Following second-quarter results, railroads appear to be on track to recovering from the operational hazards faced earlier this year. The industry’s operational efficiency amid uncertain market conditions poises it for better times in the remainder of 2014.

Despite the projection of further headwinds for coal -- one of the major product shipments of rail -- the sector emerged strongly on infrastructural developments that supported natural gas, grain crop and petrochemical product shipments.

Zacks Industry Rank

Within the Zacks Industry classification, railroads are broadly grouped within Transportation (one of 16 Zacks sectors).

We rank all the 260-plus industries in the 16 Zacks sectors, based on the earnings outlook and fundamental strength of the constituent companies in each industry. To learn more, visit: About Zacks Industry Rank.

As a guideline, the outlook for industries with Zacks Industry Rank #88 and lower is Positive, between #89 and #176 is Neutral and #177 and higher is Negative.

The Zacks Industry Rank for the railroad industry is currently #8, implying that the outlook remains positive on this sector. This provides an encouraging outlook on the industry despite the persistent adverse seasonal impact that affects products of shipments. While some of the product lines see success or suffer, depending on seasonality or other external factors influencing market demand, intermodal remains on the growth trajectory.

We continue to be optimistic, as railroads are witnessing a gradual recovery in Coal shipments. Further, the upsurge in petrochemical shipments has bolstered this industry, thereby leading to earnings improvement.

Earnings Trend of the Sector

The broader Transportation sector, of which railroads are a part, reflects a sustainable growth trend. All the sector participants have reported second-quarter results, which have been stable in terms of both beat ratios (percentage of companies coming out with positive earnings surprises) and growth.

The earnings and revenues "beat ratio” for the quarter was 81.8% for the transportation sector. Total earnings for the companies in this sector rose 11.5%, while revenue growth was 0.5%, both on a year-over-year basis. The sector is expected to register full-year earnings growth of 13.2% in 2014. In terms of revenue expectation, the sector is expected to record 5.3%.

For a detailed look at the earnings outlook for this sector and others, please read our weekly Earnings Trends reports.

Second-Quarter 2014 Financial Results

The major companies that have so far reported include CSX Corp. (CSX), Kansas City Southern (KSU), Union Pacific Corporation (UNP), Canadian National Railway Company (CNI) and Norfolk Southern Corp. (NSC). All these companies’ earnings were higher than the year-ago quarter figure and above market expectations as well. Significant growth across all commodity groups and a substantial improvement in operating ratio drove gains across most of the companies, supporting strong earnings this season.

Major Contributors in 2014

Intermodal

While most of the other commodities including Automotive and General Merchandize have shown uncertainty in growth for 2014, intermodal volumes are strong. As a result, we expect railroads to significantly focus on intermodal expansion and tap underserved markets with highway-to-rail conversions.

Railroads are now looking to the Mexican market, which is witnessing regulatory reforms, including rail reforms, initiated by President Enrique Peña Nieto to lure foreign direct investments to boost economy. Union Pacific, which serves all six gateways between the U.S. and Mexico, is likely to seek this opportunity to increase its penetration into the Mexican market.

Moreover, there are major investments to look forward to this year involving intermodal growth. These include BNSF Railway Company’s $900 million spending on terminal, line and intermodal expansion and CSX Corp.’s investments in nine projects, Montreal terminal, capacity expansion of its northwest Ohio intermodal hub, and terminal expansion in New Orleans and Savannah.

Norfolk Southern has an investment plan of $487 million on developing intermodal facilities that include six projects. Further, Kansas City Southern is looking forward to its Monterrey to Nuevo Laredo track upgrade and developing its double-track corridor between Sanchez and Nuevo Laredo. It is also expanding its Sanchez Yard and focusing on developments in Interpuerto San Luis Potosi.

Crude Shipment

According to Energy Information Administration’s (EIA) reports, crude oil growth may go up to 10 million barrels per day from 2020 to 2040. Further, AAR reported that railroads transported 407,642 carloads of crude oil in 2013, up from 234,000 carloads in 2012. Further information suggests that crude oil accounted for around 1.4% of total Class carloads in 2013, compared with 0.03% in 2008 when the concept of crude by rail started gaining importance.

According to AAR, U.S. crude oil production will increase approximately 60% from 2008 through 2014, representing estimated production of 8.5 million barrels per day by 2014 end. This surge represents an opportunity for revenue accretion, which the railroads are trying to achieve with infrastructural development.

Despite the fact that rail-based crude transportation costs more ($10–$15 per barrel as against $5 a barrel through pipeline), crude shippers are compelled to rely on rail-based transport. This is due to the lack of pipeline infrastructural support in key oil and gas fields like Bakken Shale Formation in North Dakota and Montana, Eagle Ford Shale, Barnett Shale and Permian Basin in Texas, the Gulf of Mexico and Alberta oil sand fields in Canada.

As a result, inadequate pipeline developments have given rise to higher penetration of railroad transportation for crude oil shipping in these areas. According to AAR’s article ‘Moving Crude Oil by Rail,’ railroads transported over 60% of North Dakota’s crude oil production, which contains the vast majority of new rail crude oil originations.

Further, in terms of safety, railroads offer a better transportation avenue compared to pipeline due to its better spill rate profile. According to U.S. Department of Transportation (DOT.V), spill rate for pipelines are three times higher than rail, based on crude shipments between 2002 and 2012. Additionally, railroad companies are working toward tightening rail safety measures by appealing to federal regulators to phase out old tank cars if these are not upgraded. They are also seeking improved standards for new tank cars.

Major railroad companies like Norfolk are looking for expansion strategies mainly due to development of the energy sector, including the gas exploration projects in Marcellus and Utica shale plays as well as ventures associated with coal and power generation. Over the coming years, the company plans to introduce 32 energy-related projects in 14 states under its service areas.

Canadian Pacific projects crude shipment to reach 140,000 by the end of 2015. In the coming months, we expect railroad companies to increase investment in order to create adequate service capacity for the oil and gas markets. This would lead to exponential growth in crude oil shipments across the rail industry. Consequently, we expect petroleum shipments to remain favorable and emerge as a significant revenue contributor in the long term.

Automotive

Mexico is currently a growing market for automotive production and assembly, given the lower cost of production in the region. We believe that the plants established by Honda Motor Co., Ltd. (HMC), Nissan Motor Co. (NSANY), Mazda and Audi would boost auto production in Mexico. The facilities also bode well for automotive shipments. Based on these expansions, finished vehicle production in the Mexican market is expected to reach 3.5 million units in 2015, up about 35% from the 2012 production level.

The growth will provide carriers like Kansas City Southern, which operates across the Gulf of Mexico, ample opportunities to ship raw material to Mexico and return the finished products to the domestic market as well as to the U.S. and Canada. The company projects Automotives shipment to register high double-digit growth in 2014. Increased export activities at the Port of Lázaro Cárdenas will support future growth and enable the opening of auto plants in Mexico this year. In addition, the company expects North American full-year auto sales growth in the range of 4–4.5%.

Grain Shipments

Notably, 2014 is expected to be a good year for rail in terms of grain shipment. According to the USDA, agricultural exports in 2014 are forecasted to be $135 billion, down from an estimated $140 billion for 2013. The decline will result from an expected fall in oilseeds and products, grain and feed exports as well as cotton exports. However, since imports are anticipated to rise with gains in horticultural products, sugar and tropical products, we expect agricultural products to have a neutral impact on railroad carloads in the coming year.

Coal

Reduced electricity generation from coal turned into a major foe for rail freight carriers. Class I railroads originated 6.2 million coal carloads in 2012, the lowest annual total output since 1993. Coal carloads fell below 6 million in 2013, approximately 4.4% down from 2012 levels according to AAR reports. The decline in coal carloads offset the positive impact of gains from crude oil for the U.S. railroads.

Fraught with issues raised by the regulatory environmental agency, decreasing demand from power plants for electricity generation and the shutdown of coal-fired power plants, there are slim chances for railroads to benefit from this commodity segment, which continues to contribute a large part of railroad tonnage.

However, according to EIA’s latest Short-Term Energy Outlook, U.S. coal production will increase 4.1% to 1,024 million short tons (MMst), given the higher consumption due to a severe winter that affected early 2014. Coal consumption in 2014 is expected to grow 4.2% to 964 MMst in 2014 due to higher natural gas prices than 2012 levels.

EIA projects coal exports to total 101 MMst in 2014, which is lower than the previous projection of 107 MMst. In 2015, exports can go down even further to 96 MMs owing to weak global economic conditions, slow demand growth rate in the Asian markets, rising coal production in other countries and lower international coal prices.

Rail Investments

Investments in development and expansion plans remain crucial when analyzing the prospects for the railroad industry. These capital investments are a union of binaries. While the investments put significant stress on margin performance, forgoing these would dampen growth prospects.

Railway investments are significant, given the evolving supply chain management and the growing importance of airfreight carriers in offering freight transportation services. These investments help railways in getting the required infrastructure to compete effectively in the railroad industry and with other modes of transport like truck, barges and cargo airlines.

Hence, investments in infrastructural projects have been an integral part of the development of railroads. However, this sector, characterized by huge capital influx, has been drawing funds primarily through private financing.

As a result, investment plans when undertaken, can have a considerable impact on the company’s liquidity position and could lead to a highly leveraged balance sheet. According to AAR reports, railroads invest approximately 17% of their annual revenue, which compares with only 3% of average U.S. manufactures’ revenues on capital expenditures.

According to DOT, the demand for rail freight transportation will increase approximately 88% by 2035. As a result, Class I carriers would have to increase their investments to meet this growing demand.

It is estimated that railroads would require $149 billion to improve rail network infrastructure within this stipulated period.

Given the growing demand and need to upgrade railroad infrastructure to meet new regulations, deployment of fuel-efficient locomotives, upcoming rules on track sharing, railroad safety and high-speed rail services are demanding that railroad companies infuse more capital in development projects. According to DOT, almost 90% of the railway capacity needs to be upgraded to meet the expected rise in demand level by 2035. Hence, it is important for railroad companies to balance profitability levels while investing in infrastructural development projects.

Currently, the U.S. railroad industry dominates less than 50% of total freight in America, indicating a huge opportunity for increasing market share. This opportunity can only be exploited by building railroad infrastructure that caters to the varied requirements of shippers.

OPPORTUNITIES

The railroad industry as a whole offers a number of opportunities that are difficult to ignore from the standpoint of investors.

Discretionary Pricing Power: The freight railroad operators function in a seller’s market and have enjoyed pricing power since 1980, when the U.S. government adopted the Staggers Rail Act. The idea was to allow rail transporters to hike prices 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, railroad companies are hiking their freight rates by nearly 5% per annum on average, while maintaining a double-digit profit margin.

Duopolistic Market Structures: Railroad companies have, by and large, gained by practicing discretionary pricing in the freight market. In the prevailing duopolistic rail industry, railroad operators will be able to reap maximum benefits from rising prices when the overall demand grows.

This remains evident from the geographic distribution of markets between major railroads. Union Pacific and Burlington Northern Santa Fe control the western part of the U.S., while CSX Corp. and Norfolk Southern control the eastern part. On the other hand, Canadian Pacific and Canadian National control inter country rail shipment between the U.S. and Canada.

CHALLENGES

Despite the above-mentioned positives, the freight railroad industry, like other industries, faces certain external and internal challenges. These are as follows:

Capital Intensive Nature: The railroad industry is highly capital intensive that requires continued infrastructural improvements and acquisition of capital assets. Moreover, industry players access the credit markets for funds from time to time. Adverse conditions in credit markets could increase overhead costs associated with issuing debt, and may limit the companies’ ability to sell debt securities on favorable terms.

Positive Train Control Mandate: The Rail Safety Improvement Act 2008 (:RSIA) has mandated the installation of PTC (Positive Train Control) by Dec 31, 2015 on main lines that carry certain hazardous materials and on lines that involve passenger operations. The Federal Railroad Administration (FRA) issued its final rule in Jan 2010, on the design, operational requirements and implementation of the new technology. The final rule is expected to impose significant new costs for the rail industry at large.

Price Regulations: The pricing practices of U.S. freight railroads comprise the major reason of friction with captive shippers, who move their products through rail and do not have effective alternatives. According to the latest studies by the STB, approximately 35% of the annual freight rail is captive to a single railroad, allowing it monopoly pricing practices.

The unfair pricing power exhibited by the U.S. railroads has prompted intervention of the Congress. The latter intends to implement stringent federal regulations on railroads. So far, the Congress has discussed railroad price regulation but has not passed any new rule yet.

U.S. Environmental Protection Agency: Railroad companies remain concerned about the proposed regulation by the U.S. Environmental Protection Agency (:EPA) for power plants across 27 states. The proposed guideline –– Carbon Pollution Standard for New Power Plants –– aims at restricting emission of carbon dioxide by new power plants under Section 111 of the Clean Air Act. The standard proposes new power plants to limit their carbon-dioxide emission to 1,000 pounds per megawatt-hour.

Power plants fueled by natural gas have already met these standards but the majority of the units using conventional resources like coal are exceeding the set limit, as they emit an average of 1,800 pounds of carbon dioxide per megawatt-hour. Railroads, which transport nearly two-thirds of the coal shipment, are most likely to be affected by implementation of the new regulation that could pose a significant threat to utility coal tonnage.

CSX CORP (CSX): Free Stock Analysis Report
HONDA MOTOR (HMC): Free Stock Analysis Report
KANSAS CITY SOU (KSU): Free Stock Analysis Report
NORFOLK SOUTHRN (NSC): Free Stock Analysis Report
NISSAN ADR (NSANY): Free Stock Analysis Report
UNION PAC CORP (UNP): Free Stock Analysis Report
CDN NATL RY CO (CNI): Free Stock Analysis Report


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