(UNP) U.S. Railroad Stock Outlook – September 2011 – Industry Outlook

The U.S. Freight Railroads have been able to keep up the momentum despite facing unusual weather conditions and an extremely volatile U.S. economy. Solid commodities volumes, healthy demand for coal and improved efficiencies are helping the railroads to continue their strong performance.

The railroads are also benefiting from the significant rise in the cost base of the trucking industry. This combination of cyclical and secular trends is helping the railroads carry ever more cargos, which is helping them to take the current economic uncertainties in the stride.

Fiscal 2010 was a turnaround year for the railroad industry after the downturn in 2009 due to the Great Recession. In 2011, the railroads are benefiting from strong pricing gains reflecting yield improvements and higher fuel surcharges. Importantly, industry players remain confident that this performance momentum remain in place in the back half of the year and into next year.

Driving this railroad outperformance are four key factors:

(1) Increasing worldwide demand for coal in power generation. Utility coal volumes are expected to recover year over year, mainly due to an increase in electricity generation. This trend became more visible after the devastating earthquake and Tsunami in Japan, resulting in a 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) The U.S. industrial production is expected to continue growing 2011, though the pace of expansion may moderate a bit given the economic uncertainty. This is helping drive the growth of intermodal traffic, which mainly consists of containers and trailers.

In the second-quarter 2011, core pricing of railroads improved 4.5% to 5% year over year. This strong pricing environment was primarily driven by a significant improvement of Intermodal segment pricing. We believe rail transportation companies will continue to enjoy pricing power in the near to medium term.

(3) The positive trend in the U.S. export performance works to the railroad industry’s advantage as it helps the industry carry more freight and gain market share. At present, the U.S. railroad industry commands less than 50% of total freight in America, which represents a key opportunity for the industry to increase market share.

In fact, the railroad industry is gaining market share from the trucking industry. The truck tonnage volume inched down 1.3% in July 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 makes it mandatory for freight rails to install new anti-collision technology called “Positive Train Control.” This government decision will save approximately $500 million for the industry, resulting in a roughly 20%-25% free cash flow boost for most industry operators.

Freight Railroad an Economic Growth Driver

Freight rail is a “derived demand” industry — rail services are 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. 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 gain in 2011 will also exceed inflation.

Several positive trends are helping the U.S. freight railroad operators to significantly increase their capital expenditures. Association of American Railroads (AAR), the main trade body of the industry, 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.

Investments by railroad operators for product and service improvements are far ahead of the other transportation industries. Very few U.S. industries can match with the railroad operators with respect to high capital investment rate. 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.

Greater overall freight volume across the freight railroad networks, massive surge in coal and automotive shipments, significant increase in oil deliveries from the Bakken area of North Dakota to refineries on the Gulf Coast, and a sharp rebound 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 Volume Yet to Reach the Pre-Recession Level

Although business volume increased in the last year, this is still below the pre-recession 2008 level. The current state of economic uncertainty in the U.S. and abroad may keep railroad’s top-line growth under pressure in the near future, with most sectors unable to fully recover from the Great Recession.

Railroads are particularly sensitive to economic conditions. For the week ending August 6, 2011, the AAR reported that carloads moved by the U.S. railroads inched down 1.2% year over year.

Legal Tussles

For a long time, the pricing practices of the U.S. freight railroads have been contested by captive shippers, who ship their products through railroads and do not have effective shipping alternatives. These companies are predominantly from the electric utilities, chemical, agricultural and mining sectors.

Congress has discussed railroad price regulations, but so far has not approved any new rules. In June 2011, the U.S. Surface Transportation Board, the federal agency that regulates railroads, discussed the issue in detail. A regulatory response to the industry’s pricing practices will be a net negative for the major freight rail carriers.

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 effectively 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 have been hiking their freight rates on an average of nearly 5% per annum, which is helping them maintain strong 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 the 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 would maintain current growth levels 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.

CDN NATL RY CO (CNI): Free Stock Analysis Report

CDN PAC RLWY (CP): Free Stock Analysis Report

CSX CORP (CSX): Free Stock Analysis Report

KANSAS CITY SOU (KSU): Free Stock Analysis Report

NORFOLK SOUTHRN (NSC): Free Stock Analysis Report

UNION PAC CORP (UNP): Free Stock Analysis Report

Zacks Investment Research

About vitalstocks

This is a sample profile field. Vitalstocks is the operating company for Stockbloghub. This will place the picture of the author or company in the profile. Here is another extra line of information.

Comments

Powered by Facebook Comments


Similar Posts: | | | | | | | | | | | | Railroads | Services

RSS feeds: Canadian National Railway Company | Canadian Pacific Railway Limited | CNI | CP | CSX | CSX Corporation | Kansas City Southern | KSU | Norfolk Southern Corporation | NSC | Union Pacific Corporation | UNP | Railroads | Services |

Other Posts by | RSS Feed for this author