After enduring difficulties in 2013, the railroad industry’s resilience seems to have finally paid off. The industry’s optimal operational efficiency amid an economic downturn and uncertain market conditions has readied it for a healthier 2014.
Despite predictions of further headwinds in Coal -- one of the major product shipments of rail – the sector emerged strongly on infrastructural developments that supported natural gas and petrochemical product shipments.
Zacks Industry Rank
Within the Zacks Industry classification, railroads are broadly grouped in Transportation (one of 16 Zacks sectors).
We rank all the 260-plus industries in the 16 Zacks sectors based on the earnings outlook and fundamental strength of the constituent companies in each industry. To learn more visit: About Zacks Industry Rank.
As a guideline, the outlook for industries with Zacks Industry Rank of #88 and lower is 'Positive,' between #89 and #176 is 'Neutral' and #177 and higher is 'Negative.'
The Zacks Industry Rank for the railroad industry is currently #24, implying that the outlook remains positive on this sector. This highlights an optimistic outlook on the industry as railroads are delivering margin growth with gradual recovery in Coal shipments. Further, the upsurge in petrochemical shipments has also uplifted the markets conditions of this industry leading to earnings improvement.
Earnings Trend of the Sector
The broader Transportation sector, of which railroads are part, reflects a stable growth trend. All sector participants have reported third-quarter results, which have been fairly good in terms of both beat ratios (percentage of companies coming out with positive surprises) and growth.
The earnings and revenues "beat ratio” for the quarter was 63.6% for the transportation sector. Total earnings for the companies in this sector grew 13.2% year over year on 4.5% revenue growth. Both revenues and earnings showed significant improvement from second quarter growth of 8.3% and 2.2%, respectively.
The Consensus earnings expectation is pegged at 16.7% for the fourth quarter of 2013. Overall, the sector is expected to register full-year growth of 15.8% in 2013 followed by an estimated 16.8% growth in the first quarter of 2014. In terms of revenue expectation, the sector is expected to register 4.4% growth in the fourth quarter, resulting in an annual growth rate of 3.5%. The sector is expected to register revenue growth of 4.6% in the first quarter of 2014.
For a detailed look at the earnings outlook for this sector and others, please read our weekly Earnings Trends reports.
Third Quarter 2013 Financial Results
Going by the quarterly performance of the class 1 freight railroad carriers, we see that most of the companies under Zacks coverage surpassed earnings estimates for the third quarter. These include Canadian National Railway Company (CNI - Analyst Report), Canadian Pacific Railway Ltd. (CP - Analyst Report) and CSX Corp. (CSX - Analyst Report), Norfolk Southern Corp. (NSC - Analyst Report) and Union Pacific Corp. (UNP - Analyst Report). Only one carrier, Kansas City Southern (KSU - Analyst Report), narrowly missed Zacks Consensus Estimate. However, all these carriers have shown significant growth from the year-ago quarter based on volume expansion, strong pricing and cost control measures.
Further, we believe rising employee productivity, deployment of fuel-efficient locomotives and undertaking railroad safety measures were some of the key drivers of profitability for the railroads in adverse market conditions.
Growth estimates for railroads for the upcoming quarter suggest a strong momentum in earnings. For Canadian Pacific, earnings growth projection is 46.75% and earnings estimate is pegged at $1.88. Canadian National is expected to deliver earnings growth of 10.75%, resulting in earnings per share of 78 cents as per the Zacks Consensus Estimate.
U.S. carriers like Union Pacific, Norfolk Southern and Kansas City also remain on the growth trajectory with growth estimates of 14.37%, 14.50% and 25.87%, respectively. The Zacks Consensus Estimate for Union Pacific, Norfolk Southern and Kansas City is pegged at $2.50, $1.49 and $1.15, respectively.
What to Look For in 2014
There are several near-term catalysts in the railroad industry, which will determine the road ahead for the railroads in the upcoming year.
Rising Contribution of Petroleum Product Shipment
According to the Energy Information Administration’s (EIA) reports, crude oil growth may go up to 10 million barrels per day over a period of 2020 to 2040.
This surge represents an opportunity for revenue accretion, which the railroads are trying to achieve with infrastructural development. 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.
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 due to the lack of pipeline infrastructural support in key oil and gas fields like Bakken Shale Formation in North Dakota and Montana, Eagle Ford Shale, Barnett Shale and Permian basin in Texas, the Gulf of Mexico and Alberta oil sand fields in Canada.
As a result, inadequate pipeline developments have given rise to higher penetration of railroads transportation for crude oil shipping in these areas. According to reports, rail-loading capacity is expected to grow to 200,000 b/d by 2013 for crude oil shipments from Western Canada.
Major railroad companies like Norfolk are seeking expansion strategies fueled mostly by the development of the energy sector, including the gas exploration projects in Marcellus and Utica shale plays as well as ventures associated with coal and power generation. Over the coming years, the company plans to introduce 32 energy-related projects in 14 states under its service areas.
Canadian Pacific projects crude shipment to reach up to 70,000 oil-tank cars by the year-end and move to 140,000 by the end of 2015. In the coming months, we expect railroads to accelerate their investments in order to create adequate service capacity for the oil and gas markets resulting in exponential growth in crude oil shipments across the rail industry. Consequently, we expect petroleum shipments to remain favorable and emerge as a significant revenue contributor in the long term.
Currently, Mexico is a growing market for automotive production and assembly given the lower cost of production in the region. In the first six months of 2013, auto shipments by rail in Mexico increased 2.7 while in the U.S., auto shipment via rail rose about 3.7%. This growth was largely offset by 5.9% drop in rail auto shipments in the Canadian market. However, despite a modest first half of the year, industry sources project that auto production are slated to pick up, resulting in a record level of 16 million, representing the highest sales figure since the economic downturn in 2008.
We believe upcoming plants by Honda Motor Co., Ltd. (HMC), Nissan Motor Co. (NSANY), Mazda and Audi would further boost auto production in Mexico. The facilities also bode well for automotive shipments. Based on these proposed expansion plans, finished vehicle production in the Mexican market is expected to reach 3.5 million units in 2015, up about 35% from the 2012 production level. The growth will provide carriers like Kansas City Southern, which operates across the Gulf of Mexico, ample opportunities to ship raw material into Mexico and return the finished products to the domestic market as well as to the U.S. and Canada.
The railroad industry is gaining largely from the ongoing conversion of traffic from truckload to rail intermodal. On average, railroads are considered 300% more fuel-efficient than trucks, resulting in the growing importance of rail intermodal.
As a result, railroad companies are increasingly focusing on building their intermodal network across U.S. and bordering nations. Leading freight railroad company, CSX Corp. is currently keen on tapping the underserved Eastern Intermodal market which has projected volumes of 9 million carloads spanning 550 miles yet to be converted into rail intermodal network from truckload.
The company is also concentrating on the Northwest Ohio Intermodal Terminal given the growing demand in that area. Further, the company is likely to gain from the expansion of key intermodal terminals in 2013 and awaiting completion of terminals Winter Haven in Central Florida and Salaberry-de-Valleyfield in Quebec in the upcoming year.
Fraught with issues raised by the regulatory environmental agency, decelerating demand from power plants for electricity generation and the shut down of coal-fired power plants, there is only a bleak chance for railroads to draw any benefit from this commodity segment, which continues to contribute a large part of railroad tonnage.
According to EIA’s Short-Term Energy Outlook, U.S. coal exports have gone down 8.1% in the first three quarters of 2013. EIA projects Coal exports to total 118 million short tons (MMst) in 2013, which is lower by 7 MMst from last year. In 2014, exports are predicted to go down even further to 107 MMst.
However, Coal consumption in the U.S. market also has modestly benefited from the recent hike in natural gas prices. According to EIA reports, total coal consumption for 2013 is expected to reach 928 MMst in the U.S, which shows an estimated 4.4% increase over 2012. Further, growth will continue in 2014 with estimated consumption increase of 2.2% to 948 MMst. Although, coal export shipments constitute a large part of railroad shipment, we believe an uptick in the domestic market will help railroads manage coal headwinds to some extent.
Notably, 2013 is expected to be a good year in Grain exports, implying an opportunity to benefit from volume expansion in this product segment. According to the U.S. Department of Agriculture’s (USDA) Agricultural Outlook, agricultural exports are expected to reach $140.0 billion on estimated growth in exports to countries like Canada, Brazil, European Union, offset by a likely drop in shipments to South Korea, Mexico, North Africa, and the Middle East. In addition, imports are also expected to rise the past few years to $105 billion.
According to the USDA, agricultural exports in 2014 are forecasted at $135 billion, down from an estimated $140 billion for 2013. The decline will result from an expected fall in oilseeds and products, grain and feed exports and cotton exports. However, since imports are expected to rise with gains in horticultural products, sugar and tropical products, we expect agricultural products to have a neutral impact on railroad carloads in the coming year.
Investment in development and expansion plans remain critical when analyzing railroads prospects. These capital investments are a double-edged sword. While the investments put significant stress on margin performance, forgoing these would result in lesser growth prospects.
Railway investments are paramount given the evolving supply chain management and increasing role of airfreight carriers in offering freight transportation services. These investments build the required infrastructure needed for railways to stay afloat in a competitive environment not only within the railroad industry but also with other modes like truck, barges and cargo airlines.
As a result, investments in infrastructural projects have been an integral part of railroads development. However, this sector, characterized by huge capital influx, has been drawing funds primarily through private financing.
As a result, investment plans when undertaken can have a considerable impact on the liquidity position of the company and may lead to a highly leveraged balance sheet. According to AAR reports, railroads invest approximately 17% of their annualized revenues, which compares with only 3% of average U.S. manufactures’ revenues on capital expenditures.
According to the Department of Transportation (DOT), 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 $149 billion to improve rail network infrastructure within this stipulated period. With respect to current investment requirements, railroads would invest about $24.5 billion in 2013 according to AAR. This projects an escalating trend when compared with recorded investment of $23 billion in 2012 and $12 billion in 2011, as per AAR.
Given the growing demand and need to upgrade railroad infrastructure to meet new regulations, deployment of fuel-efficient locomotives, upcoming rules on track sharing, railroad safety and high-speed rail services make it mandatory for railroads to infuse more capital on development projects. According to DOT, almost 90% of the railway capacity needs to be upgraded to meet the expected rise in demand level by 2035. Hence, for railroads it is important to balance profitability levels while investing in infrastructural development projects.
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.
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. Union Pacific and Burlington Northern Santa Fe control the western part of the U.S., while CSX Corp. and Norfolk Southern control the eastern part. On the other hand, Canadian Pacific and Canadian National control inter country rail shipment between the U.S. and Canada.
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 Dec 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 Jan 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.