Gatx Corp Q3 FY2020 Earnings Call

Good morning, everyone, and thank you for joining GATX’s 2020 third quarter earnings call. I’m joined today by Brian Kenney, President and CEO; and Tom Ellman, Executive Vice President and CFO. Please note that some of the information you’ll hear during our discussion today will consist of forward-looking statements. Actual results or trends could differ materially from those statements or forecasts. For more information, please refer to the risk factors included in our release and those discussed in GATX’s 2019 Form 10-K and its 10-Qs for 2020. GATX assumes no obligation to update or revise any forward-looking statements to reflect subsequent events or circumstances. I’ll quickly recap our third quarter financial performance and then hand it over to Brian for a short discussion on Rail North America’s maintenance operations and the Rolls-Royce and Partners Finance affiliates results. Earlier today, GATX reported 2020 third quarter net income from continuing operations of $48.2 million or $1.36 per diluted share, compared to 2019 third quarter net income from continuing operations of $37.2 million or $1.03 per diluted share. Year-to-date 2020 net income from continuing operations was $132.4 million or $3.74 per diluted share, compared to $138.7 million or $3.79 per diluted share for the same period in 2019. The 2020 third quarter and year-to-date results include a net negative impact of $12.3 million or $0.35 per diluted share related to the elimination of a previously announced tax rate reduction in the United Kingdom. The 2019 year-to-date results include a net deferred tax benefit of $2.8 million or $0.07 per diluted share related to an enacted tax rate reduction in Alberta, Canada. These items are detailed on Page 14 of our earnings release. In the second quarter of 2020, GATX completed the sale of American Steamship Company. Accordingly, this business segment is reported as discontinued operations, and prior periods have been recast to conform to the current presentation. At Rail North America, our fleet utilization remained high at 98.2%, and the renewal success rate was 58.1%. Although absolute lease rates for most car types were flat to slightly higher compared to the second quarter, we expect lease rates to remain under pressure given a continued oversupply of railcars in the market and carload volumes relative to 2019. The third quarter renewal rate change of GATX’s lease price index was negative 29.4%, reflective of the ongoing challenges in the marketplace relative to the strength of the expiring lease rates that generally commenced at the height of the market six to seven years ago. Despite higher fleet churn as a result of lower renewal success in the quarter, our maintenance cost performance was better than expected, which Brian will address further in his remarks.

Great. Thanks, Shari. Good morning, everyone. As Shari said, I want to provide some color on two items that have had a large positive effect on our earnings in 2020, and then we can go ahead and open up the line for your questions. The first one concerns Rail North America’s net maintenance expense. Coming into 2020, we expected the net maintenance trend to be higher by about $8 million to $13 million, 5% to 7% increase versus 2019. The main driver of the increase was the commercial churn that we expected in the North American rail fleet, given the ongoing weakness in the market, this was pre-COVID. By commercial churn, we mean a lower renewal success percentage on expiring leases that results in more cars being signed to new customers to keep the fleet utilized. Traditionally, this has meant more maintenance expense as expired cars often enter our maintenance network to prepare them for new customers. So as predicted, we have seen the higher commercial churn as we move through 2020, and this churn has been exacerbated by the impact of COVID-19. If you look in the third quarter, our renewal success was 58.1%, a full 17 percentage points lower than a year ago. However, year-to-date, net maintenance expense has remained flat to 2019. There are several reasons for this favorable performance, most of them positive. One of them, perhaps a little counterintuitive, is that as we move through 2020, we have continued to become more successful at increasing the amount of repairs done in our own network versus third-party shops. We have this goal of moving as much maintenance work as possible into our own shops, where we believe safety, cost, quality, and delivery metrics are superior. As an example of the progress we made, in the third quarter alone, we set up 96% of our tank car work and close to 90% of all of our cars ran through our own network. This steadily increasing volume drives down our unit repair cost. We're going to continue pushing on this initiative. The efficiency of our internal processes and systems continues to improve our ability to ensure that similar work done on similar cars is consistent across the network. These initiatives have been driving down our costs over the last couple of years. Obviously, there will be a plateau when we achieve complete uniformity across the network, but we’re not quite there yet. Third, our railroad repairs were lower than anticipated coming into 2020, as it appears that the railroads’ attention and manpower have been directed elsewhere. Lastly, on the maintenance side, sometimes the commercial churn in the fleet can lead to maintenance expenses being lower than expected. In certain cases, the market is weak enough that we've made the economic decision to scrap older cars when customers return them instead of incurring maintenance expenses to prepare them for new customers. This is most common with older cars, especially our boxcar fleet. Coming into the year, we planned for maintenance expenses to be incurred on older boxcars, anticipating we could sign new leases. Instead, the market weakened further due to COVID, and we ended up scrapping the cars when they came off lease. Although this reduced maintenance expenses, it removes planned boxcar earnings from future years. Nevertheless, I’m encouraged by our maintenance performance, and I think that lower spending trend will continue into the fourth quarter and beyond. The second topic I want to touch on is the large gain on sale at RRPF, which is our finance and leasing partnership with Rolls-Royce. We highlighted in the press release that we frequently realize residual gains in this business, but this particular transaction is both large and unique. In this instance, there was a large group of engines leased to Rolls-Royce, with approximately $300 million of debt coming due for refinancing in 2020 and 2021. Given that refinancing rates have increased dramatically for air-related businesses, it made sense to restructure the current lease to Rolls-Royce into a new long-term lease, allowing us to use the proceeds to pay down a significant portion of the associated debt rather than refinancing at a higher credit spread. This transaction reduced refinancing risk, lowered our exposure to Rolls-Royce from the JV, and importantly, generated a gain of $0.68 per diluted share in the quarter. This value is probably more reflective of a pre-COVID environment. I hope this helps explain some of the standout items in the third quarter earnings. Operator, we can go ahead and open it up to questions now.

Thank you. We will take our first question from Allison Poliniak of Wells Fargo.

Hi, guys. Good morning. Brian, I just want to go to your comments on moving the maintenance work into your own shops. I know it’s something that GATX is working on fairly successfully, but as you look at the environment today, just trying to understand the dynamics. Is that partly a function of the industry utilization of those cars that’s giving you a little bit more flexibility to bring them in-house versus out in the field? Or is this, I guess, is that irrelevant at this point? Just any thoughts there?

No, I think it’s been an initiative of ours going back years. It used to be about 50-50 between the third-party network and our own network. It just made more sense to leverage our existing investment in maintenance facilities and bring in as much as we could. The vast majority of tank work has historically been done in our own network, and now we’re doing a larger percentage of all repairs in-house. There are a lot of ins and outs of this. One thing that actually increased maintenance expense over what we expected this year is that we moved a little more work into the contract network early in the year than we planned to diversify that work in case we had a severe COVID outbreak that might close a facility for an extended time. We could have done more internally if we hadn’t made that conscious decision. But this is absolutely an initiative of ours.

And Allison, just to add to that, actually, the environment makes it more challenging to get the cars in because of the churn that Brian talked about. So you actually have more cars that need to be done.

Got it, interesting. Okay. And then just, one quarter doesn’t make a trend, but their renewal success rate dropped a little bit from last quarter. Was that just based on what cars were coming in or something else going on there?

Yes, so it’s certainly reflective of a challenging environment, but there’s one item to call out there. The renewal success percentage was 58%, down from 70% in each of the first two quarters, which was driven partly by the Covia bankruptcy. We expect to get about 500 cars back due to that bankruptcy. Without that, the renewal success percentage would have been more in the low to mid-60s, which isn’t too far off from long-term averages. It’s important to note that about half of the cars we got back were immediately remarketed to other customers. The quarterly renewal success can move around quarter-to-quarter, but generally I would expect that the long-term average renewal success percentage, which is around 65% to 70%, will probably be a better guide going forward than the 80% we’ve seen in the last couple of years.

Got it. Thank you. That was helpful.

Thank you. And we will take our next question from Matt Elkott of Cowen.

Good morning, thank you. I wanted to make sure I understand the JV transaction. Brian, did you say that all of the engines that were sold were Rolls-Royce engines or did they include a certain percentage from third-party customers? I know that about half of the third-party customers were on payment deferrals because of the current environment, so I was just wondering if there were any third-party customers, and if so, if any of those were the ones that are on payment deferrals?

No, they were all Rolls-Royce engines and they were all leased to Rolls-Royce from the JV.

Yes, Matt, I just want to make sure you understand. Everything in the large transaction that Brian talked about was on lease to Rolls-Royce, although there were other remarketing and residual realization activities that were from different sources.

Got it. And did you guys give the number of engines that were actually involved in this transaction? Just trying to gauge the future impact on earnings.

No, we did not provide that.

Is there any way you can help us gauge what the impact on earnings could be going forward from the sale?

That’s not something we have right now, but let us look into it and see what we can provide.

Got it. Thank you. And then another question on Rail North America. First of all, do you have a similar number of renewals coming up in 2021 to 2020? And if so, and if lease rates keep making modest sequential improvements like they did in 3Q, could we actually see revenue per active car in North America hold steady next year or even improve slightly?

Yes, Matt, we generally provide that information at our first quarter earnings call for the fourth quarter earnings call for the following year. But in general, it’s fair to say we’ll probably have more expirations, more renewal opportunities next year than we did this year. Likewise, the expiring rate challenge will probably be a little bit easier next year than this year.

That’s helpful, Tom. And then just sort of the last one, I’d love to get your thoughts on the sustainability of the sequential industry fleet utilization improvement. I think we’ve seen three consecutive improvements over the last three months. How much of that do you think is attributable to intermodal versus grain or other things and what it means to you guys?

Yes, so coming into the year, we anticipated a slow and gradual recovery for lease rates. Although car loadings were up 11% versus Q2, they were still down 12% versus Q3 2019. However, on the supply side, we are seeing some builders retrench, and we are seeing some scrapping activity increase. The net North American fleet declined slightly for the most recent unloading data for the second straight quarter, and the industry metrics on idle cars in storage declined by 75,000 cars. These are all positive signs. However, there are still too many idle cars in the industry. Even though we saw flat to marginally improving lease rates in the quarter, we still have a long way to go to get back to those long-term averages. Absent an unexpected demand catalyst, it will probably take several quarters before the supply correction mechanisms can meaningfully increase lease rates.

So several quarters of rail traffic improvements – rail traffic going in the right direction, decelerating again, and then growing potentially next year?

Yes. So again, hopefully this is the beginning of a trend, but it’s early innings. We’ll have to see how that develops.

Thanks, and good morning. Brian, some of the comments you provided earlier around maintenance were helpful. I wanted to see if we could get a little bit more color on what you’re expecting going forward for North American maintenance expenses. I think you said that some of the improvement should be sustainable into the fourth quarter and going forward. Does that mean that maintenance expense can remain flattish sequentially next quarter and into next year? Or is there a little bit more color you can provide around that order of magnitude?

Yes, our expectation is flat to down, and I think that trend will continue at least for the short term. I don’t want to project too far out because it heavily depends on commercial success, but looking to next quarter, I would expect this trend to continue.

Okay, that’s helpful. And then next year, just with some of the tank car recertification work that could be coming up in 2021. Do you think something kind of flattish for maintenance expense is possible relative to 2020 or is there a ballpark you can give us on that?

We’ll give it to you in January, but I will say we’ve pulled forward a lot of that compliance work on tank certification into last year and this year. We’ve evened out that workflow more, so I don’t expect a big increase, and I would hope this trend continues.

Yes, as far as remarketing gains were concerned, we did $30 million year-to-date in operating income for the JV, with gains of about $63 million, totaling $93 million. In the third quarter, gains were $37 million, which were all pre-tax.

Okay, that’s helpful. And following up on the gain in RRPF, Tom, you mentioned there was some other kind of remarketing and residual gain in the quarter. Could you provide what that number was? And then I don’t know if you have the pre-tax number for the larger gain, but that would be helpful as we kind of put together those different pieces.

Yes, yes. The year-to-date for the JV, income from operations recognized on that line item was about $30 million, and the gains were about $63 million for the total of $93 million. For the third quarter, gains and operation earnings were $10 million, and the gains were $37 million, all pre-tax, for a total of $47 million. Of that $37 million in gains, about $32 million related to the item Brian talked about being the $24 million after tax.

Okay. And on those 18 engines, anything that we should consider in terms of like a disproportionate impact on revenue, or if we look at those engines as a percentage of the total engine portfolio? Is that a good way to kind of ballpark the impact going forward?

Yes, that probably won’t work too well because they were older engines that were scrapped. It was a good way to rebalance the portfolio, but they are not a representative cross-section.

Okay. Alright, very helpful. And last question I had was on the acquisition pipeline. As the market has started to bounce back here in the third quarter, have you seen more acquisition targets come to market? Could you speak to the valuation multiples on deals if you’re seeing a pickup?

We really haven’t seen anything significant. There’s not much to talk about there. I still think opportunities through consolidation exist, but it’s just too many investments made by new and aggressive players that are economically under water. So while I think it will come, there’s really nothing significant to report. You haven’t seen anything change probably since our element transaction.

Got it, okay. And if you have anything different for Europe, I’d love to hear your thoughts?

In Europe, I think most of the growth has been organic. I’m a little disappointed that we haven’t seen portfolio acquisition opportunities in Europe materialize in a couple of years. However, the European team is working to develop a more liquid secondary market in Europe, similar to North America. Earlier in the year, we did a small fleet acquisition, but it will take time to develop this market. There’s also been recent discussions in the press stating that the SNCF Board has made the decision to sell all or part of Ermewa, so we should know in the near future if that’s a possibility.

Yes, going back to the Rolls JV, can you give us an update on the percent of revenue that’s being deferred right now? Just trying to think of the delta between revenue recognized in cash flow and if that has shifted any in the last two to four months?

Yes. Customer deferral requests have continued to slow, and the numbers are similar to what we’ve talked about previously. To date, about half of the JV's airline customers have requested deferrals. The JV is selectively granting those on a case-by-case basis. The requests typically represent three to six months of rent deferrals, with some as long as 12 months. Percentually, the requests represent a little over 10% of annual revenue.

Thank you. And does this outcome with perhaps older engines that were closer to end of life, but a fairly significant gain for just 18 of them, give you some confidence that impairment issues are perhaps overblown by some investors in that portfolio as you look to year-end testing?

So far this year, there have been no material impairments. The JV’s impairment analysis consists of cash flow analysis for each engine type and independent appraisals. Accounting rules require impairments to be taken whenever testing indicates impairment.

This transaction started very early in the year. I think the values were probably more reflective of the pre-COVID environment. While there is no question airline and engine values have come down, we still believe in the strength of the long-term outlook.

Thank you for the candid color. Just two more on North American rail. You talked about having more renewal opportunities next year. Can you provide any detail on the cadence of the expiring rate in your portfolio that exists today?

The challenge for us on providing that detail too far in advance is it changes, which is why we will stick to providing directional guidance. We expect more expirations and renewal opportunities next year than we did this year because of the short lease term. The comparator rate for expiring leases will be lower next year than this year.

I had two questions. One is you mentioned that the rate on expiring leases next year should be lower than what we saw this year. So that’s kind of a known number. Can you give us a little bit more help on the magnitude of that?

We really can’t because the mix of cars coming off is constantly changing as we do things like remarketing activity and the decisions to scrap versus repair. So we really need to stick with directional guidance.

Okay, thanks. And then just following up on lease rates, if we were to look by car type in terms of demand versus what’s in storage. What are the car types where there’s less in storage and you might see rates improve sooner, versus those where you have to work through a bunch of supply first?

Relative to last quarter, the car type that saw the greatest increase was grain cars, driven by expectations of a good harvest. That was the car type that performed best versus last quarter. Generally, tank car types have been strong since the start and have performed better against the energy market.

Hi, good morning. Thanks for fitting me in. On the sale of the engines, did you say what the dollar value of the sale was?

We did not.

Okay. You mentioned that 18 engines were sold and that there are approximately 478 in the portfolio, is that correct?

Correct.

And then just within remarketing gains and where railcar values are now versus several years ago, do you see your ability to generate those gains being possibly suppressed versus prior time periods? I mean, I think if I look back, you were doing around north of $100 million in 2015. In 2018 it was $73 million. Are we now more likely in the $50 million to $60 million range, do you think? Or just given what the market is doing, how do you think about that?

Yes. The gains on asset sales can move around quite a bit, and it’s tough to put a number to any given timeframe. We look at cars based on a portfolio management activity where we identify car types we might have a long-term hold on. Calling how those gains will move is pretty imprecise.

It’s all opportunistic. The best example would be we sold a lot of small-cube covered hoppers a few years ago before the current crisis, and that ability to do so disappeared pretty quickly. It ultimately depends on the commercial environment and this is about managing the customer, commodity, and equivalent exposure. So that could change quickly based on market conditions.

I’d like to thank everyone for their participation on the call this morning. Please contact me with any follow-up questions. Thank you.

Thank you. Ladies and gentlemen, this concludes today’s presentation. You may now disconnect.