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
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
Norfolk Southern Railway
Canadian National Railway
Canadian Pacific Railway
), BNSF Railway,
Kansas City Southern Railway
), 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
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
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
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
Going forward, railroads remain hopeful about U.S. GDP growth,
which was revised at 1.7%, up from preliminary estimate of
The railroad industry as a whole offers a number of
opportunities that are difficult to ignore from the standpoint of
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
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
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
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.
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.
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
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).
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