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Earnings Dull, New Regulations Concerning

The railroad industry has not been seeing the best of times for a while. As had been expected, second-quarter earnings also failed to reinstate hopes of an improvement for most companies. Although most railroad companies like Kansas City Southern (KSU - Free Report) , Norfolk Southern Corp. (NSC - Free Report) , Canadian National Railways Corp (CNI - Free Report) and Canadian Pacific (CP - Free Report) beat their Zacks Consensus Estimates, a majority of the companies saw a decline in earnings from year-earlier levels.

Overall, the top line was hurt by the economic slowdown which resulted in low coal demand and a decline in freight volumes across majority of transported goods. However, companies are still hopeful of an uptick in performance in the second half of 2016 as economic growth might pick up. Some companies have also planned new investments which is a major positive. While railroad companies are figuring ways to deal with declining volumes, new regulations have been proposed which might not favor the industry.

Reciprocal Switching Proposal

A recent proposal by the Surface Transportation Board (STB) of the U.S. has irked railroad companies and groups. Per this proposal, the STB plans to implement a new rule which will allow shipping companies, without access to other modes of transport, to switch their freight to competing rail lines. This reciprocal switching regulation is applicable only to “captive shippers” which are shipping companies with access to only one rail line.

The National Industrial Transportation League (NITL), which represents such shipping companies, had proposed this change to the STB in Jul 2011. As expected, the railroad industry is opposing this proposed change vehemently. Thus, there are three different perspectives of the shipping companies, railroad operators and the STB that need to be considered to evaluate this proposal.

Shippers believe that reciprocal switching will help them save millions as it will open up additional options, make operations easier and reduce freight movement costs. Shippers claim that due to existing regulations, rail freight rates have climbed up steadily over the years. Implementation of the reciprocal switching regulation is likely to intensify competition which in turn is expected to reduce prices.

The shipping industry has been going through a rough phase owing to low demand for industrial and consumer goods. Thus it is comprehensible why shippers actively support the new proposal, which is sure to boost their earnings.

Meanwhile, the STB is trying to ensure that it passes a fair judgment, keeping the welfare of both the parties in mind. In addition to making operations easier for shippers, the regulatory body intends to make certain that the law doesn’t hurt railroads much. According to a Logistics Management article, if approved, shippers will be required to prove that the arrangement is “practicable and in the public interest” or “necessary to provide competitive rail service.”

What’s Bothering the Railroads?

Railroad companies and groups do not see any positive outcome from this proposal. As per the Association of American Railroads (AAR), forcing railroads to open their lines to competitors will be a major contradiction to the deregulation stance adopted years ago. Railroads expect revenue losses to run into billions of dollars and investments are also likely to take a beating.

Moreover, it may also increase costs for railroads although the companies will be allowed to charge a switching fee. Companies fear that the regulations would lead to a decline in operational efficiency. In 2014, CSX Corporation (CSX) had stated that such a proposal would make it tough for companies to take decision related to allocation of resources like locomotives and train crews in addition to causing congestion of interchanges between railroads. Also, the company believes that this switch may affect the reliability and cost effectiveness of rail freight services.

Railroad stocks, including the big players, are currently in no position to take on any revenue cut and declining revenues can hurt future investments. We believe that any move which threatens to hurt the top line and operational efficiency could counteractive actions from railroad companies. Moreover, it is to be noted that investments by railroad companies are essential for the maintenance and continued improvement of the country’s rail network.

Proposal to Increase Crew Size

Besides reciprocal switching, the railroad industry has received another new proposal by the Freight Railroad Administration (FRA) requires at least two crew members for freight railroads instead of one in order to ensure railroad safety. The FRA, however, has no data to prove that the number of crew members is directly related to safety. Railroad companies are clearly against this proposal as well.

Notably, changes in railroad industry regulations require intense deliberation as the industry’s operational efficiency is essential for the economy.

Railroad Industry’s Economic Impact

In a report released by the AAR, it has been highlighted how railroads have a significant impact on the economy. The report comprises research findings from Towson University's Regional Economic Studies Institute (RESI) which states that seven key railroads executed approximately $274 billion worth of economic transactions, around $33 billion in revenues and supported almost 1.5 million jobs in the U.S. in 2014. Moreover, investments valued at around $28 billion went into the industry.

Railroads are almost like the lifeline of an economy as they transport bulk of the major products for industrial and personal use across the country. The transported goods include agricultural and food products, chemicals, coal, consumer durables, paper, lumber and motor vehicles. Thus, the performance of the industry lends an insight into the factors charting the economy’s growth or slump during a period.

Zacks Industry Rank

Within the Zacks Industry classification, railroads are broadly grouped within Transportation (one of the 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 #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 #101, implying a neutral outlook.

Earnings Trend

Railroads belong to the broader Transportation sector. Transportation sector’s average earnings declined 12.4% in the second quarter of 2016. Outlook for the sector does not look very appealing with average earnings decline of 20.6% expected in the third quarter of 2016 on a year over year basis.

In the Q2 earnings cycle, we currently have reports from 100% of the sector’s total market cap in the S&P 500 index. Total earnings for these Transportation sector companies are down -12.4% from the same period last year on -1.4% lower revenues, with 66.7% beating EPS estimates and only 40% coming ahead of revenue expectations.

(For a detailed look at the earnings outlook for this sector and others, please read our Earnings Trends report.)

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