RAILWAY AGE OCTOBER 2021 EDITION: Welcome to the 2022 Railroad Financial Desk Book. The rail market has had a hot summer—Donna Summer “Hot Stuff” hot. However, this year’s Desk Book is not another article praising or burying the phenomenal summertime drama of CP-KCS-CN, so curb your feelings of malaise.
Some industry watchers have been bent on following the corporate chess match to see whether CN or CP would pay KCS shareholders buckets of cash and stock. Others have been glued to the webpage tracking STB Chairman Oberman like Santa on Christmas Eve as he jets around the country from rail conference to rail conference, aggressively speaking out on railroad service issues and business practices. But the real drama of the summer is in the rail equipment industry, where more than $2 billion in equipment has received investment commitments and has or will change hands before the end of 2022.
What are the deals? Some are public knowledge, and some are the kind of industry rumor/statements of fact that never make it into print. Here’s a quick rundown:
The Andersons, Inc. on Aug. 16 announced the sale of its railcar lease fleet to AITX, an affiliate of ITE Management L.P. The sale price was approximately $550 million for approximately 24,000 railcars.
Other fleet sales and secondary market opportunities brought to market and awarded represent an additional 12,000-plus railcars being offered for sale in the second quarter of 2021. These are all private sales conducted on a confidential basis, with no publicly available information. Certainly, there are more to follow.
That’s a large number of assets—more than 46,000 railcars or the size of a larger than average operating lease company—switching owners in a short time frame. But a paltry number—3%—vs. the total number of railcars in North America: 1.65 million. Nonetheless, it’s a bit of a conundrum, even for veteran industry watchers. What seems to be happening is that certain veteran companies such as The Andersons and other unspecified companies are exiting the market while newer money (AITX/ITE, Wafra and others) is moving into that same market. Complexifying, isn’t it?
In many industries, 3% might generally not be newsworthy. However, when you consider that rail assets are long-lived assets and that investors in those assets tend to own them for the long term, a significant change in the landscape raises a few eyebrows. It gets even more interesting when a company with a successful history in railcar leasing of more than 30 years decides to exit the business.
Take it to the next level. If you believe the regulatory rhetoric, the future of the volume of railcar loadings seems to be at stake, based on the behavior of railroads. The STB, casting fire and brimstone, has chastised the railroads on several fronts, most notably committing more capital to shareholders over investment in infrastructure and using the bully pulpit to advocate for on-time service. (Is that even a thing in North American rail?) Across Railway Age, on industry blogs and from a wide-ranging percentage of car owners and operators, questions regarding railroad loadings’ growth continue.
In the midst of some industry chaos—declines or at least stagnation in railcar loadings (remember that 2021 loadings are still below 2019 pre-pandemic levels, even including a robust improvement in intermodal); an STB Chairman who is committed to extracting regulatory concessions from railroads; spikes in the prices of raw materials (steel and aluminum); and a COVID-19 pandemic that continues to place its viral fingerprint on the U.S. and global economy—investors are making considerable investments in railcar assets.
So what’s the deal? Should you be (in the words of the late, great Lawrence Beal) buying or selling?
In his virtual presentation for Rail Equipment Finance 2021, Dr. Sergio Rebelo, MUFG Bank Distinguished Professor of International Finance at Northwestern University, noted to the audience that investment returns for equity investors were declining from 6% pre-pandemic and 8% post-financial crisis to less than 4%.
On an historical basis, unleveraged (equity only) returns for rail investment were something more along the lines of 8%, and asset owners, especially operating lessors, generated extra value, the “upside,” through well-timed sales and by exploiting rental market inconsistencies to increase lease rates. This has made railcar leasing the attractive business that has kept companies like GATX, The Andersons and Trinity in high clover for decades. These companies, and more like them, have recognized the key component of railcars that makes investment successful and lucrative: the longevity of the assets (railcars) and the capability of earning lease revenue over their entire 50-year regulatory life cycle, if they have been well maintained.
However, today’s lengthy period of low interest rates has provided the investment community with a sprinkling of jet fuel. New investors can use cheap, third-party capital to compress those equity returns from the historically relevant 8% to Dr. Rebelo’s sub-4%. Low interest rates allow today’s asset purchasers to buy these assets; borrow against them; and then increase their total return to 8%, 10% or even higher.
If you are a railcar owner in today’s market, you can scrape and scrap for returns on your invested capital and potential upside over a period of 30-50 years. It works, and for savvy investors and operators, that strategy will continue to work. As an alternative, you can sell to someone with lower return thresholds, pocket the cash, pay down debt, buy back shares (sorry, not sorry Chairman Oberman), invest in a new business strategy or opportunities of your choosing, or in some cases start all over again and build up the process a second or third time. This is what Carl Icahn did four times over 30-plus years (see “Carl Icahn Knows Rail Investing”) to great success. In fact, today’s equity returns are so low that Icahn might be kicking himself for selling in 2018 far too early and for way too low of a price.
So once again, should you be buying, or should you be selling? Well, unfortunately, that returns to the fundamental aspects of the market for railcars and investor confidence in the long-term prospects for the rail industry. For example, if you feel that the following trends are going to continue for a few more years as North American rail stagnates, well, now might be the time to look at taking some chips off the table:
- Treating railcars as a commodity.
- Minimizing the value of customer service.
- Continued downward pressure on lease rates (which has, let’s be honest, been the trend in general freight cars for the past few years).
- Focusing on new freight moves that are accretive to a railroad’s EBITDA while maintaining operating ratio.
Contrarily, if you think that, less than one year into President Biden’s Administration, the government agenda includes:
- A firmer hand on the regulatory steering wheel encouraging freight price reductions.
- A focus on expanding the common carrier obligation.
- Opposing much of what underscores the “do more with less” strategy of PSR.
- A push to move more freight by rail as a strategy for curbing trucking emissions.
- The possibility of enacting more stringent emissions requirements for locomotives.
A bet on the rising demand for railcars of all types might be very prescient at this time.
North American rail and its status as the backbone of America’s transportation infrastructure is unassailable. Investors are witnesses and occasionally unwilling participants in the implementation, actualization and application of that infrastructure. Pure money plays for rail assets generally don’t match up with the culture. But perhaps low rates for equity and debt will buck that trend. Until then, buyers and sellers, as you meet each other at your respective entrances and exits, wish each other luck and enjoy the show. Any questions?
AROUND THE MARKET
Lease rates have been on the rise due to spikes in demand for certain types of railcars, in spite of languishing railcar loadings, and due to the staggeringly high price of raw materials putting a damper on new car builds in 2022. See August’s “Financial Edge” for some extended discussion on this topic. In fact, for the first time in recent memory, some car types are close to full utilization.
It’s no secret that lease rates on used railcars track the price of leasing or owning new ones. However, with new railcar prices having risen so dramatically, new car purchase and lease costs can be substantially higher. Additionally, because 2021 new railcar production rates have been roughly 2,000 cars per month, new cars are not necessarily being built for the lease market right now. Therefore, this episode of Around the Market will focus on used assets over new builds.
Grain Covered Hoppers: Grain loadings are up 11.5% YOY to date. This growth along with the scrapping of some older 4,750cf cars and some railroad service problems has led to increasing demand for grain cars of all types. The remaining 4,750cf fleet (or maybe, the remaining fleet not currently in deep storage) is almost at full utilization, with lease rates in the high $200s or low $300s full-service, if you can find them. 5,200cf cars are in the high $300s, and 5,400cf cars are north of $400 per car per month. Cars in an existing lease may be renewed at the lower ends of those ranges. There seems to be some stability here in the short term.
Plastics Covered Hoppers: Rates on existing cars (6,200cf) are still sub-$500 (net) but there seems to be some tightening of supply in the market. This market has not yet reached parity. Additionally, the price of a new car right now is likely to scare off purchasers looking to purchase railcars to lease and may also scare the OEMs into better pricing. Natural gas price increases have an impact on the pricing of plastics, so if natural gas stays above or near $5.00 MMBTU (it’s $4.80 today), there could be some impact on demand. 5,800cf cars are still a mixed opportunity, and the rates there are still around the $300 level.
Sand and Cement Covered Hoppers: Small-cube hoppers continue to be returned to lessors in large numbers. However, there has been some intermittent demand leading to occasional lease prices in the mid-$100s (that’s up from double-digit numbers). It doesn’t seem like there is long-term strength at this level. Lessors are happy to get what they can for these cars, but loadings for sand and gravel are down YOY. Don’t place great hope on the infrastructure bill and cement demand to lift this market. Incremental demand will not be enough to be the straw that stirs the drink, and there are still 130,000-plus covered hopper cars in storage. It’s safe to assume the majority of them are small-cube. Cars in cement service may command a premium over cars in a sand move, but that delta is shrinking as lessors look for opportunities to consume their off-lease assets.
Coal: Here are some words that many thought would never be said together again: Coal cars are having a moment. An eclectic mix of factors, railroad service problems, a highly segmented but generally very hot summer, some organized scrapping of some older (and some newer) coal cars, and the higher price of natural gas has led to an increase in coal loadings of about 12% YOY. That is not up to 2019’s levels, so please do not run around shouting, “Coal is back!” A 12% increase annualized is roughly 300,000 carloads, so no one seems to be complaining. Gondola cars and rapid discharge hopper cars are both participating in the rally. For investors, the long-term future of coal is not being revised, so term length seems to be the challenge. Deciding which poison to take—higher rates for a shorter term or the opposite, lower rates for a longer term—is never fun. Lease rates are all over the place, impacted by age, term, and whether the lease is net or full. Full-service rates are rumored to be as high as the low-$300s on gondolas and hoppers. Net leases are still low, with prices in the mid- to low-$100s. Again, the spread on renewal vs. new opportunity here can be significant. While higher rates might be available with a new customer right now if the music stops, losing the seat as the incumbent could mean storage in your future.
Tank Cars: The mix of oversupply, interpretation of regulatory changes with some confusion, and embargoing and storage of cars that were moving into and out of Mexico in refined fuel moves has continued to stress this market segment. DOT-117R (retrofit) cars are leasing for high-$500s (full service), while DOT-117Js (new) are leasing for high-$700s, depending on the timing of delivery. There is some fluctuation based on size, 29,000-gallon vs. 25,000-gallon, but it is not a huge (HUUUGE) deviation. Pressure cars for LPG are in the low-$600s (full service), but rates are expected to increase as inventories of available cars decline. This isn’t the first time inventory of pressure cars has been forecast to dry up, but bets that pressure tank cars will continue to be available at lower prices favor the house (car owner) at this junction, so expect rates to increase.
Boxcars: In what felt like an instant, the available inventory of 60-foot boxcars got snapped up a month or two ago. New boxcar orders are being placed, and this market is pretty hot right now. Why? Intermodal congestion stresses the boxcar supply pool, but more likely, it’s supply chain contagion in general, and boxcars are not moving with greatest of fluidity. Rental rates for 50-foot Plate F boxes (non per diem) are in the mid-$500s (full service) and 60-foot Plate F boxcars are in the low-$600s. Can rates go up from here? Certainly, they can, but any additional increases will be modest, as car availability seems to be the issue at hand.
Mill Gons: These are like grain hoppers right now, with inventories low and rising rates. With steel prices climbing high, new builds probably don’t make much sense right now, so expect tightness to continue. Lease rates on 52-foot gons are in the high-$400s (full service), and 66-foot gon rates are in the high-$500s. Expect rates to rise from here. Will they rise enough to encourage new builds? That’s a big move from current levels.