Financial Edge: REF 2017 roundup

Written by David Nahass, Financial Editor
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Following in the spirit of its predecessors, the 31st annual Rail Equipment Finance Conference was a huge success and an incredible opportunity to get a complete understanding of today’s rail equipment market and where the market may be headed into 2017. Here is a summary of what happened at REF 2017 and what the experts had to say about equipment and the U.S. and global rail economy.

The conference opened with a summary of the state of global and domestic economy by Sergio Rebello, Ph.D. from the Kellogg School of Management. Rebello touched on the oil market and capital investment patterns and discussed how The Federal Reserve’s confidence in the economy’s ability to function in a strong and healthy manner drives the decision to leave interest rates at historically low levels for such a long time. Rebello also discussed the unemployment rate and how the U.S. economy has continued to lose certain repetitive (think factory and manufacturing) jobs, even as the economy has climbed out of the last few recessions. Net/net? Rebello does not see a domestic manufacturing boom any time soon and expects interest rates to rise while the Federal Reserve tries to manage to encourage growth will maintaining stability.

In discussing the national railcar fleet, David Humphrey, PhD of Railinc, discussed that new car production has decreased and that scrapping of older units has been slow due to the depressed scrap markets. The national railcar fleet increased by 1.5% YOY, the largest increases coming in potentially depressed markets for covered hoppers and tank railcars. The age of the national fleet decreased slightly and certain car type (mill gons, boxcars and grain hoppers) have fleets still in need of refurbishment.

Philip Baggaley, from Standard and Poor’s, discussed the economy and the potential headwinds for growth such as rising interest rates and an unstable manufacturing environment. He also touched on the potential fiscal changes in the economy as a result of the new administration including changes in the corporate tax rate and the potential for trade related issues and their potential impact on the economy.

Robert Pickel from National Steel Car talked about the environment for new manufacturing. He reflected cautious optimism about the pace of new orders. Pickel suggested that the range of new car builds for 2017 will be near or just above 40,000 cars, while he acknowledged that many people in the market are suggesting orders closer to 30,000.

Chad Soares from PriceWaterhouse Coopers discussed changes in lease accounting headed to firms in the U.S. These changes will eliminate accounting rules around operating leases that have been in place for decades. These are changes eliminating off balance sheet treatment of leases in compliance with FASB rule 13. Soares also discussed changes in sale/leaseback transactions. Get ready for these changes beginning December 15, 2018.

Nicole Leonard from S&P Global Platts discussed a weakening CBR picture as pipelines come on line. Where’s the opportunity? Stranded markets in the costal areas not receiving pipeline access remain as the best potential for growth in the CBR market. Also, NGL transportation demand is projected to increase.

Dave Murawski from Union Tank Car discussed the drop off in new tank car orders and production as well as in the commodities served by those types of cars. Forecasting a return to normalcy, UTC sees production in the more nominal and historical range in the low to mid teens for the coming three years. UTC also sees a change in the natural gas transportation market and an increase in exports. UTC also sees an increase in retrofits for tank railcars in need of modification in the coming years to insure regulatory compliance.

Tom Simpson of the Railway Supply Institute and Don Croteau of Vertex Rail discussed the difficult picture for railcar manufacturers and concerns about trade policy’s impact on railcar building. Is the North American railcar and component manufacturing community concerned about trade policy and its implications? Yes they are. However, like so many constituents, they are in a wait and see mode. Simpson also discussed the retrofit market identifying that there have been to date about 3500 tank railcars retrofit to comply with the 117R design. Surprisingly for the audience, 35% of those cars have been DOT 111 legacy cars.

Trey Savage of the David J. Joseph Company and Brenda Wheeler from CSX Transportation, discussed a still weak but improving scrap and finished steel market. Savage discussed that the scrap steel market is not back to pre-recession levels due to low demand and expressed caution as China’s role as the primary steel producer globally continues to increase, potentially changing China from a net importer to a net exporter of scrap steel. Steel needs infrastructure and added industrial production for growth. Wheeler sees the market improving especially if trade cases slow the dumping of foreign steel but also sees a need for construction to rebound to keep demand increasing. Concerns? An auto market that has been on fire for a couple of years is on everyone’s list of worries.

Rod Case from Oliver Wyman sees the future in an 18 wheel long haul truck that has no driver behind the wheel. Case set forth the idea that the driverless truck future is now and that the rail industry must adapt to a changing environment or risk getting left behind. What’s on the immediate horizon? Driver platooning of multiple trucks to be followed by driverless line haul in the near future. Case stated that the railroads must evolve to be more competitive or risk losing key shares of the intermodal business.

Ron Sucik of RSE Consulting discussed the need for the railroads to more aggressively pursue the share of the intermodal business they do not currently have. Mr Sucik believes that the Class I railroads should pursue and move to attract 6MM additional loads away from over the road service. Certain markets, such as the intermediate and shorter haul and surprisingly, the long haul market, have ample untapped capacity for rail to pursue. Sucik echoed concerns of Case as well.

Anthony Hatch of ABH Consulting discussed how Class I Railroad Capex will need to change to address the changing rail economy, without coal, under intermodal stress, and with a need to innovate to increase business levels. The market for freight rail is worried about trade, NAFTA and government regulation or reregulation, Amazon’s expansion (and its use of trucks) and maybe even 3D printing. This may be overcome by intermodal opportunities and optimism for plastics and infrastructure plays like aggregates.

Bruce Ridely from Packaging Corporation of America and Chris Maffett from CSX Transportation let the REF audience know that the 50’ boxcar is alive and well and not going anywhere. Both panelists affirmed the need and desire for an ongoing and healthy boxcar feet to move paper and other rail borne goods. Maffet expressed concern over long term decreasing trends in boxcar loadings. While Ridley confirmed that the 50-foot boxcar is the boxcar of the future due to capacity and curvature restrictions.

After boxcars, the conference turned back to finance as Joe Devoe from DVB Bank discussed the changing interest rate and bank regulatory environment. Devoe also discussed the state of the asset backed lending market and some alternative structures that became available to borrowers in 2016.

In Class I Equipment Update, Patrick “Paddy” O’Neill from Norfolk Southern gave a broad based update on the Class I perspective on most major equipment markets (grain, steel, auto racks and others). In taking a non-scientific pulse of the market, O’Neill found that most car types seem either adequately supplied or slightly over or strongly supplied. This is not a surprise considering the recent pace of equipment orders and the current state of system velocity. The only area where car supply was deemed less than adequate? That’s right you guessed it: Wood chip cars (we know you didn’t guess!). This was a surprise for all in attendance and a great new addition to the REF program.

In Railcar Valuation, Leasing and Lease Rates, Edward Biggs, Robert Blankemeyer, Chuck Brown , Pat Mazzanti and Dave Murawski gave us their points of view on the used equipment market overall. One high level takeaway is the divergent values between cars that are off lease and cars that are on lease. No surprise, but in the current weak market, the difference is quite significant. The panel was focused on retirement of older assets and projected increased retirement when scrap rises to $300 a ton and beyond. Again reflecting market weakness, rental rate premiums on newer, larger capacity, regulatory compliant cars remain existent but the difference in price from older, non-compliant cars has narrowed in some cases. All parties agreed values need to come down before they begin to go up again.

Day two began with a discussion on coal by Ted Baun from FreightCar America. Undergoing a short-term uptick, coal was a hot topic as coal tons being moved have increased in the last six months. While not a trend in the making, Baun felt that coal had “bottomed out” in 2016 and was headed to a better level of stability in 2017. A thesis supported by the trends in coal loadings. Not as happy as many investors would like, but an improvement from the doom and gloom recently seen in this market.

Sebastian de Meel from PriceWaterhouse Coopers discussed the cutting edge topic of block chain and how it might impact the rail economy. Block Chain, a security protocol developed as a part of Bitcoin technology, allows for more diverse and secure transactions using a common ledger for confirming the security of a transaction. By decentralizing the security process every part of a supply chain becomes part of the security of the supply chain. Get ready, block chain will be headed your way fast.

The REF Tuesday Keynote was Ken Fischel, Vice Chairman of the Marmon group. Fischl has 40 companies that report to him inside The Marmon Group, and having come up though the ranks at Union Tank Car, Fischl was in a unique position to discuss the rail economy and the industrial economy. Key takeaways from Fischl’s presentation were about the aging U.S. workforce and its impact on the perceived need for a manufacturing economy and the challenges that might pose. Mr Fischl also noted that the current recovery, driven primarily by personal spending, needs more manufacturing investment. Fischl discussed a common theme at REF, what will take the place of coal and crude loadings that have disappeared. He focused on chemicals and plastics as partial replacements (with higher margins) for some of those lost loadings. Fischl was also the recipient of the 2017 Norman W. Seip award for in Industry Excellence.

Eric Starks of FTR Associates and Kristine Kubacki, a Research Analyst, covered Marketplace Trends and Topics. Starks looked at the potential risks of policies being discussed and potentially proposed by the Trump administration. First noting that manufacturing is improving slightly as inventories (in business and housing) are decreasing from high levels, Starks discussed that rail freight with Mexico in terms of tons and loads favors export. Furthermore, loads into Mexico are going as carload freight and returning as empties. What was surprising was that the rail business with Mexico represented a small fraction of the total North American rail business. Starks maintained a positive bias about the overall economy and a moderate to negative bias about the rail economy. Kubacki, was less optimistic about the overall economy and the rail economy noting that globally there is excess manufacturing capacity and an inventory of used industrial equipment. Kubacki does not see capex moving to levels necessary to encourage what she feels is optimism for growth in 2017. While industrial cycles are at multi year lows without showing signs of recovery, asset valuations continue to creep up. This is a warning sign for the anticipated growth. Kubacki asked what would be the next big rail commodity cycle to lift overall loadings.

Michael Weiss of Greenbriar Equity Group discussed new rail safety trends coming out of Europe from Frauscher Tracking Systems. Using fiber optic technology the Frauscher system performs and centralizes many rail safety tasks and equipment health systems in use today. Weiss also discussed the state of the M&A market with a focus on rail. Adding to Kubacki’s point, Weiss noted that purchase price multiples today for M&A deals are as high as they have ever been while M&A volumes are at high annualized levels (but off a 2015 peak). Weiss noted that opportunities exist but the easy deals are all pretty much gone and deals may be more difficult in the future.

Graham Brisben of PLG Consulting discussed Downstream Impacts of the U.S. Energy Revolution. Brisben sees shale gas opportunities as a partial replacement for the loss of loads of crude by rail (and coal) and feels that these loads are sustainable long term. Brisben sees sand levels stable and increasing as sand volumes in frac wells continue to increase; he sees increasing plastics production as low feedstock costs encourage growth; and he sees an increase in NGL production in east coast shale drilling. Brisben also sees an increase in the fertilizer business with domestic fertilizer production to grow steadily over the next few years.

On the topic of covered hoppers, Todd Kahn provided data suggesting that the covered hopper fleets are both overbuilt but right sized if certain market dynamics (cycle times and system velocity) and demand fundamental move unfavorably for rail service. As more sand goes into frac wells, Kahn noted, the small cube hopper fleet could go from oversized to undersized in a short time frame. Similarly, for grain hoppers, Kahn noted that while the fleet is in need of refurbishment, low returns, improved asset utilization and refusal by car owners to scrap cars is stalling investment. On plastics hoppers, Kahn sees over production of new railcars and lease rate denigration as a result.

Tuesday’s cleanup hitter, Thomas Ellman of GATX, laid out a three pronged potential “next step” in the railcar market: a long term, moderate term and short term recovery period for railcar utilization and lease rates. Ellman highlighted that the near term future is unknown but faces basic and fundamental hurdles such as low scrap prices, over-speculation in the building of new railcars, investor failures such as creating too much exposure to individual markets and not managing term expirations. While hopeful for the short term recovery period, Ellman was less sanguine, expecting more moderate to long term depending on economic growth and railcar loadings.

On Wednesday, attention turned to locomotives. Leading off again was David Humphrey, Ph.D from Railinc. Humphrey reported a modest increase in total fleet size, an increase in the average age of the national locomotive fleet and an increase in the split between DC and AC power (more AC than last year). As has been consistent, most new builds added have been six-axle high horsepower units.

Jacob Brown from Cummins Inc. described the company’s Tier 4 EPA compliant engines and their deployment in the industry today. Cummins right now has five Tier 4 certified engines operating in switcher, passenger, maintenance and long-haul/high-horsepower capacities. The Tier 4 engines emissions are low and show minimal impact on fuel consumption loss.

Tom Chenworth from NRE gave an update on EPA emissions standards and clued the audience in on how commonly misapplied terms like remanufactured, refurbished, upgraded and repowered (in addition to other terms d’art in the world of locomotives) impacted what EPA standard was applied to which unit. Chenworth also covered how EPA requirements must be met based on part value and whether parts are used or new. Great clarity into an often-fuzzy issue was provided.

Drew Schoessel of Wells Fargo Rail discussed the lease market for locomotives and locomotive values. While off the peak storage numbers of 2016, the number of locomotives stored serviceable remains just under 4,000. In describing lease rates, Schoessel used a technical term, saying that they were in the “toilet.” Surprisingly, locomotive valuations, in Schoessel’s opinion, have remained more robust perhaps indicating some future optimism or decreases in velocity that will drive more units back onto the rails.

Graciela Trillanes from GE Transportation discussed GE’s Tier 4 locomotive and GE’s initiatives in alternative fuel use in locomotive power. GE supports an LNG system of alternative fuel and is bringing together five components of operation, a new design tender, changes in infrastructure, regulatory compliance and a new locomotive for the alternative fuel product. New production of this unit is expected by January 2018. Trillanes also discussed the implementation of the GE Tier 4 unit in the marketplace. GE’s Tier 4 unit has delivered 800 units to date and reduces common emissions by more than 70%. Trillanes also discussed GE’s efforts to improve locomotive health maintenance through technology and communication.

Stuart Biggs of Biggs Appraisal told the REF audience about the state of locomotive orders. Biggs noted that there were 728 new locomotives ordered in 2016. As for 2017 orders, Biggs said that new orders for 2017 were expected to be weak and did not see anything on the horizon that would suggest a near-term pickup in new locomotive demand.

Gary Eelman of Progress Rail Services (owner of EMD) discussed Progress Rail’s current Tier 4 compliant locomotives offerings. He discussed the Progress Rail freight, passenger and a four axel 2000 hp switcher locomotive. Eelman also presented how Progress Rail is getting more involved in alternative fuel locomotive technology including with a dual fuel locomotive that had been operating since 2013. For the first time, Progress Rail is putting a Caterpillar engine into some of its locomotives. Eelman also discussed repowering locomotives with Tier 4 technology that fits into the existing engine cabinet.

Pedro Santos of CNGmotive Inc. discussed his company’s progress in bringing compressed natural gas (CNG) to market as a viable alternative to both diesel powered locomotives and as an alternative to the use of LNG. CNG presents a lower price point for being cost effective, less regulation, faster start up, and faster filling for the end user of the fuel. CNGmotive is moving to development of its first tender to hold CNG for locomotive fueling. The tender will have a capacity of the equivalent of 5,000 diesel gallons of fuel and will be built by Kasgro Rail Corp. in New Castle, Pa. Santos also discussed CNGmotive’s high-pressure direct injection solution to insure continuous CNG supply to a locomotive. He also noted that cost efficiency will help rail to compete with autonomous trucks.

Jason Kuehn of Oliver Wyman, took on the topic of why the rail industry has not made more aggressive efforts to embrace alternative fuel locomotives. Citing competitiveness, cost effectiveness and efficiency, Kuehn noted that, in his opinion, failure to more progressively forward on this issue holds back rail’s ability to be competitive with trucks and the inevitable incorporation of autonomous trucking. Kuehn also advocated a stronger platform for the railroads to push for more autonomous rail trains, while admitting that government regulation continues to oppose these initiatives. From Kuehn’s perspective, all parts of the railroad transportation supply chain (railroad, government, suppliers, testing agencies) must work together to bring these ideas forward to insure implementation.

In the final panel of REF 2017, locomotive valuation and leasing, Steven Beal of NRE, Pat Mazzanti of Railroad Appraisal Associates and Greg Schmid of Residco, covered locomotive values and the market. As Schoessel noted before them, used locomotive values have drifted downward. Surprisingly, even in the weak market, they have drifted down less than would be expected. Rental rates are at low points and even thought here has been a recent pick up in demand, lease term and lease rate continue to be less than desirable. Investors in this market are likely to stay put and engage in bargain hunting when more desirable units become available at reasonable prices.

A plethora of information and knowledge was provided to the conference attendees. This article barely scratches the surface. We are already looking forward to REF 2018.

Got questions? Set them free at [email protected].

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