(The following story by Peter Smith appeared at Morningstar.com on June 26.)
In the classic board game Monopoly, railroads are a pretty good investment. In contrast, real-world railroad stocks have been perennial underperformers, making disappointed investors wish they possessed the portfolio equivalent of a “get out of jail free” card. Until recently, that is. During the last few years, railroads have been singing a more dulcet tune, one that they might continue to croon even if the economy takes a protracted dive.
A Brief History
From their inception in the 1830s through the first half of the 20th century, railroads transported most of North America’s freight. In 1956, however, President Eisenhower signed landmark legislation that spawned the modern highway system, which, in turn, gave rise to the trucking industry. Subsequent government acts freed truckers and railroads from government regulation (for the most part), further intensifying the natural competition between the two.
As could be expected, truckers’ superior service records and greater flexibility prompted shippers, over time, to shift their freight to trucks instead of railroads. The railroads had a tough time remaining competitive; only certain freight groups, such as coal, were immune to these pressures because they could not easily be shipped by truck. Many believed that the government would eventually take over the industry, a la Amtrak.
Another factor didn’t help: Railroads have to maintain their tracks while truckers look to the government to foot the bill for highway maintenance. As a result, the railroad industry spends a greater percentage of sales on capital expenditures than any North American industry. Correspondingly, the industry as a whole has not been able to earn its cost of capital–that is, create economic value–for many years.
The Present
Today, six railroads dominate the North American landscape: Burlington Northern Santa Fe BNI and Union Pacific UNP govern the western two thirds of the United States, CSX CSX and Norfolk Southern NSC operate east of the Mississippi, and Canadian National CNI and Canadian Pacific CP run extensive networks throughout Canada and parts of the United States. Each company is a collection of many smaller railroads, the end product of years of industry consolidation. Other small regional railroads also exist, but in the interest of focus, I will stick to trends affecting “The Big Six.”
Unbeknownst to many, these firms have been absolutely crushing the market in the last couple of years. “But wait,” I hear you saying, “you said this was an industry that doesn’t earn its cost of capital, so why is everyone so excited?” True, the industry as a whole is still struggling to create economic value, but several recent trends have converged to produce perhaps the best operating environment for railroads in a half-century. As part of that, the trucking industry is facing a host of challenges that have threatened its competitive advantage over railroads. Let’s look more closely at three freight groups to get a better grasp of the situation:
Coal
Coal is the largest commodity transported by railroads and, as such, has always been one of the industry’s most profitable and stable freight groups. Railroads move about 60% of the United States’ coal, primarily because it is too heavy for trucks to transport cost-effectively over long distances. This is all well and good, but historically demand for coal hasn’t grown all that much.
That has changed recently, however, as growth in electric demand has skyrocketed, both here and abroad. Natural-gas prices remain much higher than historical levels, and nuclear generation is operating at full capacity. As a result, utilities are burning more coal to generate power. Morningstar coal analyst Elizabeth Collins expects demand for coal to continue, especially as new coal-fired electric-generating plants are built over the next several years.
Coal constitutes about 25% of revenue for both CSX and Norfolk Southern, but the firms likely to see the most volume growth in coal are the two western railroads, Burlington Northern Santa Fe and Union Pacific, whose coal franchises represent closer to 20% of sales. These two carriers serve the Powder River Basin (PRB), an area of Wyoming where low-sulfur coal is particularly abundant. Though PRB coal has lower energy content, it is cheaper than other types of coal, and its low sulfur content makes it more environmentally friendly. As emissions standards tighten, many utilities are opting for the cheaper, cleaner PRB coal in order to be in compliance.
Agricultural Products
Agricultural products are another important commodity group for the railroads. Trucks shy away from hauling grain, corn, and the like because of their inherently low weight/value ratio and because their delivery is not typically time-sensitive. Two factors are likely to keep demand for agricultural products strong despite an economic swoon. First, people in several emerging markets, China in particular, are consuming more beef as their diets evolve to include more protein. As a result, their countries have begun importing more agricultural products that can be used as livestock feed.
The other factor has to do with one of today’s hottest industries: ethanol. The Big Six have found themselves right in the middle of the ethanol craze and stand to benefit in several ways. As ethanol production increases, the railroads will be transporting corn needed for production to the facilities and then moving the final product to fuel-mixing plants, since ethanol cannot be transported via pipelines (though it can be hauled in trucks). In addition, the byproducts of ethanol production have value as a feedstock, so the railroads are likely to transport those as well.
The only railroads that wouldn’t be a good play on these trends are CSX and Norfolk Southern. The other four are all big players in the agricultural transportation market and are strategically positioned to handle both the increase in exports as well as the increase in domestic demand stemming from growing ethanol production.
Intermodal
Last, but not least, is intermodal transportation. Intermodal refers to the process of moving a container or trailer via more than one mode (e.g., truck and rail). A simple intermodal transaction might go like this: A container arrives at port via steamship, a truck moves the container from port to local railyard, a railroad moves the container to Chicago, and a truck moves the container from Chicago to the local distribution center.
Intermodal transportation has grown substantially in recent years and is projected to grow at 6%-7% annually over the next five years. Three related reasons are driving this growth: First, the domestic trend toward outsourcing manufacturing operations has greatly lengthened supply chains, meaning more goods are traveling longer distances to reach their destinations. Second, the trucking industry is in the midst of one of its worst-ever driver shortages as potential drivers spurn the long hours away from home for relatively low pay. As a result, trucking firms have had a tough time expanding fleets to accommodate all the containers coming into the ports. Third, fuel prices have been on the rise (you noticed?), and rail transportation is as much as 3 times more fuel-efficient than truck transportation, especially over longer distances. None of these factors is expected to change much in the near future.
Intermodal transportation is a significant revenue source for several of the railroads, but particularly Burlington Northern Santa Fe, Norfolk Southern, and Canadian Pacific. For each firm, intermodal jobs account for at least 20% of total revenue, and the companies are tweaking their networks to open up capacity for future growth.
Closing Thoughts
The Monopoly analogy is particularly apt, given that some shippers claim that the railroads themselves are a monopoly (or an oligopoly functioning as a monopoly). Whether you agree or not, what cannot be argued is that these are some pretty good times for the railroads, and, in my view, the party should continue for at least a little while longer. Sure, there are reasons to be skeptical: Transportation rates may rise to the point that outsourcing is no longer as attractive as it once was, the trucking industry could find some sort of Band-Aid for its driver shortage, and the railroads’ less-than-stellar service record could invite further government regulation as the industry continues to hike its rates. And let’s not forget that railroads still haul some highly cyclical products (e.g., automobiles, chemicals, etc.), remain extremely capital-intensive, and refuse to add capacity until their returns improve.
Railroad executives like to tout the long-term “structural changes” that have gone on in the industry over the last few years. But Norfolk Southern CEO Wick Moorman admitted at his firm’s recent annual meeting that “we will not know how deep and how significant these underlying [structural changes] are until we see a soft patch in the economy.” That time may be upon us, and only time will tell if the “rail renaissance” ultimately, uh, derails. My hunch, though, is that the industry will still continue to thrive, and while Mr. Market may not agree with me, his broad violent thrashes could create what I’d view as some excellent bargains.