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Railroad Growth Stays Grounded, Speedy Pickup Unlikely

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The railroad sector has not been able to put up a decent second quarter earnings season. Across the board, most stocks suffered year-over-year declines in earnings. Though most Class 1 railroad companies beat the Zacks Consensus Estimate, the declining earnings trend is a matter of concern. Furthermore, there has been no major development to suggest a speedy recovery for the industry. Energy markets and continued issues with the factor sector appear to be the key reasons behind the slump in earnings performance.

Lack of Uniform Growth

For the railroad industry, steady economic growth is an essential requirement to boost freight volumes. The U.S. economy keeps giving out mixed signals, making it tough for anyone to gauge where it is headed. This uncertain environment is the primary reason keeping the Fed on hold from announcing the next rate increase. While parts of the U.S. economy appear to be doing fine, bug chunks remain in a depressed state.

The manufacturing sector in particular is barely in expansionary territory, though some of the recent signs suggest that the wort may be behind us. As a result, GDP growth has barely reached the 1% level in each of the last three quarters, though expectations remain high for a rebound in the current period.

Beyond the U.S. economy, the outlook remains fairly uncertain for many of our trading partners, with Britain’s exit from the European Union adding another source of uncertainty to an already cloudy environment. Questions about China, recession in Brazil and an overall weak global growth environment is having a negative impact as well, particularly through the trade channel.

Energy Markets’ Impact on Earnings

The energy market has a significant impact on railroad revenues. Coal, a major freight product for most railroad companies, has been observing a consistent decline in volumes. This has hurt the top line of companies like Union Pacific Corp. UNP, CSX Corp. (CSX - Free Report) , Canadian National Railways Corp. CNI and Norfolk Southern Corp. NSC. Coal volumes have suffered do to two key reasons. First, sluggish industrial growth has resulted in low demand for coal.

Industrial growth in the U.S. is unlikely to improve significantly in the coming few months as a result of which coal volumes are expected to trudge along at a slow pace. Second reason hampering coal volumes: the shift to renewable and more environment friendly sources for electricity. As per the Institute for Energy Economics and Financial Analysis (“IEEFA”), new carbon related regulations will result in a 25% decline in coal production by 2040. Clean energy requirements could significantly reduce coal consumption by power plants.

Moreover, even if changes do not take place, coal demand is expected to stay flat over the next 25 years. A McKinsey report recently highlighted that by 2020, natural gas is expected to surpass coal as the major source of electricity production in the U.S. The growing popularity and need for renewable sources of energy such as solar and wind energy will eventually reduce reliance on coal. Thus, railroad companies are not expected to see any improvement in coal-related revenues.

Another energy component, crude oil, has also been impacting rail revenues. Crude oil prices have remained low over the past couple of months in addition to lower demand for the commodity. While low crude prices have helped railroads cut costs, it has taken a toll on revenues due to reduced income from low fuel surcharge.

According to the U.S. Energy Information Administration, Brent crude oil prices are expected to average $44 per barrel in 2016 and $52 per barrel in 2017. Thus not much change is expected from fuel surcharge revenues for railroads over the next couple of months.

New Regulation Threat

The Surface Transportation Board (STB) of the U.S. has come up with a new proposal to allow reciprocal switching for captive shippers. This proposal was presented to the STB in 2011 by shippers. After evaluation, the proposal was recently tabled to railroad companies. As per the proposal, captive shippers who have access to only one railroad will be allowed to switch between rail lines of different companies. This proposal has received intense opposition from railroad stocks since it may result in revenue loss and an increase in costs for such companies.

Moreover, rail companies are also skeptical of operational issues and safety concerns arising from the proposed regulation. Another new regulation proposed by Freight Railroad Administration (FRA) is for increasing the crew size on railways from one to a minimum of two persons. This proposal too is being opposed by railroad companies as it would increase operating expenses. If these proposals get sanctioned, especially the reciprocal switching one, these are likely to adversely impact the profits in the railroad industry.

To Conclude

We are skeptic about the railroad stocks’ ability to perform well in the current market scenario. There is a pressing need for a positive indicator to drive growth. For the time being, it is to be seen whether rail companies can return to growth despite the prevailing challenges.

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.

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