(The following story by Marilyn Alva appeared on the Investor’s Business Daily website on July 3.)
In the face of floods, fuel prices and a feeble economy, the railroads keeping chugging along. The rail boom that began almost five years ago shows no signs of derailing.
Cargo shipments have declined for consumer goods, autos and anything related to housing, such as lumber. But demand for coal and agricultural commodities — corn, wheat and soybeans — keeps soaring. Railroads haul much of it.
“It’s a tale of two economies,” said Wick Moorman, chief executive of Norfolk Southern. (NSC)
The segments that are doing well more than make up for those that aren’t.
What’s more, the industry has pricing power while the ailing trucking industry continues to reel from high fuel costs, labor shortages and highway congestion — all factors that play to railroad’s strengths.
Railroads are more fuel-efficient and emissions-friendly than trucks: A single intermodal train can move the equivalent of 280 truck loads. Averaged over the total load, a ton of freight transported by train can go 436 miles on a gallon of fuel, four times further than it can by truck.
“Even as the economy has cooled, the railroads have not,” said Tony Hatch, an industry consultant at ABH Consulting.
Most railroads are racking up double-digit earnings growth. As of Thursday, rail transport stocks ranked No. 14 among IBD’s 197 industry groups.
Major railroad freight firms include Union Pacific, (UNP) the largest in the U.S.; Kansas City Southern; (KSU) CSX; (CSX) Norfolk Southern; and BNSF Railway, a subsidiary of Burlington Northern Santa Fe. (BNI)
Canadian National (CNI) runs several freight lines in the U.S. as well as Canada, where it has invested in infrastructure to serve western Canadian ports.
1. Business
Railroad transport is a gritty business. Railroads own and maintain their own tracks and equipment, making freight rail one of the most capital-intensive industries in the U.S.
Railroads move about 40% of the U.S.’ freight, says the American Association of Railroads (AAR). They connect businesses across the country and with markets overseas.
They invest almost 18% of their revenue on new equipment and infrastructure vs. 3% for the average U.S. manufacturer, according to the AAR. Including maintenance, the amount ticks up to 40 cents for every dollar of sales.
Fortunately, the rail companies have become more efficient and productive since the industry was largely deregulated in 1980.
Since then, the industry has consolidated, trimming excess capacity and labor. Still, operators had to cut prices in the 1980s and ’90s to compete with truckers and with each other.
Getting into fighting shape took years for the railroads, but by 2003 the industry was “right-sized,” observers say. It happened around the same time the trucking industry, which had long overpowered rail, hit a wall.
Rail volumes grew. Suddenly, the railroads could start raising rates.
“That was the beginning of the rail renaissance,” Moorman said. “Even with the economy where it is today, we’re operating much closer to capacity than we did from 1980 to 2000.”
Railroads aren’t immune to rising diesel fuel costs. While customer contracts typically include fuel surcharges, those extra fees trail real-world fuel-price changes by about two months.
“So if fuel prices spike suddenly, the railroad is exposed until the fuel surcharge rate can catch up,” said Adam Longson, a research analyst with Morgan Stanley, in an e-mail. “Any sudden swings in fuel cause short-term earnings volatility.”
Name Of The Game: Pricing is a “key pillar to earnings growth,” according to Morgan Stanley analysts. Operators also improve returns by finding ways to channel more shipments through a finite number of rails and cars.
2. Market
The two biggest drivers of rail-transport growth are agricultural commodities and coal.
Through mid-June, grain carloads jumped almost 17% from the same period in 2007, says the AAR.
Rising demand for export grains due to global shortages has spurred growth out of West Coast ports and the railroads that serve them, most notably BNSF.
Coal cars rose 3.6%, while lumber and wood carloads dropped 18.7%. Autos and car parts fell 14%.
Rail moves more coal than any other single product — some 3.29 million tons in the U.S. through mid-June alone. Most is used to generate electricity.
Utilities in the East are becoming more interested in securing low-sulfur coal from the Powder River Basin in Wyoming. The largest Powder River coal shipments typically move to generating plants in the Midwest and Texas.
Meanwhile, export demand for Appalachian coal has spiked — as have prices — since coal-producer China began limiting coal exports so that it could better meet internal needs. That’s good news for Eastern operators Norfolk Southern and CSX.
Besides commodity products, trains carry intermodal trailers and containers, which move from vessels or trucks onto flatbed rail cars, often in double stacks.
Railroads are increasingly collaborating with trucking companies to go the long haul. So in that respect, trucks are customers rather than rivals.
Until the economy started slowing last year, intermodal traffic had been the fastest-growing segment of the rail industry. But intermodal traffic fell more than 3% through mid-June vs. the first half of 2007.
The decline reflects the slowdown in consumer goods, especially those shipped in containers from China and other parts of Asia.
“When the economy is hitting on all cylinders, railroads do pretty well. When it doesn’t, they don’t escape,” said Ken Kremar, economist with Global Insight.
Fortunately for the railroads, he added, “Coal and grain march to their own drummer.”
3. Climate
Fuel and weather issues cause earnings volatility. The weather can — literally — slow trains to a stop.
Nowhere did weather impact the railroads more than in the Midwest in June as heavy rains caused the worst flooding in years.
Most major railroads were affected either directly or indirectly. Union Pacific, followed by BNSF and Canadian National, were hit most by the floods, analysts say. But the impact is temporary.
A weak auto industry and continued plant closings continue to hamper railroad auto volumes, though Kansas City Southern saw auto revenue rise 19% in the first quarter over 2007’s, due in part to higher prices.
JPMorgan estimates that autos make up 8% to 11% of total sales for major railroads with the exception of BNSF, where it’s only 3% to 4%.
On the closely watched legislative front, the industry is fighting a bill that would increase regulation. It also is asking Congress to limit railroads’ liability for accidents involving toxic materials and wants tax credits and more public funds to expand.
Meanwhile, shareholder activists have distracted CSX’s management recently. Two hedge funds fought a proxy battle to replace five directors. CSX said the vote on June 25 was too close to call and would announce the results at its annual meeting on July 25.
4. Technology
Sophisticated software systems are helping railroads run more efficiently. New gate-control hardware and software enables drivers and terminal clerks to communicate better, which allows terminals to handle more intermodal traffic.
Hatch, the consultant, points to tests of new traffic management and global positioning systems that could improve safety and perhaps increase capacity up to 20%.
At the same time, new locomotives promise to reduce fuel use and emissions.
5. Outlook
Analysts expect railroads to enjoy strong pricing power for the foreseeable future.
While coal is a hot commodity this year, some say it could dampen top lines next year as production slows a little due to a recent buildup of coal inventories.
Coal exports will likely slow next year as well, says Kremar, which could lead to a slight drop next year in rail ton-miles.
Ethanol will likely continue to drive domestic demand for corn. Demand for corn and wheat exports from the West Coast should remain strong due to global droughts and food shortages.
However, flood-related damage to U.S. crops could result in poor harvests in the fall and reduce grain shipments.
Efforts to boost productivity and yields could offset some of the negative head winds.
Upside: When the economy turns around, railroads will likely get an extra push. Consumer spending could show signs of life starting next year, some say.
“Beyond 2009, we’re generally optimistic on where the economy is going,” Kremar said. “When housing and consumer spending comes back, intermodal traffic should pick up.”
Risks: Regulatory changes — especially the possibility of re-regulation — might take some of the steam out of railroads’ growth engine. Accidents and bad weather are ever-present threats.