The year 2014 set the railroads on a choppy track. Harsh winter
weather had taken its toll on most of the freight transportation
companies and railroads seem to be no exception. Operational
efficiencies went down, while costs went up, leading some major
railroads to lower their bottom-line expectations for
Zacks Industry Rank
Within the Zacks Industry classification, railroads are broadly
grouped within the 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 #32,
implying that the outlook remains positive on this sector. This
highlights an encouraging earnings outlook for the industry despite
being persistently prone to seasonality factors. While the outlook
of some of the product lines will fluctuate with seasonally, the
demand outlook for Intermodal offerings remains consistently
Expectations of improved U.S. economic growth in the coming
quarters and beyond is a net positive for this economically
sensitive sector. We remain optimistic as railroads are witnessing
gradual recovery in Coal shipments. Further, the upsurge in
petrochemical shipments has also uplifted the markets conditions of
this industry leading to earnings improvement.
Earnings Trends of the Sector
The broader Transportation sector, of which railroads are part,
reflects a sustainable growth trend. In the currently underway Q1
earnings season, 95% of the sector market capitalization have
reported results, with total earnings up +7% on +3.3% higher
revenues, with 66.7% beating EPS estimates and 33.3% beating
revenue estimates. This is better performance than the broader
S&P 500, but weaker than what we saw from the same group of
companies in 2013 Q4 and the 4-quarter average.
Nevertheless, the sector is expected to register full-year earnings
growth of 7.4% in 2014. In terms of revenue expectation, the sector
is expected to register 4.4% growth.
For a detailed look at the earnings outlook for this sector and
others, please read our weekly
Earnings Trends report
First Quarter 2014 Financial Results
The major companies that have so far reported include
Kansas City Southern
Union Pacific Corporation
). While Union Pacific and Kansas City reported year-over-year
increases in earnings, CSX recorded a drop. However, year-over-year
top-line growth has consistently been on the rise for these
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. According to the
Association of American Railroads (AAR), North American Rail
Traffic was driven by 3.3% growth in Intermodal volumes in the
first quarter. The growth was largely seen in U.S. intermodal
business with volume expanding 3.8% year over year.
Railroads are now looking forward 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.
) 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 Potosi.
According to the Energy Information Administration's (EIA) reports,
crude oil growth may go up to 10 million barrels per day over a
period of 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
to 0.03% in 2008 when the concept of crude by rail started gaining
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 - railroad moved over 60% of North Dakota's crude oil
production, which contains the vast majority of new rail crude oil
Further, in terms of safety, railroads offer a better
transportation avenue compared to pipeline given 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, railroads are
simultaneously working toward tightening rail safety measures by
appealing federal regulators to phase out old tank cars if these
are not upgraded. Railroads are also seeking improved standards for
new tank cars.
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.
Canadian Pacific projects crude shipment to reach 140,000 by the
end of 2015. In the coming months, 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.
Although, total North American automotive shipment by rail fell
3.5% in the first quarter, the Mexican market saw a 12.8% rise in
auto shipments by rail according to AAR freight rail traffic
Despite a modest first quarter, industry sources project that auto
production are slated to pick up, resulting in a record level of 16
million, representing the highest sales figure since the economic
downturn in 2008.
We believe plants established 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 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 into 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 along with the opening of new 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. North American grain shipment for the first quarter
increased 9.5%, led by 15% growth in grain shipment by the U.S.
However, shipping difficulties due to winter weather debarred
Canadian railroads like Canadian Pacific and Canadian National
Railway from extraordinary gains derived from a strong Canadian
harvest in 2013.
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 dipped below 6 million in 2013, approximately 4.4%
down from 2012 levels according to AAR reports. The decline in coal
carloads offset the positive impacts of gains from crude oil for
Fraught with issues raised by the regulatory environmental agency,
decelerating demand from power plants for electricity generation
and the shutdown of coal-fired power plants, there is only a bleak
chance for railroads to draw any benefit from this commodity
segment, which continues to contribute a large part of railroad
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 higher consumption due to 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 as a result of weak global economic
conditions, slow demand growth rate in Asian markets, rising coal
production in other countries and lower international coal prices.
Investments in development and expansion plans remain crucial 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 lesser 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 leveraged balance sheet. According to AAR
reports, railroads invest approximately 17% of their annualized
revenues, which compares with only 3% of average U.S. manufactures'
revenues on capital expenditures.
According to 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
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 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
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.
CSX CORP (CSX): Free Stock Analysis Report
HONDA MOTOR (HMC): Free Stock Analysis Report
KANSAS CITY SOU (KSU): Free Stock Analysis
NISSAN ADR (NSANY): Get Free Report
NORFOLK SOUTHRN (NSC): Free Stock Analysis
UNION PAC CORP (UNP): Free Stock Analysis
To read this article on Zacks.com click here.