Consistent with the macro trends, railroads delivered mixed
results in the second quarter of the year. According to the rail
traffic report for the first six months of 2013, growth in
automotive and petroleum products' shipments was steady, while coal
and grain shipments continued to cast a shadow over the rail
According to the Association of American Railroads' (AAR) rail
traffic report, cumulative performance by the North American
railroads (U.S. , Canadian and Mexico) rose 1.4% year over year at
quarter end. The biggest contributor to this growth has been the
surge in petroleum and petroleum products carloads offset by lesser
Zacks Industry Rank
Within the Zacks Industry classification, railroads are grouped in
Transportation sector (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
of #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
#186, implying that the outlook remains Negative on this sector.
This highlights a subdued outlook for the industry with a number of
near-term headwinds likely to offset the long-term growth
opportunities for the industry.
Earnings Trend of the Sector
The broader Transportation sector, of which railroads are part,
reflects a stable growth trend. So far, 100% of the sector
participants have reported second-quarter results, which have been
fairly good in terms of both beat ratios (percentage of companies
coming out with positive surprises) and growth.
The earnings "beat ratio" was 60%, while the revenue "beat ratio"
was 20.0% in the second quarter. Total earnings for the companies
in this sector grew 3.5% year over year on 2.7% revenue growth.
Although earnings showed modest improvement from 3.3%
year-over-year growth in first quarter 2013, revenue growth in the
second quarter was lower in comparison to 3.1% year-over-year
growth achieved in the first quarter.
The Consensus earnings expectation, pegged at 10.4% for the third
quarter 2013 and 12.2% in the subsequent quarter. Overall, the
sector is expected to register full-year growth of 10.1%. In terms
of revenue expectation, the sector is expected to register 4.5% and
4.8% year-over-year growth in the third and fourth quarters of the
year, resulting in an annual growth rate of 4%.
Second Quarter 2013 Financial Results
Going by the quarterly performance of the class 1 railroad, we see
volume growth from most of these carriers. Most of the carriers
Kansas City Southern
Canadian National Railway Company
Canadian Pacific Railway Ltd.
Norfolk Southern Corp.
) showed modest volume growth. One of the largest class 1
railroads in North America --
Union Pacific Corp.
) -- registered a decline in volume due to agricultural shipments.
Volume growth aided year-year-year top-line improvement the in all
but Norfolk Southern. Despite a modest volume growth, Norfolk
Southern was down year over year and missed the Zacks Consensus
Estimate. While most of the class 1 railroads generated higher
bottom line results beating earnings estimates, Norfolk Southern
lagged year over year and failed to meet our expectation.
The primary catalyst to this bottom-line performance for most of
the carriers was operational efficiency even in times of low market
demand. Rising employee productivity, deployment of fuel-efficient
locomotives and undertaking railroad safety measures were some of
the key drivers of profitability even in adverse market conditions.
Rail carriers like Canadian Pacific recorded operating ratio
improvement of 1,060 basis points year over year. Continued focus
on maintaining asset efficiencies, safety measures and increased
productivity have been the prime contributors to Canadian Pacific's
success in the second quarter. There are several other near-term
growth catalysts in the railroad industry.
Rising Contribution of Petroleum Product Shipment
According to the AAR report, rail traffic from petroleum products
has seen a whopping 38% growth in the first six months. According
to the Energy Information Administration's (EIA) reports, U.S.
crude oil reached 7.5 million barrels per day production in Jul
2013, representing record growth since the last two decades.
On average, EIA expects crude oil growth at around 7.4 million
to 8.2 million barrels per day, suggesting a stable market
condition. This growth may go up to 10 million barrels per
day over a period of 2020 to 2040, according to EIA reports.
As a result, this surge represents an opportunity for revenue
accretion, which the railroads are trying to achieve with
infrastructural development. According to industry sources, the
role of crude oil as a revenue contributor has grown by leaps and
bounds in a four-year span from a mere 3% to 30% of the oil and
petroleum products shipment by railroads.
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 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 railroads transportation for crude oil
shipping in these areas. According to reports, rail-loading
capacity is expected to grow to 200,000 b/d by 2013 for crude oil
shipments from Western Canada.
Major railroad companies like Norfolk are seeking expansion
strategies fueled mostly by the 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.
Another railroad company, Canadian Pacific projects crude shipment
to reach up to 70,000 oil-tank cars by the year end and move to
140,000 by the end of 2015. In the coming days, we expect railroads
to accelerate their investments in order to create adequate service
capacity for the oil and gas markets resulting in 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.
Currently, Mexico is a growing market for automotive production and
assembly given the lower cost of production in the region. In the
first six months of 2013, auto shipments by rail in Mexico
increased 2.7 while in the U.S., auto shipment via rail rose about
3.7%. This growth was largely offset by 5.9% drop in rail auto
shipments in the Canadian market.
However, despite a modest first half of the year, industry
sources project that auto production are slateed to pick up in the
second half, resulting in a record level of 16 million,
representing the highest sales figure since the economic downturn
We believe upcoming plants by
Honda Motor Co., Ltd.
Nissan Motor Co.
), Mazda and Audi would further boost auto production in Mexico.
The facilities also bode well for automotive shipments. Based on
these proposed expansion plans, 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 into Mexico and
return the finished products to the domestic market as well as to
the U.S. and Canada.
The railroad industry is gaining largely from the ongoing
conversion of traffic from truckload to rail intermodal. Intermodal
is gaining popularity among shippers given its cost effectiveness
over truck. On average, railroads are considered 300% more
fuel-efficient than trucks, resulting in growing importance of rail
intermodal. According to AAR's rail traffic report, intermodal
volume was up 3.7% on container traffic in Canada, which rose 4.4%.
Currently, rail intermodal accounts for over 20% of the railroads'
revenue, second in line after coal. In the coming years, we expect
this contribution to only rise given the growing dependence of
shippers on intermodal services.
Coal is an important commodity and accounts for over 40% of
railroad tonnage. According to AAR traffic reports, coal volumes in
North America decreased 4% year over year. According to EIA
reports, coal production was 21 million short tons (MMst) in first
half 2013, representing a 4% decline from the year-ago
However, with rising natural gas prices and consumption in the
electric power plants the second half of the year will see growth
in total coal production to 1,016 MMst in 2013. EIA also projects
coal production to reach 1,050 MMst in 2014, representing 3.3%
growth from the 2013 level.
Since 2012, the grain market has been experiencing lows due the
drought in the Mid-West markets. According the rail traffic report
of AAR, North American grain shipment registered a decline of
almost 10% in the first six months of 2013, which was largely
offset by 64% growth in Mexican grain shipment.
In Aug 2013, the U.S. Department of Agriculture (USDA) released
the World Agricultural Supply and Demand Estimates report, which
states that global corn supplies will be 2.7 million tons lower due
to lesser corn production in the U.S., Mexico, Europe, Russia and
Serbia. This projection lends an unfavorable trend for railroad
grain shipments in the upcoming months.
Further, U.S. corn export outlook also remain subdued on lower
production forecast. We believe that the impact of lowered
estimates would be felt on railroad shipment as rail freight serves
the majority of export shipment in the crop market.
Investment in development and expansion plans remain critical when
analyzing railroads prospects. These capital investments are a
double-edged sword. While the investments put significant stress on
margin performance, forgoing these would result in a loss of growth
Railway investments are paramount given the evolving supply chain
management and increasing role of airfreight carriers in offering
freight transportation services. These investments build the
required infrastructure needed for railways to stay afloat in a
competitive environment not only within the railroad industry but
also with other modes like truck, barges and cargo airlines.
As a result, investments in infrastructural projects have been an
integral part of railroads development. 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 liquidity position of the company and
may lead to a highly leverage balance sheet. According to AAR
reports, railroads invest approximately 17% of their annualized
revenue, which compares with only 3% of average U.S. manufactures'
revenue on capital expenditures.
According to the Department of Transportation (DOT), 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 $149 billion to
improve rail network infrastructure within this stipulated period.
In respect of current investment requirements, railroads would
invest about $24.5 billion in 2013 according to AAR. This figures
project an escalating trend when compared with recorded investment
of $23 billion in 2012 and $12 billion in 2011 as per AAR.
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 make it mandatory for
railroads to infuse more capital on 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,
for railroads it is important to balance profitability levels while
investing in infrastructural development projects.
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, railroads are hiking their
freight rates by nearly 5% per annum on 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 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:
Railroad is a highly capital intensive industry 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 are the major
reasons 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
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.
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.
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