Railroads: Investing Essentials

Four decades ago, long haul truckers and cargo airlines seemed poised to displace a rusty, aging rail network. But deregulation and more tightfisted management allowed railroads to avoid the route to irrelevancy.

Today, the 150-year-old railroad industry is not just relevant, but thriving. That once ancient rail network is now considered the "envy of the world" by industry journalists and executives alike. Meanwhile, Warren Buffett endorsed rail transport with a $44 billion acquisition of the largest carrier in 2009 - a bet that's paying off handsomely .

The reasons for the railroad's renaissance are critical for investors to understand. So are the signals that will show us its ability to endure. For those not wanting to be left at the station, here are some key things to know about the industry.

Source: Wikipedia/ Kabelleger

What is the railroad industry?

When we talk about the railroad industry, we are referring to the business of hauling freight on tracks that crisscross North America.

Freight includes the things we come in contact with everyday, like cars and consumer products. It also includes the things we need but rarely see, like coal and chemicals. What it does not include, however, are passengers. Amtrak, a publicly funded railroad service, has conducted the long distance transport of passengers since 1971. This separation of freight and passenger services was instrumental in allowing carriers to survive on a stand-alone basis.

Today, there are seven major railroads that control 69% of total U.S. freight rail mileage. They are designated "Class I" carriers, a distinction that separates them from the short-line and regional operators that compete over the remaining 31% of the freight market. The chart below lists pertinent information about the seven Class I carriers and one of the largest short-line carriers, Genesee & Wyoming :

Country Miles of Track Market Share 2013 Sales
Burlington Northern Santa Fe U.S. 32,000 25% 22,014
Union Pacific U.S. 32,000 24% 21,963
CSX U.S. 21,000 14% 12,026
Norfolk Southern U.S. 20,000 14% 11,245
Canadian National Railway Canada 20,421 11% 10,269
Canadian Pacific Railway Canada 15,000 7% 5,956
Kansas City Southern U.S. 6,000 3% 2,369
Genesee and Wyoming U.S. 7,400 1% 1,569

Sales in USD millions. Source: Freight Rail Works and Bloomberg

Each railroad operates in a specific area of the continent so that no single carrier can monopolize a region or major route. BNSF and Union Pacific canvas the western half of the U.S, CSX and Norfolk Southern serve the eastern corridor, and the Canadian carriers span our neighboring country to the north. Kansas City Southern covers a region that extends from Missouri all the way to Central America.

How big is the railroad industry?

While there are numerous ways to measure the size of a railroad, the most relevant statistic for the industry is the percentage of American goods moved by rail. Each carrier aims to offer a viable transportation alternative relative to other modes. That shared objective is one of the reasons the railroad has remained relevant over the years. Today, the railroads move approximately 40% of U.S. freight measured by ton-miles (the length freight travels). Trucks, pipelines, and ships haul a respective 28.6%, 19.6%, and 12% of the remaining intercity freight.

At first glance, it might seem as though railroads tower over the competition. But railroads capture the lion's share of heavy bulk freight, which tends to give them a leg up in terms of total weight shipped. At the same time, they work closely with trucking companies to ship consumer goods efficiently in stackable and easily transferrable "intermodal" containers. Intermodal has been the rail's fastest-growing business since 1980.

Size is of significant concern to regulators who could suspect that the seven carriers are colluding to fix prices. However, a smoothly functioning transportation system is also critical. Further, railroads are private organizations that are responsible for their own maintenance and improvement projects, which separates them from a trucking industry that relies on federal funding to improve the highways. In fact, the railroad industry frequently reminds regulators and customers of its role in removing traffic from our congested highway systems.

In terms of revenue, Bloomberg estimates the overall industry revenue is roughly $82 billion.

How does the railroad industry work?

Source: Flickr/ cta web

Mark Twain once said that "A railroad is like a lie -- you have to keep building it to make it stand." Although he was a steamboat captain - and not a conductor - the man knew a thing or two about rail.

Even today, railroads require constant investment just to keep existing operations intact, safe, and reliable. Only a small amount of cash - roughly 15%-20% of capital expenditures - can go toward growth and expansion.

This is one of the most important economic aspects of railroads that investors need to understand. It's one that Buffett grappled with before pulling the trigger on BNSF because he loathes capital-intensive businesses. He was probably well aware of this little-known statistic: The railroad industry as a whole failed to earn returns higher than its cost of capital for 70 years prior to 2011. That's astonishing and perhaps terrifying to would-be investors.

Nevertheless, railroads benefit today from the fact that regulation maintains high barriers to entry in the industry. Each year the Surface Transportation Board assesses whether rails are earning a return on capital that is sufficient to attract investment. All Class I carriers have earned above this hurdle rate every year since 2011. On top of that, a few key drivers are moving in the right direction for rail.

What are the drivers of the railroad industry?

Source: Flickr/ Roy Luck

The rationale for investing in railroads can be summed up in one simple statement from Buffett: "It's the right way to move goods around the country if you can do it."

Buffett was talking about his thesis on railroads in an interview with Charlie Rose. His observation, as usual, was spot-on.

Rail is undoubtedly the cheapest and most energy-efficient way to move bulk goods across the vast expanse of North America. According to the Association of American Railroads, a ton of freight can be transported an average of 476 miles on one gallon of fuel - roughly the distance between Boston and Washington, D.C. That makes rail more efficient than trucking and thereby highly competitive during a period of high energy prices.

And even when the domestic energy boom threatens to depress prices, the rails manage to benefit in other ways. Delayed fuel pipelines, like the Keystone, result in a substantial boost in crude oil transport for many major carriers. The amount of crude oil hauled by Class I railroads ballooned more than 4,000% in the past six years, from 9,500 carloads in 2008 to 400,000 carloads in the last twelve months. Even Buffett couldn't have imagined the bonanza that would result from the transportation of domestic energy.

To be sure, railroads are not exactly revisiting the Gilded Age. While oil transport is spiking, coal is fading . And each carrier must still grapple with all sorts of issues, including safety concerns, regulatory risk, potential workers' strikes, and the need for substantial hub upgrades near ports and metropolitan areas. But relative to where it stood some 40 years ago, this industry's moving steadily in the right direction.

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The article Railroads: Investing Essentials originally appeared on

Isaac Pino, CPA has no position in any stocks mentioned. The Motley Fool recommends Canadian National Railway and Genesee & Wyoming. The Motley Fool owns shares of Canadian National Railway and CSX. Try any of our Foolish newsletter services free for 30 days . We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy .

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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.

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