Following second-quarter results, railroads appear to be on
track to recovering from the operational hazards faced earlier this
year. The industry's operational efficiency amid uncertain market
conditions poises it for better times in the remainder of 2014.
Despite the projection of further headwinds for coal -- one of the
major product shipments of rail -- the sector emerged strongly on
infrastructural developments that supported natural gas, grain crop
and petrochemical product shipments.
Zacks Industry Rank
Within the Zacks Industry classification, railroads are broadly
grouped within Transportation (one of 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 #8,
implying that the outlook remains positive on this sector. This
provides an encouraging outlook on the industry despite the
persistent adverse seasonal impact that affects products of
shipments. While some of the product lines see success or suffer,
depending on seasonality or other external factors influencing
market demand, intermodal remains on the growth trajectory.
We continue to be optimistic, as railroads are witnessing a
gradual recovery in Coal shipments. Further, the upsurge in
petrochemical shipments has bolstered this industry, thereby
leading to earnings improvement.
Earnings Trend of the Sector
The broader Transportation sector, of which railroads are a part,
reflects a sustainable growth trend. All the sector participants
have reported second-quarter results, which have been stable in
terms of both beat ratios (percentage of companies coming out with
positive earnings surprises) and growth.
The earnings and revenues "beat ratio" for the quarter was 81.8%
for the transportation sector. Total earnings for the companies in
this sector rose 11.5%, while revenue growth was 0.5%, both on a
year-over-year basis. The sector is expected to register full-year
earnings growth of 13.2% in 2014. In terms of revenue expectation,
the sector is expected to record 5.3%.
For a detailed look at the earnings outlook for this sector and
others, please read our weekly
Second-Quarter 2014 Financial Results
The major companies that have so far reported include CSX Corp. (
), Kansas City Southern (
), Union Pacific Corporation (
), Canadian National Railway Company (
) and Norfolk Southern Corp. (
). All these companies' earnings were higher than the year-ago
quarter figure and above market expectations as well. Significant
growth across all commodity groups and a substantial improvement in
operating ratio drove gains across most of the companies,
supporting strong earnings this season.
Major Contributors in 2014
While most of the other commodities including Automotive and
General Merchandize have shown uncertainty in growth for 2014,
intermodal volumes are strong. As a result, we expect railroads to
significantly focus on intermodal expansion and tap underserved
markets with highway-to-rail conversions.
Railroads are now looking to the Mexican market, which is
witnessing regulatory reforms, including rail reforms, initiated by
President Enrique Peña Nieto to lure foreign direct investments to
boost economy. Union Pacific, which serves all six gateways between
the U.S. and Mexico, is likely to seek this opportunity to increase
its penetration into the Mexican market.
Moreover, there are major investments to look forward to this year
involving intermodal growth. These include BNSF Railway Company's
$900 million spending on terminal, line and intermodal expansion
and CSX Corp.'s investments in nine projects, Montreal terminal,
capacity expansion of its northwest Ohio intermodal hub, and
terminal expansion in New Orleans and Savannah.
Norfolk Southern has an investment plan of $487 million on
developing intermodal facilities that include six projects.
Further, Kansas City Southern is looking forward to its Monterrey
to Nuevo Laredo track upgrade and developing its double-track
corridor between Sanchez and Nuevo Laredo. It is also expanding its
Sanchez Yard and focusing on developments in Interpuerto San Luis
According to Energy Information Administration's (EIA) reports,
crude oil growth may go up to 10 million barrels per day from 2020
to 2040. Further, AAR reported that railroads transported 407,642
carloads of crude oil in 2013, up from 234,000 carloads in 2012.
Further information suggests that crude oil accounted for around
1.4% of total Class carloads in 2013, compared with 0.03% in 2008
when the concept of crude by rail started gaining importance.
According to AAR, U.S. crude oil production will increase
approximately 60% from 2008 through 2014, representing estimated
production of 8.5 million barrels per day by 2014 end. This surge
represents an opportunity for revenue accretion, which the
railroads are trying to achieve with infrastructural development.
Despite the fact that rail-based crude transportation costs more
($10-$15 per barrel as against $5 a barrel through pipeline), crude
shippers are compelled to rely on rail-based transport. This is due
to the lack of pipeline infrastructural support in key oil and gas
fields like Bakken Shale Formation in North Dakota and Montana,
Eagle Ford Shale, Barnett Shale and Permian Basin in Texas, the
Gulf of Mexico and Alberta oil sand fields in Canada.
As a result, inadequate pipeline developments have given rise to
higher penetration of railroad transportation for crude oil
shipping in these areas. According to AAR's article 'Moving Crude
Oil by Rail,' railroads transported over 60% of North Dakota's
crude oil production, which contains the vast majority of new rail
crude oil originations.
Further, in terms of safety, railroads offer a better
transportation avenue compared to pipeline due to its better spill
rate profile. According to U.S. Department of Transportation (DOT),
spill rate for pipelines are three times higher than rail, based on
crude shipments between 2002 and 2012. Additionally, railroad
companies are working toward tightening rail safety measures by
appealing to federal regulators to phase out old tank cars if these
are not upgraded. They are also seeking improved standards for new
Major railroad companies like Norfolk are looking for expansion
strategies mainly due to development of the energy sector,
including the gas exploration projects in Marcellus and Utica shale
plays as well as ventures associated with coal and power
generation. Over the coming years, the company plans to introduce
32 energy-related projects in 14 states under its service areas.
Canadian Pacific projects crude shipment to reach 140,000 by the
end of 2015. In the coming months, we expect railroad companies to
increase investment in order to create adequate service capacity
for the oil and gas markets. This would lead to exponential growth
in crude oil shipments across the rail industry. Consequently, we
expect petroleum shipments to remain favorable and emerge as a
significant revenue contributor in the long term.
Mexico is currently a growing market for automotive production and
assembly, given the lower cost of production in the region.
We believe that the plants established by Honda Motor Co., Ltd. (
), Nissan Motor Co. (
), Mazda and Audi would boost auto production in Mexico. The
facilities also bode well for automotive shipments. Based on these
expansions, finished vehicle production in the Mexican market is
expected to reach 3.5 million units in 2015, up about 35% from the
2012 production level.
The growth will provide carriers like Kansas City Southern, which
operates across the Gulf of Mexico, ample opportunities to ship raw
material to Mexico and return the finished products to the domestic
market as well as to the U.S. and Canada. The company projects
Automotives shipment to register high double-digit growth in 2014.
Increased export activities at the Port of Lázaro Cárdenas will
support future growth and enable the opening of auto plants in
Mexico this year. In addition, the company expects North American
full-year auto sales growth in the range of 4-4.5%.
Notably, 2014 is expected to be a good year for rail in terms of
grain shipment. According to the USDA, agricultural exports in 2014
are forecasted to be $135 billion, down from an estimated $140
billion for 2013. The decline will result from an expected fall in
oilseeds and products, grain and feed exports as well as cotton
exports. However, since imports are anticipated to rise with gains
in horticultural products, sugar and tropical products, we expect
agricultural products to have a neutral impact on railroad carloads
in the coming year.
Reduced electricity generation from coal turned into a major foe
for rail freight carriers. Class I railroads originated 6.2 million
coal carloads in 2012, the lowest annual total output since 1993.
Coal carloads fell below 6 million in 2013, approximately 4.4% down
from 2012 levels according to AAR reports. The decline in coal
carloads offset the positive impact of gains from crude oil for the
Fraught with issues raised by the regulatory environmental agency,
decreasing demand from power plants for electricity generation and
the shutdown of coal-fired power plants, there are slim chances for
railroads to benefit from this commodity segment, which continues
to contribute a large part of railroad tonnage.
However, according to EIA's latest Short-Term Energy Outlook, U.S.
coal production will increase 4.1% to 1,024 million short tons
(MMst), given the higher consumption due to a severe winter that
affected early 2014. Coal consumption in 2014 is expected to grow
4.2% to 964 MMst in 2014 due to higher
than 2012 levels.
EIA projects coal exports to total 101 MMst in 2014, which is lower
than the previous projection of 107 MMst. In 2015, exports can go
down even further to 96 MMs owing to weak global economic
conditions, slow demand growth rate in the Asian markets, rising
coal production in other countries and lower international coal
Investments in development and expansion plans remain crucial when
analyzing the prospects for the railroad industry. These capital
investments are a union of binaries. While the investments put
significant stress on margin performance, forgoing these would
dampen growth prospects.
Railway investments are significant, given the evolving supply
chain management and the growing importance of airfreight carriers
in offering freight transportation services. These investments help
railways in getting the required infrastructure to compete
effectively in the railroad industry and with other modes of
transport like truck, barges and cargo airlines.
Hence, investments in infrastructural projects have been an
integral part of the development of railroads. However, this
sector, characterized by huge capital influx, has been drawing
funds primarily through private financing.
As a result, investment plans when undertaken, can have a
considerable impact on the company's liquidity position and could
lead to a highly leveraged balance sheet. According to AAR reports,
railroads invest approximately 17% of their annual revenue, which
compares with only 3% of average U.S. manufactures' revenues on
According to DOT, the demand for rail freight transportation will
increase approximately 88% by 2035. As a result, Class I carriers
would have to increase their investments to meet this growing
It is estimated that railroads would require $149 billion to
improve rail network infrastructure within this stipulated period.
Given the growing demand and need to upgrade railroad
infrastructure to meet new regulations, deployment of
fuel-efficient locomotives, upcoming rules on track sharing,
railroad safety and high-speed rail services are demanding that
railroad companies infuse more capital in development projects.
According to DOT, almost 90% of the railway capacity needs to be
upgraded to meet the expected rise in demand level by 2035.
Hence, it is important for railroad companies to balance
profitability levels while investing in infrastructural development
Currently, the U.S. railroad industry dominates less than 50% of
total freight in America, indicating a huge opportunity for
increasing market share. This opportunity can only be exploited by
building railroad infrastructure that caters to the varied
requirements of shippers.
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, railroad companies are hiking their freight
rates by nearly 5% per annum on average, while maintaining a
double-digit profit margin.
Duopolistic Market Structures:
Railroad companies have, by and large, gained by practicing
discretionary pricing in the freight market. In the prevailing
duopolistic rail industry, railroad operators will be 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. Union Pacific and Burlington Northern
Santa Fe control the western part of the U.S., while CSX Corp. and
Norfolk Southern control the eastern part. On the other hand,
Canadian Pacific and Canadian National control inter country rail
shipment between the U.S. and Canada.
Despite the above-mentioned positives, the freight railroad
industry, like other industries, faces certain external and
internal challenges. These are as follows:
Capital Intensive Nature:
The railroad industry is highly capital intensive that requires
continued infrastructural 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.
Positive Train Control Mandate:
The Rail Safety Improvement Act 2008 (RSIA) has mandated the
installation of PTC (Positive Train Control) by Dec 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 Jan 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.
The pricing practices of U.S. freight railroads comprise the major
reason 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
The unfair pricing power exhibited by the U.S. railroads has
prompted intervention of the Congress. The latter intends to
implement stringent federal regulations on railroads. So far, the
Congress has discussed railroad price regulation but has not passed
any new rule yet.
U.S. Environmental Protection Agency:
Railroad companies 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 affected by implementation of the new regulation that could
pose a significant threat to utility coal tonnage.
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