When George Bush backed ethanol as the solution to America’s “addiction to oil” in 2006, it was as if God himself had spoken.
US corn farmers wasted no time diverting their crop to production of the alternative fuel – bio-refineries sprung up among corn fields across the Midwest and it wasn’t long before almost half of US corn production was being burned in an ethanol plant.
The last time there was such a shift in agriculture in the Midwest was “when electricity came to rural people”, one ethanol farmer told USA Today at the time.
But the farmers forgot one thing – how to transport all that ethanol. You can’t send ethanol along gasoline pipelines, it’s corrosive and picks up impurities, so most has to be transported by rail. But the rail industry isn’t up to the job. After years of underinvestment, there was a massive shortage of railcars available to carry goods from the Midwest to the coast. Ethanol tanks soon began to stack up, Wall Street got worried about a glut and the ethanol price dived from its $4 a gallon peak in 2006, to $1.50 today.
But corn-belt farmers shouldn’t give up yet – the railcars are on their way. The US’s big railroad firms have embarked on huge capital-spending projects that are overloading railcar builders with work. And with massive barriers to entry for the industry, only a handful of rail builders are positioned to take on the business. The big railcar makers have more than a year and half’s work backed up, says Dave Maechling of tank car maker American Railcar Industries, and that’s not counting all the coal that will have to be shipped out to Asia in the coming years.
There are three big reasons why the rebirth of these railcar builders will continue long term. Energy costs are the main one. For transport companies, pouring petrol into a truck for a journey that stretches half way across the States is becoming a painful experience. Railroads provide a cheap alternative – you can save 12 to 14 cents per gallon when delivering ethanol from the central plains to the coast, using just a third of the energy. With oil showing no signs of falling far from $100 a barrel, rail transport looks the way to go.
The state of America’s roads is the second big factor that will play into the hands of rail firms. A recent report by UBS says that highways in the main metropolitan areas are rapidly reaching capacity. Traffic congestion is already a $78bn annual drain on the US economy and companies will be eager to shift to rail to stave off mounting delays rather than – as is the case in India – see their crops spoil in the fields and rot in lorries while waiting to be delivered.
Finally, there’s coal. Rail is favoured by the US coal industry. Exports to Asia have played a big part in the resurgence of the rail industry – volumes have jumped 25% since 2002 alone – and will continue to be a big boon to the companies leasing and building railcars. Coal exports are expected to double this year alone.
Of course, the railroad industry is closely tied to economic growth. With housing and the consumer being hit by the subprime blowout, the volume of cars and construction materials has dropped off recently (down 2.5% in the final quarter of last year). But with such a healthy backlog for railcar builders and the need to replace ageing fleets, the industry will see out any short-term downturn. We have a look at a company ideally placed to benefit below.
The best bet in the rail sector
The firm that’s been taking the biggest orders from railroad companies is Trinity Industries (NYSE:TRN), the largest railcar builder in the US. The stock has taken a bit of a nosedive since August over concerns about a US recession and falling rail volumes for cars and construction materials. But the $2bn company has remained very profitable in that time. Just as the stock price was slipping, Trinity turned in its best ever quarter, with $1bn of sales, and adding 4,500 cars to its backlog. As of October, it has an order backlog of 32,000 cars, valued at approximately $2.5bn. There is also steady money from leasing its fleet of 35,500 cars. The company also has an interest in wind farms, ending the year with a $750m backlog of orders for steel wind structures.
New railcar orders are expected to slow in the year ahead, but the writedown still looks harsh in the circumstances. The stock is poised for a turnaround, according to Brian Pacampara of Motley Fool – Trinity’s market leadership, sizeable backlog of orders, recent insider buying and steady dividends (currently offering 1% yield) are all “reasons to be bullish”. Valued on a forward p/e of 7.3, and with a price-to-earnings growth ratio of 0.63, “it’s a pretty cheap bet on demand picking up over the long term,” says Pacampara.