Buy Buffett's scraps: RailAmerica
Why this train is worth jumping on.
It's the day after Thanksgiving, and our thoughts naturally turn to leftovers. We try to extract as much value out of our turkey meal as we can by eating the scraps -- and Michael Olsen shows us the same works for investing. (Sorry, I stretched that analogy as much as I did my stomach yesterday.)
Rex Moore, Motley Fool Top Stocks editor
Blame Warren Buffett, that octogenarian superinvestor of Berkshire Hathaway (BRK.A) fame. A few years back, he let the cat out of the bag: Railroads are tremendous businesses. Our folksy friend's blessing drew investors to railroads like cats to catnip.
I hate him for it. Railroads haven't looked cheap since, and they never found a place on my watchlist.
But today, that changes: RailAmerica's (RA) our ticket, folks. A previously mismanaged business, the lingering and onerous debts from a leverage buyout, and seemingly feeble profits mask a burgeoning cash machine -- with multiple means of value creation. And all of a sudden, I'm just a little less bitter that Buffett blew it for us. This is a classic value.
RailAmerica is a short-line and regional railroad. Where the major (Class I, as the pros call them) railroads' tracks end, RailAmerica's lines connect them to customers. The mind-numbing intricacy of replicating a rail system, and huge cost, affords meaty competitive advantages. The advent of newfound technology and persistence of $75 oil make railroads a no-brainer compared to trucking, a la YRC Worldwide (YRCW). They're virtual monopolies, really.
Class I railroads are hip to these economics, and they've taken advantage, consistently passing price increases in excess of inflation, sometimes as high as 7%. The majority of RailAmerica's and peer Genesee & Wyoming's (GWR) lines hook up to Class I railroads, and they've followed the Class I's lead on pricing, consistently passing higher-than-inflation price increases. It's basically a license to print cash. So then, why is RailAmerica so cheap?
Three years ago, a horrendously managed RailAmerica was taken private by Fortress Group (FIG). At the time, the company's operating margins were running in the 10%-13% range, where Genesee's -- widely held to be the best-in-class short-line operator -- were around 17%. Making matters worse, the company's pricing was badly lagging its peers.
Fortress saw that. It installed a new management team, made vast operational improvements, and took it public again. But the market didn't take notice: RailAmerica's profitability still lags its peers, and the Fortress buyout left it strapped with high-rate debt ($710 million of 9.25% notes at IPO), rendering the company unprofitable on paper and positively ugly on a cursory glance at its financials.
That leaves an investment with great potential, value-oriented friends. I see four specific sources of value, in fact.
1. An unheralded turnaround and burgeoning earnings power
RailAmerica's management -- a group of old railroad hands with a lot of turnaround experience -- have improved operating margins some 10 percentage points, and brought average revenue per carload in line with Genesee. If its peers, most notably Genesee, are indicative, there's still significant room for improvement. Despite paper losses, RailAmerica actually produced free cash flow in the past 12 months -- a function of accounting arcana associated with previous debt repayments.
Moreover, industry dynamics afford rail operators great potential. Class I railroads have passed some meaty price increases in recent years, in the 5%-7% range, dramatically bolstering their earnings power. I'd wager that for the foreseeable future, that's apt to continue: For example, Union Pacific (UNP) increased revenue per carload 5.5% last quarter. Because 90% of RailAmerica's rails hook up to Class I's, that spells pricing power and growing margins.
2. Debt reduction and refinancing
That debt is ugly, but RailAmerica's got cash to burn and plenty of cash flow, and if it chooses, it can refinance its debt in 2013. To wit: Management's paid down $150 million of debt since coming public and has committed to ongoing debt reduction. At a 9.25% rate, every bit of debt reduction accrues value straight to shareholders.
Looking out toward 2013, I'd wager RailAmerica's margins and cash generation will be meaningfully higher, giving management a good shot at refinancing for attractive rates. And that could accrue a lot of value for shareholders.
3. Possibility of acquisition(s)
The short-line space is populated by a lot of small, inefficient operators, and RailAmerica's management seems a shrewd, value-oriented sort. At the right price, an acquisition can make a lot of money for shareholders, and management's looking.
4. Not-so-hidden tax assets
RailAmerica's market cap is approximately $635 million, and the company was possessor to $127 million in federal tax credits and $95 million worth in rail-specific tax credits. Reflect on that for a moment: That's $222 million in tax credits against a $635 million market cap. Huge. No surprise, management estimates that it won't pay significant cash taxes for seven to eight years.
So add it all up. I see significant unrealized earnings potential, pricing power, potential for margin expansion, and debt reduction. Though recent price increases have been in the 4% range, I'd wager management can sustainably increase prices in the 4%-5% range (perhaps a little higher), if Class I peers and recent results are any indication. I anticipate ongoing pricing strength coupled with productivity initiatives will drive operating margin improvements. Add in a little debt reduction and the possibility of debt refinancing, and I get shares worth $15-$20.
Because transaction costs can get a little prohibitive on position sizes much smaller than $500 (unless the potential for reward is great), I'm opening a $500 position, or 2.9% of our first year's capital, and will look to add as conditions warrant.
I see three risks here. The first falls in the realm of high impact and low probability. The short-line rail credit, which affords short lines meaty tax benefits, is currently up for renewal. Congress indicated widespread support, and it's likely to pass. But in a world where budget deficits dominate the headlines, it's possible that it won't. Today's prices afford some protection against downside, but that'd take cash out of RailAmerica's coffers. Not good.
The next risk is the very same reason we have our opportunity: Fortress. The hedge fund still owns 55% of RailAmerica. That means its interests should be aligned with ours, but it could use that influence for its own purposes. The answer, here, isn't to avoid RailAmerica altogether, but position-size appropriately.
Last is the debt. RailAmerica's improving cash flow position it well enough to cover interest obligations, and it doesn't have significant principal payments until 2017. But that's a lot of debt. I think it's unlikely, but if sales and/or profitability fall too much, it could spell trouble.
My Foolish bottom line
In my experience, it's a rare day when you can find a stellar business, depressed valuation, and accompanying value catalysts. But today's the day. RailAmerica's a train I'm going to hop aboard, and I suggest you think about joining me.
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Michael Olsen owns shares of Berkshire Hathaway. Berkshire Hathaway is a Motley Fool Inside Value selection. Berkshire Hathaway is a Motley Fool Stock Advisor pick. Genesee & Wyoming is a Motley Fool Hidden Gems choice. The Fool owns shares of Berkshire Hathaway. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
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