Railroads continue to benefit from the ongoing highway
conversion due to their cost effectiveness over truckloads.
Currently, rail intermodal services are considered as one of the
most fuel-efficient modes of freight transportation, and
therefore remain the backbone of the railroad freight business.
Year 2012 was a mixed bag for the U.S. Freight Railroad Industry,
though results of the final quarter are just getting underway.
Railroads started the year with stellar first quarter results and
continued the growth trajectory with a fair second quarter
performance in an otherwise subdued economy.
During this period, the industry leveraged its operating
capabilities, improving service metrics and improving cost
management to compensate the lack of market demand, which
resulted in poor freight carloads. Post mid-2012, railroads
experienced a setback in their performances despite the growing
demand for intermodal services. This was due to the
much-anticipated slowdown in coal shipments that hampered growth
in other commodities and core pricing.
The current market dynamics of the rail industry remains
challenged by a slowing volume trend, mostly of coal. However,
the bright spot continues to remain the unparalleled pricing
power of this industry over shippers. Based on these factors,
earnings growth for railroads operators in the third quarter
ranged from negative 22% to positive 18%. Revenues also
registered a similar level of fluctuation and ranged between
negative 7% and positive 8%.
Operational efficiency of the railroads, as indicated by
operating ratio (OR), also plunged. Most the companies reported
OR in the low 70s range in the third quarter of 2012 as against
their past performances this year that mainly hovered around
mid-to-high 60s.
The statistics stated above are based on the quarterly
performance of class I railroads. The principal behind
considering these railroads as the benchmark is explained below.
Railroad 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
revenues.
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 alteration.
Currently, there are 9 major railroads in America that are
classified under Class I freight railroads. These include
Union Pacific Corporation
(
UNP
),
CSX Corporation
(
CSX
),
Norfolk Southern Corp.
(
NSC
),
Canadian National Railway Company
(
CNI
),
Canadian Pacific Railway
(
CP
), BNSF Railway,
Kansas City Southern
(
KSU
), Ferromex and Kansas City Southern de México (wholly owned
subsidiary of Kansas City Southern Railway).
These carriers can be further categorized on the basis of 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 operates
predominantly 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, these control more than 90% of
freight revenues and employment generated in the industry.
Consequently, Class I carriers are good indicators of the
performance of the rail industry and are crucial when analyzing
railroad trends.
The Track Ahead
The year 2013 depicts a mixed picture for the railroads. The U.S.
GDP forecast for 2013 is also not very encouraging due to the
macroeconomic environment. Going by the latest reports, the
growth rate for 2013 is expected to hover around 1.5% to 2%.
Uncertainties over the fiscal cliff and perpetuating impacts of
the impending tax increases would likely weigh over the country's
economic growth, pulling it down from the 2012 level. Thus, the
impacts on railroads will not be any different from the other
sectors.
However, railroads do have certain windows of opportunity, which
can be banked upon. The key among these is the rise in intermodal
alongside petroleum and automotive shipments.
Intermodal Runs the Show
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, and we believe that
intermodal will play an important role in driving the rail
industry based on the growing awareness among shippers about its
benefits.
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.
Petroleum Fuels Growth
Surge in shale oil and natural gas sales catapulted growth in
petroleum product shipments. 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 by leaps and bounds in a four-year span
from a mere 3% to 30% of the oil and petroleum products shipment
by railroads. According to the EIA, production for U.S. crude oil
is estimated at approximately 6.8 million barrels per day for
2013, representing record growth in two decades.
Natural gas production would, however, experience a slowdown on a
pricing uptick. Consumption would register modest growth on a
rise in residential, commercial and industrial consumption
compensating for the decline in its usage for electricity
generation.
Automotive a Good Ride
Automotive shipments also form a significant part of rail
shipments, as automotive sales are set to recover from their
downturn in 2009 when U.S. sales hit their lowest in three
decades. In 2012, automotives maintained their growth trajectory
with U.S. light vehicle sales ranging between 14 million and 15
million. However, in the coming year, the growth can be slightly
muted by the onslaught of the expected fiscal cliff.
According to market reports, auto sales may see single-digit
growth due to a change in consumer behavior owing to the U.S. tax
policy changes. If the situation improves on the macro front,
there should not be a cyclical downturn in the way of
Automotives.
Besides all these positive catalysts leading the way into 2013,
railroads still have to face a challenging market scenario in
Coal.
Coal Worries Continue to Linger
Coal represents one of the single-most important commodities and
accounts for over 40% of railroad tonnage.
Domestic coal demand, of which utility coal accounts for
approximately 93%, is witnessing persistent declines. Lower
natural gas prices imply that gas is largely substituting the
demand for utility coal. Additionally, higher stockpile levels
have resulted in lower utility coal demand.
Over 90% of the total coal production in the U.S. is dedicated to
electricity generation. Going by market reports, in 2012, only
one-third of the U.S. power plants used coal for electricity
generation, a steep decline from approximately 50% in 2008.
Natural gas prices, another important factor that resulted in the
decline of coal-powered plants are the environmental issues
associated with coal burning.
However, the Energy Information Administration (EIA) projects
coal consumption by power plants to grow 6% in 2013 on an
anticipated rise in natural gas prices. 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.
This represents approximately one-sixth of the existing coal
capacity in the U.S. and approximately 5% of total electricity
generation nationwide.
On the export front, U.S. coal, mostly metallurgical coal gained
significant market traction with the U.S. emerging as a global
coal export hub. According to EIA projections, U.S. coal exports
experienced its prime time in 2011 with 10% of total coal
production, representing the highest point in the past 20 years.
EIA remains positive on the U.S. coal export outlook, which is
expected to get stronger in the coming days.
However, in 2013, there is a foreseeable decline in coal exports
according to EIA. Factors like an economic overhang in European
markets, higher stockpile levels and increased exports from
Indonesia and a recovery in the Australian mines are the primary
reasons for the expected decline. Overall, the expected uptick in
the domestic market will likely balance the declines in the
export market for coal, representing a flat picture in 2013 in
terms of year-over-year growth.
OPPORTUNITIES
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. 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.
WEAKNESSES
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 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.
Price Regulations:
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 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.
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.
Investment Possibilities
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
their 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 for
increasing market share. This opportunity can only be exploited
by 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 over $140 billion to improve rail network
infrastructure within this stipulated period.
We have a Zacks #3 Rank, implying a Hold rating over the short
term (1-3 months) on Union Pacific Corporation, Norfolk Southern,
Canadian Pacific Railway and Kansas City Southern. For Canadian
National Railway and CSX Corporation, we have a Zacks #4 Rank,
implying a short-term Sell rating.
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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