TransContainer — Structural and cyclical locomotion

TransContainer is the market leader in Russian rail container freight. In recent years it has expanded its customer offering to include truck deliveries and rail handling. On top of its legacy rail freight business this now means the company offers integrated end-to-end logistics services to Russian and international industry. It has revenue exposure to a broad range of industries with a particular exposure to chemicals, consumer goods, paper, construction materials and machine tools.

We forecast TransContainer will grow (company definition) EBITDA at a CAGR of 20% in the coming three years. The stock’s 6.0x one-year forward EV/EBITDA versus an average of global transportation and logistics peers of 9.0x looks undemanding in comparison to this growth rate. This is supported by our own DCF valuation of RUB5,051 and our multiple-based valuation RUB4,750, which, when averaged – RUB4,900 – offers equity holders 23% upside to current levels. In other words, trading at current levels, TransContainer’s attractive earnings story, underpinned by structural and cyclical growth drivers, offers investors significant upside to its intrinsic fair value.

Following a commodity-driven cyclical downturn in 2014 and 2015, TransContainer’s earnings prospects have since materially improved. The company’s 48% improvement at H117 in EBITDA, driven by top line expansion of 49%, coupled with the fact that end-markets are continuing to grow (+21% July 2017 vs July 2016) gives us confidence in our increased earnings forecasts. Our 52% FY17 year-on-year (company definition) EBITDA growth forecast and 20% three-year (FY16-19) (company definition) EBITDA CAGR are well-supported by current market trends and buttressed by the company’s strong levels of operating efficiency. The result is that our underlying EPS forecasts for FY17 and FY18 are increased by 41% and 29%, respectively.

TransContainer is principally exposed to macroeconomic risk and political risk.

TransContainer, a former state-owned firm, was fully listed in 2010. In the intervening period it has transitioned from a rail container-focused operation to a fully integrated freight-forwarding business. TransContainer owns almost all of the assets it uses including 23,561 flatcars, 70,990 ISO containers, 62 rail-side terminals and 184 trucks. It currently has a 46.7% market share in Russian rail-based container transportation. Plus it is number three in rail-side container handling with 19.3% market share. The Russian rail network operator, JSC UTLC, owns 50% plus two shares of the issued equity.

Two factors underpin TransContainer’s strong current growth trajectory: GDP growth, which in turn drives rail freight volumes; and ‘containerisation’, or an increasing proportion of rail cargo shipped by container. Containerisation levels reached 6.2% in H117 according to the company. This implies a market share CAGR of 6.7% since 2001 and is well below the European average of 14%. This structural earnings driver is complemented by economic growth (currently trending at 2.5% in Q217 although volatile, as 0.5% expansion in Q1 shows) in supporting the observed 20% h-o-h rail container transportation volume growth seen in H117. Given its dominant market position, TransContainer has a strong competitive position from which to benefit from these current trends, although we note that its market share is trending downwards as the market opens up to competition.

TransContainer’s management team have continually shown their competence regarding managing costs and deploying capital, especially during the recent period of economic contraction. In 2014 and 2015, management reduced controllable costs to cushion the effects of the economic downturn (controllable costs declined by 14% in FY14). Likewise, management showed restraint in capital spending in 2015 and 2016 by cutting investment in flatcars as volumes contracted. It is to management’s credit that it has been able to cope with increased flatcar demand in Russia during H117 by improving flatcar utilisation. Management’s focus on cost efficiency and cash conservation underpin our forecasts for EBITDA (company definition) margins to recover to 40% this year.

TransContainer has transitioned its business from a disjointed point-to-point transportation operation to a fully integrated logistics business. In 2013, 41% of the company’s adjusted revenues came from Integrated Freight Forwarding and Logistics. By H117, this figure had climbed to 71%. This is a function of management strategically building out the company’s capabilities in rail-terminal handling and last mile transportation. Given most of the company’s key customers and end-markets are complex and multinational in nature, this integrated offering makes sense from a competitive positioning perspective. Ultimately, this should allow TransContainer to grow market share in the overall transportation and logistics market in Russia and grow profitability too.

With a 46.7% market share in rail-based container transportation and a 19.3% share of terminal handling, TransContainer has a strong competitive position in key Russian rail segments and offers investors a solid means of exploiting strong rail cargo volume growth. Management has invested in the provision of a fully integrated end-to-end customer offering noted for high service levels and a strong focus on operating efficiency. For shareholders, TransContainer offers a unique way to play attractive growth trends with the protection of a well-regarded management team.

Despite its suitability (ie, large land area and long shipping distances), Russia has always lagged other large economies in terms of rail containerisation rates. Currently, the rate of 6.2% compares to Europe on 14%, India on 16% and the US on 18%. This is a marked increase from 2.2% in Russia in 2001 but illustrates the potential for further growth. Given the cost advantage to Russian industry from transitioning away from either truck or rail boxcars, we believe the 6.7% CAGR in market share for containerised rail freight is likely to continue.

In H117 Russian rail container volumes grew by 19.8% versus the same period a year earlier. In July, the growth rate was 21.3% versus July 2016. Management attributes the bulk of this growth to increased rail containerisation. However, we should note that after slowing in 2014 and contracting in 2015, Russian economic output started to grow modestly in Q416 and in Q217 grew by a y-o-y rate of 2.5%. This has taken place against a backdrop of recovering commodity prices, which are important for the Russian economy and TransContainer’s customers. Several of the company’s most important verticals are heavily cyclical such as chemicals, construction and machine tools. This gives us confidence TransContainer will continue to see demand growth in the coming months.

TransContainer’s business model has transitioned to focus on ‘Integrated Freight Forwarding and Logistics’ in comparison to its more disjointed customer offering in the past. 71% of revenues in H117 came from ‘integrated’ services. This compares favourably with 41% in FY13. For customers, integration means goods can be shipped end-to-end and require only one freight handler rather than several with niche skillsets such as truck deliveries, terminal handling, etc. This has the twin effect of significantly enhancing TransContainer’s competitive offering while allowing shareholders to benefit from superior returns via efficiency and scale gains.

In H117, management managed the operating fleet’s performance very well. 79% of freight runs were ‘profit making’ rather than ‘empty run’. This is in comparison to 77% in FY16 and 74% in FY15. Management were able to absorb the significant uplift in demand without any new flatcars, although capex is forecast to increase in FY17 to c RUB8bn with c RUB5bn to be invested in new flatcars, which is a sign of management confidence in continued recovery. In other words, TransContainer’s management has proved itself capable of reducing controllable costs and investment to protect cash flow in the face of end-market weakness in 2014 and 2015 and has now shown the capacity to increase utilisation and investment as demand recovers.

TransContainer will grow EBITDA (company definition) by a CAGR of 20% between FY16 and FY19 based on our earnings forecasts. The bulk of the growth will come from Integrated Freight Forwarding as this continues to be a focus area for management. The main driver of revenue growth is rail container volume growth, which has averaged 8.3% since 2001. This, in turn, is supported by rail containerisation – rail container cargo as a percentage of overall rail freight has grown at an average of 6.7% since 2001 – and GDP growth, which for several years has been patchy at best.

During H117, TransContainer managed to keep its controllable cost (controllable costs are defined by management as all internal costs less third-party costs associated with integrated freight forwarding) increase to 15% despite the 20% increase in the top line. Management said it managed to keep empty run rates, salaries and administration costs under control. It also attributed the efficient performance to improved fleet management and optimisation measures taken at terminals. This enabled TransContainer to post H117 (company definition) EBITDA margins of 40% and Q2 margins of 44%. In this context, our 40% margin forecast for FY17 looks realistic. We base our cost forecasts on management guidance, the margin improvement witnessed over H117 and on a realistic (company definition) EBITDA margin target of c 40%.

We forecast FY17 capex will increase to c RUB8bn in line with company guidance. The bulk of the investment (c RUB5bn) will be in new flatcars, which will be required due to high levels of current demand growth.

TRC Chairman Andrey Starkov, a graduate of the Moscow State Textile University and the Moscow State University of Economics, previously carried out several roles at JSC RZD. General Director of TransContainer Petr Baskakov and his team have managed the business over the last decade. Mr Baskakov, in common with several other directors, has had a long career in the Russian rail industry. His 24 years in the industry started after graduating from the Moscow Institute for Railway Transport Engineers in 1986 with a degree in the management of railway transportation processes.

TRC has sensitivities ranging from macro factors such as economic output to several technical factors such as illiquidity:

We take two valuation methodologies into account in arriving at our fair value of RUB4,900 per share, an increase of 37% from our previous fair value of RUB3,580. We compare TransContainer to its closest listed peers on an EV/EBITDA basis and apply a 7.0x multiple to the company’s next full year EBITDA, which is a 23% discount to the global average, and implies a fair value of RUB4,750 per share. We also conduct a DCF analysis (WACC 9.8%, terminal growth 3%), which implies a fair value of RUB5,051 per share. The average of the two methodologies is RUB4,900 per share, which offers investors 23% upside. This fair value increase is primarily driven by the enhanced cash flow outlook for the business as well as a lower cost of capital in the case of the DCF and slightly higher multiple (7.0x vs 6.7x) in the multiple-derived model, as well as the benefit of a rolled-forward (and increased) EBITDA forecast.

As shown in Exhibit 6, the global average of transportation and logistics stocks is 9.0x next year EV/EBITDA. However, the same figure for Europe-listed names is only 5.2x, while in emerging markets the figure is 13.7x, albeit this is skewed by one outlier. Stripping out the effect of this one stock, the average is 7.6x. Furthermore Globaltrans, another Russian freight company, trades at 4.8x one-year forward EV/EBITDA. In this context and taking into account TransContainer’s mixture of emerging and developed market exposure, in tandem with macro/commodity and geopolitical risk, we believe a 7.0x one-year forward EV/EBITDA multiple is appropriate. The fair value per share implied by this is RUB4,750 per share.

See Exhibit 6 for a global peer comparison.

Our DCF implies a fair value of RUB5,051 per share. We explicitly forecast four years of cash flows, discount them at 9.8% and apply a 3% terminal growth rate.

In Exhibit 8 we flex our DCF assumptions and find that for a 1% increase in our WACC assumption, our fair value per share decreases by RUB810 (16%), and for a 1% decrease in our WACC assumption our fair value per share increases by RUB1,089 (22%).

We increase our earnings across the forecast period to reflect the much enhanced reported operating performance at H117. Our 26% FY17 and 21% FY18 (company definition) EBITDA forecast increases are driven by 12% adjusted revenue forecast increases in both years together with operating cost control delivering a return to 40% EBITDA margins (company definition). This flows down the income statement resulting in an increase in underlying EPS of 41% in FY17 and 29% in FY18. We increase the dividend payout ratio to reflect the improved operating performance. Despite our capex forecast for FY17 remaining unchanged, our net debt estimate for FY17 is higher as a result of a higher than expected dividend payment (totalling RUB5.45bn).

H117 numbers showed TransContainer is operating in a very strong market and, through its focus on operating and cost efficiency, is able to convert this into strong earnings growth. Our three-year (company definition) EBITDA CAGR of 20% and underlying three-year EPS CAGR of 25% demonstrate its strong growth trajectory.

TransContainer will increase its capex spend during FY17 as it invests in new flatcars. Thereafter we forecast the group will reduce capex to the RUB5bn to RUB6bn range. We forecast the group will payout 40% of underlying earnings to shareholders, which will equate to a cash payment of c RUB2.5bn (note this comes after a large RUB5.45bn dividend payment relating to FY16, paid in FY17). Therefore, from FY18, based on operating cash flows of just over RUB10bn, TransContainer will generate enough cash flow to finance its capital requirements and dividend obligations while also paying down a moderate amount of debt. That said, net debt to (company definition) EBITDA of 1.1x in FY17 and 1.0x in FY18 do not give cause for alarm and are, in fact, another indicator of a company positioned sensibly for cyclical end markets.