Following stellar first quarter results, railroads continued on a growth trajectory and delivered fairly good second quarter results in an otherwise subdued economy. During this period, the industry leveraged its operating capabilities, improving service metrics and improving cost management to counterbalance the lack of market demand, which has resulted in poor freight carloads.
Most of the North American Class I railroads registered second quarter earnings growth in the range of 15% to 20% with operating ratios hovering in the high 60s.
Railroads continue to benefit from the ongoing highway conversion due to their cost effectiveness over truckload. Currently, rail intermodal services are considered to be one of the most fuel-efficient modes of freight transportation, and therefore remain the backbone of the railroad freight business.
Railroads’ Network of Operations
The vast expanse of the U.S. is covered by over 600 freight railroads comprising Class I, regional railroads and local line haul operators. These railroads operate across 150,000 miles of railroad tracks and generate over $50 billion in annual freight revenues.
Based on their operating revenues, freight railroads are categorized into three segments: Class I with annual operating revenues above $346 million, Class II with revenues in the range of approximately $27.8 million to $346 million, and Class III for the rest. Operating revenue based classification standards are provided by the Surface Transportation Board (STB). However, in the light of inflation and the changing macroeconomic environment, revenue benchmarks are subject to change.
Currently, there are 9 major railroads in America that are classified under Class I freight railroads. These include Union Pacific Railroad (UNP - Free Report) , CSX Corporation (CSX - Free Report) , Norfolk Southern Railway (NSC), Canadian National Railway (CNI - Free Report) , Canadian Pacific Railway (CP - Free Report) , BNSF Railway, Kansas City Southern Railway (KSU), Ferromex and Kansas City Southern de Mexico (wholly owned subsidiary of Kansas City Southern Railway).
These carriers can be further categorized based on their network of operations. BNSF Railway, Canadian National, Canadian Pacific, CSX Corp. and Norfolk Southern have their presence in the U.S. as well as the Canadian Market. Union Pacific operates only in the U.S. with no footprint in Canada or Mexico. It represents the largest freight railroad and predominantly operates in the western part of the U.S. Kansas City Southern Railway operates between U.S. and Mexico, Kansas City Southern de México and Ferromex cater only to the Mexican market.
Although these Class I carriers represent only 1% of the total freight railroads in America, they control more than 90% of freight revenues and employment generated in the industry. Consequently, they are a good indicator of the performance of the rail industry and are crucial when analyzing railroad trends.
Second Quarter Flashback
Despite the drop in carloads, Class I carriers managed to hold on to their sound earnings performance through strong operational improvements. Results for the second quarter depict continued bottom-line growth, which offset the decline in volumes.
Beginning with Union Pacific, the company delivered adjusted earnings of $2.10 per share, up 32% from the year-ago quarter. Revenue climbed 7% year over year to a record $5.2 billion.
CSX Corporation reported earnings of 49 cents, up 7% year over year. Revenues remained flat year over year at $3,012 million. Norfolk Southern’s earnings grew 15.9% to $1.60 per share. Like CSX Corp., Norfolk Southern’s revenue growth remained flat year over year at $2,874 million. Kansas City Southern earnings grew 19.7% to 85 cents per share. Total revenues clocked in at $545 million, up 2% year over year.
The growth story remains the same for the top Canadian railroads, Canadian National and Canadian Pacific. Canadian National’s adjusted earnings for the second quarter were 19% higher, up to C$1.50 (approximately $1.49), backed by revenue gains of 13% year over year to C$2,543 million (approximately $2,518.3 million). Canadian Pacific’s earnings grew 20% to 90 Canadian cents (approximately 89.1 cents) per share. Revenues for the quarter increased 8% year over year to C$1.4 billion (approximately $1.353 billion).
According to the Association of American Railroads’ (AAR) report, North American railroad traffic (including U.S. and Canada) dropped 2.2% in the second quarter, (more than the 1% decline registered in the first quarter) primarily due to the 12.7% and 10.6% decline in coal and grain volumes, respectively. Apart from these declines, most of the product lines reflected positive momentum, resulting in second quarter growth.
The primary benefactors of second quarter results were petroleum products and automotive shipments that grew 44.2% and 20.6%, respectively. Trailing behind were nonmetallic minerals (includes frac sand, gravels, stone glass products) shipments and forest products (wood, lumber, pulp and paper) that grew 4.2% and 2.5%, respectively. Rail intermodal continued to show positive trends with a 4.7% growth year over year.
The drop in fuel prices also improved the operating metrics of railroad stocks translating into lower operating ratios. However, decline in fuel prices also meant lower fuel surcharge revenues for the railroads, thereby rendering the net impact neutral.
Further, productivity metrics like train velocity, dwell times, cycle times, on-time arrivals, overall network fluidity and safety measures continued to improve, resulting in productivity gains.
Coal – Concern or Opportunity
As speculations continue to surround coal, it becomes even more difficult to estimate the exact consequences of this product on railroads. Although current market reports chart a murky road for coal shipments, we believe there are some windows of opportunity that can, to some extent, pull back declining coal carloads.
Coal represents one of the single-most important commodities and accounts for over 40% of railroad tonnage. Coal has gained significant market traction given the emerging position of the U.S. as a global coal export hub. Global supply constraints for coal exports due to disruptions in Australia and the growing demand for coal in Asian countries for steel manufacturing improved the market position of U.S. coal exports.
However, coal volumes registered a setback compared to the second half of 2011, given lower coal production by U.S. producers. Following this, the U.S. Energy Information Administration (EIA) released a lower coal production outlook for 2012.
EIA projects coal production to decline 6.1% in 2012 given lower domestic consumption. Domestic coal demand, of which utility coal accounts for approximately 93%, is witnessing persistent declines. Lower natural gas prices have meant that gas is largely substituting the demand for utility coal. Additionally, higher stockpile levels have resulted in lower utility coal demand.
According to the latest report from EIA, coal consumption by coal fired power plants would total 829 million short tons (MMst) in 2012, representing the lowest amount in 20 years. However, in 2013, coal consumption by power plants is expected to grow 7.8% to 894 MMst due to a rise natural gas prices. Further, the EIA remains positive on the U.S. coal export outlook, which is expected to get stronger and exceed the 2011 benchmark of 107 MMst.
The agency expects coal exports to touch 116 MMst in 2012. However, a decline can be foreseen in 2013 owing to economic overhang in China and higher stockpile levels and increased exports from Indonesia and a recovery in the Australian mines. EIA expects coal exports to decline approximately 16% by 2013.
Over the long-term, projections are not very encouraging for the domestic coal business. According to Annual Energy Outlook 2012, coal-fired power grids in the U.S would lose 49 gigawatts of capacity through 2020, representing approximately one-sixth of the existing coal capacity in the U.S. and less than 5% of total electricity generation nationwide.
Other Freight Commodities
Apart from coal, grain shipments are also expected to pose near-term headwinds for the railroads. Global food grain production remain impacted by dry weather in Eastern Europe, lower grain production from major grain exporting countries such as Russia and Kazakhstan, and a poor monsoon in India. According to data from the U.S. Department of Agriculture (USDA), grain shipments through rail until June 2012 were down approximately 43,000 carloads year over year.
Additionally, higher prices of U.S. grain also limited exports to the global market. The strength in the U.S. dollar and the economic slowdown due to the European debt crisis are also important factors adversely affecting the U.S. agriculture and commodities markets.
Moving to petroleum products, we foresee healthy growth going forward in this segment. According to AAR reports, petroleum product volumes soared 49% year over year in August 2012 given higher crude oil shipments. Meanwhile, the EIA reported that crude oil and petroleum products shipments by U.S. railways during the first half of 2012 increased 38% year over year.
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 because of the lack of pipeline infrastructural support in key oil and gas fields like North Dakota's Bakken region. According to industry sources, the role of crude oil as a revenue contributor has grown leaps and bounds in a four-year span from a mere 3% to 30% of the oil and petroleum products shipments by railroads.
However, railroads’ chemical business remains affected by poor ethanol production. Corn crop, the primary feedstock in ethanol production, witnessed low production which consequently affected ethanol production. This was primarily due to drought in some of the major corn producing regions in the U.S. like the Midwest and the Greater Plains. In the EIA’s short-Term Energy Outlook, ethanol production forecast for 2012 was slashed from 13.8 billion gallons per day to 13.3 billion gallons with production in the second half of 2012 averaging 12.8 billion gallons per day.
Further, North American automotive sales are estimated to be more than 14 million vehicles this year, up by almost 13% from 2011. The projection implies higher shipments for the railroads.
Going forward, railroads remain hopeful about U.S. GDP growth, which was revised at 1.7%, up from preliminary estimate of 1.5%.
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 an 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 are 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. The western part of the U.S. is controlled by Union Pacific and Burlington Northern Santa Fe, while the eastern part is controlled by CSX Corp. and Norfolk Southern. On the other hand, Canadian Pacific and Canadian National control inter country rail shipment between the U.S. and Canada.
Momentum in Intermodal: The railroad industry is largely gaining from the ongoing conversion of traffic from truckload to rail intermodal. Shippers are increasingly attracted by intermodal given its cost effectiveness over truck. On average, railroads are considered 300% more fuel efficient than trucks and given the uptrend in fuel prices, we believe that intermodal will play an important role in driving the rail industry.
Despite the above mentioned positives, the freight railroad industry, like other industries, faces certain external and internal challenges. These are as follows:
Positive Train Control Mandate: The Rail Safety Improvement Act 2008 (RSIA) has mandated the installation of PTC (Positive Train Control) by December 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 January 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.
According to the FRA, PTC installation would require over $5 billion in investment by the freight rail industry through 2015. Financial benefits from PTC can only be seen over a period of 20 years, resulting in savings of up to $1 billion. Safety benefits from the installation are expected to range between $440 million and $674 million over a 20 year period. In summary, the cost-to-benefit ratio of installing PTC is 20-to-1 according to the FRA.
On the basis of the report submitted by the FRA to Congress, it is suggested that the deadline of 2015 for implementing PTC is unlikely to be met. In the report, the FRA highlighted several issues that stand in the way of timely implementation of PTC. One of these is financial limitations. Besides the $250 million in federal grants, capital requirements for implementing PTC are largely funded privately by railroads, which make this act an unfunded mandate.
Further, the FRA pointed out that the initial PTC Implementation Plans (PTCIP) submitted by the applicant railroads to FRA for approval stated that they would complete implementation by 2015. However, their plans are based on ambiguous assumptions that the PTC system adopted by them involves no issues related to design, development, integration, deployment, and testing.
Another key concern is that PTC implementation may draw out a lot of funds that can be utilized for capacity expansion, creating a void in meeting railroad demand. Therefore, the mandate lacks the required fund sponsorship from external sources.
Price Regulations: The pricing practices of U.S. freight railroads are a major cause 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.
In February 2012, shippers forwarded a joint letter to the Congress appealing it to support Amendment 1591 of the Surface Transportation bill to abolish freight rail industry exemptions from U.S. antitrust laws. The amendment proposed by Senator Herb Kohl would create healthier competition among freight rail shippers and stop unfair pricing polices. We believe that any amendment by the Congress or STB on regulating pricing policies calls for a serious threat to railroads, especially when economic uncertainty is hurting volume growth and pricing has become a dominant factor for generating revenues.
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.
Capital Intensive Nature: Railroad is a highly capital intensive industry that requires continued infrastructure 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.
Unionized Labor: Most of the railroad operators’ employees are unionized and are covered by collective bargaining agreements. These agreements are bargained nationally by the National Carriers’ Conference Committee. In the railroad industry, negotiations generally take place over a number of years. Failure to negotiate amicably could result in strikes by the workers, resulting in loss of business.
Investment by railroad operators for product and service improvement is far ahead of other transportation industries. Very few U.S. industries can match railroad operators with respect to the high capital investment rate. Investments in capacity, innovations and use of several state-of-the-art technologies have led to service improvements and enhanced reliability.
Currently, the U.S. railroad industry dominates less than 50% of total freight in America , indicating a huge opportunity to increase market share. This opportunity can only be exploited through building railroad infrastructure that caters to the varied requirements of shippers.
According to the Department of Transportation, 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 $39 billion, approximately $1.4 billion per year of investments, to improve rail network infrastructure.
The AAR claims that freight rail transporters together invested a significant amount of $44 billion in the previous two years for railroad track expansion and maintenance. In recent years, railroads have been investing roughly 17% of their annual revenue on capital expenditures. Major freight railroads are expected to invest approximately $13 billion in capital expenditures in 2012. Additionally, these railroads also expect to grow their workforce by over 15,000 this year to meet operational requirements.
Currently, we maintain our long-term Neutral recommendation on Union Pacific Corporation, Norfolk Southern, CSX Corp., Canadian National, Canadian Pacific and Kansas City Southern. For the short term (1–3 months), these stocks hold a Zacks #3 Rank (Hold) except for Canadian National and Union Pacific Corporation, which retain a Zacks #2 Rank (Buy).