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Industry Outlook

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Despite the uncertainties surrounding the demand for U.S. coal, railroads delivered stellar first quarter results. Contrary to market expectations, freight railroads emerged unscathed by coal's woes, with most of the big players surpassing their earnings estimates.

According to market reports, North American Class I railroads registered growth of approximately 29% in their first quarter earnings. Strong pricing coupled with commodities volume, effective cost management and improved rail efficiency helped U.S. railroads to continue their strong performances.

The railroads continue to benefit from the ongoing highway conversion due to the significant rise in fuel costs of truckers. Currently, rail intermodal services are considered one of the most fuel-efficient modes of fright transportation, and therefore remain the backbone of the railroad freight business.

Railroads’ Network of Operation

The vast geography of the U.S. is covered by over 600 freight railroads comprising Class I, regional railroads and local line haul operators. These railroads operate across 150,000 miles of railroad tracks and generate over $50 billion in annual freight revenues.

Based on their operating revenues, freight railroads are categorized into three segments: Class I with annual operating revenues above $346 million, Class II with revenues in the range of approximately $27.8 million to $346 million, and Class III for the rest. These operating revenue based classification standards are generally set by the Surface Transportation Board (STB). However, in light of inflation and the changing macroeconomic environment, the revenue benchmark is subject to change.

Currently, there are 9 major railroads in America that are classified under Class I freight railroads. These include Union Pacific Railroad (UNP - Analyst Report), CSX Corporation (CSX - Analyst Report), Norfolk Southern Railway (NSC - Analyst Report), Canadian National Railway (CNI - Analyst Report), Canadian Pacific Railway (CP - Analyst Report), BNSF Railway, Kansas City Southern Railway (KSU - Analyst Report), Ferromex and Kansas City Southern de México (wholly owned subsidiary of Kansas City Southern Railway).

These carriers can be further categorized based on their network of operations. BNSF Railway, Canadian National, Canadian Pacific, CSX Corp. and Norfolk Southern have their presence in the U.S. as well as Canadian Market. Union Pacific operates only in the U.S. with no footprint in Canada or Mexico. It represents the largest freight railroad that predominantly operates on the western part of the U.S. While Kansas City Southern Railway operates between the U.S. and Mexico, Kansas City Southern de México and Ferromex cater to the Mexican market.

Although these Class I carriers merely represent 1% of the total freight railroads in America, they dictate more than 90% of the freight revenues and employment generated in the industry. Consequently, they represent the performance indicators of the rail industry and are therefore crucial for analyzing railroad trends.

First Quarter Flashback

As mentioned earlier, railroads’ performance in the first quarter of the year was well above market expectation. The Class I carriers made a positive head start that rose above the negative sentiments hovering around them.

Beginning with Union Pacific, the company delivered adjusted earnings of $1.79 per share, up 38.8% from the year-ago quarter. Revenue climbed 16% year over year to a record $5.1 billion.

CSX Corporation reported earnings of 43 cents, up 23% year over year. Revenues registered an uptrend with almost 6% growth year over year. Norfolk Southern’s earnings grew 25.6% to $1.13 per share. Revenue also grew substantial from $2.6 billion to $2.7 billion. Kansas City Southern delivered 29.3% earnings growth to 75 cents per share and total revenue of $547.5 million, up 12.1% year over year.

The same story goes for the top Canadian railroads, Canadian National and Canadian Pacific. Canadian National’s adjusted earnings in the first quarter shot up 31% to C$1.18 backed by revenue gains of 13% year over year to C$2,346 million. Canadian Pacific reported a robust quarter with a whopping 310% increase to 82 Canadian cents per share from 20 Canadian cents earned a year ago.

Primary Catalysts

According to Association of American Railroads (AAR) reports, North American railroad traffic (including U.S. and Canada) dropped 1%, primarily due to an 8.6% decline in coal volumes. However, Intermodal volumes were up 3.3%.

Apart from coal, agricultural & food products (down 3.7% in the first quarter) and chemicals (down 4.5%), most of the product lines aided the first quarter results.

Railroads benefited the most from petroleum products and automotive shipments that grew 24% and 16.6%, respectively, in the reported quarter. Trailing behind were metals (comprising iron and steel products, ores and scrap) and nonmetallic minerals (includes frac sand, gravels, stone glass products) shipments that grew 9.4% and 7.3%, respectively. Forest products -- constituting wood, lumber, pulp and paper -- also went up 3.1% year over year.

Despite the modest growth in carloads, railroads managed to showcase an outperforming quarter due to the current momentum in freight pricing and fuel surcharges. The upsurge in the rail Intermodal services driven by a demand shift from the truckload market is allowing railroads to gain through higher freight pricing.

Additionally, fuel surcharges allow railroads to pass on higher fuel expenses to shippers and continue to aid revenue. As a result, railroads are witnessing solid yield improvements despite the lacking strength in volumes.

Coal – Concern or Opportunity

As speculations continue to surround coal, it becomes even more difficult to estimate the exact implications of this product on the U.S. railroads. Although current market reports provide a murky road ahead for coal shipments, we believe there are some windows of opportunity that can, to some extent, pull back declining coal carloads.

Coal, representing one of the single-most important commodities, accounts for over 40% of railroad tonnage. Coal gained significant market traction given the emerging position of the U.S. as the global coal export hub. Global supply constraints for export coal due to disruptions in Australia and the growing demand for coal in Asian countries for steel manufacturing elevated the market position of the U.S. coal exports.

However, coal volumes registered a setback from the second half of 2011, given lower coal production by the U.S. producers. Following this, the U.S. Energy Information Administration (EIA) projected a lower coal production outlook for 2012.

According to the EIA report, U.S. coal exports are expected to decline to an estimated 100 million short tons (MMst) in 2012 from 107 MMst in 2011. The decline is primary related to the recoveries in Australian mining activities. Further, in the domestic market, utility coal which accounts for approximately 93% of the domestic coal demand is witnessing persistent falls.

Lower natural gas prices are largely substituting the demand for utilities. Additionally, higher stockpile levels and warmer winter weather also resulted in lower utility coal demand.

However, in 2013, the EIA projects that electricity generation from coal will increase 7%, as coal prices would moderate while natural gas prices would gain some upward momentum. The EIA also projects coal’s share in the U.S. electricity generation to increase 40.9% in FY13 from 39.3% in FY12.

Railroads along with shippers are making efforts to reduce transportation cost to make U.S. coal more economical for the domestic market. As a result, declines in domestic volumes are expected to moderate. Further, the post summer period this year may mark some improvements in the utilities volume given the expected rise in electricity generation and replenishment of stock piles.

Going forward, utility coal exports are gaining momentum with demand mostly from Asian and European markets. Many developing countries are in the process of building electricity grids that are expected to bode well for U.S. utility coal.

Other Freight Commodities

Apart from coal, grain shipments are also expected to pose near-term headwinds for the railroads. U.S. grain exports are trending downward mostly due to higher supplies from the emerging markets and corn supplies mainly through truck to ethanol facilities.

Additionally, higher prices of U.S. grain also limit exports to the global market. The strength in U.S. dollar and the economic slowdown due to European debt crisis are also important factors adversely affecting the U.S. agriculture and commodities markets.

However, petroleum products are one of the major growth areas that railroads can benefit from over the near term.  According to AAR reports, petroleum product volumes soared 43% year over year in April 2012 given higher crude oil shipments.

Further, North American auto production is estimated to be over 14 million vehicles this year, up by almost 13% from 2011. The projection implies greater profits for the railroads. According to AAR, railroads registered 17.5% higher carloads in Automotives in April compared to the year-ago month.

Additionally, low natural gas prices would generate new ethane-based production units, resulting in more chemicals and plastics shipments. The chemicals business retains competitive pricing by the U.S. chemical producers, which have in turn benefited from the boom in shale drilling activities and lower natural gas prices.

OPPORTUNITIES

The railroad industry as a whole offers a number of attributes that are difficult to ignore from the standpoint of investors.

Discretionary Pricing Power: The freight railroad operators function in a seller’s market and have enjoyed pricing power since 1980, when the U.S. government adopted the Staggers Rail Act. The idea was to allow rail transporters to hike prices on captive shippers like electric utilities, chemical and agricultural companies in order to improve profitability of the struggling railroad industry. As a result of the Staggers Rail Act, railroads are hiking their freight rates by nearly 5% per annum on average, while maintaining a double-digit profit margin.

Duopolistic market structures: Railroads have by and large gained by practicing pricing discretion in the freight market. In the prevailing duopolistic rail industry, railroad operators are able to reap maximum benefits from rising prices when the overall demand grows.

This remains evident by the geographic distribution of markets between major railroads. The western part is controlled by Union Pacific and Burlington Northern Santa Fe, while the eastern part is controlled by CSX Corp. and Norfolk Southern. On the other side, Canadian Pacific and Canadian National control inter country rail shipment between the U.S. and Canada.

Momentum in Intermodal: The railroad industry is largely gaining from the ongoing conversion of traffic from truckload to rail intermodal. Shippers are increasingly attracted to intermodal given its cost effectiveness over truck. On average, railroads are considered 300% more fuel efficient than the trucks and given the uptrend in fuel prices, we believe that intermodal will play an important role in driving the rail industry.

Challenges

Despite the above mentioned positives, the freight railroad industry, like other industries, faces certain external and internal challenges. These are as follows:

Positive Train Control Mandate: The Rail Safety Improvement Act 2008 (RSIA) has mandated the installation of PTC (Positive Train Control) by December 31, 2015 on main lines that carry certain hazardous materials and on lines that involve passenger operations. The Federal Railroad Administration (FRA) issued its final rule in January 2010, on the design, operational requirements and implementation of the new technology. The final rule is expected to impose significant new costs for the rail industry at large.

According to the FRA, PTC installation would require over $5 billion in investment by the freight rail industry through 2015. Financial benefits from PTC can only be seen over a period of 20 years, as savings of up to $440–$674 million. As of January 2012, Congress was trying to extend the PTC deadline beyond 2015 in order to bring some respite to U.S. railroads.

Price Regulations: The pricing practice of the U.S. freight railroads is a major cause of friction with captive shippers which move their products through rail and do not have effective alternatives. Per the latest studies by STB, approximately 35% of the annual freight rail is captive to a single railroad, allowing it monopoly pricing practices. The unfair pricing power exhibited by the U.S. railroads has summoned congressional intervention for exercising stringent federal regulations on the railroads. Congress has discussed railroad price regulation but has not passed any new rule so far.

In February 2012, shippers forwarded a joint letter to the Congress appealing to support Amendment 1591 to the Surface Transportation bill to abolish freight rail industry exemptions from the U.S. antitrust laws. The amendment, proposed by Senator Herb Kohl, would create healthier competition among freight rail shippers and stop unfair pricing polices. We believe that any amendment by the Congress or STB on regulating pricing policies calls for a serious threat to railroads, especially when the economic uncertainty is hurting volume growth and pricing has become a dominant factor for generating revenues.

U.S. Environmental Protection Agency: Railroads remain concerned about the proposed regulation by the U.S. Environmental Protection Agency (EPA) for power plants across 27 states. The proposed guideline –– Carbon Pollution Standard for New Power Plants –– aims at restricting emission of carbon dioxide by new power plants under Section 111 of the Clean Air Act. The standard proposes new power plants to limit their carbon-dioxide emission to 1,000 pounds per megawatt-hour. Power plants fueled by natural gas have already met these standards but the majority of the units using conventional resources like coal are exceeding the set limit, as they emit an average of 1,800 pounds of carbon-dioxide per megawatt-hour. Railroads, which transport nearly two-third of the coal shipment, are most likely to be impacted by the implementation of the new regulation that could pose a significant threat to utility coal tonnage.

Capital Intensive Nature: Railroad is a highly capital intensive industry that requires continued infrastructure improvements and acquisition of capital assets. Moreover, industry players access the credit markets for funds from time to time. Adverse conditions in credit markets could increase overhead costs associated with issuing debt, and may limit the companies’ ability to sell debt securities on favorable terms.

Unionized Labor: Most of the railroad operator’s employees are unionized and are covered by collective bargaining agreements. These agreements are bargained nationally by the National Carriers’ Conference Committee. In the railroad industry, negotiations generally take place over a number of years. Failure to negotiate amicably could result in strikes by the workers, resulting in loss of business.

Investment Possibilities

Investment by railroad operators for product and service improvement is far ahead than other transportation industries. Very few U.S. industries can match the railroad operators with respect to high capital investment rate. Investments in capacity, innovations and use of several state-of-the-art technologies led to service improvements and enhanced reliability.

Currently, the U.S. railroad industry dominates less than 50% of total freight in America, indicating a huge opportunity to increase market share. This opportunity can only be capitalized through building railroad infrastructure that caters to the diversified requirements of the shippers.

According to the Department of Transportation, the demand for rail freight transportation will increase approximately 88% by 2035. As a result, Class I carriers would have to expedite their investments to meet this growing demand. It is estimated that railroads would require $39 billion or approximately $1.4 billion per year of investments to bring infrastructure improvements with the rail network.

AAR claims that freight rail transporters together invested a significant amount of $44 billion in the previous two years for railroad track expansion and maintenance. In recent years, railroads have been investing roughly 17% of their annual revenue on capital expenditures. Major freight railroads are expected to invest approximately $13 billion in capital expenditures in 2012. Additionally, these railroads also expect to add headcount over 15,000 this year to meet operational requirements.

Currently, we maintain our long-term Neutral recommendation on Union Pacific Corporation, Norfolk Southern, CSX Corp., Canadian National, Canadian Pacific and Kansas City Southern. For the short term (1–3 months), these stocks hold a Zacks #3 Rank (Hold) except for Canadian Pacific (CP - Analyst Report), which retains a Zacks #2 Rank (Buy).

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