Stocks in the railroad space are witnessing good times on the back of a number of tailwinds like an improved coal and intermodal scenario, financial prosperity and prudent cost management, among others. Despite the air of optimism, there are certain roadblocks one must be mindful of before investing in the sector. Let’s delve into the details.
Declining Automotive Volumes
Weakness in the automotive sector, due to sluggish vehicle production in the United States, has been hurting railroads for quite some time and the third quarter of 2017 was no exception. Results of major railroad operators like Union Pacific Corp. (UNP - Free Report) and Norfolk Southern Corp. (NSC - Free Report) were distorted due to softness in this key sector.
Automotive volumes declined 10% and 5% at Norfolk Southern and Union Pacific, respectively, in the third quarter of 2017. What is worse is that the situation on this front is unlikely to improve dramatically in the fourth quarter.
Union Pacific on its third-quarter conference call said that light vehicle sales for full-year 2017 are projected at 17 million units, reflecting a 3% decline from the 2016 levels. With the automotive sector accounting for a significant chunk of their revenues, softness in automotive volumes in the fourth quarter will hurt them significantly.
The recent hurricanes hurt operations of railroads by damaging important rail lines. Freight costs skyrocketed following the natural disasters. With fuel costs on the rise, the bottom line of these companies were hurt in the third quarter due to higher costs as a result of the hurricanes.
For instance, at Union Pacific, operating expenses increased 6% year over year to $3.4 billion in the third quarter, primarily due to Harvey. Furthermore, third-quarter operating ratio (operating expenses as a percentage of revenues) deteriorated 70 basis points to 62.8% at Union Pacific. Operating ratio also deteriorated at the likes of Canadian National Railway (CNI - Free Report) in the third quarter due to high fuel costs.
Though operations have been normalized to a large extent, re-occurrence of such violent acts of nature have the potential to hurt the bottom lines of railroads significantly by increasing costs. In fact, such acts of nature throw railroad schedules out of gear by rendering multiple miles of track out of service.
Uncertainty surrounding the future of the North American Free Trade Agreement (NAFTA) is a major overhang on railroads. NAFTA refers to the trade pact inked in 1994 between the United States, Canada and Mexico in a bid to secure better terms for domestic workers. NAFTA has basically done away with almost all tariff among the three nations.
However, President Trump has repeatedly stated that he does not find the deal favorable to the United States. The President has called it “the worst trade deal.” Trump has in fact threatened to terminate the deal, if the negotiations, which are currently in progress, fail to yield the desired results. Consequently, any unfavorable development on NAFTA has the potential to hit railroads like Kansas City Southern (KSU - Free Report) that have significant exposure to Mexico.
Kansas City Southern carries a Zacks Rank #3 (Hold). You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.
Service disruptions at CSX Corp. (CSX - Free Report) , earlier in the year, battered the company. In fact, it had to attend a hearing of the U.S. Surface Transportation Board in October, due to service issues.
Company CEO Hunter Harrison, while apologizing to customers, attributed the disruptions to some of its employees resisting his attempts to boost earnings at CSX through cost-cutting efforts. The company has already laid off more than 2,000 employees so far this year. The workforce at CSX is expected to be trimmed further by year-end.
Naturally, Harrison’s efforts at streamlining operations have met with resistance from employees. Though the company stated on the third-quarter conference call that the issues are a thing a past, the occurrence of such customer-related problems are unwelcome and should be avoided.
Moreover, repealing the Clean Power Plan (CPP), aimed at benefiting the coal industry and therefore railroads, is a time-consuming affair. Furthermore, even if CPP is repealed, as envisaged by President Trump, demand for coal might not pick up due to factors like cheap natural gas, according to many market watchers. In the event of the scenario materializing, railroads won’t be benefited much, if at all, even if CPP is done away with.
Furthermore, proposals concerning reciprocal switching (referred to as forced access by the Association of American Railroads, if implemented, could result in significant loss of revenues for railroads. This is because the proposal pertaining to reciprocal switching would require railroads t0 share rail traffic with their competitors, most likely at below-market rates.
The write-up clearly indicates that stocks in the railroad space are not free from headwinds in spite of the optimism surrounding the space. The problems, unless solved quickly, can result in investors, especially the risk-averse ones, shying away from the sector.
Check out our latest Railroad Industry Outlook for more news on the current state of affairs in this market from an earnings perspective, and how the trend looks ahead for this important sector at the moment.