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Railroads continue to benefit from the ongoing highway conversion due to their cost effectiveness over truckloads. Currently, rail intermodal services are considered as one of the most fuel-efficient modes of freight transportation, and therefore remain the backbone of the railroad freight business.

Year 2012 was a mixed bag for the U.S. Freight Railroad Industry, though results of the final quarter are just getting underway. Railroads started the year with stellar first quarter results and continued the growth trajectory with a fair second quarter performance in an otherwise subdued economy.

During this period, the industry leveraged its operating capabilities, improving service metrics and improving cost management to compensate the lack of market demand, which resulted in poor freight carloads. Post mid-2012, railroads experienced a setback in their performances despite the growing demand for intermodal services. This was due to the much-anticipated slowdown in coal shipments that hampered growth in other commodities and core pricing.

The current market dynamics of the rail industry remains challenged by a slowing volume trend, mostly of coal. However, the bright spot continues to remain the unparalleled pricing power of this industry over shippers. Based on these factors, earnings growth for railroads operators in the third quarter ranged from negative 22% to positive 18%. Revenues also registered a similar level of fluctuation and ranged between negative 7% and positive 8%.

Operational efficiency of the railroads, as indicated by operating ratio (OR), also plunged. Most the companies reported OR in the low 70s range in the third quarter of 2012 as against their past performances this year that mainly hovered around mid-to-high 60s.

The statistics stated above are based on the quarterly performance of class I railroads. The principal behind considering these railroads as the benchmark is explained below.

Railroad Network of Operations

The vast expanse 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. Operating revenue based classification standards are provided by the Surface Transportation Board (STB). However, in the light of inflation and the changing macroeconomic environment, revenue benchmarks are subject to alteration.

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

These carriers can be further categorized on the basis of 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 the Canadian Market. Union Pacific operates only in the U.S. with no footprint in Canada or Mexico. It represents the largest freight railroad and operates predominantly in the western part of the U.S. Kansas City Southern Railway operates between U.S. and Mexico, Kansas City Southern de México and Ferromex cater only to the Mexican market.

Although these Class I carriers represent only 1% of the total freight railroads in America, these control more than 90% of freight revenues and employment generated in the industry. Consequently, Class I carriers are good indicators of the performance of the rail industry and are crucial when analyzing railroad trends.

The Track Ahead

The year 2013 depicts a mixed picture for the railroads. The U.S. GDP forecast for 2013 is also not very encouraging due to the macroeconomic environment. Going by the latest reports, the growth rate for 2013 is expected to hover around 1.5% to 2%. Uncertainties over the fiscal cliff and perpetuating impacts of the impending tax increases would likely weigh over the country’s economic growth, pulling it down from the 2012 level. Thus, the impacts on railroads will not be any different from the other sectors.

However, railroads do have certain windows of opportunity, which can be banked upon. The key among these is the rise in intermodal alongside petroleum and automotive shipments.

Intermodal Runs the Show

The railroad industry is gaining largely from the ongoing conversion of traffic from truckload to rail intermodal. Intermodal is gaining popularity among shippers given its cost effectiveness over truck. On average, railroads are considered 300% more fuel-efficient than trucks, and we believe that intermodal will play an important role in driving the rail industry based on the growing awareness among shippers about its benefits.

Currently, rail intermodal accounts for over 20% of the railroads’ revenue, second in line after coal. In the coming years, we expect this contribution to only rise given the growing dependence of shippers on intermodal services.

Petroleum Fuels Growth

Surge in shale oil and natural gas sales catapulted growth in petroleum product shipments. Despite the fact that rail-based crude transportation costs five times more ($10–$15 per barrel), crude shippers are compelled to rely on rail-based transport. This is because of the lack of pipeline infrastructural support in key oil and gas fields like North Dakota's Bakken region.

According to industry sources, the role of crude oil as a revenue contributor has grown by leaps and bounds in a four-year span from a mere 3% to 30% of the oil and petroleum products shipment by railroads. According to the EIA, production for U.S. crude oil is estimated at approximately 6.8 million barrels per day for 2013, representing record growth in two decades.

Natural gas production would, however, experience a slowdown on a pricing uptick. Consumption would register modest growth on a rise in residential, commercial and industrial consumption compensating for the decline in its usage for electricity generation.

Automotive a Good Ride

Automotive shipments also form a significant part of rail shipments, as automotive sales are set to recover from their downturn in 2009 when U.S. sales hit their lowest in three decades. In 2012, automotives maintained their growth trajectory with U.S. light vehicle sales ranging between 14 million and 15 million. However, in the coming year, the growth can be slightly muted by the onslaught of the expected fiscal cliff.

According to market reports, auto sales may see single-digit growth due to a change in consumer behavior owing to the U.S. tax policy changes. If the situation improves on the macro front, there should not be a cyclical downturn in the way of Automotives.

Besides all these positive catalysts leading the way into 2013, railroads still have to face a challenging market scenario in Coal.

Coal Worries Continue to Linger

Coal represents one of the single-most important commodities and accounts for over 40% of railroad tonnage.

Domestic coal demand, of which utility coal accounts for approximately 93%, is witnessing persistent declines. Lower natural gas prices imply that gas is largely substituting the demand for utility coal. Additionally, higher stockpile levels have resulted in lower utility coal demand.

Over 90% of the total coal production in the U.S. is dedicated to electricity generation. Going by market reports, in 2012, only one-third of the U.S. power plants used coal for electricity generation, a steep decline from approximately 50% in 2008. Natural gas prices, another important factor that resulted in the decline of coal-powered plants are the environmental issues associated with coal burning.

However, the Energy Information Administration (EIA) projects coal consumption by power plants to grow 6% in 2013 on an anticipated rise in natural gas prices. Over the long term, projections are not very encouraging for the domestic coal business.

According to Annual Energy Outlook 2012, coal-fired power grids in the U.S. would lose 49 gigawatts of capacity through 2020. This represents approximately one-sixth of the existing coal capacity in the U.S. and approximately 5% of total electricity generation nationwide.

On the export front, U.S. coal, mostly metallurgical coal gained significant market traction with the U.S. emerging as a global coal export hub. According to EIA projections, U.S. coal exports experienced its prime time in 2011 with 10% of total coal production, representing the highest point in the past 20 years. EIA remains positive on the U.S. coal export outlook, which is expected to get stronger in the coming days.

However, in 2013, there is a foreseeable decline in coal exports according to EIA. Factors like an economic overhang in European markets, higher stockpile levels and increased exports from Indonesia and a recovery in the Australian mines are the primary reasons for the expected decline. Overall, the expected uptick in the domestic market will likely balance the declines in the export market for coal, representing a flat picture in 2013 in terms of year-over-year growth.

OPPORTUNITIES

The railroad industry as a whole offers a number of opportunities 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 discretionary pricing in the freight market. In the prevailing duopolistic rail industry, railroad operators will be able to reap maximum benefits from rising prices when the overall demand grows.

This remains evident from the geographic distribution of markets between major railroads. The western part of the U.S. 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 hand, Canadian Pacific and Canadian National control inter country rail shipment between the U.S. and Canada.

WEAKNESSES

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

Capital Intensive Nature: Railroad is a highly capital intensive industry that requires continued infrastructural 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.

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.

Price Regulations: The pricing practices of U.S. freight railroads are the major reasons of friction with captive shippers, who move their products through rail and do not have effective alternatives. According to the latest studies by the 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 attracted congressional intervention for exercising stringent federal regulations on railroads. Congress has discussed railroad price regulation but has not passed any new rule so far.

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-thirds 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.

Investment Possibilities

Investment by railroad operators for product and service improvement is far ahead of other transportation industries. Very few U.S. industries can match railroad operators with respect to their high capital investment rate. Investments in capacity, innovations and use of several state-of-the-art technologies have 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 for increasing market share. This opportunity can only be exploited by building railroad infrastructure that caters to the varied requirements of 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 over $140 billion to improve rail network infrastructure within this stipulated period.

We have a Zacks #3 Rank, implying a Hold rating over the short term (1–3 months) on Union Pacific Corporation, Norfolk Southern, Canadian Pacific Railway and Kansas City Southern. For Canadian National Railway and CSX Corporation, we have a Zacks #4 Rank, implying a short-term Sell rating.

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