GATX: Closer, But Not Yet

It's been just under three months since I suggested that GATX Corporation (NYSE:GATX) is an interesting business, but has too much risk in an article with the mind-numbingly original title "GATX: Interesting, But Too Risky." Since then, the shares have lost about 17% against a loss of about 5% for the S&P 500. While this gratifies my fragile ego, it means that I need to revisit the name. After all, the company has reported earnings again, and a stock trading at $108.22 is, definitionally, a less risky investment than the same stock when it's trading at $131. I'll decide whether or not to buy the stock based on the combination of the latest financials and the current valuation. Additionally, I need to put the current valuation in the context of the 10-year Treasury Note to see if investors are being adequately compensated for the risks of investing in a stock relative to alternatives.

I like to buy shares when they're more cheaply priced. The word "cheap" can have a very obvious, but also a more subtle meaning. A stock trading at $108.22 is obviously a cheaper investment than when it's trading at $131. There's a more subtle definition of "cheaper" that we should consider alongside this one in my view. We want to consider how many units of risk an investor must pay in order to earn a given return. On this basis, the investment with the higher price may actually be much cheaper because it offers a return that is more certain. When that return with its higher levels of certainty comes with higher cash flows, then fuhgeddaboudit. With that preamble out of the way, I'll point out that I'm going to continue to eschew these shares, though it's much more emotionally difficult for me to do so today than it was in July. The problem, in my view, is that investors in this stock will receive significantly less income from this "dividend king" than they would from a 10-Year Treasury Note. Additionally, the Note comes with zero uncertainty, unlike this highly levered stock. The shares may rally from here, and I'll miss out on those gains, but I really like my sleep. When I can earn more cash risk-free, owning the stock is pointless in my view. All that written, I fully acknowledge that the company is an excellent inflation hedge, and that operations are doing really well, and that the dividend is well covered. In my view, the only risk here is the capital structure, but that can be worked out over time. In the relativistic world of investing, though, the stock is just not compelling. TINA no longer exists.

Financial Snapshot

Before getting into the financials, I want to repeat a point I made in my previous article because I think it's important. GATX is an excellent inflation hedge in my view. The company owns a large number of hard assets around the world, which is part of the hedge. Additionally, lease rates are priced against the alternative, which is obviously to build a new railcar. If inflation drives the cost of the new car higher, through higher steel input costs for instance, then the lease rates follow suit. I think that's an important element to this story to keep in mind when reviewing the latest financial results.

In my view, these results here have been blemish free apart from the deterioration in the capital structure. Revenue, and net income were up by 8.4% and 79.5% respectively when compared to the same period last year, and up by 25.3% and 22.24% in 2018. EPS is higher in 2023 than 2022 by $1.69 or 72%. The result of this is that the company has been able to increase the dividend yet again, but the payout ratio has plummeted to 28.4%. As I wrote above, GATX has benefited from inflation by having the economic power to raise their lease rates. I can't say how long this dynamic will persist, but it's been an obvious boon for the business.

The only problem, from my perspective, can be found in the capital structure. The level of indebtedness has increased by about $510.1 million, or 8.13%, and, as a result, interest expenses are up 19% from the year ago period. Indeed, long-term debt is up by about 54% since 2018, which is quite a startling jump in only five years. I would like to see the company make some serious efforts to clean up the balance sheet over the next few years.

That written, though, I think the dividend remains very well covered, and I'd be happy to buy this stock at the right price.

The Stock

Those who read my stuff know that I treat the stock as a thing quite distinct from the underlying business. The business is a global railcar lessor, obviously. The company makes money leasing rolling stock. The stock, on the other hand, is an ownership claim on the future cash flows of the company, and the stock bounces around fairly dramatically in price, much more dramatically than should be justified by anything that happens at the company. In other words, the company doesn't change that much from day to day, but the stock rises and falls dramatically. Additionally, the stock is affected by things that have little to do with the business, like the demand for "stocks" as an asset class. Given that, I think it makes sense to take as little risk when buying stocks as possible, and the way we do that is by buying stocks when they're cheaply priced. Cheaper shares are lower risk for the very obvious reason that they don't have as far to fall as shares that are priced more dearly.

Those who read me regularly know that I measure the cheapness of a stock in a few ways, ranging from the simple to the more complex. On the simple side, I like to look at various ratios, and I want to see a stock trading at a discount to both its own history and the overall market. When I last reviewed GATX, the PE ratio was about 29.5 times, the PS ratio was about 3.6 times, and the dividend yield was a paltry 1.65%, which was 212 basis points lower than was the 10-Year Treasury Note at the time. At the moment, the shares are about 40% cheaper on a PE basis, and about 19.5% cheaper on a PS basis. Additionally, the dividend yield has risen by about 21%, per the following:

Source: YCharts

Source: YCharts

Source: YCharts

All of this is encouraging in my view. Consider the following, though. At the moment, the rolling 12-month dividend will be $2.20 and the price is about $108.22. Using the arithmetic skills not so lovingly beaten into me by the good sisters at Holy Spirit School years ago, I can calculate that that represents a dividend yield of just over 2%, which is about 270 basis points below the level of the 10-Year Treasury Note. So the situation has improved somewhat, but it's still not great in my view. For instance, even if we assume that the company will grow the dividend at the same rate that it has over the past decade (CAGR of 5.9%), then in the year 2033, annual dividend payments will be only $3.90. That would represent a dividend yield on today's stock price of about 3.6%. In other words, even with fairly robust dividend growth over the next decade, an investor would still receive far less income from this investment than they would from a risk-free investment.

At this point, you may be prompted to ask "exactly how much more income would the investor in the risk-free investment earn?" I'm glad you asked me that, my rhetorically convenient friend. If we assume the dividend will grow at a CAGR of 5.9% over the next decade, the common stock investor will receive $32.76 in cash from dividends. If, instead of buying the shares, the investor buys the 10-Year Treasury Note, they'll receive $55.95 in income from that investment. I don't need Sister Winifred looming over me with a huge ruler in one hand, and a "sometimes rosary, sometimes flail" in the other to know that $55.95 is greater than $32.76. There are obvious tax implications for both strategies, though, and every individual's situation is different. If the cash flows are earned within a tax sheltered account, there's no contest that the 10-Year Note is the superior investment in my view. Additionally, the level of risk here is quite different. An investor who buys the Treasury Note would live a much more predictable life, knowing exactly how much they will receive and when. The owner of the stock, on the other hand, may start to read more articles like this one, where a stranger on the internet causes them to fret about an overly levered balance sheet leading to slowing dividend growth.