By David Randall
NEW YORK (Reuters) - Rail car makers, little-known winners of the North American energy boom, are capturing the attention of fund managers and regulators alike.
A string of derailments, some of them deadly, of trains carrying crude oil have prompted U.S. and Canadian authorities to look into stricter safety rules for tank cars carrying crude oil and other volatile materials. While sweeping regulations have yet to be announced in the United States, fund managers look to be already picking a winner among rail car manufacturers.
Thirty five funds initiated a position in Dallas-based Trinity Industries Inc in the most recent quarter, increasing the total fund ownership in the company by 20.6 percent, according to data from fund tracker Morningstar.
A total of 553 funds now hold a position in the $6 billion market cap railcar manufacturer, a level that is considered high for a company of its size. Among them: the $2.7 billion Franklin Small Cap Value fund, the $2.7 billion Dreyfus Opportunistic Mid-Cap Fund, and the $5.4 billion American Beacon Small Cap Value fund.
Fund ownership in smaller rival American Railcar Industries Inc increased 15.5 percent to 231 funds, in the same period.
What Trinity has going for it, beyond a strong balance sheet and a stock buyback plan that has won it fans among value-oriented investors, is that it is seen as the leading supplier of newer model tank cars that are likely to meet stronger safety regulations, fund managers say.
Approximately 50 percent of the company's revenues come from making tank cars, analysts say, and that figure could grow if customers like Kinder Morgan Inc increase orders to replace models phased out by new safety guidelines.
For the moment, though, Trinity has seen orders slow as customers wait for the U.S. to announce new rules before making purchases. Canada's Transportation Safety Board said on April 23 that it will phase out by May 2017 older so-called DOT-111 tank cars, which are seen as being vulnerable to puncturing and leakage, and require all tank cars to meet stricter standards that since 2011 have applied to new rail stock. The U.S. Department of Transportation is expected to announce its own rules by September.
Trinity told analysts during its April 30 earnings call that it expects demand to increase after the U.S. rules are in place in September.
"Our customers, like us, are assessing the potential impacts pending regulatory changes," said Steve Menzies, who heads its rail and railcar-leasing business, during the call.
Even with the slowdown in orders, the company posted $2.85 in earnings per share, well above the consensus analyst expectations of $2.53 per share, on the strength of its leasing business and rail deliveries.
Shares of the company are up 38 percent so far this year, well above the 1.7 percent gain in the benchmark Standard & Poor's 500, and trade at a trailing price-to-earnings ratio of 15.9, roughly in line with the broader market.
Fund managers say that any new government rules will make the company's revenues lumpy over the next few quarters, as tank orders come in spurts.
"The safety regulations are still the wild card out there," said Eric Marshall, a portfolio manager of the $1.2 billion Hodges Small Cap Fund.
Yet Marshall has been adding to his position in Trinity because he is attracted to the company's leasing program, which allows it to smooth its earnings over time by sidestepping the cyclical nature of order flows.
The railcar industry typically operates on a five-to-six year boom and bust cycle, he said, but having a leasing business allows the company to have a cushion against a sudden contraction. Its business constructing barges and railroad safety equipment, which provides 10 percent of revenue, also helps provide balance.
The current boom cycle may last longer than those in the past, said David James, a portfolio manager of the $3.1 billion James Balanced Golden Rainbow fund. Shipments of crude oil by rail have jumped more than 25-fold since 2008 in the U.S. alone, according to the Association of American Railroads, an industry group representing major freight railroads in the U.S., Canada, and Mexico.
Delays to the controversial Keystone XL Pipeline, a project by TransCanada Corp that would run from Alberta through South Dakota en route to the Gulf Coast, will likely continue to push more traffic onto rails through at least 2017, when the construction of other pipelines in the region are expected to be completed. At the same time, rail cars carrying loads of sand and other materials used for fracking to produce oil and gas should make up for any declines in coal shipments, James said.
Analysts largely share fund managers' rosy views. The average price target among the 12 analysts who cover the stock tracked by Thomson Reuters has risen to $85.25, from $60.11, over the past 90 days, a jump of 41 percent. Even with the rally this year, shares of Trinity remain 10.5 percent below analysts' average target. On Friday, Trinity closed at $76.28 per share.
Arthur Hatfield, an analyst at Raymond James, has the only 'underperform' rating on the stock, the lowest rating of any analyst tracked by Thomson Reuters. The impact of the upgrade cycle will likely be shortlived and has been overstated, leaving a glut of tank cars "likely at some point." Hatfield wrote late last year. Hatfield did not return calls for comment.
Bascome Majors, an analyst at Susquehanna Financial Group, raised his target price on May 2 to $84 from $72. While newer safety regulations will be one catalyst for the company's growth, he is also buoyed by gains in the company's barge business and expectations that the company will acquire competitors to expand its non-rail business lines, he said.
"While trees don't grow in the sky, we see fundamental momentum and positive catalysts remaining in Trinity's corner," he said.
(Reporting by David Randall; Editing by Linda Stern, Martin Howell)