Wednesday, August 31, 2011

A primer, of sorts, for operating lessors

Written by  Tony Kruglinski, Financial Editor

I’m sitting here during the Dog Days of summer recuperating from major surgery as well as the experience of advising one of the potential purchasers of GE’s railcar leasing business, which was for sale up until recently.

The surgery was the easier of the two experiences.

My client was among a dozen or so interested parties going full tilt at the GE ”opportunity” until GE took the deal off the table. GE’s reason for doing so has been expressed as a renewed faith in the railcar operating leasing business and a willingness to stay the course as an owner and investor. The opinion of many of those bidding the deal was that bidders, who were spending hundreds of thousands of dollars on due diligence, were not coming up with values for the company that the seller found adequate enough to sell.

Whatever the reason for GE’s action in pulling the deal, it was not that much of a surprise to industry insiders who were aware of GE’s target for the sale. The overall value just wasn’t there, even in today’s somewhat heated recovering market for the operating lease of railcars.

Having said this, I devote this month’s column to a bit of a primer on the economic basics of the railcar operating leasing industry serving railroads and shippers. (It’s perfect for those of our readers who dream of going to sleep and waking up as operating lessors!)

Even in the depths of the depression in operating leasing rental rates during the last few years, no one was selling railcars at a significant (more than 10%) discount. The only significant sales at discounts involved insolvencies and these were few. The apparent reason that railcars did not mimic aircraft and ships which were deeply discounted during the same period was a deep and abiding belief by owners of these assets that the values for railcars under lease would come roaring back at the first turn of the economy.

It appears that they were right. (They probably had their eyes open during the last business downturn.)

Railcars today, and for the last decade, have been very “finely” priced. Their values have held up during the last business downturn. These values also reflect the tax advantages (depreciation) of ownership, and this is what readers should keep in mind when considering market values for these assets.

Put another way: With the exception of the very largest of the railcar operating lessors, which generate their own tax “capacity” through the earnings they produce, it is very difficult to pay the current prices for railcars as investments (and achieve the return you seek) unless you are otherwise in a business that can use the depreciation allowances associated with ownership. Again, that’s because those depreciation allowances are priced into the railcar values that the market is paying for those assets and you will have to “pay up” to buy them.

I don’t know what was in GE’s mind when it considered the value it could achieve in a sale of its railcar leasing assets. But I have to believe that they (and/or their advisors) put a substantial value on the leasing company as a “going concern.” This would not be unusual, as at least one other large lessor for sale in the past has been pulled from sale for (we believe) the same reason. It’s our view that the unique and fungible nature of railcar assets will pose a problem for anyone selling a large operating lessor and seeking a substantial value for the lessor as a going concern.

A hard look at how to get the most value for the railcar assets will quickly devolve to a view to considering the assets’ value to other operating lessors who can add them to existing fleets at a marginal cost. (And without the cost of carrying the large operating lessor’s total overhead.)

Far from being a value for which the market will pay, the overhead of a large lessor may be seen as a drag on the value of the assets.

Having said this, there was one recent sale of a railcar operating lessor as a going concern where the purchaser from outside the industry did “pay up” for the lessor as a going concern. We believe, however, that in the end, even this transaction may end up being valued as an asset play by the investor.

So what do operating lessors seek to earn on their investments? While there is no uniform target, in our experience those in the industry for a long time target a return of 15% a year. Now some will tell you that this is a return target without the value of the tax savings due to depreciation. Others will suggest that their 15% target includes this value.

By the way, what do the venture capitalists, who (in large part) were bidding on the GE deal, target as their sought after return on investment? 20%.

Now the only way to achieve that target on GE’s portfolio would have been to buy it at a substantial discount. That was not on GE’s agenda.