Railroad Stocks Navigate a Choppy Track - Zacks Analyst Interviews

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 2014.

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 positive.

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 CSX Corp. ( CSX ), Kansas City Southern ( KSU ) and Union Pacific Corporation ( UNP ). 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 companies.

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.

Norfolk Southern ( NSC ) 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.

Crude Shipment

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 ground.

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 originations.

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 report.

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. ( HMC ), Nissan Motor Co. ( NSANY ), 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%.

Grain Shipments

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. railroad.

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 U.S. railroads.

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 tonnage.

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 natural gas prices 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.

Rail Investments

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 prospects.

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 demand.

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 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. 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.

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.

CSX CORP (CSX): Free Stock Analysis Report

HONDA MOTOR (HMC): Free Stock Analysis Report

KANSAS CITY SOU (KSU): Free Stock Analysis Report

NISSAN ADR (NSANY): Get Free 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 Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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