Freight Car America

Anyone who read Joel Greenblatt’s wonderful “Little Book that beats the market” and subsequently went on http://www.magicformulainvesting.com/ had to come across company with ticker RAIL. Freightcar America has over 100% ROIC (350% to be exact), trades at only 2.1x EV/EBIT and seems to be one of those old economy companies that many value investors dreams are made of. Unfortunately, similar to most dreams, if something is too good to be true it probably is.


FreightCar America is a manufacturer of open hopper railcars that are used in US primarily for transportation of coal. It has 80% market share in its segment due to products that are more energy efficient, cheaper and easier to handle than competitors. The company is well run, conscious of shareholder values (currently performing a 50M USD buyback) and in general one of those organizations that you want to be a part-owner of. It has a misfortune of operating in a highly cyclical industry with very uncertain cash flows. You can see from the graph on the left that overall railcar industry continuously goes through periods of peaks and valley.


It is obvious that last couple of years was exceptional for the industry and Freightcar America. It has produced 13,000 and 18,700 cars in 2005 and 2006 respectively and put out profitability numbers that make current valuation seem ridiculously low. The trick to figuring out intrinsic value is as usual normalized earnings and that’s where the company falters.
Through conversation with industry experts I have established that normalized level of replacement demand for current railroad stock is approximately 8 to 9 thousand railcars per year. This takes into account the total of 250,000 open hopper cars that are on the roads today and the fact that their average age is over 25 years old. On top of that we can add cars that will be necessary to satisfy future US energy needs which is anywhere between 3 to 5K depending on the metric you use. With total demand of approximately 13 thousand cars and RAIL’s market share of 80% I estimate the normalized demand for coal cars to be somewhere around 10,400 per year.

The other question is Freightcar America’s operating leverage. Based on results from last few years we can see that significant proportion of their costs are fixed and when production goes down significantly profitability can easily become negative. The company put a lot of effort into de-levering its cost structure and moved a large chunk of its production from inefficient Johnstown plant to newer Denville and Roanoke facilities. Through conversations with the company, guesstimates and a fair degree of black magic I think I came up with more or less reasonable calculation of company’s profitability at different levels of production. Calculation shows that at normalized level of demand of 10,400 the justified price per share is only $38 and company needs to produce around 11,000 cars per year to justify today’s share price.


This is why I believe that unfortunately the company does not represent an attractive investment at today’s prices. Since I like the management and its dominant market share I will continue to monitor the company and look for an attractive entry point. Any good research usually cannot happen without friends and I want to thank everyone who helped me gather this info.