Will Sluggish Automotive Production Derail Railroads?

It is a well-established fact that coal-related headwinds battered stocks in the railroad space over the past few years, however things are looking up now on that front thanks to President Trump’s favorable views on the commodity. An improving economy also means good news for railroads. Despite this optimism, one must be mindful of certain factors still hurting stocks in the space before investing in the sector. Let’s delve into the details.

Sluggish Automotive Production: Major Headwind

Weakness in the automotive sector had hurt the results of major railroads in the second quarter, with production in the U.S. declining substantially. However, the major worry is that the scenario is expected to worsen ahead, thereby hurting railroads big time. In fact, sector participants like Union Pacific Corp. (UNP), CSX Corp. (CSX) and Norfolk Southern Corp (NYSE:NSC). (NSC) have issued disappointing views for the back half of the year.

Union Pacific on its second-quarter conference call said that light vehicle production in North America for the third quarter is projected to decline approximately 6%. Moreover, light vehicle sales for full-year 2017 are projected at 17.1 million units, reflecting a 2% decline from 2016 levels. Norfolk Southern, meanwhile, said that automotive production, which declined 6.5% year over year in the U.S. in the second quarter, is projected to be worse with a 9.3% decline in the third quarter.

The disappointing commentaries above imply a bleak outlook for railroads pertaining to automotive volumes in the remaining quarters of the year. With the automotive sector accounting for a significant chunk of their revenues, softness in automotive volumes will hurt railroads big time.

Reciprocal Switching – What Lies Ahead?

The regulations concerning reciprocal switching proposed by the Department of Transportation’s Surface Transportation Board (STB) could hurt railroads big time, if implemented. The proposal — also referred to as forced access by the Association of American Railroads (AAR) — implies that shippers without access to other transportation modes will be permitted to use a competing rail line without any additional pricing and possibly at below-market rates.

AAR is against the implementation of the proposal as it might lead to the top line of railroads shrinking significantly. Moreover, increased costs are likely to hurt the bottom line. In Jul 2017, AAR’s President and Chief Executive Officer Edward Hamberger reportedly urged STB not to implement proposals pertaining to forced switching among others. Consequently, investors interested in the railroad would keenly wait for updates on this burning issue.

Other Headwinds

One of President Trump’s efforts to revive the coal industry is to do away with the Clean Power Plan (CPP), which is a favorable development for railroads. However, the task is easier said than done, with many hurdles along the way. Moreover, Norfolk Southern’s commentary on coal for the latter half of the year is also troubling. According to the company, though the coal scenario is projected to improve further in the second half of 2017, the pace will be sluggish primarily due to a slowdown in export of the commodity. The company said that export tonnage is likely to be lower than the levels witnessed in the first half of the year. It is projected to come down to the range of 4 million to 5 million ton per quarter.

Moreover, the Trump administration is making efforts to renegotiate the North American Free Trade Agreement (NAFTA) – the trade pact inked in 1994 between the U.S., Canada and Mexico – in a bid to secure better terms for domestic workers. We note that railroads like Kansas City Southern (NYSE:KSU) have significant exposure to Mexico. In this scenario, any unfavorable development on NAFTA has the potential to hit these companies hard.

Kansas City Southern carries a Zacks Rank #2 (Buy). You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.

Conclusion

The above write-up clearly indicates that railroads are not bereft of headwinds despite the optimism surrounding the space. The challenges can result in investors, especially the risk-averse ones, shying away from the sector.

Check out our latest Railroad Industry Outlook for more news on the current state of affairs in this market from an earnings perspective, and how the trend looks ahead for this important sector at the moment.

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