Takeaways from REF 2020: Cowen

Cowen and Co. analyst Matt Elkott participated in the 2020 Rail Equipment Finance Conference (REF) in La Quinta, Calif., the largest annual gathering dedicated to North American freight railcars and locomotives. He offers the following observations:

Overall, “demand remains soft but not meaningfully below levels described during earnings season,” Elkott says. “While it was the common topic in discussions, the Coronavirus has not yet had a quantifiable impact on railcar suppliers. The secondary market remains active, and valuations have only shown small signs of easing.

“Based on discussions we had with industry contacts, rail suppliers have not yet seen impacts on their businesses that are traceable to the Coronavirus. Specifically, no customer cancellations or deferments appear to have occurred yet as a result of the outbreak.

“There appears to be consensus that freight demand will come under further pressure in the next several weeks as a result of Coronavirus disruptions of global supply chains and negative impact on consumer spending. However, if springtime virus containment hopes materialize, a somewhat abrupt rebound could occur, driven by replenishment of depleted inventories.

“Railcar inquiries remain fairly solid, but translation into orders continues to be low. Industry orders came in at 9,500 and 8,400 units in 3Q19 and 4Q19, respectively. This is below replacement demand of 10,000-12,000 units quarterly. We are modeling for 36,000 units in orders this year, down from 39,400 units in 2019. We are projecting orders of 51,500 units in 2021. We expect a recovery in deliveries to 50,500 units in 2021, from our projected 44,400 units this year. This would represent a 1.02 book-to-bill ratio, above our expected 0.81 estimate this year and the first time the ratio would be above 1.0 since 2018, when it registered at 1.53. We believe our 2021 estimate for orders may be higher than some expectations, despite being 14% below the 2005-18 average of 59,800 units.

“These aforementioned estimates do not assume continued escalation in the Coronavirus outbreak beyond the spring. Additionally, they assume moderating rail traffic declines in the remainder of 1H20 and modest growth in 2H20 culminating in largely flat volumes for the year. If these dynamics play out in a much more unfavorable way relative to our assumptions, we see the downside risk to our estimate for 2020 industry orders manifesting in a realistic worst-case scenario of 23,000 units, in line with 2016, the worst year for railcar demand as measured by orders and (likely) lease rates since the Great Recession.

“Secondary market activity may have eased slightly but remains fairly robust. Valuations remain somewhat elevated, supported in part by financial investors looking for yield. Interest rate cuts could further drive capital into railcar assets. The dichotomy between weak underlying demand for railcars and secondary market valuations is nothing new. It is best illustrated by a look at 2016, when demand was depressed but a robust secondary market enabled some lessors, like GATX, to offset demand weakness with higher remarketing income. This is a dynamic that can prove advantageous again for GATX and Trinity. On the flip side, it may limit their opportunities to acquire assets.

“With Wells Fargo (which owns the largest railcar lease fleet in North America at ~180,000 units) under a fairly new CEO, its railcar fleet, long thought to be for sale, could go on the market again. Trinity and GATX may be interested in big parts of the fleet at the right valuations. That said, we would not be surprised if they are outbid by banks looking to deploy capital into yield generating assets with tax advantages amid a low interest rate environment in North America and other regions around the world. We would not rule out other transactions within the North American railcar leasing sector.

“The boxcar fleet needs to be homogenized: This appears to be a widely held view across industry stakeholders. Where they differ is the number of types the fleet should be reduced to, a number that ranges between one and a handful of types. Such an undertaking would require collaboration by many industry participants and a willingness by some shippers to modify their infrastructures.”