrap prices have pushed to higher levels, the most easily accessible railcars for scrap have already been grabbed and scrapped. In other words, railcars for scrapping have recently become harder to come by. As a result, margins for parties scrapping cars might be open to negotiation, but beware: Unlike the local services that may come to your house to pick up items for salvage with nothing more than a truck, most scrap transactions are priced F.O.B (freight on board) the scrap yard. That means the railcar owner is responsible for delivering the railcar to the facility. Empty cars moving to a scrap yard may be transported at the carrying railroad's tariff rate. That can eat into those high prices quickly.

How long will this trend in scrap prices continue? Unfortunately, future scrap pricing is unclear. Scrap prices, sources tell me, are driven by foreign demand and domestic mill capacity. Both factors seem to favor pricing remaining stable in the near to medium term. However, without a clear direction in the growth of the global economy, there are no guarantees that the demand curve will support a price higher than $400 per ton. On the flip side, growth in the export market and domestic demand may drive summertime or fall prices back to $425 per ton and even higher. One other note: Scrap, unlike most other commodity markets, does not have a futures market, so the prices on scrap generally get hedged only by those parties who are doing the scrapping. Lack experience in this market? Go in with your eyes open and work with someone you feel you can trust.