For quite some time now, the freight railroad industry has been facing the brunt of weak domestic coal shipment volumes and deteriorating oil prices . Being a mature industry, railroads require steady investments to maintain competitiveness, which in turn makes it vulnerable to certain external and internal challenges.
Further, as rail-based companies need to access the capital markets on a regular basis, the chance of default is always high. Moreover, the cyclical nature of business coupled with government regulations and volatile exchange rates continue to act as headwinds for railroad operators.
Below, we discuss key factors which investors should consider while investing in railroad stocks:
Oil Price Decline
Over the last few months, oil prices have been hovering around the $55 mark. However, increased supplies have triggered oil prices to slip below 6-year low and are currently hovering around $42 per barrel.
Earlier, rising crude prices lent competitive cost advantage to the railroad industry against transportation modes like trucking. However, declining oil prices will not only generate lower fuel surcharges from clients for rail companies but will also intensifies competition as truckers benefit from the price slump.
Meanwhile, pipeline developments across oil fields have boosted demand for transportation through pipelines over railroads, thereby denting profits for major rail companies.
After recording impressive numbers in 2014, The United States Department of Agriculture (USDA) expects agricultural exports to stoop to its lowest level since 2012 at $140.5 billion in 2015, down by $12 billion from the previous year. Such a massive decline in agricultural exports may hurt railroad carloads in the forthcoming year.
Capital-Intensive Nature: The capital-intensive nature of the railroad industry leads to continuous network upgrades and infrastructural developments on a timely basis. As a result, the need for huge investments becomes the priority for railroad companies. To meet capital needs, these companies borrow significant funds, thereby expanding its leverage position. Moreover, this practice may lead to higher interest rate payments and declining cash flow for railroad companies.
Meanwhile, Kansas City Southern, which generally invests in the U.S., Mexico and Panama region, trimmed its capital spending target for 2015 to the range of $650 million to $670 million, from the earlier projected band of $700 million to $720 million. We believe that the uncertainty prevailing in the energy markets coupled with the weakening of the Mexican peso versus the U.S. dollar has prompted the outlook cut.
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 of nearly $2.3 billion for the rail industry over a four-year period. We believe that the implementation of the GROW AMERICA act, may certainly improve the safety standards of railroad operators. However, the need to invest in advanced research work associated with it may drive costs.
U.S. Environmental Protection Agency: Railroad companies are presently concerned about the proposed regulation of the U.S. Environmental Protection Agency (EPA) for power plants across 27 states. The projected 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 affected by implementation of the new regulation that could pose a significant threat to utility coal tonnage.
Meanwhile, the oil shale boom in North Dakota and Montana has resulted in a consistent increase in the volume of flammable liquids transported by rail over the past one decade. However, this rise in crude-by-rail shipments has brought about derailment of entailed multiple railcars owing to inadequate safety standards.
According to a Associated Press report, there have been at least 23 oil-train and 33 ethanol train accidents since 2006 in the U.S. and Canada alone. The accidents were mostly cases of fire or derailment, several of which resulted in large-scale oil spills. We believe that such mishaps will continue to hurt the overall railroad industry.
Coal is a key revenue driver for the railroad business. Deteriorating business from coal continues to impact rail freight carriers. Moreover, coal is an essential unit for electricity generation. However, declining oil prices have compelled most power plants to substitute coal for cheaper natural gas for electricity production. EIA expects coal consumption in the electric power unit to drop by 7.4% in 2015 from 2014. Such a scenario is also responsible for lackluster domestic demand for coal.
Moreover, sluggish global demand, unfavorable international coal prices, strict environmental regulatory norms, and improving coal production in other countries are poised to hurt coal carloads further. Furthermore, the EIA believes that annual coal production for 2015 is likely to decline by 82.8 MMst, mainly because of weaker domestic demand and exports. EIA also believes that production in 2016 will be around 926.7 MMst.
The second quarter of 2015 has not been a pleasant one for railroad companies like Norfolk Southern Corporation ( NSC ) and Union Pacific Corp. ( UNP ). Both companies witnessed a 10% drop in revenues from the last-year quarter mainly influenced by a 21% and 26% decline in coal volumes, respectively.
Weaker coal shipments have also prompted Union Pacific Corp. to cut hundreds of management jobs. While Kansas City Southern was the most affected with a 43% drop in coal volumes, CSX Corp. expects domestic coal volumes to decline 10% in 2015.
Considering these bearish factors, we believe that currently the railroad industry is braving multiple headwinds. Despite CSX Corp. ( CSX ) and Canadian National Railway Co. ( CNI ) reporting earnings growth in the second quarter of 2015, we remain highly apprehensive about the future prospects of these companies.
Check out our latest Railroad Industry Outlook here for more on the current state of affairs in this market from an earnings perspective, and how the trend is looking for this important sector of the economy now.
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