U.S. Railroad Industry Outlook (May 2011)

Early indications are painting a rosy picture for the U.S. Freight Railroads in 2011. In the first quarter of 2011, the U.S. rail carload volume was up nearly 5.3% compared with the prior-year quarter.

A recent report of the Association of American Railroads (AAR), the main trade body of the U.S. Freight Railway industry, stated that the first quarter 2011 rail carload volume, excluding grain and coal, is up nearly 7.9% to 4.6 million compared with the prior-year quarter. This was the second best first quarter, after a rise of 9.3% last year.

Fiscal 2010 was a turnaround year for the railroad industry after a huge downturn in 2009 due to the recession. The industry has achieved this result despite a severe winter storm during this period. Importantly, industry players are now more confident that this performance will get further momentum during the rest of 2011.

Excluding coal and grain, rail cars generally ship all those materials that are required as inputs for industrial production. As such, the significant growth in rail car volumes is indicative of broader macro-economic improvement in the U.S. economy.

There are four reasons for this strong performance by the railroad operators:

(1) Increasing worldwide demand for coal in power generation. Utility coal volumes are expected to recover year over year mainly due to increase in electricity generation. Recently, this trend becomes more visible after the devastating earthquake and Tsunami in Japan, which resulted in serious nuclear power crisis in that country. Coal exports to Europe and other Asian countries are also likely to remain buoyant in the near future.

(2) Industrial production in the U.S. is expected to grow more than 3% in 2011. Intermodal traffic, mainly consisting of containers and trailers, is growing at a whopping rate. In the first quarter of 2011, intermodal shipment volume upped 8%-9% year over year.

(3) The U.S. government has taken several measures to boost American manufacturing and raise its exports. At present, the U.S. railroad industry commands less than 50% of total freight in America indicating a huge opportunity to increase market share.

In fact, the railroad industry is gaining market share from the trucking industry. The truck tonnage volume inched down 2.9% in the first quarter of 2011, mainly attributable to driver shortage, massive rise in fuel costs, and highway congestion.

(4) The U.S. government has decided to scale back its ruling that made it mandatory for freight rails to install new anti-collision technology called “Positive Train Control.” This will save approximately $500 million for the industry and may enable every freight rail operators to increase its respective free cash flow by around 20%-25%.

Freight Railroad: Economic Growth Driver

Freight rail is a “derived demand” industry — demand for rail services is tied to the demand for the products that railroads haul. Rail traffic, therefore, acts as a solid barometer for the overall health of the economy. With the U.S. economy on an uptrend, notwithstanding some near-term jitters, the fortunes of the railroad industry are on the mend.

Several railroad operators have expressed their confidence that growth rate of business volume in 2011 will exceed the U.S. GDP and industrial production growth rate. Similarly, core pricing gains in 2011 will also exceed inflation.

Several positive trends (both macro-economic and inter-industry) are helping the U.S. freight railroad operators to significantly increase their capital expenditures. AAR has reported that the freight railroads will spend a record high of $12 billion in 2011 for manpower recruitment, installation of new rail tracks and other capital projects. The railroad industry is expected to hire 10,000 new employees in 2011.

Investment by railroad operators for product and service improvement is far ahead of other transportation industries. Very few U.S. industries can match the railroad operators with respect to high capital investment rates. Fiscal 2010 witnessed a record breaking $10.7 billion capital investment, which is now expected to grow by another 12%-13% in 2011. Investments in capacity, innovations and use of several state-of-the-art technologies led to service improvements and enhanced reliability.

An improving U.S. economy, the rebound in automotive shipments, and improvements in many end-markets are expected to fuel the future growth of the Railroad industry. Nevertheless, despite this impressive growth, some near-term concerns still persist.

Carload Yet to Reach Pre-Recession Levels

The January 2011 report of the Association of American Railroads (AAR), the main trade body of the industry, clearly stated that although total carloads on U.S. railroads grew 7.3% year over year in 2010 and total intermodal volume increased 14.2% year over year in 2010, both figures are still way behind the pre-recession 2008 level. Volume levels of almost all the product categories are yet to reach the 2008 high.

Moreover, coal consisting of approximately 37% of total U.S. railway carloads in 2010 is significant. Coal carloads in 2010 have inched up 2.2% year over year but remain significantly below the 9% of the pre-recession 2008 level.

OPPORTUNITIES

The railroad industry as a whole offers a number of attributes that are difficult to ignore from the standpoint of investors.

Discretionary Pricing Power: The freight railroad operators function in a seller’s market enjoying pricing power since 1980 when the U.S. government adopted the Staggers Rail Act. The idea was to allow rail transporters to hike price 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, the railroads are hiking their freight rates on an average by nearly 5% per annum and are maintaining double digit profit margins.

Competitive Advantage: From the customers’ point of view, rail transport is cheaper and fuel-efficient than truck and ship transport. As a result, railroads are gaining market share from other means of transport. Several truck operators went bankrupt during the peak recessionary period that helped railroads to become default freight transporters for mid-to-long distances.

Technical Superiority: Overall, investment by railroad operators for product and service improvement is far ahead than other transportation industries. Investments in capacity, innovations and use of several state-of-the-art technologies have led to service improvements and enhanced reliability. AAR claims that freight rail transporters together invested a significant amount of $42 billion in the previous two years for railroad track expansion and maintenance.

Currently, we remain Neutral on Union Pacific Corp. (UNP), Kansas City Southern (KSU), CSX Corp. (CSX), Norfolk Southern Corp. (NSC), Canadian Pacific Railway Ltd. (CP) and Canadian National Railway Co. (CNI). However, due to strong growth momentum of the industry, our long-term view remains positive for all these Class 1 freight railroad operators.

WEAKNESSES

Despite the above-mentioned positives, the freight railroad industry, like other industries, also has some structural weaknesses. These are as follows:

Government Regulations: Railroads are subject to the ratification of laws by Congress that could increase regulation of the industry. A 2010 report presented by the U.S. Senate Commerce Committee stated that the discretionary pricing power enjoyed by the Class I freight rail transport companies are putting excessive pressure on freight customers.

The Senate Commerce Committee headed by Sen. John D. Rockefeller has opined that the railroads have become financially stable and a higher transportation rate is actually impacting household budgets. It remains to be seen how the railroad industry maintains growth if any adverse changes occur related to its discretionary pricing policy.

Capital Intensive Nature: Railroad is a highly capital intensive industry that requires continued infrastructure improvements and acquisition of capital assets. Industry players access the credit markets for funds from time to time. Adverse conditions in the credit markets could increase overhead costs associated with issuing debt, and may limit the companies’ ability to sell debt securities on favorable terms.

Unionized Labor: Most of the railroad operator’s employees are unionized and are covered by collective bargaining agreements. These agreements are bargained nationally by the National Carriers’ Conference Committee. In the railroad industry, negotiations generally take place over a number of years. Failure to negotiate amicably could result in strikes by the workers resulting in loss of business.

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