Fleet Financing

Cowen: GATX “Improving yield dynamics”

Written by

Matt Elkott, Transportation OEM Analyst, Cowen and Company

Matt Elkott

GATX has taken advantage of low interest rates in recent years to improve its debt profile, currently fixed at 90%, with an average maturity of 10 years. Meanwhile, spot rental rates are expected to continue their seven-quarter sequential growth. This should lead to progressively higher returns for the company, which should now focus on locking in much higher rental terms.

Cowen and Company held June 29 investor meetings with GATX CEO Bob Lyons, who took over as CEO on April 22; CFO Tom Ellman; and Shari Hellerman, Director of Investor Relations. Here are our main takeaways.

• We remain confident in our 2022 EPS estimate of $5.90, which is above the consensus of $5.67. After rising steadily from $5.04 in early July 2021 to $5.96 on June 9, 2022, the consensus fell to $5.67. This recent decline may be the result of deteriorating macro sentiment, but we believe there is an underappreciated disconnect between the broader economy and fundamentals specific to GATX and the wagon industry. GATX has taken advantage of the low interest rates of recent years to improve its debt profile, currently fixed at 90%, with an average maturity of 10 years. At the same time, we expect spot rental rates to continue their seven-quarter sequential growth, driven by continued favorable momentum, particularly on the supply side. This should lead to progressively higher returns for the business, which is now likely to focus on locking in lease terms much higher than the 30-month average at the end of Q1 2022. For many cars that come out of the lease now, GATX will likely begin tenure discussions in the five to seven year range. This should lead to steady increases in the average duration over the coming quarters. We expect average durations of 39 months, 42 months and 45 months in the second, third and fourth quarters, respectively. Historically, the average lease length has reached around 70 months, but we don’t expect that to happen in this cycle.

• We see a gradual improvement in yields over the next few quarters due to maturities (average 10 years) on approximately 90% of debt which is fixed, well beyond the average lease term of approximately three years. This is critical in an environment where we expect spot rental rates to continue their seven-quarter sequential growth. Industry scrap rates have been in the range of 40,000 to 50,000 cars over the past three years, above the more normal level of around 30,000 units. Scrapping is expected to remain high this year, although closer to the low end of the 40,000 to 50,000 car range, with the deceleration partly attributable to limited scrap capacity. This, combined with two years of production below replacement level for the industry in 2020 and 2021 (just above replacement level this year) and our forecast of incremental improvements in rail traffic, should maintain the momentum of rental rate. Railcar industry fleet utilization has improved from a dismal 68% in mid-2020 to around 82% today and approaching the mid-80s, which we would consider a almost full use. As we noted in our GATX Q1 2022 Earnings Note, we believe GATX is likely to raise its guidance when it reports Q2 later this month.

• We have long argued that continued scaling by GATX could bring benefits not only to the lessor itself, but also to a wide range of industry stakeholders. GATX is widely regarded as one of the best operating donors. But the largest lenders in North America are financial institutions. Rental is not their core business. Their asset acquisitions are not informed by direct industry knowledge; they are limited in what they can directly provide to their online service customers throughout the lease term, and they have less extensive customer networks. All of this typically leads to an inefficiently managed fleet, with sub-optimal utilization (the utilization gap between operational and financial owners can exceed 10 percentage points). As such, any transfer of assets from financial institutions to lessor operators could be beneficial to most stakeholders. Banks would offload non-essential assets; lessor-operators would increase and unlock more value from the fleet; and customers could receive better service. Everything seems logical. So why didn’t it happen?

• The answer is simply evaluation. It is well known in the industry that the Wells Fargo fleet (the largest in North America) has gone on sale at times over the past few years. GATX has probably bid unsuccessfully in the past; some financial institutions may have done the same. A transaction like this would be a game-changer for GATX, which would more than double its fleet. The company would likely work hard to secure funding if it found the valuation compelling. But that’s a big “if”. Given some sub-optimal parts of the fleet, we believe GATX would seek a discount to book value – not as deep today as it would have demanded two years ago, but still a discount. For Wells Fargo, it’s hard to imagine a better time to sell the fleet given the strength of the secondary market. As the railcar manufacturing bull cycle begins in earnest in the second half of 2022 and lasts through at least 2023 according to our projections, new unit additions should begin to temper secondary market valuations.

Review of 1Q22 results

The strength of the secondary market resulted in the majority of GATX’s projected remarketing revenue for 2022 being realized in the first quarter. This was the main driver of the pace of big profits. Although strong secondary market sales likely mean that the fullthe annual forecast looks even more conservative than before, it’s not dramatically more conservative, in our view. Yes, the Q1 result gives us even more confidence in our remarketing revenue assumption (above GATX’s original forecast), but the company’s fleet is currently near optimal in terms of quality and utilization. Any additional significant sales could mean that the company would have to tap into the aftermarket or replacement manufacturers in order to continue to meet customer demand, maintain good customer relations and sustain strong rental revenue levels.

• In the first quarter of 2022, adjusted EPS was $2.34, well above our estimates and consensus of $1.37 and $1.39, respectively. This pace was aided by the fact that most of the company’s projected remarketing revenue for the year occurred in the first quarter. Compared to our model assumptions, remarketing revenue added $0.96 to adjusted earnings. Adjusted for this, EPS would have been $1.38, a penny above our estimate and a penny below consensus.

• Revenues were $316.6 million, below our estimates and consensus of $323.8 million and $322.8 million, respectively. LPI was 9.3%, better than our estimate of 5.0% and -0.7% in Q4 2021. Average renewal length was 30 months, below our estimate of 38 months and of the 37 months of the fourth quarter of 2021.

• GATX said its spot rental rates showed a quarterly sequential increase in the first quarter: mid to high teens. This is a strong acceleration from the mid-to-high single-digit increases it had achieved in the six quarters prior to the first quarter. The big increases are for freight cars (as opposed to tank cars).

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