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Trinity: On Track for Solid Growth

From Standard & Poor's Equity Research

We expect Trinity Industries (TRN

; recent price, $38) to continue to maintain its leading North American railcar market share of about 30%, given its diversified fleet and solid backlog. Additionally, the company's other business segments are performing well, with strong demand for barges, construction products, and wind towers, while it continues to expand its leasing operations. We also believe the company will benefit from the new federal transportation and energy bills enacted in 2005.

Based on the company's solid railcar and barge backlog, strength in all segments and improved operating efficiencies, we look for further margin expansion and solid earnings growth.

Additionally, we believe the stock's valuation is compelling, with the shares trading at a discount to its industry peers and about 28% below our 12-month target price of $53. Given these attributes, we see the stock significantly outperforming the S&P MidCap 400-stock index over the next 12 months. Our recommendation is 5 STARS (strong buy).

BUILT-IN AGILITY. Trinity is a more than $3 billion (revenues) railcar manufacturer, which also makes highway construction products, inland barges, and energy equipment. It also offers railcar leasing and management services, and it has foreign operations in Brazil, the Czech Republic, Mexico, Romania, Slovakia, and Britain. In 2005, foreign customers—mainly in Europe and Mexico—accounted for nearly 7% of revenues.

The leading freight railcar manufacturer in North America, Trinity provides a variety of railcars used for transporting liquids, gases, and dry cargo. The rail group manufactures tank cars, auto carrier cars, hopper cars, boxcars, intermodal cars, gondola cars, and specialty cars. We believe the production of a wide range of railcars allows Trinity to benefit from changing industry trends. Customers include railroads, leasing companies, and shippers, such as utilities, petrochemical companies, grain shippers, and major construction and industrial companies.

Railcars accounted for 54% of total revenues in 2005, with operating profits of $94 million. The construction group (23% of 2005 revenues; $64 million in operating profits) makes highway guard-rail and barrier systems and girders. The concrete and aggregates unit makes ready-mix concrete, aggregates, and baggage-handling systems. The inland barge group (8.3%; $16 million in operating profits) produces river hoppers, inland tank barges, and fiberglass barge covers. Trinity is the largest U.S. producer of inland barges, and one of the largest producers of fiberglass barge covers.

WIND WINDFALL? Railcar leasing and management services (7%; $56 million in operating profits), mainly under Trinity Industries Leasing, leases specialized railcars to industrial companies in the petroleum, chemical, grain, food-processing, fertilizer, and other industries.

In the third quarter of 2005, due to an increase in structural wind tower revenue, the company restructured its industrial-products group to include its structural wind tower operations, and renamed the segment the energy equipment group. The increased revenue is due, in part, to the Energy Act of 2005, which provides production tax credits on wind-generated energy. Trinity projects wind tower revenues of over $120 million in 2006, up from $67 million in 2005 and $11 million in 2004.

Trinity's long-term goal is to ship between 35% to 50% of its North American railcars from Mexico. Recently, 33% of the company's railcars were being produced in Mexico. We believe North American railcar margins will expand on improved operating efficiencies, mainly reflecting low-cost production in Mexico. Shipments from a new facility in Mexico began in the 2006 second quarter, and production output at the facility is expected to expand within 18 months to 24 months. Furthermore, we expect margins to benefit as new orders are priced with current steel costs over the next few months, replacing the fixed-price agreements currently in Trinity's backlog.

WEAKNESS IN EUROPE. The company continues to review its strategic options for what we view as its weak European railcar business. This business continues to incur losses, although the market showed some signs of recovery in first-quarter 2006.

At Mar. 31, 2006, the company's debt-to-capital ratio was 38.6%, up from 37% at year-end 2005. Debt levels have trended upward in recent years, from a 21% average ratio over the past nine years through 2005, to 33% during the past three years. Meanwhile, following a cyclical downturn in the railcar industry, from basically 2000 through 2003, revenues soared in 2004, with growth averaging nearly 28% over the past three years, vs. 11% for the five-year period ending in 2005.

Operating earnings before interest, taxes, depreciation, and amortization (EBITDA) margins have widened in each of the past four years, reaching 9.7% in 2005, up from 6.8% in 2002. We see this favorable trend continuing for at least the next two years. In our view, free cash generation (cash flow from operations less capital expenditures) will be positive this year, reaching about $150 million. We project free cash flow of nearly $200 million for 2007.

COST EFFICIENCIES. We believe Trinity's financial strength positions it to fund niche acquisitions and other initiatives, while accelerating its top-line growth and continuing to return cash to its shareholders in the form of dividends. The recent yield on the stock was 0.6%.

For 2006, we project 15% revenue growth, primarily reflecting increased demand for North American railcars. We also see strength in the railcar leasing, construction products, inland barge, and energy equipment segments. We expect demand to remain strong during 2007, although growth may moderate slightly.

We look for operating margins to expand by more than 200 basis points in 2006, to 12.5%, as sales orders are priced with current steel costs, replacing the fixed-price agreements in Trinity's backlog over the next few months. We believe North American railcar margins will widen on pricing pass-throughs and improved operating efficiencies, and assuming no major steel supply problems. Employee-training costs should decline and see less price erosion, and we anticipate fewer order delays and supply shortages.

RAILCAR-ORDER BACKLOG. For 2006, we project earnings per share (EPS) of $2.30 (including the deferral of 57 cents a share on railcar sales to the leasing group from the rail group and $0.03 of projected stock option expense). For 2007, we forecast EPS of $2.95. (All figures are adjusted for a 3-for-2 stock split in June, 2006.) The company recently increased its EPS guidance for the 2006 second quarter by 8 cents, to a range of 60 cents to 65 cents, based on strength in all businesses, especially in the rail and barge groups, and favorable construction weather in the Southwest.

We see a further improvement in the North American railcar business, as shipments in the first quarter of 2006 reached their highest level in five years, while the barge business rebounded as well. In the first quarter, the company received new orders for 12,941 railcars in North America (about 35% of total industry orders). Trinity's backlog was 25,541 railcars ($1.9 billion), 29% of the industry's 88,100 units, which is the highest industry backlog since 1998. About 91% of the company's railcar backlog was covered by price escalators or had the higher steel costs locked into the contracts.

Trinity is now targeting railcar shipments of 6,200 to 6,600 units per quarter during 2006, following shipments of 6,164 railcars in the first quarter, its highest quarterly total since 1999. We expect railcar shipments to approach 26,000 units in 2006, following shipments of almost 23,000 in 2005.

COMPELLING VALUATION. The continued growth in its leasing business should help Trinity develop long-term relationships with the end users of its railcars, resulting in a stable earnings stream. The average age of the railcars in the lease fleet was recently 4.8 years, which an average remaining lease of over six years. Lease backlog at the end of the first quarter of 2006 comprised 45% of the company's North American production backlog. We expect lease rates to continue to rise due to a high fleet utilization, new railcar building, and an increase in new railcar prices.

Our Standard & Poor's Core Earnings estimates for 2006 and 2007 reflect a minor adjustment to pension costs. Trinity expects to contribute $17.9 million to its defined-benefit pension plans in 2006. It also sponsors defined-contribution profit-sharing plans. Stock option expenses are now included in our operating earnings estimates, as new accounting standards require all employee stock options to be expensed. We estimate $3.8 million (pretax) in stock option expense for 2006, which translates to 3 cents per share on an after-tax basis.

We view the stock's valuation as compelling, recently trading at 17 times our 2006 EPS estimate of $2.30, and 13 times our 2007 EPS estimate of $2.95, both below Trinity's closest peer levels and at a modest discount to the S&P MidCap 400. Based mainly on our favorable outlook for the railcar business for at least two more years, and our relative valuation metrics, which include a 2006 price-earnings-to-5-year EPS growth rate (PEG) of 0.85 times, vs. the S&P MidCap 400's 1.1 times, we believe the stock deserves a forward p-e multiple above peer and historical averages. Additionally, the shares are trading 20% below our intrinsic value calculation of $47, based on our discounted cash flow model.

ASSESSING THE RISKS. We arrive at our 12-month target price of $53 by blending these metrics, applying a p-e multiple of 23 times to our 2006 EPS estimate.

We view Trinity's corporate-governance practices as generally sound, although we have some concerns related to board issues. Positive aspects, in our view, are that directors receive all or a portion of their compensation in the form of equity, the audit committee is comprised of independent outside directors, no former chief executive officer serves on the board, and there were no "related party" transactions involving the CEO.

Negative factors, in our opinion, include the fact that the positions of chairman and CEO are combined, the compensation and nominating committees include affiliated outsiders, and the board is authorized to increase or decrease the size of the board without shareholder approval.

Risks to our recommendation and target price, in our opinion, include inadequate steel and other basic material supplies, delays in ramping up production, a cyclical downturn, sharply higher interest rates, customers not fully accepting steel price pass-throughs, further weakness and losses in the European railcar segment, and a loss of market share as the company's competitors lower prices.

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