Rail Equipment Conference Call Takeaways: Cowen

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

Photo courtesy TrinityRail

On May 31, we held a discussion with five expert panelists who provided insights into the current state and outlook of the rail, locomotive and railcar leasing and manufacturing markets. Overall, railcar demand recovery has been driven largely by freight cars, but our panelists indicated that tank car utilization and rates are rising. If this continues and eventually leads to higher tank builds, it could be a margin tailwind for manufacturers. As for the broader railcar market, inquiries remain strong, but labor and disruptions could limit production. Locomotive upgrades remain solid.

The panelists suggested that a short, mild recession could actually help reset the rail network and allow the Class I’s to clean up the disruptions more quickly than the current pace in addition to improving their access to labor. We think it is plausible that whatever demand reduction a mild recession might cause could be more than offset by a greatly improved ability to meet remaining demand that the Class I’s are currently scrambling to satisfy amid labor tightness and other disruptions. Our panelists described a still-suboptimal rail network lacking in fluidity. We note that lower velocity and higher dwell typically result in a need for more railcars and locomotives to haul the same amount of freight. However, longer term, persistently poor rail service could result in unfavorable modal shifts that would be lose-lose for the carriers and equipment suppliers. 

Overall, inquiries and orders for newly manufactured railcars remain strong. Cars in high demand (even experiencing shortages in some cases) include gondolas for metals, certain boxcar types, grain cars, plastics, recyclables and aggregates. While our manufacturing expert panelist sounded decidedly positive on demand conditions, he expressed caution regarding the industry’s ability to produce quite to the level warranted by the underlying need, at least in the near-to-intermediate term. Access to labor remains tough, and parts and materials are not much better. We are modeling for 2022 industry deliveries of 42,800 units, a level our panelist seemed to think the industry should be content with if achieved. Because of the steel premium as well as labor/materials/components issues, our panelist did not rule out a less-pronounced but prolonged production upcycle, with 2023 and 2024 being around the low 50,000-unit level. We are forecasting 55,4000 units of delivery in 2023 and do not currently have a 2024 industry estimate but would be unsurprised if that year ends up largely in line with 2023. We may get a better idea later this year on whether the steel premium and production limitations could indeed smooth out and elongate the expected production expansion and lead to flat or slightly higher deliveries in 2024. We do not sense that current sell-side expectations reflect continued production growth in 2024. 

According to the leasing expert on our call, absolute railcar lease rates should see continued Q/Q increases. This would extend a seven-quarter run of improving spot rates. The expert believes the ongoing leasing recovery feels sustainable for the foreseeable future, and inflation in the economy generally bodes well for hard assets. Longer term, a strong build cycle could moderate the lease rate expansion, but the earnings cycle for lessors has a built-in lag effect due to the staggered nature of leasing. 

The railcar demand recovery has been driven largely by freight cars, but our panelists indicated that tank car utilization and rates are rising. If this continues and eventually leads to higher tank builds, it could be a margin tailwind for manufacturers. The panelists noted that tank car availability is gradually becoming more constrained, although still not extremely tight yet. Additionally, it is questionable whether stakeholders concerned about safety will redeploy into service DOT111 ethanol cars coming off lease. 

Overall, underlying rail freight demand remains solid across several industrial end markets, although actual traffic continues to be hampered by: 

  • Port congestion.
  •  Supply chain disruptions. 
  • Labor tightness. 
  • Winter weather. 
  • The China lockdown. 

Through May 28 this year, total rail traffic, including intermodal, is down ~2.6% y/y. Many traffic groups are down, except coal, up 8.4%, as coal increases on the western Class I’s and CN more than offset coal decreases at the Eastern Class I’s, CP, and KCS. The other key growth areas through May 28 are chemicals, primary forest products, grain mill products, food and kindred products, waste and scrap materials, and crushed stone, sand and gravel, up 4%. 

The North American locomotive new-build outlook remains depressed, but modernizations are robust, driven by several factors, including:

  • 1. The railroads’ ongoing efforts to optimize productivity.
  • 2. Strength in underlying freight demand, which should eventually lead to traffic growth this year (we are expecting ~1.0% in 2022, back-half weighted, and ~2.5% in 2023). 
  • 3. The railroads’ hesitancy to place big orders of new diesel locomotives as they contemplate the new power technologies of the future. For North America’s two main locomotive manufacturers that effectively form a duopoly (Wabtec and Caterpillar subsidiary Progress Rail/Electromotive Diesel), full modernizations/conversions generate roughly half the revenue of new builds but at much higher margins, making the income dollars of a modernization not far below a new build. 
Tags: ,