U.S. Railroads Expect Bright 2011 - Analyst Blog

Early indications are pointing a rosy picture for the U.S. freight railroads in 2011. In the first quarter of 2011, railroad carload volume is up nearly 5.3% compared with the prior-year quarter. The industry has achieved this result despite of experiancing severe winter storm during this period. Importantly, industry players are now more confident that this fabulous performance will get further momentum during the rest of 2011. Fiscal 2010 was a turnaround year for the railroad industry after a huge downturn in 2009 due to severe recession. However, fiscal 2011 is most likely to beat the prior-year operating metrics.

Primarily there are four reasons for this strong performance:

(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) The U.S. industrial production 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 raised its exports. At present, the U.S. railroad industry commands less than 50% of total freight in America indicating 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 February 2011, mainly attributable to driver shortage, massive rise in fuel costs, and highway congestion.

(4) Recently, the U.S. government has decided to scale back its ruling that makes its mandatory for freight rails to install new anticollision technology called “Positive Train Control”. The latest government decision 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 an 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 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. 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 (both macro-economic and inter-industry) 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 $12 billion in 2011 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 than 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.

Recommendation

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. Currently, we remain Neutral on Union Pacific Corp. (UNP), Kansas CitySouthern (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.