U.S. Rail Industry Outlook - June 2010

Along with all other industries in the U.S., railroads also suffered during the economic downturn. Freight rail is a “derived demand” industry -- demand for the rail service is tied with demand for the products that the railroads haul. Rail traffic, therefore, acts as a solid barometer of the overall health of the economy.

Since around 2003−2004, a number of factors have led to an increase in rail freight volume in the U.S:

• Rising fuel costs led to an increased demand for rail, since railroads are on an average four times more fuel-efficient than trucks.
• A surge in U.S. imports and record U.S. agricultural exports boosted rail shipments to and from ports.
• A rise in natural gas prices caused power plants to burn more coal to generate electricity, and most coal is shipped by rail.
• Railroad investments in capacity, innovations and use of technology led to service improvements and enhanced reliability.

By 2006, America’s railroads were carrying more freight than ever before in the country’s history. However, the recent downturn that officially began in December 2007 witnessed reduced traffic and volumes. In 2009, carload traffic was down 16.1% compared with 2008 and down 18.2% compared with 2007.

With the economy now out of the recession, the fortunes of the railroad industry are also on the mend. The overall sentiment with respect to railroads is clearly improving, with total traffic for the 17th week of 2010 increasing 15.0%, preceded by a traffic increase of 14.8% year-over-year in the 16th week, 16.1% in the 15th week and 17.2% in the 14th week. The volumes grew steadily due to a pick-up in end market demand. Moreover, structural cost cuts during the downturn are expected to help railroads generate high incremental margins.

Although the macro picture has improved, the recovery appears to be sluggish and fragile, at least over the next few quarters. Our long-term outlook for rail transport is positive. As the U.S. economy recovers, manufacturing production picks up and consumers begin spending again, industry revenue will return to steady growth. Adding to our confidence is Warren Buffett’s investment in the sector − Buffett’s Berkshire Hathaway (BRK.A - Snapshot Report, BRK.B - Analyst Report) acquisition of the rail company Burlington Northern Santa Fe is what we are talking about here. His investment in the group is clearly a seal of approval.

On a modestly negative note is the lingering concern about legislative/regulatory changes that may affect industry profitability and operating conditions.

OPPORTUNITIES

One railroad company that we like with a Zacks #1 Rank (Strong Buy) is Kansas City Southern (KSU - Analyst Report), which has great momentum. Its capital position improved with increased liquidity and reduced leverage, followed by the recent equity issuance. Management expects double-digit growth in fiscal 2010, with volume growing in the mid- to high-single digits along with growth in revenue yield. We are optimistic about new business wins and growth prospects for fiscal 2010 and beyond, given the overall improvement in the economy.

Another of our picks is CSX Corporation (CSX - Analyst Report), which looks attractive based on the its earnings power, pricing power, potential improvements in network fluidity, cost controls, probable improvements in safety and fewer distractions. Cost-cutting efforts undertaken during the past few years will now accrue to the earnings. Steady pricing, improving volumes and cost saving efforts will likely help the company to outperform its peers in the near term.

Canadian National Railway (CNI - Analyst Report) is also poised to benefit from the eventual rebound in the economy as suggested by the recent volume gains.  

Elsewhere, we are Neutral on Canadian Pacific Railway (CP - Analyst Report), Norfolk Southern (NSC - Analyst Report) and Rail America (RA - Snapshot Report). Our Neutral recommendations for these operators primarily reflect the lack of near-term earnings momentum in their businesses.

WEAKNESSES

The economic growth is tardy and difficult conditions are expected to continue through 2010, with U.S. consumers still conservative in their expenditure. Coupled with this, the new home construction market continues to be weak, which in turn affects a number of commodities transported.

Growth in automotive sales also will take time before getting into full swing. These sluggish economic conditions will delay the industry recovery.

We shouldn’t lose sight of the growing concerns about the sustainability of the U.S. recovery given the headwinds from Europe and uncertainty about China’s outlook. While we view the U.S. economic growth trajectory to be essentially on track, some downside risks can not entirely be ruled out. And given the economic sensitivity of the rail transport sector, any diminution of the U.S. growth prospects remains a risk factor for the industry.

Another potential headwind facing the rail industry is the ongoing debate on increasing regulations in the industry. If this materializes, it may weigh on further efficiency gains and earnings growth.

Read the full analyst report on KSU

Read the full analyst report on CNI

Read the full analyst report on CP

Read the full analyst report on CSX

Read the full analyst report on NSC

Read the full analyst report on UNP

Read the full analyst report on BRK.A

Read the full analyst report on BRK.B