Railroad Industry Stock Outlook - Feb. 2012 - Industry Outlook

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The U.S. Freight Railroads performed exceptionally well in 2011 despite difficult weather conditions and an extremely volatile U.S. economy. Solid commodities volumes, effective cost management, and improved rail efficiency helped U.S railroads to continue their strong performance.

The railroads are gaining momentum over the trucking industry due to significant rise in fuel costs of truckers. Currently, the railroads are carrying more cargos, which is helping them gain market share.

During fiscal 2011, the railroads benefited from strong pricing gain reflecting both solid yield improvement and higher fuel surcharges. Shipments of construction components, lumber and motor vehicle volumes increased over 30% year over year. Petroleum product shipment rose 29% year over year.

Importantly, industry players are now more confident that this excellent performance will get further momentum during fiscal 2012. In the first half of January 2012, total rail carloads increased 5.5% year over year, of which intermodal volume rose 7.4%.

Here are some of the key attributes of the U.S. railroad industry:

  1. The Railroad industry is characterized as high barriers to entry. It is not easy to lay railway tracks and start shipments. The rail operators need to spend a significant amount of money as capital expenditures to maintain safety and technical improvements. Association of American Railroads (AAR), the main trade body of the industry, reported that the freight railroads together have spent a record high of $12 billion in 2011 for manpower recruitment, installation of new rail tracks and other capital projects.
  2. There are six large freight railroad operators in the U.S., and they actually enjoy a duopolistic situation. While the western part is controlled by Union Pacific and Burlington Northern Santa Fe, the eastern part is controlled by CSX Corp. and Norfolk Southern. On the other side, Canadian Pacific and Canadian National control inter-country rail shipment between the U.S. and Canada. This duopolistic situation helps freight railroad operators to reap maximum benefit from rising prices as overall demand for the economy grows.
  3. The U.S. government has taken several measures to boost American manufacturing while raising its exports. At present, the U.S. railroad industry commands less than 50% of total freight in America indicating huge opportunity to increase market share. In fact, the railroad industry is gaining market share from the trucking industry. On average, railroads are 300% more fuel efficient than the trucks. We expect fuel cost to go up in future, which may drastically shift the industry dynamics in favor of the railroads.
  4. The U.S. government decided to scale back its ruling that makes it mandatory for freight rails to install new anticollision technology called "Positive Train Control." The latest government decision will save approximately $500 million for the industry and may enable every freight rail operators to increase its respective free cash flow by around 20%-25%.


Freight Railroad - an Economic Growth Driver

Freight rail is a "derived demand" industry and rail services are tied to the demand for the products that railroads haul. Rail traffic, therefore, acts as a solid barometer for the overall health of the economy.

Several railroad operators have expressed their confidence that growth rate of business volume in 2012 will exceed the U.S. GDP and industrial production growth rate. Similarly, core pricing gains in 2012 will also exceed inflation.

In 2011, core pricing of railroads improved 4.5% - 5% year over year. This strong pricing environment was primarily driven by a significant improvement of intermodal segment pricing. We believe rail transportation companies will continue to push price increase toward their customers throughout 2012.

Investment by railroad operators for product and service improvement is far ahead than other transportation industries. Very few U.S. industries can match with the railroad operators with respect to high capital investment rate. Investments in capacity, innovations and use of several state-of-the-art technologies led to service improvements and enhanced reliability.

Greater overall freight volume across the freight railroad networks, massive surge in coal and automotive shipments, significant increase in oil deliveries from the Bakken area of North Dakota to refineries on the Gulf Coast, and a sharp rebound in many end markets are expected to fuel the future growth of the Railroad industry. Nevertheless, despite this impressive growth, some near-term concerns still persist.

Carload Volume Yet to Reach the Pre-Recession Level

Although business volume increased in the last year, this is still below the pre-recession 2008 level. The current state of volatile economy in the U.S. and abroad may keep railroad's top-line growth under pressure in the near future, with most sectors unable to fully recover from the global economic recession. Railroads are particularly sensitive to economic conditions.

Coal Demand Worries

In September 2011, Alpha Natural Resources and Walter Energy, the two large coal mining companies forecasted a decline in coal shipments in near future. The current global volatility that affected mining activities, the sudden drop in demand from the Asian markets sighting problems over quality along with harsh weather conditions in the Pacific region have resulted in a major setback for these coal companies.

Lower natural gas prices and higher utility stockpile levels have also raised their concerns. This is a big blow to rail operators as they banked mostly on these coal producers for shipments to domestic as well as international markets.

Legal Tussles

For a long time, the pricing practice of the U.S. freight railroads is a major cause of tussle with captive shippers, who ship their products through railroad and do not have effective alternatives for shipping. These companies are predominantly from electric utilities, chemical, agricultural and mining sectors.

Congress has discussed about railroad price regulation but so far did not approve any new rules. In June 2011, the U.S. Surface Transportation Board, the federal agency that regulates railroads, discussed the issue in details. We believe if the regulators decide to scrap pricing power, the major freight rail carriers will be severely affected.

OPPORTUNITIES

The railroad industry as a whole offers a number of attributes that are difficult to ignore from the standpoint of investors.

Discretionary Pricing Power: The freight railroad operators function in a seller's market enjoying pricing power since 1980 when the U.S. government adopted the Staggers Rail Act. The idea was to allow rail transporters to hike price 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, the railroads are hiking their freight rates on an average by nearly 5% per annum while maintaining a double digit profit margin.

Competitive Advantage: From the customers' point of view, rail transport is cheaper and fuel-efficient than truck and ship transport. As a result, railroads are gaining market share from other means of transport. Several truck operators went bankrupt during the peak recessionary period that helped railroads to become default freight transporters for mid-to-long distances.

Technical Superiority: Overall, investment by railroad operators for product and service improvement is far ahead than other transportation industries. Investments in capacity, innovations and use of several state-of-the-art technologies have led to service improvements and enhanced reliability. 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.

Currently, we remain Neutral on Union Pacific Corp. ( UNP ), Kansas City Southern ( KSU ), CSX Corp. ( CSX ), Norfolk Southern Corp. ( NSC ), Canadian Pacific Railway Ltd. ( CP ) and Canadian National Railway Co. ( CNI ). However, due to strong growth momentum of the industry, our long-term view remains positive for all these Class 1 freight railroad operators.

WEAKNESSES

Despite the above mentioned positives, the freight railroad industry, like other industries, also has some structural weaknesses. These are as follows:

Government Regulations: Railroads are subject to the ratification of laws by Congress that could increase regulation of the industry. A 2010 report presented by the U.S. Senate Commerce Committee stated that the discretionary pricing power enjoyed by the Class I freight rail transport companies are putting excessive pressure on freight customers.

The Senate Commerce Committee headed by Sen. John D. Rockefeller has opined that the railroads have become financially stable and a higher transportation rate is actually impacting household budgets. It remains to be seen how the railroad industry maintains growth if any adverse changes occur related to its discretionary pricing policy.

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 operator's 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.


 
CDN NATL RY CO ( CNI ): Free Stock Analysis Report
 
CDN PAC RLWY ( CP ): Free Stock Analysis Report
 
CSX CORP ( CSX ): Free Stock Analysis Report
 
KANSAS CITY SOU ( KSU ): Free Stock Analysis Report
 
NORFOLK SOUTHRN ( NSC ): Free Stock Analysis Report
 
UNION PAC CORP (UNP): Free Stock Analysis Report
 
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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , Business , Investing Ideas , Stocks

Referenced Stocks: CNI , CP , CSX , KSU , NSC

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