- KPB & Co Research
There have been a lot of wallstreet commotion around Genesee & Wyoming (NYSE: GWR) since it was leaked back in early March 2019 that they are seeking strategic alternatives. Since then a number of private equity sponsors have expressed an interest, and they are now at the second round negotiations. Brookfield Asset Management, Blackstone Group, Stonepeak Infrastructure Partners, and EQT Partners are reported to be part of a group of investors who are now at the second round of bidding. With the standard operating model of private equity companies, and Genesee & Wyoming's unique situation in mind, it is somewhat bewildering how private equity sponsors expect to deliver alpha in this particular situation.
Genesee & Wyoming is a Connecticut based freight railroad owner and lessor with a market capitalization of close to US$5.3Bn - based on post announcement stock price. The corporation owns or leases 120 freight railroads worldwide, making it a mid sized railroad owner and operator. According to the company's form 10-k, the company is structured into 9 operating regions that encompasses rail assets in USA and Canada -- includes 114 short line and regional freight railroads, Australia - 51.1% owned by GWR and 48.9% owned Macquarie Infrastructure and Real Assets (MIRA), the European union and the UK. The company also engages in rail services such as rail-ferry, transload, contract coal loading, and industrial railcar switching and repair. See the company's recent investor presentation for more below.
The company has a track record of engaging with private equity, but ...
Over the years, the company has gotten involved with private equity interests on a number of deals, perhaps due to the background of the Chairman, President and Chief Executive Officer - John C. Hellmann. In 2012, Carlyle Group invested US$800Mn in the company to enable it to acquire RailAmerica. In 2016, Genesee & Wyoming bought Glencore Rail and sold a 49 percent stake in that business to Macquarie's Infrastructure funds. The company also has a track record of getting into value enhancing acquisitions as outlined in the company's regulatory filing and extrapolating from the movement in the stock price over time:
Since 2000, we have added 105 railroads through the execution of our acquisition and investment strategy. Historically, our acquisition, investment strategy includes the acquisition or long-term lease of existing railroads, as well as investment in rail equipment and/or track infrastructure to serve new and existing customers. ... acquisitions of international railroads and transportation service providers.
The company's track record of successful private equity deal making, acquisition strategy, and operational excellence are to be expected, given the domain expertise of the Board of Directors. The CEO himself is a former investment banker from Lehman Brothers, the head of the audit and compensation committee is a former investment banker with over 35 years of experience, and one of two females carrying the flag of diversity - Cynthia L. Hostetler is a former head of private equity and vice president of investment funds at Overseas Private Investment Corporation.
The purpose of the sale leaves me wondering
According to reports, management is seeking to explore a deal with an investor that could do either an upfront investment of capital to aid it in acquiring a large company, or an outright 100% buy out of the equity. Based on recent news reports, it appears that the likely path that will be pursued is an outright sale of the company to a financial sponsor. The word on the street is that management is seeking to sell the company because valuations are very high today. High valuations prohibit the company from making additional value enhancing plays through the acquisition of more rail based hard assets. At one point in time the company was considering repurchasing its own stock which it deemed would provide more value than purchasing more assets. Pardon my skepticism, but if the management of the company who has such in-depth domain expertise in capital markets finds it difficult to do additional value enhancing plays, where will private equity find alpha ?
Company's Financial Profile Suits A Strategic
At the end of fiscal year 2018, Genesee & Wyoming had an operating margin of around 18%. Other well operated railway companies in the industry tend carry operating profit margins in the region of 30% to 40%, which at face value leaves a lot of room for expansion and additional value on the part of GWR. On the other hand, the railway business comes with a lot of fixed costs that makes it difficult for sub-scale companies to carry high margins. At US$2.3Bn in revenues GWR is very small relative to competitors such as CSX with US$12Bn in revenues and Canadian National Railway with US$11.1Bn. Of course one can also present the argument that the company is operated inefficiently, but in this case that may be unlikely given the that it would mean that the CEO is signing off on his own job termination. Under private equity ownership, the management team would definitely be replaced to ensure that alpha is generated.
Overtime the railway industry in North America has gotten very consolidated, and everyone knows who the main players are. The big players are BNSF Railway, Canadian National Railway, Canadian Pacific Railway, CSX Transportation, Kansas City Southern Railway, Norfolk Southern Railway, and Union Pacific Railroad. It is quite unlikely that any private equity shop would have a sizeable railway company in their portfolio that can assist GWR in achieving scale. As such for the private equity sponsor to benefit from scale advantages, they would have to buy two railways, which is remarkably risky. Moreover the mere fact that the CEO of GWR choose to sell the company rather than repurchase the corp's stock, tells the story that at 24 times earnings the company's valuation is sky high.
Private equity companies can also generate alpha by throwing on a ton of debt on corporations, and bank on their steady free cashflow to meet the payments. In the case of GWR there is steady growing free cashflow, and the company is asset rich, but the company carries a debt to capital ratio of about 40%. There is not a lot room to maneuver today, and any further increase in debt beyond 55% or 60% of capital is running the risk of bankruptcy later on. Moreover, in an environment where US economic growth slows by even a whisker, the resulting thinning of free cashflows is likely to lead to big problems.
In concluding, Genesee & Wyoming is definitely one of those companies that would be good for private equity investment in another time period, but not today. In today's world there is an elevate risk of a slowdown in economic growth, at the same time valuations are a bit stretched. The company also appears to be cost optimized, but could benefit from additional scale. In spite of low interest rates, it would be difficult for a private equity company to bring additional value to the table.