Railroad Industry Stock Outlook: Mixed Results

Consistent with the macro trends, railroads delivered mixed results in the second quarter of the year. According to the rail traffic report for the first six months of 2013, growth in automotive and petroleum products’ shipments was steady, while coal and grain shipments continued to cast a shadow over the rail freight industry.

According to the Association of American Railroads’ (AAR) rail traffic report, cumulative performance by the North American railroads (U.S. , Canadian and Mexico) rose 1.4% year over year at quarter end. The biggest contributor to this growth has been the surge in petroleum and petroleum products carloads offset by lesser grain volumes.

Zacks Industry Rank
Within the Zacks Industry classification, railroads are grouped in Transportation sector (one of 16 Zacks sectors).

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 #186, implying that the outlook remains Negative on this sector. This highlights a subdued outlook for the industry with a number of near-term headwinds likely to offset the long-term growth opportunities for the industry.

Earnings Trend of the Sector
The broader Transportation sector, of which railroads are part, reflects a stable growth trend. So far, 100% of the sector participants have reported second-quarter results, which have been fairly good in terms of both beat ratios (percentage of companies coming out with positive surprises) and growth.

The earnings "beat ratio" was 60%, while the revenue "beat ratio" was 20.0% in the second quarter. Total earnings for the companies in this sector grew 3.5% year over year on 2.7% revenue growth. Although earnings showed modest improvement from 3.3% year-over-year growth in first quarter 2013, revenue growth in the second quarter was lower in comparison to 3.1% year-over-year growth achieved in the first quarter.

The Consensus earnings expectation, pegged at 10.4% for the third quarter 2013 and 12.2% in the subsequent quarter. Overall, the sector is expected to register full-year growth of 10.1%. In terms of revenue expectation, the sector is expected to register 4.5% and 4.8% year-over-year growth in the third and fourth quarters of the year, resulting in an annual growth rate of 4%.

Second Quarter 2013 Financial Results
Going by the quarterly performance of the class 1 railroad, we see volume growth from most of these carriers. Most of the carriers including Kansas City Southern (KSU), Canadian National Railway Company (CNI), Canadian Pacific Railway Ltd. (CP), CSX Corp. (CSX) and Norfolk Southern Corp. (NSC) showed modest volume growth. One of the largest class 1 railroads in North America -- Union Pacific Corp. (UNP) -- registered a decline in volume due to agricultural shipments.

Volume growth aided year-year-year top-line improvement the in all but Norfolk Southern. Despite a modest volume growth, Norfolk Southern was down year over year and missed the Zacks Consensus Estimate. While most of the class 1 railroads generated higher bottom line results beating earnings estimates, Norfolk Southern lagged year over year and failed to meet our expectation.

The primary catalyst to this bottom-line performance for most of the carriers was operational efficiency even in times of low market demand. Rising employee productivity, deployment of fuel-efficient locomotives and undertaking railroad safety measures were some of the key drivers of profitability even in adverse market conditions.

Rail carriers like Canadian Pacific recorded operating ratio improvement of 1,060 basis points year over year. Continued focus on maintaining asset efficiencies, safety measures and increased productivity have been the prime contributors to Canadian Pacific’s success in the second quarter. There are several other near-term growth catalysts in the railroad industry.

Rising Contribution of Petroleum Product Shipment
According to the AAR report, rail traffic from petroleum products has seen a whopping 38% growth in the first six months. According to the Energy Information Administration’s (EIA) reports, U.S. crude oil reached 7.5 million barrels per day production in Jul 2013, representing record growth since the last two decades.

On average, EIA expects crude oil growth at around 7.4 million to 8.2 million barrels per day, suggesting a stable market condition. This growth may go up to 10 million barrels per day over a period of 2020 to 2040, according to EIA reports.

As a result, this surge represents an opportunity for revenue accretion, which the railroads are trying to achieve with infrastructural development. According to industry sources, the role of crude oil as a revenue contributor has grown by leaps and bounds in a four-year span from a mere 3% to 30% of the oil and petroleum products shipment by railroads.

Despite the fact that rail-based crude transportation costs five times more ($10–$15 per barrel), 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 railroads transportation for crude oil shipping in these areas. According to reports, rail-loading capacity is expected to grow to 200,000 b/d by 2013 for crude oil shipments from Western Canada.

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.

Another railroad company, Canadian Pacific projects crude shipment to reach up to 70,000 oil-tank cars by the year end and move to 140,000 by the end of 2015. In the coming days, 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.

Automotive
Currently, Mexico is a growing market for automotive production and assembly given the lower cost of production in the region. In the first six months of 2013, auto shipments by rail in Mexico increased 2.7 while in the U.S., auto shipment via rail rose about 3.7%. This growth was largely offset by 5.9% drop in rail auto shipments in the Canadian market.

However, despite a modest first half of the year, industry sources project that auto production are slateed to pick up in the second half, resulting in a record level of 16 million, representing the highest sales figure since the economic downturn in 2008.

We believe upcoming plants 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 proposed expansion plans, 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.

Intermodal
The railroad industry is gaining largely from the ongoing conversion of traffic from truckload to rail intermodal. Intermodal is gaining popularity among shippers given its cost effectiveness over truck. On average, railroads are considered 300% more fuel-efficient than trucks, resulting in growing importance of rail intermodal. According to AAR’s rail traffic report, intermodal volume was up 3.7% on container traffic in Canada, which rose 4.4%.

Currently, rail intermodal accounts for over 20% of the railroads’ revenue, second in line after coal. In the coming years, we expect this contribution to only rise given the growing dependence of shippers on intermodal services.

Coal
Coal is an important commodity and accounts for over 40% of railroad tonnage. According to AAR traffic reports, coal volumes in North America decreased 4% year over year. According to EIA reports, coal production was 21 million short tons (MMst) in first half 2013, representing a 4% decline from the year-ago corresponding period.

However, with rising natural gas prices and consumption in the electric power plants the second half of the year will see growth in total coal production to 1,016 MMst in 2013. EIA also projects coal production to reach 1,050 MMst in 2014, representing 3.3% growth from the 2013 level.

Grain Shipments
Since 2012, the grain market has been experiencing lows due the drought in the Mid-West markets. According the rail traffic report of AAR, North American grain shipment registered a decline of almost 10% in the first six months of 2013, which was largely offset by 64% growth in Mexican grain shipment.

In Aug 2013, the U.S. Department of Agriculture (USDA) released the World Agricultural Supply and Demand Estimates report, which states that global corn supplies will be 2.7 million tons lower due to lesser corn production in the U.S., Mexico, Europe, Russia and Serbia. This projection lends an unfavorable trend for railroad grain shipments in the upcoming months.

Further, U.S. corn export outlook also remain subdued on lower production forecast. We believe that the impact of lowered estimates would be felt on railroad shipment as rail freight serves the majority of export shipment in the crop market.

Rail Investments
Investment in development and expansion plans remain critical 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 a loss of 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 leverage balance sheet. According to AAR reports, railroads invest approximately 17% of their annualized revenue, which compares with only 3% of average U.S. manufactures’ revenue on capital expenditures.

According to the Department of Transportation (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. In respect of current investment requirements, railroads would invest about $24.5 billion in 2013 according to AAR. This figures project an escalating trend when compared with recorded investment of $23 billion in 2012 and $12 billion in 2011 as per AAR.

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.

OPPORTUNITIES
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.

CHALLENGES
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.

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