SFG Takeaways From REF 2023

Written by Bascome Majors, Senior Equity Research Analyst – Industrials, Susquehanna Financial Group

Three days with hundreds of rail equipment industry participants at Rail Equipment Finance 2023 reveal a railcar market that is healthier than we’ve feared into 2023 (lease rate inflation overwhelming the demand-side drag from anemic rail volumes), while the runway for continued investment in diesel locomotives appears to stretch into the 2030s (both rebuilds and new).

Our Susquehanna Financial Group condensed takeaways from several days spent with railcar lessors, builders, other railcar buyers, consultants, and locomotive market participants follows:

Lease Rate Rising Tide Carrying Railcars

We’ve been fearful toward peak earnings and valuation dynamics returning to railcar since late last year (November sector downgrades here), but our cyclical conversations with stakeholders this week were more constructive than we expected. No, weak railroad volumes aren’t helping from the demand side, and if rail carloads remain stagnant into late 2023 and 2024, the railcar industry has a cyclical problem.

But intermodal has been the biggest volume drag and just isn’t a big market for lessors, while inflationary pressures are offsetting shaky railcar utilization for now (utilization improved in February but deteriorated 7 of the past 10 months).

In the 12 years we’ve joined the REF conference at La Quinta, Calif., the number of attendees has been a clear indicator of participants’ cyclical expectations and the depth of the secondary market, and we were frankly surprised to see 20%-30% more people at REF this year vs. last year (our constructive 2022 recap here).

Asset values remain high (steel, component, labor, and constrained new car supply), secondary markets that drive record gains on sale remain deep (no reports of falling bid quantity or quality in recent months), and lease rates are rising materially to compensate car owners for the asset price inflation and higher costs of capital to fund them (recall GATX’s and Trinity’s outlooks for mid-20% lease rate renewals in 2023).

The bad news for Greenbrier and Trinity? Manufacturing margins remain the problem, and while we don’t see a quick fix, our conversations this week suggest the worst is probably behind us.

Fear of Unintended Consequences as Congress Gets More Involved in Rail Safety

Stakeholders were in consensus that Washington and Congress would do something in response to the fallout from Norfolk Southern’s East Palestine derailment (referencing Chatsworth in 2008 leading to PTC, Lac Mégantic in 2013 leading to new tank car and operational standards for flammable liquids), but there was no consensus on what Congress would do.

Some credible contacts expect an ECP brake mandate (which was already attempted in the wake of Lac Mégantic and would benefit Wabtec, yet likely be fought hard by the rail industry). That said, most people we spoke to see a higher probability of faster tank car phaseouts (we view as a modest positive for OEMs) and stricter safety mandates on wayside detectors and hazmat train operations.

The industry seems most concerned about unintended consequences from “one size fits all” operational restrictions that hurt rail network fluidity without truly helping safety; we agree on this point.

Railcar Market: What’s Hot?

Covered hoppers are the largest part of the North American railcar fleet and already require a replacement level of 5,000-6,000 units per year, but strength in plastic pellets and ag products continues to drive replacement-plus demand for hoppers, particularly as North American ag export opportunities increase.

Certain types of out-of-work tank cars (i.e., older, larger-capacity cars that are being phased out of flammable liquids service) are being scrapped more than they’re retrofitted for continued service, though we could see modest new car and retrofit tailwinds from regulatory changes in response to the East Palestine derailment (we estimate ~16,000 cars in flammable service whose retirement deadline could move from 2029 to 2025).

Elevated steel prices continue to provide incentives for scrapping of older cars but are also beneficial for U.S. export steel business, suggesting strength in mill and coil gondolas that support steel supply chains (both inbound scrap for EAFs and outbound product for all steel plants).

Railcar Market: What’s Not So Hot?

Despite coal’s recent resurgence driving high utilization rates and rising lease pricing for long-dormant open hoppers and coal gondolas, there’s no new car investment given coal’s longer-term trajectory to ~10% of U.S. electricity generation (i.e., great for lessors, less helpful for builders like FreightCar America).

Intermodal’s relatively young fleet and recently muted volume aren’t helping the investment incentive for key customers (railroads and railroad-owned TTX), with potentially rising asset turns only further muting new equipment needs in 2023. However, intermodal still has longer-term growth potential if volumes help take freight share off the highways and help railroad customers meet their emissions targets (scope three).

Diesel Locomotive Investment Still Hitting the Gas

Our conversations with several credible experts suggest the race for next-generation “cleaner” freight locomotive propulsion could not be more open in early 2023, with no clear leader between emerging technologies in hydrogen, battery/hybrid power, or biofuels (including renewable diesel). Each of these potential next-generation “greener” solutions still faces significant technical challenges that make broader adoption unlikely before at least the 2030s, and the railroads demand a clear return on locomotives, which are by far their largest equipment investment.

Against that backdrop, we (SFG) believe the incrementally fuel-efficient (and capital-efficient) solution of rebuilding ~20-year-old diesel-powered locomotives to add another 15-20 years of useful life has a long runway ahead. Wabtec currently has a lock on this rebuild market in North America, and their multi-year backlogs of work were well supported by our conversations this week.

Tags: , ,