Railroad Industry Outlook - Feb. 2011 - Industry Outlook

An improving U.S. economy, a significant 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, demand for carriage also becomes robust and the momentum is expected to sustain in the long-run. During 2010, all the Class 1 freight railroad operators in the U.S. achieved commendable results, on the back of significant improvement the operating metrics, massive growth in business volume and pricing gains. Nevertheless despite this impressive growth, some near-term concerns still persist.

Carload Volume Yet to Reach Pre-recession Level

The January 2011 report of the Association of American Railroads (AAR), the main trade body of the industry, clearly stated that although total carloads on U.S. railroads increased 7.3% year over year in 2010 and total intermodal volume increased 14.2% year over year in 2010, both figures are still way behind the pre-recession level. Volume levels of almost all the product categories have yet to reach the 2008 high.

Particularly important is coal, which constituted approximately 37% of total U.S. railway carloads in 2010. Coal carloads in 2010 have increased 2.2% year over year but remain significantly below 9% from the pre-recession 2008 level.

Improved Industrial Activity

With the U.S. industrial production expected to grow more than 3% in 2011, the outlook for Intermodal traffic, mainly consisting of containers and trailers, remains positive. Metal and Energy products are particularly well placed. Demand is particularly strong for iron ore, rolled steel, several metal scraps, oil and natural gas drilling accessories including pipe, sand and different types of clays.

Coal is also expected to drive continued strength, 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 was that China, the largest emerging economy, is turning out to be a net importer of agricultural commodities.

The decision of the Russian Government to stop wheat exports may become a major catalyst for the U.S. grain exporters. Additionally, demand for potash fertilizer, corn and soybeans also remain 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 freight rates on average by nearly 5% and maintaining double-digit 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 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, 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 remain exposed to increased government regulations. A recent report 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 operators'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.

 
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