TransContainer — Revenue and cost initiatives paying off

TC is the leading intermodal container transportation and logistics company in Russia and the Commonwealth of Independent States (CIS). The company has a 43% share of the Russian rail container market. It is benefiting from an increased rate of rail containerisation in Russia, but at 6.2%, potential containerisation rates remain considerably below other countries. TC has transitioned from a point-to-point logistics company to one able to handle customer orders across the whole supply chain, so that Integrated Services now accounts for 82% of adjusted revenues. The company’s EBITDA margin has risen, boosted by the higher profitability of Integrated Services and efficiency savings coming from an increase in profit-making runs and the amount of containers that travel in block trains.

We continue to value TC at RUB5,200/share, which is a 12% premium to the current share price of RUB4,640. Our valuation is based on a DCF model, which we believe is appropriate for a cash-generative company like TC. Our DCF uses a WACC of 10.4%, to reflect Russian country risk, and a terminal growth rate of 1%. TC seems undervalued on a 2019e P/E of 9.2x compared to the average of our international peer group of rail-related companies at 15.9x, although some discount is probably merited for Russian risk.

Q218 showed 6% adjusted revenue growth and 13% EBITDA growth y-o-y. Adjusted revenue was boosted by containerisation and recovery in the Russian economy. We think TC’s adjusted revenue outlook is strong as the Russian rail container market saw acceleration in volumes in July. Moreover, the World Bank expects Russia’s economy to strengthen further in 2019.

TC’s EBITDA margin rose from 43.8% in Q217 to 46.7% in Q218, due mainly to a 5% reduction in costs as profit-making runs increased. We expect the annual margin to rise from 41.3% in FY17 to 45.2% in FY20, as we see upside from operational gearing, mix and ongoing productivity improvements (note that Q2 is a seasonally stronger quarter).

To support growth, TC is increasing capex, having cut back during the recession. We believe the company has the balance sheet capacity to finance more capex, while supporting a 50% dividend payout, with net debt/EBITDA of only 0.7x in Q218. We model the ratio peaking at 1.9x in FY20 as capex increases.

TC is the leading intermodal container transportation and logistics company in Russia and the CIS. It operates 25,405 flatcars, 67,909 ISO containers, 60 rail-side container terminals, 175 trucks and 312 semi-trailers. The company was established in 2006, having formerly been part of JSC Russian Railways (RZD), the Russian rail network owner, and fully listed, in both Moscow and London, in 2010. In 2014, RZD contributed its 50%+ two-share stake in TC to JSC United Transportation and Logistics Company (UTLC). UTLC is a 100% subsidiary of RZD.

TC’s customer and sector base is well diversified (Exhibit 1). Note that oil and petrochemical is part of the ‘Other’ category.

Management’s strategy is based around four areas (Exhibit 2).

TC’s adjusted revenue fell during the last Russian recession, when GDP contracted by 2.8%, but has since recovered and reached a new peak (Exhibit 3).

The Russian rail container market saw 9.0% CAGR (2001-07) due to a mix of Russian real GDP growth and containerisation.

Since 2016, the Russian rail container market has seen y-o-y growth each month (Exhibit 6). Growth accelerated from 11.9% in Q218 to 16.5% in July, which bodes well for TC’s Q318 results.

The Russian rail container market should benefit from a strengthening economy, especially given that container growth is procyclical (Exhibit 7). The Russian economy is recovering from the disruption caused by international trade sanctions in connection with the conflict between Russia and Ukraine over Crimea in 2014 and benefiting from a rise in energy prices, although new sanctions, the sell-off in emerging markets and the weakness of the Russian rouble could provide a headwind.

Currently only 6.2% of Russia’s potentially containerisable rail cargo is actually transported in containers and although this figure rose from 2.2% in 2001 it is still much lower than in the US (18%), India (16%) and Europe (14%). There are a number of factors that are boosting containerisation:

TC is the leader in the rail-based container transportation market, with a 43% share, and as a result enjoys a considerable scale advantage (Exhibit 10). That said, TC has gradually lost market share as the market opens up. It is also the leading independent company in the rail-side container terminal handling market.

One of TC’s goals is to increase the proportion of revenues generated by Integrated Services away from the historical origins of point-to-point transportation as it seeks to control more of the logistics of container handling. In the last three years, Integrated Services has risen from 62% to 82% of revenues (Exhibit 11). To facilitate this transition, TC has invested in rail terminal handling and last mile transportation.

We model TC’s revenue by division (Exhibit 12). The company switched to a simpler divisional classification in FY18. The company’s definition excludes third-party charges from revenue as these are passed straight through to customers.

In FY17, TC generated 14% of its revenues from customers outside Russia (Exhibit 13).

TC’s international exposure is even higher than the direct revenues suggest, as the non-domestic segments (transit, import and export) comprise 53% of transport volumes (Exhibit 14).

TC’s market share is slightly higher on domestic routes, suggesting it could aim to gain share on international ones (Exhibit 15). We think international expansion is important for the long term growth of the company given that it is already the market leader in Russia.

TC has a presence in Russia and in other countries of Europe and Asia (Exhibit 16). Management is keen to grow its international operations, with the company recently strengthening its China base and launching new routes across Mongolia. Management has also set out the ambition to target routes to India and the Gulf states.

TC’s EBITDA margin declined during the last Russian recession as revenue fell, but has recovered to a new peak (Exhibit 17). Management had previously targeted a 40% margin and this was exceeded in FY17.

TC’s main costs, excluding third-party costs, are directly from handling freight and transportation (32%), and employee costs (28%) (Exhibit 18). Management has said that costs are fairly evenly split between fixed and variable.

Generally, TC has been able to grow revenue ahead of costs and shown good cost control management. However, during downturns the cost base leads to some negative operational gearing. For example, TC’s costs declined by 10% during the downturn in FY14, albeit not enough to offset the 19% reduction in revenue (Exhibits 19 and 20). In our forecasts, we assume some cost growth linked to volumes, but that TC can continue to be productive and thus increase the margin.

TC’s EBITDA margin has risen sequentially since 2015, in part due to the benefit of operational gearing as revenues recovered. Another tailwind has been the rising proportion of Integrated Services revenues, which we believe are higher margin, although TC does not split out the divisional margins, as they offer a more valued-added service to customers and are more scalable.

The company has planned better, thus increasing the proportion of profit-making runs, for example by balancing import and export routes, which reached a high of 81.1% in H118 (Exhibit 21). When there are empty runs, the costs are allocated to ‘freight handling and transportation services’, which is mainly why these costs reduce proportionally when profit-making runs increase.

TC has also improved efficiency by increasing the proportion of containers transported in block trains, for which it receives a discount from RZD as they take up less capacity on the railway (Exhibit 22).

TC’s Q218 results showed a further y-o-y improvement, especially at the EBITDA level (Exhibit 23). Adjusted revenue growth was 6%, less than the 10% in Q118, but EBITDA showed a 13% increase after 14% in Q118.

Adjusted Revenue growth was fastest in Integrated Services, which partly came at the expense of the ‘Other’ category as customers switched services (Exhibit 24). We forecast 9% CAGR in revenue supported by forecast GDP growth (2018-20e), led by an 18% CAGR in revenues from Integrated Services. Our 9% CAGR forecast is less than the 26% growth in FY17, albeit that year benefited from Russia’s economic recovery.

The Q218 margin increase was boosted by a 5% reduction in costs, despite a 6% increase in revenue (Exhibit 25). The main reason for this was that a further rise in the proportion of profit-making runs led to a further reduction in freight handling and transportation services costs, which declined by 19%.

We forecast a further improvement in the EBITDA margin to 45.2% in FY20 due to the operational gearing from higher revenue, a mix benefit from a higher proportion of revenues coming from Integrated Services and further efficiency improvements.

Capex is TC’s main capital requirement, reflecting its asset-intensive business model. However, the company is able to flex capex through cycles, for example it stopped spending on flatcars during the last recession (Exhibit 26). Management has said that capex will increase over the next three years, mainly on new flatcars, to support an improved trading outlook.

TC’s ability to flex its capex is helped by its average flatcar age of 15.3 years, compared to a useful life of 32 years (Exhibit 27).

TC has maintained a strong balance sheet position. Net debt of RUB2.25bn at end H118 was almost unchanged vs the end-FY17 position and represented just 0.19x net debt/EBITDA (Exhibit 28). We model an increase in net debt due to the rise in capex, which supports a new peak in revenue, but the net debt/EBITDA at peak is still only 1.86x. All of TC’s debt is rouble denominated and fixed rate, with most financed by bonds.

We assume a 50% dividend payout, which is the policy for state-owned companies.

Both chairman Andrey Starkov and chief executive Petr Baskakov have a long history in the Russian railways industry. Mr Starkov is currently deputy CEO of the Russia Railways and Mr Baskakov has been CEO of TC since 2006. We believe management has demonstrated good cost and capital management during the recessions in Russia, as well as pursuing a range of growth and efficiency initiatives.

We use a DCF model to value TC, which believe is especially suitable for cash-generative companies like TC. Our DCF value is unchanged at RUB5,200/share and provides 12% upside to the current share price of RUB4,640 (Exhibit 29). We use a WACC of 10.4%, to reflect Russian country risk, and a terminal growth rate of 1%. During our forecast period (2019-29), we model 8% CAGR in revenues, as TC benefits from a recovering Russian economy and ongoing containerisation, backed by the large increase in capex. We also increase the EBITDA margin from 41.3% in 2017 to 46.1% by 2029, primarily due to operational gearing from higher revenue. The next scheduled event will be the Q318 results in November, which could be a positive catalyst if the current growth trend continues.

In the table below we set out the sensitivities of our DCF to different levels of WACC and revenue CAGR (Exhibit 30).

For the peer group, we have chosen companies who operate in rail freight (Exhibit 31). On a 2019e P/E of 9.2x, TC trades at a 42% discount to the average of 15.9x of this group, which we believe primarily reflects a Russian discount. That said, we note that TC trades at a premium to Globaltrans, another quoted Russian rail freight company, which trades on 7.3x FY19e P/E.