An improving U.S. economy, massive surge in automotive shipments, and a sharp rebound in many end-markets are expected to fuel the future growth of the railroad industry. 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 of the overall health of the economy. With the U.S. economy emerging from the recession, the fortunes of the railroad industry are also on the mend.
The U.S. freight railroad industry is witnessing gradual improvement since early 2010. As the U.S. economy continues to grow, albeit at the pace of expansion moderating modestly temporarily in the second half of 2010, demand for carriage also becomes robust and the momentum is expected to sustain in the long-run.
In the second quarter of 2010, all the Class 1 freight railroad operators in the U.S. achieved commendable results, primarily due to significant improvement in operating metrics, massive growth in business volume and pricing gains. The latest report of the Association of American Railroads (AAR), the main trade body of the industry, is even more encouraging.
Increasing Freight Loads
The recent AAR report clearly shows that freight load activity is quickly approaching the pre-recession 2008 level, and if the trend continues, volumes will likely exceed the 2008 level. In August 2010, total carload volume per week was higher than any month since November 2008. The positive momentum is affirmed as the report says carload volume of the first week of September was highest so far in 2010.
Improved Industrial Activity
The U.S. industrial production is expected to grow more than 3% in the second half of 2010. Intermodal traffic, mainly consisting of containers and trailers, is growing at a ramped-up rate. According to the AAR report, weekly average intermodal traffic in August 2010 was 234,000, the highest since October 2008 and up 20% year-over-year.
Metal and Energy products are witnessing massive shipments. The AAR report shows that demand is particularly strong for iron ore, rolled steel, several metal scraps, and oil and natural gas drilling accessories including pipe, sand and different types of clays.
Coal is also expected to drive continued strength for the rest of the year driven by industrial and export demand. Going forward, utility coal volumes are expected to recover year-over-year mainly due to increase in electricity generation. Furthermore, coal exports to Europe and Asia are also likely to remain buoyant in the near future.
Growing Global Agricultural Demand
Demand for agricultural products throughout the world is also increasing. From railroad operators’ point of view, agricultural product demand is less cyclical in nature and is a hedge against economic uncertainty. The most revealing feature in the latest AAR report was that China, the largest emerging economy, is turning out to be a net importer of agricultural commodities. The recent decision of the Russian government to stop wheat exports may become a major catalyst for the U.S. grain exporters. Additionally, the AAR report states that demand for potash fertilizer, corn and soybeans also remains healthy.
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. Because of the Staggers Rail Act, the railroads are hiking their freight rates on an average by nearly 5% per annum and maintaining double digit profit margin.
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 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 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, our best pick in the railroad industry is Union Pacific Corp. (UNP) for which we have an Outperform recommendation. Additionally, we remain Neutral on 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 recent 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 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
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