The Hidden Railroad Play

 | Mar 06, 2012 | 11:30 AM EST
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When Warren Buffett's Berkshire Hathaway (BRK.A) bought the Burlington Northern Santa Fe railroad a couple of years back for nearly $44 billion, which at the time was a hefty premium to the stock price, the usual criticism was let loose. Buffett's investment in a capital-intensive, low-margin business was seen as out of touch.

Fast forward to today, and railroads are booming. Thanks to stubbornly high oil prices and a slowly recovering economy, railroads are experiencing growth in freight tons hauled, and profits are soaring. Over the past couple of years, shares in railroad stocks have appreciated considerably, and if Burlington Northern were for sale today, it would probably fetch north of $60 billion, given peer valuation multiples. It's no surprise that activist investor Bill Ackman's newest activist efforts involve Canadian Pacific Railway (CP).

The outlook for the country's rail lines remains very attractive. The price of oil will stay high, because of turmoil in the Middle East and China's growing demand, and that bodes well for railroads that can transport goods at a fraction of the price. And because the economy is recovering from a low point, continued incremental improvement is going to have an exaggerated effect on the operating performance of the railroads.

Against that fundamental backdrop, a railroad investment play can be made in Greenbrier Companies (GBX). Greenbrier is a leading designer and manufacturer of railroad freight car equipment, in addition to offering leasing, repair and parts services to the railroad industry. In addition, the company makes ocean-going marine barges and related products.

Thanks to a boom in spending by the railroad industry, Greenbrier should experience attractive growth in the years ahead. The company is the industry leader, commanding a 64% market share in intermodal railcars, 56% share in boxcars, 30% share in flatcars and 18% share in hoppers. The company has shut down a high-cost manufacturing facility in Canada and opened lower-cost facilities in Mexico.

What makes Greenbrier attractive is its franchise-like business model. Besides selling railcars, it has a rapidly growing repair business. Starting from $100 million in revenue in 2005, the repair segment alone now generates about $500 million in annual revenue. When railcars age, Greenbrier sells or leases replacements and then services those railcars until the next purchasing cycle. The result is a company that has become less reliant new railcar sales, resulting in a less cyclical business.

Shares currently change hands at $24, or a market cap of $660 million and an enterprise value of $1.1 billion. The company owns a fleet of 9,000 railcars that it can lease at very favorable terms, thanks to its strong financing relationships with the banks. More importantly, the company is in the midst of boom in new rail car sales as profitable railroads look to upgrade aging fleets. The company's current backlog as of Nov. 30, 2011 was worth $1.1 billion, up nearly 100% from the year-ago level.

Trading at 29x trailing earnings, Greenbrier is not a statistically cheap stock, and the valuation may not leave much space for a slip-up. But after a couple of years of virtually no growth, the company is in the midst of a massive growth cycle as railroads boost capital expenditures. Indeed, while the share price advance from less than $10 a couple of years back to $24 today is a huge run-up, Greenbrier is posed to deliver annualized earnings growth of 50% (albeit from a low starting point) over the next several years. Results for the company's first fiscal quarter ended Nov. 30, 2011, included 100% growth in revenue to $398 million, and EPS was $0.48, compared with a loss in the year-ago period.

For the current fiscal year, EPS estimates are $2.17, followed by $2.87 the following year. The growth estimates explain why the shares are currently trading for 29x earnings. But if one assumes a reasonable P/E multiple of 20 on the aforementioned projection, shares could be trading between $40 and $55 over the next two years, a tidy pop from today's $24 share price.

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