Follow-up Thoughts to “Amid Rising Demand, Who’s ‘Steeling’ the Show”

Written by Matt Elkott, Transportation OEM Analyst, TD Cowen
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Matt Elkott

Here are a few follow-up thoughts to our May 7 report, Car Conundrum: Amid Rising Demand, Who’s “Steeling” the Show. We believe a cyclical inflection point and a number of macro factors could elevate interest in leased railcar assets by financial investors.

Financial investors (including banks, private equity, and other financial institutions) have long been attracted to leased railcar assets due to tax and yield advantages as well as diversified exposure to the industrial economy. A current confluence of sector and macro factors could pique the interest of such investors: 

1. Rising railcar lease rates, driven by recovering freight demand and a decreasing railcar population. 
2. Low interest rates in several world regions. 
3. Anticipation of an infrastructure bill. 
4. Jittery sentiment about some other asset classes and financial securities.

SNCF, France’s national state owned railway company, reached an agreement in April to sell its freight railcar fleet to asset managers CDPQ and DWS Group.

The largest North American railcar fleet is Wells Fargo (~180K units, utilization likely in the 80s). The bank has insinuated in recent comments that it no longer views its fleet, long thought to be for sale, as a core asset. If it is sold to another financial institution, the transaction would bring more attention to lessors like GATX and TRN and potentially boost their valuation further.

Another possible outcome would be for GATX and TRN (TrinityRail) to each buy a portion of the Wells Fargo fleet. For this to happen, the bank would likely need to be willing to take a loss, selling at a valuation well below book value. As top-five operating lessors, GATX and TRN would be well-positioned to embark on such transactions, scrap/divest parts of the fleet, and manage the retained assets to much higher utilization and returns. Their ability to manage fleets much more effectively than financial institutions can stem from their wide, diverse network of customers, something that creates ample opportunities to allocate the same railcar type to multiple end markets, based on demand trends. 

GATX had a fleet utilization of 97.8% at the end of 1Q21 (we project it to reach 98.5% by year-end), and TRN’s fleet utilization was 94.5% (we project it to reach 96.4% by year-end). These are both well above Wells Fargo’s railcar fleet utilization, which, again, we estimate to be in the 80s.

Additional industry channel checks were not inconsistent with our view that lease rate increases could accelerate in the coming quarters. We estimate that lease rates have risen by low- to mid-single-digits sequentially in each of the past three quarters.

Inquiries for newly manufactured railcars continue to increase, but translation into orders remains hindered by the steel premium. That said, CN on May 7 did announce an order for 1,000 grain cars with TRN. While many railcar buyers (made up of lessors, shippers and railroads) are likely to continue to attempt delaying big manufacturing orders in the near term to avoid commodity-driven price premiums, the industry’s cars-in-storage population, down ~30% since mid-summer 2020, is no longer sufficient to fully support rising demand. As such, we believe more buyers will have to begin pulling the trigger on larger orders. We are modeling for gradual increases in the balance of the year and into 2022. Some investors are trying to gauge the price increase magnitude that builders need to impose in order to offset steel price increases. We estimate this to be at least 15%, and potentially as high as 25%

Chris Rooney, analyst at Vanness Company, offers this context concerning the steel business:

Chris Rooney

“There are two types of steel producers now: integrated mills that have the ability to melt iron ore and benefacted taconite pellets or briquetted iron pellets, and Electric Arc Furnace (EAF) operators who can melt briquetted iron and primarily scrap steel. 

“There are only four integrated producers in North America: Cleveland Cliffs and US Steel in the U.S., and Stelco and Algoma in Canada. Together, these integrated mills have a melting capacity of about 25-30 million tons per year. All of the integrated producers have supplies of iron ore. The rest of the roughly 120 million tons of the U.S. and Canadian market is served by EAF furnaces melting overwhelmingly steel scrap and some briquetted iron pellets. 

“For a long while, the trend was toward EAF production because of favorable pollution results, the fact that production could be highly tailored to serve close by markets, and because of generally favorable scrap pricing for a long period of time. 

“But, alas, that happy environment for EAF production is changing due to macro trends such as lighter automobiles (hence less scrap weight), and now—very important—because of changing Chinese regulations. China has been the major producer of raw steel from iron and coke in integrated mills—almost all of these State Owned Enterprises, many of which had become antiquated and major polluters. For a time, it appeared that the regime prior to President Xi Jinping was closing the oldest mills to reduce pollution. Jinping reversed this because it had created unrest among the core of the Chinese Communist Party, who traditionally work at SOEs. To maintain production as domestic consumption leveled off, steel was dumped abroad. But now, secure in place, the Jinping regime is beginning to push its modern agenda toward cleaner air and modern EAF mills. This means more scrap purchases and demand pressure on world markets.

“Our few integrated producers will be advantaged and so far have maintained strict pricing discipline to maximize profits and pay down debts. The EAF mills—frequently the price makers—are making more than adequate returns at today’s prices. Normally, they would be price disruptive, but as scrap prices rise, they will not be incentivized to reduce prices and instead will probably want to raise them further.”

“For these reasons, I see no major retrenchment of high steel prices for the immediately foreseeable future absent a significant economic downturn.