Carbuilder consolidation might make sense: Cowen and Co.

In the current down market, a “strong case” can be made for consolidation in the freight car building sector, according to Cowen and Company analyst Matt Elkott.

“Builders could revisit mergers as a strategic step to soften the blow of the extended contraction of proprietary backlog projects,” says Elkott in a report titled Consolidation Could Make Sense Now (downloadable at the link below). It’s described as “a deep-dive report addressing potential combinations, their strategic and financial sense, and likely multiples.”

Among the carbuilders referenced in the report are FreightCar America, The Greenbrier Cos., ARI (American Railcar Industries) and National Steel Car.

For FreightCar America, “the transition toward a diversified product portfolio is a sound strategy, but we believe it presents unique challenges in a down cycle,” notes Elkott. “We’ve identified bright spots in the backlog that could, among other things, make the company attractive to an acquirer. Our valuation study suggests upside—just not enough to warrant a more constructive view at this point.”

Cowen has initiated coverage of FreightCar America, described as “a century-old builder in transition,” with a Market Perform rating and a $15 share price target. The company “is a well-established , with a rich history,” says Elkott. “In the near to intermediate term, however, it faces the uneasy task of further solidifying its competitive position in markets outside coal railcars during a downturn. Our proprietary backlog forecast, which is the culmination of an extensive study of demand elements and collaboration with four Cowen research teams, projects a more prolonged but less steep contraction than in the two worst down cycles of the past couple of decades. We are projecting FreightCar America’s share of the industry backlog to decline slightly over the next several quarters, but it could grow again, longer-term. The possibility of FreightCar America attracting acquirer interest is one source of potential upside to our near-term neutral view, which is otherwise based on existing fundamentals and organic prospects.”

ARI, like FreightCar America initiated at a Market Perform level but with a $40 share price target, “may be overexposed to two broad railcar types, including energy-related equipment, but we think further stock price decline is limited for this quality builder,” Elkott says. “Indeed, we believe the industry headwinds are largely reflected in current investor expectations. The leasing business should provide some stability, and valuation appears fair at current levels. ARI’s narrow product offering relative to larger peers limits its ability to benefit from the few emerging favorable demand trends we have identified for the industry in the intermediate term. These include gondolas for shipment of aggregates, and boxcar replacement. While pockets of opportunity exist within the company’s two primary railcar types, they are outweighed, at least in the near term, by challenges posed by weak demand for energy-related equipment. We project that ARI’s share of the industry backlog will decline slightly by the end of this year. We are expecting its top-line headwinds to be somewhat more pronounced than in the case of larger competitors. Our model calls for 28% and 15% revenue declines in 2016 and 2017, respectively.”

“That said, ARI’s higher leasing component, relative to peers, should limit margin compression,” says Elkott. “Indeed, as manufacturing operating income has declined steadily throughout the downturn, leasing operating income has remained much more stable, with the two coming in almost in line with each other in 1Q16. Our assumption for nearly 300 bps operating margin compression is less severe than what we have modeled for some peers, although largely in line with the group average.”

Greenbrier, notes Elkott, would be a good merger partner for FreightCar America or ARI. As well, ARI and FreightCar America would be a good combination. “We view a Greenbrier/FreightCar America merger as the most complementary,” he says. “Our channel checks suggest that FreightCar America’s backlog, while not without risks, contains a material portion of aggregate gondolas, a promising growth area in which Greenbrier does not have a strong competitive advantage.”

“ARI could also take part in a combination,” says Elkott. “We estimate transactions could occur in a 4.5x-6.5x EV/EBITDA multiple range and be immediately accretive. We expect balance sheet cash and new debt to finance deals. The possibility of ARI being party to a transaction is one source of upside to our near-term neutral view, which is otherwise based on existing fundamentals and organic prospects. We would view a Greenbrier/ARI or an ARI/FreightCar America merger as complementary. We believe both combinations would significantly broaden ARI’s product portfolio and boost its market share. ARI’s narrower product mix presents unique challenges for the company during an industry contraction.” “We would view an acquisition of FreightCar America by Greenbrier as one of the more likely transactions due to its complementary nature and immediate accretion,” says Elkott. “Other combinations could include a Greenbrier-National Steel Car deal, an acquisition of FreightCar America by ARI, a private equity transaction involving FreightCar America, or FreightCar America taking itself private. As far as outside interest, we would not rule out that the low valuations, coupled with the long-term intrinsic value inherent in the railcar manufacturing business and its supply-chain importance to the industrial economy, would attract conglomerates or financial investors.”