Tue, 24 Dec 2013
Morningstar's Matt Coffina and Keith Schoonmaker discuss why companies in this sector have wide moats and which are the best railroads for long-term investors.
Matt Coffina: For Morningstar StockInvestor, I'm Matt Coffina. I'm joined today by Keith Schoonmaker, who is the director of our industrials team, and we're going to talk about railroads.
Keith, thanks for joining me.
Keith Schoonmaker: Thank you, Matt. Glad to be here.
Coffina: We recently upgraded the economic moat ratings on all of the large North American railroads we cover to wide. Can you tell me a little bit about the reasons for this and, in particular, why we think railroads have a cost advantage over other forms of transportation, like trucking?
Schoonmaker: Sure, Matt. I'd be glad to. Rails have wide economic moats derived from two sources: The first is the cost advantage and the second is an efficient scale. These are two of Morningstar's legitimate moat sources that we use in our methodology.
Under cost advantage, let's think about railroads compared to other modes of transportation, particularly land transportation. You could have aircraft, which is a very expensive way to transport freight or we could have trucking, which is less expensive than aircraft, but more than railroads. Then in the lower end of this spectrum would be barging, which is in fact the cheapest mode, except for the fact that it is constrained by where we have rivers or canals.
The reason railroads are cheaper than trucking is pretty simple. It's about efficiency of labor and efficiency of fuel principally. This is despite the fact that railroads have to maintain their own rights of way; that's something quite different from barging, which uses public rivers or trucking, which uses public highways. Yes, they pay a fuel tax, but they are not entirely responsible for maintenance of their own way like a railroad is.
Under labor, let's think of something like intermodal. This is movement of containers. This could be done by trucks or by rail. If we are going to move 200 containers on an efficient railroad, this could be done with 100 train cars and, let's say, two drivers at the most at a time for the journey. So that's two drivers, 200 containers.
To accomplish that by trucking, it would take between 100 and 200 drivers for the same thing. For fuel efficiency, the rails are about quadruple the fuel efficiency of trucking per ton mile moved. That's ton mile per gallon.
Coffina: The rails also benefit from very high barriers to entry. Why is it that you couldn't start a new railroad today even if you wanted to?
Schoonmaker: I think there are two reasons for that, Matt. It's the cost, pure and simple, millions of dollars per mile to construct it, and the existing railroads already have these lines, tens of thousands of lines spanning our country into remote resources, where they tend to reach out and get coal or potash or sand.
So one is simply the cost. The second is, it would be very difficult to re-create the rights of way that the railroads already have to build up their networks. If you and I decided we wanted to start a railroad and had to convince landowners to give us a straight line passing through consecutive properties, basically this would have to involve the government taking the property by eminent domain. We think that's very unlikely and politically untenable when there exists currently two competitors in each region who can already haul goods by rail.
Coffina: It's only in the last decade or so that railroads have really become as good of a business as they are, and that's largely due to pricing discipline as well as increased operational efficiency. What do you think it was about the last decade that made the rail start acting more rationally?
Schoonmaker: I think you are right that it's those two things. It's much better operations, which gives customers better service. Therefore customers are willing to pay more and can pay more if they are getting better, faster service. And they get available capacity, but mostly we think its pricing is really important for the railroad success and what's key here is not some massive 10% or 20% price increase every year, but at least keeping up with railroad cost inflation.
How to explain the fact that railroads used to have less discipline in price and now have more discipline in price? I think that's a difficulty from the outside. Suffice it to say there is a generation of leadership that now prices for value and this started in about 2004. I come from an industry, the paper industry, Matt, where we used to say, "Well, yeah, sure, we lose money on every roll we make, but we'll make it up on volume."
I think railroads used to have that mind-set, too, where they might be losing money on a single trainload or a carload, maybe they didn't know they were losing money, but also they just thought throughput and asset utilization are what's important. Since about 2004, managers have price per value, they've had the technology to evaluate profitability per carload of goods that they are shipping and importantly, the industry adapted fuel surcharges and with effective fuel surcharges massive swings in diesel fuel prices can no longer erode the value that the roads are producing because of sudden shocks in this commodity pricing.
Generally those are able to be pushed through to customers with about a two-month lag, and the industry accepts this as standard. Now trucking does, too. FedEx and UPS do, as well, so in general the transportation industry has become more rational when it comes to pushing through the commodity risks to their customers.
Coffina: So regulation is an issue in this industry. Could you just very briefly describe how is the industry regulated and do you see this as a threat to profits over the long run?
Schoonmaker: The industry is regulated in many ways. It's regulated in safety, labor, and pricing. Generally when we say regulation risk, what we're talking about is price controls.
About 70% of most railroads' book is hauled under private contracts, so that's not as subject to these tariff constraints. We think that the general public will not tolerate a lot of price controls on the railroads because of the desirability of having the railroads continue to invest in their own networks to haul goods off of the highways and on the railroads away from commuter traffic. That's our long-run take.
Coffina: The other big threat that everyone is worried about right now is declining coal volumes. Which of the rails that are most exposed here and do you see this as an issue over the long run?
Schoonmaker: Yes, we think it's an issue that's largely had its steepest impact in the last couple of years. In fact, year-to-date rail carload volume is down about 3.6% in general for North America. The railroads that are most exposed are those that haul Central Appalachian coal, that's CSX and Norfolk Southern, and that's because the Central App coal is more expensive to mine. And the Powder River Basin coal that's hauled by Union Pacific is less expensive to mine--it's a surface-mining technology, where it's closer to the surface. We think that business is less likely to decline as rapidly due to its lower cost of acquisition.
Coffina: There aren't a lot of values right now in the railroad industry, but for investors that like the space and just want to have a name on their radar, which companies do you think they should keep their eyes on?
Schoonmaker: Well, it's true that all the railroads are performing extremely well, Matt, and the stock prices have done very well in the last couple of years. We'd encourage investors to keep an eye on Kansas City Southern. This is the smallest rail. It has tremendous exposure to Mexico, about half of its revenue there, and we think there is lots of room for growth in Mexico.
For example, Mexico is adding 30% additional automotive production capability in the next couple of years, and Kansas City Southern will get a good portion of that business. Kansas City Southern also hauls to a region of Mexico where shale may be developed, if Mexico gets its energy policy in order such that foreign entities can help it develop and take advantage of the natural resources it has. This is an opportunity for Kansas City Southern to haul sand and steel pipes to that region, even if the crude that comes out or the gas that comes out is hauled away by other means.
We also like Union Pacific. Union Pacific has a book of business that includes Powder River Basin coal, which is less subject to displacement by natural gas because of its cheaper cost, and it has a really balanced book of business, balanced between automotive, intermodal traffic, coal, other commodities. It's a balanced portfolio without a lot of exposure to a single risk. As well, it still has a book of legacy business that the rest of the rails don't have where it can reprice old rates still over the next several years and increase rates more significantly than others can.
Coffina: Thanks for joining me, Keith.
Schoonmaker: My pleasure, Matt.
Coffina: In conclusion, the railroads are a wide-moat business in our view, very high barriers to entry, increasingly rational pricing in operations. Although there aren't a lot of values right now, Kansas City Southern and Union Pacific would be two names to keep on your radar.
For Morningstar StockInvestor, I'm Matt Coffina.
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